CHAPTER 10
Long-Term Liabilities
OVERVIEW OF EXERCISES, PROBLEMS, AND CASES
Learning Outcomes
Exercises
Estimated
Time in
Minutes
Level
1. Identify the components of the long-term liability
category of the balance sheet.
2. Define the important characteristics of bonds payable.
1
10
Easy
3. Determine the issue price of a bond using compound
interest techniques.
2
3
15
25
Easy
Mod
4. Show that you understand the effect on the balance
sheet of issuance of bonds.
4
16*
17*
18*
10
15
20
20
Mod
Mod
Mod
Mod
5. Find the amortization of premium or discount
using effective interest method.
16*
17*
18*
15
20
20
Mod
Mod
Mod
6. Find the gain or loss on retirement of bonds.
5
6
10
10
Mod
Mod
7. Determine whether a lease agreement must be
reported as a liability on the balance sheet.
7
8
9
10
10
20
Mod
Mod
Mod
9. Explain the effects that transactions involving long-term
liabilities have on the statement of cash flows.
10
11
12
5
20
10
Easy
Mod
Mod
10. Explain deferred taxes and calculate the deferred tax liability.
(Appendix)
13
14
5
10
Easy
Easy
8. Explain how inventors use ratios to evaluate long-term
liabilities.
*Exercise, problem, or case covers two or more learning outcomes
Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
10-1
10-2
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
Estimated
Time in
Minutes
Level
10*
20
Mod
3. Determine the issue price of a bond using compound
interest techniques.
1
15
Mod
4. Show that you understand the effect on the balance
sheet of issuance of bonds.
9*
20
Mod
5. Find the amortization of premium or discount
using effective interest method.
2
3
9*
25
25
20
Mod
Mod
Mod
6. Find the gain or loss on retirement of bonds.
4
9#
15
20
Mod
Mod
7. Determine whether a lease agreement must be
reported as a liability on the balance sheet.
5
35
Diff
6
7
10*
15
30
20
Mod
Diff
Mod
Learning Outcomes
1. Identify the components of the long-term liability
category of the balance sheet.
Problems
and
Alternates
2. Define the important characteristics of bonds payable.
8. Explain how investors use ratios to evaluate long-term
liabilities.
9. Explain the effects that transactions involving long-term
liabilities have on the statement of cash flows.
10. Explain deferred taxes and calculate the deferred tax liability.
(Appendix)
*Exercise, problem, or case covers two or more learning outcomes
#Alternate problem only
Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
CHAPTER 10 • LONG-TERM LIABILITIES
Learning Outcomes
1. Identify the components of the long-term liability
category of the balance sheet.
Cases
Estimated
Time in
Minutes
10-3
Level
1*
2*
4
40
40
25
Mod
Mod
Mod
2*
40
Mod
6. Find the gain or loss on retirement of bonds.
5
15
Mod
7. Determine whether a lease agreement must be
reported as a liability on the balance sheet.
1*
6
25
30
Mod
Mod
3*
25
Mod
3*
25
Mod
2. Define the important characteristics of bonds payable.
3. Determine the issue price of a bond using compound
interest techniques.
4. Show that you understand the effect on the balance
sheet of issuance of bonds.
5. Find the amortization of premium or discount
using effective interest method.
8. Explain how investors use ratios to evaluate long-term
liabilities.
9. Explain the effects that transactions involving long-term
liabilities have on the statement of cash flows.
10. Explain deferred taxes and calculate the deferred tax liability.
(Appendix)
*Exercise, problem, or case covers two or more learning outcomes
Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
10-4
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
QUESTIONS
1. The issue price of a bond should always be calculated using the market rate of interest. The face rate determines the dollar amount of interest, but the market rate is
used to calculate the present value that represents the issue price.
2. The tax advantage for bonds is the fact that interest paid on bonds is an expense
that is deductible for tax purposes, whereas dividends paid on stock are not deductible.
3. When bonds are issued at a premium, it is an indication that the face rate is higher
than the market rate.
4. By basing each period’s interest expense on a decreasing or increasing amount, the
amount of interest expense is different each period, but the rate of interest remains
the same.
5. Amortization affects interest expense because premium or discount is amortized to
the interest expense account. Amortization of premium decreases interest expense.
Amortization of discount increases interest expense.
6. Amortization of premium decreases the bond carrying value because it decreases
the Premium on Bonds Payable account. Since Discount on Bonds Payable is a
contra liability account, amortization of discount increases the bond carrying value.
7. Gain or loss on bond redemption will almost always occur when bonds are
redeemed or retired before their scheduled due date. The gain or loss is computed
as the difference between the bond carrying value at the redemption date and the
reacquisition price.
8. Leases are not all accounted for in the same manner because of the variety of provisions that can be found in lease agreements. Some leases are only short-term rental
arrangements to use the asset, and others are actually purchases of the asset over
a long time period. It may be possible to develop an accounting rule to treat all leases similarly. However, the rule must also be flexible enough to cover the wide variety
of financial arrangements that are all called leases.
9. Off-balance-sheet financing refers to transactions whereby a party obtains the use of
an asset but is not required to record the related liability on the balance sheet. Firms
may favor off-balance-sheet arrangements because they believe there are benefits
in not recording an obligation as a liability. Benefits may include the maintenance of
borrowing capacity and flexibility in meeting debt/equity or similar requirements in
existing loan contracts.
10. An operating lease is not recorded on the balance sheet of the lessee, and the only
expense on the income statement is the rental payments. A capital lease is shown
as an asset and a liability by the lessee. Expense on the income statement includes
interest on the liability and depreciation on the asset.
CHAPTER 10 • LONG-TERM LIABILITIES
10-5
11. Depreciation should be recorded on leased assets treated as capital leases. Generally, depreciation should be recorded over the time period benefited by the asset,
which normally is the term of the lease.
12. Deferred tax is an account that reconciles the differences between the accounting
for tax purposes and the accounting for the financial statement prepared for stockholders. If the deferred tax account has a credit balance, it represents a liability. If
the account has a debit balance, it should be presented as an asset on the balance
sheet.
13. A permanent difference affects only book accounting but not tax accounting, or vice
versa, tax accounting but not book accounting. Temporary differences affect both
book and tax accounting but in different time periods.
14. The amount of tax expense on the income statement does not represent the amount
of tax actually paid to the IRS. Tax expense represents the expense computed using
the accounting methods adopted for financial statement purposes. It does not reflect
the accounting methods actually used for tax accounting purposes.
15. Accounting liabilities are not necessarily legal liabilities. Accounting takes a broader
view and considers some items as liabilities that are not legally enforceable claims.
Examples include accrued liabilities, some unearned income amounts, and deferred
tax.
10-6
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
BRIEF EXERCISES
LO 1
BRIEF EXERCISE 10-1 CLASSIFICATION OF LONG-TERM LIABILITIES
Normally Bonds Payable would be long-term and the other accounts would be shortterm.
