Acc 400 Week 3 Assignments

financial_accounting_4e_ch10.pdf

Home >Business & Finance homework help >Accounting homework help >Acc 400 Week 3 Assignments

ee eBook Collection

And Then There Were Two

Debt can help a company acquire the things itneeds to grow, but it is often the very thing that kills a company. A brief history of Maxwell Car Company illustrates the role of debt in the U.S. auto industry. In 1920 Maxwell Car Company was on the brink of financial ruin. Because it was axle-deep in debt and unable to pay its bills, its creditors stepped in and took over. They hired a former General Motors executive named Walter Chrysler to reorganize the company. By 1925 he had taken over the company and renamed it Chrysler. By 1933 Chrysler was booming, with sales surpassing even those of Ford.

But the next few decades saw Chrysler make a series of blunders. During the 1940s, while its com- petitors were making yearly design changes to boost customer interest, Chrysler made no changes. During the 1960s, when customers wanted large cars, Chrysler produced small cars. During the 1970s, when cus- tomers wanted small cars, Chrysler offered big “boats.” By 1980, with its creditors pounding at the gates, Chrysler was again on the brink of financial ruin.

At that point Chrysler brought in a former Ford executive named Lee Iacocca to save the company. Iacocca, considered by many as good a politician as a businessman, argued that the United States could not afford to let Chrysler fail because of the loss of jobs.

Reporting and Analyzing Liabilities

S T U D Y O B J E C T I V E S

10C H A P T E R10

F E A T U R E S T O R Y After studying this chapter, you should be able to:

1 Explain a current liability and identify the major types of current liabilities.

2 Describe the accounting for notes payable.

3 Explain the accounting for other current liabilities.

4 Identify the types of bonds.

5 Prepare the entries for the issuance of bonds and interest expense.

6 Describe the entries when bonds are redeemed.

7 Identify the requirements for the finan- cial statement presentation and analysis of liabilities.

●❍ THE NAVIGATOR ✓✓

●❍ T H E N A V I G A T O R

● Scan Study Objectives

● Read Feature Story

● Read Preview

● Read text and answer Before You Go On p. 479 p. 483 p. 489 p. 496

● Work Using the Decision Toolkit

● Review Summary of Study Objectives

● Work Demonstration Problem

● Answer Self-Study Questions

Complete Assignments

✔✔

joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka

Last #1 Head 473

He convinced the federal government to grant loan guarantees—promises that if Chrysler failed to pay its creditors, the government would pay them. Iacocca then streamlined operations and brought out some profitable products. Chrysler repaid all of its government-guaranteed loans by 1983, seven years ahead of the scheduled final payment.

What has happened since? In the 1990s Chrysler knew both feast and famine: In 1991 it operated in the red, with Iacocca leaving the company under pressure in 1992. By 1995 Chrysler was the most profitable U.S.-based car manufac- turer and the envy of the entire industry.

But to compete in today’s global vehicle mar- ket, you must be big—really big. So in 1998 Chrysler merged with German automaker Daimler-Benz, to form DaimlerChrysler. This left just two U.S.-based auto manufacturers—General Motors and Ford.

These companies are giants. General Motors and Ford typically rank among the top five U.S. firms in total assets. But General Motors and Ford have accumulated a truckload of debt on their way to getting this big. Combined, they have approximately $600 billion in total outstanding liabilities. Although debt has made it possible to get so big, the Chrysler story makes it clear that debt can also threaten a company’s survival.

473

On the World Wide Web DaimlerChrysler:

www.daimlerchrysler.com Ford: www.ford.com General Motors: www.gm.com

●❍ THE NAVIGATOR ✓✓

474 CHAPTER 10 Reporting and Analyzing Liabilities

The Feature Story suggests that General Motors and Ford have tremendous amounts of debt. It is unlikely that they could have grown so large without this debt, but at times the debt threatens their very existence. Given this risk, why do companies borrow money? Why do they sometimes borrow short-term and other times long-term? Besides bank borrowings, what other kinds of debts do compa- nies incur? In this chapter we address these issues.

The content and organization of the chapter are as follows.

What Is a Current Liability? You have learned that liabilities are defined as “creditors’ claims on total assets” and as “existing debts and obligations.” Companies must settle or pay these claims, debts, and obligations at some time in the future by transferring assets or services. The future date on which they are due or payable (the maturity date) is a significant feature of liabilities.

As explained in Chapter 2, a current liability is a debt that a company reasonably expects to pay (1) from existing current assets or through the cre- ation of other current liabilities, and (2) within one year or the operating cy- cle, whichever is longer. Debts that do not meet both criteria are long-term liabilities.

Financial statement users want to know whether a company’s obligations are current or long-term. A company that has more current liabilities than current assets often lacks liquidity, or short-term debt-paying ability. In addition, users want to know the types of liabilities a company has. If a company declares bank- ruptcy, a specific, predetermined order of payment to creditors exists. Thus, the amount and type of liabilities are of critical importance.

●❍ THE NAVIGATOR ✓✓●❍ THE NAVIGATOR ✓✓

S T U D Y O B J E C T I V E

1 Explain a current liability

and identify the major types of current liabilities.

P R E V I E W O F C H A P T E R 1 0

S E C T I O N O N E

CURRENT LIABILITIES

• Bond basics

• Accounting for bond issues

• Accounting for bond retirements

• Financial statement presentation and analysis

• Off-balance-sheet financing

• What is a current liability?

• Types of current liabilities

Current Liabilities Long-Term Liabilities

REPORTING AND ANALYZING LIABILITIES

d FoFoFoFordddd haveveveve ttttrerrerememememendnndndouuououssss

Types of Current Liabilities 475

Types of Current Liabilities The different types of current liabilities include notes payable, accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest. In this section we discuss a few of the common and more important types of current liabilities.

NOTES PAYABLE Companies record obligations in the form of written notes as notes payable. They often use notes payable instead of accounts payable because notes payable give the lender written documentation of the obligation in case legal remedies are needed to collect the debt. Companies frequently issue notes payable to meet short-term financing needs. Notes payable usually require the borrower to pay interest.

Notes are issued for varying periods of time. Those due for payment within one year of the balance sheet date are usually classified as current liabilities. Most notes are interest-bearing.

To illustrate the accounting for notes payable, assume that First National Bank agrees to lend $100,000 on September 1, 2007, if Cole Williams Co. signs a $100,000, 12%, four-month note maturing on January 1. When a company issues an interest-bearing note, the amount of assets it receives generally equals the note’s face value. Cole Williams Co. therefore will receive $100,000 cash and will make the following journal entry.

In the December 31 financial statements, the current liabilities section of the balance sheet will show notes payable $100,000 and interest payable $4,000. In addition, the company will report interest expense of $4,000 under “Other ex- penses and losses” in the income statement.

At maturity (January 1), Cole Williams Co. must pay the face value of the note ($100,000) plus $4,000 interest ($100,000 � 12% � �1

4 2 �). It records payment

of the note and accrued interest as follows.

Helpful Hint In previous chap- ters we explained the entries for accounts payable and the adjusting entries for some current liabilities.

Sept. 1 Cash 100,000 Notes Payable 100,000

(To record issuance of 12%, 4-month note to First National Bank)

A � L � SE �100,000

�100,000

Cash Flows �100,000

Interest accrues over the life of the note, and the issuer must periodically record that accrual. If Cole Williams Co. prepares financial statements annually, it makes an adjusting entry at December 31 to recognize interest expense and interest payable of $4,000 ($100,000 � 12% � �1

4 2 �):

Dec. 31 Interest Expense 4,000 Interest Payable 4,000

(To accrue interest for 4 months on First National Bank note)

Cash Flows no effect

A � L � SE �4,000 Exp

�4,000

Jan. 1 Notes Payable 100,000 Interest Payable 4,000

Cash 104,000 (To record payment of First National Bank interest-bearing note and accrued interest at maturity)

A � L � SE �100,000

�4,000 �104,000

Cash Flows �104,000

S T U D Y O B J E C T I V E

2 Describe the accounting for

notes payable.

payayayayabbbblelelele,

Helpful Hint In previous cha teeers wwwwe explaaaia nedddd tttht e eee eeene trtrtrtrieieieie foor aaacccounts ppppaayayaabaa le andndndnd th adadadadjuuuststststinininggg enenenentrttrtrieieiesss fofofofor soooomemememe

476 CHAPTER 10 Reporting and Analyzing Liabilities

Appendix 10C at the end of this chapter discusses the accounting for long-term installment notes payable.

SALES TAXES PAYABLE Many of the products we purchase at retail stores are subject to sales taxes. Many states are now implementing sales taxes on purchases made on the In- ternet as well. Sales taxes are expressed as a percentage of the sales price. The retailer (or selling company) collects the tax from the customer when the sale occurs and periodically (usually monthly) remits the collections to the state’s department of revenue.

Under most state laws, the selling company must ring up separately on the cash register the amount of the sale and the amount of the sales tax collected. (Gasoline sales are a major exception.) The company then uses the cash regis- ter readings to credit Sales and Sales Taxes Payable. For example, if the March 25 cash register readings for Cooley Grocery show sales of $10,000 and sales taxes of $600 (sales tax rate of 6%), the journal entry is:

When the company remits the taxes to the taxing agency, it decreases (debits) Sales Taxes Payable and decreases (credits) Cash. The company does not report sales taxes as an expense; it simply forwards to the government the amount paid by the customer. Thus, Cooley Grocery serves only as a collection agent for the taxing authority.

Sometimes companies do not ring up sales taxes separately on the cash register. To determine the amount of sales in such cases, divide total receipts by 100% plus the sales tax percentage. For example, assume that Cooley Grocery rings up total receipts of $10,600. Because the amount received from the sale is equal to the sales price 100% plus 6% of sales, or 1.06 times the sales total, we can compute sales as follows: $10,600 � 1.06 � $10,000. Thus, we can find the sales tax amount of $600 by either (1) subtracting sales from total receipts ($10,600 � $10,000) or (2) multiplying sales by the sales tax rate ($10,000 � 6%).

PAYROLL AND PAYROLL TAXES PAYABLE Assume that Susan Alena works 40 hours this week for Pepitone Inc., earning a wage of $10 per hour. Will Susan receive a $400 check at the end of the week? Not likely. The reason: Pepitone is required to withhold amounts from her wages to pay various governmental authorities. For example, Pepitone will withhold amounts for Social Security taxes and for federal and state income taxes. If these withholdings total $100, Susan will receive a check for only $300. Illustration 10-1 summarizes the types of payroll deductions that normally occur for most companies.

As a result of these deductions, companies withhold from employee pay- checks amounts that must be paid to other parties. Pepitone therefore has incurred a liability to pay these third parties, and must report this liability in its balance sheet.

As a second illustration, assume that Cargo Corporation records its payroll for the week of March 7 with the journal entry shown on page 477.

Helpful Hint Watch how sales are rung up at local retailers to see whether the sales tax is computed separately.

Mar. 25 Cash 10,600 Sales 10,000 Sales Taxes Payable 600

(To record daily sales and sales taxes)

A � L � SE �10,600

�10,000 Rev �600

Cash Flows �10,600

S T U D Y O B J E C T I V E

3 Explain the accounting for

other current liabilities.

accacccounuuu tiiinngnn for long term

Types of Current Liabilities 477

In this case Cargo reports $100,000 in wages and salaries expense. In addi- tion, it reports liabilities for the wages payable as well as liabilities to gov- ernmental agencies. Rather than pay the employees $100,000, Cargo instead must withhold the taxes and make the tax payments directly. In summary, Cargo is essentially serving as a tax collector.

In addition to the liabilities incurred as a result of withholdings, employers also incur a second type of payroll-related liability. With every payroll, the employer in- curs liabilities to pay various payroll taxes levied upon the employer. These payroll taxes include the employer’s share of Social Security (FICA) taxes and state and fed- eral unemployment taxes. Based on Cargo Corp.’s $100,000 payroll, the company would record the employer’s expense and liability for these payroll taxes as follows.

