Chapter 9
9-1
Current liabilities are obligations that fall due within the coming
year (or within one operating cycle, if longer than a year). Longterm liabilities fall due beyond one year from the balance sheet
date.
9-2
Accounts payable are obligations arising from purchasing
goods and services on credit. Notes payable are promises to
repay principal plus interest at specific future dates. Salaries
and wages payable are amounts earned by employees but not
yet paid. Income taxes payable are taxes yet to be paid to the
government on recorded income. Current portion of long-term
debt is the amount of principal due within the next year on longterm debt. Interest and rent are additional accruals.
9-3
Except for additional clerical costs, withholding taxes do not add
to employer costs. It is true that social security taxes have two
parts – a portion withheld from the employee and an equal
portion paid by the employer.
9-4
No. Warranty obligations should be accrued at the time of sale.
Such recognition requires an estimate of warranty claims, but a
best estimate is better than ignoring the obligation for warranty
services.
9-5
A mortgage bond is secured by the pledge of specific property.
A debenture is a general claim against the total assets of the
firm. If the same company issues both mortgage bonds and
debentures, the mortgage bond is safer because mortgage
bondholders have first claim on funds from liquidation of the
pledged asset or assets.
Chapter 9
Liabilities and Interest
433
9-6
If no lien exists against specific assets, the bond is called a
debenture. Holders of debentures have no specific claim
against the assets beyond their general claim against the total
assets -- a claim shared with other general creditors, such as
trade creditors. Subordinated debentures give bondholders a
claim that is junior to other general creditors' claims against the
total assets. If the debentures are unsubordinated, the holders
would have the same priority as general creditors.
9-7
No. Protective covenants generally protect bondholders.
9-8
Covenants benefit the lender or investor. They restrict the
issuer's behavior. This is important because without such a
restriction, the issuer could do things detrimental to the
investor's interest. For example, in KKR's buyout of RJR
Nabisco substantial new debt was issued that increased RJR
Nabisco's debt/equity ratio. Existing debt became more risky
and its price fell significantly.
9-9
The call provision benefits the issuer who obtains a choice in
managing future financial affairs.
The call premium
compensates the investor for the investor's risk that the issuer
will choose to redeem the bond early, to the investor's detriment.
9-10 No. The face amount is the payment due at maturity. If market
interest rates for similar bonds are above the coupon interest
rate of a particular bond, the market price of this bond would be
less than the face amount, and vice versa.
9-11 The bond markets compound interest semi-annually. Therefore,
a 12 percent rate really means 6 percent interest for every 6
month period, compounded.
9-12 If market rates are above 10%, there will be a discount. If they
are below 10%, there will be a premium.
434
9-13 When a bond is issued at a discount, interest expense includes
an amortization of the bond discount in addition to the amount
of the interest payments to bondholders.
9-14 (1) If there is a premium, the cash proceeds exceed the face
amount, whereas with a discount, the face amount exceeds the
proceeds. (2) The account "Premium on Bonds Payable" is
added to the face amount, whereas the contra account
"Discount on Bonds Payable" is deducted from the face
amount. (3) Amortization of bond premium decreases the
interest expense, whereas amortization of bond discount
increases it.
9-15 No. Interest must be accrued each period using the market rate
at time of issuance multiplied by the carrying value of the bond
(book value). However, no interest payment is required until the
bond matures.
9-16 Capital leases require the same accounting as a purchase with
the implicit borrowing of the purchase price. An asset and a
liability are recorded on the balance sheet.
9-17 A capital lease is equivalent to the purchase of an asset and the
financing of that asset with a loan. At the time the lease is
signed, an equal amount is entered into an asset account and a
liability account. The former recognizes the company's claim to
the benefits from the leased assets. The latter recognizes the
company's obligation to make lease payments.
9-18 No. They are recorded differently on both the balance sheet and
the income statement. The operating lease is not placed on the
balance sheet while the capital lease results in both an asset and
a liability. The income statement treatment differs because the
lease payment is an expense for an operating lease, while the
amortization of the leased asset and the interest on the lease
liability comprise the expense for a capital lease.
Chapter 9
Liabilities and Interest
435
9-19 The issues regarding capital lease status involve the lessee's
economic involvement. If the contract covers the majority of the
asset's life or value, it is a capital lease. Other items examined
are transfer of ownership and bargain purchase options.
9-20 No. Financial Accounting Standards Board Opinions No. 87 and
88 require recognition of a liability when the accumulated
pension obligation exceeds the fair value of the assets in a
pension fund.
9-21 Permanent differences are items of revenue or expense that are
recognized for reporting to shareholders but are not recognized
for tax purposes, or vice versa. They affect the current financial
statements but have no future effect. In contract, temporary
differences arise because revenues or expenses are recognized
at a different time for tax purposes and financial reporting
purposes. Such differences in timing will be reversed in future
periods.
9-22 No. Differences in tax and GAAP reporting result in different
timing of depreciation expense, but the total amount of expense
charged is the same for both types of statements. Usually,
larger depreciation expenses are charged in early years of an
asset’s life in tax statements, but that means that less
depreciation expense will be charged in later years.
9-23 No. The purposes of tax reports and financial reports to the
public differ. Managers must follow the rules for each. In
addition, they have an obligation to shareholders to minimize
taxes and to delay them as long as the law allows unless
economic considerations indicate otherwise.
9-24 Contingent liabilities may have either definite or estimated
amounts. Contingent liabilities are potential liabilities that
depend on future events, but arise out of past transactions.
436
9-25 Each item in Table 9A-3 consists of the sum of the items in the
same column of Table 9A-2, up to and including the number in
the same row. For example, the number in the 5-period row, 10%
column of Table 9A-3 is the sum of the numbers in the 10%
column of Table 9A-2 starting with period 1 and ending with
period 5.
9-26 Adding a loan covenant creates a possible default condition that
might permit the lender to call for immediate repayment to
renegotiate a higher interest rate. The idea of linking it to the
debt-to-total-assets ratio is to limit the amount of borrowing that
the company can do and similarly to restrict the total dividends
the company can pay. Both of these steps increase the
likelihood that the company will pay the obligation when due.
9-27 The prize that is cited by New York State is the sum of a series of
payments over 26 years. This person must have chosen the
lump-sum option, in which case the payments are discounted at
the interest rate at which New York State borrows money. That
reduces the total sharply. In addition, the federal and state
governments withhold estimated tax liabilities from the check
before the state delivers it to the winner.
9-28 The key is that when bonds trade at a discount, it means the
market rate of interest has risen compared to the coupon rate. If
this company kept its total interest payments constant in a world
of rising interest rates, the new bond issue would raise exactly
the amount that was required to purchase its existing bonds in
the open market. Yes, there would be an accounting “gain on
redemption of bonds,” but economically there would be no
change in annual interest payments going forward and there
would be transactions costs. That means that it would cost
something to redeem the old bonds and it would cost something
to issue the new bonds. Economically, this is a bad idea.
9-29 The interest-coverage ratio is aimed at measuring the firm’s
ability to meet interest obligations. Interest payments must be
Chapter 9
Liabilities and Interest
437
paid. However, at the extreme, zero coupon bonds have interest
expense but no requirement for interest payments. The
suggestion is a reasonable one. Thus, a very low interestcoverage ratio for a company with 20-year zero-coupon bonds
would not necessarily be a cause for concern.
9-30 (10 min.) Three items listed are not liabilities: cash and cash
equivalents, prepaid expenses, and retained earnings. The liabilities
are:
Krispy Kreme Company
Liabilities
February 2, 2003
(In Thousands of Dollars)
Current liabilities:
Short-term debt
$ 12,275
Accounts payable
14,055
Accrued expenses
20,981
Arbitration award
9,075
Current maturities of long-term debt
3,301
Total current liabilities
59,687
Long-term liabilities:
Deferred income taxes*
9,849
Revolving line of credit, long-term
7,288
Long-term debt, net of current portion 49,900
Other long-term obligations
5,218
Total long-term liabilities
72,255
Total liabilities
$131,942
* Most likely this is a long-term liability, but it might also be a
current liability if the deferred taxes are likely to be due
within the next year.
438
9-31 (5 min.)
1.
2.
Compensation expense
Cash
Accrued salaries and wages payable
To recognize compensation expense.
