Ch14 180205115701 Answers For The Practice Questions [PDF]

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Ch14-180205115701 - answers for the practice questions. Financial market & institution (‫)ةقراشلا ةعماج‬



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Intermediate Accounting IFRS Edition-2nd Questions & Solutions Chapter 14



Non-Current Liabilities



Donald E. Kieso Jerry J. Weygandt Terry D. Warfield Downloaded by Mikaela O. ([email protected])



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BRIEF EXERCISES (All calculations are to be rounded to nearest whole currency unit, unless otherwise stated.) 3



BE14-1 Whiteside Corporation issues ¥500,000 of 9% bonds, due in 10 years, with interest payable semiannually. At the time of issue, the market rate for such bonds is 10%. Compute the issue price of the bonds.



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BE14-2 The Colson Company issued €300,000 of 10% bonds on January 1, 2015. The bonds are due January 1, 2020, with interest payable each July 1 and January 1. The bonds are issued at face value. Prepare Colson’s journal entries for (a) the January issuance, (b) the July 1 interest payment, and (c) the December 31 adjusting entry.



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BE14-3 Assume the bonds in BE14-2 were issued at 108.11 to yield 8%. Prepare the journal entries for (a) January 1, (b) July 1, and (c) December 31.



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BE14-4 Assume the bonds in BE14-2 were issued at 92.6393 to yield 12%. Prepare the journal entries for (a) January 1, (b) July 1, and (c) December 31.



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BE14-5 Devers Corporation issued £400,000 of 6% bonds on May 1, 2015. The bonds were dated January 1, 2015, and mature January 1, 2017, with interest payable July 1 and January 1. The bonds were issued at face value plus accrued interest. Prepare Devers’ journal entries for (a) the May 1 issuance, (b) the July 1 interest payment, and (c) the December 31 adjusting entry.



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BE14-6 On January 1, 2015, JWS Corporation issued $600,000 of 7% bonds, due in 10 years. The bonds were issued for $559,224, and pay interest each July 1 and January 1. Prepare the company’s journal entries for (a) the January 1 issuance, (b) the July 1 interest payment, and (c) the December 31 adjusting entry. Assume an effective-interest rate of 8%.



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BE14-7 Assume the bonds in BE14-6 were issued for $644,636 with the effective-interest rate of 6%. Prepare the company’s journal entries for (a) the January 1 issuance, (b) the July 1 interest payment, and (c) the December 31 adjusting entry.



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BE14-8 Tan Corporation issued HK$600,000,000 of 7% bonds on November 1, 2015, for HK$644,636,000. The bonds were dated November 1, 2015, and mature in 10 years, with interest payable each May 1 and November 1. The effective-interest rate is 6%. Prepare Tan’s December 31, 2015, adjusting entry.



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BE14-9 Coldwell, Inc. issued a €100,000, 4-year, 10% note at face value to Flint Hills Bank on January 1, 2015, and received €100,000 cash. The note requires annual interest payments each December 31. Prepare Coldwell’s journal entries to record (a) the issuance of the note and (b) the December 31 interest payment.



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BE14-10 Samson Corporation issued a 4-year, £75,000, zero-interest-bearing note to Brown Company on January 1, 2015, and received cash of £47,664. The implicit interest rate is 12%. Prepare Samson’s journal entries for (a) the January 1 issuance and (b) the December 31 recognition of interest.



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BE14-11 McCormick Corporation issued a 4-year, $40,000, 5% note to Greenbush Company on January 1, 2015, and received a computer that normally sells for $31,495. The note requires annual interest payments each December 31. The market rate of interest for a note of similar risk is 12%. Prepare McCormick’s journal entries for (a) the January 1 issuance and (b) the December 31 interest.



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BE14-12 Shlee Corporation issued a 4-year, €60,000, zero-interest-bearing note to Garcia Company on January 1, 2015, and received cash of €60,000. In addition, Shlee agreed to sell merchandise to Garcia at an amount less than regular selling price over the 4-year period. The market rate of interest for similar notes is 12%. Prepare Shlee Corporation’s January 1 journal entry.



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BE14-13 On January 1, 2015, Henderson Corporation retired $500,000 of bonds at 99. At the time of retirement, the unamortized premium was $15,000. Prepare Henderson’s journal entry to record the reacquisition of the bonds.



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Exercises 687 6



BE14-14 Refer to the note issued by Coldwell, Inc. in BE14-9. During 2015, Coldwell experiences financial difficulties. On January 1, 2016, Coldwell negotiates a settlement of the note by issuing to Flint Hills Bank 20,000 €1 par Coldwell ordinary shares. The ordinary shares have a market price of €4.75 per share on the date of the settlement. Prepare Coldwell’s entries to settle this note.



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BE14-15 Refer to the note issued by Coldwell, Inc. in BE14-9. During 2015, Coldwell experiences financial difficulties. On January 1, 2016, Coldwell negotiates a modification of the terms of the note. Under the modification, Flint Hills Bank agrees to reduce the face value of the note to €90,000 and to extend the maturity date to January 1, 2020. Annual interest payments on December 31 will be made at a rate of 8%. Coldwell’s market interest rate at the time of the modification is 12%. Prepare Coldwell’s entries for (a)the modification on January 1, 2016, and (b) the first interest payment date on December 31, 2016.



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BE14-16 Shonen Knife Corporation has elected to use the fair value option for one of its notes payable. The note was issued at an effective rate of 11% and has a carrying value of HK$16,000. At year-end, Shonen Knife’s borrowing rate has declined; the fair value of the note payable is now HK$17,500. (a) Determine the unrealized gain or loss on the note. (b) Prepare the entry to record any unrealized gain or loss, assuming that the change in value was due to general market conditions.



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BE14-17 At December 31, 2015, Hyasaki Corporation has the following account balances: Bonds payable, due January 1, 2023 Interest payable



$1,912,000 80,000



Show how the above accounts should be presented on the December 31, 2015, statement of financial position, including the proper classifications.



EXERCISES (All calculations are to be rounded to nearest whole currency unit, unless otherwise stated.) 2



E14-1 (Classification of Liabilities) Presented below are various account balances. (a) Bank loans payable of a winery, due March 10, 2018. (The product requires aging for 5 years before sale.) (b) Serial bonds payable, €1,000,000, of which €250,000 are due each July 31. (c) Amounts withheld from employees’ wages for income taxes. (d) Notes payable due January 15, 2017. (e) Credit balances in customers’ accounts arising from returns and allowances after collection in full of account. (f) Bonds payable of €2,000,000 maturing June 30, 2016. (g) Overdraft of €1,000 in a bank account. (No other balances are carried at this bank.) (h) Deposits made by customers who have ordered goods. Instructions Indicate whether each of the items above should be classified on December 31, 2015, as a current liability, a non-current liability, or under some other classification. Consider each one independently from all others; that is, do not assume that all of them relate to one particular business. If the classification of some of the items is doubtful, explain why in each case.



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E14-2 (Classification) The following items are found in the financial statements. (a) (b) (c) (d) (e) (f) (g)



Interest expense (credit balance). Bond issue costs. Gain on repurchase of debt. Mortgage payable (payable in equal amounts over next 3 years). Debenture bonds payable (maturing in 5 years). Notes payable (due in 4 years). Income bonds payable (due in 3 years).



Instructions Indicate how each of these items should be classified in the financial statements.



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688 Chapter 14 Non-Current Liabilities 3



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E14-3 (Entries for Bond Transactions) Presented below are two independent situations. 1. On January 1, 2015, Divac Company issued €300,000 of 9%, 10-year bonds at par. Interest is payable quarterly on April 1, July 1, October 1, and January 1. 2. On June 1, 2015, Verbitsky Company issued €200,000 of 12%, 10-year bonds dated January 1 at par plus accrued interest. Interest is payable semiannually on July 1 and January 1. Instructions For each of these two independent situations, prepare journal entries to record the following. (a) The issuance of the bonds. (b) The payment of interest on July 1. (c) The accrual of interest on December 31.



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E14-4 (Entries for Bond Transactions) Foreman Company issued €800,000 of 10%, 20-year bonds on January 1, 2015, at 119.792 to yield 8%. Interest is payable semiannually on July 1 and January 1. Instructions Prepare the journal entries to record the following. (a) The issuance of the bonds. (b) The payment of interest and the related amortization on July 1, 2015. (c) The accrual of interest and the related amortization on December 31, 2015.



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E14-5 (Entries for Bond Transactions) Assume the same information as in E14-4, except that the bonds were issued at 84.95 to yield 12%. Instructions Prepare the journal entries to record the following. (Round to the nearest euro.) (a) The issuance of the bonds. (b) The payment of interest and related amortization on July 1, 2015. (c) The accrual of interest and the related amortization on December 31, 2015.



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E14-6 (Amortization Schedule) Spencer Company sells 10% bonds having a maturity value of £3,000,000 for £2,783,724. The bonds are dated January 1, 2015, and mature January 1, 2020. Interest is payable annually on January 1. Instructions Set up a schedule of interest expense and discount amortization. (Hint: The effective-interest rate must be computed.)



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E14-7 (Determine Proper Amounts in Account Balances) Presented below are three independent situations. Instructions (a) McEntire Co. sold $2,500,000 of 11%, 10-year bonds at 106.231 to yield 10% on January 1, 2015. The bonds were dated January 1, 2015, and pay interest on July 1 and January 1. Determine the amount of interest expense to be reported on July 1, 2015, and December 31, 2015. (b) Cheriel Inc. issued $600,000 of 9%, 10-year bonds on June 30, 2015, for $562,500. This price provided a yield of 10% on the bonds. Interest is payable semiannually on December 31 and June 30. Determine the amount of interest expense to record if financial statements are issued on October 31, 2015. (c) On October 1, 2015, Chinook Company sold 12% bonds having a maturity value of $800,000 for $853,382 plus accrued interest, which provides the bondholders with a 10% yield. The bonds are dated January 1, 2015, and mature January 1, 2020, with interest payable December 31 of each year. Prepare the journal entries at the date of the bond issuance and for the first interest payment.



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E14-8 (Entries and Questions for Bond Transactions) On June 30, 2014, Macias Company issued R$5,000,000 face value of 13%, 20-year bonds at R$5,376,150 to yield 12%. The bonds pay semiannual interest on June 30 and December 31. Instructions (a) Prepare the journal entries to record the following transactions. (1) The issuance of the bonds on June 30, 2014. (2) The payment of interest and the amortization of the premium on December 31, 2014. (3) The payment of interest and the amortization of the premium on June 30, 2015. (4) The payment of interest and the amortization of the premium on December 31, 2015.



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Exercises 689 (b) Show the proper statement of financial position presentation for the liability for bonds payable on the December 31, 2015, statement of financial position. (c) Provide the answers to the following questions. (1) What amount of interest expense is reported for 2015? (2) Determine the total cost of borrowing over the life of the bond. 3



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E14-9 (Entries for Bond Transactions) On January 1, 2015, Osborn Company sold 12% bonds having a maturity value of £800,000 for £860,651.79, which provides the bondholders with a 10% yield. The bonds are dated January 1, 2015, and mature January 1, 2020, with interest payable December 31 of each year. Instructions (a) Prepare the journal entry at the date of the bond issuance. (b) Prepare a schedule of interest expense and bond amortization for 2015–2017. (c) Prepare the journal entry to record the interest payment and the amortization for 2015. (d) Prepare the journal entry to record the interest payment and the amortization for 2017.



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E14-10 (Information Related to Various Bond Issues) Pawnee Inc. has issued three types of debt on January 1, 2015, the start of the company’s fiscal year. (a) $10 million, 10-year, 13% unsecured bonds, interest payable quarterly. Bonds were priced to yield 12%. (b) $25 million par of 10-year, zero-coupon bonds at a price to yield 12% per year. (c) $15 million, 10-year, 10% mortgage bonds, interest payable annually to yield 12%. Instructions Prepare a schedule that identifies the following items for each bond: (1) maturity value, (2) number of interest periods over life of bond, (3) stated rate per each interest period, (4) effective-interest rate per each interest period, (5) payment amount per period, and (6) present value of bonds at date of issue.



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E14-11 (Entries for Zero-Interest-Bearing Notes) On January 1, 2015, McLean Company makes the two following acquisitions. 1. Purchases land having a fair value of €300,000 by issuing a 5-year, zero-interest-bearing promissory note in the face amount of €505,518. 2. Purchases equipment by issuing a 6%, 8-year promissory note having a maturity value of €400,000 (interest payable annually). The company has to pay 11% interest for funds from its bank. Instructions (a) Record the two journal entries that should be recorded by McLean Company for the two purchases on January 1, 2015. (b) Record the interest at the end of the first year on both notes.