Illustration 10-1 Payroll deductions

Mar. 7 Salaries and Wages Expense 100,000 FICA Taxes Payable1 7,650 Federal Income Taxes Payable 21,864 State Income Taxes Payable 2,922 Salaries and Wages Payable 67,564

(To record payroll and withholding taxes for the week ending March 7)

Cash Flows no effect

A � L � SE �100,000 Exp

�7,650 �21,864

�2,922 �67,564

Cargo then records payment of this payroll on March 7 as follows.

Mar. 7 Salaries and Wages Payable 67,564 Cash 67,564

(To record payment of the March 7 payroll)

A � L � SE �67,564

�67,564

Cash Flows �67,564

1 Social Security taxes are commonly called FICA taxes. In 1937 Congress enacted the Federal

Insurance Contribution Act (FICA). As can be seen in this journal entry and the payroll tax journal entry, the employee and employer must make equal contributions to Social Security. The Social Security rate in 2005 was 7.65% for each.

Gross Pay Net Pay

Federal Income Tax

FICA Taxes State and City Income Taxes

Insurance, Pensions, and/or Union Dues

Charity

478 CHAPTER 10 Reporting and Analyzing Liabilities

Companies classify the payroll and payroll tax liability accounts as current liabilities because they must be paid to employees or remitted to taxing au- thorities periodically and in the near term. Taxing authorities impose substan- tial fines and penalties on employers if the withholding and payroll taxes are not computed correctly and paid on time.

UNEARNED REVENUES A magazine publisher such as Sports Illustrated may receive a customer’s check when magazines are ordered. An airline company such as American Airlines of- ten receives cash when it sells tickets for future flights. Season tickets for con- certs, sporting events, and theatre programs are also paid for in advance. How do companies account for unearned revenues that are received before goods are delivered or services are provided?

1. When the company receives an advance, it increases (debits) Cash and also increases (credits) a current liability account identifying the source of the unearned revenue.

2. When the company earns the revenue, it decreases (debits) the unearned rev- enue account and increases (credits) an earned revenue account.

To illustrate, assume that Superior University sells 10,000 season football tickets at $50 each for its five-game home schedule. The entry for the sales of season tickets is:

Aug. 6 Cash 500,000 Unearned Football Ticket Revenue 500,000

(To record sale of 10,000 season tickets)

A � L � SE �500,000

�500,000

Cash Flows �500,000

As each game is completed, Superior records the earning of revenue with the following entry.

Sept. 7 Unearned Football Ticket Revenue 100,000 Football Ticket Revenue 100,000

(To record football ticket revenues earned)

Cash Flows no effect

A � L � SE �100,000

�100,000 Rev

The account Unearned Football Ticket Revenue represents unearned revenue, and the university would report it as a current liability. As the school earns the revenue, it reclassifies the amount from unearned revenue to earned revenue. Unearned revenue is material for some companies: In the airline industry, tick- ets sold for future flights represent almost 50% of total current liabilities. At United Airlines, unearned ticket revenue recently was the largest current liabil- ity, amounting to more than $1 billion.

Illustration 10-2 shows specific unearned and earned revenue accounts used in selected types of businesses.

Mar. 7 Payroll Tax Expense 13,850 FICA Taxes Payable 7,650 Federal Unemployment Taxes Payable 800 State Unemployment Taxes Payable 5,400

(To record employer’s payroll taxes on March 7 payroll)

Cash Flows no effect

A � L � SE �13,850 Exp

�7,650 �800

�5,400

1131313,8,8,8,850000 7,656565000

80808080000

Types of Current Liabilities 479

CURRENT MATURITIES OF LONG-TERM DEBT Companies often have a portion of long-term debt that comes due in the current year. As an example, assume that Wendy Construction issues a five-year, interest- bearing $25,000 note on January 1, 2006. This note specifies that each January 1, starting January 1, 2007, Wendy should pay $5,000 of the note. When the com- pany prepares financial statements on December 31, 2006, it should report $5,000 as a current liability and $20,000 as a long-term liability. Companies often identify current maturities of long-term debt on the balance sheet as long-term debt due within one year. At December 31, 2003, the Automotive Division of General Motors had $1,090 million of such debt.

It is not necessary to prepare an adjusting entry to recognize the current ma- turity of long-term debt. At the balance sheet date, all obligations due within one year are classified as current, and all other obligations are classified as long-term.

Illustration 10-2 Unearned and earned revenue accounts

Type of Account Title

Business Unearned Revenue Earned Revenue

Airline Unearned Passenger Ticket Revenue Passenger Ticket Revenue Magazine publisher Unearned Subscription Revenue Subscription Revenue Hotel Unearned Rental Revenue Rental Revenue

A decision that all companies must make is to what extent to rely on short-term versus long-term financing. The critical nature of this decision was highlighted in the fall of 2001, after the World Trade Center disaster. Prior to September 11, short-term interest rates had been extremely low relative to long-term rates. In order to minimize interest costs, many companies were relying very heavily on short-term financing to purchase things they normally would have used long- term debt for. The problem with short-term financing is that it requires compa- nies to continually find new financing as each loan comes due. This makes them vulnerable to sudden changes in the economy.

After September 11, lenders and short-term investors became very reluctant to loan money. This put the squeeze on many companies: as short-term loans came due, they were unable to refinance. Some were able to get other financing, but at extremely high rates (for example, 12% as compared to 3%). Others were unable to get loans and instead had to sell assets to generate cash for their immediate needs.

Source: Henny Sender, “Firms Feel Consequences of Short-Term Borrowing,” Wall Street Journal Online (October 12, 2001).

Based on this story, what is a good general rule to use in choosing between short-term and long-term financing?

Account ing across the Organ izat ion

B E F O R E Y O U G O O N . . .

� Review It

1. What are the two criteria for classifying a debt as a current liability? 2. What are some examples of current liabilities? 3. What are three items generally withheld from employees’ wages or salaries?

Illustration 10 2 UnUUU eaeaeaearned aaaandndndd eeeearaararnennn dddd reveeennue accccocococounuuu tsenueueueue

Revevvv nueeee

480 CHAPTER 10 Reporting and Analyzing Liabilities

4. List three examples of unearned revenues. 5. Identify the liabilities classified as current by Tootsie Roll. The answer to

this question appears on page 531.

� Do It

During the month of September, Lake Corporation’s employees earned wages of $60,000. Withholdings related to these wages were $3,500 for Social Security (FICA), $6,500 for federal income tax, and $2,000 for state income tax. Costs incurred for unemployment taxes were $90 for federal and $150 for state.

Prepare the September 30 journal entries for (a) wages expense and wages payable assuming that all September wages will be paid in October and (b) the company’s payroll tax expense.

Action Plan • Remember that wages earned are an expense to the company, but withhold-

ings reduce the amount due to be paid to the employee. • Payroll taxes are taxes the company incurs related to its employees.

Solution (a) To determine wages payable, reduce wages expense by the withholdings for

FICA, federal income tax, and state income tax.

Sept. 30 Wages Expense 60,000 FICA Taxes Payable 3,500 Federal Income Taxes Payable 6,500 State Income Taxes Payable 2,000 Wages Payable 48,000

Sept. 30 Payroll Tax Expense 3,740 FICA Taxes Payable 3,500 Federal Unemployment Taxes Payable 90 State Unemployment Taxes Payable 150

(b) Payroll taxes would be for the company’s share of FICA, as well as for fed- eral and state unemployment tax.

Long-term liabilities are obligations that a company expects to pay after one year. In this section we explain the accounting for the principal types of obliga- tions reported in the long-term liabilities section of the balance sheet. These obligations often are in the form of bonds or long-term notes.

Bond Basics Bonds are a form of interest-bearing note payable issued by corporations, uni- versities, and governmental agencies. Bonds, like common stock, are sold in small denominations (usually $1,000 or multiples of $1,000). As a result, bonds attract many investors.

TYPES OF BONDS Bonds may have different features. In the following sections we describe some commonly issued types of bonds.

●❍ THE NAVIGATOR ✓✓

S E C T I O N T W O LONG-TERM LIABILITIES

S T U D Y O B J E C T I V E

4 Identify the types of bonds.

otstststsieieieie R R RRololololllll. ThTT e aanswwweeer tttto

Bond Basics 481

Secured and Unsecured Bonds Secured bonds have specific assets of the issuer pledged as collateral for the bonds. Unsecured bonds are issued against the general credit of the borrower. Large corporations with good credit ratings use unsecured bonds extensively. For example, in a recent annual report, Dupont reported more than $2 billion of unsecured bonds outstanding.

Convertible and Callable Bonds Bonds that can be converted into common stock at the bondholder’s option are convertible bonds. Bonds that the issuing company can retire at a stated dollar amount prior to maturity are callable bonds. Convertible bonds have features that are attractive both to bondholders and to the issuer. The conversion often gives bondholders an opportunity to benefit if the market price of the common stock in- creases substantially. Furthermore, until conversion, the bondholder receives inter- est on the bond. For the issuer, the bonds sell at a higher price and pay a lower rate of interest than comparable debt securities that do not have a conversion option. Many corporations, such as USAir, United States Steel Corp., and General Motors Corporation, have convertible bonds outstanding.

During the boom times of the late 1990s, many rapidly growing companies is- sued large quantities of convertible bonds. Investors found the convertible bonds attractive because they paid regular interest but also had the upside potential of being converted to stock if the stock price increased. At the time, stock prices were increasing rapidly, so many investors viewed convertible bonds as a cheap and safe way to buy stock.

As a consequence, companies were able to pay much lower interest rates on convertible bonds than on standard bonds. When the bonds were issued, company managers assumed that the bonds would be converted. Thus the company would never have to repay the debt with cash. It seemed too good to be true—and it was.

When stock prices plummeted in the early 2000s, investors no longer had an incentive to convert, since the market price was below the conversion price. Now many of these massive bonds are coming due, and companies are being forced either to pay them off or to issue new debt at much higher rates.

The drop in stock prices did not change the debt to total assets ratios of these companies. Discuss how the perception of a high debt to total assets ratio changed before and after the fall in stock prices.

Account ing across the Organ izat ion

ISSUING PROCEDURES A bond certificate is issued to the investor to provide evidence of the investor’s claim against the company. As Illustration 10-3 (page 482) shows, the bond cer- tificate provides information such as the name of the company that issued the bonds, the face value of the bonds, the maturity date of the bonds, and the con- tractual interest rate. The face value is the amount due at the maturity date. The maturity date is the date that the final payment is due to the investor from the issuing company. The contractual interest rate is the rate used to deter- mine the amount of cash interest the borrower pays and the investor receives. Usually the contractual rate is stated as an annual rate, and interest is generally paid semiannually.

Alternative Terminology The contractual rate is often referred to as the stated rate.

Convert

Convertible Bonds

Callable Bonds

Bond

Stock

“Hey Harv, call in those

bonds”

Bond

al fffforororor t t t thehehehe borrrrrorororowewewewerr.r

BondBo

482 CHAPTER 10 Reporting and Analyzing Liabilities

DETERMINING THE MARKET VALUE OF BONDS If you were an investor wanting to purchase a bond, how would you determine how much to pay? To be more specific, assume that Coronet, Inc. issues a zero- interest (pays no interest) bond with a face value of $1,000,000 due in 20 years. For this bond, the only cash you receive is $1 million at the end of 20 years. Would you pay $1 million for this bond?

We hope not, because $1 million received 20 years from now is not the same as $1 million received today. The term time value of money is used to indicate the relationship between time and money––that a dollar received today is worth more than a dollar promised at some time in the future. If you had $1 million today, you would invest it and earn interest so that at the end of 20 years, your investment would be worth much more than $1 million. Thus, if someone is going to pay you $1 million 20 years from now, you would want to find its equiv- alent today, or its present value. In other words, you would want to determine how much must be invested today at current interest rates to have $1 million in 20 years.

The current market value (present value) of a bond is therefore a function of three factors: (1) the dollar amounts to be received, (2) the length of time until the amounts are received, and (3) the market interest rate. The market interest

Illustration 10-3 Bond certificate

Contractual interest rate

Face or par value

Maturity date

Issuer of bonds

2007

Same dollars at different times are not equal.