LO 2
BRIEF EXERCISE 10-2 BOND FEATURES
Debenture bonds—bonds backed by the general credit of the company
Secured bonds—bonds backed by a specific collateral of the company
Convertible bonds—bonds which can be converted into common stock
Callable bonds—bonds which can be redeemed at the option of the issuing company
Face value of the bonds—the maturity amount of the bonds as indicated on the face of
the bond contract
Face rate of interest—the amount of interest that will be paid on the bonds as indicated
in the bond contract
Issue price—the amount of money the issuing company will receive at the time the
bonds are issued. This amount represents the present value of the cash flows the
bond will produce.
LO 3
BRIEF EXERCISE 10-3 BOND ISSUE PRICE
1. $100,000 × 0.744 =
$ 74,400
Table 9-2 n = 10, i = 3%
4,000 × 8.530 =
34,120
Table 9-4 n = 10, i = 3%
Issue price
$108,520
2. If the face rate is equal to the market rate, the bond will be issued at face value or
$100,000.
3. $100,000 × 0.614 =
$61,400
Table 9-2 n = 10, i = 5%
4,000 × 7.722 =
30,888
Table 9-4 n = 10, i = 5%
Issue price
$92,288
CHAPTER 10 • LONG-TERM LIABILITIES
LO 4
10-7
BRIEF EXERCISE 10-4 EFFECT OF BOND ISSUANCE
1. If the bond was issued at a discount, then the market rate of interest exceeded the
face rate.
2. Bonds payable
$10,000
Less: Discount on bonds
(800)
$ 9,200
3. Since the discount will be amortized, the amount will be higher than $9,200.
LO 5
BRIEF EXERCISE 10-5 AMORTIZATION OF PREMIUM OR DISCOUNT
Cash
Interest Expense
$4,000.00
4,000.00
$3,255.60
3,233.27
Amortized
$744.40
766.73
Present Value
$108,520.00
107,775.60
107,008.90
1. Amount amortized is $744.40
Amount of interest expense is $3,255.60
2. Amount amortized is $766.73
Amount of interest expense is $3,233.27
LO 6
BRIEF EXERCISE 10-6 GAIN OR LOSS ON BONDS
1. Gain = carrying value – call price
Gain = $107,008.90 – 102,000.00
Gain = $5,008.90
2. Bond Payable
Premium on Bonds
Cash
Gain on Bond Redemption
To record redemption of bonds
100,000.00
7,008.90
102,000.00
5,008.90
10-8
LO 7
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
BRIEF EXERCISE 10-7 LEASE CLASSIFICATION
1. This lease is a capital lease because the length of the lease exceeds 75% of the life
of the asset.
2. Leased Asset $5,000 × 6.710 =
Lease Obligation
$33,550
$33,550
3. Leased Asset
Less: accumulated depreciation
$33,550
3,355
$30,195
Lease Obligation
($33,550 – $2,326 amortized)
$31,224
LO 8
Table 9-4, n =10, i = 8%
BRIEF EXERCISE 10-8 DEBT TO EQUITY RATIO
Total Liabilities = Current Liabilities, $10,000 + Bonds Payable, $3,000 + Lease Obligations, $4,000 + and Notes Payable, $600 = $17,600
Total stockholders' equity was $12,000.
Debt to equity ratio = $17,600/$12,000 = 1.47
Correct answer is D
LO 9
BRIEF EXERCISE 10-9 LONG-TERM LIABILITIES AND CASH FLOW
Increase in long-term liabilities—a positive in the financing category
Decrease in long-term liabilities—a negative in the financing category
Interest expense—when using the indirect method, the interest expense is in the operating category. It is not shown separately, but is part of the net income amount.
Depreciation expense on leased assets—a positive amount in the operating category
Increase in deferred tax—a positive amount in the operating category
LO 10
BRIEF EXERCISE 10-10 DEFERRED TAX
1. Deferred tax = $6,000
($40,000 – $25,000) × 0.4
2. The amount will be a deferred tax liability.
3. At December 31, 2012, the amount of deferred tax will be zero.
CHAPTER 10 • LONG-TERM LIABILITIES
10-9
EXERCISES
LO 2
EXERCISE 10-1 RELATIONSHIPS
1.
Cash
Interest
C
Interest
Expense
I
Amort.
Disc./Prem.
I
Carrying
Value
I
2.
C
D
I
D
LO 3
EXERCISE 10-2 ISSUE PRICE
1. a. $500,000
b. $500,000
c. $500,000
2. a. $500,000 × 8% × 1/2 year = $20,000
b. $500,000 × 8% × 1/2 year = $20,000
c. $500,000 × 8% × 1/2 year = $20,000
3. a. $ 20,000 × 13.590
$500,000 × 0.456
Issue price
(Table 9-4, n = 20, i = 4%) =
(Table 9-2, n = 20, i = 4%) =
$271,800
228,000
$499,800*
*Should equal $500,000; the difference is due to rounding in present value
factors.
b. $ 20,000 × 14.877
$500,000 × 0.554
Issue price
(Table 9-4, n = 20, i = 3%) =
(Table 9-2, n = 20, i = 3%) =
$297,540
277,000
$574,540
c. $ 20,000 × 12.462
$500,000 × 0.377
Issue price
(Table 9-4, n = 20, i = 5%) =
(Table 9-2, n = 20, i = 5%) =
$249,240
188,500
$437,740
10-10
LO 3
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
EXERCISE 10-3 ISSUE PRICE
a. $500,000
$ 40,000*
×
×
0.621 (n = 5, i = 10%) =
3.791 (n = 5, i = 10%) =
$ 310,500
151,640
$ 462,140
*500 bonds × $1,000 par × 8% = $40,000.
b. $500,000
$ 20,000*
×
×
0.614 (n = 10, i = 5%) =
7.722 (n = 10, i = 5%) =
$ 307,000
154,440
$ 461,440
*500 bonds × $1,000 par × 8% × 6/12 = $20,000.
c. $800,000
$ 32,000*
× 0.377 (n = 20, i = 5%) =
× 12.462 (n = 20, i = 5%) =
$ 301,600
398,784
$ 700,384
*800 bonds × $1,000 par × 8% × 6/12 = $32,000.
d. $1,000,000 × 0.231 (n = 30, i = 5%) =
$ 60,000* × 15.372 (n = 30, i = 5%) =
$ 231,000
922,320
$1,153,320
*2,000 bonds × $500 par × 12% × 6/12 = 60,000.
LO 4
EXERCISE 10-4 IMPACT OF TWO BOND ALTERNATIVES
1. If the company issues bonds with a face rate of 8% when the market rate is 9%, the
bonds will be issued at a discount. The real interest cost the company incurs is the
market rate of interest of 9%. Thus, the company cannot “save money” by issuing
bonds at a discount.