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E14-12 (Imputation of Interest) Presented below are two independent situations. Instructions (a) On January 1, 2015, Spartan Inc. purchased land that had an assessed value of $390,000 at the time of purchase. A $600,000, zero-interest-bearing note due January 1, 2018, was given in exchange. There was no established exchange price for the land, nor a ready market price for the note. The  interest rate charged on a note of this type is 12%. Determine at what amount the land should be recorded at January 1, 2015, and the interest expense to be reported in 2015 related to this transaction. (b) On January 1, 2015, Geimer Furniture Co. borrowed $4,000,000 (face value) from Aurora Co., a major customer, through a zero-interest-bearing note due in 4 years. Because the note was zerointerest-bearing, Geimer Furniture agreed to sell furniture to this customer at lower than market price. A 10% rate of interest is normally charged on this type of loan. Prepare the journal entry to record this transaction and determine the amount of interest expense to report for 2015.



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E14-13 (Imputation of Interest with Right) On January 1, 2015, Durdil Co. borrowed and received 500,000 from a major customer evidenced by a zero-interest-bearing note due in 3 years. As consideration for the zero-interest-bearing feature, Durdil agrees to supply the customer’s inventory needs for the loan period at lower than the market price. The appropriate rate at which to impute interest is 8%.



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690 Chapter 14 Non-Current Liabilities Instructions (a) Prepare the journal entry to record the initial transaction on January 1, 2015. (b) Prepare the journal entry to record any adjusting entries needed at December 31, 2015. Assume that the sales of Durdil’s product to this customer occur evenly over the 3-year period. 3



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E14-14 (Entry for Retirement of Bond; Bond Issue Costs) On January 2, 2012, Prebish Corporation issued $1,500,000 of 10% bonds to yield 11% due December 31, 2021. Interest on the bonds is payable annually each December 31. The bonds are callable at 101 (i.e., at 101% of face amount), and on January 2, 2015, Prebish called $1,000,000 face amount of the bonds and retired them. Instructions (a) Determine the price of the Prebish bonds when issued on January 2, 2012. (b) Prepare an amortization schedule for 2012–2016 for the bonds. (c) Ignoring income taxes, compute the amount of loss, if any, to be recognized by Prebish as a result of retiring the $1,000,000 of bonds in 2015 and prepare the journal entry to record the retirement.



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E14-15 (Entries for Retirement and Issuance of Bonds) On June 30, 2007, Mendenhal Company issued 8% bonds with a par value of £600,000 due in 20 years. They were issued at 82.8414 to yield 10% and were callable at 104 at any date after June 30, 2015. Because of lower interest rates and a significant change in the company’s credit rating, it was decided to call the entire issue on June 30, 2016, and to issue new bonds. New 6% bonds were sold in the amount of £800,000 at 112.5513 to yield 5%; they mature in 20 years. Interest payment dates are December 31 and June 30 for both old and new bonds. Instructions (a) Prepare journal entries to record the retirement of the old issue and the sale of the new issue on June 30, 2016. Unamortized discount is £78,979. (b) Prepare the entry required on December 31, 2016, to record the payment of the first 6 months’ interest and the amortization of premium on the bonds.



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E14-16 (Entries for Retirement and Issuance of Bonds) Kobiachi Company had bonds outstanding with a maturity value of ¥5,000,000. On April 30, 2016, when these bonds had an unamortized discount of ¥100,000, they were called in at 104. To pay for these bonds, Kobiachi had issued other bonds a month earlier bearing a lower interest rate. The newly issued bonds had a life of 10 years. The new bonds were issued at 103 (face value ¥5,000,000). Instructions Ignoring interest, compute the gain or loss and record this refunding transaction.



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E14-17 (Settlement of Debt) Strickland Company owes $200,000 plus $18,000 of accrued interest to Moran State Bank. The debt is a 10-year, 10% note. During 2015, Strickland’s business deteriorated due to a faltering regional economy. On December 31, 2015, Moran State Bank agrees to accept an old machine and cancel the entire debt. The machine has a cost of $390,000, accumulated depreciation of $221,000, and a fair value of $180,000. Instructions (a) Prepare journal entries for Strickland Company to record this debt settlement. (b) How should Strickland report the gain or loss on the disposition of machine and on restructuring of debt in its 2015 income statement? (c) Assume that, instead of transferring the machine, Strickland decides to grant 15,000 of its ordinary shares ($10 par), which have a fair value of $180,000 in full settlement of the loan obligation. Prepare the entries to record the transaction.



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E14-18 (Loan Modification) On December 31, 2015, Sterling Bank enters into a debt restructuring agreement with Barkley Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, £3,000,000 note receivable by the following modifications: 1. Reducing the principal obligation from £3,000,000 to £2,400,000. 2. Extending the maturity date from December 31, 2015, to January 1, 2019. 3. Reducing the interest rate from 12% to 10%. Barkley’s market rate of interest is 15%. Barkley pays interest at the end of each year. On January 1, 2019, Barkley Company pays £2,400,000 in cash to Sterling Bank.



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Problems 691 Instructions (a) Can Barkley Company record a gain under the term modification mentioned above? Explain. (b) Prepare the amortization schedule of the note for Barkley Company after the debt modification. (c) Prepare the interest payment entry for Barkley Company on December 31, 2017. (d) What entry should Barkley make on January 1, 2019? 6



E14-19 (Loan Modification) Use the same information as in E14-18 except that Sterling Bank reduced the principal to £1,900,000 rather than £2,400,000. On January 1, 2019, Barkley pays £1,900,000 in cash to Sterling Bank for the principal. Instructions (a) Prepare the journal entries to record the loan modification for Barkley. (b) Prepare the amortization schedule of the note for Barkley Company after the debt modification. (c) Prepare the interest payment entries for Barkley Company on December 31 of 2016, 2017, and 2018. (d) What entry should Barkley make on January 1, 2019?



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E14-20 (Entries for Settlement of Debt) Consider the following independent situations. Instructions (a) Gottlieb Co. owes €199,800 to Ceballos Inc. The debt is a 10-year, 11% note. Because Gottlieb Co. is in financial trouble, Ceballos Inc. agrees to accept some land and cancel the entire debt. The land has a book value of €90,000 and a fair value of €140,000. Prepare the journal entry on Gottlieb’s books for debt settlement. (b) Vargo Corp. owes $270,000 to First Trust. The debt is a 10-year, 12% note due December 31, 2015. Because Vargo Corp. is in financial trouble, First Trust agrees to extend the maturity date to December 31, 2017, reduce the principal to $220,000, and reduce the interest rate to 5%, payable annually on December 31. Vargo’s market rate of interest is 8%. Prepare the journal entries on Vargo’s books on December 31, 2015, 2016, and 2017.



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E14-21 (Fair Value Option) Fallen Company commonly issues long-term notes payable to its various lenders. Fallen has had a pretty good credit rating such that its effective borrowing rate is quite low (less than 8% on an annual basis). Fallen has elected to use the fair value option for the long-term notes issued to Barclay’s Bank and has the following data related to the carrying and fair value for these notes. (Assume that changes in fair value are due to general market interest rate changes). December 31, 2015 December 31, 2016 December 31, 2017



Carrying Value



Fair Value



€54,000 44,000 36,000



€54,000 42,500 38,000



Instructions (a) Prepare the journal entry at December 31 (Fallen’s year-end) for 2015, 2016, and 2017, to record the fair value option for these notes. (b) At what amount will the note be reported on Fallen’s 2016 statement of financial position? (c) What is the effect of recording the fair value option on these notes on Fallen’s 2017 income? (d) Assuming that general market interest rates have been stable over the period, does the fair value data for the notes indicate that Fallen’s creditworthiness has improved or declined in 2017? Explain. (e) Assuming the conditions that exist in (d), what is the effect of recording the fair value option on these notes in Fallen’s income statement in 2015, 2016, and 2017? 9



E14-22 (Long-Term Debt Disclosure) At December 31, 2015, Redmond Company has outstanding three long-term debt issues. The first is a $2,000,000 note payable which matures June 30, 2018. The second is a $6,000,000 bond issue which matures September 30, 2019. The third is a $12,500,000 sinking fund debenture with annual sinking fund payments of $2,500,000 in each of the years 2017 through 2021. Instructions Prepare the required note disclosure for the long-term debt at December 31, 2015.



PROBLEMS (All calculations are to be rounded to nearest whole currency unit, unless otherwise stated.) 3



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P14-1 (Analysis of Amortization Schedule and Interest Entries) The amortization and interest schedule on page 692 reflects the issuance of 10-year bonds by Capulet Corporation on January 1, 2009, and the subsequent interest payments and charges. The company’s year-end is December 31, and financial statements are prepared once yearly.



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692 Chapter 14 Non-Current Liabilities Amortization Schedule Year 1/1/2009 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018



Cash €11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000



Interest €11,322 11,361 11,404 11,452 11,507 11,567 11,635 11,712 11,797 11,894



Amount Unamortized €5,651 5,329 4,968 4,564 4,112 3,605 3,038 2,403 1,691 894



Book Value € 94,349 94,671 95,032 95,436 95,888 96,395 96,962 97,597 98,309 99,106 100,000



Instructions (a) Indicate whether the bonds were issued at a premium or a discount and how you can determine this fact from the schedule. (b) Determine the stated interest rate and the effective-interest rate. (c) On the basis of the schedule, prepare the journal entry to record the issuance of the bonds on January 1, 2009. (d) On the basis of the schedule, prepare the journal entry or entries to reflect the bond transactions and accruals for 2009. (Interest is paid January 1.) (e) On the basis of the schedule, prepare the journal entry or entries to reflect the bond transactions and accruals for 2016. Capulet Corporation does not use reversing entries. 3



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P14-2 (Issuance and Retirement of Bonds) Venzuela Co. is building a new hockey arena at a cost of $2,500,000. It received a down payment of $500,000 from local businesses to support the project and now needs to borrow $2,000,000 to complete the project. It therefore decides to issue $2,000,000 of 10.5%, 10-year bonds. These bonds were issued on January 1, 2014, and pay interest annually on each January 1. The bonds yield 10%. Instructions (a) Prepare the journal entry to record the issuance of the bonds on January 1, 2014. (b) Prepare a bond amortization schedule up to and including January 1, 2018. (c) Assume that on July 1, 2017, Venzuela Co. retires half of the bonds at a cost of $1,065,000 plus accrued interest. Prepare the journal entry to record this retirement.



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P14-3 (Negative Amortization) Good-Deal Inc. developed a new sales gimmick to help sell its inventory of new automobiles. Because many new car buyers need financing, Good-Deal offered a low down payment and low car payments for the first year after purchase. It believes that this promotion will bring in some new buyers. On January 1, 2015, a customer purchased a new €33,000 automobile, making a down payment of €1,000. The customer signed a note indicating that the annual rate of interest would be 8% and that quarterly payments would be made over 3 years. For the first year, Good-Deal required a €400 quarterly payment to be made on April 1, July 1, October 1, and January 1, 2016. After this one-year period, the customer was required to make regular quarterly payments that would pay off the loan as of January 1, 2018. Instructions (a) Prepare a note amortization schedule for the first year. (b) Indicate the amount the customer owes on the contract at the end of the first year. (c) Compute the amount of the new quarterly payments. (d) Prepare a note amortization schedule for these new payments for the next 2 years. (e) What do you think of the new sales promotion used by Good-Deal?



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P14-4 (Effective-Interest Method) Samantha Cordelia, an intermediate accounting student, is having difficulty amortizing bond premiums and discounts using the effective-interest method. Furthermore, she cannot understand why IFRS requires that this method be used. She has come to you with the following problem, looking for help. On June 30, 2015, Hobart Company issued R$2,000,000 face value of 11%, 20-year bonds at R$2,171,600, a yield of 10%. Hobart Company uses the effective-interest method to amortize bond premiums or discounts. The bonds pay semiannual interest on June 30 and December 31. Compute the amortization schedule for four periods.



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Problems 693 Instructions Using the data above for illustrative purposes, write a short memo (1–1.5 pages double-spaced) to Samantha, explaining what the effective-interest method is, why it is preferable, and how it is computed. (Do not forget to include an amortization schedule, referring to it whenever necessary.) 5



P14-5 (Entries for Zero-Interest-Bearing Note) On December 31, 2015, Faital Company acquired a computer from Plato Corporation by issuing a £600,000 zero-interest-bearing note, payable in full on December 31, 2019. Faital Company’s credit rating permits it to borrow funds from its several lines of credit at 10%. The computer is expected to have a 5-year life and a £70,000 residual value. Instructions (a) Prepare the journal entry for the purchase on December 31, 2015. (b) Prepare any necessary adjusting entries relative to depreciation (use straight-line) and amortization on December 31, 2016. (c) Prepare any necessary adjusting entries relative to depreciation and amortization on December 31, 2017.



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P14-6 (Entries for Zero-Interest-Bearing Note; Payable in Installments) Sabonis Cosmetics Co. purchased machinery on December 31, 2014, paying $50,000 down and agreeing to pay the balance in four equal installments of $40,000 payable each December 31. An assumed interest of 8% is implicit in the purchase price. Instructions Prepare the journal entries that would be recorded for the purchase and for the payments and interest on the following dates. (a) December 31, 2014. (b) December 31, 2015. (c) December 31, 2016.