24,000
Salaries and wages payable
$6,000
20,000
4,000
Wages earned during March are $24,000. If $20,000 is paid and $2,000 of it is
to compensate workers for work performed in February, the remaining
$18,000 is for work in March. If workers earn $24,000 in March but are
paid only $18,000, the remaining payable at month’s end is $6,000.
Chapter 9
Liabilities and Interest
439
9-32 (5-10 min.)
The sales are shown, and then the payments of sales taxes to the
state are shown:
A
+142,800
–2,800
⎡Increase ⎤
⎢⎣ Cash ⎥⎦
=
=
⎡Decrease ⎤ =
⎢⎣ Cash ⎥⎦
L
+
+2,800
⎡ Increase
⎢Sales Tax
⎢⎣ Payable
⎤
⎥
⎥⎦
–2,800
⎡ Decrease ⎤
⎢Sales Tax ⎥
⎢⎣ Payable ⎥⎦
SE
+140,000
⎡Increase ⎤
⎢⎣ Sales ⎥⎦
Instructors may wish to point out that a common student error
would show sales in the income statement at $142,800 and sales tax
as an ordinary expense of $2,800. But the tax is levied on the
consumer, not the entity. The latter is merely the collecting agent for
the government.
The journal entries follow.
Cash
Sales
Sales tax payable
Sales tax payable
Cash
440
142,800
140,000
2,800
2,800
2,800
9-33 (10 min.)
1.
Cash
Sales revenue
Warranty expense
Liability for warranties
To record sales and the estimated
liability for warranties.
800,000
800,000
24,000
24,000
2.
Liability for warranties
20,400
Cash
20,400
Note that the fact that $4,500 of the expenditures were for
products sold in 20X4 is irrelevant.
3.
Beginning liability balance
Additions for 20X4 sales
Reductions for services provided
Ending liability balance
$11,600
24,000
(20,400)
$15,200
9-34 (5-10 min.) Amounts are in millions.
1.
2.
Cash
Unearned revenue
To recognize subscriptions paid for in cash.
37
Unearned revenue
Revenues
To recognize the earning of unearned
revenue by delivering magazines.
30
Unearned revenue, 6/30/03
Subscriptions paid for in cash
Earning of unearned revenue
Unearned revenue, 7/31/03
Chapter 9
Liabilities and Interest
37
30
$415
37
(30)
$422
441
9-35 (10-15 min.)
1.
Claims
First mortgage bonds
payable
Accounts payable
Unsubordinated debentures
Total claims
*
$13,000,000
3,000,000
5,000,000
$21,000,000
Distribution of Proceeds
In full
3/8 of remainder*
5/8 of remainder*
Total distribution
$13,000,000
1,875,000
3,125,000
$18,000,000
Total general unsecured claims = $3,000,000 + $5,000,000 = $8,000,000, so
remaining proceeds of $18,000,000 – $13,000,000, or $5,000,000, will be split
3/8, 5/8, or 62.5 cents per dollar of claim ($5,000,000 ÷ 8,000,000).
2.
Claims
First mortgage bonds
payable
Accounts payable
Subordinated debentures
Total claims
$13,000,000
3,000,000
5,000,000
$21,000,000
Distribution of Proceeds
In full
In full
Remainder
Total distribution
$13,000,000
3,000,000
2,000,000
$18,000,000
Ordinary trade creditors have a higher priority than subordinated
debenture holders who would now receive only 40 cents per
dollar of claim.
If only $14.5 million cash becomes available, the first mortgage
holders would get $13 million, the trade creditors would receive
$1.5 million (only 50 cents for each dollar claimed), and the
holders of subordinated debentures would receive nothing.
9-36 (20-25 min.)
See Exhibit 9-36 on the following page.
442
EXHIBIT 9-36
Computation of Market Value of Bonds
Sketch of Cash Flows
Present Total
Value Present
Factor
Value
0
Valuation at 12%, or 6% per period
Principal, 6-period line, Table 9A-2:
.7050 x $1,000 = $705
.7050
705
Interest, 6-period line, Table 9A-3:
4.9173 x $60 = $295
4.9173
295
Total
2
3
4
5
6
1,000
60
60
60
60
60
60
60
1,000
60
60
1,000
60
1,000
Valuation at 14%, or 7% per period
Principal
Interest
Total
.6663
4.7665
666
286
952
Valuation at 10%, or 5% per period
Principal
Interest
Total
.7462
5.0757
746
305
1,051
Chapter 9
1
Liabilities and Interest
60
60
60
60
60
60
60
60
443
9-37 (5 min.)
a.
b.
c.
Operating lease
Capital lease
Capital lease
d.
e.
Capital lease
Operating lease
9-38 (10 min.)
A
Cash
−250,000
=
L
Pension Obligations
=
+550,000
Pension expense
Pension obligations
Cash
To record $800,000 of pension expense,
of which $250,000 was paid in cash.
9-39
1.
2.
444
+
SE
Retained Earnings
Pension ⎤
− 800,000 ⎡⎢Expense
⎥
⎣
⎦
800,000
550,000
250,000
(10 min.) Amounts are in millions.
Income tax expense
2,344
Income taxes payable
Deferred income taxes
To record income tax expense.
Income taxes payable
2,281
Cash
To record payment of income taxes.
These two transactions could have been combined:
Income tax expense
2,344
Deferred income taxes
Cash
To record income tax expense and payments.
The deferred tax liability increases by $2,344 − $2,281= $63.
2,281
63
2,281
63
2,281
9-40 (20-35 min.)
1.
2.
Cash or accounts receivable
Sales
3,000,000
3,000,000
Warranty expense
Liability for warranties
.03 x $3,000,000 = $90,000
90,000
Liability for warranties
Cash, accounts payable,
accrued payroll, etc.
82,000
90,000
82,000
Cash
Deposits on bottles
To recognize a liability.
105,000
Deposits on bottles
Cash
To reduce the liability.
95,000
105,000
95,000
If you have time, you may wish to indicate that the deposits
are far less than the cost of a returnable container. For example,
the sturdy bottles placed on deposit might cost $500,000. (It is
not unusual to ask the customer for a deposit much smaller than
the cost of the container.) Containers are usually amortized over
their average useful lives.
Chapter 9
Liabilities and Interest
445
9-40 (continued)
3.
Journal Entries
April 1
June 30
July 1
4.
(a)
Cash
Deposits
Interest expense
Deposits
(.04 x 4,000) x 3/12
Deposits
Cash
446
40
40
4,040
4,040
150,000
150,000
Unearned Sales Revenue would be less by $30,000, and
Stockholders' Equity would rise by $30,000:
Unearned sales revenue
Sales
5.
4,000
Cash and Unearned Sales Revenue would be higher by
$150,000:
Cash
Unearned sales revenue
(b)
4,000
30,000
30,000
The newspaper should show a definite liability and expense in
the amount of $600,000. An accompanying footnote could
indicate the details and the company's optimism regarding a
reversal.
9-41 (10 min.)
1.
a.
b.
FV = $6,000(1.3605) = $8,163
FV = $6,000(1.5735) = $9,441
2.
a.
b.
PV = $6,000(.7350)
PV = $6,000(.6355)
3.
Halve the rates and double the number of periods. Present
values decline:
a.
b.
= $4,410
= $3,813
PV = $6,000(.7307) = $4,384.20
PV = $6,000(.6274) = $3,764.40
9-42 (10-20 min.)
1.
a.
b.
2.
The annual rates would be halved and the periods doubled.
Present values decline:
a.
b.
3.
PV = $20,000(.6830) = $13,660
PV = $20,000(.4823) = $ 9,646
PV = $20,000(.6768) = $13,536
PV = $20,000(.4665) = $ 9,330
Present values rise because the money is repaid more quickly:
a.
b.
Chapter 9
PV = $5,000(3.1699) = $15,849.50
PV = $5,000(2.5887) = $12,943.50
Liabilities and Interest
447
9-43 (10-15 min.)
1.
2.
Equipment
Discount on note payable
Cash
Contract payable (or note payable)
Equipment is capitalized at its cashequivalent cost. There is a $212,000
discount on the $800,000 note payable.