2. If the company issues bonds with a face rate of 10% when the market rate is 9%, the
bonds will be issued at a premium. The company will receive an amount in excess of
the par value of the bonds, but that amount is offset by the fact that the company
must then pay interest at 10%. The result is that the company incurs a real interest
cost of 9%, which is the market rate of interest. Thus, the company does not “benefit” by issuing bonds at 10%.
CHAPTER 10 • LONG-TERM LIABILITIES
LO 6
10-11
EXERCISE 10-5 REDEMPTION OF BONDS
1. Redemption Price: $75,000 × 1.03
=
Carrying Value:
$75,000 – $1,750 =
$77,250
73,250
$ (4,000) Loss
2. The gain or loss on bond redemption should be presented on the income statement.
In most cases, the gain or loss on bond redemption should not be considered unusual or infrequent and therefore should not be presented in the section of the statement where extraordinary items are presented.
LO 6
EXERCISE 10-6 REDEMPTION OF A BOND AT MATURITY
Since the bonds are fully matured, the carrying value equals the face value and there
will be no gain or loss on the redemption of the bonds.
The effect on the accounting equation of the redemption of the bonds is as follows:
BALANCE SHEET
Assets
Cash
LO 7
=
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Liabilities
(250,000) Bonds Payable
(250,000)
EXERCISE 10-7 LEASED ASSET
1. Payment × Table Factor Ord. Annuity = PV Min. Lease Payments
$8,000 × 6.418 (Table 9-4, n = 10, i = 9%) = $51,344
2. $80,000 is not a correct amount to record because it does not recognize the time
value of money. Since the payments will extend over 10 years, the lease must be
recorded at the present value of the payments.
LO 7
EXERCISE 10-8 FINANCIAL STATEMENT IMPACT OF A LEASE
1. Payment × Table Factor Ord. Annuity = PV Min. Lease Payment
Payment × 4.355 (Table 9-4, n = 6, i = 10%) = $13,065
Payment = $13,065/4.355 = $3,000 per year
2. $9,508.65
Date
1/01/08
12/31/08
12/31/09
Lease
Payment
3,000
3,000
Interest
Expense
1,306.50
1,137.15
Reduction of
Obligation
1,693.50
1,862.85
Lease
Obligation
13,065.00
11,371.50
9,508.65
10-12
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
EXERCISE 10-9 LEASED ASSETS
LO 7
1. a. The value of the forklift will not appear on the balance sheet.
b. The lease payments will appear on the income statement as lease expense.
2. a. 2008
Jan. 1
Leased Asset
Lease Liability
To record signing of lease.
BALANCE SHEET
Assets
Leased Asset
=
5,001*
5,001
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Liabilities
Lease Liability
5,001
5,001
*$1,510 × 3.312 (Table 9-4, n = 4, i = 8%) = $5,001
The leased asset should be reported at the present value of the payments which is
$5,001, not at $6,040.
b. Dec. 31 Lease Liability
Interest Expense
Cash
1,110
400*
1,510
BALANCE SHEET
Assets
Cash
(1,510)
=
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Liabilities
Lease Liability
(1,110)
Interest Expense
*$5,001 × 8% = $400
c. Depreciation expense = $5,001/4 years = $1,250.
d. Current Liabilities:
Lease Liability (current portion)
$1,199*
*($5,001 – $1,110) × 8% = $311.
$1,510 – $311 = $1,199.
Long-Term Liabilities:
Lease Liability
$2,692**
**$5,001 – $1,110 – $1,199 = $2,692
LO 9
EXERCISE 10-10 IMPACT OF TRANSACTIONS INVOLVING BONDS ON
STATEMENT OF CASH FLOWS
F—Proceeds from issuance of bonds payable
O—Interest expense
F—Redemption of bonds payable at maturity
(400)*
CHAPTER 10 • LONG-TERM LIABILITIES
LO 9
10-13
EXERCISE 10-11 IMPACT OF TRANSACTIONS INVOLVING CAPITAL LEASES ON
STATEMENT OF CASH FLOWS
1. Vega obtained the equipment by signing a lease; no cash changed hands. As a result, this transaction would be reported as a non-cash investing and financing transaction on the statement of cash flows.
2. F—Reduction of lease obligation (principal portion of lease payment)
O—Interest expense
O—Depreciation expense—leased assets
LO 9
EXERCISE 10-12 IMPACT OF TRANSACTIONS INVOLVING TAX LIABILITIES ON
STATEMENT OF CASH FLOWS
O (deduct from net income)—Decrease in taxes payable
O (add to net income)—Increase in deferred taxes
LO 10
EXERCISE 10-13 TEMPORARY AND PERMANENT DIFFERENCES (Appendix)
1. Permanent
4. Temporary
2. Permanent
5. Temporary
3. Temporary
6. Permanent
10-14
LO 10
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
EXERCISE 10-14 DEFERRED TAX (Appendix)
Balance of deferred tax account:
2008 Tax depreciation
Book depreciation
Difference
× Tax rate
Entry to deferred tax
Balance of account
=
=
=
$10,667
6,400
$ 4,267
× 0.40
= $1,707 credit
= $1,707 credit
2009 Tax depreciation
Book depreciation
Difference
× Tax rate
Entry to deferred tax
Balance of account
=
=
=
2010 Tax depreciation
Book depreciation
Difference
× Tax rate
Entry to deferred tax
Balance of account
=
=
=
2011 Tax depreciation
Book depreciation
Difference
× Tax rate
Entry to deferred tax
Balance of account
=
=
=
2012 Tax depreciation
Book depreciation
Difference
× Tax rate
Entry to deferred tax
Balance of account
=
=
=
$10,667
6,400
$ 4,267
× 0.40
= $1,707 credit
= $3,414 credit
$10,666
6,400
$ 4,266
× 0.40
= $1,706 credit
= $5,120 credit
$
0
6,400
$(6,400)
× 0.40
= $2,560 debit
= $2,560 credit
$
0
6,400
$(6,400)
× 0.40
= $2,560 debit
= $
0
CHAPTER 10 • LONG-TERM LIABILITIES
10-15
MULTICONCEPT EXERCISES
EXERCISE 10-15 ISSUANCE OF A BOND AT FACE VALUE
LO 4,5
1. $300,000* × 0.614
$ 15,000** × 7.722
Issuance price
(Table 9-2, n = 10, i = 5%) =
(Table 9-4, n = 10, i = 5%) =
$184,200
115,830
$300,030***
*300 × $1,000 = $300,000.
**$300,000 × 10% × 1/2 year = $15,000.
***Should equal $300,000; difference due to rounding in present value factors.
2008
Jan. 1
Cash
Bonds payable
To record issuance of bond.