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(d) December 31, 2017. (e) December 31, 2018.



P14-7 (Issuance and Retirement of Bonds; Income Statement Presentation) Chen Company issued its 9%, 25-year mortgage bonds in the principal amount of ¥30,000,000 on January 2, 2001, at a discount of ¥2,722,992 (effective rate of 10%). The indenture securing the issue provided that the bonds could be called for redemption in total but not in part at any time before maturity at 104% of the principal amount, but it did not provide for any sinking fund. On December 18, 2015, the company issued its 11%, 20-year debenture bonds in the principal amount of ¥40,000,000 at 102, and the proceeds were used to redeem the 9%, 25-year mortgage bonds on January 2, 2016. The indenture securing the new issue did not provide for any sinking fund or for retirement before maturity. The unamortized discount at retirement was ¥1,842,888. Instructions (a) Prepare journal entries to record the issuance of the 11% bonds and the retirement of the 9% bonds. (b) Indicate the income statement treatment of the gain or loss from retirement and the note disclosure required.



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P14-8 (Comprehensive Bond Problem) In each of the following independent cases, the company closes its books on December 31. 1. Sanford Co. sells $500,000 of 10% bonds on March 1, 2015. The bonds pay interest on September 1 and March 1. The due date of the bonds is September 1, 2018. The bonds yield 12%. Give entries through December 31, 2016. 2. Titania Co. sells $400,000 of 12% bonds on June 1, 2015. The bonds pay interest on December 1 and June 1. The due date of the bonds is June 1, 2019. The bonds yield 10%. On October 1, 2016, Titania buys back $120,000 worth of bonds for $126,000 (includes accrued interest). Give entries through December 1, 2017. Instructions For the two cases, prepare all of the relevant journal entries from the time of sale until the date indicated. (Construct amortization tables where applicable.) Amortize premium or discount on interest dates and at year-end. (Assume that no reversing entries were made; round to the nearest dollar.)



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694 Chapter 14 Non-Current Liabilities 3



4 6



P14-9 (Issuance of Bonds Between Interest Dates, Retirement) Presented below are selected transactions on the books of Simonson Corporation. July 1, 2015



Dec. 31 Jan. 1, 2016 Jan. 2 Dec. 31



Bonds payable with a par value of €900,000, which are dated January 1, 2015, are sold at 119.219 plus accrued interest to yield 10%. They are coupon bonds, bear interest at 12% (payable annually at January 1), and mature January 1, 2025. (Use interest expense account for accrued interest.) Adjusting entries are made to record the accrued interest on the bonds, and the amortization of the proper amount of premium. Interest on the bonds is paid. Bonds of par value of €360,000 are called at 102 and extinguished. Adjusting entries are made to record the accrued interest on the bonds, and the proper amount of premium amortized.



Instructions Prepare journal entries for the transactions above. 3



4 6



P14-10 (Entries for Life Cycle of Bonds) On April 1, 2015, Sarkar Company sold 15,000 of its 11%, 15-year, R$1,000 face value bonds to yield 12%. Interest payment dates are April 1 and October 1. On April 2, 2016, Sarkar took advantage of favorable prices of its shares to extinguish 6,000 of the bonds by issuing 200,000 of its R$10 par value ordinary shares. At this time, the accrued interest was paid in cash. The company’s shares were selling for R$31 per share on April 2, 2016. Instructions Prepare the journal entries needed on the books of Sarkar Company to record the following. (a) (b) (c) (d)



5



6



April 1, 2015: issuance of the bonds. October 1, 2015: payment of semiannual interest. December 31, 2015: accrual of interest expense. April 2, 2016: extinguishment of 6,000 bonds. (No reversing entries made.)



P14-11 (Modification of Debt) Daniel Perkins is the sole shareholder of Perkins Inc., which is currently under protection of the U.S. bankruptcy court. As a “debtor in possession,” he has negotiated the following revised loan agreement with United Bank. Perkins Inc.’s $600,000, 12%, 10-year note was refinanced with a $600,000, 5%, 10-year note. Perkins has a market rate of interest of 15%. Instructions (a) What is the accounting nature of this transaction? (b) Prepare the journal entry to record this refinancing on the books of Perkins Inc.



5



6



P14-12 (Modification of Note under Different Circumstances) Halvor Corporation is having financial difficulty and therefore has asked Frontenac National Bank to restructure its $5 million note outstanding. The present note has 3 years remaining and pays a current rate of interest of 10%. The present market rate for a loan of this nature is 12%. The note was issued at its face value. Instructions Presented below are three independent situations. Prepare the journal entry that Halvor would make for each of these restructurings. (a) Frontenac National Bank agrees to take an equity interest in Halvor by accepting ordinary shares valued at $3,700,000 in exchange for relinquishing its claim on this note. The ordinary shares have a par value of $1,700,000. (b) Frontenac National Bank agrees to accept land in exchange for relinquishing its claim on this note. The land has a book value of $3,250,000 and a fair value of $4,000,000. (c) Frontenac National Bank agrees to modify the terms of the note, indicating that Halvor does not have to pay any interest on the note over the 3-year period.



6



P14-13 (Debtor/Creditor Entries for Continuation of Debt with New Effective Interest) Crocker Corp. owes D. Yaeger Corp. a 10-year, 10% note in the amount of £330,000 plus £33,000 of accrued interest. The note is due today, December 31, 2015. Because Crocker Corp. is in financial trouble, D. Yaeger Corp. agrees to forgive the accrued interest, £30,000 of the principal and to extend the maturity date to December 31, 2018. Interest at 10% of revised principal will continue to be due on 12/31 each year. Given Crocker’s financial difficulties, the market rate for its loans is 12%. Instructions (a) Prepare the amortization schedule for the years 2015 through 2018. (b) Prepare all the necessary journal entries on the books of Crocker Corp. for the years 2015, 2016, and 2017.



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Concepts for Analysis 695 3



4



6



9



P14-14 (Comprehensive Problem: Issuance, Classification, Reporting) Presented below are three independent situations. Instructions (a) On January 1, 2015, Langley Co. issued 9% bonds with a face value of $700,000 for $656,992 to yield 10%. The bonds are dated January 1, 2015, and pay interest annually. What amount is reported for interest expense in 2015 related to these bonds? (b) Tweedie Building Co. has a number of long-term bonds outstanding at December 31, 2015. These long-term bonds have the following sinking fund requirements and maturities for the next 6 years. 2016 2017 2018 2019 2020 2021



Sinking Fund



Maturities



$300,000 100,000 100,000 200,000 200,000 200,000



$100,000 250,000 100,000 — 150,000 100,000



Indicate how this information should be reported in the financial statements at December 31, 2015. (c) In the long-term debt structure of Beckford Inc., the following three bonds were reported: mortgage bonds payable $10,000,000; collateral trust bonds $5,000,000; bonds maturing in installments, secured by plant equipment $4,000,000. Determine the total amount, if any, of debenture bonds outstanding.



C O N C E P T S F O R A N A LY S I S CA14-1 (Bond Theory: Statement of Financial Position Presentations, Interest Rate, Premium) On January 1, 2016, Nichols Company issued for $1,085,800 its 20-year, 11% bonds that have a maturity value of $1,000,000 and pay interest semiannually on January 1 and July 1. Bond issue costs were not material in amount. Below are three presentations of the non-current liability section of the statement of financial position that might be used for these bonds at the issue date. 1. Bonds payable (maturing January 1, 2036)



$1,085,800



2. Bonds payable—principal (face value $1,000,000 maturing January 1, 2036) Bonds payable—interest (semiannual payment $55,000)



$ 142,050a 943,750b



Total bond liability 3. Bonds payable—principal (maturing January 1, 2036) Bonds payable—interest ($55,000 per period for 40 periods) Total bond liability



$1,085,800 $1,000,000 2,200,000 $3,200,000



a



The present value of $1,000,000 due at the end of 40 (6-month) periods at the yield rate of 5% per period. The present value of $55,000 per period for 40 (6-month) periods at the yield rate of 5% per period.



b



Instructions (a) Discuss the conceptual merit(s) of each of the date-of-issue statement of financial position presentations shown above for these bonds. (b) Explain why investors would pay $1,085,800 for bonds that have a maturity value of only $1,000,000. (c) Assuming that a discount rate is needed to compute the carrying value of the obligations arising from a bond issue at any date during the life of the bonds, discuss the conceptual merit(s) of using for this purpose: (1) The coupon or nominal rate. (2) The effective or yield rate at date of issue. (d) If the obligations arising from these bonds are to be carried at their present value computed by means of the current market rate of interest, how would the bond valuation at dates subsequent to the date of issue be affected by an increase or a decrease in the market rate of interest? CA14-2 (Various Non-Current Liability Conceptual Issues) Schrempf Company has completed a number of transactions during 2015. In January, the company purchased under contract a machine at a total price of €1,200,000, payable over 5 years with installments of €240,000 per year. The seller has considered the transaction as an installment sale with the title transferring to Schrempf at the time of the final payment.



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696 Chapter 14 Non-Current Liabilities On March 1, 2015, Schrempf issued €10 million of general revenue bonds priced at 99 with a coupon of 10% payable July 1 and January 1 of each of the next 10 years. The July 1 interest was paid and on December 30, the company transferred €1,000,000 to the trustee, Flagstad Company, for payment of the January 1, 2016, interest. As the accountant for Schrempf Company, you have prepared the statement of financial position as of December 31, 2015, and have presented it to the president of the company. You are asked the following questions about it. 1. Why has depreciation been charged on equipment being purchased under contract? Title has not passed to the company as yet and, therefore, it is not our asset. Why should the company not show on the left side of the statement of financial position only the amount paid to date instead of showing the full contract price on the left side and the unpaid portion on the right side? After all, the seller considers the transaction an installment sale. 2. Bond interest is shown as a current liability. Did we not pay our trustee, Flagstad Company, the full amount of interest due this period? Instructions Outline your answers to these questions by writing a brief paragraph that will justify your treatment. CA14-3 (Bond Theory: Price, Presentation, and Retirement) On March 1, 2016, Sealy Company sold its 5-year, £1,000 face value, 9% bonds dated March 1, 2016, at an effective annual interest rate (yield) of 11%. Interest is payable semiannually, and the first interest payment date is September 1, 2016. Sealy uses the effective-interest method of amortization. The bonds can be called by Sealy at 101 at any time on or after March 1, 2017. Instructions (a) (1) How would the selling price of the bond be determined? (2) Specify how all items related to the bonds would be presented in a statement of financial position prepared immediately after the bond issue was sold. (b) What items related to the bond issue would be included in Sealy’s 2016 income statement, and how would each be determined? (c) Would the amount of bond discount amortization using the effective-interest method of amortization be lower in the second or third year of the life of the bond issue? Why? (d) Assuming that the bonds were called in and extinguished on March 1, 2017, how should Sealy report the retirement of the bonds on the 2017 income statement? CA14-4 (Bond Theory: Amortization and Gain or Loss Recognition) Part I: The required method of amortizing a premium or discount on issuance of bonds is the effectiveinterest method. Instructions How is amortization computed using the effective-interest method, and why and how do amounts obtained using the effective-interest method provide financial statement readers useful information about the cost of borrowing? Part II: Gains or losses from the early extinguishment of debt that is refunded can theoretically be accounted for in three ways: 1. Amortized over remaining life of old debt. 2. Amortized over the life of the new debt issue. 3. Recognized in the period of extinguishment. Instructions (a) Develop supporting arguments for each of the three theoretical methods of accounting for gains and losses from the early extinguishment of debt. (b) Which of the methods above is generally accepted under IFRS and how should the appropriate amount of gain or loss be shown in a company’s financial statements? CA14-5 (Off-Balance-Sheet Financing) Matt Ryan Corporation is interested in building its own soda can manufacturing plant adjacent to its existing plant in Partyville, Kansas. The objective would be to ensure a steady supply of cans at a stable price and to minimize transportation costs. However, the company has been experiencing some financial problems and has been reluctant to borrow any additional cash to fund the project. The company is not concerned with the cash flow problems of making payments but rather with the impact of adding additional long-term debt to its statement of financial position.



