Ch12 Financial Accounting Liabilities & Equities
Note:
Round computations to the nearest euro throughout this assignment unless instructed otherwise.
Question 1 (15 marks)
Computer question
Randy Corporation issued four-year bonds with a €600,000 par value on October 1, 2005. The bonds carried a stated interest rate of 6% (payable each April 1 and October1). The bonds were dated April 1, 2005, and mature on March 31, 2009. They were sold to yield 7% interest. The accounting period for Randy Corporation ends on December 31.
Required
Note:
Parts (a), (b), and (c) are independent.
a.(8 marks)
Complete worksheet FA3L2Q1 on the supplied data disk to prepare an amortization schedule from the date of sale to maturity using the effective and interest amortization methods. Calculate the total interest expense for 2006.
b.(4 marks)
Repeat part (a), assuming the bonds were sold to yield 10% with a stated annual interest rate of 8%.
c.(3 marks)
Repeat part (a), assuming the bonds were sold to yield 8% with a stated annual interest rate of 11%.
Procedure
Part (a)
1.Open the file FA3L2Q1. This file contains three worksheets, L2Q1A, L2Q1B, and L2Q1C. Click the L2Q1A worksheet tab.
2.Examine the layout of the worksheet. It is similar to the one used in Computer illustration 21, with the addition of two partially completed income statements in the range A52 to F69.
3.Complete the data table by entering the appropriate values or formulas in cells F8, F13 to F16, F19, and F20.
4.Enter the appropriate formula in cell F22 to calculate the sale price of the bonds.
5.Complete the amortization schedule for the interest method by entering the appropriate formulas in cells D33 to D39 and cells E32 to E39. Use the same logic as used in Computer illustration 2-1.
6.Enter the appropriate formulas in cells D63 to calculate the interest expense to complete the income statements.
7.Save the file.
Part (b)
1.Click the L2Q1B worksheet tab. Complete the information in the data table to match the requirements for part (b). You may want to copy the data table from worksheet L2Q1A to worksheets L2Q1B and L2Q1C to save time re-entering data. That way you only need to input the new interest rates. You do not need to provide any formulas for this part.
2.Save the file.
Part (c)
1.Click the L2Q1C worksheet tab. Complete the information in the data table to match the requirements for part (c). You do not need to provide any formulas for this part.
2.Save the file.
Question 2 (10 marks)
Habek Hardware, Inc., provides a product warranty for defects on two major lines of items sold since the beginning of 20X5. Line A carries a two-year warranty for all labour and service (but not parts). The company contracts with a local service establishment to service the warranty (both parts and labour). The local service establishment charges a flat fee of €60 per unit payable at date of sale regardless of whether the unit ever requires servicing. Line B carries a three-year warranty for parts and labour on service. Habek purchases the parts needed under the warranty and has service personnel who perform the work and are paid by the job. On the basis of experience, it is estimated that for Line B, the three-year warranty costs are 3% of sales or parts and 7% for labour and overhead. Additional data available are as follows:
20X520X620X7
Sales in units, Line A7001,000nil
Sales price per unit, Line A €610 €660 n/a
Sales in units, Line B 600 800 nil
Sales price per unit, Line B €700 €750 n/a
Actual warranty outlays, Line B
Parts Labour & Overhead €3,000 €9,600 €12,000
€7,000€22,000€30,000
There were no sales of either product in 20X7.
Required
Complete the tabulation below:
Year-end amounts
20X520X620X7
Warranty expenses (on the income statement)
Estimated provision for warranty (balance sheet)
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2, FirstEdition (McGraw-Hill Ryerson, 2000), Question P13-1, page 761. Adapted with permission.
Question 3 (8 marks)
For each of the following items, indicate whether appropriate accounting treatment is to
A — Accrue a provision in the balance sheet and report a loss on the income statement.
B — Disclose the provision in the notes to the financial statements.
C —Neither record nor disclose.
- A customer has sued the company for €1 million. The company will likely successfully defend itself. The amount would have a significant impact on the company’s financial position.
- A customer has sued the company for €1 million. The company will likely successfully defend itself. The amount is immaterial.
- A customer has sued the company for €1 million. The company may lose but will more likely settle the suit for €600,000 in the next six months. The amount would have a significant impact on the company’s financial position.
- A customer has sued the company for €1 million, and it is likely that the company will lose but the amount will be less than €1 million. The amount cannot be estimated reliably. The amount would have a significant impact on the company’s financial position.
- The company self-insures for fire hazards: that is, it carries no fire insurance.
- The company has guaranteed a €10 million loan of an associated company. This amount is material. The other company has a good credit rating.
- The company is being audited by the local tax authority for the three prior years; there is no indication at present that anything is amiss.