788,000
212,000
200,000
800,000
The imputed interest rate makes the present value of the
payments equal to the cash price:
€200,000 + (€800,000 x (4-year, Y% factor in Table 9A-2)) =
788,000
Factor = (€788,000 – €200,000) ÷ €800,000 = .7350
From the 4-year row of Table 9A-2, Y = 8%, interest expenses in
years 1 and 2 are:
Yr. 1: .08 x €588,000 = €47,040
Yr. 2: .08 x (€588,000 + 47,040) =.08 x €635,040 = €50,803
Journal entries are:
Year 1
Year 2
448
Interest expense
Discount on note payable
47,040
Interest expense
Discount on note payable
50,803
47,040
50,803
9-44 (10-15 min.)
The general approach to these exercises centers on one
fundamental question: Which of the basic tables am I dealing with?
No calculations should be made until after this question is answered
with assurance.
1.
The $20,000 is a lump-sum amount of future worth. You
want the present value of that amount:
PV =
FV
(1 + i)n
The present value factors for n = 5, 1/(1 + i)5, for various values of
i, are on line 5 of Table 9A-2. Substituting:
PV @ 5% = $20,000(.7835) = $15,670
PV @ 10% = $20,000(.6209) = $12,418
PV @ 20% = $20,000(.4019) = $ 8,038
(a)
(b)
(c)
Note that the higher the interest rate, the lower the present
value.
2.
The $3,000 withdrawal is a uniform annual amount, an
annuity. You need to find the present value of an annuity
for five years using values from Table 9A-3:
PVA = Annual withdrawal x F, where F is the annuity present
value factor
PVA @ 5% = $3,000(4.3295) = $12,988.50
PVA @ 10% = $3,000(3.7908) = $11,372.40
PVA @ 20% = $3,000(2.9906) = $ 8,971.80
Chapter 9
Liabilities and Interest
(a)
(b)
(c)
449
9-45 (10-15 min.)
a.
From Table 9A-3:
You have $100,000, the present value of your contemplated
annuity. You must find the annuity that will just exhaust the
invested principal in five years:
b.
1.
@ 8%:
PVA
$100,000
Annual Withdrawal
2.
@ 10%:
$100,000
Annual withdrawal
=
=
=
=
=
=
=
Annual withdrawal x F
Annual withdrawal x 3.9927
$100,000 ÷ (3.9927)
$25,045.71
Annual withdrawal x 3.7908
$100,000 ÷ (3.7908)
$26,379.66
From Table 9A-2: Mining is preferable; its present value exceeds
farming by $38,516.
Present Value @ Present Value Present Value
Year 16% from Table 9A-2
of Mining
of Farming
1.
2.
3.
4.
5.
.8621
.7432
.6407
.5523
.4761
$ 86,210
59,456
38,442
22,092
9,522
$215,722
$ 17,242
29,728
38,442
44,184
47,610
$177,206
Note that the nearer dollars are more valuable than the
distant dollars.
450
9-46 (10-15 min.)
1.
Future amount = $20,000 x 2.4364
= $48,728
2.
$20,000 = Future amount x .4104
Future amount = $20,000 ÷ .4104
= $48,733
This differs from the answer in requirement 1 only due to a
rounding error.
3.
$20,000 = Future annual amounts x 3.2743
Future annual amounts =
=
$20,000 ÷ 3.2743
$6,108.18
9-47 (5-10 min.)
Use Table 9A-3 to find the present value of the 9 payments of
$20,000 each @ 16%:
$20,000 x 4.6065 = $92,130
Total present value includes the immediate payment:
Total present value = $25,000 + $92,130
= $117,130
Chapter 9
Liabilities and Interest
451
9-48 (15-20 min.)
1.
Analysis of Payroll Transactions
A
=
Cash
L
+ SE
Withheld Withheld
Accrued Income
Social Payable
Wages
Taxes Security to Credit Retained
Payable Payable Taxes
Union Earnings
Recognize liabilities
= +131,800 +44,000* +14,200** +10,000 –200,000
Pay cash to employees –133,800 = –131,800
Pay cash to government – 58,200 =
–44,000 –14,200
Pay cash to credit union – 10,000 =
–10,000
* .22 x 200,000
** .071 x 200,000
2.
= 44,000
= 14,200
Compensation expense
200,000
Accrued wages payable
Withheld income taxes payable
Withheld social security taxes payable
Payable to Credit Union
To recognize compensation expense
for the week ended January 27.
Accrued wages payable
Cash
To pay employees.
452
131,800
44,000
14,200
10,000
131,800
131,800
Withheld income taxes payable
Withheld social security taxes payable
Cash
To pay the government on January 31.
44,000
14,200
Payable to Credit Union
Cash
To pay the Credit Union for employee
Deposit on January 31
10,000
58,200
10,000
9-48 (continued)
3.
Compensation expense
(or employee benefit expense)
Employer payroll taxes payable
(.09 x $200,000)
Health insurance premiums payable
Pension fund contributions payable
To record fringe benefits on the
payroll for the week ended January 27.
Employee payroll taxes payable
Health insurance premiums payable
Pension fund contributions payable
Cash
To record payment of various
payroll-related liabilities.
Chapter 9
Liabilities and Interest
46,000
18,000
12,000
16,000
18,000
12,000
16,000
46,000
453
9-49 (15-20 min.)
1.
€2,500,000,000 x .01375 = €34,375,000
2.
Probably not. Even though a bondholder could get €60 x 17.8 =
€1,068 worth of stock for a bond worth €1,000, it would not be
worth converting because holding the bond and continuing to
receive interest is a hedge against a decline in the price of the
stock. It is possible that Siemens’s share price might again fall
below €56, making the stock’s value less than the €1,000 maturity
value of the bond. Meanwhile, it is likely that Siemens will pay
dividends that are more than the interest on the bond (€13.75
interest versus €17.8 of dividends). If dividends where much
greater than the interest, a bondholder might be motivated to
convert earlier. As it is, the bondholder can wait, being assured
that he or she can participate in stock price increases by
converting at a later date. Meanwhile, the bondholder does not
have to accept the risk of declines in the stock price.
3.
If the maturity date of the bonds approaches, the bondholder
would convert. The option of waiting is no longer available. If the
bondholder felt that the risk of the stock price falling below €56
per share is too great, he or she could convert and immediately
sell the common shares at €60, realizing a €68 gain, (17.8 x €60) –
€1,000. The bondholder would not convert if the price were €50
per share.
454
9-50 (20-30 min.)
1.
$30 million. Proceeds equal face amount when issued at par.
2.
Note that interest expense equals interest payment.
Interest payment = 1/2 x 10% x $30,000,000 = $1,500,000
Analysis of Bond Transactions
(In Thousands of Dollars)
Issuer's Records
a.
Issuance
A
=
Cash
=
+30,000 =
b.
First semi-annual interest
– 1,500 =
c.
Maturity value
Bond related totals*
–30,000 =
–15,000 =
L
Bonds
Payable
+
SE
Retained Earnings
+30,000
– 1,500
–30,000
0
⎡Increase ⎤
⎢ Interest ⎥
⎢⎣Expense⎥⎦
−
–15,000
*Totals represent five years, 10 periods, at a constant $1,500 per period.
Chapter 9
Liabilities and Interest
455
9-50 (continued)
3.
Sample Journal Entries
Bond Transactions
(In Thousands of Dollars)
Issuer's Records
a.
b.
c.
4.
Cash
Bonds payable
To record proceeds upon issuance
of 10% bonds maturing on
December 31, 2008.
Interest expense
Cash
To record payment of interest.
30,000
1,500
1,500
Bonds payable
Cash
To record payment of maturity
value of bonds and their retirement.
30,000
30,000
Bonds issued at par are presented as long-term liabilities on the
balance sheet at the face amount (in thousands):
Issuer's Balance Sheet
Bonds payable, 10% due December 31, 2008
456
30,000
December 31, 2003 June 30, 2004
$30,000
$30,000
9-51 (20-30 min.)
1.
$15 million. Proceeds equal face amount when issued at par.
2.
Note that interest expense equals interest payment.
Interest payment = 1/2 x 6% x $15,000,000 = $450,000
Analysis of Bond Transactions
(In Thousands of Dollars)
Issuer's Records
A
=
Cash
=
L
Bonds
Payable
+15,000
a.