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Using Your Judgment 697 The president of Ryan, Andy Newlin, approached the president of the Aluminum Can Company (ACC), its major supplier, to see if some agreement could be reached. ACC was anxious to work out an arrangement since it seemed inevitable that Ryan would begin its own can production. Aluminum Can Company could not afford to lose the account. After some discussion, a two-part plan was worked out. First, ACC was to construct the plant on Ryan’s land adjacent to the existing plant. Second, Ryan would sign a 20-year purchase agreement. Under the purchase agreement, Ryan would express its intention to buy all of its cans from ACC, paying a unit price which at normal capacity would cover labor and material, an operating management fee, and the debt service requirements on the plant. The expected unit price, if transportation costs are taken into consideration, is lower than current market. If Ryan did not take enough production in any one year and if the excess cans could not be sold at a high enough price on the open market, Ryan agrees to make up any cash shortfall so that ACC could make the payments on its debt. The bank will be willing to make a 20-year loan for the plant, taking the plant and the purchase agreement as collateral. At the end of 20 years, the plant is to become the property of Ryan. Instructions (a) What are project financing arrangements using special purpose entities? (b) What are take-or-pay contracts? (c) Should Ryan record the plant as an asset together with the related obligation? If not, should Ryan record an asset relating to the future commitment? (d) What is meant by off-balance-sheet financing? CA14-6 (Bond Issue) Donald Lennon is the president, founder, and majority owner of Wichita Medical Corporation, an emerging medical technology products company. Wichita is in dire need of additional capital to keep operating and to bring several promising products to final development, testing, and production. Donald, as owner of 51% of the outstanding shares, manages the company’s operations. He places heavy emphasis on research and development and long-term growth. The other principal shareholder is Nina Friendly who, as a non-employee investor, owns 40% of the shares. Nina would like to deemphasize the R & D functions and emphasize the marketing function to maximize short-run sales and profits from existing products. She believes this strategy would raise the market price of Wichita’s shares. All of Donald’s personal capital and borrowing power is tied up in his 51% share ownership. He knows that any offering of additional shares will dilute his controlling interest because he won’t be able to participate in such an issuance. But, Nina has money and would likely buy enough shares to gain control of Wichita. She then would dictate the company’s future direction, even if it meant replacing Donald as president and CEO. The company already has considerable debt. Raising additional debt will be costly, will adversely affect Wichita’s credit rating, and will increase the company’s reported losses due to the growth in interest expense. Nina and the other minority shareholders express opposition to the assumption of additional debt, fearing the company will be pushed to the brink of bankruptcy. Wanting to maintain his control and to preserve the direction of “his” company, Donald is doing everything to avoid a share issuance and is contemplating a large issuance of bonds, even if it means the bonds are issued with a high effectiveinterest rate. Instructions (a) Who are the stakeholders in this situation? (b) What are the ethical issues in this case? (c) What would you do if you were Donald?



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SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 14-1 Present value of the principal ¥500,000 X .37689.......................................................... Present value of the interest payments ¥22,500 X 12.46221........................................................ Issue price ...............................................................



¥188,445 280,400 ¥468,845



BRIEF EXERCISE 14-2 (a)



(b)



(c)



Cash ....................................................................... Bonds Payable .............................................



300,000



Interest Expense.................................................... Cash (€300,000 X 10% X 6/12) .....................



15,000



Interest Expense.................................................... Interest Payable............................................



15,000



300,000



15,000



15,000



BRIEF EXERCISE 14-3 (a)



(b)



(c)



14-10



Cash (€300,000 X 1.0811) ...................................... Bonds Payable .............................................



324,330



Interest Expense (€324,330 X 8% X 6/12) ............ Bonds Payable....................................................... Cash (€300,000 X 10% X 6/12) .....................



12,973 2,027



Interest Expense (€324,330 – €2,027) X 8% X 6/12 ........................ Bonds Payable....................................................... Interest Payable............................................



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324,330



15,000



12,892 2,108



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BRIEF EXERCISE 14-4 (a) (b)



(c)



Cash (€300,000 X .926393) ................................... Bonds Payable .............................................



277,918



Interest Expense (€277,918 X 12% X 6/12) .......... Bonds Payable ............................................. Cash (€300,000 X 10% X 6/12) ....................



16,675



Interest Expense (€277,918 + €1,675) X 12% X 6/12) .................... Bonds Payable ............................................. Interest Payable ...........................................



277,918 1,675 15,000 16,776 1,776 15,000



BRIEF EXERCISE 14-5 (a)



(b) (c)



Cash ....................................................................... Bonds Payable ............................................. Interest Expense (£400,000 X 6% X 4/12 = £8,000) ..............



408,000



Interest Expense ................................................... Cash (£400,000 X 6% X 6/12 = £12,000) .....



12,000



Interest Expense ................................................... Interest Payable ...........................................



12,000



400,000 8,000 12,000 12,000



BRIEF EXERCISE 14-6 (a) (b)



Cash ....................................................................... Bonds Payable .............................................



559,224



Interest Expense ($559,224 X 8% X 6/12) ............ Cash ($600,000 X 7% X 6/12) ...................... Bonds Payable .............................................



22,369



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21,000 1,369



14-11



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BRIEF EXERCISE 14-6 (Continued) (c)



Interest Expense [($560,593 X 8% X 6/12 = $22,424)]...................... Interest Payable.............................................. Bonds Payable ...............................................



22,424 21,000 1,424



BRIEF EXERCISE 14-7 (a)



Cash ................................................................ 644,636,000 Bonds Payable ...................................... 644,636,000



(b)



Interest Expense............................................. Bonds Payable................................................ Cash ....................................................... ($644,636 X 6% X 6/12 = $19,339,000) ($600,000 X 7% X 6/12 = $21,000,000)



(c)



Interest Expense ($642,975 X 6% X 6/12 = $19,289) ............... Bonds Payable................................................ Interest Payable.....................................



19,339,000 1,661,000 21,000,000



19,289 1,711 21,000



BRIEF EXERCISE 14-8 Interest Expense .............................................................. 6,446,360* Bonds Payable ................................................................. 553,640 Interest Payable ...................................................... 7,000,000** *HK$644,636,000 X 6% X 2/12 = HK$6,446,360 **HK$600,000,000 X 7% X 2/12 = HK$7,000,000



14-12



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BRIEF EXERCISE 14-9 (a)



(b)



Cash ....................................................................... Notes Payable ..............................................



100,000



Interest Expense ................................................... Cash (€100,000 X 10% = €10,000) ...............



10,000



100,000



10,000



BRIEF EXERCISE 14-10 (a)



(b)



Cash ....................................................................... Notes Payable ..............................................



47,664



Interest Expense ................................................... Notes Payable .............................................. (£47,664 X 12%)



5,720



47,664



5,720



BRIEF EXERCISE 14-11 (a)



(b)



Equipment ............................................................. Notes Payable ..............................................



31,495



Interest Expense ................................................... Cash .............................................................. Notes Payable .............................................. ($31,495 X 12% = $3,779) ($40,000 X 5% = $2,000)



3,779



31,495



2,000 1,779



BRIEF EXERCISE 14-12 Cash .................................................................................. Notes Payable ......................................................... Unearned Sales Revenue [€60,000 – (€60,000 X .63552) = €21,869] ...........



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38,131 21,869



14-13



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BRIEF EXERCISE 14-13 Bonds Payable ($500,000 + $15,000) .............................. Gain on Extinguishment of Debt ........................... Cash (.99 X $500,000) .............................................



515,000 20,000 495,000



BRIEF EXERCISE 14-14 Notes Payable .................................................................. Share Capital—Ordinary ........................................ Share Premium—Ordinary (€4.75 – €1) X 20,000 ........................................... Gain on Extinguishment of Debt ...........................



100,000 20,000 75,000 5,000



BRIEF EXERCISE 14-15 (a)



Present value of restructured cash flows: Present value of principal €90,000 due in 4 years at 12% (€90,000 X .63552) ..................... Present value of interest €7,200 paid annually for 4 years at 12% (€7,200 X 3.03735) ............... Fair value of note................................................... Notes Payable (Old) .............................................. Gain on Extinguishment of Debt ................ Notes Payable (New) ....................................



(b)



€ 57,197 21,869 € 79,066 100,000



Interest Expense.................................................... Cash (€90,000 X 8%) .................................... Notes Payable...............................................



20,934 79,066 9,488* 7,200 2,288



*€79,066 X 12%



14-14



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BRIEF EXERCISE 14-16 (a) (b)



Unrealized loss = HK$17,500 – HK$16,000 = HK$1,500 Unrealized Holding Gain or Loss—Income ........ 1,500 Notes Payable ..............................................



1,500



BRIEF EXERCISE 14-17 Non-current liabilities Bonds Payable, due January 1, 2023 ................... Current liabilities Interest Payable ......................................................



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80,000



14-15



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SOLUTIONS TO EXERCISES EXERCISE 14-1 (15–20 minutes) (a) (b) (c) (d)



(e) (f)



(g) (h)



Current liability if current assets are used to satisfy the debt. Current liability, €250,000; long-term liability, €750,000. Current liability. Probably non-current, although if operating cycle is greater than one year and current assets are used, this item would be classified as current. Current liability. Current liability unless (a) a fund for liquidation has been accumulated which is not classified as a current asset or (b) arrangements have been made for refinancing. Current liability. Current liability.



EXERCISE 14-2 (15–20 minutes) (a)



Interest expense (credit balance)—Reclassify to interest payable on statement of financial position.



(b)



Bond issue costs—Reduction of the issue amount of the bond payable.



(c)



Gain on repurchase of debt—Classify as part of Other income and expense on the income statement.



(d)



Mortgage payable—Classify one-third as current liability and the remainder as non-current liability on statement of financial position.



(e)



Debenture bonds payable—Classify statement of financial position.



(f)



Notes payable—Classify as non-current liability on statement of financial position.



(g)



Income bonds payable—Classify as non-current liability on statement of financial position.



14-16



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EXERCISE 14-3 (15–20 minutes) 1.



Divac Company: (a)



1/1/15



(b) 7/1/15



(c)



2.



Cash ..................................................... 300,000 Bonds Payable ........................... Interest Expense (€300,000 X 9% X 3/12) .................... Cash ............................................



12/31/15 Interest Expense ................................. Interest Payable .........................



300,000



6,750 6,750 6,750 6,750



Verbitsky Company: (a)



6/1/15



(b) 7/1/15



(c)



Cash ..................................................... 210,000 Bonds Payable ........................... Interest Expense (€200,000 X 12% X 5/12) ......... Interest Expense ................................. Cash (€200,000 X 12% X 6/12) ..



12,000



12/31/15 Interest Expense ................................. Interest Payable .........................



12,000



200,000 10,000



12,000



12,000



Note to instructor: Some students may credit Interest Payable on 6/1/15. If they do so, the entry on 7/1/15 will have a debit to Interest Payable for €10,000 and a debit to Interest Expense for €2,000.



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EXERCISE 14-4 (15–20 minutes) (a)



(b)



(c)



1/1/15



7/1/15



Cash (€800,000 X 1.19792)........................ 958,336 Bonds Payable ................................. Interest Expense (€958,336 X 8% X 6/12) ........................... Bonds Payable .......................................... Cash (€800,000 X 10% X 6/12) .........



38,333 1,667



12/31/15 Interest Expense (€958,336 – €1,667) X 8% X 6/12 ............ Bonds Payable .......................................... Interest Payable ...............................



38,267 1,733



958,336



40,000



40,000



EXERCISE 14-5 (15–20 minutes) (a)



(b)



(c)



14-18



1/1/15



7/1/15



Cash (€800,000 X .8495) ............................ 679,600 Bonds Payable ................................. Interest Expense (€679,600 X 12% X 1/2) ........................... Bonds Payable........................................... Cash (€800,000 X 10% X 6/12) .........



12/31/15 Interest Expense [(€679,600 + €776) X 12% X 1/2] ............ Bonds Payable ................................. Interest Payable ...............................



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40,776 776 40,000



40,823



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EXERCISE 14-6 (15–20 minutes) The effective-interest or yield rate is 12%. It is determined through trial and error using Table 6-2 for the discounted value of the principal (£1,702,290) and Table 6-4 for the discounted value of the interest (£1,081,434); £1,702,290 plus £1,081,434 equals the proceeds of £2,783,724. (A financial calculator may be used to determine the rate of 12%.) Schedule of Discount Amortization Effective-Interest Method (12%)



Year



Cash Paid



(1) Jan. 1, 2015 Dec. 31, 2015 Dec. 31, 2016 Dec. 31, 2017 Dec. 31, 2018 Dec. 31, 2019



(2) — £300,000 300,000 300,000 300,000 300,000



Interest Expense (3) — £334,046.88 * 338,132.51 342,708.41 347,833.42 353,554.78 **



Discount Amortized



Carrying Amount of Bonds



(4) — £34,046.88 38,132.51 42,708.41 47,833.42 53,554.78



£2,783,724.00 2,817,770.88 2,855,903.39 2,898,611.80 2,946,445.22 3,000,000.00



*£334,046.88 = £2,783,724 X .12. **Rounded. EXERCISE 14-7 (15–20 minutes) (a)



Bond selling price ($2,500,000 X 1.06231) ........................



$ 2,655,775



July 1, 2015 Interest expense reported ($2,655,775 X 10% X 6/12) ......



$



132,789



$



265,578*



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14-19



December 31, 2015 Interest expense reported .................................................. *$2,655,775 X 10% X 6/12 = $132,789 ($2,655,775 – $132,789) X 10% X 6/12 = $132,779



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EXERCISE 14-7 (Continued) (b)



June 30, 2015 Carrying amount of bonds ................................................. Effective-interest rate for the period from June 30 to October 31, 2015 (.10 X 4/12) ...................................... Interest expense to be recorded on October 31, 2015 ....