BALANCE SHEET
Assets
Cash
=
300,000
Liabilities
300,000
300,000
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Bonds Payable 300,000
2. If the market rate of interest had been higher than 10%, the issue price would have
been less than the face value of the bonds. The bonds would have been issued at a
discount.
3. The effect on the accounting equation of the payment of interest, on July 1, 2008, is
as follows:
July 1
Interest Expense
Cash
To record payment of interest.
BALANCE SHEET
Assets
Cash
=
Liabilities
15,000
15,000
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
(15,000)
Interest
Expense
(15,000)
4. The amount of interest to be accrued, on December 31, 2008, is calculated as follows:
$300,000 × 10% × 1/2 year = $15,000.
10-16
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
LO 4,5
1. 2008
Jan. 1
EXERCISE 10-16 IMPACT OF A DISCOUNT
Cash
Discount on Bonds Payable
Bonds Payable
To record issuance of bond.
BALANCE SHEET
Assets
Cash
=
91,526
91,526
8,474
100,000
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Liabilities
Bonds Payable
100,000
Discount on
Bonds Payable (8,474)
Bonds payable
Less: Discount on bonds payable
$100,000
8,474
$ 91,526
2.
Dec. 31
Interest Expense
Cash (100,000 × 9%)
Discount on Bonds Payable
To record payment of interest and
amortization of discount.
BALANCE SHEET
Assets
Cash
=
9,000
153
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Liabilities
(9,000)* Discount on
Bonds Payable
9,153*
153
Interest
Expense
(9,153)**
*$100,000 × 9% × 1 year = $9,000
**$91,526 × 10% × 1 year = $9,153
Bonds Payable
Less: Discount on Bonds Payable
$100,000
8,321*
$ 91,679
*8,474 – 153 = 8,321
3. The market rate of interest was greater than the interest rate that Berol Corporation.
is paying. Therefore, the issuance price, discounted at 10%, the market rate, will be
less than face value.
10-17
CHAPTER 10 • LONG-TERM LIABILITIES
EXERCISE 10-17 IMPACT OF A PREMIUM
LO 4,5
1. 2008
Jan. 1
Cash
Premium on Bonds Payable
Bonds Payable
To record the issuance of bonds.
BALANCE SHEET
Assets
Cash
=
109,862
Liabilities
109,862
9,862
100,000
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Bonds Payable
100,000
Premium on
Bonds Payable
9,862
Bonds payable
Plus: Premium on bonds payable
2. 2008
Dec. 31
$100,000
9,862
$109,862
Interest Expense
Premium on Bonds Payable
Cash (100,000 × 9%)
To record interest and amortize
premium on bond.
BALANCE SHEET
Assets
Cash
=
Liabilities
(9,000)* Premium on
Bonds Payable
8,789*
211
9,000
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
(211)
Interest
Expense
(8,789)**
*$100,000 × 9% × 1 year = $9,000
**$109,862 × 8% × 1 year = $8,789
Bonds Payable
Plus: Premium on Bonds Payable
$100,000
9,651*
$109,651
*9,862 – 211 = 9,651
3. The market rate of 8% is lower than the interest rate Berol is paying. Therefore, investors will be willing to pay more on the basis of the future cash flows discounted at
the market rate.
10-18
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
PROBLEMS
LO 3
PROBLEM 10-1 FACTORS THAT AFFECT THE BOND ISSUE PRICE
1. a. The bonds would be issued at par, since the face or coupon rate is equal to the
market rate of interest.
b. The bonds would be issued at a discount in this situation because investors
would demand a 7% return on their investment. Since the cash flows are fixed,
the investment must be decreased to increase the effective interest rate.
2. a. $100,000 ×
0.554
$ 3,000* × 14.877
Total present value =
(Table 9-2, n = 20, i = 3%) =
(Table 9-4, n = 20, i = 3%) =
$ 55,400
44,631
$100,031**
*100,000 × 6% × 6/12 = 3,000
**Should be $100,000; difference due to rounding.
b. $100,000 ×
0.508
$ 6,000* ×
7.024
Total present value =
(Table 9-2, n = 10, i = 7%) =
(Table 9-4, n = 10, i = 7%) =
$ 50,800
42,144
$ 92,944
*100,000 × 6% = 6,000.
LO 5
PROBLEM 10-2 AMORTIZATION OF DISCOUNT
1.
Discount Amortization
Effective Interest Method of Amortization
Date
1/01/08
12/31/08
12/31/09
12/31/10
12/31/11
12/31/12
Totals
Col. 1
Cash
Interest
10%
1,000
1,000
1,000
1,000
1,000
5,000
Col. 2
Interest
Expense
12%
Col. 3
Discount
Amortized
Col. 2 – Col. 1
1,113
1,127
1,142
1,159
1,184*
5,725
*Amount needed to bring carrying value to face value.
113
127
142
159
184
725
Col. 4
Carrying
Value
9,275
9,388
9,515
9,657
9,816
10,000
CHAPTER 10 • LONG-TERM LIABILITIES
10-19
PROBLEM 10-2 (Concluded)
2. Interest expense =
Cash interest payment =
Discount amortized =
3. 2010
Dec. 31
$5,725
5,000
$ 725
Interest Expense
Discount on Bonds Payable
Cash
To record interest and amortize discount.
BALANCE SHEET
Assets
Cash
=
(1,000)
1,142
142
1,000
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Liabilities
Discount on
Bonds Payable
Interest Expense
Bonds payable
Less: Discount on bonds payable
LO 5
(1,142)
142
$10,000
343
$ 9,657
PROBLEM 10-3 AMORTIZATION OF PREMIUM
1.
Premium Amortization
Effective Interest Method of Amortization
Date
1/01/08
12/31/08
12/31/09
12/31/10
12/31/11
12/31/12
Totals
Col. 1
Cash
Interest
10%
1,000
1,000
1,000
1,000
1,000
5,000
Col. 2
Interest
Expense
8%
Col. 3
Premium
Amortized
Col. 2 – Col. 1
864
853
842
829
809*
4,197
*Amount needed to bring carrying value to face value.
2. Interest expense =
Cash interest payment =
Premium amortized =
$4,197
5,000
$ 803
136
147
158
171
191
803
Col. 4
Carrying
Value
10,803
10,667
10,520
10,362
10,191
10,000
10-20
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
PROBLEM 10-3 (Concluded)
3. 2010
Dec. 31
Interest Expense
Premium on Bonds Payable
Cash
To record interest and amortize premium.