$1 million

2027 ≠

$1 million

Maaatturity daddad te

Accounting for Bond Issues 483

rate is the rate investors demand for loaning funds. The process of finding the present value is referred to as discounting the future amounts.

To illustrate, assume that Acropolis Company on January 1, 2007, issues $100,000 of 9% bonds, due in five years, with interest payable annually at year- end. The purchaser of the bonds would receive the following two types of cash payments: (1) principal of $100,000 to be paid at maturity, and (2) five $9,000 interest payments ($100,000 � 9%) over the term of the bonds. Illustration 10-4 shows a time diagram depicting both cash flows.

Illustration 10-4 Time diagram depicting cash flows

The current market value of a bond is equal to the present value of all the future cash payments promised by the bond. Illustration 10-5 lists and totals the present values of these amounts, assuming the market rate of interest is 9%.

Present value of $100,000 received in 5 years $ 64,993 Present value of $9,000 received annually for 5 years 35,007

Market price of bonds $100,000

Illustration 10-5 Computing the market price of bonds

Tables are available to provide the present value numbers to be used, or these values can be determined mathematically.2 Appendix C, near the end of the book, provides further discussion of the concepts and the mechanics of the time value of money computations.

B E F O R E Y O U G O O N . . .

� Review It

1. What are bonds? 2. What are secured versus unsecured bonds and callable versus convertible

bonds? 3. Explain the terms face value and contractual interest rate. 4. Explain why you would prefer to receive $1 million today rather than five

years from now.

Accounting for Bond Issues A corporation records bond transactions when it issues or retires (buys back) bonds and when bondholders convert bonds into common stock. If bondhold- ers sell their bond investments to other investors, the issuing firm receives no

2 For those knowledgable in the use of present value tables, the computations in this example are:

$100,000 � .64993 � $64,993 and $9,000 � 3.88965 � $35,007 (rounded).

●❍ THE NAVIGATOR ✓✓

5-year period 0 1 2 3 4 5

$9,000 $9,000 $9,000 $9,000 $9,000 Interest

$100,000 Principal

nnnndiidiing theee

7, isisisissuuuueesee

484 CHAPTER 10 Reporting and Analyzing Liabilities

further money on the transaction, nor does the issuing corporation journal- ize the transaction (although it does keep records of the names of bondhold- ers in some cases).

Bonds may be issued at face value, below face value (discount), or above face value (premium). Bond prices for both new issues and existing bonds are quoted as a percentage of the face value of the bond. Face value is usually $1,000. Thus, a $1,000 bond with a quoted price of 97 means that the selling price of the bond is 97% of face value, or $970.

ISSUING BONDS AT FACE VALUE To illustrate the accounting for bonds issued at face value, assume that Devor Corporation issues 100, five-year, 10%, $1,000 bonds dated January 1, 2007, at 100 (100% of face value). The entry to record the sale is:

S T U D Y O B J E C T I V E

5 Prepare the entries for the

issuance of bonds and interest expense.

Jan. 1 Cash 100,000 Bonds Payable 100,000

(To record sale of bonds at face value)

Devor reports bonds payable in the long-term liabilities section of the balance sheet because the maturity date is January 1, 2012 (more than one year away).

Over the term (life) of the bonds, companies make entries to record bond interest. Interest on bonds payable is computed in the same manner as interest on notes payable, as explained earlier. If we assume that interest is payable annually on January 1 on the bonds described above, Devor accrues interest of $10,000 ($100,000 � 10% � �11

2 2�) on December 31.

At December 31 Devor recognizes the $10,000 of interest expense incurred with the following adjusting entry.

Dec. 31 Bond Interest Expense 10,000 Bond Interest Payable 10,000

(To accrue bond interest)

A � L � SE �100,000

�100,000

Cash Flows �100,000

Helpful Hint Interest Expense � Principal � Rate � Time

Cash Flows no effect

A � L � SE �10,000 Exp

�10,000

The company classifies bond interest payable as a current liability because it is scheduled for payment within the next year. When Devor pays the interest on January 1, 2008, it decreases (debits) Bond Interest Payable and decreases (credits) Cash for $10,000.

Devor records the payment on January 1 as follows.

A � L � SE �10,000

�10,000

Cash Flows �10,000

Jan. 1 Bond Interest Payable 10,000 Cash 10,000

(To record payment of bond interest)

DISCOUNT OR PREMIUM ON BONDS The previous illustrations assumed that the contractual (stated) interest rate and the market (effective) interest rate paid on bonds were the same. Recall that the contractual interest rate is the rate applied to the face (par) value to arrive at the interest paid in a year. The market interest rate is the rate investors de- mand for loaning funds to the corporation. When the contractual interest rate and the market interest rate are the same, bonds sell at face value.

iiiingngngng corooo poooorration journal f ththththe ee e nnnan memmm sss offff b b bbondhdhdhdh loldd-dd

l (ddddi )) bb

Accounting for Bond Issues 485

However, market interest rates change daily. The type of bond issued, the state of the economy, current industry conditions, and the company’s individ- ual performance all affect market interest rates. As a result, the contractual and market interest rates often differ. To make bonds salable when the two rates differ, bonds sell below or above face value.

To illustrate, suppose that a company issues 10% bonds at a time when other bonds of similar risk are paying 12%. Investors will not be interested in buying the 10% bonds, so their value will fall below their face value. In this case, we say the 10% bonds are selling at a discount. As a result of the decline in the bonds’ selling price, the actual interest rate incurred by the company increases to the level of the current market interest rate.

Conversely, if the market rate of interest is lower than the contractual in- terest rate, investors will have to pay more than face value for the bonds. That is, if the market rate of interest is 8% but the contractual interest rate on the bonds is 10%, the issuer will require more funds from the investor. In these cases, bonds sell at a premium. Illustration 10-6 shows these relationships graphically.

Helpful Hint Bond prices vary inversely with changes in the market interest rate: As market interest rates decline, bond prices will increase. When a bond is issued, if the market interest rate is below the con- tractual rate, the price will be higher than the face value.

Illustration 10-6 Interest rates and bond prices

Issuance of bonds at an amount different from face value is quite com- mon. By the time a company prints the bond certificates and markets the bonds, it will be a coincidence if the market rate and the contractual rate are the same. Thus, the issuance of bonds at a discount does not mean that the financial strength of the issuer is suspect. Conversely, the sale of bonds at a premium does not indicate that the financial strength of the issuer is exceptional.

ISSUING BONDS AT A DISCOUNT To illustrate the issuance of bonds at a discount, assume that on January 1, 2007, Candlestick Inc. sells $100,000, five-year, 10% bonds at 98 (98% of face value) with interest payable on January 1. The entry to record the issuance is:

Helpful Hint Some bonds are sold at a discount by design. “Zero-coupon” bonds, which pay no interest, sell at a deep discount to face value.

Jan. 1 Cash 98,000 Discount on Bonds Payable 2,000

Bonds Payable 100,000 (To record sale of bonds at a discount)

A � L � SE �98,000

�2,000 �100,000

Cash Flows �98,000

Although Discount on Bonds Payable has a debit balance, it is not an asset. Rather it is a contra account, which is deducted from bonds payable on the balance sheet as shown in Illustration 10-7 (page 486).

Bond Contractual

Interest Rate 10%

10%

12%

Market Interest Rate

Bonds Sell at

Issued when

Premium

Face Value

Discount

sususus eedee , theee iiiindndndndivivivividididid----

ntrrrracacacactuuuuaaala hhhh

486 CHAPTER 10 Reporting and Analyzing Liabilities

The $98,000 represents the carrying (or book) value of the bonds. On the date of issue this amount equals the market price of the bonds.

The issuance of bonds below face value causes the total cost of borrow- ing to differ from the bond interest paid. That is, the issuing corporation not only must pay the contractual interest rate over the term of the bonds but also must pay the face value (rather than the issuance price) at maturity. Therefore, the difference between the issuance price and the face value of the bonds—the discount—is an additional cost of borrowing. The company records this cost as bond interest expense over the life of the bonds. The to- tal cost of borrowing $98,000 for Candlestick Inc. is $52,000, computed as shown in Illustration 10-8.

CANDLESTICK INC. Balance Sheet (partial)

Long-term liabilities Bonds payable $100,000 Less: Discount on bonds payable 2,000 $98,000

Illustration 10-7 Statement presentation of discount on bonds payable

Illustration 10-8 Computation of total cost of borrowing—bonds issued at discount

Bonds Issued at a Discount

Annual interest payments ($100,000 � 10% � $10,000; $10,000 � 5) $ 50,000

Add: Bond discount ($100,000 � $98,000) 2,000

Total cost of borrowing $52,000

Illustration 10-9 Alternative computation of total cost of borrowing— bonds issued at discount

Bonds Issued at a Discount

Principal at maturity $100,000 Annual interest payments ($10,000 � 5) 50,000

Cash to be paid to bondholders 150,000 Cash received from bondholders 98,000

Total cost of borrowing $ 52,000

Alternatively, we can compute the total cost of borrowing as shown in Illus- tration 10-9.

To follow the matching principle, companies allocate bond discount to ex- pense in each period in which the bonds are outstanding. This is referred to as amortizing the discount. Amortization of the discount increases the amount of interest expense reported each period. That is, after the company amortizes the discount, the amount of interest expense it reports in a period will exceed the contractual amount. As shown in Illustration 10-8, for the bonds issued by Candlestick Inc., total interest expense will exceed the contractual interest by $2,000 over the life of the bonds.

As the discount is amortized, its balance declines. As a consequence, the car- rying value of the bonds will increase, until at maturity the carrying value of the bonds equals their face amount. This is shown in Illustration 10-10. Appendix 10A and Appendix 10B at the end of this chapter discuss procedures for amor- tizing bond discount.

Helpful Hint The carrying value (book value) of bonds issued at a discount is deter- mined by subtracting the bal- ance of the discount account from the balance of the Bonds Payable account.

Accounting for Bond Issues 487

ISSUING BONDS AT A PREMIUM We can illustrate the issuance of bonds at a premium by now assuming the Can- dlestick Inc. bonds described above sell at 102 (102% of face value) rather than at 98. The entry to record the sale is:

Illustration 10-10 Amortization of bond discount

Candlestick adds the premium on bonds payable to the bonds payable amount on the balance sheet, as shown in Illustration 10-11.

The sale of bonds above face value causes the total cost of borrowing to be less than the bond interest paid because the borrower is not required to pay the bond premium at the maturity date of the bonds. Thus, the premium is con- sidered to be a reduction in the cost of borrowing that reduces bond interest expense over the life of the bonds. The total cost of borrowing $102,000 for Can- dlestick Inc. is $48,000, computed as in Illustration 10-12.

Helpful Hint Both a discount and a premium account are valuation accounts. A valuation account is one that is needed to value properly the item to which it relates.

Jan. 1 Cash 102,000 Bonds Payable 100,000 Premium on Bonds Payable 2,000

(To record sale of bonds at a premium)

A � L � SE �102,000

�100,000 �2,000

Cash Flows �102,000

CANDLESTICK INC. Balance Sheet (partial)

Long-term liabilities Bonds payable $100,000 Add: Premium on bonds payable 2,000 $102,000

Illustration 10-11 Statement presentation of bond premium

Illustration 10-12 Computation of total cost of borrowing—bonds issued at a premium

Bonds Issued at a Premium

Annual interest payments ($100,000 � 10% � $10,000; $10,000 � 5) $ 50,000

Less: Bond premium ($102,000 � $100,000) 2,000

Total cost of borrowing $48,000

C ar

ry in

g V

al ue $100,000

Time$98,000

1 2 3 4 5 Years

Illustration 10 10 AmAAA orororortitt zationononon oooof fff bobobobondnnn dddiscccoount

ars

488 CHAPTER 10 Reporting and Analyzing Liabilities

Alternatively, we can compute the cost of borrowing as shown in Illustra- tion 10-13.