Issuance
+15,000
=
b.
First semi-annual interest
–
450
=
c.
Maturity value
Bond related totals*
–15,000
–9,000
=
=
+
SE
Retained Earnings
– 450
–15,000
0
⎡Increase⎤
⎢ Interest ⎥
⎢⎣Expense⎥⎦
–9,000
* Totals represent ten years, 20 periods at a constant $450 per period.
Chapter 9
Liabilities and Interest
457
9-51 (continued)
3.
Sample Journal Entries
Bond Transactions
(In Thousands of Dollars)
Issuer's Records
a.
b.
c.
4.
Cash
Bonds payable
To record proceeds upon issuance
of 6% bonds maturing on
December 31, 2013.
15,000
Interest expense
Cash
To record payment of interest.
450
450
Bonds payable
Cash
To record payment of maturity
value of bonds and their retirement.
15,000
15,000
Bonds issued at par are presented in the long-term liabilities
section of balance sheets at the face amount (in thousands):
Issuer's Balance Sheet
Bonds payable, 6% due December 31, 2013
458
15,000
December 31, 2003
June 30, 2004
$15,000
$15,000
9-52 (15-30 min.)
1.
Cash interest payments,
.09 x $100,000,000 x 1/2
First semi-annual interest expense,
.05 x $91,191,000
Amortization of discount
$4,500,000
4,559,550
$ 59,550
Analysis of Bond Transactions
(In Thousands of Dollars)
A
Cash
=
= Bonds
Payable
L
+
Discount on
Bonds Payable
a.. Issuance
+91,191 = +100,000 –8,809
⎡Increase ⎤
⎢⎣ Discount ⎥⎦
b. Semi-annual
interest (repeated
for twenty years)
– 4,500 =
⎡Decrease ⎤
⎢⎣ Discount ⎥⎦
c. Maturity Value
+ 60
SE
Retained Earnings
– 4,560
⎡Increase ⎤
⎢ Interest ⎥
⎢⎣Expense⎥⎦
–100,000 = –100,000
Bond-related totals* –188,809 =
0
0
–188,809
* Bond totals include 40 semi-annual payments of $4,500 each and
repayment of $8,809 in excess of the original borrowing.
Chapter 9
Liabilities and Interest
459
9-52 (continued)
2.
Sample Journal Entries
Bond Transactions
(In Thousands of Dollars)
Issuer's Records
a.
b.
c.
3.
Cash
Discount on bonds payable
Bonds payable
To record proceeds upon issuance
of 9% bonds maturing on
March 1, 2023.
91,191
8,809
Interest expense
Discount on bonds payable
Cash
To record payment of interest and
amortization of discount.
4,560
Bonds payable
Cash
To record payment of maturity value
of bonds and their retirement.
100,000
60
4,500
100,000
100,000
When presented on balance sheets, unamortized discounts are
deducted from the face value of the related bonds:
March 1
Issuer's Balance Sheet (in thousands)
Bonds payable, 9% due March 1, 2023
Deduct: Discount on bonds payable
Net carrying amount
2003
$100,000
8,809
$ 91,191
* $8,809 – 60 – (5% x [$100,000 – (8,809 – 60)] – $4,500)) = 8,686
460
2004
$100,000
8,686*
$ 91,314
9-53 (25-40 min.)
1.
Proceeds equal the present values of interest and maturity
payments at the market rate:
Interest payment = 1/2 x 6% x $10,000,000 = $300,000
PV of interest payments, $300,000 x 8.1109*
$2,433,270
PV of maturity payment, $10,000,000 x .6756*
6,756,000
Proceeds
$9,189,270
* From Tables 9A-3 and 9-A2, respectively, 4% column, 10-period row
Using a computer to avoid rounding errors, the present value is
PV of interest payments
PV of maturity payment
Proceeds
$2,433,268.73
6,755,641.69
$9,188,910.42
For the remainder of this problem we will use the numbers
derived from the tables. If you used the more precise calculation,
your numbers will be just slightly different.
2.
First semi-annual interest expense,
4% x $9,189,270
Semi-annual interest payment
Amortization of bond discount
$367,571
300,000
$ 67,571
Analysis of Bond Transactions
A
=
=
Cash
a. Issuance
b. First semi-annual
interest
L
Bonds
Payable
+
Discount on
Bonds
Payable
SE
Retained Earnings
+9,189,270 = +10,000,000 – 810,730
– 300,000 =
c. Maturity value
–10,000,000 = –10,000,000
Bond related totals* – 3,810,730
+ 67,571
0
Increase
– 367,571 ⎡⎢Interest ⎤⎥
⎣⎢Expense ⎦⎥
−3,810,730
* Bond totals include 10 semi-annual payments of $300,000 plus repayment
of $810,730 in excess of the original borrowing.
Chapter 9
Liabilities and Interest
461
9-53 (continued)
3.
a.
Cash
9,189,270
Discount on bonds payable
810,730
Bonds payable
10,000,000
To record proceeds upon issuance
of 6% bonds maturing on
January 1, 2009.
b.
Interest expense
Discount on bonds payable
Cash
To record amortization of discount
and payment of interest.
c.
4.
67,571
300,000
Bonds payable
10,000,000
Cash
10,000,000
To record payment of maturity
value of bonds and their retirement.
When presented on balance sheets, unamortized discounts are
deducted from the face value of the related bonds:
Bonds payable, 6% due January 1, 2009
Deduct: Discount on bonds payable
Net Liability
* 810,730 – 67,571 = 743,159
462
367,571
January 1, 2004
$10,000,000
810,730
$ 9,189,270
July 1, 2004
$10,000,000
743,159*
$ 9,256,841
9-54 (30 – 40 min.)
1. In the following table, we have assumed the proceeds to be the
exact amount of $9,188,910.42 to avoid rounding errors. We also used a
spreadsheet, so there was no rounding of intermediate numbers.
For 6
Months
Ended
1/01/2004
6/30/2004
12/31/2004
6/30/2005
12/31/2005
6/30/2006
12/31/2006
6/30/2007
12/31/2007
6/30/2008
12/31/2008
2.
Chapter 9
Beg.
Net
Liability
—
$9,188,910
9,256,467
9,326,726
9,399,795
9,475,786
9,554,818
9,637,010
9,722,491
9,811,391
9,903,846
Interest Nominal
Ending
Expense*
Int.
Discount Unamortized
@ 8%** @ 6% Amortized Discount
—
$367,556
370,259
373,069
375,992
379,031
382,193
385,480
388,900
392,456
396,154
—
$300,000
300,000
300,000
300,000
300,000
300,000
300,000
300,000
300,000
300,000
Interest expense
385,480
Cash
Discount on bonds
Liabilities and Interest
—
$67,556
70,259
73,069
75,992
79,031
82,193
85,480
88,900
92,456
96,154
$811,090
743,533
673,274
600,205
524,214
445,182
362,990
277,509
188,609
96,154
0
Ending
Net
Liability
$9,188,910
9,256,467
9,326,726
9,399,795
9,475,786
9,554,817
9,637,011
9,722,491
9,811,391
9,903,846
10,000,000
300,000
85,480
463
9-55 (25 - 35 min.)
Analysis of Bond Transactions
(In Thousands of Norwegian Kroner)
A
=
Cash
a. Issuance
7,881
=
b. First semi-annual interest
– 500* =
c. Maturity value
Bond related totals***
–10,000
–12,119
=
=
L
+
SE
Discount
on
Bonds
Bonds
Payable Payable
Retained Earnings
+10,000
–2,119
+ 52
–10,000
0
0
⎡Increase ⎤
– 552** ⎢ Interest ⎥
⎣⎢Expense ⎦⎥
–12,119
* NKR10,000,000 x 10% x 1/2
** NKR7,881,000 x 14% x 1/2
*** Twenty semi-annual payments of NKR500 plus repayment of NKR2,119 in
excess of the original borrowing.
464
9-55 (continued)
2.
Sample Journal Entries
Bond Transactions
(In Thousands of Norwegian Kroner)
a.
b.
c.
3.
Cash
Discount on bonds payable
Bonds payable
To record proceeds upon issuance
of 10% bonds maturing on
December 31, 2014.