$562,500 X.033333 $ 18,750*



*Alternative computation: $562,500 X .10 X 4/12 (c)



October 1, 2015 Cash ($853,382 + $72,000) ....................................... Bonds payable ................................................. Interest Expense ($800,000 X 12% X 9/12) ....



925,382 853,382 72,000



December 31, 2015 Interest Expense ....................................................... Bonds Payable .......................................................... Cash ($800,000 X 12%) ....................................



93,335 2,665* 96,000



*($800,000 X 12%) – $72,000 = $24,000 net cash paid ($853,382 X 10% X 3/12) (21,335) interest expense $2,665 premium amortized



14-20



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EXERCISE 14-8 (20–30 minutes) (a)



(1)



June 30, 2014 Cash .................................................... Bonds Payable ..........................



(2)



5,376,150 5,376,150



December 31, 2014 Interest Expense (R$5,376,150 X 12% X 6/12) ............ Bonds Payable ................................... Cash (R$5,000,000 X 13% X 6/12) ...



(3)



322,569 2,431 325,000



June 30, 2015 Interest Expense [(R$5,376,150 – R$2,431) X 12% X 6/12] ................................. Bonds Payable ................................... Cash ...........................................



(4)



322,423 2,577 325,000



December 31, 2015 Interest Expense [(R$5,376,150 – R$2,431 – R$2,577) X 12% X 6/12] ................. Bonds Payable ................................... Cash ...........................................



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EXERCISE 14-8 (Continued) (b)



Non-current Liabilities: Bonds payable, 13% (due on June 30, 2034) .............



R$5,368,410*



*R$5,376,150 – (R$2,431 + R$2,577 + R$2,732) = R$5,368,410 (c)



(1)



(2)



14-22



Interest expense for the period from January 1 to June 30, 2015 from (a) 3. ............. Interest expense for the period from July 1 to December 31, 2015 from (a) 4. .......... Amount of bond interest expense reported for 2015 ............................................... Total interest to be paid for the bond (R$5,000,000 X 13% X 20).................................. Less: Premium (R$5,376,000 – R$5,000,000) .... Total cost of borrowing over the life of the bond .........................................................



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EXERCISE 14-9 (15–20 minutes) (a)



January 1, 2015 Cash ............................................................ Bonds Payable ..................................



(b)



860,651.79 860,651.79



Schedule of Interest Expense and Bond Premium Amortization Effective-Interest Method 12% Bonds Sold to Yield 10%



Date



Cash Paid



Interest Expense



1/1/15 12/31/15 12/31/16 12/31/17



— £96,000.00 96,000.00 96,000.00



— £86,065.18 85,071.70 83,978.87



(c)



Premium Amortized — £ 9,934.82 10,928.30 12,021.13



Carrying Amount of Bonds £860,651.79 850,716.97 839,788.67 827,767.54



December 31, 2015 Interest Expense ........................................ Bonds Payable ........................................... Cash ...................................................



(d)



86,065.18 9,934.82 96,000.00



December 31, 2017 Interest Expense ........................................ Bonds Payable ........................................... Cash ...................................................



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EXERCISE 14-10 (20–30 minutes) Unsecured Bonds (1)



Maturity value



(2)



Number of interest periods (10 X 4)



(3)



Stated rate per period



(4)



Effective rate per period



(5)



Payment amount per period



(6)



Present value



(a)



$10,000,000



$25,000,000



$15,000,000



40



10



10



3.25% (



13% ) 4



0



10%



3% (



12% ) 4



12%



12%



$325,000(a)



0



$ 1,500,000(b)



$10,577,900(c)



$8,049,250(d)



$13,304,880(e)



$15,000,000 X 10% = $1,500,000



Present value of an annuity of $325,000 discounted at 3% per period for 40 periods ($325,000 X 23.11477) .......................... Present value of $10,000,000 discounted at 3% per period for 40 periods ($10,000,000 X .30656) ............................................



(d)



(e)



Mortgage Bonds



$10,000,000 X 13% X 1/4 = $325,000



(b) (c)



Zero-Coupon Bonds



Present value of $25,000,000 discounted at 12% for 10 periods ($25,000,000 X .32197) ............................................



Present value of an annuity of $1,500,000 discounted at 12% for 10 periods ($1,500,000 X 5.65022) ............................................ Present value of $15,000,000 discounted at 12% for 10 years ($15,000,000 X .32197) ............................................



14-24



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EXERCISE 14-11 (15–20 minutes) (a)



1.



2.



January 1, 2015 Land ........................................................... Notes Payable ................................. (The €300,000 capitalized land cost represents the present value of the note discounted for five years at 11%.)



300,000



Equipment ................................................. Notes Payable .................................



297,079*



300,000



297,079



*Computation of the present value of the note: Present value of €400,000 due in 8 years at 11%— €400,000 X .43393 ......................... Present value of €24,000 payable annually for 8 years at 11% annually— €24,000 (€400,000 X .06) X 5.14612 .......................................... Present value of the note (b)



1.



2.



Interest Expense ...................................... Notes Payable (€300,000 X .11) ............................ Interest Expense (€297,079 X .11) ..................................... Notes Payable ................................. Cash (€400,000 X .06) .....................



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EXERCISE 14-12 (15–20 minutes) (a)



(b)



Face value of the zero-interest-bearing note ................... Discounting factor (12% for 3 periods)............................. Amount to be recorded for the land at January 1, 2015 ....



$600,000 X .71178 $427,068



Carrying value of the note at January 1, 2015 ................. Applicable interest rate (12%) ........................................... Interest expense to be reported in 2015 ...........................



$427,068 X .12 $ 51,248



January 1, 2015 Cash .............................................................. Notes Payable ..................................... Unearned Sales Revenue ..................



4,000,000 2,732,040 1,267,960*



*$4,000,000 – ($4,000,000 X .68301 (Table 6-2; 4 years, 10%)) = $1,267,960 Carrying value of the note at January 1, 2015 ................................ $2,732,040 Applicable interest rate (10%)................... X .10 Interest expense to be reported for 2015 ................................. $ 273,204



EXERCISE 14-13 (15–20 minutes) (a)



Cash ............................................................... Notes Payable ...................................... Unearned Sales Revenue (₺500,000 – ₺396,915) ........................ Face value ......................................... Present value of 1 at 8% for 3 years ...................................... Present value ....................................



14-26



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500,000 396,915 103,085



₺500,000 X .79383 ₺396,915



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EXERCISE 14-13 (Continued) (b)



Interest Expense (₺396,915 X 8%) ................ Notes Payable ......................................



31,753



Unearned Sales Revenue (₺103,085 ÷ 3) ..... Sales Revenue......................................



34,362



31,753



34,362



EXERCISE 14-14 (20–25 minutes)



(a)



Present value of the principal: $1,500,000 X .35218 (Table 6-2; 10 years, 11%) ....... Present value of the interest payments: ($1,500,000 X 10%) X 5.88923 (Table 6-4; 10 years, 11%) ........................................................... Present value (selling price) of the bonds .....................



(b)



$ 528,270



883,385 $1,411,655



AMORTIZATION SCHEDULE 10-Year, 10% Bonds Sold to Yield 11%



Date



Cash Paid



Interest Expense



Discount Amortized



Carrying Amount of Bonds



1/2/12 12/31/12 12/31/13 12/31/14 12/31/15 12/31/16



— $150,000 150,000 150,000 150,000 150,000



— $155,282 155,863 156,508 157,224 158,019



— $5,282 5,863 6,508 7,224 8,019



$1,411,655 1,416,937 1,422,800 1,429,308 1,436,532 1,444,551



(c)



Bonds Payable ($1,429,308 X $1,000,000/$1,500,000) .......... Loss on Extinguishment of Debt .................... Cash ($1,000,000 X 101%) ......................



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EXERCISE 14-15 (12–16 minutes) (a)



June 30, 2016 Bonds Payable (£600,000 – £78,979)............. Loss on Extinguishment of Debt................... Cash........................................................



521,021 102,979 624,000



Reacquisition price (£600,000 X 104%)......... Net carrying amount of bonds redeemed: (£600,000 – £78,979) ............................. Loss on extinguishment ................................ Cash (£800,000 X 112.5513%) ........................ Bonds Payable ....................................... (b)



£ 624,000 (521,021) £ 102,979 900,410 900,410



December 31, 2016 Interest Expense ............................................. Bonds Payable ................................................ Cash........................................................



22,510* 1,490 24,000**



*(£900,410 X 5% X 6/12) **(.03 X £800,000 = £24,000) EXERCISE 14-16 (10–15 minutes) Reacquisition price (¥5,000,000 X 104%) ............... Less: Net carrying amount of bonds redeemed: Par value ....................................................... ¥5,000,000 Unamortized discount .................................. (100,000) Loss on Extinguishment of Debt ............................ Bonds Payable ......................................................... Loss on Extinguishment of Debt ............................ Cash ............................................................... (To record extinguishment of bonds payable)



4,900,000 300,000



Cash (¥5,000,000 X 103%) ....................................... Bonds Payable .............................................. (To record issuance of new bonds)



5,150,000



14-28



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¥5,200,000



4,900,000 ¥ 300,000



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EXERCISE 14-17 (15–20 minutes) (a)



Transfer of property on December 31, 2015: Strickland Company (Debtor): Notes Payable .............................................. Interest Payable ........................................... Accumulated Depreciation—Equipment.... Machine................................................. Gain on Disposition of Equipment ..... Gain on Extinguishment of Debt ........



200,000 18,000 221,000 390,000 11,000a 38,000b



a



$180,000 – ($390,000 – $221,000) = $11,000. ($200,000 + $18,000) – $180,000 = $38,000.



b



(b)



“Gain on Disposition of Equipment” and the “Gain on Extinguishment of Debt” should be reported under Other income and expense in the income statement.



(c)



Granting of equity interest on December 31, 2015: Strickland Company (Debtor): Notes Payable .............................................. Interest Payable ........................................... Share Capital—Ordinary ($15,000 X $10) .................................. Share Premium—Ordinary ($180,000 – $150,000)........................ Gain on Extinguishment of Debt ........



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EXERCISE 14-18 (25–30 minutes) (a)



Yes, Barkley can record a gain on extinguishment equal to the difference between the note’s carrying value and the fair value of the restructured note. The note’s fair value is computed as follows: Present value of restructured cash flows: Present value of principal £2,400,000 due in 3 years at 15% ............................... Present value of interest £240,000 (£2,400,000 X .10) paid annually for 3 years at 15% ............. Fair value of note ...................................................



£1,578,048a 547,975b £2,126,023



a



£2,400,000 X .65752 = £1,578,048. £240,000 X 2.28323 = £547,975.



b



(b)



The amortization schedule is prepared as follows: BARKLEY COMPANY Amortization Schedule After Debt Modification Market-Interest Rate 15%



Date



Cash Paid (10%)



12/31/15 12/31/16 12/31/17 12/31/18 Total



— £240,000a 240,000 240,000 £720,000



Interest Expense (15%) — £318,903b 330,739 344,335* £993,977



Amortization — £ 78,903c 90,739 104,335 £273,977



Carrying Value £2,126,023 2,204,926 2,295,665 2,400,000



a



£2,400,000 X 10% = £240,000. £2,126,023 X 15% = £318,903. c £318,903 – £240,000 = £78,903. *Rounded £15. b



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EXERCISE 14-18 (Continued) (c)



Interest payment entry for Barkley Company is: December 31, 2017 Interest Expense .................................................. Notes Payable ............................................. Cash .............................................................



(d)



330,739 90,739 240,000



The payment entry at maturity is: January 1, 2019 Notes Payable....................................................... 2,400,000 Cash ...............................................................



2,400,000



EXERCISE 14-19 (20–30 minutes) (a)



The note’s fair value can be calculated as follows: Present value of restructured cash flows: Present value of principal £1,900,000 due in 3 years at 15% ....................................... £1,249,288a Present value of interest £190,000 (£1,900,000 X .10) paid annually for 3 years at 15%..................... 433,814b Fair value of note ................................................ £1,683,102 a



£1,900,000 X .65752 = £1,249,288 £190,000 X 2.28323 = £433,814



b



December 31, 2015 Notes Payable (Old) ............................................. 1,900,000 Gain on Extinguishment of Debt ............... Notes Payable (New)...................................



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EXERCISE 14-19 (Continued) (b)



The amortization schedule is prepared as follows: BARKLEY COMPANY Amortization Schedule After Debt Modification Market-Interest Rate 15%



Date



Cash Paid (10%)



Interest Expense (15%)



12/31/15 12/31/16 12/31/17 12/31/18 Total



— £190,000a 190,000 190,000 £570,000



— £252,465b 261,835 272,598 £786,898



Amortization — £ 62,465c 71,835 82,598 £216,898



Carrying Value £1,683,102 1,745,567 1,817,402 1,900,000



a



£1,900,000 X 10% = £190,000. £1,683,102 X 15% = £252,465. c £252,465 – £190,000 = £62,465. b



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EXERCISE 14-19 (Continued) (c)



Interest payment entries for Barkley Company are: December 31, 2016 Interest Expense .................................................. Notes Payable ............................................. Cash .............................................................