Illustration 10-13 Alternative computation of total cost of borrowing— bonds issued at a premium

Bonds Issued at a Premium

Principal at maturity $100,000 Annual interest payments ($10,000 � 5) 50,000

Cash to be paid to bondholders 150,000 Cash received from bondholders 102,000

Total cost of borrowing $ 48,000

Similar to bond discount, companies allocate bond premium to expense in each period in which the bonds are outstanding. This is referred to as amortizing the premium. Amortization of the premium decreases the amount of interest expense reported each period. That is, after the company amortizes the premium, the amount of interest expense it reports in a period will be less than the con- tractual amount. As shown in Illustration 10-12, for the bonds issued by Can- dlestick Inc., contractual interest will exceed the interest expense by $2,000 over the life of the bonds.

As the premium is amortized, its balance declines. As a consequence, the carrying value of the bonds will decrease, until at maturity the carrying value of the bonds equals their face amount. This is shown in Illustration 10-14. Appendix 10A and Appendix 10B at the end of this chapter discuss procedures for amortizing bond premium.

Illustration 10-14 Amortization of bond premium

Accounting for Bond Retirements Bonds are retired when the issuing corporation purchases (redeems) them. The appropriate entries for these transactions are explained next.

REDEEMING BONDS AT MATURITY Regardless of the issue price of bonds, the book value of the bonds at maturity will equal their face value. Assuming that the company pays and records sepa- rately the interest for the last interest period, Candlestick records the redemp- tion of its bonds at maturity as:

Bonds Payable 100,000 Cash 100,000

(To record redemption of bonds at maturity)

A � L � SE �100,000

�100,000

Cash Flows �100,000

S T U D Y O B J E C T I V E

6 Describe the entries when

bonds are redeemed.

C ar

ry in

g V

al ue

$102,000

$100,000 1 2 3 4 5 Years

Time

wwwwininining asaaa shohohoown in Illustra

Accounting for Bond Retirements 489

REDEEMING BONDS BEFORE MATURITY Bonds may be redeemed before maturity. A company may decide to retire bonds before maturity in order to reduce interest cost and remove debt from its balance sheet. A company should retire debt early only if it has sufficient cash resources.

When bonds are retired before maturity, it is necessary to: (1) eliminate the carrying value of the bonds at the redemption date, (2) record the cash paid, and (3) recognize the gain or loss on redemption. The carrying value of the bonds is the face value of the bonds less unamortized bond discount or plus unamortized bond premium at the redemption date.

To illustrate, assume at the end of the fourth period, Candlestick Inc., hav- ing sold its bonds at a premium, retires the bonds at 103 after paying the an- nual interest. Assume that the carrying value of the bonds at the redemption date is $100,400. Candlestick records the redemption at the end of the fourth interest period (January 1, 2011) as:

Jan. 1 Bonds Payable 100,000 Premium on Bonds Payable 400 Loss on Bond Redemption 2,600

Cash 103,000 (To record redemption of bonds at 103)

A � L � SE �100,000

�400 �2,600 Exp

�103,000

Cash Flows �103,000

Note that the loss of $2,600 is the difference between the $103,000 cash paid and the $100,400 carrying value of the bonds.

B E F O R E Y O U G O O N . . .

� Review It

1. What entry is made to record the issuance of bonds payable of $1 million at 100? At 96? At 102?

2. Why do bonds sell at a discount? At a premium? At face value? 3. Explain the accounting for redemption of bonds at maturity and before ma-

turity by payment in cash.

� Do It

Assume a company issued bonds with the following characteristics: (a) interest to be paid $50,000, (b) interest expense to be recorded $52,000, and (c) amortization $2,000. Answer these questions: (1) Were the bonds sold at a premium or a dis- count? (2) After recording the interest expense, will the bond carrying value in- crease or decrease?

Action Plan • Know the effects that the amortization of bond discount and bond premium

have on bond interest expense and on the carrying value of the bonds. • Remember bond discount amortization increases both bond interest expense

and the carrying value of the bonds. Bond premium amortization has the re- verse effects.

Solution (1) Interest expense is $2,000 greater than the interest paid. This difference is equal to the amortization amount. Thus, the bonds were sold at a discount. (2) The interest entry will decrease Discount on Bonds Payable and increase the car- rying value of the bonds.

●❍ THE NAVIGATOR ✓✓

ree ee bobobobondndndndssss s baaaalllal ncncncnce

490 CHAPTER 10 Reporting and Analyzing Liabilities

Financial Statement Presentation and Analysis

BALANCE SHEET PRESENTATION Current liabilities are the first category under Liabilities on the balance sheet. Companies list each of the principal types of current liabilities separately within the category.

Within the current liabilities section, companies usually list notes payable first, followed by accounts payable. Other items sometimes are listed in the order of their magnitude. In your homework, you should present notes payable first, followed by accounts payable, and then other liabilities in order of magnitude.

Companies report long-term liabilities in a separate section of the balance sheet immediately following “Current liabilities.” An example is shown in Illus- tration 10-15.

MARAIS COMPANY Balance Sheet (partial)

Liabilities

Current liabilities Notes payable $ 250,000 Accounts payable 125,000 Current maturities of long-term debt 300,000 Accrued liabilities 75,000

Total current liabilities $ 750,000 Long-term liabilities

Bonds payable 1,000,000 Less: Discount on bonds payable 80,000 920,000

Notes payable, secured by plant assets 540,000 Lease liability 500,000

Total long-term liabilities 1,960,000

Total liabilities $2,710,000

Illustration 10-15 Balance sheet presentation of liabilities

Disclosure of debt is very important. Failures at Enron, WorldCom, and Global Crossing, have made investors very concerned about companies’ debt obligations. Summary data regarding debts may be presented in the balance sheet with detailed data (such as interest rates, maturity dates, conversion priv- ileges, and assets pledged as collateral) shown in a supporting schedule in the notes. Companies should report current maturities of long-term debt as a current liability.

STATEMENT OF CASH FLOWS PRESENTATION The balance sheet presents the balances of a company’s debts at a point in time. The statement of cash flows also presents information about a company’s debts. Information regarding cash inflows and outflows during the year that resulted from the principal portion of debt transactions appears in the “Financing activities” section of the statement of cash flows. Interest expense is reported in the “Operating activities” section, even though it resulted from debt transactions.

Illustration 10-16 presents the cash flows from financing activities from the statement of cash flows for the Automotive Division of General Motors. From this we learn that the division issued new long-term debt of $758 million and repaid long-term debt of $79 million.

S T U D Y O B J E C T I V E

7 Identify the requirements

for the financial statement presentation and analysis of

liabilities.

nnnn aaaannnndddd AAAAnnnnalyyyssiiissnnnn aaaannnndddd AAAAnnnnalyyyyssssiiiissss

Financial Statement Presentation and Analysis 491

ANALYSIS Careful examination of debt obligations helps you assess a company’s ability to pay its current and long-term obligations. It also helps you determine whether a company can obtain debt financing in order to grow. We will use the following information from the financial statements of General Motors to illustrate the analysis of a company’s liquidity and solvency.

GENERAL MOTORS CORPORATION— AUTOMOTIVE DIVISION

Statement of Cash Flows (partial) 2004

(in millions)

Cash flows from financing activities Net increase (decrease) in loans payable $ (803) Long-term debt—borrowings 758 Long-term debt—repayments (79) Cash dividends paid to stockholders (1,129)

Net cash (used in) provided by financing activities $ (1,253)

Illustration 10-16 Financing activities section of statement of cash flows

GENERAL MOTORS CORPORATION— AUTOMOTIVE DIVISION

Balance Sheets December 31, 2004 and 2003

(in millions)

Assets 2004 2003

Total current assets $ 55,515 $ 57,855 Noncurrent assets 103,788 103,930

Total assets $159,303 $161,785

Liabilities and Stockholders’ Equity

Total current liabilities $ 74,892 $ 71,264 Noncurrent liabilities 78,894 85,397

Total liabilities 153,786 156,661 Total stockholders’ equity 5,517 5,124

Total liabilities and stockholders’ equity $159,303 $161,785

Illustration 10-17 Simplified balance sheets for General Motors Corporation

Liquidity Liquidity ratios measure the short-term ability of a company to pay its matur- ing obligations and to meet unexpected needs for cash. A commonly used mea- sure of liquidity is the current ratio (presented in Chapter 2). The current ratio is calculated as current assets divided by current liabilities. Illustration 10-18 presents the current ratio for General Motors along with the industry average.

Illustration 10-18 Current ratio

Industry General Motors Average

($ in millions) 2004 2003 2004

� .74:1 � .81:1 1.59:1$57,855�� $71,264

$55,515 � $74,892

Current Ratio

Illustration 10 16 FiFFF naaaancnnn ing acacaactititivivivivititititieseseses ssectttioon of sssstatatatatetetetementntntnt oo o of cccac shhshsh f ffloololowswswsws

492 CHAPTER 10 Reporting and Analyzing Liabilities

General Motors’ current assets are less than its current liabilities. Therefore its current ratio is less than 1 in both 2003 and 2004. The industry average cur- rent ratio for manufacturers of autos and trucks is 1.59:1.3 Thus, General Motors appears to lack liquidity.

Many companies today minimize their liquid assets (such as cash, accounts receivable, and inventory) in order to improve profitability measures, such as return on assets. This is particularly true of large companies such as GM. Com- panies that keep fewer liquid assets on hand must rely on other sources of liq- uidity. One such source is a bank line of credit. A line of credit is a prearranged agreement between a company and a lender that permits the company, should it be necessary, to borrow up to an agreed-upon amount. The disclosure re- garding debt in General Motors’ financial statements states that it has $8.3 bil- lion of unused lines of credit. This represents a substantial amount of available cash. In addition, the Management Discussion and Analysis section of GM’s an- nual report provides an extensive discussion of the company’s liquidity. In it, GM notes that even though its credit rating was downgraded during the year, its “access to the capital markets remained sufficient to meet the Corporation’s capital needs.” Thus, even though General Motors has a low current ratio, its available lines of credit as well as other sources of financing appear adequate to meet any short-term cash deficiency it might experience.

Decision Toolkit

Can the company obtain short-term financing when necessary?

Available lines of credit, from notes to the financial state- ments.

Compare available lines of credit to current liabilities. Also, evaluate liquidity ratios.

If liquidity ratios are low, then lines of credit should be high to compensate.

Decision Checkpoints Info Needed for Decision Tool to Use for Decision How to Evaluate Results

Solvency Solvency ratios measure the ability of a company to survive over a long period of time. The Feature Story in this chapter mentioned that although there once were many U.S. automobile manufacturers, only two U.S.-based companies remain today. Many of the others went bankrupt. This highlights the fact that when making a long-term loan or purchasing a company’s stock, you must give consideration to a company’s solvency.

To reduce the risks associated with having a large amount of debt during an economic downturn, U.S. automobile manufacturers have taken two pre- cautionary steps. First, they have built up large balances of cash and cash equivalents to avoid a cash crisis. Second, recently they have been reluctant to build new plants or hire new workers to meet their production needs. Instead, they have asked existing workers to put in overtime, or they “outsource” work to other companies. In this way, if an economic downturn occurs, they avoid having to make debt payments on idle production plants, and they minimize layoffs.

In Chapter 2 you learned that one measure of a company’s solvency is the debt to total assets ratio. This is calculated as total liabilities divided by total as- sets. This ratio indicates the extent to which a company’s assets are financed with debt.

3 Market Guide based this and subsequent industry ratios used in this chapter on a group of

29 companies that manufacture cars and trucks (see multex.com).

rrrrreereent lllliabibibiillill ties. Therefore ThThThThe eee inininindudududusssts ryryry aveveverageee currrr- :1.3333 ThThThThuusuu , GeGGeneeerral MoMoMoMotorssss

Financial Statement Presentation and Analysis 493

Other measures can also be useful in assessing solvency. One such measure is the times interest earned ratio, which provides an indication of a company’s ability to meet interest payments as they come due. It is computed by dividing income before interest expense and income taxes by interest expense. It uses income before interest expense and taxes because this number best represents the amount available to pay interest.

We can use the balance sheet information presented on page 491 and the ad- ditional information below to calculate solvency ratios for the Automotive Divi- sion of General Motors.