BALANCE SHEET
Assets
Cash
=
(1,000)
Liabilities
Premium on
Bonds Payable
842
158
1,000
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Interest Expense
Bonds payable
Plus: Premium on bonds payable
LO 6
(842)
(158)
$10,000
362
$10,362
PROBLEM 10-4 REDEMPTION OF BONDS
1. Redemption price
Carrying value
Gain on redemption
$200,000 × 1.01 =
$200,000 + ($4,500 – $1,000) =
$202,000
203,500
$ 1,500
2. Redemption price
Carrying value
Loss on redemption
$200,000 × 1.03 =
$200,000 + $3,500 =
$206,000
203,500
$ 2,500
3. The gain or loss on bond redemption should be presented on the income statement.
In most cases, the gain or loss on bond redemption should not be considered unusual or infrequent and therefore should not be presented in the section of the statement where extraordinary items are presented.
4. Bonds are redeemed early only if it is advantageous to the issuing firm. However,
early redemption is usually not favorable to the investor because it usually means
the investor can no longer benefit from a favorable interest rate. To compensate the
investor for foregone interest, as well as for the costs and inconvenience involved,
the call price is normally set at an amount higher than 100.
CHAPTER 10 • LONG-TERM LIABILITIES
10-21
PROBLEM 10-5 FINANCIAL STATEMENT IMPACT OF A LEASE
LO 7
1.
Col. 1
Lease
Payment
Date
1/01/08
12/31/08
12/31/09
12/31/10
12/31/11
12/31/12
28,300
28,300
28,300
28,300
28,300
Col. 2
Interest
Expense
8%
9,040
7,499
5,835
4,038
2,088
Col. 3
Reduction of
Obligation
Col. 1 – Col. 2
19,260
20,801
22,465
24,262
26,212*
Col. 4
Lease
Obligation
113,000
93,740
72,939
50,474
26,212
0
*Amount needed to pay off lease obligation.
2. 2008
Jan. 1
Leased Truck
Lease Liability
To record acquisition by lease.
BALANCE SHEET
Assets
=
Leased Truck 113,000
3. 2009
Dec. 31
Liabilities
Lease Liability
INCOME STATEMENT
113,000
BALANCE SHEET
Cash
=
(28,300)
Dec. 31
Liabilities
Lease Liability
Assets
=
Accumulated
Depreciation—
Leased Truck (22,600)*
*$113,000/5 years = $22,600
Liabilities
20,801
7,499
28,300
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
(20,801)
Depreciation Expense—Leased Truck
Accumulated Depreciation—Leased Truck
To record depreciation of leased asset
BALANCE SHEET
113,000
+ Stockholders’ Equity + Revenues – Expenses
Lease Liability
Interest Expense
Cash
To record payment of lease liability
and interest.
Assets
113,000
Interest Expense
(7,499)
22,600
22,600
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Depreciation
Expense—
Leased Truck
(22,600)
10-22
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
PROBLEM 10-5 (Concluded)
4. Long-term assets:
Leased truck
Less: Accumulated depreciation
$113,000
45,200*
$ 67,800
*$22,600 × 2 years = $45,200.
Current liabilities:
Lease liability
$ 22,465
Long-term liabilities:
Lease liability
$ 50,474
LO 10
PROBLEM 10-6 DEFERRED TAX (Appendix)
1. 2008
Dec. 31
Income Tax Expense
Deferred Tax
Income Tax Payable
To record tax expense for the year 2007.
BALANCE SHEET
Assets
=
Liabilities
Income Tax Payable
Deferred Tax
200
80
120
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
120
80
Income Tax
Expense
(200)
2. The deferred tax account exists to reconcile the difference between the accounting
done for tax purposes and that done for reporting to stockholders, also referred to as
book purposes. The balance of the deferred tax account represents all temporary
differences between book and tax accounting reflected at the corporate tax rate. The
amount of the temporary differences is entered into the deferred tax account when it
originates. In theory, the items will be removed from the account when they reverse,
and the balance of the account will be reduced at that time.
The current provision for tax of $120 represents the amount paid or payable to
the government for 2007 taxes. The deferred portion of $80 represents the increase
in the balance of the deferred tax account.
The deferred amount of $80 in the footnote represents the entry to deferred tax
during the current year. The amount of $180 in the liability category of the balance
sheet represents the year-end balance of the account.
CHAPTER 10 • LONG-TERM LIABILITIES
LO 10
1. 2006
2007
2008
10-23
PROBLEM 10-7 DEFERRED TAX CALCULATIONS (Appendix)
Income before taxes
Less: Excess of tax depreciation over
book depreciation ($50,000 – $26,667*)
Taxable income
Tax paid or payable (35%)
*($88,000 – $8,000)/3 years = $26,667.
Income before taxes
Plus: Excess of book depreciation over
tax depreciation ($26,667 – $20,000)
Taxable income
Tax paid or payable (35%)
$210,000
(23,333)
$186,667
$ 65,333
$240,000
6,667
$246,667
$ 86,333
Income before taxes
Plus: Excess of book depreciation over
tax depreciation ($26,667 – $10,000)
Taxable income
Tax paid or payable (35%)
$280,000
2. 2006
Income before taxes
Income tax expense (35%)
$210,000
$ 73,500
2007
Income before taxes
Income tax expense (35%)
$240,000
$ 84,000
2008
Income before taxes
Income tax expense (35%)
$280,000
$ 98,000
3.
Year
2006
2007
2008
Col. 1
Income Tax
Expense
73,500
84,000
98,000
*Difference due to rounding.
Col. 2
Income Tax
Payable
65,333
86,333
103,833
16,667
$296,667
$103,833
Col. 3
Col. 1 –
Col. 2
8,167
–2,333
–5,834*
Col. 4
Deferred Tax
Account
8,167 credit
5,834 credit
0
10-24
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
MULTICONCEPT PROBLEM
LO 4,5
PROBLEM 10-8 BOND TRANSACTIONS
1. 2008
April 1
Cash
Bonds Payable
To record the issuance of bonds.
BALANCE SHEET
Assets
Cash
=
1,000,000
2. Oct. 1
1,000,000
BALANCE SHEET
Cash
+ Stockholders’ Equity + Revenues – Expenses
Interest Expense
Cash
To record interest payment:
Assets
=
1,000,000
INCOME STATEMENT
Liabilities
Bonds
Payable
1,000,000
Liabilities
(60,000)
60,000
60,000
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Interest
Expense
(60,000)*
*$1,000,000 × 0.12 × 6/12 = $60,000
3. Additional interest must be recorded on December 31 to accrue interest for the time
period of October 1–December 31. The interest should be recorded as an expense
when it is incurred under the accrual accounting process. The accrual does not affect the amount of interest paid on April 1, 2009. A full semiannual payment of
$60,000 should occur on that date.
4. Total cash inflow to Brand
Total cash outflow:
Interest $60,000 × 16 payments
Principal
Total outflow
Difference
$1,000,000
$ 960,000
1,000,000
1,960,000
$ 960,000
CHAPTER 10 • LONG-TERM LIABILITIES
LO 1,8,10
10-25
PROBLEM 10-9 PARTIAL CLASSIFIED BALANCE SHEET FOR WALGREENS
1. The following is the liabilities section of the consolidated balance sheet of Walgreens
at August 31, 2006. (All amounts are in millions.)