- The company has been audited by the local tax authority, resulting in a tax assessment for €4.2 million, an amount that would have a significant impact on the company’s financial position. The company has appealed the decision, and feels it has a good case
Question 4 (13 marks)
Sable Company purchased merchandise for resale on January 1, 20X5, for €5,000 cash plus a €20,000, two-year note payable. The principal is due on December 31 20X6; the note specified 8% interest payable each December 31. Assume that Sable’s going rate of interest for this type of debt was 15%. The company’s fiscal year end is December31.(4marks for Requirement 1, 6 marks for Requirement 2, and 3marks for Requirement 3)
Required
- Give the entry to record the purchase on January 1, 20X5. Show computations (round to the nearest euro).
- Complete the following tabulation:
Amount of cash interest paid each December 31______
Total interest expense for the two-year period______
Amount of interest reported on income statement for 20X5______
Amount of net liability reported on the balance sheet at
December 31, 20X5 (excluding any accrued interest)______
- Give the entries at each year end for Sable.
Hint: You may find that a debt amortization schedule is helpful for the calculations.
Source: Thomas Beechy and Joan Conrod, International Accounting, Vol. 2, FirstEdition (McGraw-Hill Ryerson, 2000), Question P13-3, page 763. Adapted with permission.
Question 5 (16 marks)
In order to take advantage of lower interest rates in the United States, Lane Ltd., a company domiciled in Canada, borrowed US$8 million from a US bank on May 1, 20X6. The borrowings carried an interest rate of 7.25%, with annual interest payments due May1. The principal was due May 1, 20X9. Lane Ltd. has a fiscal year end of December31.
US$1 = Cdn
May 1, 20X6$1.29
December 31, 20X6$1.32
May 1, 20X7$1.34
December 31, 20X7$1.30
Average for the 8 months ended December 31, 20X6$1.31
Average for the 12 months ended December 31, 20X7$1.29
Required
- How could this loan be hedged? Would this be desirable? How would the financial statements reflect a fully hedged loan? (4 marks)
- Calculate the loan principal that would appear on the December 31, 20X6 and 20X7, balance sheets, along with the related exchange gain or loss that would appear on the profit and loss statement. (8 marks)
- Calculate the interest expense for the years ended December 31, 20X6 and 20X7. Why would there be an exchange gain or loss related to interest expense? Calculate this gain or loss for the year ended December 31, 20X6. (4 marks)
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2, FirstEdition (McGraw-Hill Ryerson, 2000), Question P13-14, pages 766-767. Adapted with permission.
Question 6 (18 marks)
On April 1, 20X7, Raptor Company sold 10,000 of its 11%, 15-year, €1,000 face-value bonds when the market rate was 12%. Interest is paid semi-annually on April 1 and October 1.
Note:
Parts (1), (2), and (3) are independent.
Required
- What is the entry that would have been made on April 1, 20X7? (4 marks)
- Assume the bonds were issued on April 30, 20X7, at 101 plus accrued interest. (4marks)
- Suppose the bonds were issued on June 1, 20X7, for 99 plus accrued interest. What is the entry that would have been made on June 1, 20X7? (4 marks)
- Refer to requirement (1). On April 1, 20X8, Raptor had excess cash and decided to repurchase 30% of the bonds on the open market at 110 plus accrued interest. What would be the journal entries to record (6 marks)
- October 1, 20X7
- December 31, 20X7
- April 1, 20X8
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2, SecondEdition (Toronto: McGraw-Hill Ryerson, 2003), Question A13-22, page 777. Adapted with permission.
Question 7 (8 marks)
European Airlines (EA) has an accumulated liability of 4 billion kilometres due to its frequent flyer program. Industry analysts estimate that this estimated liability for free flights will amount to €270 million in lost revenue, but it could be as much as €40 million higher, depending on the assumptions regarding the prices of fares foregone.
The airline argues that the actual cost of each free flight is negligible — about €8 per flight — for food, insurance, and other miscellaneous costs. EA states that the €8 is the cost of filling an otherwise empty seat. The airline further argues that people who fly “free” tend to bring along a paying companion, which more than offsets the negligible cost of the free flight. Therefore, the provision that ought to be disclosed should only be a fraction of what the analysts insist is the case.
Required
What accounting policy would you recommend European Airlines follow, and why?
Question 8 (12 marks)
“You know, Kevin, cash flow is really all that’s important to us.” B. J. Jollimore, the president and CEO of DCI Productions Ltd., has asked you, Kevin Ng, to provide recommendations on how to account for the €5 million loan that he has just negotiated with the Triellen Money Market Fund. DCI Productions Ltd. needed long-term financing for a sound stage facility built to house DCI’s music productions. The excess capacity will be rented to other local producers. DCI had spent four years developing the project, but had experienced difficulty finding a lender. Mr. Jollimore is delighted to finally get the green light. The terms of the loan are as follows:
- €5,000,000 will be advanced to DCI at the inception of the loan.