($ in millions) 2004 2003

Net income (loss) $(89) $995 Interest expense 2,480 1,780 Tax expense (refund) (2,325) (869)

The debt to total assets ratios and times interest earned ratios for General Motors and averages for the industry are shown in Illustration 10-19.

Illustration 10-19 Solvency ratios

Debt to Total Assets Ratio � Total Liabilities ��

Total Assets

Industry General Motors Average

($ in millions) 2004 2003 2004

84.6%

6.38 times

� .03 times � 1.07 times

$995 � $1,780 � $869 ��

$1,780 $(89) � $2,480 � $2,325 ��

$2,480Times Interest Earned Ratio

$156,661

$161,785 � 97%

$153,786

$159,303 � 97%

Debt to Total Assets Ratio

� Net Income � Interest Expense � Tax Expense ��

Interest Expense Times Interest Earned

Ratio

General Motors’ debt to total assets ratio remained constant at 97%. The in- dustry average for manufacturers of autos and trucks is 84.6%. Thus, General Motors’ ratio is very high, especially considering that we are looking only at the automotive division and have excluded the financing division of the company, which traditionally has a very high debt to total assets ratio.

General Motors’ times interest earned ratio declined from 1.07 times in 2003 to .03 in 2004. The industry average for manufacturers of autos and trucks is much higher at 6.38 times. In 2004, General Motors’ income before interest ex- pense and taxes—that is, income after adding back interest expense and in this case, deducting a tax refund—was only $66 million. The company’s high debt to total assets ratio, combined with its interest coverage ratio of .03, should be of obvious concern to the company’s creditors and investors. This concern was reflected in a downgrade to GM’s credit rating by debt-rating services.

mmemm assssureee ompmpmpmpanananany’yyyssss

didididivivivividiiiingngngng I

494 CHAPTER 10 Reporting and Analyzing Liabilities

Off-Balance-Sheet Financing A concern for analysts when they evaluate a company’s liquidity and solvency is whether that company has properly recorded all of its obligations. The bankruptcy of Enron Corporation, one of the largest bankruptcies in U.S. history, demon- strated how much damage can result when a company does not properly record or disclose all of its debts. Many would say Enron was practicing off-balance-sheet financing. Off-balance-sheet financing is an attempt to borrow funds in such a way that the obligations are not recorded. Two common types of off-balance-sheet financing result from contingencies and lease transactions.

CONTINGENCIES One reason a company’s balance sheet might not fully reflect its potential obli- gations is due to contingencies. Contingencies are events with uncertain out- comes. A common type of contingency is lawsuits. Suppose, for example, that you were analyzing the financial statements of a cigarette manufacturer and did not consider the possible negative implications of existing unsettled lawsuits. Your analysis of the company’s financial position would certainly be misleading. Other common types of contingencies are product warranties and environmental clean- up obligations. For example, in 2004 Novartis AG began offering a money-back guarantee on its blood-pressure medications The creation of this guarantee will necessitate an accrual for the estimated claims that will result from returns.

The Williams Companies recently faced the prospect of a credit-rating down- grade by Moody’s Investors Service Inc. Lenders are heavily influenced by these ratings, so a downgrade would make it harder for the company to borrow funds, as well as make borrowing more expensive. The company quickly announced plans to improve its liquidity and solvency. It said it would sell assets of $1.5 to $3.0 billion, issue common stock of $1 to $1.5 billion, and cut annual costs by $100 million. It also said it would continue to evaluate the size of its dividend payment on common stock. It said it would use the funds generated by these actions to pay down existing debt and to increase its liquidity.

Source: “Williams Unveils Measures to Bolster its Balance Sheet,” Wall Street Jour- nal Online (May 28, 2002).

Explain how the sale of plant assets could improve the company’s solvency.

Business Insight I nvestor Perspect ive

Decision Toolkit

Can the company meet its obli- gations in the long term?

Interest expense and net in- come before interest and taxes

High ratio indicates ability to meet interest payments as scheduled.

Net income � Interest expense

� Tax expense Interest expense

Times interest � earned ratio

Decision Checkpoints Info Needed for Decision Tool to Use for Decision How to Evaluate Results

Off-Balance-Sheet Financing 495

Accounting rules require that companies disclose contingencies in the notes; in some cases they must accrue them as liabilities. For example, suppose that Waterbury Inc. is sued by a customer for $1 million due to an injury sustained by a defective product. If at the company’s year-end, the lawsuit had not yet been resolved, how should Waterbury account for this event? If the company can de- termine a reasonable estimate of the expected loss and if it is probable it will lose the suit, then the company should accrue for the loss. It records the loss by increasing (debiting) a loss account and increasing (crediting) a liability such as Lawsuit Liability. If both of these conditions are not met, then the company dis- closes the basic facts regarding this suit in the notes to its financial statements.

LEASING One common type of off-balance-sheet financing results from leasing. Most lessees do not like to report leases on their balance sheets because the lease in- creases the company’s total liabilities. Recall from Chapter 9 that operating leases are treated like rentals—no asset or liabilities show on the books. Capital leases are treated like a purchase—increasing both assets and liabilities. As a result, many companies structure their lease agreements to avoid meeting the criteria of a capital lease.

Recall from Chapter 9 that many U.S. airlines lease a large portion of their planes without showing any debt related to them on their balance sheets. For example, the total increase in assets and liabilities that would result if Southwest Airlines recorded on the balance sheet its off-balance-sheet “operating” leases would be approximately $2.7 billion. Illustration 10-20 presents Southwest Air- lines’ debt to total assets ratio using the numbers presented in its balance sheet and also shows the ratio after adjusting for the off-balance-sheet leases. After those adjustments, Southwest has a ratio of 61% versus 51% before. This means that of every dollar of assets, 61 cents was funded by debt. This would be of in- terest to analysts evaluating Southwest’s solvency.

Illustration 10-20 Debt to total assets ratio adjusted for leases

Using numbers as presented Adjusted for off-balance- on balance sheet sheet leases

� 51% � 61% $5,813 � $2,677 �� $11,337 � $2,677

$5,813 � $11,337

Debt to total assets ratio

Critics of off-balance-sheet financing contend that many leases represent un- avoidable obligations that meet the definition of a liability, and therefore com- panies should report them as liabilities on the balance sheet. To reduce these concerns, companies are required to report in a note their operating lease obli- gations for subsequent years. This allows analysts and other financial statement users to adjust a company’s financial statements by adding leased assets and lease liabilities if they feel that this treatment is more appropriate.

Decision Toolkit

Does the company have any contingent liabilities?

Does the company have sig- nificant off-balance-sheet fi- nancing, such as unrecorded lease obligations?

Knowledge of events with un- certain negative outcomes

Information on unrecorded obli- gations, such as a schedule of minimum lease payments from the lease note

Notes to financial statements and financial statements

Compare liquidity and solvency ratios with and without un- recorded obligations included.

If negative outcomes are possi- ble, determine the probability, the amount of loss, and the potential impact on financial statements.

If ratios differ significantly after including unrecorded obli- gations, these obligations should not be ignored in analysis.

Decision Checkpoints Info Needed for Decision Tool to Use for Decision How to Evaluate Results

hhhhee ee noooottett s;;; poooossses tttthahahahatttt suststststaiaaa nenenenedddd

496 CHAPTER 10 Reporting and Analyzing Liabilities

B E F O R E Y O U G O O N . . .

� Review It

1. What is meant by solvency? 2. What information does the times interest earned ratio provide, and how is

the ratio calculated? 3. What is meant by “off-balance-sheet financing”? What is a common exam-

ple of off-balance-sheet financing? 4. What are contingent liabilities? ●❍ THE

NAVIGATOR ✓✓

Using the Decision Toolkit Ford Motor Company has enjoyed some tremendous successes, including its popular Taurus and Explorer vehicles. Yet observers are looking for the next big hit. Devel- opment of a new vehicle costs billions. A flop is financially devastating, and the financial effect is magnified if the company has large amounts of outstanding debt.

The balance sheets below provide financial information for the Automotive Di- vision of Ford Motor Company as of December 31, 2004 and 2003. We have chosen to analyze only the Automotive Division rather than the total corporation, which includes Ford’s giant financing division. In an actual analysis you would want to analyze the major divisions individually as well as the combined corporation as a whole.

Instructions

1. Evaluate Ford’s liquidity using appropriate ratios, and compare to those of General Motors and to industry averages.

2. Evaluate Ford’s solvency using appropriate ratios, and compare to those of General Motors and to industry averages.

3. Comment on Ford’s available lines of credit.

FORD MOTOR COMPANY— AUTOMOTIVE DIVISION

Balance Sheets December 31, 2004 and 2003

(in millions)

Assets 2004 2003

Current assets $ 44,703 $ 43,742 Noncurrent assets 71,719 71,702

Total assets $116,422 $115,444

Liabilities and Shareholders’ Equity

Current liabilities $ 55,027 $ 52,292 Noncurrent liabilities 57,612 64,612

Total liabilities 112,639 116,904 Total shareholders’ equity 3,783 (1,460)

Total liabilities and shareholders’ equity $116,422 $115,444

Other Information

Net income (loss) $ (155) $ (1,908) Tax expense (refund) (30) (175) Interest expense 1,221 1,323 Available lines of credit (Automotive Division) 7,100

....

Summary of Study Objectives 497

Solution

1. Ford’s liquidity can be measured using the current ratio:

2004 2003

Current ratio � .81:1 � .84:1

Like that of General Motors, Ford’s current ratio is well below the industry average of 1.59:1 and below 1—indicating that its current assets are less than its current liabilities. These are increasingly common levels for large companies that have reduced the amount of cash, inventory, and receivables they hold. As noted earlier, these low current ratios are not necessarily cause for concern, but they do require more careful monitoring. Ford must also make sure to have other short-term financing options available, such as lines of credit.

2. Ford’s solvency can be measured with the debt to total assets ratio and the times interest earned ratio:

2004 2003

Debt to total assets ratio � 97% � 101%

Times interest earned ratio

� .85 times � 0 times

The debt to total assets ratio suggests that Ford, like General Motors, relies very heavily on debt financing. The ratio decreased from 2003 to 2004, indicat- ing that the company’s solvency improved slightly. In 2003 its ratio exceeds 1. This is possible because we have calculated the ratio for the Automotive Division only, rather than the whole company. The debt to total assets ratio for the entire company is 94.5%. This is extremely high.

The times interest earned ratio increased from a zero in 2003 to .85 in 2004. The 2003 ratio is zero because, even after adding back interest and taxes, the company’s income was negative. This is well below the industry average of 6.38 times. It is likely that the company’s solvency was a concern to investors and creditors and would be closely monitored.

3. Ford has available lines of credit of $7.1 billion. These financing sources signifi- cantly improve its liquidity.

$(1,908)� $1,323� $175 ��

$1,323 $(155) � $1,221 � $30 ��

$1,221

$116,904 � $115,444

$112,639 � $116,422

$43,742 � $52,292

$44,703 � $55,027

●❍ THE NAVIGATOR ✓✓

Summary of Study Objectives

1 Explain a current liability and identify the major types of current liabilities. A current liability is a debt that a company can reasonably expect to pay (a) from ex- isting current assets or through the creation of other current liabilities, and (b) within one year or the op- erating cycle, whichever is longer. The major types of current liabilities are notes payable, accounts payable, sales taxes payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest payable.

2 Describe the accounting for notes payable. When a promissory note is interest-bearing, the amount of assets received upon the issuance of the note is

generally equal to the face value of the note, and interest expense is accrued over the life of the note. At maturity, the amount paid is equal to the face value of the note plus accrued interest.

3 Explain the accounting for other current liabilities. Companies record sales taxes payable at the time the related sales occur. The company serves as a collec- tion agent for the taxing authority. Sales taxes are not an expense to the company. Companies hold employee withholding taxes, and credit them to appropriate li- ability accounts, until they remit these taxes to the governmental taxing authorities. Unearned revenues are initially recorded in an unearned revenue account.

498 CHAPTER 10 Reporting and Analyzing Liabilities

As the company earns the revenue, a transfer from un- earned revenue to earned revenue occurs. Companies should report the current maturities of long-term debt as a current liability in the balance sheet.