Current
Liabilities
Trade accounts payable
Accrued expenses and other liabilities
Income taxes payable
Total current liabilities
$4,039.2
1,713.3
2.8
$5,755.3
Long-Term
Liabilities
Deferred income tax
Other noncurrent liabilities
Total long-term liabilities
$ 141.1
1,118.9
$1,260.0
2. Computation of debt-to-equity ratios:
2005:
$6719.3/$8,889.7 = 0.76
2006:
$7015.3/$10,115.8 = 0.69
Walgreens’ debt-to-equity ratio has declined somewhat from 2005 to 2006. This
means that the company has maintained a stable financing pattern from year to
year. Most investors would prefer a decrease rather than an increase in this ratio
over time. Debt has fixed repayment terms, and its repayment must include interest.
Equity never has to be repaid, and dividend payments are optional. Also, the debt
represents a claim on the company’s assets. In the event of liquidation, this claim
would need to be repaid before any assets are distributed to stockholders. However,
overall Walgreens is a very safe company with a low level of debt compared to most
other companies.
3. Walgreens’ lenders want to be sure that the company can repay the principal and
pay the interest on the loan. They would be interested in Walgreens’ times interest
earned and debt service coverage ratios. Both ratios measure the degree to which a
company can make its debt payments out of current cash flows.
10-26
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
ALTERNATE PROBLEMS
LO 3
PROBLEM 10-1A FACTORS THAT AFFECT THE BOND ISSUE PRICE
1. a. The bonds would be issued at par, since the face or coupon rate is equal to the
market rate of interest.
b. The bonds would be issued at a premium in this situation because investors
would bid the price upward on a bond with a 5% return. Since the cash flows are
fixed, the investment must be increased to decrease the effective interest rate.
2. a. $500,000
$ 12,500*
Total
×
×
0.610
15.599
(n = 20, i = 2 1/2%) =
(n = 20, i = 2 1/2%) =
$305,000
194,988
$499,988**
*$500,000 × 5% × 6/12 = $12,500.
**Should be $500,000; difference is due to rounding.
Note: The tables provided with the text do not give values for 2 1/2%. Students
must find the values by using a calculator or by interpolating the values in the existing tables.
b. $500,000
$ 25,000*
Total
×
×
0.676
8.111
(n =10, i = 4%) =
(n =10, i = 4%) =
*$500,000 × 5% = $25,000.
$338,000
202,775
$540,775
CHAPTER 10 • LONG-TERM LIABILITIES
LO 5
10-27
PROBLEM 10-2A AMORTIZATION OF DISCOUNT
1.
Discount Amortization
Effective Interest Method of Amortization
Date
1/01/08
12/31/08
12/31/09
12/31/10
12/31/11
12/31/12
Totals
Col. 1
Cash
Interest
5%
Col. 2
Interest
Expense
8%
Col. 3
Discount
Amortized
Col. 2 – Col. 1
2,500
2,500
2,500
2,500
2,500
12,500
3,521
3,603
3,691
3,786
3,888*
18,489
1,021
1,103
1,191
1,286
1,388
5,989
Col. 4
Carrying
Value
44,011
45,032
46,135
47,326
48,612
50,000
*Amount needed to bring carrying value to face value.
2. Interest expense =
Cash interest payments =
Discount amortized =
3. 2010
Dec. 31
$18,489
12,500
$ 5,989
Interest Expense
Discount on Bonds Payable
Cash
To record interest and amortization of
discount.
BALANCE SHEET
Assets
Cash
=
(2,500)
1,191
2,500
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Liabilities
Discount on
Bonds Payable
3,691
Interest Expense
(3,691)
1,191
Bonds payable
Less: Discount on bonds payable
$50,000
2,674
$47,326
10-28
LO 5
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
PROBLEM 10-3A AMORTIZATION OF PREMIUM
1.
Premium Amortization
Effective Interest Method of Amortization
Date
1/01/08
12/31/08
12/31/09
12/31/10
12/31/11
12/31/12
Totals
Col. 1
Cash
Interest
5%
Col. 2
Interest
Expense
4%
Col. 3
Premium
Amortized
Col. 1 – Col. 2
2,500
2,500
2,500
2,500
2,500
12,500
2,089
2,073
2,056
2,038
2,014*
10,270
411
427
444
462
486
2,230
Col. 4
Carrying
Value
52,230
51,819
51,392
50,948
50,486
50,000
*Amount needed to bring carrying value to face value.
2. Interest expense =
Cash interest payment =
Premium amortized =
3. 2010
Dec. 31
$10,270
12,500
$ 2,230
Interest Expense
Premium on Bonds Payable
Cash
To record interest and amortization of
premium.
BALANCE SHEET
Assets
Cash
=
(2,500)
Liabilities
Premium on
Bonds Payable
Bonds payable
Add: Premium on bonds payable
2,056
444
2,500
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Interest Expense
(2,056)
(444)
$50,000
948
$50,948
CHAPTER 10 • LONG-TERM LIABILITIES
LO 6
10-29
PROBLEM 10-4A REDEMPTION OF BONDS
1. Redemption price $100,000 × 1.01 =
Carrying value $100,000 + ($5,500 – $2,000) =
Gain on redemption
$101,000
103,500
$ 2,500
2. Redemption price $100,000 × 1.04 =
Carrying value $100,000 + $3,500 =
Loss on redemption
$104,000
103,500
$
500
3. The gain or loss on bond redemption should be presented on the income statement.
In most cases, the gain or loss on bond redemption should not be considered unusual or infrequent and therefore should not be presented in the section of the statement where extraordinary items are presented.
4. Bonds are redeemed early only if it is advantageous to the issuing firm. However,
early redemption is usually not favorable to the investor because it usually means
the investor can no longer benefit from a favorable interest rate. To compensate the
investor for foregone interest, as well as for the costs and inconvenience involved,
the call price is normally set at an amount higher than 100.
LO 7
PROBLEM 10-5A FINANCIAL STATEMENT IMPACT OF A LEASE
1.
Date
1/01/08
12/31/08
12/31/09
12/31/10
12/31/11
12/31/12
12/31/13
Col. 1
Lease
Payment
Col. 2
Interest
Expense
9%
Col. 3
Reduction of
Obligation
Col. 1 – Col. 2
21,980
21,980
21,980
21,980
21,980
21,980
8,874
7,694
6,409
5,007
3,480
1,816
13,106
14,286
15,571
16,973
18,500
20,164*
*Rounded to bring carrying value to zero.
Col. 4
Lease
Obligation
98,600
85,494
71,208
55,637
38,664
20,164
0
10-30
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
PROBLEM 10-5A (Concluded)
2. 2008
Jan. 1
Leased Machine
Lease Liability
To record acquisition by lease.
