CHAPTER 10 – LONG-TERM LIABILITIES PROBLEM SOLUTIONS
Assessing Your Recall
10.1Indenture Agreement- A formal agreement between a borrowing entity
and lender that specifies the terms of the contract. In the case of a bond offering, it specifies (among other things) the face value, the maturity date, the interest rate, the collateral, and the covenants.
Bond Covenants – Provisions included in an indenture agreement that restrict the borrowing entity in some way. Typically these covenants would restrict the ability of the borrowing entity to pay dividends or to obtain additional borrowings. The restrictions often take the form of restrictions on the level of certain ratios. For instance, a covenant may state that the company must maintain a current ratio of at least 2.
Face Value – The measure of denomination of a bond. Typically a single bond has a face value of $1,000. For bonds the face value also determines the cash payout at maturity and is used to determine the periodic interest payments.
Maturity Date – The date at which the bond pays back the face value and the date at which interest payments cease.
Bond Interest Rate – A percentage that is used to determine the periodic interest payments that a bond provides. The rate is multiplied by the face value to determine the total annual payout.
Interest Payments – The periodic payments that a bond provides. The payments are typically paid at the end of each six month period through the maturity date. The amount of the payment is calculated by multiplying the face value by the bond interest rate and dividing by two (assuming semiannual payments).
Collateral – Assets that the borrower pledges to the lender in the event that the borrower defaults on the loan.
10.2The role of the investment banker is to provide advice and counsel to the borrower in structuring the bond offering. In addition the investment banker may be responsible for the initial sale of the bonds to its customers. The investment banker can make a guarantee to the borrower to sell all of the bonds (and take the risk that they don’t sell) or can sell the bonds on a “best efforts” basis. For its services the investment bank receives a fee which is typically a percent of the total bond offering.
10.3The term “best efforts basis” means that the investment bankers will make their best effort to attempt to sell the bonds, that the borrower is offering, to their clients. In the event that the bonds become unattractive to their clients or there is very little demand for these bonds, the bonds are returned to the borrower. The impact on the company is that there is no guarantee that it will be able to raise the amount of financing it wants.
10.4When a company wants to borrow money using a bond issue it contacts an investment banker. With the help of an investment banker the company structures the bond offering with terms that will have the most appeal to investors while still satisfying the company’s objectives. The bonds are then priced by the investment banker by calculating the present value of the cash flows from the bond using a discount rate that the investment banker thinks its customers will find attractive. The investment banker then sells the bonds to its customers and when all the bonds are sold, they can then be traded on the bond market. The price can then fluctuate depending on the discount rate that investors find appropriate given current market conditions. If interest rates, in general, are moving upward the price of the bond will decrease and if the rates are moving downward the price will increase.
10.5The terms par, premium, and discount refer to whether the selling price of a bond is at, or above, or below the face value of the bond. For a typical bond with a $1,000 face value it would sell at par if its selling price is $1,000, at a premium if the selling price is above $1,000 and at a discount if the selling price is below $1000.
10.6A discount on a bond refers to the amount by which the current market price differs from (is less than) the face value. The face value simply refers to the amount that will be paid on the maturity date of the bond. The current market value is the present value of the maturity payment along with the present value of the interest payments that the bond will make over its life. When the bond is recorded on the books of the borrower the accountant records the present value of the bond at its issuance but splits this into two accounts: the bond liability account contains the face value of the bond and the discount account (a contra liability) contains the amount of the discount. The net of the two accounts is the present value of the bond. Since the liability of the company to pay back the face value must equal the amount in the bond liability account (the face value) at the maturity date, the amount in the discount account must decrease over time and be zero at the maturity date. The periodic decrease of this account over time is referred to as the amortization of the discount. In terms of the accounting entry to record the cash outflow and the expense recognition for the interest payments, the amortization of the discount means that the cash outflow for the interest payments is less than the interest expense and consequently the discount account is reduced and the principal of the liability increases. The following entry demonstrates this:
SE–Interest expense XXXX
XL –Discount on bond payableXXXX
A–Cash (or L–Interest payable)XXXX
10.7When debt is retired before maturity, the cost to settle the debt is compared with the current carrying value of the debt on the books. The difference between these two amounts represents a gain or loss on the retirement of the debt. A company may choose to retire debt early because interest rates have dropped and it can borrow today at a lower interest rate. It will borrow at a lower rate and use the proceed to pay off the higher interest cost debt. Another reason for retiring debt early may be to use available cash to settle the debt so that future interest payments do not have to be made.