7,881
2,119
Interest expense
Discount on bonds payable
Cash
To record amortization of discount
and payment of interest.
552
Bonds payable
Cash
To record payment of maturity value
of bonds and their retirement.
10,000
52
500
10,000
10,000
When presented on balance sheets, unamortized discounts are
deducted from the face value of the related bonds (in
thousands):
December 31, 2004
Bonds payable, 10% due December 31, 2014
Deduct: Discount on bonds payable
Net liability
NKR10,000
2,119
NKR 7,881
June 30, 2005
NKR10,000
2,067*
NKR 7,933
* 2,119 – 52 = 2,067
Chapter 9
Liabilities and Interest
465
9-56 (25-40 min.)
1.
2.
Proceeds equal the present values of interest and maturity
payments at the market interest rate.
Interest payment = 1/2 x 10% x $4,000,000 =
$ 200,000
PV of interest payments, $200,000 x 8.1109*
PV of maturity payment, $4,000,000 x .6756**
Proceeds
* From Table 9A-3, 4% column, 10-period row
** From Table 9A-2, 4% column, 10-period row
$1,622,180
2,702,400
$4,324,580
First semi-annual interest expense, 4% x $4,324,580
Semi-annual interest payment
Amortization of bond premium
$172,983
200,000
$ 27,017
Analysis of Bond Transactions
A
=
=
Cash
L
+
Bonds
Payable
a. Issuance
4,324,580
= +4,000,000
b. First semi-annual interest
− 200,000
=
c. Maturity value
Bond related totals*
SE
Premium on
Bonds
Payable
+ 324,580
− 27,017
−4,000,000
= −4,000,000
−1,675,420
=
0
Retained Earnings
– 172,983
⎡Increase ⎤
⎢ Interest ⎥
⎢⎣Expense ⎥⎦
0 −1,675,420
* Bond related totals represent 10 semi-annual payments of $200,000 less
repayment of $324,580 less than the proceeds at issue.
466
9-56 (continued)
3.
a.
b.
c.
4.
Cash
4,324,580
Bonds payable
Premium on bonds payable
To record proceeds upon issuance
of 10% bonds maturing on
January 1, 2009.
Interest expense
Premium on bonds payable
Cash
To record amortization of premium
and payment of interest.
4,000,000
324,580
172,983
27,017
Bonds payable
4,000,000
Cash
To record payment of maturity value
of bonds and their retirement.
200,000
4,000,000
When presented on balance sheets, unamortized premiums are
added to the face value of the related bonds:
Bonds payable, 10% due January 1, 2009
Add: Premium on bonds payable
Net Liability
January 1, 2004
July 1, 2004
$4,000,000
324,580
$4,324,580
$4,000,000
297,563*
$4,297,563
* $324,580 – $27,017 = $297,563
Chapter 9
Liabilities and Interest
467
9-57 (25-35 min.)
Proceeds were $11,359,150.
1.
Analysis of Bond Transactions
(In Thousands of Dollars)
A
=
Cash
+11,359 =
a. Issuance
L
+
SE
Premium
Bonds on Bonds
Payable Payable
Retained Earnings
+10,000
+1,359
⎡Increase⎤
b. First semi-annual interest
c. Maturity value
Bond related totals***
– 500* =
–10,000 =
– 8,641 =
– 46
–10,000
0
0
– 454** ⎢ Interest ⎥
⎢⎣Expense⎥⎦
−8,641
* $10,000,000 x 10% x 1/2
** $11,359,000 x 8% x 1/2
*** Bond related totals represent 20 semi-annual payments of $500 less
repayment of $1,359 less than the proceeds at issue.
2.
Journal Entries
(In Thousands of Dollars)
a.
b.
468
Cash
Bonds payable
Premium on bonds payable
To record proceeds upon issuance
of 10% bonds maturing on
December 31, 20Y4.
11,359
Interest expense
Premium on bonds payable
Cash
To record amortization of premium
and payment of interest.
454
46
10,000
1,359
500
9-57 (continued)
c.
3.
Bonds payable
Cash
To record payment of maturity value
of bonds and their retirement.
10,000
10,000
When presented on balance sheets, unamortized premiums are
added to the face value of the related bonds (in thousands):
December 31, 20X4
Bonds payable, 10% due December 31, 20Y4
Add: Premium on bonds payable
Net liability
$10,000
1,359
$11,359
June 30, 20X5
$10,000
1,313*
$11,313
* 1,359 – 46 = 1,313
Chapter 9
Liabilities and Interest
469
9-58 (20-40 min.)
1.
To compute the gain or loss, first calculate the net liability at
December 31, 2004:
Face amount
Proceeds
Discount at issuance
6/30/04 discount amortization
12/31/04 discount amortization
Bond discount at 12/31/04
*
**
†
$20,000,000
17,880,800 *
2,119,200
(51,656) **
(55,272) †
$ 2,012,272
($1,200,000 x 10.5940) + ($20,000,000 x .2584)
(7% x $17,880,800) – (6% x $20,000,000)
(7% x ($17,880,800 + $51,656)] - (6% x $20,000,000)
The net liability is the face amount less the discount:
Face amount
$20,000,000
Bond discount at 12/31/04
2,012,272
Net liability at 12/31/04
$17,987,728
The amount by which the cash payment for the debentures
exceeds the net liability is the loss on early extinguishment.
Amounts are in thousands:
Cash payment
Net liability at 12/31/04
Loss on early extinguishment of debt
470
$19,000
17,988
$ 1,012
9-58 (continued)
2.
Analysis of Early Extinguishment of Debt
(In Thousands of Dollars)
A
=
L
Bonds
= Payable
+
Discount on
Bonds Payable
SE
Issuer's Record
Cash
Retained Earnings
Redemption,
⎡ Loss on Early ⎤
⎡Decrease ⎤
December 31, 2004 –19,000 = –20,000 +2,012 ⎢⎣ Discount ⎥⎦ –1,012 ⎢⎣Extinguish ment ⎥⎦
3.
Journal Entry
(In Thousands)
Issuer's Records
December 31, 2004
Bonds payable
Loss on early extinguishment of debt
Discount on bonds payable
Cash
To record open-market acquisition of
entire issue of 12% bonds for $19 million.
4.
20,000
1,012
2,012
19,000
A gain arises if the bond is extinguished for less than the
carrying value, $17,987,728 – $500,000 gives a price of
$17,487,728.
Chapter 9
Liabilities and Interest
471
9-59 (10-15 min.) Amounts are in thousands of dollars.
1.
Net liability equals face or par value
Cash received
Difference, gain on early extinguishment of debt
SFR10,000
9,000
SFR 1,000
2.
Analysis of Early Extinguishment of Debt
(In Thousands of Swiss Francs)
Issuer's Records
a. Redemption,
December 31, 2006
A
=
Cash
=
–9,000
L
Bonds
Payable
= –10,000
+
SE
Retained Earnings
+1,000 ⎡ Gain on Early ⎤
⎢⎣Extinguish ment ⎥⎦
Journal Entry (Thousands of Swiss Francs)
Issuer's Records
December 31, 2006
Bonds payable
10,000
Gain on early extinguishment of debt
Cash
To record open-market acquisition of entire
issue of 8% bonds for SFR 9.0 million.
472
1,000
9,000
9-60 (20-25 min.) Amounts are in dollars.
1.
Analysis of Transactions
Discounted Notes
A
Cash
Borrower
Proceeds of loan
=
Notes
= Payable
+36,000* =
Discount amortization
Payment of note
Change after one year
L
+40,000
=
–40,000
– 4,000
=
+
Discount
on Notes
Payable
SE
Retained Earnings
–4,000
+4,000
–40,000
0
–4,000
0
⎡ Interest ⎤
⎢⎣Expense ⎥⎦
–4,000
*40,000 − (10% x $40,000) = $36,000
2.
Journal Entries
Borrower
Inception Cash
Discount on notes payable
Notes payable
Interest
Maturity
3.
Interest expense
Discount on notes payable
Notes payable
Cash
36,000
4,000
40,000
4,000
4,000
40,000
40,000
Interest ÷ proceeds = interest rate
$4,000 ÷ $36,000 = 11.1% per year.
Chapter 9
Liabilities and Interest
473
9-61 (15-25 min.)
1.