4 Identify the types of bonds. The following different types of bonds may be issued: secured and unsecured bonds, and convertible and callable bonds.

5 Prepare the entries for the issuance of bonds and inter- est expense. When companies issue bonds, they debit Cash for the cash proceeds and credit Bonds Payable for the face value of the bonds. In addition, they use the accounts Premium on Bonds Payable and Discount on Bonds Payable to show the bond premium and bond discount, respectively. Bond discount and bond premium are amortized over the life of the bond.

6 Describe the entries when bonds are redeemed. When companies redeem bonds at maturity, they credit Cash and debit Bonds Payable for the face value of the bonds. When companies redeem bonds before matu-

rity, they (a) eliminate the carrying value of the bonds at the redemption date, (b) record the cash paid, and (c) recognize the gain or loss on redemption.

7 Identify the requirements for the financial statement presentation and analysis of liabilities. Current lia- bilities appear first on the balance sheet, followed by long-term liabilities. Companies should report the nature and amount of each liability in the balance sheet or in schedules in the notes accompanying the statements. They report inflows and outflows of cash related to the principal portion of long-term debt in the financing section of the statement of cash flows.

The liquidity of a company may be analyzed by computing the current ratio. The long-run solvency of a company may be analyzed by computing the debt to total assets ratio and the times interest earned ratio. Other factors to consider are contingent liabilities and lease obligations.

●❍ THE NAVIGATOR ✓✓

Decision Toolkit—A Summary

Can the company obtain short-term financing when necessary?

Can the company meet its obli- gations in the long term?

Does the company have any contingent liabilities?

Does the company have sig- nificant off-balance-sheet fi- nancing, such as unrecorded lease obligations?

Available lines of credit, from notes to the financial state- ments

Interest expense and net in- come before interest and taxes

Knowledge of events with un- certain negative outcomes

Information on unrecorded obli- gations, such as a schedule of minimum lease payments from the lease note

Compare available lines of credit to current liabilities. Also, evaluate liquidity ratios.

Notes to financial statements and financial statements

Compare liquidity and solvency ratios with and without un- recorded obligations included.

If liquidity ratios are low, then lines of credit should be high to compensate.

High ratio indicates ability to meet interest payments as scheduled.

If negative outcomes are possi- ble, determine the probability, the amount of loss, and the po- tential impact on financial statements.

If ratios differ significantly after including unrecorded obli- gations, these obligations should not be ignored in analysis.

Net income � Interest expense

� Tax expense Interest expense

Times interest � earned ratio

Decision Checkpoints Info Needed for Decision Tool to Use for Decision How to Evaluate Results

A P P E N D I X 1 0 A STRAIGHT-LINE AMORTIZATION

Amortizing Bond Discount To follow the matching principle, companies allocate bond discount to expense in each period in which the bonds are outstanding. The straight-line method of amortization allocates the same amount to interest expense in each interest period. The calculation is presented in Illustration 10A-1.

S T U D Y O B J E C T I V E

8 Apply the straight-line

method of amortizing bond discount and bond premium.

hehehehe cc carryryryryingg g g vvavv lue of the bonds (bbbb) ) )) reeeecocococordddd t hehehehe caaasa h hhh paidddd,, anannandddd

r loooossssssss o oon n nn rerrr deeemmptttioon.

Amortizing Bond Premium 499

In the Candlestick Inc. example (page 485), the company sold $100,000, five-year, 10% bonds on January 1, 2007, for $98,000. This resulted in a $2,000 bond discount ($100,000 � $98,000). The bond discount amortization is $400 ($2,000 � 5) for each of the five amortization periods. Candlestick records the first accrual of bond interest and the amortization of bond discount on Decem- ber 31 as follows.

Illustration 10A-1 Formula for straight-line method of bond discount amortization

� � Bond

Discount Amortization

Number of Interest

Periods

Bond Discount

Dec. 31 Bond Interest Expense 10,400 Discount on Bonds Payable 400 Bond Interest Payable 10,000

(To record accrued bond interest and amortization of bond discount)

Cash Flows no effect

A � L � SE �10,400 Exp

�400 �10,000

Over the term of the bonds, the balance in Discount on Bonds Payable will de- crease annually by the same amount until it has a zero balance at the maturity date of the bonds. Thus, the carrying value of the bonds at maturity will be equal to the face value of the bonds.

Preparing a bond discount amortization schedule, as shown in Illustration 10A-2, is useful to determine interest expense, discount amortization, and the carrying value of the bond. As indicated, the interest expense recorded each pe- riod is $10,400. Also note that the carrying value of the bond increases $400 each period until it reaches its face value of $100,000 at the end of period 5.

BOND DISCOUNT AMORTIZATION SCHEDULE Straight-Line Method—Annual Interest Payments

$100,000 of 10%, 5-Year Bonds

(A) (B) (C) (D) (E) Interest To Interest Expense Discount Unamortized Bond

Interest Be Paid To Be Recorded Amortization Discount Carrying Value Periods (10% � $100,000) (A) � (C) ($2,000 � 5) (D) � (C) ($100,000 � D)

Issue date $2,000 $ 98,000 1 $10,000 $10,400 $ 400 1,600 98,400 2 10,000 10,400 400 1,200 98,800 3 10,000 10,400 400 800 99,200 4 10,000 10,400 400 400 99,600 5 10,000 10,400 400 0 100,000

$50,000 $52,000 $2,000

Column (A) remains constant because the face value of the bonds ($100,000) is multiplied by the annual contractual interest rate (10%) each period. Column (B) is computed as the interest paid (Column A) plus the discount amortization (Column C). Column (C) indicates the discount amortization each period. Column (D) decreases each period by the same amount until it reaches zero at maturity. Column (E) increases each period by the amount of discount amortization until it equals the face value at maturity.

Illustration 10A-2 Bond discount amortization schedule

Amortizing Bond Premium The amortization of bond premium parallels that of bond discount. Illustration 10A-3 presents the formula for determining bond premium amortization under the straight-line method.

Alternative Terminology The amount in the Discount on Bonds Payable account is often referred to as Unamortized Discount on Bonds Payable.

Illustration 10A 1 FoFFF rmmmmuluu a foooorr stststrarararaigggghthththt-linnnneeee mmmethod of bobobobondndnnd disssscocococoun aaama oroorortititizaazazatittt onononon

500 CHAPTER 10 Reporting and Analyzing Liabilities

Illustration 10A-3 Formula for straight-line method of bond premium amortization

� � Bond

Premium Amortization

Number of Interest

Periods

Bond Premium

Continuing our example, assume Candlestick Inc., sells the bonds described above for $102,000, rather than $98,000. This results in a bond premium of $2,000 ($102,000 � $100,000). The premium amortization for each interest pe- riod is $400 ($2,000 � 5). Candlestick records the first accrual of interest on December 31 as follows.

Cash Flows no effect

A � L � SE �9,600 Exp

�400 �10,000

Dec. 31 Bond Interest Expense 9,600 Premium on Bonds Payable 400

Bond Interest Payable 10,000 (To record accrued bond interest and amortization of bond premium)

Over the term of the bonds, the balance in Premium on Bonds Payable will decrease annually by the same amount until it has a zero balance at maturity.

A bond premium amortization schedule, as shown in Illustration 10A-4, is useful to determine interest expense, premium amortization, and the carrying value of the bond. As indicated, the interest expense Candlestick records each period is $9,600. Note that the carrying value of the bond decreases $400 each period until it reaches its face value of $100,000 at the end of period 5.

BOND PREMIUM AMORTIZATION SCHEDULE Straight-Line Method—Annual Interest Payments

$100,000 of 10%, 5-Year Bonds

(A) (B) (C) (D) (E) Interest To Interest Expense Premium Unamortized Bond

Interest Be Paid To Be Recorded Amortization Premium Carrying Value Periods (10% � $100,000) (A) � (C) ($2,000 � 5) (D) � (C) ($100,000 � D)

Issue date $2,000 $102,000 1 $10,000 $ 9,600 $ 400 1,600 101,600 2 10,000 9,600 400 1,200 101,200 3 10,000 9,600 400 800 100,800 4 10,000 9,600 400 400 100,400 5 10,000 9,600 400 0 100,000

$50,000 $48,000 $2,000

Column (A) remains constant because the face value of the bonds ($100,000) is multiplied by the annual contractual interest rate (10%) each period. Column (B) is computed as the interest paid (Column A) less the premium amortization (Column C). Column (C) indicates the premium amortization each period. Column (D) decreases each period by the same amount until it reaches zero at maturity. Column (E) decreases each period by the amount of premium amortization until it equals the face value at maturity.

Illustration 10A-4 Bond premium amortization schedule

BoBoBoBondnnn Prrrrememememiummm

AAAA ti titi

Appendix Effective-Interest Amortization 501

Summary of Study Objective for Appendix 10A

8 Apply the straight-line method of amortizing bond dis- count and bond premium. The straight-line method of

amortization results in a constant amount of amor- tization and interest expense per period.

A P P E N D I X 1 0 B EFFECTIVE-INTEREST AMORTIZATION

To follow the matching principle, companies allocate bond discount to ex- pense in each period in which the bonds are outstanding. However, to com- pletely comply with the matching principle, interest expense as a percentage of carrying value should not change over the life of the bonds. This percent- age, referred to as the effective-interest rate, is established when the bonds are issued and remains constant in each interest period. Unlike the straight- line method, the effective-interest method of amortization accomplishes this result.

Under the effective-interest method, the amortization of bond discount or bond premium results in periodic interest expense equal to a constant per- centage of the carrying value of the bonds. The effective-interest method results in varying amounts of amortization and interest expense per period but a con- stant percentage rate. In contrast, the straight-line method results in constant amounts of amortization and interest expense per period but a varying per- centage rate.

Companies follow three steps under the effective-interest method:

1. Compute the bond interest expense by multiplying the carrying value of the bonds at the beginning of the interest period by the effective-interest rate.

2. Compute the bond interest paid (or accrued) by multiplying the face value of the bonds by the contractual interest rate.

3. Compute the amortization amount by determining the difference between the amounts computed in steps (1) and (2).

Illustration 10B-1 depicts these steps.

Illustration 10B-1 Computation of amortization using effective-interest method

(1) (2) (3) Bond Interest Expense Bond Interest Paid

� � � � Amortization

Amount

Contractual Interest

Rate

Face Amount of Bonds

Effective Interest

Rate

Carrying Value of Bonds

at Beginning of Period

Both the straight-line and effective-interest methods of amortization re- sult in the same total amount of interest expense over the term of the bonds. Furthermore, interest expense each interest period is generally comparable in amount. However, when the amounts are materially different, generally accepted accounting principles (GAAP) require use of the effective-interest method.

S T U D Y O B J E C T I V E

9 Apply the effective-interest method of amortizing bond

discount and bond premium.

0000AAAA0AAAA ressuuluu ts iiiinnn n a cocococonsssstaatanttntnt a a a amommomoununununt offff a aaam

502 CHAPTER 10 Reporting and Analyzing Liabilities

Amortizing Bond Discount To illustrate the effective-interest method of bond discount amortization, assume that Wrightway Corporation issues $100,000 of 10%, five-year bonds on January 1, 2007, with interest payable each January 1. The bonds sell for $92,790 (92.79% of face value), which results in bond discount of $7,210 ($100,000 � $92,790) and an effective-interest rate of 12%. (Note that the $92,790 can be proven as shown in Appendix C at the end of this book.)

Preparing a bond discount amortization schedule as shown in Illustration 10B-2 facilitates the recording of interest expense and the discount amortization. Note that interest expense as a percentage of carrying value remains constant at 12%.