10.8From the lessee’s point of view one of the advantages of leasing is that the risk of obsolescence remains with the lessor. In addition, depending on the contract the lessee may or may not have responsibility for servicing the equipment and may or may not have responsibility if the equipment fails. In general, then the lessee has reduced risk. Another advantage to the lessee is that it does not need to have all the financing in place that would be necessary if it were considering buying the asset. The advantage to the lessor is that as the owner of the asset, the company can earn a return on an asset that it does not need to use in its own operations. In addition, if the lessor can take advantage of the capital cost allowance deduction, then the lease payments that the lessee makes will be reduced as a result of the decrease in the lessor’s cost.
10.9GAAP specifies the criteria for a capital lease. If any one of the following is met the lease qualifies as a capital lease.
Capital Lease Criteria
- The title to the asset passes to the lessee by the
end of the lease term
- The lease term is equal to or greater than 75% of
the useful life of the asset.
- The present value of the minimum lease payments
is greater than 90% of the fair value of the
leased asset.
The first criteria would indicate that the title to the asset will pass to the buyer by the end of the lease term and, therefore, the asset is being purchased by the lessee. The last two criteria indicate that the company will have use of the asset during most of its useful life even though title does not necessarily pass to the lessee. The substance of the transaction is, therefore, a purchase.
10.10Defined contribution pension plans are plans in which the employer agrees to contribute a set amount each period to the retirement fund of the employee. There is no guarantee by the employer as to the level of the benefits that the employee will receive upon retirement. The benefits depend on the investment success of the pension fund itself. A defined benefit plan, on the other hand, is one in which the employer agrees to provide a set amount of benefits upon retirement. The benefits are usually determined by the use of a formula that incorporates the number of years of service of the employee and some measure of the amount of salary earned. The employer may or may not set aside assets to pay for the benefits granted to employees.
10.11Overfunded – An overfunded pension plan is one in which the value of the assets held in trust exceeds the value of the liabilities to pay benefits.
Underfunded – An underfunded pension plan is one in which the value of the assets held in trust is less than the value of the liabilities to pay benefits.
Fully funded – A fully funded pension plan is one in which the value of the assets held in trust equals the value of the liabilities to pay benefits.
10.12Post-employment benefits, other than pensions, are benefits provided to retirees such as health care and life insurance. Companies are required to treat them similar to pension obligations because the company offers these benefits in return for the services that employees render. Thus, the expense of offering these benefits should be accrued as employees render services, rather than when the cash is paid out to retirees.
10.13The debt/equity ratio measures the amount of assets that are financed through debt. If a company is carrying too much debt it will run the risk of being unable to meets its interest and debt payments. The times interest earned ratio measures the company’s ability to meet its interest payment from operating income.