- Interest is €480,000 per year, paid at the end of each year.
- Loan security is a first charge on the sound stage facility, a general charge on all company assets, and a personal guarantee from Mr. Jollimore.
- DCI has agreed to maintain a current ratio of 3 to 1, a debt-to-equity ratio of 2 to 1, and declare no dividends for the life of the loan.
- DCI is to repay the lender €6 million, €1 million more than the amount advanced, at the loan maturity date. The loan is a seven-year loan.
“How much interest expense will there be each year? I think we should just expense it as we pay it. Kevin, if there arc alternatives here, tell me how much interest expense would be recognized on the income statement in each year of the loan. Keep your eye on these covenants, OK?”
Required
Prepare a report for Mr. Jollimore.
Suggested solutions
Question 1 (15 marks)
Computer solution
a.(8 marks)
b.(4 marks)
c.(3 marks)
Question 2 (10 marks)
(4 marks for warranty expense and 6 marks for the liability balance)
Year-End Amounts
Accounts20x520x620x7
Warranty expense (on income statement)€ 84,0001 €120,0002 —
Estimated warranty liability (on balance sheet) 32,0003 60,4004 € 18,4005
1€42,000, A (700 units €60 per unit sold) + €42,000, B (600 units €700 per unit 10% of sales) (2 marks)
2€60,000, A (1,000 units €60 per unit sold) + €60,000, B (800 units €750 per unit 10%) (2 marks)
3€84,000 – €42,000* – €10,000 (2 marks)
4€32,000 + €120,000 – €60,000* – €31,600 (2 marks)
5€60,400 – €42,000 (2 marks)
*Flat fee warranties for Line A, which have no further liability.
Question 3 (8 marks)
(1 mark each)
1.B
2.C
3.A
4.BBut should estimate if at all possible and follow A; students should state this assumption if A is offered as a solution.
5.C
6.B
7.C
8.BThe answer following the lesson notes’ criteria is B, so B is the acceptable answer. (If experience suggests that one should be pessimistic about the success of appeals on the local tax agency rulings, A is also an acceptable response.)
Question 4 (13 marks)
Requirement 1 (4 marks)
Inventory, merchandise, or purchases (€5,000 + €17,724)...... 22,724
Discount on notes payable...... 2,276
Cash...... 5,000
Note payable...... 20,000*
*Computation
Principal: €20,000 (PVIF, 15%, 2) (0.75614)...... € 15,123
Interest: (€20,000 8%) (PVIFA, 15%, 2) (1.62571)...... 2,601
Present value of note...... € 17,724
Discount: (€20,000 – €17,724)...... € 2,276
Requirement 2
(6 marks: 1 mark each for a and b; 2 marks each for c and d)
a)Amount of cash interest paid each December 31 (€20,000 8%)€ 1,600
b)Total interest expense for the two-year period
[(€20,000 + €3,200) – €17,724] [or, see below]€ 5,476
c)Amount of interest reported on income statement for 20x5
(€17,724 15%)€ 2,659
d)Amount of net liability reported on balance sheet December 31, 20x5,
excluding accrued interest (see debt amortization schedule)€ 18,783
Debt Amortization Schedule
(not required)
Carrying ValueCashInterest ExpenseIncreaseCarrying Value
BalancePayments@ 15%in BalanceBalance
Start€ 17,724
20x5€ 1,600€ 2,659€ 1,059 €18,783
20x6 1,600 2,817 1,217 20,000
€ 3,200€ 5,476
Requirement 3 (3 marks)
Entries for Sable Year End:
20X520X6Maturity
Interest expense...... 2,6592,817
Notes payable...... 20,000
Discount...... 1,0591,217
Cash...... 1,6001,60020,000
Question 5 (16 marks)
Requirement 1 (4 marks)
The loan could be hedged through an arrangement of operating cash flows, sales to US customers in US dollars or through a forward exchange contract. It would be desirable to decrease the risk of exchange fluctuations. If the loan were hedged, no gain or loss would appear on the income statement as a result of exchange fluctuations. The repayment terms would be established by the forward rate in the hedge, if an exchange contract were utilized.
Requirement 2 (8 marks)
Loan Balance(Gain)/Loss
May 1, 20X6@ $1.29 C$10,320,000
December 31, 20X6@ $1.32 10,560,000 C$240,000
December 31, 20X7@ $1.30 10,400,000 (160,000)
Income Statement, year ended Dec. 31, 20X6
Exchange loss
re: principal 240,000
December 31, 20X6, balance sheet
Loan payable C$10,560,000
December 31, 20X7, balance sheet
Loan payable 10,400,000
Income statement, year ended December 31, 20X7
Exchange (gain)
re: principal (160,000)
Requirement 3 (4 marks)
Interest Expense
20X6US$8,000,000 .0725 8/12 $1.31 C$506,533
20X7US$8,000,000 .0725 $1.29 C$748,200
Exchange G/L (Interest)
20X6
Interest payable at December 31, 20X6
(US$8,000,000 .0725 8/12 $1.32)C$ 510,400
Interest expense (above) 506,533
Exchange loss C$ 3,867
There is an exchange gain or loss on interest expense because it is accrued at the average rate and paid at a specific date when the exchange rate is different from the average.