252,465 62,465 190,000



December 31, 2017 Interest Expense .................................................. Notes Payable ............................................. Cash .............................................................



261,835 71,835 190,000



December 31, 2018 Interest Expense .................................................. Notes Payable ............................................. Cash ............................................................. (d)



272,598 82,598 190,000



The payment entry at maturity is: January 1, 2019 Notes Payable....................................................... 1,900,000 Cash .............................................................



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EXERCISE 14-20 (15–20 minutes) (a)



Gottlieb Co.’s entry: Notes Payable ......................................................... Land ................................................................ Gain on Disposition of Land (€140,000 – €90,000) .................................. Gain on Extinguishment of Debt ..................



199,800 90,000 50,000 59,800*



*€199,800 – €140,000. (b)



Present value of restructured cash flows: Present value of $220,000 due in 2 years at 8%, interest payable annually (Table 6-2); ($220,000 X .85734) ................ Present value of $11,000 interest payable annually for 2 years at 8% (Table 6-4); ($11,000 X 1.78326) ..................................... Fair value of note ....................................................



$188,615



19,616 $208,231



Vargo Corp.’s entries: December 31, 2015 2015 Notes Payable (Old) ....................................... Gain on Extinguishment of Debt .......... Note Payable (New) ...............................



270,000 61,769 208,231



December 31, 2016 2016 Interest Expense ($208,231 X 8%) ................ Notes Payable ........................................ Cash (5% X $220,000) ............................



16,658 5,658 11,000



December 31, 2017 2017 Interest Expense [($208,231 + $5,658) X .08] .................... Notes Payable ........................................ Cash [$220,000 + (5% X $220,000)] .........................



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EXERCISE 14-21 (10–15 minutes) (a)



December 31, 2015 No entry since the carrying value is equal to the notes’ fair value. December 31, 2016 Notes Payable (€44,000 – €42,500) ............................... Unrealized Holding Gain or Loss—Income ........



1,500 1,500



December 31, 2017 Unrealized Holding Gain or Loss—Income.................. Notes Payable [(€38,000 – €36,000) + €1,500].....



3,500 3,500



(b)



The note will be reported at €42,500 on Fallen’s 2016 statement of financial position.



(c)



Fallen’s 2017 income is €3,500 lower since the change in fair value is reported as part of net income.



(d)



Fallen’s creditworthiness has declined since the fair value of its debt declined. Since the general market interest rates have been stable, the fair value decline must have been caused by a decline in Fallen’s creditworthiness.



(e)



When the value of a liability changes due to a company’s specific credit risk, this change in value is reported in other comprehensive income (assuming a company has chosen the fair value option), as a result changes in value do not affect net income or net loss.



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EXERCISE 14-22 (10–15 minutes) At December 31, 2015, disclosures would be as follows: Maturities and sinking fund requirements on long-term debt are as follows: 2016 2017 2018 2019 2020



14-36



$ 0 2,500,000 4,500,000 8,500,000 2,500,000



($2,000,000 + $2,500,000) ($6,000,000 + $2,500,000)



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SOLUTIONS TO PROBLEMS PROBLEM 14-1



(a)



The bonds were sold at a discount of €5,651. Evidence of the discount is the January 1, 2009 book value of €94,349, which is less than the maturity value of €100,000 in 2018.



(b)



The stated rate is 11% (€11,000 ÷ €100,000). The effective rate is 12% (€11,322 ÷ €94,349).



(c)



January 1, 2009 Cash ...................................................................... Bonds Payable ............................................



(d)



94,349



December 31, 2009 Interest Expense .................................................. Bonds Payable ............................................ Interest Payable ..........................................



(e)



94,349



11,322 322 11,000



January 1, 2016 (Interest Payment) Interest Payable.................................................... Cash .............................................................



11,000 11,000



December 31, 2016 Interest Expense .................................................. Bonds Payable ............................................ Interest Payable ..........................................



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PROBLEM 14-2



(a)



Present value of the principal $2,000,000 X .38554 (PV10, 10%) ..........................



$ 771,080



Present value of the interest payments $210,000* X 6.14457 (PVOA10, 10%) ....................



1,290,360



Present value (selling price of the bonds) ........



$2,061,440



*$2,000,000 X 10.5% = $210,000 Cash ....................................................................... 2,061,440 Bonds Payable .............................................



Cash Paid



Interest Expense



Premium Amortization



Carrying Amount of Bonds



— $210,000 210,000 210,000 210,000



— $206,144 205,758 205,334 204,868



— $3,856 4,242 4,666 5,132



$2,061,440 2,057,584 2,053,342 2,048,676 2,043,544



(b) Date 1/1/14 1/1/15 1/1/16 1/1/17 1/1/18 (c)



14-40



2,061,440



Carrying amount as of 1/1/17 ............................... Less: Amortization of bond premium ($5,132 ÷ 2) .................................................. Carrying amount as of 7/1/17 ...............................



$2,048,676



Reacquisition price ............................................... Carrying amount as of 7/1/17 ($2,046,110 ÷ 2) ................................................... Loss ........................................................................



$1,065,000



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PROBLEM 14-2 (Continued) Entry for accrued interest Interest Expense ($204,868 X 1/2 X 1/2) ............ Bonds Payable .................................................... Cash ($210,000 X 1/2 X 1/2) .......................



51,217 1,283



Entry for reacquisition Bonds Payable .................................................... 1,023,055* Loss on Extinguishment of Debt ....................... 41,945 Cash ............................................................



52,500



1,065,000



*Premium as of 7/1/17 to be written off ($2,046,110 – $2,000,000) X 1/2 = $23,055 The loss is reported as other income and expense.



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PROBLEM 14-3



(a)



Date 1/1/15 4/1/15 7/1/15 10/1/15 1/1/16



Cash Paid — €400 400 400 400



Interest Expense — €640 645 650 655



Discount Amortized — €240 245 250 255



Carrying Amount of Note €32,000 32,240 32,485 32,735 32,990



(b)



At this point, we see that the customer owes €32,990, or €990 more than at the beginning of the year.



(c)



To earn 8% over the next two years the quarterly payments must be €4,503 computed as follows: €32,990 ÷ 7.32548 (PVOA8, 2%) = €4,503



(d)



Date 1/1/16 4/1/16 7/1/16 10/1/16 1/1/17 4/1/17 7/1/17 10/1/17 1/1/18



Cash Paid — €4,503 4,503 4,503 4,503 4,503 4,503 4,503 4,503



Interest Expense — €660 583 505 425 343 260 175 83*



Discount Amortized — €3,843 3,920 3,998 4,078 4,160 4,243 4,328 4,420



Carrying Amount of Note €32,990 29,147 25,227 21,229 17,151 12,991 8,748 4,420 0



*rounded up €5 (e)



14-42



The new sales gimmick may bring people into the showroom the first time but will drive them away once they learn of the amount of their year 2 and year 3 payments. Many will not have budgeted for these increases, and will be in a bind because they owe more on their car than it’s worth. One should question the ethics of a dealer using this tactic. Copyright © 2014 John Wiley & Sons, Inc.



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PROBLEM 14-4



Dear Samantha, When a bond is issued at face value, the annual interest expense and the interest payout equals the face value of the bond times the interest rate stated on its face. However, if the bond is issued to yield a higher or lower interest rate than what is stated on its face, the interest expense and the actual interest payout will differ. Labeled as a discount or premium respectively, this difference in interest must be systematically associated with the interest periods which occur over the bond’s life through a process called amortization. Assume a premium: the theory behind the effective-interest method is that, as time passes, the difference between the face value of the bond and its carrying amount becomes smaller, resulting in a lower interest expense every period. (The carrying amount equals the face value of the bond plus any unamortized portion of the premium.) Because the carrying amount of the bond becomes smaller over time, the interest expense also does. Since the stated interest rate remains constant, the resulting difference between the actual interest payout and the interest expense recognized must be reflected when interest expense is recorded for the period. To amortize the premium applying this method to the data provided, you must know the bond’s face amount, its stated rate of interest, its effective rate of interest, and its carrying value. 1. Multiply the stated rate times the face amount. This is the interest payout. 2. Multiply the bond’s carrying amount by the effective rate which gives you the actual interest expense.



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PROBLEM 14-4 (Continued) 3. Subtract the amount calculated in #2 above from that found in #1. This is the amount to be amortized for the period. 4. Subtract the difference computed in #3 from the carrying amount. The process begins all over when you apply the effective rate to this new carrying amount for the following period. The schedule below illustrates this calculation. The face value (R$2,000,000) is multiplied by the stated rate of 11 percent, while the carrying amount (R$2,171,600) is multiplied by the effective rate of 10 percent. Because this bond pays interest semiannually, you must also multiply these amounts by 6/12. The result is the interest payout of R$110,000 and interest expense of R$108,580. The difference (R$1,420) is amortized, lowering the carrying amount of the bond to R$2,170,180. For the next period, this new carrying amount will be multiplied by the effective rate times 6/12 and subtracted from the constant R$110,000. Obviously this time the interest expense will be lower than it was last period, resulting in a greater amount of amortization in the next period. Follow these steps and you should have no trouble amortizing premiums and discounts over the life of a bond. Sincerely,



Attachment to letter



Date 6/30/15 12/31/15 6/30/16 12/31/16 6/30/17



14-44



HOBART COMPANY Interest and Discount Amortization Schedule 11% Bond Issued to Yield 10% Interest Carrying Cash Paid Expense Premium Amount of (11%) (10%) Amortized Bond — — — R$2,171,600 R$110,000 R$108,580 R$1,420 2,170,180 110,000 108,509 1,491 2,168,689 110,000 108,434 1,566 2,167,123 110,000 108,356 1,644 2,165,479



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PROBLEM 14-5



(a)



December 31, 2015 Equipment............................................................. 409,806.00 Notes Payable ............................................. (Computer capitalized at the present value of the note—£600,000 X .68301[pv4,10%])



(b)



409,806.00



December 31, 2016 Depreciation Expense .......................................... 67,961.20 Accumulated Depreciation—Equipment [(£409,806 – £70,000) ÷ 5] ........................



67,961.20



Interest Expense .................................................. 40,980.60 Notes Payable .............................................



40,980.60



Schedule of Note Discount Amortization Date



Debit, Interest Expense Credit, Notes Payable



Carrying Amount of Note



12/31/15 12/31/16 12/31/17 12/31/18 12/31/19



— £40,980.60 45,078.66 49,586.53 54,548.21*



£409,806.00 450,786.60 495,865.26 545,451.79 600,000.00



*£3.03 adjustment due to rounding. (c)



December 31, 2017 Depreciation Expense .......................................... 67,961.20 Accumulated Depreciation—Equipment...



67,961.20



Interest Expense .................................................. 45,078.66 Notes Payable .............................................



45,078.66



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PROBLEM 14-6



(a)



December 31, 2014 Machinery ........................................... 182,485.20* Cash........................................... 50,000.00 Notes Payable ........................... 132,485.20 *To record machinery at the present value of the note plus the immediate cash payment: PV of $40,000 annuity @ 8% for 4 years ($40,000 X 3.31213) ......... $132,485.20 Down payment ................................... 50,000.00 Capitalized value of machinery ........ $182,485.20



(b)



December 31, 2015 Notes Payable .................................... Cash...........................................



40,000.00



Interest Expense ................................ Notes Payable ...........................



10,598.82



40,000.00



10,598.82



Schedule of Note Discount Amortization Date



Cash Paid



12/31/14 12/31/15 12/31/16 12/31/17 12/31/18



— $40,000.00 40,000.00 40,000.00 40,000.00



Interest Expense — $10,598.82 8,246.72 5,706.46 2,962.80**



Amortization



Carrying Amount of Note



— $29,401.18 31,753.28 34,293.54 37,037.20



$132,485.20 103,084.02* 71,330.74 37,037.20 —



*$103,084.02 = $132,485.20 – $29,401.18. **$0.18 adjustment due to rounding.



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PROBLEM 14-6 (Continued) (c)



(d)



(e)



December 31, 2016 Notes Payable..................................... Cash ...........................................



40,000.00



Interest Expense ................................ Notes Payable ...........................



8,246.72



40,000.00



8,246.72



December 31, 2017 Notes Payable..................................... Cash ...........................................



40,000.00



Interest Expense ................................ Notes Payable ...........................



5,706.46



40,000.00



5,706.46



December 31, 2018 Notes Payable..................................... Cash ...........................................



40,000.00



Interest Expense ................................ Notes Payable ...........................