10.14a) Issuance Price:
PV of Bonds = PV of Interest Payment + PV of Maturity Payment
= ($5,0001 x PVAF6%,60) + ($100,0002 x PVF6%,60)
= ($5,000 x 16.16143) + ($100,000 x 0.03031)
= $80,807 + $3,031
= $83,838
Journal Entry
A–Cash83,838
XL –Discount on bond payable16,162
L – Bond payable100,000
1 Face value x Bond interest rate x 6/12 = $100,000 x 10% x 6/12 = $5,000
2 Face value per bond x # of Bonds = $1,000 x 100 = $100,000
b)Interest Entries for the first six months:
Interest Expense = Carrying Value x Yield Rate x Time
= $83,838 x 12% x 6/12 = $5,030
Journal Entry
SE–Interest expense5,030
XL–Discount on bond payable30
L–Interest payable15,000
L–Interest payable5,000
A–Cash5,000
Interest Expense for the second six months:
Interest Expense = $83,8682 x 12% x 6/12 = $5,032
Journal Entry
SE–Interest expense5,032
XL–Discount on bond payable32
L–Interest payable15,000
L–Interest payable5,000
A–Cash5,000
1 Interest Payable= Face Amount x Bond Interest Rate x Time
= $100,000 x 10% x 6/12
= $5,000
2 Ending Carrying Value = Beginning Carrying Value + Interest Expense –
Payments
= $83,838 + 5,030 – 5,000
= $83,868
10.15a)
Amortization Table - Bond Sold at Par: Bond interest rate = 8%,
Yield rate = 8%
(1)(2)(3)(4) (5)
Period / Beginning Carrying Value1 / Interest(2) x 8% x 6/12 / Payment ($200,000 x 8% x 6/12) / Ending Carrying value
(2) + (3) -(4)
1 / 200,000 / 8,000 / 8,000 / 200,000
2 / 200,000 / 8,000 / 8,000 / 200,000
3 / 200,000 / 8,000 / 8,000 / 200,000
4 / 200,000 / 8,000 / 8,000 / 200,000
5 / 200,000 / 8,000 / 8,000 / 200,000
6 / 200,000 / 8,000 / 208,000 / 0
1Since the yield rate equals the interest rate, the bond sells at par value and the beginning carrying value equals the face value.
b)Amortization Table - Bond Sold at a Discount: Bond Interest Rate = 8%, Yield rate = 10%
(1) (2)(3)(4) (5)
Period / Beginning Carrying value1 / Interest(2) x 10% x 6/12 / Payment ($200,000 x 8% x 6/12) / Ending Carrying Value
(2) + (3) -(4)
1 / 189,849 / 9,492 / 8,000 / 191,341
2 / 191,341 / 9,567 / 8,000 / 192,908
3 / 192,908 / 9,645 / 8,000 / 194,553
4 / 194,553 / 9,728 / 8,000 / 196,281
5 / 196,281 / 9,814 / 8,000 / 198,095
6 / 198,095 / 9,905 / 208,000 / 0
1First period carrying value = Present Value (PV) of Bonds + PV of Interest
= $149,243 + $40,606
= $189,849
c) Amortization Table - Bond Sold at a Premium:
Bond Interest Rate = 8%, Yield rate = 6%
(1) (2) (3) (4) (5)
Period / Beginning Carrying Value1 / Interest(2) x 6% x 6/12 / Payment ($200,000 x 8% x 6/12) / Ending Carrying Value
(2) + (3) -(4)
1 / 210,834 / 6,325 / 8,000 / 209,159
2 / 209,159 / 6,275 / 8,000 / 207,434
3 / 207,434 / 6,223 / 8,000 / 205,657
4 / 205,657 / 6,170 / 8,000 / 203,827
5 / 203,827 / 6,115 / 8,000 / 201,942
6 / 201,942 / 6,058 / 208,000 / 0
1First period carrying value = Present Value (PV) of Bonds + PV of Interest
= $167,496 + $43,338
= $210,834
10.16a) Journal entry for issuance:
A-Cash703,267
XL-Discount on bonds payable 46,733
L-Bonds payable750,000
b) Journal entries for interest expense in Year 1:
Interest payments: $750,000 x 9% x 6/12 = $33,750
Interest expense on June 30, 2001: $703,267 x 10% x 6/12 = $35,163
Interest expense on Dec. 31, 2001: ($703,267 + $35,163 - $33,750) x 10% x 6/12 = $35,234
Total interest expense for Year 1 = $35,163 + $35,234 = $70,397
June 30 / SE-Interest expenseA-Cash
XL-Discount on bonds payable / 35,163
33,750
1,413
Dec. 31 / SE-Interest expense
A-Cash
XL-Discount on bonds payable / 35,234
33,750
1,484
c) Investors were not willing to pay $750,000 for the bonds because
the interest rate required for the risk that investors bear (the yield of 10%) exceeds the interest rate offered on the bonds (9%). Consequently, the bonds sell at less than their par value, and the company is not able to raise the $750,000 that it had hoped for.
