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 October 1). 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 2-1, 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:
20X5
Sales in units, Line A
Sales price per unit, Line A
20X6
20X7
700
1,000
nil
€610
€660
n/a
600
800
nil
€700
€750
n/a
€3,000
€7,000
€9,600
€22,000
€12,000
€30,000
Sales in units, Line B
Sales price per unit, Line B
Actual warranty outlays, Line B
Parts
Labour & Overhead
There were no sales of either product in 20X7.
Required
Complete the tabulation below:
20X5
Year-end amounts
20X6
20X7
Warranty expenses (on the income statement)
Estimated provision for warranty (balance sheet)
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2,
First Edition (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.
1. 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.
2. A customer has sued the company for €1 million. The company will likely
successfully defend itself. The amount is immaterial.
3. 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.
4. 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.
5. The company self-insures for fire hazards: that is, it carries no fire insurance.
6. The company has guaranteed a €10 million loan of an associated company. This
amount is material. The other company has a good credit rating.
7. 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.
8. 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 December 31.
(4 marks for Requirement 1, 6 marks for Requirement 2, and 3 marks for
Requirement 3)
Required
1. Give the entry to record the purchase on January 1, 20X5. Show computations (round
to the nearest euro).
2. 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)
___________
___________
___________
___________
3. 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,
First Edition (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
May 1. The principal was due May 1, 20X9. Lane Ltd. has a fiscal year end of
December 31.
US$1 = Cdn
May 1, 20X6
December 31, 20X6
May 1, 20X7
December 31, 20X7
Average for the 8 months ended December 31, 20X6
Average for the 12 months ended December 31, 20X7
$1.29
$1.32
$1.34
$1.30
$1.31
$1.29
Required
1. How could this loan be hedged? Would this be desirable? How would the financial
statements reflect a fully hedged loan? (4 marks)
2. 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)
3. 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,
First Edition (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
1. What is the entry that would have been made on April 1, 20X7? (4 marks)
2. Assume the bonds were issued on April 30, 20X7, at 101 plus accrued interest.
(4 marks)
3. 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)
4. 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)
a. October 1, 20X7
b. December 31, 20X7
c. April 1, 20X8
Source: Thomas Beechy and Joan Conrod, Intermediate Accounting, Vol. 2,
Second Edition (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)
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
A
B
Maturity amount of the bonds
Date of the bonds
Maturity date
Issue date
C
D
Stated annual interest rate
Interest rate per period
Price or effective interest rate (annual)
Interest rate per period
April 1 and October 1
2
7
€581,656
Total sale price of bonds, Oct 1, 2005
D
2,358
2,441
2,526
2,614
2,706
2,801
2,899
42
43
44
45
46
47
48
49
E
18,344
15,723
13,103
10,482
7,862
5,241
2,621
0
63
D
40,882
E
18,344
15,986
13,545
11,019
8,405
5,699
2,899
0
E
F
41,241
F
22 =PV(F16,F20,-(F8*F14))+F8/(1+F16)^F20
D
32
33
34
35
36
37
38
39
=ABS(+C33-B33)
=ABS(C34-B34)
=ABS(C35-B35)
=ABS(C36-B36)
=ABS(C37-B37)
=ABS(C38-B38)
=ABS(C39-B39)
F
€600,000
April 1, 2005
March 31, 2009
October 1, 2005
6.00%
3.00%
7.00%
3.50%
Interest payment dates
Number of interest periods per year
Total number of interest periods
32
33
34
35
36
37
38
39
E
E
=ABS($F$8-$F$22)
=E32-D33
=E33-D34
=E34-D35
=E35-D36
=E36-D37
=E37-D38
=E38-D39
42
43
44
45
46
47
48
49