BALANCE SHEET
Assets
Leased
Machine
=
98,600
3. 2009
Dec. 31
INCOME STATEMENT
98,600
Lease Liability
Interest Expense
Cash
To record payment of lease liability
and interest.
BALANCE SHEET
Assets
Cash
=
(21,980)
Dec. 31
(14,286)
BALANCE SHEET
=
21,980
INCOME STATEMENT
Depreciation Expense—Leased
Machine
Accumulated Depreciation—Leased
Machine
To record depreciation of leased asset
Assets
14,286
7,694
+ Stockholders’ Equity + Revenues – Expenses
Liabilities
Lease Liability
98,600
+ Stockholders’ Equity + Revenues – Expenses
Liabilities
Lease Liability
98,600
Liabilities
Accumulated
Depreciation—
Leased
Machine
(16,433)
4. Long-term assets:
Leased machine
Less: Accumulated depreciation
Interest Expense
(7,694)
16,433
16,433
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Depreciation
Expense—
Leased
Machine
(16,433)
$98,600
32,866*
$65,734
*$16,433 × 2 years = $32,866
Current liabilities:
Lease liability—current portion
$15,571
Long-term liabilities:
Lease liability
$55,637
CHAPTER 10 • LONG-TERM LIABILITIES
10-31
PROBLEM 10-6A DEFERRED TAX (Appendix)
LO 10
1. The effect on the accounting equation of the December 31, 2008 income tax expense, deferred tax, and income tax payable is as follows:
BALANCE SHEET
Assets
=
Liabilities
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Income Tax Payable 120
Deferred Tax
(20)
Income Tax
Expense
(100)
2. The deferred tax account exists to reconcile the difference between the accounting
done for tax purposes and that done for reporting to stockholders, also referred to as
book purposes. The balance of the deferred tax account represents all temporary
differences between book and tax accounting reflected at the corporate tax rate. The
amount of the temporary differences is entered into the deferred tax account when it
originates. In theory, the items will be removed from the account when they reverse
and the balance of the account will be reduced at that time.
LO 10
1. Year 1
Year 2
Year 3
PROBLEM 10-7A DEFERRED TAX CALCULATIONS (Appendix)
Income before taxes
Less: Tax-exempt income
Less: Excess of tax depreciation over book
depreciation ($30,000 – $20,000)
Taxable income
Taxes paid or payable (40%)
$ 120,000
(5,000)
Income before taxes
Less: Tax-exempt income
Plus: Excess of book depreciation over
tax depreciation ($20,000 – $20,000)
Taxable income
Taxes paid or payable (40%)
$ 120,000
(5,000)
Income before taxes
Less: Tax-exempt income
Plus: Excess of book depreciation over
tax depreciation ($20,000 – $10,000)
Taxable income
Taxes paid or payable (40%)
$ 120,000
(5,000)
(10,000)
$ 105,000
$ 42,000
0
$ 115,000
$ 46,000
10,000
$ 125,000
$ 50,000
10-32
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
PROBLEM 10-7A (Concluded)
2. The deferred tax account for years 1–3 would contain the following information:
Year 1 entry:
Tax expense greater than
tax payable $10,000 × 40% = $4,000 credit
Year 1 balance
= $4,000 credit, a liability
Year 2 entry:
Year 2 balance
=0
= $4,000 credit, a liability
Year 3 entry:
Tax payable greater than
tax expense $10,000 × 40% = $4,000 debit
Year 3 balance
=0
The account would not appear on the balance sheet at the end of year 3.
CHAPTER 10 • LONG-TERM LIABILITIES
10-33
ALTERNATE MULTICONCE PT PROBLEMS
LO 4,6
PROBLEM 10-8A FINANCIAL STATEMENT IMPACT OF A BOND
1. 2008
July 1
Cash
Discount on Bonds Payable
Bonds Payable
To record issuance of bond.
BALANCE SHEET
Assets
Cash
=
916,200
916,200
83,800
1,000,000
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Liabilities
Bonds
Payable
1,000,000
Discount on
Bonds Payable (83,800)
$50,000* × 8.384 (Table 9-4, n = 12, i = 6%) =
$1,000,000 × 0.497 (Table 9-2, n = 12, i = 6%) =
$ 419,200
497,000
$ 916,200
*1,000,000 × 10% × 6/12 = $50,000
2. Dec. 31
Interest Expense ($916,200 × 6%)
Discount on Bonds Payable
Interest Payable
To record interest and amortization
of discount.
BALANCE SHEET
Assets
=
4,972*
50,000
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
Liabilities
Interest Payable
Discount on
Bonds Payable
54,972
50,000
Interest
Expense
(54,972)*
4,972**
*$916,200 × 6% = $54,972
**Discount amortized = $54,972 – $50,000 = $4,972
3. 2009
Jan. 1
Interest Payable
Cash
To record payment of interest.
BALANCE SHEET
Assets
Cash
(50,000)
=
Liabilities
Interest
Payable
50,000
50,000
INCOME STATEMENT
+ Stockholders’ Equity + Revenues – Expenses
(50,000)
10-34
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
PROBLEM 10-8A (Concluded)
4. On the maturity date, July 1, 2014, the balance in the Discount on Bonds Payable
will have been reduced to zero. The only remaining amount to be paid is the principal on the bond as shown in the Bonds Payable account, $1,000,000.
LO 1,8,10
PROBLEM 10-9A PARTIAL CLASSIFIED BALANCE SHEET FOR BOEING
1. The following is the liabilities section of the consolidated balance sheet of Boeing,
Inc., at December 31, 2006. (All amounts are in millions.)
Liabilities
Current liabilities:
Accounts payable and other liabilities
Income tax payable
Short-term debt and current portion of long-term debt
Advances in excess of related costs
Total current liabilities
$16,201
670
1,381
11,449
$29,701
Long-term debt
Accrued retiree healthcare costs
8,157
7,671
Accrued pension liability
Other long-term liabilities
1,135
391
2. Computation of debt-to-equity ratios:
2005
$48,937/$11,059 = 4.43 to 1
2006
($29,701 + $8,157 + $7,671 + 1,135 + 391 )/$4,739 = $47,055/$4,739 = 9.93 to 1
Boeing’s debt-to-equity ratio increased dramatically during 2006. This means that
Boeing has more debt for each dollar of equity: $4.43 of debt per $1 of equity in
2005 compared with $9.93 of debt per $1 of equity in 2006. Most investors would
prefer a decrease rather than an increase in this ratio. Debt has fixed repayment
terms, and its repayment must include interest. Equity never has to be repaid, and
dividend payments are optional. Also, the debt represents a claim on the company’s
assets. In the event of liquidation, this claim would need to be repaid before any assets are distributed to stockholders. Overall, the debt-to-equity ratio is fairly high and
indicates the company has a high level of debt.