2.
Cash
Discount on bonds payable
Bonds payable
Cash is present value at 10% of $1
to be received at the end of ten years,
.3855, multiplied by $20,000,000.
a.
7,710,000
12,290,000
20,000,000
Straight line amortization
First Year and Second Year
Interest expense is identical
Interest expense
Discount on bonds payable
Amortization is spread evenly
over 10 years.
$12,290,000 ÷ 10 = $1,229,000.
b.
1,229,000
1,229,000
Effective-interest approach
First Year
Interest expense
771,000
Discount on bonds payable
Amortization for first year is
market rate at issue times book value.
.10 x $7,710,000 = $771,000
474
771,000
9-61 (continued)
Second Year
Interest expense
Discount on bonds payable
Amortization for second year is
.10 x ($7,710,000 + $771,000) =
.10 x $8,481,000 = $848,100
3.
848,100
848,100
.35 x ($1,229,000 – $771,000) = $160,300
Note that in the early years the company will recognize higher
interest expense and pay lower taxes under the previously
allowed straight-line amortization method. This was the benefit
that companies such as J.C. Penney and General Motors
Acceptance found so desirable when they initiated this type of
borrowing. Over the life of the loan, the two methods will
recognize equal total interest expense. Therefore, in later years
the effective-interest method will result in higher interest expense
and lower income taxes than the straight-line method. The
important issue for tax planning is the opportunity to delay
payments to the government. This delay amounts to an interest
free loan.
4.
Taxpayers who own such bonds would pay significant taxes on
the “imputed interest” even though they received no cash
interest. Thus, non-taxable investors might be an especially
appropriate investment clientele, including pension plans and
personal investments in tax deferred activities such as Keogh’s
and IRA’s
Chapter 9
Liabilities and Interest
475
9-62 (15-20 min.) This problem requires interpolation of an interest
rate, which was not discussed in the text.
1.
$5,000 x PV factor for 22 years = $1,800
PV factor for 22 years = $1,800 ÷ $5,000 = .3600
Therefore, the interest rate is between 4% and 5%. We can
interpolate as follows:
4% factor = .4220
X% factor = .3600
5% factor = .3418
(.4220 - .3600) ÷ (.4220 - .3418) = .0620 ÷ .0802 = .77
Therefore, X = 4% + .77% = 4.77%
$5,000 x PV factor for 3 years = $4,750
PV factor for 3 years = .95
Therefore, the 3-year market interest rate is less than 3%. 2002
was a time when short-term rates were lower than long-term
rates, so it makes sense that the rate on 3-year bonds is much
lower than the rate on 22-year bonds.
2.
3.
4.
476
Cash
Zero coupon bonds payable
To record issuance of one $5,000 22-year
zero-coupon bond.
1,800
Interest expense
Zero-coupon bonds payable
To record interest expense for fiscal 2002
(three months) on zero-coupon bonds,
.0477 x $1,800 x .25 = $21.47 or $21.
21
$1,800 + $21= $1,821.
1,800
21
9-63 (20-30 min.)
Some instructors may prefer to (a) ask students to prepare
entries for two years only here and (b) also assign the next problem.
1.
PVA = $40,000 x Annuity Factor for 3 years at 18%
= $40,000 x 2.1743
= $86,972
2.
Equipment leasehold
Lease liability, current*
Lease liability, long-term
To record capital lease.
86,972
24,345
62,627
Analysis of first installment:
Total amount
Interest, .18 x $86,972
Principal portion, current liability
Total liability
Current liability
Long-term liability
$40,000
15,655
$24,345
$86,972
24,345
$62,627
Entry for straight-line amortization of the asset for each of
three years:
Amortization of equipment leasehold
Equipment leasehold
To record straight-line amortization:
$86,972 ÷ 3 = $28,991.
Chapter 9
Liabilities and Interest
28,991
28,991
477
9-63 (continued)
Lease Payments and Liability Reclassifications
End of Year One
Interest expense
Lease liability, current
Cash
To record interest expense and
reduction of liability.
15,655
24,345
Lease liability, long term
Lease liability, current
To reclassify next installment of
long-term debt as short-term debt.
28,727
40,000
28,727
Analysis of second installment:
Total
Interest portion:
.18 x ($86,972 – $24,345)
= .18 x $62,627 =
Principal portion, current liability
Total liability
Current liability
Long-term liability
478
$40,000
11,273
$28,727
$62,627
28,727
$33,900
9-63 (continued)
End of Year Two
Interest expense
Lease liability, current
Cash
To record interest expense and
reduction of liability.
11,273
28,727
Lease liability, long-term
Lease liability, current
To reclassify next installment
of long-term debt as short-term debt.
33,900
End of Year Three
Interest expense
Lease liability, current
Cash
40,000
33,900
6,100
33,900
40,000
Analysis of third installment:
Total amount
Interest, .18 x $33,900
Principal
$40,000
6,102
$33,898*
* Rounding causes this amount to differ from the $33,900 liability. These
rounding errors occur because the present value tables are carried to four
places only rather than to five or more places. This rounding causes the
present value of the lease to be rounded at its inception.
Chapter 9
Liabilities and Interest
479
9-64 (30-40 min.)
Amounts are in dollars. Note how the capital lease shows higher
expenses in the first two years.
Operating Lease
Capital Lease
Difference
Total expenses:
Year 1
Year 2
Two years together
40,000
40,000
80,000
44,646 a
40,264 a
84,910
4,646
264
4,910
End of Year 1:
Total assets
Total liabilities
Retained earnings
–
–
–40,000
57,981 b
62,627 c
–44,646
57,981
62,627
– 4,646
End of year 2:
Total assets
Total liabilities
Retained earnings
–
–
–80,000
28,990 b
33,900 c
–84,910
28,990
33,900
– 4,910
a.
Amortization
Interest
Total expenses
b.
Yr. 1
Yr. 2
Yr. 3
Year 1
28,991
15,655
44,646
Equipment Leasehold
86,972
28,991
57,981
28,991
28,990
Year 2
28,991
11,273
40,264
c.
Total Lease Liabilities
24,345 86,972
28,727 62,627
33,900
Some instructors may wish to point out that you can also
compute the differences between the operating lease and the
capital lease in pretax income by analyzing the changes in the
asset and liability during a given year. Consider year 2:
480
9-64 (continued)
Beginning balance
Ending balance
Change
Asset
57,981
28,990
28,991
Lease
Liabilities
62,627
33,900
28,727
Difference
264
Similarly, the difference in retained earnings can be measured by
the difference in the leasehold asset and lease liabilities.
For the end of the second year, $28,990 – $33,900 = –$4,910.
9-65 (35-50 min.)
1.
2.
Let X
$100,000
$100,000
X
X
=
=
=
=
=
rental payment
P.V. of annuity of X per year for 3 years at 10%
2.4869 X
$100,000 ÷ 2.4869
$40,211 rental per year
If all accounting for rentals were on the operating lease basis, the
entries would be straightforward:
Each year the journal entry would be:
Rent expense
Cash
To record lease payment.
Chapter 9
Liabilities and Interest
40,211
40,211
481
9-65 (continued)
A
Cash
Signing of
Lease Payment:
Year 1
Year 2
Year 3
Cumulative Totals
=
L
Equipment = Lease
Leasehold
Liability
+
SE
Retained Earnings
No Entry
– 40,211
=
– 40,211
– 40,211
– 40,211
−120,633
=
=
=
– 40,211
– 40,211
−120,633
⎡Increase⎤
⎢ Rent ⎥
⎣⎢Expense⎦⎥
Under today's accounting rules, this lease must be accounted for
as a capital lease. This means that both a leasehold asset and a
lease liability must be placed on the balance sheet at the present
value of future lease payments, $100,000 in this illustration. The
signing of the lease would require the following journal entry:
Equipment leasehold under capital lease
Obligation under capital lease
To record the acquisition of an asset
and its accompanying liability.
100,000
100,000
At the end of each of the three years, the asset must be
amortized. Straight-line amortization would be $100,000 ÷ 3 =
$33,333 annually.
3.