E
=ABS($F$8-$F$22)
=E42-D43
=E43-D44
=E44-D45
=E45-D46
=E46-D47
=E47-D48
=E48-D49
D
63 =(C33*0.5)+C34+(C35*0.5)
E
F
=(C43*0.5)+C44+(C45*0.5)
b. (4 marks)
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
A
B
Maturity amount of the bonds
Date of the bonds
Maturity date
Issue date
C
Stated annual interest rate
Interest rate per period
Price or effective interest rate (annual)
Interest rate per period
Interest payment dates
Number of interest periods per year
Total number of interest periods
Total sale price of bonds, Oct 1, 2005
D
32
33
34
35
36
37
38
39
4,264
4,477
4,701
4,936
5,183
5,442
5,714
42
43
44
45
46
47
48
49
E
34,718
29,758
24,799
19,839
14,879
9,919
4,960
0
E
34,718
30,454
25,977
21,276
16,339
11,156
5,714
0
D
E
F
€600,000
April 1, 2005
March 31, 2009
October 1, 2005
8.00%
4.00%
10.00%
5.00%
April 1 and October 1
2
7
€565,282
D
56,960
63
E
F
57,919
c. (3 marks)
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
A
B
Maturity amount of the bonds
Date of the bonds
Maturity date
Issue date
C
D
E
F
€600,000
April 1, 2005
March 31, 2009
October 1, 2005
Stated annual interest rate
Interest rate per period
Price or effective interest rate (annual)
Interest rate per period
11.00%
5.50%
8.00%
4.00%
Interest payment dates
Number of interest periods per year
Total number of interest periods
April 1 and October 1
2
7
€654,018
Total sale price of bonds, Oct 1, 2005
D
32
33
34
35
36
37
38
39
6,839
7,113
7,397
7,693
8,001
8,321
8,654
42
43
44
45
46
47
48
49
E
54,018
46,302
38,585
30,868
23,151
15,434
7,717
0
63
D
51,769
E
54,018
47,179
40,066
32,669
24,976
16,975
8,654
0
E
F
50,566
Question 2 (10 marks)
(4 marks for warranty expense and 6 marks for the liability balance)
Accounts
20X5
Year-End Amounts
20X6
20X7
Warranty expense (on income statement)
€ 84,0001
Estimated warranty liability (on balance sheet)
32,0003
€ 120,0002
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.
2.
3.
4.
5.
6.
7.
8.
B
C
A
B But should estimate if at all possible and follow A; students should state this
assumption if A is offered as a solution.
C
B
C
B The 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)................
Discount on notes payable .................................................................
Cash .............................................................................................
Note payable ................................................................................
*Computation
Principal: €20,000  (PVIF, 15%, 2) (0.75614) ..........................
Interest: (€20,000  8%)  (PVIFA, 15%, 2) (1.62571)..............
Present value of note ....................................................................
Discount: (€20,000 – €17,724) ....................................................
22,724
2,276
5,000
20,000*
€ 15,123
2,601
€ 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%)
b) Total interest expense for the two-year period
[(€20,000 + €3,200) – €17,724] [or, see below]
c) Amount of interest reported on income statement for 20X5
(€17,724  15%)
d) Amount of net liability reported on balance sheet December 31, 20X5,
excluding accrued interest (see debt amortization schedule)
€ 1,600
€ 5,476
€ 2,659
€ 18,783
Debt Amortization Schedule
(not required)
Carrying Value
Cash
Balance
Payments
Start
20X5
20X6
Interest Expense
@ 15%
€ 1,600
1,600
€ 3,200
Increase Carrying Value
in Balance
Balance
€ 2,659
2,817
€ 5,476
€ 17,724
€ 18,783
20,000
€ 1,059
1,217
Requirement 3 (3 marks)
Entries for Sable Year End:
20X5
Interest expense ...............
Notes payable...................
Discount .....................
Cash ...........................
2,659
20X6
Maturity
2,817
20,000
1,059
1,600
1,217
1,600
20,000
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
May 1, 20X6
December 31, 20X6
December 31, 20X7
(Gain)/Loss
@ $1.29
@ $1.32
@ $1.30
C$10,320,000
10,560,000
10,400,000
Income Statement, year ended Dec. 31, 20X6
Exchange loss
re: principal .....................................................