Question 6 (18 marks)
Requirement 1 (4 marks)
Principal:€10,000,000 (PVIF, 6%, 30) (.17411) = €1,741,100
Interest payments:€550,000 (PVIFA, 6%, 30) (13.76483) = 7,570,657
Bond price €9,311,757
April 1, 20X7
Cash...... 9,311,757
Discount on bonds payable...... 688,243
Bonds payable...... 10,000,000
Requirement 2 (4 marks)
April 30, 20X7
Cash (€10,000,000 101%) + (€10,000,000 11% 1/12).. 10,191,667
Premium on bonds payable (1% of par)...... 100,000
Interest expense (or payable) (€10,000,000 11% 1/12) 91,667
Bonds payable...... 10,000,000
Requirement 3 (4 marks)
June 1, 20X7
Cash (€10,000,000 99%) + (€10,000,000 11% 2/12).. 10,083,334
Discount on bonds payable (1% of par)...... 100,000
Interest expense (or payable) (€10,000,000 11% 2/12) 183,334
Bonds payable...... 10,000,000
Requirement 4 (1.5 marks each)
October 1, 20X7
Interest expense (€9,311,757 6%)...... 558,705
Discount on bonds payable ...... 8,705
Cash...... 550,000
Carrying value of bond now €9,320,462 (€9,311,757 + €8,705)
December 31, 20X7
Interest expense (€9,320,462 6% = €559,227 3/6)..... 279,614
Discount on bonds payable ...... 4,614
Interest payable (€550,000 3/6)...... 275,000
April 1, 20X8
Interest expense (€9,320,462 6% = €559,227 3/6)..... 279,613
Interest payable...... 275,000
Discount on bonds payable ...... 4,613
Interest payable ...... 550,000
April 1, 20X8
Bonds payable (€10,000,000 30%)...... 3,000,000
Loss on bond redemption...... 501,093
Discount on bonds payable
(€688,243 – €8,705 – €4,614 – €4,613) 30% 201,093
Cash (€3,000,000 110%)...... 3,300,000
Question 7 (8 marks)
The issue at stake is the appropriate measurement of the provision — at lost revenue (analyst) or cost (airlines). The airline, like all other public companies, has an ethical and fiduciary responsibility to report all information that could make a difference to potential investors and creditors. These companies should use estimates that reflect the underlying economic effects of past transactions and accrue the appropriate liability and income charge. Under IAS 37, if the liability for free airline tickets is likely and estimable, a provision and corresponding expense (or revenue adjustment) must be recognized in the period the points are earned. The amount to be recognized should reflect the actual future amount due. This provision is similar to the provision for container deposits or warranties. What amount is due?
As the number of free flights earned increases, the probability that paying passengers are displaced increases. The airline’s claim that the cost of a free ticket is only €8 implies that its financial position is sufficiently strong to fly large numbers of flights without paying customers. Financial problems in the industry suggest otherwise for smaller carriers, but this may be appropriate for larger companies. Cost estimates seem to dominate current practice.
Question 8 (12 marks)
Objectives of Financial Reporting
DCI Productions has the feel of a small and risky operation. Its president and CEO is primarily concerned with cash flow, and it has tried to get its current project off the ground for four years. Note that none of the accounting methods suggested will directly impact on cash flow, which is settled by the terms of the loan itself. Tax treatment is independent of accounting treatment. However, there may be indirect cash flows changed by the accounting numbers (bonus, covenants, and so on).
DCI may wish to present financial information that
1.clearly reflects cash flows, or
2.maximizes net profit, or
3.minimizes net profit, or
4.conforms to GAAP.
DCI should formalize its objectives of financial reporting before final choice of accounting policies is made. The company must ethically choose policies that do not distort or misrepresent their financial position or results of operations.
Loan Agreement
Loan interest is 8% in nominal terms, but including the €1,000,000 repayment discount is effectively 11.60652% (solved by spreadsheet). Loan interest and the discount could be expensed as paid, or the discount inherent in the final payment could be amortized over the life of the bond using the effective interest method.
1.Expensed as paid
This would conform to cash flow, but would not be GAAP. The loan would be reflected on the balance sheet at its net amount until repaid. The accounting policy would have no impact on the current ratio but would minimize debt and maximize equity (minimize expense) over the life of the liability.