2,962.80



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PROBLEM 14-7



(a)



Entry to record the issuance of the 11% bonds on December 18, 2015: Cash (¥40,000,000 X 102%) .................................. 40,800,000 Bonds Payable .............................................



40,800,000



Entry to record the retirement of the 9% bonds on January 2, 2016: Bonds Payable (¥30,000,000 – ¥1,842,888)......... 28,157,112 Loss on Extinguishment of Debt......................... 3,042,888 Cash (¥30,000,000 X 104%) ......................... [The loss represents the excess of the cash paid (¥31,200,000) over the carrying amount of the bonds (¥28,157,112).]



31,200,000



(b) The loss is reported as an other income and expense item. Note 1. Loss on Bond Extinguishment The loss represents a loss of ¥3,042,888 from the extinguishment and retirement of ¥30,000,000 of the Company’s outstanding bond issue due in 2026. The funds used to purchase the mortgage bonds represent a portion of the proceeds from the sale of ¥40,000,000 of 11% debenture bonds issued December 18, 2015 and due in 2035.



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PROBLEM 14-8 1. Sanford Co. March 1, 2015 Cash ................................................................................ Bonds Payable .....................................................



472,090* 472,090



*Present value of $500,000 due in 7 periods at 6% ($500,000 X .66506) .................................................... Present value of interest payable semiannually ($25,000* X 5.58238) .................................................. Proceeds from sale of bonds ...................................... *$500,000 X .1 X 1/2



$332,530 139,560 $472,090



September 1, 2015 Interest Expense ............................................................ Bonds Payable ..................................................... Cash ......................................................................



28,325* 3,325 25,000



(See amortization table on next page) December 31, 2015 Interest Expense ............................................................ Bonds Payable ($3,525 X 4/6) ..................................................... Interest Payable ($25,000 X 4/6) ..........................



19,017 2,350 16,667



March 1, 2016 Interest Expense ............................................................ Interest Payable ............................................................. Bonds Payable ($3,525 X 2/6) ..................................................... Cash ......................................................................



9,508 16,667 1,175 25,000



September 1, 2016 Interest Expense ............................................................ Bonds Payable ..................................................... Cash ......................................................................



28,736 3,736 25,000



December 31, 2016 Interest Expense ............................................................ Bonds Payable ($3,961 X 4/6) ..................................................... Interest Payable .................................................... Copyright © 2014 John Wiley & Sons, Inc.



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PROBLEM 14-8 (Continued) Schedule of Bond Discount Amortization Effective-Interest Method 10% Bonds Sold to Yield 12%



Date 3/1/15 9/1/15 3/1/16 9/1/16 3/1/17 9/1/17 3/1/18 9/1/18



Cash Paid — $25,000 25,000 25,000 25,000 25,000 25,000 25,000



Interest Expense — $28,325 28,525 28,736 28,961 29,198 29,450 29,715*



Carrying Amount of Bonds $472,090 475,415 478,940 482,676 486,637 490,835 495,285 500,000



Discount Amortized — $3,325 3,525 3,736 3,961 4,198 4,450 4,715



*Rounded $2. 2. Titania Co. June 1, 2015 Cash ................................................................................ Bonds Payable ...................................................... Present value of $400,000 due in 8 periods at 5% ($400,000 X .67684) ..................................................... Present value of interest payable semiannually ($24,000* X 6.46321) .................................................... Proceeds from sale of bonds ........................................ *$400,000 X .12 X 1/2 December 1, 2015 Interest Expense ............................................................ Bonds Payable ............................................................... Cash ($400,000 X .12 X 6/12) ................................



425,853 425,853 $270,736 155,117 $425,853



21,293* 2,707 24,000



(See amortization table on Page 14–52) December 31, 2015 Interest Expense ($21,157 X 1/6) .................................. Bonds Payable ($2,843 X 1/6) ............................................................... Interest Payable ($24,000 X 1/6) .......................... 14-50



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PROBLEM 14-8 (Continued) June 1, 2016 Interest Expense ($21,157 X 5/6) .................................. Interest Payable ............................................................. Bonds Payable ($2,843 X 5/6) ....................................... Cash ......................................................................



17,631 4,000 2,369 24,000



October 1, 2016 Interest Expense ($21,015 X .3* X 4/6) .................................................... Bonds Payable ($2,985 X .3 X 4/6)................................ Cash ......................................................................



4,203 597 4,800



*$120,000 ÷ $400,000 = .3 October 1, 2016 Bonds Payable ............................................................... Gain on Extinguishment of Bonds ..................... Cash ......................................................................



125,494 4,294* 121,200



*Reacquisition price $126,000 – ($120,000 X 12% X 4/12) Net carrying amount of bonds redeemed: ($420,303* X .30) – $597 .................................... Gain on extinguishment ......................................



$121,200 (125,494) $ (4,294)



*From amortization table on page 14–52 December 1, 2016 Interest Expense ($21,015 X .7*)................................... Bonds Payable ($2,985 X .7) ......................................... Cash ($24,000 X .7) ...............................................



14,711 2,089 16,800



*($400,000 – $120,000) ÷ $400,000 = .7



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PROBLEM 14-8 (Continued) December 31, 2016 Interest Expense ($20,866 X .7 X 1/6) ................... Bonds Payable ($3,134 X .7 X 1/6) ........................ Interest Payable ($24,000 X .7 X 1/6) ...........



2,434 366 2,800



June 1, 2017 Interest Expense ($20,866 X .7 X 5/6) ................... Interest Payable ..................................................... Bonds Payable ($3,134 X .7 X 5/6) ........................ Cash ($24,000 X .7) .......................................



12,172 2,800 1,828 16,800



December 1, 2017 Interest Expense ($20,709 X .7) ............................ Bonds Payable ($3,291 X .7) ................................. Cash ($24,000 X .7) .......................................



14,496 2,304 16,800



Cash Paid



Interest Expense



Premium Amortized



Carrying Amount of Bonds



6/1/15



—



—



—



$425,853



12/1/15



$24,000



$21,293



$2,707



423,146



6/1/16



24,000



21,157



2,843



420,303



12/1/16



24,000



21,015



2,985



417,318



6/1/17



24,000



20,866



3,134



414,184



12/1/17



24,000



20,709



3,291



410,893



6/1/18



24,000



20,545



3,455



407,438



12/1/18



24,000



20,372



3,628



403,810



6/1/19



24,000



20,190*



3,810



400,000



Date



*$.50 adjustment due to rounding.



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PROBLEM 14-9 July 1, 2015 Cash (€900,000 X 1.19219) + (€900,000 X 12% X 6/12) .. 1,126,971.00 Bonds Payable ................................................. 1,072,971.00 Interest Expense (€900,000 X 12% X 6/12) ..... 54,000.00 December 31, 2015 Interest Expense (€900,000 X 12%) .......................... 108,000.00 Interest Payable ................................................ 108,000.00 Bonds Payable ........................................................... Interest Expense [(€108,000 – €54,000) – (€1,072,971 X 10% X 6/12)] ...........................



351.45 351.45



January 1, 2016 Interest Payable ......................................................... 108,000.00 Cash .................................................................. 108,000.00 January 2, 2016 Bonds Payable ............................................................. 429,047.82* Cash (€360,000 X 102%) .................................... 367,200.00 Gain on Extinguishment of Debt....................... 61,847.82 *[(€360,000 ÷ €900,000) X (€1,072,971 – €351.45)]. Reacquisition price (€360,000 X 102%)................................................ Net carrying value of bonds redeemed: (€1,072,971 – €351.45) X (€360,000 ÷ €900,000) ... Gain on redemption................................................



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PROBLEM 14-9 (Continued) December 31, 2016 Interest Expense (€540,000* X .12) ............................ Interest Payable ................................................. *$900,000 – $360,000



64,800.00



Bonds Payable ............................................................ Interest Expense [(€1,072,971 – €351.45 – €429,047.82) X .10] – €64,800 .......................



442.83



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PROBLEM 14-10



(a)



April 1, 2015 Cash ............................................................ Bonds Payable ................................



13,967,634* 13,967,634



*Present value of R$15,000,000 due in 30 periods at 6% (R$15,000,000 X .17411) ......................... Present value of interest payable semiannually (R$825,000 X 13.76483)............................ (b)



11,355,984 R$13,967,634



October 1, 2015 Interest Expense ........................................ Cash ................................................. Bonds Payable ................................ *R$13,967,634 X .12 X 6/12 = R$838,058 **R$15,000,000 X .11 X 6/12 = R$825,000



(c)



R$ 2,611,650



838,058* 825,000** 13,058



December 31, 2015 Interest Expense ........................................ 419,421* Interest Payable .............................. Bonds Payable ................................



412,500 6,921



*(R$13,967,634 + R$13,058) X .12 X 3/12 (d)



April 1, 2016 Interest Payable ......................................... Interest Expense ........................................ Cash ................................................. Bonds Payable ................................



412,500 419,628* 825,000** 7,128



*R$15,000,000 X .11 X 6/12 **R$13,987,613 X .12 X 3/12



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PROBLEM 14-10 (Continued) The reacquisition price: 200,000 shares X R$31 = R$6,200,000. The loss on extinguishment of the bonds is: Reacquisition price ...................................................... R$6,200,000 Less: Carrying amount (R$13,987,613 + R$7,128) X 40% ................................. 5,597,896 Loss ............................................................................... R$ 602,104 The entry to record extinguishment of the bonds is: April 2, 2016 Bonds Payable ........................................... 5,597,896 Loss on Extinguishment of Debt ............. 602,104 Share Capital—Ordinary ................... Share Premium—Ordinary ...............



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PROBLEM 14-11



(a)



It is an extinguishment of debt with modification of terms.



(b)



Notes Payable (Old) ............................................. Gain on Extinguishment of Debt ............... Notes Payable (New) ..................................



600,000 301,123* 298,877



*Calculation of gain. Pre-restructure carrying amount ........................ Present value of restructured cash flows: Present value of $600,000 due in 10 years at 15%, interest payable annually (Table 6-2); ($600,000 X .24719) ......................................... $148,314 Present value of $30,000 interest payable annually for 10 years at 15% (Table 6-4); ($30,000 X 5.01877) ......................................... 150,563 Debtor’s gain on extinguishment .......................



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PROBLEM 14-12



(a)



Notes Payable ...................................................... 5,000,000 Share Capital—Ordinary ............................ Share Premium—Ordinary ........................ Gain on Extinguishment of Debt...............



1,700,000 2,000,000 1,300,000



Carrying amount of debt.... $5,000,000 Fair value of equity ............ (3,700,000) Gain on extinguishment of debt .............................. $1,300,000 (b)



Notes Payable ...................................................... 5,000,000 Land ............................................................. Gain on Disposition of Land ..................... Gain on Extinguishment of Debt............... Fair value of land ......................... Book value of land....................... Gain on disposition of real estate .................................. Note payable (carrying amount) ..................................... Fair value of land ......................... Gain on extinguishment of debt .......................................



14-58



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3,250,000 750,000 1,000,000



$4,000,000 (3,250,000) $ 750,000



$5,000,000 (4,000,000) $1,000,000



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PROBLEM 14-12 (Continued) (c)



Notes Payable (Old) ............................................ 5,000,000 Gain on Extinguishment of Debt .............. Notes Payable (New) .................................



1,441,100* 3,558,900



*Calculation of gain. Pre-restructure carrying amount ..................... Less: Present value of restructured cash flows: Present value of $5,000,000 due in 3 years at 12% (Table 6-2); ($5,000,000 X .71178) ................................... Debtor’s gain on extinguishment ...............................



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PROBLEM 14-13



(a)



Present value of restructured cash flows: Present value of principal £300,000 due in 3 years at 12% (£300,000 X .71178) ............... Present value of interest £30,000 paid annually for 3 years at 12% (£30,000 X 2.40183) ......................................... Fair value of note ..................................................



£213,534



72,055 £285,589



AMORTIZATION SCHEDULE AFTER DEBT MODIFICATION MARKET INTEREST RATE 12% Date 12/31/15 12/31/16 12/31/17 12/31/18



Cash Paid



Interest Expense



Amortization



Carrying Value



— £30,000 30,000 30,000



— £34,271* 34,783 35,357



— £4,271 4,783 5,357



£285,589 289,860 294,643 300,000



*£34,271 = £285,589 X 12%.



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*PROBLEM 14-13 (Continued) (b) December 31, 2015 Interest Payable ..................................................... 33,000 Notes Payable (Old) ............................................... 300,000 Gain on Extinguishment of Debt ................. Note Payable (New) ......................................



47,411* 285,589



*(£300,000 + £33,000) – £285,589 December 31, 2016 Interest Expense .................................................... Notes Payable ............................................... Cash ...............................................................



34,271 4,271 30,000



December 31, 2017 Interest Expense .................................................... Notes Payable ............................................... Cash ...............................................................



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4,783 30,000



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PROBLEM 14-14



(a)



Langley Co. Carrying amount of the bonds on 1/1/15 ................. Effective-interest rate (10%) ..................................... Interest expense to be reported for 2015 ................