C$240,000
(160,000)
240,000
December 31, 20X6, balance sheet
Loan payable ......................................................... C$10,560,000
December 31, 20X7, balance sheet
Loan payable .........................................................
Income statement, year ended December 31, 20X7
Exchange (gain)
re: principal .....................................................
Requirement 3 (4 marks)
Interest Expense
10,400,000
(160,000)
20X6
20X7
US$8,000,000  .0725  8/12  $1.31
US$8,000,000  .0725  $1.29
C$506,533
C$748,200
Exchange G/L (Interest)
20X6
Interest payable at December 31, 20X6
(US$8,000,000  .0725  8/12  $1.32)
Interest expense (above)
Exchange loss
C$510,400
506,533
C$ 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:
Interest payments:
Bond price
€10,000,000  (PVIF, 6%, 30) (.17411) = €1,741,100
€550,000  (PVIFA, 6%, 30) (13.76483) = 7,570,657
€9,311,757
April 1, 20X7
Cash ...........................................................................................
Discount on bonds payable ........................................................
Bonds payable ......................................................................
9,311,757
688,243
10,000,000
Requirement 2 (4 marks)
April 30, 20X7
Cash (€10,000,000  101%) + (€10,000,000  11%  1/12) ....
Premium on bonds payable (1% of par) ..............................
Interest expense (or payable) (€10,000,000  11%  1/12)
Bonds payable ......................................................................
10,191,667
100,000
91,667
10,000,000
Requirement 3 (4 marks)
June 1, 20X7
Cash (€10,000,000  99%) + (€10,000,000  11%  2/12) ......
Discount on bonds payable (1% of par) ....................................
Interest expense (or payable) (€10,000,000  11%  2/12)
Bonds payable ......................................................................
10,083,334
100,000
183,334
10,000,000
Requirement 4 (1.5 marks each)
October 1, 20X7
Interest expense (€9,311,757  6%) ..........................................
Discount on bonds payable .................................................
Cash .....................................................................................
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)..............
Discount on bonds payable .................................................
Interest payable (€550,000  3/6) ........................................
558,705
8,705
550,000
279,614
4,614
275,000
April 1, 20X8
Interest expense (€9,320,462  6% = €559,227  3/6)..............
Interest payable ..........................................................................
Discount on bonds payable .................................................
Interest payable ...................................................................
April 1, 20X8
Bonds payable (€10,000,000  30%) ........................................
Loss on bond redemption...........................................................
Discount on bonds payable
(€688,243 – €8,705 – €4,614 – €4,613)  30% ................
Cash (€3,000,000  110%) ..................................................
279,613
275,000
4,613
550,000
3,000,000
501,093
201,093
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.
2.
3.
4.
clearly reflects cash flows, or
maximizes net profit, or
minimizes net profit, or
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.
2.
The effective interest rate method
This method does not conform to cash flow, but is GAAP and measures the effective
interest on the net outstanding balance each year. It is better for the debt-to-equity
ratio as it minimizes debt and maximizes equity.
Conclusion
If the company wishes to have financial statements that reflect cash flow and need not
conform to GAAP, interest expense would be measured using the cash flow method.
If statements must conform to GAAP, then the effective interest rate method is most
sympathetic to the debt/equity covenant. If statements are sensitive to some other cash
flow variable, then the specific variable vis-à-vis the expense variable should be
examined.
Calculations
Year
1
2
3
4
5
6
7
Total
Cash flow
Effective
Int Amort
€
€
480,000
480,000
480,000
480,000
480,000
480,000
1,480,000
€ 4,360,000
580,326*
591,970
604,966
619,470
635,658
653,724
673,886
€ 4,360,000
*€5,000,000  11.60652%; (€5,000,000 + €580,326 – €480,000)  11.60652%, and so
on.