WRIGHTWAY CORPORATION Bond Discount Amortization

Effective-Interest Method—Annual Interest Payments 10% Bonds Issued at 12%

(B) Interest Expense (C) (D) (E)

(A) to Be Recorded Discount Unamortized Bond Interest Interest to Be Paid (12% � Preceding Bond Amortization Discount Carrying Value Periods (10% � $100,000) Carrying Value) (B) � (A) (D) � (C) ($100,000 � D)

Issue date $7,210 $ 92,790 1 $10,000 $11,135 (12% � $92,790) $1,135 6,075 93,925 2 10,000 11,271 (12% � $ 93,925) 1,271 4,804 95,196 3 10,000 11,424 (12% � $ 95,196) 1,424 3,380 96,620 4 10,000 11,594 (12% � $ 96,620) 1,594 1,786 98,214 5 10,000 11,786 (12% � $ 98,214) 1,786 –0– 100,000

$ 50,000 $ 57,210 $ 7,210

Column (A) remains constant because the face value of the bonds ($100,000) is multiplied by the annual contractual interest rate (10%) each period. Column (B) is computed as the preceding bond carrying value times the annual effective-interest rate (12%). Column (C) indicates the discount amortization each period. Column (D) decreases each period until it reaches zero at maturity. Column (E) increases each period until it equals face value at maturity.

Illustration 10B-2 Bond discount amortization schedule

For the first interest period, the computations of bond interest expense and the bond discount amortization are as follows.

Illustration 10B-3 Computation of bond discount amortization

Bond interest expense ($92,790 � 12%) $11,135 Bond interest paid ($100,000 � 10%) 10,000

Bond discount amortization $ 1,135

Helpful Hint Note that the amount of periodic interest ex- pense increases over the life of the bonds when the effective- interest method is used for bonds issued at a discount. The reason is that a constant percentage is applied to an increasing bond carrying value to compute interest expense. The carrying value is increasing because of the amortization of the discount.

As a result, Wrightway Corporation records the accrual of interest and amorti- zation of bond discount on December 31, as follows.

Dec. 31 Bond Interest Expense 11,135 Discount on Bonds Payable 1,135 Bond Interest Payable 10,000

(To record accrued interest and amortization of bond discount)

Cash Flows no effect

A � L � SE �11,135 Exp

�1,135 �10,000

ounnnnt t t t ammmmoooro tizazazationooo , ,, asaaa ssusuumememee

Amortizing Bond Premium 503

For the second interest period, bond interest expense will be $11,271 ($93,925 � 12%), and the discount amortization will be $1,271. At December 31, Wrightway makes the following adjusting entry.

Cash Flows no effect

A � L � SE �11,271 Exp

�1,271 �10,000

Dec. 31 Bond Interest Expense 11,271 Discount on Bonds Payable 1,271 Bond Interest Payable 10,000

(To record accrued interest and amortization of bond discount)

Amortizing Bond Premium The amortization of bond premium by the effective-interest method is similar to the procedures described for bond discount. As an example, assume that Wrightway Corporation issues $100,000, 10%, five-year bonds on January 1, with interest payable on January 1. In this case, the bonds sell for $107,985, which results in bond premium of $7,985 and an effective-interest rate of 8%. Illustra- tion 10B-4 shows the bond premium amortization schedule.

WRIGHTWAY CORPORATION Bond Premium Amortization

Effective-Interest Method—Annual Interest Payments 10% Bonds Issued at 8%

(B) Interest Expense (C) (D) (E)

(A) to Be Recorded Premium Unamortized Bond Interest Interest to Be Paid (8% � Preceding Bond Amortization Premium Carrying Value Periods (10% � $100,000) Carrying Value) (A) � (B) (D) � (C) ($100,000 � D)

Issue date $7,985 $107,985 1 $10,000 $ 8,639 (8% � $107,985) $1,361 6,624 106,624 2 10,000 8,530 (8% � $ 106,624) 1,470 5,154 105,154 3 10,000 8,412 (8% � $ 105,154) 1,588 3,566 103,566 4 10,000 8,285 (8% � $ 103,566) 1,715 1,851 101,851 5 10,000 8,149* (8% � $ 101,851) 1,851 –0– 100,000

$50,000 $ 42,015 $7,985

Column (A) remains constant because the face value of the bonds ($100,000) is multiplied by the contractual interest rate (10%) each period. Column (B) is computed as the carrying value of the bonds times the annual effective-interest rate (8%). Column (C) indicates the premium amortization each period. Column (D) decreases each period until it reaches zero at maturity. Column (E) decreases each period until it equals face value at maturity.

*$1 difference due to rounding.

Illustration 10B-4 Bond premium amortization schedule

Helpful Hint When a bond sells for $107,985 it is quoted at 107.985% of face value. Note that $107,985 can be proven as shown in Appendix C.

For the first interest period, the computations of bond interest expense and the bond premium amortization are:

Illustration 10B-5 Computation of bond premium amortization

Bond interest paid ($100,000 � 10%) $10,000 Bond interest expense ($107,985 � 8%) 8,639

Bond premium amortization $ 1,361

$$1$$ 1,,,27222 1111 mmmmbebebeber r r r 31313131,,,,

504 CHAPTER 10 Reporting and Analyzing Liabilities

The entry Wrightway makes on December 31 is:

Cash Flows no effect

A � L � SE �8,639 Exp

�1,361 �10,000

Dec. 31 Bond Interest Expense 8,639 Premium on Bonds Payable 1,361

Bond Interest Payable 10,000 (To record accrued interest and amortization of bond premium)

For the second interest period, interest expense will be $8,530, and the pre- mium amortization will be $1,470. Note that the amount of periodic interest expense decreases over the life of the bond when companies apply the effective- interest method to bonds issued at a premium. The reason is that a constant percentage is applied to a decreasing bond carrying value to compute interest expense. The carrying value is decreasing because of the amortization of the premium.

Summary of Study Objective for Appendix 10B

9 Apply the effective-interest method of amortizing bond discount and bond premium. The effective-interest method results in varying amounts of amortization and interest expense per period but a constant per-

centage rate of interest. When the difference between the straight-line and effective-interest method is ma- terial, GAAP requires use of the effective-interest method.

A P P E N D I X 1 0 C

ACCOUNTING FOR LONG-TERM NOTES PAYABLE

The use of notes payable in long-term debt financing is quite common. Long- term notes payable are similar to short-term interest-bearing notes payable ex- cept that the terms of the notes exceed one year. In periods of unstable interest rates, lenders may tie the interest rate on long-term notes to changes in the mar- ket rate for comparable loans. Examples are the 8.03% adjustable rate notes is- sued by General Motors and the floating-rate notes issued by American Express Company.

A long-term note may be secured by a document called a mortgage that pledges title to specific assets as security for a loan. Individuals widely use mortgage notes payable to purchase homes, as do many small and some large companies to acquire plant assets. For example, at one time approximately 18% of McDonalds’ long-term debt related to mortgage notes on land, buildings, and improvements.

Like other long-term notes payable, the mortgage loan terms may stipulate either a fixed or an adjustable interest rate. Typically, the terms require the bor- rower to make equal installment payments over the term of the loan. Each pay- ment consists of (1) interest on the unpaid balance of the loan and (2) a reduc- tion of loan principal. The interest decreases each period, while the portion applied to the loan principal increases.

Companies initially record mortgage notes payable at face value, and subse- quently make entries for each installment payment. To illustrate, assume that Porter Technology Inc. issues a $500,000, 12%, 20-year mortgage note on December 31, 2007, to obtain needed financing for the construction of a new research laboratory.

S T U D Y O B J E C T I V E

10 Describe the accounting for

long-term notes payable.

Helpful Hint Electronic spreadsheet programs can cre- ate a schedule of installment loan payments. This allows you to put in the data for your own mortgage loan and get an illus- tration that really hits home.

8888 639999

Glossary 505

The terms provide for semiannual installment payments of $33,231 (not in- cluding real estate taxes and insurance). The installment payment schedule for the first two years is as follows.

Illustration 10C-1 Mortgage installment payment schedule

(B) (C) (D) Semiannual (A) Interest Reduction Principal

Interest Cash Expense of Principal Balance Period Payment (D) � 6% (A) � (B) (D) � (C)

Issue date $500,000 1 $33,231 $30,000 $3,231 496,769 2 33,231 29,806 3,425 493,344 3 33,231 29,601 3,630 489,714 4 33,231 29,383 3,848 485,866

Porter Technology records the mortgage loan and first installment payment as follows.

Dec. 31 Cash 500,000 Mortgage Notes Payable 500,000

(To record mortgage loan)

A � L � SE �30,000 Exp

�3,231 �33,231

Cash Flows �33,231

A � L � SE �500,000

�500,000

Cash Flows �500,000

June 30 Interest Expense 30,000 Mortgage Notes Payable 3,231

Cash 33,231 (To record semiannual payment on mortgage)

In the balance sheet, the company reports the reduction in principal for the next year as a current liability, and classifies the remaining unpaid prin- cipal balance as a long-term liability. At December 31, 2008, the total liabil- ity is $493,344, of which $7,478 ($3,630 � $3,848) is current and $485,866 ($493,344 � $7,478) is long-term.

Summary of Study Objective for Appendix 10C

10 Describe the accounting for long-term notes payable. Each payment consists of (1) interest on the un- paid balance of the loan, and (2) a reduction of

loan principal. The interest decreases each period, while the portion applied to the loan principal in- creases each period.

Glossary

Bond certificate A legal document that indicates the name of the issuer, the face value of the bonds, and such other data as the contractual interest rate and the matu- rity date of the bonds. (p. 481)

Bonds A form of interest-bearing notes payable is- sued by corporations, universities, and governmental entities. (p. 480)

Callable bonds Bonds that are the issuing company can retire at a stated dollar amount prior to maturity. (p. 481)

Capital lease A type of lease whose characteristics make it similar to a debt-financed purchase and that is consequently accounted for in that fashion. (p. 495)

((nnonn t in edudududuleeee f f f forrrr

506 CHAPTER 10 Reporting and Analyzing Liabilities

Contingencies Events with uncertain outcomes, such as a potential liability that may become an actual liabil- ity sometime in the future. (p. 494)

Contractual (stated) interest rate Rate used to de- termine the amount of interest the borrower pays and the investor receives. (p. 481)

Convertible bonds Bonds that permit bondholders to convert them into common stock at their option. (p. 481)

Current liability A debt that a company reasonably expects to pay (1) from existing current assets or through the creation of other current liabilities, and (2) within one year or the operating cycle, whichever is longer. (p. 474)

Discount (on a bond) The difference between the face value of a bond and its selling price, when a bond is sold for less than its face value. (p. 485)

Effective-interest method of amortization A me- thod of amortizing bond discount or bond premium that results in periodic interest expense equal to a con- stant percentage of the carrying value of the bonds. (p. 501)

Effective-interest rate Rate established when bonds are issued that remains constant in each interest period. (p. 501)

Face value Amount of principal due at the maturity date of the bond. (p. 481)

Long-term liabilities Obligations that a company ex- pects to pay more than one year in the future. (p. 480)

Market interest rate The rate investors demand for loaning funds to the corporation. (p. 482)

Maturity date The date on which the final payment on a bond is due from the bond issuer to the investor. (p. 481)

Mortgage note payable A long-term note secured by a mortgage that pledges title to specific units of property as security for the loan. (p. 504)

Notes payable An obligation in the form of a written promissory note. (p. 475)

Off-balance-sheet financing The intentional effort by a company to structure its financing arrangements so as to avoid showing liabilities on its books. (p. 494)

Operating lease A contractual arrangement giving the lessee temporary use of the property with continued own- ership of the property by the lessor. Accounted for as a rental. (p. 495)

Premium (on a bond) The difference between the sell- ing price and the face value of a bond when a bond is sold for more than its face value. (p. 485)

Present value The value today of an amount to be received at some date in the future after taking into account current interest rates. (p. 482)

Secured bonds Bonds that have specific assets of the issuer pledged as collateral. (p. 481)

Straight-line method of amortization A method of amortizing bond discount or bond premium that allo- cates the same amount to interest expense in each inter- est period. (p. 498)

Time value of money The relationship between time and money. A dollar received today is worth more than a dollar promised at some time in the future. (p. 482)

Times interest earned ratio A measure of a company’s solvency, calculated by dividing income before interest expense and taxes by interest expense. (p. 493)

Unsecured bonds Bonds issued against the general credit of the borrower. (p. 481)

Demonstration Problem

Snyder Software Inc. successfully developed a new spreadsheet program. However, to produce and market the program, the company needed $2.0 million of additional financing. On January 1, 2007, Snyder borrowed money as follows.