Analytical Schedule of Lease Payments
(1)
482
(2)
(3)
(4)
(3) – (2)
(5)
(1) – (4)
End of
Year
1
2
3
Lease Liability
at Beginning
Interest at
of Year
10% Per Year
$100,000
69,789
36,557
$10,000
6,979
3,656
Cash for
Lease
Payment
$40,211
40,211
40,211
Reduction in
Beginning
Lease Liability
Lease Liability at End of Year
$30,211
33,232
36,555
$99,998*
$69,789
36,557
2*
*Should be zero and $100,000, respectively. Differences are due to rounding.
4 and 5. See Exhibit 9-65.
Chapter 9
Liabilities and Interest
483
EXHIBIT 9-65
4.
For brevity, the account, Obligation Under Capital Lease, is called Lease Liability below.
Analysis of Transactions
Accounting for a Capital Lease
A
Cash
Signing of lease
Equipment
Leasehold
+100,000
=
L
+
=
Lease Liability
=
+100,000
SE
Retained Earnings
Lease payments*:
End of Year 1
– 40,211
=
– 30,211
– 10,000
End of Year 2
End of Year 3
– 40,211
– 40,211
=
=
– 33,232
– 36,555
– 6,979
– 3,656
+
– 33,333
– 33,333
– 33,334
–120,635*
⎡ Interest ⎤
⎢⎣Expense ⎥⎦
Amortization of leasehold**:
End of Year 1
End of Year 2
End of Year 3
Cumulative totals
* Rounding error of $2.
484
–120,633
– 33,333
– 33,333
– 33,334
0
=
=
=
=
2*
⎡ Amortization ⎤
⎣⎢ of lease - hold⎦⎥
EXHIBIT 9-65
5.
(continued)
The yearly journal entries would be:
Year 1
Interest expense
Lease liability
Cash
10,000
30,211
Amortization of leasehold**
Equipment leasehold
33,333
Year 2
6,979
33,232
40,211*
3,656
36,555
40,211
33,333
33,333
Year 3
40,211
33,334
33,333
33,334
* An accompanying exhibit contains the schedule of lease payments. Small differences are because of rounding.
** Straight-line amortization is usually followed in practice. A separate account for Accumulated Amortization –
Leasehold could be presented, but the amortization is shown here as a direct reduction of Equipment
Leasehold.
Chapter 9
Liabilities and Interest
485
9-66 (15-20 min.) Amounts are in millions.
1.
Each quarterly payment is $40 ÷ 4 = $10
First quarter:
Total
Interest is .02 x $127
Principal
$10.00
2.54
$ 7.46
Second quarter:
Total
Interest is .02 x ($127 − $7.46)
Principal
$10.00
2.39
$ 7.61
2.
Interest expense
Lease liability
Cash
3.
First Quarter
2.54
7.46
10.00
Second Quarter
2.39
7.61
10.00
This is a 15-year annuity at 8%. From Table 9A-3 the factor is
8.5595. The present value of these commitments is 8.5595 ×
$1,000 million = $8,559.5 million
Delta acquires far more of its aircraft and other leased assets
under operating leases than under capital leases. Under
reasonable assumptions making these leases capital leases,
Delta's debt level and assets could each be about $8.5 billion
higher.
486
9-67 (15-20 min.) Total dollars are in millions.
1.
2.
Payment
1,368
1,285
1,192
1,155
1,045
8,342
a.
b.
x
x
x
x
x
x
Factor
.9091
.8264
.7513
.6830
.6209
.5645
=
=
=
=
=
=
Equipment under leases
Obligations under capitalized
leases
Interest expense*
Obligations under capitalized leases
Cash
$1,244
1,062
896
789
649
4,709
$9,349
9,349
9,349
935
433 **
1,368
* .10 x $9,349
** $1,368 − $935
3.
Debt-to-equity ratio = $8,097 ÷ $7,266 = 1.1
After capitalizing the operating leases, the debt-to-equity ratio is:
($8,097 + $9,349) ÷ $7,266 = 2.4
The debt-to-equity ratio more than doubles. This is a signal that,
if the operating leases are essentially liabilities, FedEx is more
risky than it at first appears from its financial statements.
Chapter 9
Liabilities and Interest
487
9-68 (10-15 min.) (in millions)
1.
2.
Capital lease obligations
Interest expense
Cash
To record lease payments.
7
45
524
Asset: $352 − (1/20) x $352 = $334.40
Liability: $318
3.
At the initiation of a lease, the amount entered into the asset
account equals the amount entered into the liability account.
However, the lease asset account is amortized (depreciated) on a
straight-line basis, while the liability is amortized using the
effective interest method. Because of this, the asset account will
generally be smaller than the liability account.
9-69 (5-10 min.)
1.
General Motors has obligations for pensions and postretirement
benefits of about $149 billion. Fund assets of $63 billion will
cover part of this obligation, but it still leaves $86 billion of
promised benefits that rely on the future financial viability of GM.
This amount vastly exceeds both its stockholders' equity ($7
billion) and its market value ($23 billion). It would not take a large
decline in GM's fortunes to cause problems in meeting these
obligations to retirees.
2.
The General Motors example illustrates why reporting of
pensions and other postretirement benefits is important. These
are obligations that a company must meet in the future. Just
because they are not due today is no reason to exclude them
from the company's liabilities. For some companies, these
obligations are among their largest liabilities.
488
9-70 (10-15 min.) Amounts in millions.
1.
Income taxes paid = £255 − £56 = £199
2.
Income tax expense on ordinary activities
Cash
Deferred tax liability
3.
255
199
56
There are two reasons that taxes paid can differ from the tax
expense. One reason would be if there is a change in the
amount of taxes currently payable. That is not the case here.
The second is that some of the tax is deferred. In this case, the
pretax income in the report to tax authorities must have been
less than the pretax income reported to shareholders. The
existence of a deferred tax liability means that this difference is
temporary, that is, it will reverse in the future. At that time, the
other £56 of income taxes will become due.
Chapter 9
Liabilities and Interest
489
9-71 (25 – 30 min.)
1.
Deferred taxes arise from differences between book and tax
depreciation. For example, in 20X0 book depreciation is $20,000
and tax depreciation is $40,000. Thus, pretax income is $20,000
higher for book purposes than it is for tax purposes. Eventually,
the company will need to pay taxes on that $20,000. However, in
20X0 the taxes will be 40% x $20,000 = $8,000 less on the tax
income than on the book income. Thus, the company deferred
the $8,000 in taxes until a later year. Applying this same
reasoning each year results in the following table of deferred
taxes:
Year
20X0
20X1
20X2
20X3
20X4
20X5
20X6
20X7
20X8
20X9
Straightline
Deprec.
$20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
Doubledeclining
balance
Deprec.
$40,000
32,000
25,600
20,480
16,384
13,107
13,107
13,107
13,107
13,107
DDB
Increase
Less
(Decrease)
S-L
in Deferred
Deprec.
Taxes
$20,000
$8,000
12,000
4,800
5,600
2,240
480
192
-3,616
-1,446
-6,893
-2,757
-6,893
-2,757
-6,893
-2,757
-6,893
-2,757
-6,893
-2,757
Ending
Deferred
Tax
Liability
$8,000
12,800
15,040
15,232
13,786
11,028
8,271
5,514
2,757
0
2. This is a deferred tax liability. Castillo Company is postponing
taxes, but eventually it must pay them. Thus, it incurs an obligation for
future taxes. In 20X4 the situation turns around, and Castillo begins
paying more taxes, so its liability begins to fall.
490
3. At the end of the asset’s life the deferred tax liability must be zero.
The total depreciation on the asset is $200,000 for both book and tax
purposes, so the total taxes paid will equal the tax expense for
financial reporting purposes. The delay in payment of taxes results in
an increasing liability in the early years of an asset’s life, and a reversal
that decreases the liability in the later years.
9-72 (15-20 min.) Amounts are in millions.
1.
2.
Income tax expense
Income tax payable ($137 + $93 + $24)
Deferred tax liability ($29 - $6 − $2)
275
254
21
Net income = $858 − $275 = $583
Chapter 9
Liabilities and Interest
491
9-73 (15-25 min.)
1.
Debt-to-Equity Ratios
2002
AT&T
MICRON
AMGEN
2.