10.17a) The issue price of the bonds is $200,000. Since the yield rate equals the interest rate paid on the bonds, the bond sells at par and the issue price thus equals the face value of the bonds.
A-Cash200,000
L-Bonds payable200,000
b) Five years after issuance, the book value of the bonds is still
$200,000 because the interest expense is equal to the interest paid each period. Since there is no premium or discount to amortize, the book value of the bond remains at its face amount.
c) Market value of bonds = PV of Interest Payments + PV of Maturity Payment
$180,933 = $47,665 + $133,268
(Note: n = 6 semiannual periods, yield = 7% per period, payments =
200,000 x 10% x 6/12 = $10,000)
d) The difference between the book value and market value of the
bonds is $19,067 ($200,000 - $180,933). The difference is attributable to the fact that the interest rate that investors require has increased from 10% to 14%. Consequently, the price of the bonds fell.
10.18a) Amount of cash received:
1) 8% - The amount of cash received is $500,000. Since the yield rate equals the interest rate paid on the bonds, the bonds sell at par.
2) 6% - Cash received = PV of Interest Payments + PV of Maturity Payment
$549,770 = $199,080 + $350,690
3) 10% - Cash received = PV of Interest Payments + PV of Maturity Payment
$455,685 = $177,265 + $278,420
b)Journal entry recorded at issuance:
1.A-Cash500,000
L-Bonds payable500,000
2.A-Cash549,770
L-Bonds payable 500,000
L-Premium on bonds payable49,770
3.A-Cash455,685
XL-Discount on bonds payable 44,315
L-Bonds payable500,000
c) A mortgage bond offers a real asset as collateral in the event that the company defaults on payment. The fact that Alphabet Toy Company offers a mortgage bond would decrease the interest rate that the market demands, because, all else being equal, the risk that investors bear through purchasing a mortgage bond is less.
10.19a) Journal entries if bonds sells at par
June 30, 2000 / SE-Interest expense1A-Cash / 16,000
16,000
Dec. 31, 2000 / SE-Interest expense
A-Cash / 16,000
16,000
June 30, 2001 / SE-Interest expense
A-Cash / 16,000
16,000
Dec. 31, 2001 / SE-Interest expense
A-Cash / 16,000
16,000
1Interest expense = cash paid = $400,000 x 8% x 6/12 = $16,000
b)Journal entries if bond sells at 104
Issue price of bond = 1.04 x $400,000 = $416,000
June 30, 2000 / SE-Interest expenseL-Premium on bonds payable
A-Cash / 15,4541
546
16,000
Dec. 31, 2000 / SE-Interest expense
L-Premium on bonds payable
A-Cash / 15,4342
566
16,000
June 30, 2001 / SE-Interest expense
L-Premium on bonds payable
A-Cash / 15,4133
587
16,000
Dec. 31, 2001 / SE-Interest expense
L-Premium on bonds payable
A-Cash / 15,3914
609
16,000
1$416,000 x .0743 x 6/12 = $15,454
2 ($416,000 - $546) x .0743 x 6/12 = $15,434
3 ($415,454 - $566) x .0743 x 6/12 = $15,413
4 ($414,888 - $587) x .0743 x 6/12 = $15,391
c)Journal entries if bond sells at 94
Issue price of bond = 0.94 x 400,000 = $376,000
June 30, 2000 / SE-Interest expenseXL-Discount on bonds payable
Cash / 16,7701
770
16,000
Dec. 31, 2000 / SE-Interest expense
XL-Discount on bonds payable
A-Cash / 16,8042
804
16,000
June 30, 2001 / SE-Interest expense
XL-Discount on bonds payable
A-Cash / 16,8403
840
16,000
Dec. 31, 2001 / SE-Interest expense
XL-Discount on bonds payable
A-Cash / 16,8774
877
16,000
1$376,000 x .0892 x 6/12 = $16,770
2 ($376,000 + $770) x .0892 x 6/12 = $16,804
3 ($376,770 + $804) x .0892 x 6/12 = $16,840
4 ($377,574 + $840) x .0892 x 6/12 = $16,877
d) Amortization of the premium or discount must be included in the computation of the annual interest expense, because interest expense is determined in financial bond markets, and not through the interest that is paid on the bonds. Thus, if the bond markets demand a greater interest rate than the rate that is paid on the bonds, the bonds sell at a discount. The fact that the par repayment is greater than the market price is a reflection of the greater interest expense demanded in bond markets. Consequently, the company should amortize the discount to interest expense over the life of the bond. If the bond markets demand a lesser interest rate than the rate that is paid on the bonds, the bonds sell at a premium. The fact that the par repayment is less than the market price is a reflection of the lesser interest expense demanded in bond markets. Consequently, the company should amortize the premium as a reduction to interest expense over the life of the bond.