$656,992 X 0.10 $ 65,699



(b)



Tweedie Building Co. Maturities and sinking fund requirements on long-term debt for the next five year are as follows: 2016 $400,000 2019 $200,000 2017 350,000 2020 350,000 2018 200,000



(c)



Beckford Inc. Since the three bonds reported by Beckford Inc. are secured by either real estate, securities of other corporations, or plant equipment, none of the bonds are classified as debenture bonds.



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SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 14-1 (a) 1. This is a common statement of financial position presentation and has the advantage of being familiar to users of financial statements. The total of $1,085,800 is the objectively determined exchange price at which the bonds were issued. It represents the fair value of the bond obligations given. Thus, this is in keeping with the usual accounting practice of using exchange prices as a primary source of data. 2. This presentation indicates the dual nature of the bond obligations. There is an obligation to make periodic payments of $55,000 and an obligation to pay the $1,000,000 at maturity. The amounts presented on the statement of financial position are the present values of each of the future obligations discounted at the initial effective rate of interest. The proper emphasis is placed upon the accrual concept, that is, that interest accrues through the passage of time. The emphasis upon premiums and discounts is eliminated. 3. This presentation shows the total liability which is incurred in a bond issue, but it ignores the time value of money. This would be a fair presentation of the bond obligations only if the effective-interest rate were zero. (b) When an entity issues interest-bearing bonds, it normally accepts two types of obligations: (1) to pay interest at regular intervals and (2) to pay the principal at maturity. The investors who purchase Nichols Company bonds expect to receive $55,000 each January 1 and July 1 through January 1, 2036 plus $1,000,000 principal on January 1, 2036. Since this ($55,000) is more than the 10% per annum ($50,000 semiannually) that the investors would be willing to accept on an investment of $1,000,000 in these bonds, they are willing to bid up the price—to pay a premium for them. The amount that the investors should be willing to pay for these future cash flows depends upon the interest rate that they are willing to accept on their investment(s) in this security. The amount that the investors are willing to pay (and the issuer is willing to accept), $1,085,800, is the present value of the future cash flows discounted at the rate of interest that they will accept. Another way of viewing this is that the $1,085,800 is the amount which, if invested at an annual interest rate of 10% compounded semiannually, would allow withdrawals of $55,000 every six months from July 1, 2016 through January 1, 2036 and $1,000,000 on January 1, 2036. Even when bonds are issued at their maturity value, the price paid coincides with the maturity value because the coupon rate is equal to the effective rate. If the bonds had been issued at their maturity value, the $1,000,000 would be the present value of future interest and principal payments discounted at an annual rate of 11% compounded semiannually. Here the effective rate of interest is less than the coupon rate, so the price of the bonds is greater than the maturity value. If the effective rate of interest was greater than the coupon rate, the bonds would sell for less than the maturity value. (c) 1. The use of the coupon rate for discounting bond obligations would give the face value of the bond at January 1, 2016, and at any interest-payment date thereafter. Although the coupon rate is readily available while the effective rate must be computed, the coupon rate may be set arbitrarily at the discretion of management so that there would be little or no support for accepting it as the appropriate discount rate.



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CA 14-1 (Continued) 2. The effective-interest rate at January 1, 2016 is the market rate to Nichols Company for longterm borrowing. This rate gives a discounted value for the bond obligations, which is the amount that could be invested at January 1, 2016 at the market rate of interest. This investment would provide the sums needed to pay the recurring interest obligation plus the principal at maturity. Thus, the effective-interest rate is objectively determined and verifiable. The market or yield rate of interest at the date of issue should be used throughout the life of the bond because it reflects the interest obligation which the issuer accepted at the time of issue. The resulting value at the date of issue was the current value at that time and is similar to historical cost. Also, this yield rate is objectively determined in an exchange transaction. The continued use of the issue-date yield rate results in a failure to reflect whether the burden is too high or too low in terms of the changes which may have taken place in the interest rate. (d) Using a current yield rate produces a current value, that is, the amount which could currently be invested to produce the desired payments. When the current yield rate is lower than the rate at the issue date (or than at the previous valuation date), the liabilities for principal and interest would increase. When the current yield is higher than the rate at the issue date (or at the previous valuation date), the liabilities would decrease. Thus, holding gains and losses could be determined. If the debt is held until maturity, the total of the interest expense and the holding gains and losses under this method would equal the total interest expense using the yield rate at issue date.



CA 14-2 1.



Use of the asset requires a depreciation charge in each year of use. This in turn requires carrying the equipment as an asset. The company has contracted to purchase the equipment and, thus, has a real liability which affects financial condition and must be shown.



2.



The obligation of a company is to its bondholders, not to the trustee. Until the bondholders have received payment, the company still has a liability. (Note to instructor: The student may have difficulty with this statement because this type of situation was not discussed in the chapter. It therefore provides an opportunity to emphasize that payment to an agent or trustee does not constitute payment of the liability for bond interest. When the trustee dispenses the funds to bondholders, the liability should be reduced. A separate Bond Interest Fund account is established at the time payment is made to the trustee.)



CA 14-3 (a) 1. The selling price of the bonds would be the present value of all of the expected net future cash outflows discounted at the effective annual interest rate (yield) of 11 percent. The present value is the sum of the present value of its maturity amount (face value) plus the present value of the series of future semiannual interest payments. 2. Immediately after the bond issue is sold, the current asset, cash, would be increased by the proceeds from the sale of the bond issue. A non-current liability, bonds payable, would be presented in the statement of financial position at the face value of the bonds net of the discount.



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CA 14-3 (Continued) (b) The following item related to the bond issue would be included in Sealy’s 2016 income statement: Interest expense would be included for ten months (March 1, 2016, to December 31, 2016) at an effective-interest rate (yield) of 11 percent. This is composed of the nominal interest of 9 percent adjusted for the amortization of the related bond discount. Bond discount should be amortized using the effective-interest method over the period the bonds will be outstanding, that is, the period from the date of sale (March 1, 2016) to the maturity date (March 1, 2021). (c) The amount of bond discount amortization would be lower in the second year of the life of the bond issue. The effective-interest method of amortization uses a uniform interest rate based upon a changing carrying value which results in increasing amortization each year when there is a bond discount. (d) The retirement of the bonds would result in a loss from extinguishment of debt that should be included in the determination of net income and classified as an Other income and expense item.



CA 14-4 Part I. Before the effective-interest method of amortization can be used, the effective yield or interest rate of the bond must be computed. The effective yield rate is the interest rate that will discount the two components of the debt instrument to the amount received at issuance. The two components in the value of a bond are the present value of the principal amount due at the end of the bond term and the present value of the annuity represented by the periodic interest payments during the life of the bond. Interest expense using the interest method is based upon the effective yield or interest rate multiplied by the carrying value of the bond (par value adjusted for unamortized premium or discount). The amount of amortization is the difference between recognized interest expense and the interest actually paid (par value multiplied by the nominal rate). When a premium is being amortized, the dollar amount of the periodic amortization will increase over the life of the instrument. This is due to the decreasing carrying value of the bond instrument multiplied by the constant effective-interest rate, which is subtracted from the amount of cash interest paid. In the case of a discount, the dollar amount of the periodic amortization will increase over the life of the bond. This is due to the increasing carrying value of the bond instrument multiplied by the constant effective-interest rate from which is subtracted the amount of cash interest paid.



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CA 14-4 (Continued) Part II. (a) 1. Gain or loss to be amortized over the remaining life of old debt. The basic argument supporting this method is that if refunding is done to obtain debt at a lower cash outlay (interest cost), then the gain or loss is truly a cost of obtaining the reduction in cash outlay. As such, the new rate of interest alone does not reflect the cost of the new debt, but a portion of the gain or loss on the extinguishment of the old instrument must be matched with the nominal interest to reflect the true cost of obtaining the new debt instrument. This argument states that this matching must continue for the unexpired life of the old debt in order to reflect the true nature of the transaction and cost of obtaining the new debt instrument. 2. Gain or loss to be amortized over the life of the new debt instrument. This argument states that the gain or loss from early extinguishment of debt actually affects the cost of obtaining a new debt instrument. However, this method asserts that the effect should be matched with the interest expense of the new debt for the entire life of the new debt instrument. This argument is based on the assumption that the debt was refunded to take advantage of new lower interest rates or to avoid projected high interest rates in the future and that any gain or loss on early extinguishment should be reflected as an element of this decision and total interest cost over the life of the new instrument should be stated to reflect this decision. 3. Gain or loss recognized in the period of extinguishment. Proponents of this method state that the early extinguishment of debt to be refunded actually does not differ from other types of extinguishment of debt where the consensus is that any gain or loss from the transaction should be recognized in full in current net earnings. The early extinguishment of the debt is prompted for the same reason that other debt instruments are extinguished, namely, that the value of the debt instrument has changed in light of current financial circumstances and early extinguishment of the debt would produce the most favorable results. Also, it is argued that any gain or loss on the extinguishment is directly related to market interest fluctuations related to prior periods. If the true market interest rate had been known at the time of issuance, there would be no gain or loss at the time of extinguishment. Also, even if market interest rates were not known but the carrying value of the bond was periodically adjusted to market, any gain or loss would be reflected at the interim dates and not in a future period. The call premium paid on extinguishment and any unamortized premium or discount are actually adjustments to the actual effective-interest rate over the outstanding life of the bond. As such, any gain or loss on the early extinguishment of debt is related to prior-period valuation differences and should be recognized immediately. (b) The immediate recognition principle is the only acceptable method of reflecting gains or losses on the early extinguishment of debt, and these amounts, if material, must be reflected as other income and expense.



CA 14-5 (a) Such financing arrangements arise when (1) two or more entities form another entity to construct an operating plant that will be used by both parties; (2) the new entity borrows funds to construct the project and repays the debt from the proceeds received from the project; and (3) payment of the debt is guaranteed by the companies that formed the new entity.



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CA 14-5 (Continued) (b) In some cases, project financing arrangements become more formalized through the use of takeor-pay contracts or similar types of contracts. In a simple take-or-pay contract, a purchaser of goods signs an agreement with the seller to pay specified amounts periodically in return for products or services. The purchaser must make specified minimum payments even if delivery of the contracted products or services is not taken. (c) Ryan should not record the plant as its asset. The plant is to be constructed and operated by ACC. Although Ryan agrees to purchase all of the cans produced by ACC, Ryan does not have the property right to the plant, nor the right to use the plant. Accounting for purchase commitments is unsettled and controversial. Some argue that these contracts should be reported as assets and liabilities at the time the contract is signed; others believe that our present recognition at the delivery date is most appropriate. Note that a purchase commitment involves both an item that might be recorded as an asset and an item that might be recorded as a liability. That is, it involves both a right to receive assets and an obligation to pay . . . If both the right to receive assets and the obligation to pay were recorded at the time of the purchase commitment, the nature of the loss and the valuation account that records it when the price falls would be clearly seen. Although the discussion does not exclude the possibility of recording assets and liabilities for purchase commitments, it contains no conclusions or implications about whether they should be recorded. According to current practice, Ryan does not record an asset relating to the future purchase commitment. However, if the dollar amount involved is material, the details of the contract should be disclosed in a footnote to the statement of financial position. In addition, if the contracted price is in excess of the purchase market price and it is expected that losses will occur when the purchase is effected, losses should be recognized in the accounts in the period during which such declines in prices take place. (d) Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations are not recorded in a company’s statement of financial position. The reasons for off-balance-sheet financing are many. First, many believe that removing debt or otherwise keeping it from the statement of financial position enhances the quality of the statement of financial position and permits credit to be obtained more readily and at less cost. Second, loan covenants often impose a limitation on the amount of debt a company may have. As a result, off-balance-sheet financing is used because these types of commitments might not be considered in computing the debt limitation. Third, it is argued by some that the asset side of the statement of financial position is severely understated because of the use of certain accounting methods (like accelerated depreciation methods). As an offset to these lower values, some believe that part of the debt does not have to be reported. Note to instructor: Additional discussion of these type arrangements is presented in Appendix 17B related to variable interest entities.



CA 14-6 (a) The stakeholders in the Wichita case are: Donald Lennon, president, founder, and majority shareholder. Nina Friendly, minority shareholder. Other minority shareholders. Existing creditors (debt holders). Future bondholders. Employees, suppliers, and customers. 14-68



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CA 14-6 (Continued) (b) The ethical issues: The desires of the majority shareholder (Donald Lennon) versus the desires of the minority shareholders (Nina Friendly and others). Doing what is right for the company and others versus doing what is best for oneself. Questions: Is what Donald wants to do legal? Is it unethical? Is Donald’s action brash and irresponsible? Who may benefit/suffer if Donald arranges a high-risk bond issue? Who may benefit/suffer if Nina Friendly gains control of Wichita? (c) The rationale provided by the student will be more important than the specific position because this is a borderline case with no right answer.



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