$42,960 ÷ $12,312 =
$1,189 ÷ $ 6,306
=
$6,170 ÷ $ 18,286 =
1992
3.49
.19
.34
$17,122 ÷ $20,313 =
$ 213 ÷ $ 511 =
$ 440 ÷ $ 934 =
.84
.42
.47
AT&T is a large company with well-established credit reputations
and large amounts of fixed assets to use as collateral for debt.
Earnings are relatively stable. Therefore, AT&T has the ability to
borrow large amounts, as shown by the high debt-to-equity ratio.
In contrast, Micron Technologies and Amgen are newer, smaller
companies in volatile high-tech industries. They have not yet
established the credit worthiness to borrow as much as AT&T.
3.
492
Each company's ratio changes over the ten-year period, but the
direction is not consistent. Thus, the changes appear more
idiosyncratic than economy driven. For many firms, a single new
issue of debt or equity can have a large immediate effect on the
ratios.
9-74 (20-25 min.) All amounts are in millions of dollars.
1.
a.
Accumulated Depreciation
Accumulated depreciation
Balance
of property, plant and
equipment disposed of
X
Depreciation in 2003
Balance
5,753
966
6,158
Let X = Accumulated depreciation on disposals
5,753 + 966 – X = 6,158
X = 561
b.
Balance
Purchases for 2003
Balance
Property, Plant, and Equipment
15,035 Original cost of property,
plant, and equipment
disposed of
1,258
15,187
X
Let X = Original cost of disposals
15,035 + 1,258 – X = 15,187
X = 1,106
2.
Net decrease in Long-term Debt =
($4,950 + $105) − ($5,060+ $123) = $128 decrease
Chapter 9
Liabilities and Interest
493
9-75 (10 min.)
When a company uses one set of numbers for its internal
decision-making and another set for reporting to the public, there is
legitimate reason to raise ethical questions. After all, companies are
supposed to report as accurately as possible all information that could
make a difference to potential investors and creditors. Assuming that
management is using the "best" information for its own decisions, any
different information reported to the public must be biased.
Sometimes differences in estimates used for internal and
external purposes are caused by restrictions in generally accepted
accounting principles (GAAP). When this occurs, management
cannot be blamed. Instead, the appropriateness of GAAP might be
questioned. For example, suppose GAAP requires an unreasonably
large liability for free flights. Financially secure airlines may favor such
a requirement, and even lobby for it, because the financial
consequences are likely to be more severe for their less stable
competitors than for them. Yet, it would not result in accurate
information for investors and creditors.
Another explanation offered for differences in internal and
external information is that the externally reported information is more
conservative. For example, some people would not object if too large
a liability for free flights were required, because that would be a more
conservative accounting policy. However, even a conservative bias
will potentially hurt some investors. Suppose a conservative bias
leads to too high a liability number being reported for free flights and
that this in turn leads to an unrealistically low market value for the
airline's stock. Current investors are potentially hurt while potential
investors benefit.
494
9-75 (continued)
The main potential ethical violation occurs when management is
able to report accurate numbers, but in an attempt to achieve some
goal (a bonus target or a bond covenant threshold) reports biased
numbers instead. Suppose an airline reports too low a number for
frequent-flier liabilities so that it does not violate a bond covenant that
required maintenance of a minimum current ratio, even though it
knows its real liability will be higher. This is a clear ethical violation,
because it reports information that may mislead potential investors or
creditors.
9-76 (10-15 min.)
Annual Cash
Flow
1.
Signing Bonus
$ 2,000,000
st
1 4 years’ salary
21,000,000
Next 2 years’ salary 25,000,000
Final 4 years’ salary 27,000,000
Total present value
PV Factors
Present Value
3.7908
$ 7,581,600
3.1699
66,567,900
1.7355 x .6830
29,633,663
3.1699 x .5645
48,314,029
$152,097,192
2.
$10,000,000 – $7,581,600 = $2,418,400
3.
The contract was not worth $252 million. The total, undiscounted
dollars are $252,000,000, but the present value is only
$152,097,192. The way a contract is structured can greatly affect
its value. Even though Rodriguez will receive a total of $252
million dollars, his most correct assessment of the value of the
contract is the present value of $152,097,192. Of course, this
present value depends on the discount rate used. If the rate were
less than 10%, the value would be greater than $152,097,192; if it
were greater than 10%, the value would be less than
$152,097,192.
Chapter 9
Liabilities and Interest
495
9-77 (60 minutes or more)
The purpose of this exercise is to determine the factors that
affect the interest rates on bonds and to generally gain a better
understanding of bonds. The individual research on the bonds of a
particular company may take some ingenuity. The information asked
for is not readily available. Therefore, it will be a good research
experience for students. It will get them out of the environment where
a problem has a definite answer and into one where the problem is to
find out as much as possible. Students will have to make a judgment
about what level of information is sufficient, and they may need to
search multiple sources for the required information.
The group aspect of the exercise allows students to compare the
information they gleaned. It both creates an incentive to get the
information to contribute to the group and allows analysis of a larger
set of data than one student has time to gather. By comparing the
factors affecting bond interest rates, students will begin to gain an
appreciation of the business setting in which accounting for bonds
occurs.
9-78 (50 min. or more)
The purpose of this exercise is to examine the conceptual basis
of liabilities. Students will need to examine their beliefs about what
makes an obligation a liability. Is the legal status of the obligation
important? Does it make any difference whether the obligation would
be enforced if the company were bankrupt? They will need to develop
logical arguments to defend their position. The presentation in class
will develop communication skills. The rebuttals are especially
important because they will require quick thinking -- "thinking on their
feet."
496
9-79 (50-60 min)
Each solution will be unique and will change each year. The
purpose of this problem is to learn about the potential impact of
capitalized leases on the balance sheet of companies that have large
leases.
9-80 (20 min.) Amounts are in thousands.
Debt-to-equity, 2003:
$647,319 ÷ $2,082,427 = .31
1. a.
b.
Debt-to-equity, 2002:
$491,203 ÷ $1,723,189 = .29
Debt-to-total-assets, 2003:
$647,319 ÷ $2,729,746 = .24
Debt-to-total-assets, 2002:
$491,203 ÷ $2,214,392 = .22
Debt as a percentage of both total assets and equity has increased
slightly in 2003 over 2002.
2. In 2003 Starbucks had nearly $609 million of current liabilities and
only $39 million of long-term liabilities (most of which is deferred
income taxes). Starbucks has very little long-term debt. Most of its
debt relates to the liabilities necessary to support operations such as
accounts payable, accrued expenses, and deferred revenue.
Chapter 9
Liabilities and Interest
497
9-81 (30-60 min.)
NOTE TO INSTRUCTOR. This solution is based on the Web site as it
was in late 2004. Be sure to examine the current Web site before
assigning this problem, as the information there may have changed.
1.
May leases 27% of its retail space, and therefore it owns 73%.
May has both operating and capital leases, but the operating leases
are about 10 times larger than the capital leases.
2.
In the year ended January 31, 2004, May’s income statement
expense for its operating leases was $121 million. There is no
recognition of these operating leases on May’s balance sheet. If May
had purchased instead of leasing this retail space, there would be both
an asset and a liability on the balance sheet. By treating these as
operating leases, May avoids the listing of a liability – creating what
some call “invisible debt.”
3.
May has three items in its long-term debt:
1. Unsecured notes and sinking fund
debentures
$3,970 million
2. Mortgage notes and bonds
18 million
3. Capital lease obligations
48 million
Total long-term debt
$4,036 million
Of this $4,036 million, $239 million is due within the next year and is
listed among current liabilities, leaving net long-term debt of $3,797
million. All components of long-term debt decreased in the last year,
but there is not enough information to know whether the reduction
was because debt was retired without issuing new debt or whether the
amount of retirements simply exceeded the amount of new issues.
498
4.
May’s pensions cover a wide range of employees, anyone who
works more than 1,000 hours per year and is over 21 years old. The
accrued benefit liability of $118 million is included in accrued
expenses and other liabilities. It represents the excess of the
accumulated pension obligations over the fair value of the plan assets.
In 2004 May used a discount rate of 6.0%, compared to the 6.75% used
in 2003. The lower interest rate will increase the amount of the pension
obligation. The pension expense of $108 million is reported on the
income statement, probably as part of selling, general and
administrative expenses.
Chapter 9
Liabilities and Interest
499