10.20 a) Amount received = $600,000 x 1.3458 = $807,480
A-Cash807,480
L-Bonds Payable600,000
L-Premium on Bonds payable207,480
b) Cash paid to bondholders each 6 months =
$600,000 x 12% x 6/12 = $36,000
June 30, 2001
SE-Interest expense32,299
L-Premium on bonds payable 3,701
A-Cash36,000
$807,480 x .08 x 6/12 = $32,299
Dec. 31, 2001
SE-Interest expense32,151
L-Premium on bonds payable 3,849
A-Cash36,000
($807,480 - $3,701) x .08 x 6/12 = $32,151
c) If interest payments were made on July 1 and Jan 1instead of on June 30 and Dec. 31, the journal entries would be the same, except that the credit would be to interest payable instead of to cash. On July 1 and Jan 1, the interest payable account would be eliminated and the cash paid out.
10.21a) Issue price of the bond = PV of interest payments + PV of maturity payment:
$231,179 = $137,639 + $93,540
Jan. 1, -01A-Cash231,179
XL-Discount on bonds payable 68,821
L-Bonds payable300,000
b)Interest paid each 6 month period =
$300,000 x 8% x 6/12 = $12,000
June 30, -01 SE-Interest expense13,871
A-Cash 12,000
XL-Discount on bonds payable1,871
$231,179 x .12 x 6/12 = $13,871
Dec. 31, -01 SE-Interest expense13,983
A-Cash12,000 XL-Discount on bonds payable 1,983
($231,179 + $1,871) x .12 x 6/12 = $13,983
c)Balance sheet presentation:
Bonds payable$300,000
Less: discount on bonds payable 64,9671
$235,033
1$64,967 = $68,821 - ($1,871 + $1,983)
10.22a) Interest expense for 2001 = $51,033*
Issue price for first issue = PV of interest payments + PV of maturity
repayment
$454,363 = $271,807 + $182,556
*Interest expense for 2001 = $18,026 + $17,947 = $35,973
Issue price for second issue = PV of interest payments + PV of
maturity repayment
$183,777 = $48,665 + $135,112
*Interest expense for 2001 = $7,351 + $7,405 = $14,756
b)Journal entries for 2001
July 1, 2001SE-Interest expense18,026
L-Premium on bonds payable1,974
A-Cash20,000
SE-Interest expense7,351
XL-Discount on bonds payable1,351
A-Cash6,000
Dec. 31, 2001SE-Interest expense17,947
L-Premium on bonds payable 2,053
L-Interest payable20,000
SE-Interest expense7,405
XL-Discount on bonds payable1,405
L-Interest payable6,000
c) It is reasonable that both bond issues are sold to yield 8% because different bond issues of the same company bear the same default risk, so long as nothing significant has occurred since the first issue that would cause investors to demand a different yield rate.
10.23a) The lease is an operating lease because none of the capitalization criteria appear to be satisfied in the terms of the lease. The automobiles are returned to the lessor at the end of the lease, the lease does not extend for 75% of the useful life, and the present value of the minimum lease payments is not 90% of the fair market value of the vehicles.
b) Lease related expenses = $105,600 = $400 x 12 months x 22 cars
c) The $5,000 deposit per car should be reported as a noncurrent prepaid asset at the inception of the lease, and can be classified as a current asset when one year remains in the lease.