3. Boeing’s lenders want to be sure that the company can repay the principal and pay
the interest on the loan. They would be interested in Boeing’s times interest earned
and debt service coverage ratios. Both ratios measure the degree to which a company can make its debt payments out of current cash flows.
CHAPTER 10 • LONG-TERM LIABILITIES
10-35
CASES
READING AND INTERPRETING FINANCIAL STATEMENTS
LO 1,8
DECISION CASE 10-1 EVALUATING THE LIABILITIES OF GENERAL MILLS
1. General Mills has the following long-term liabilities:
Long-term debt decreased from 2005 to 2006
Deferred income taxes decreased from 2005 to 2006
Other liabilities decreased from 2005 to 2006
2. Debt to equity ratio for 2005 $11,257/$5,676 = 1.98
Debt to equity ratio for 2006 $11,299/$5,772 = 1.96
Times interest earned for 2005 $2,359/$455 = 5.18
Times interest earned for 2006 $2,030/$399 = 5.09
The company had a higher amount of interest payments in 2005 but also had a
higher amount of income before tax and interest. As a result, the times interest
earned ratio was slightly higher in 2005 than 2006. In both years the company has a
fairly high ratio indicating they have the ability to meet its interest obligations.
10-36
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
LO 9,10
DECISION CASE 10-2 COMPARING TWO COMPANIES: GENERAL MILLS AND
KELLOGG’S
1. Debt to Equity Ratio for General Mills:
2005—$11,257/$5,676 = 1.98
2006—$11,299/$5,772 = 1.96
Debt to Equity Ratio for Kellogg’s
2005—$8,289/$2,283 = 3.63
2006—$8,645/$2,069 = 4.18
The debt to equity ratio increased for Kellogg’s and remained nearly stable for General Mills from 2005 to 2006. The companies maintain a fairly high level of debt
compared to equity. However, in the food/cereal industry the companies have an
ability to generate cash to pay interest obligations and repay debt so they can manage their debt levels rather easily.
2. The long-term liabilities of General Mills decreased from 2005 to 2006. The most important decline was related to long-term debt. The long-term liabilities of Kellogg’s
were nearly stable. The long-term debt account declined somewhat but that was offset by a slight increase in other liabilities. A decrease in long-term liabilities requires
the use of cash. An increase in long-term liabilities would usually be shown as an increase in cash.
3. General Mills shows an increase in cash because of changes in notes payable and
this was offset by a decrease in cash because of payment of long-term debt. Kellogg’s had a variety of activities that affected the amount of cash but the most important was the issuance of notes payable. Kellogg’s received cash from issuance of
notes, but overall they decreased the long-term liabilities on the balance sheet. It is
not clear how the company managed to do so, but it is possible that money from the
issuance of debt was used to pay off other loans or liabilities.
CHAPTER 10 • LONG-TERM LIABILITIES
LO 9,10
10-37
DECISION CASE 10-3 READING PEPSICO’S STATEMENT OF CASH FLOWS
1. Proceeds from debt is a positive amount on the cash flows statement because it indicates that the company has incurred a loan and received cash. Payment of debt is
a negative amount because it indicates that the company has used cash to repay a
loan or other form of debt.
2. When interest rates are at low levels, companies often pay off loans that carry interest at a rate that is higher than the current rate. It makes good economic sense to
pay off loans that have a high rate of interest because money borrowed at the current rate of interest will be less than the rate on debt that was incurred previously.
3. When a company has a Deferred Tax Asset account, an increase in the account
should be presented as a negative on the cash flows statement because it indicates
that the amount of taxes actually paid was more than the amount reflected in the net
income amount presented in the operating activities section of the balance sheet.
Changes in the Deferred Tax Asset account should be presented in the operating
activities section of the cash flows statement because it is related to operating activities and affects the net income amount.
MAKING FINANCIAL DECISIONS
LO 1,7
DECISION CASE 10-4 MAKING A LOAN DECISION
1. The bank’s policy is that a 2 to 1 ratio of assets to debt must be maintained. The
note in Molitor’s annual report indicates that generally accepted accounting principles do not require the item to be recorded. This is an example of an off-balancesheet financial arrangement. A strict interpretation of the policy and the accounting
principle does not require the item to be recorded, and the ratio is $660,000/300,000
= 2.2. If the amount is included, the ratio is $860,000/500,000 = 1.7.
2. The bank should adopt a more flexible policy to consider those financing techniques
that are off-balance-sheet. However, it is very difficult to develop a policy that accommodates the wide variety of financial arrangements that fall into this category.
Some are, in substance, liabilities and should be considered as such. Others are not
liabilities and are more appropriately excluded from the bank’s policy.
10-38
LO 6
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
DECISION CASE 10-5 BOND REDEMPTION DECISION
DATE:
TO:
Controller
FROM: Student Name
RE:
Retirement of Outstanding Bonds
The outstanding bonds have increased in value because they pay 10% in a market that
requires only a 4% return. The holders of these instruments would sell them for
$148,710 ($100,000 × 0.676) + ($100,000 × 10% × 8.111). The company is required to
pay this amount for the bonds in order to purchase them from the bondholders. If the
company issues bonds at 4%, the new issuance will yield the company $100,000. The
company would be required to use $48,710 of working capital to reissue the bonds at
the lower rate. The benefit to the company is that in the future ten years, the company is
required to pay only $4,000 each year rather than $10,000 in annual interest. Discounting the savings of $6,000 per year yields a net benefit to the company of $48,710
($6,000 × 8.111 rounded). I recommend that the company retire the outstanding bonds
and reissue the bonds at the lower rate in order to reduce future cash outflow.
It should be noted that if the company had issued the original bonds with a call price
of less than 148.71, the company would be able to call the bonds at lower than market.
ACCOUNTING AND ETHICS: WHAT WOULD YOU DO?
LO 7
DECISION CASE 10-6 DETERMINATION OF ASSET LIFE
1. The purpose of the case is to illustrate the judgment necessary in recording leases.
Even though criteria exist that govern lease accounting, significant judgment is necessary in the application of the criteria. If Jen believes that the first source of information is valid, she should record the lease as a capital lease. If the trade publication is more valid, she should record the lease as an operating lease. Jen should
gather additional information and consult other experts or opinions in forming her
decision. However, in the final analysis, she must make an informed decision that
represents her best professional judgment.
2. In this case, either judgment can be supported provided that it represents Jen’s best
professional judgment using all available information. If, however, Jen decides the
issue because Hale’s does not want the lease recorded as a capital lease, then
probably she is acting unethically. Accounting decisions should be based on the
substance of the transaction and should not be based on a desire to achieve a certain objective, such as a desire to “hide” information or a desire to please one’s
boss.
REAL WORLD PRACTICE 10.1
Long-term Debt, Deferred Income Taxes, and Other Liabilities all increased.