1. Snyder issued $500,000, 11%, 10-year bonds. The bonds sold at face value and pay interest on January 1.

2. Snyder issued $1.0 million, 10%, 10-year bonds for $886,996. Interest is payable on January 1. Snyder uses the straight-line method of amortization.

Instructions

(a) For the 11% bonds, prepare journal entries for the following items. (1) The issuance of the bonds on January 1, 2007. (2) Accrue interest expense on December 31, 2007. (3) The payment of interest on January 1, 2008.

(b) For the 10-year, 10% bonds: (1) Journalize the issuance of the bonds on January 1, 2007. (2) Prepare the entry for the redemption of the bonds at 101 on January 1, 2010,

after paying the interest due on this date. The carrying value of the bonds at the redemption date was $920,897.

A A AA loolongggg term mmm note secured by e totototo s pepepepeciccc fififificcc c ununununitsss s ofooo proooopeppepertrtrtrtyyyy 500004)4)4)4)

i i hhhh f fff i

Self-Study Questions 507

Solution to Demonstration Problem

●❍ THE NAVIGATOR ✓✓

(a) (1) 2007 Jan. 1 Cash 500,000

Bonds Payable 500,000 (To record issue of 11%, 10-year bonds at face value)

(2) 2007 Dec. 31 Bond Interest Expense 55,000

Bond Interest Payable 55,000 (To record accrual of bond interest)

(3) 2008 Jan. 1 Bond Interest Payable 55,000

Cash 55,000 (To record payment of accrued interest)

(b) (1) 2007 Jan. 1 Cash 886,996

Discount on Bonds Payable 113,004 Bonds Payable 1,000,000

(To record issuance of bonds at a discount)

(2) 2008 Jan. 1 Bonds Payable 1,000,000

Loss on Bond Redemption 89,103* Discount on Bonds Payable 79,103 Cash 1,010,000

(To record redemption of bonds at 101)

*($1,010,000 � $920,897)

Action Plan • Record the discount on bonds

issued as a contra liability account.

• Compute the loss on bond redemption as the excess of the cash paid over the carrying value of the redeemed bonds.

*Note: All Questions, Exercises, and Problems marked with an asterisk relate to mate- rial in the appendixes to the chapter.

Self-Study Questions

Answers are at the end of the chapter. 1. The time period for classifying a liability as

current is one year or the operating cycle, whichever is: (a) longer. (c) probable. (b) shorter. (d) possible.

2. To be classified as a current liability, a debt must be expected to be paid: (a) out of existing current assets. (b) by creating other current liabilities. (c) within 2 years. (d) Either (a) or (b)

3. Corricten Company borrows $88,500 on Sep- tember 1, 2007, from Harrington State Bank by signing an $88,500, 12%, one-year note. What is the accrued interest at December 31, 2007?

(a) $2,655. (c) $4,425. (b) $3,540. (d) $10,620.

4. Andre Company has total proceeds from sales of $4,515. If the proceeds include sales taxes of 5%, what is the amount to be credited to Sales? (a) $4,000. (b) $4,300. (c) $4,289.25. (d) The correct answer is not given.

5. Which of the following is not a mea- sure of liquidity? (a) Debt to total assets ratio. (b) Working capital. (c) Current ratio. (d) Current cash debt coverage.

(SO 1)

(SO 3)

(SO 7)

(SO 2)

508 CHAPTER 10 Reporting and Analyzing Liabilities

6. What term is used for bonds that have specific assets pledged as collateral? (a) Callable bonds. (b) Convertible bonds. (c) Secured bonds. (d) Discount bonds.

7. Cuso Inc. issues 10-year bonds with a maturity value of $200,000. If the bonds are issued at a premium, this indicates that: (a) the contractual interest rate exceeds the

market interest rate. (b) the market interest rate exceeds the

contractual interest rate. (c) the contractual interest rate and the

market interest rate are the same. (d) no relationship exists between the two

rates.

8. On January 1, 2007, Scissors Corp. issues $200,000, 5-year, 7% bonds at face value. The entry to record the issuance of the bonds would include a: (a) debit to cash for $14,000. (b) debit to bonds payable for $200,000. (c) credit to bonds payable for $200,000. (d) credit to bond interest expense of

$14,000.

9. Kant Corporation retires its $100,000 face value bonds at 105 on January 1, following the pay- ment of interest. The carrying value of the bonds at the redemption date is $103,745. The entry to record the redemption will include a: (a) credit of $3,745 to Loss on Bond

Redemption. (b) debit of $3,745 to Premium on Bonds

Payable. (c) credit of $1,255 to Gain on Bond

Redemption. (d) debit of $5,000 to Premium on Bonds

Payable.

10. In a recent year Day Corporation had net income of $150,000, interest expense of $30,000, and tax expense of $20,000. What was Day Corporation’s times interest earned ratio for the year? (a) 5.00. (c) 6.67. (b) 4.00. (d) 7.50.

*11. On January 1 Pierce Corporation issues $500,000, 5-year, 12% bonds at 96 with interest payable on January 1. The entry on December 31 to record accrued bond interest and the amortization of bond discount using the straight-line method will include a: (a) debit to Interest Expense, $57,600. (b) debit to Interest Expense, $60,000. (c) credit to Discount on Bonds Payable,

$4,000. (d) credit to Discount on Bonds Payable,

$2,000.

*12. For the bonds issued in question 11, what is the carrying value of the bonds at the end of the third interest period? (a) $492,000. (c) $472,000. (b) $488,000. (d) $464,000.

*13. On January 1, Daisey Duke Inc. issued $1,000,000, 9% bonds for $939,000. The mar- ket rate of interest for these bonds is 10%. In- terest is payable annually on December 31. Daisey Duke uses the effective-interest method of amortizing bond discount. At the end of the first year, Daisey Duke should report unamor- tized bond discount of: (a) $54,900. (c) $51,610. (b) $57,100. (d) $51,000.

*14. On January 1, Anthony Corporation issued $1,000,000, 14%, 5-year bonds with interest payable on December 31. The bonds sold for $1,072,096. The market rate of interest for these bonds was 12%. On the first interest date, us- ing the effective-interest method, the debit en- try to Bond Interest Expense is for: (a) $120,000. (b) $125,581. (c) $128,652. (d) $140,000.

Go to the book’s website, www.wiley.com/ college/kimmel, to access additional Self-Study Questions.

Questions

1. Georgia Lazenby believes a current liability is a debt that can be expected to be paid in one year. Is Georgia correct? Explain.

2. Travelyan Company obtains $25,000 in cash by sign- ing a 9%, 6-month, $25,000 note payable to First Bank on July 1. Travelyan’s fiscal year ends on Sep-

tember 30. What information should be reported for the note payable in the annual financial statements?

3. (a) Your roommate says, “Sales taxes are reported as an expense in the income statement.” Do you agree? Explain.

(SO 4) (SO 8)

(SO 8)

(SO 9)

(SO 5)

(SO 6)

(SO 7)

●❍ THE NAVIGATOR ✓✓

rcrcrcr ee e CoCCC rppppooroo ation issues bobobobondddds sss atttt 9 9 9 96 66 6 wiwww thththh i nterrrresesessttt . ThThThTheee e enenenentttrt y oon DDDeecembebebeer d bbbbondddd inteeeererereestttt aaanddndnd tttthehehe

( )

Questions 509

(b) Hard Wok Cafe has cash proceeds from sales of $10,550. This amount includes $550 of sales taxes. Give the entry to record the proceeds.

4. Holt University sold 8,000 season football tickets at $90 each for its five-game home schedule. What en- tries should be made (a) when the tickets are sold and (b) after each game?

5. Identify three taxes commonly withheld by the em- ployer from an employee’s gross pay.

6. (a) Identify three taxes commonly paid by employ- ers on employees’ salaries and wages.

(b) Where in the financial statements does the em- ployer report taxes withheld from employees’ pay?

7. (a) What are long-term liabilities? Give two examples. (b) What is a bond?

8. Contrast these types of bonds: (a) Secured and unsecured. (b) Convertible and callable.

9. Explain each of these important terms in issuing bonds: (a) Face value. (b) Contractual interest rate. (c) Bond certificate.

10. (a) What is a convertible bond?

(b) Discuss the advantages of a convertible bond from the standpoint of the bondholders and of the issuing corporation.

11. Describe the two major obligations incurred by a company when bonds are issued.

12. Assume that Mimi Inc. sold bonds with a face value of $100,000 for $104,000. Was the market interest rate equal to, less than, or greater than the bonds’ contractual interest rate? Explain.

13. Magda and Helga are discussing how the market price of a bond is determined. Magda believes that the market price of a bond is solely a function of the amount of the principal payment at the end of the term of a bond. Is she right? Discuss.

14. If a 6%, 10-year, $600,000 bond is issued at face and interest is paid annually, what is the amount of the interest payment at the end of the first period?

15. If the Bonds Payable account has a balance of $900,000 and the Discount on Bonds Payable account has a balance of $36,000, what is the carrying value of the bonds?

16. Which accounts are debited and which are credited if a bond issue originally sold at a premium is re- deemed before maturity at 97 immediately following the payment of interest?

17. Stephanie Wolcott, the chief financial offi- cer of Hangers Inc., is considering the options avail- able to her for financing the company’s new plant. Short-term interest rates right now are 6%, and long- term rates are 8%. The company’s current ratio is 2.2:1. If she finances the new plant with short-term

debt, the current ratio will fall to 1.5:1. Briefly dis- cuss the issues that Stephanie should consider.

18. (a) In general, what are the requirements for the

financial statement presentation of long-term liabilities?

(b) What ratios may be computed to evaluate a company’s liquidity and solvency?

19. Valentin Zukovsky says that liquidity and solvency are the same thing. Is he correct? If not, how do they differ?

20. The management of Ultra Vehicle Corpora- tion is concerned because survey data suggest that many potential customers do not buy vehicles due to quality concerns. It is considering taking the bold step of increasing the length of its warranty from the industry standard of 3 years up to an unprecedented 10 years in an effort to increase confidence in its qual- ity. Discuss the business as well as accounting impli- cations of this move.

21. Hector Gonzales needs a few new trucks for his business. He is considering buying the trucks but is concerned that the additional debt he will need to borrow will make his liquidity and sol- vency ratios look bad. What options does he have other than purchasing the trucks, and how will these options affect his financial statements?

22. Empire Corporation has a current ratio of 1.1. Tom has always been told that a corpo- ration’s current ratio should exceed 2.0. Empire ar- gues that its ratio is low because it has a minimal amount of inventory on hand so as to reduce operat- ing costs. Empire also points out that it has signifi- cant available lines of credit. Is Tom still correct? What do some companies do to compensate for hav- ing fewer liquid assets?

23. What are the implications for analysis if a company has significant operating leases?

24. What criteria must be met before a contin- gency must be recorded as a liability? How should the contingency be disclosed if the criteria are not met?

*25. Explain the straight-line method of amortizing dis- count and premium on bonds payable.

*26. Osato Corporation issues $200,000 of 6%, 5-year bonds on January 1, 2007, at 104. Assuming that the straight-line method is used to amortize the pre- mium, what is the total amount of interest expense for 2007?

*27. Maria Lopez is discussing the advantages of the effective-interest method of bond amortization with her accounting staff. What do you think Maria is saying?

*28. Snooper Corporation issues $400,000 of 9%, 5-year bonds on January 1, 2007, at 104. If Snooper uses the effective-interest method in amortizing the premium, will the annual interest expense increase or decrease over the life of the bonds? Explain.

rrrrenenenent raaaatio wwiww ll fall to 1.5:1. Briefly d s ththththatatatat S S SSteeeephphphphananana ieeee ss sshoulllld d d d cocooconsnsnsnsididididerererer....

hhhh h i f h

510 CHAPTER 10 Reporting and Analyzing Liabilities

Brief Exercises

Issue Stock Issue Bond

Income before interest and taxes $1,000,000 $1,000,000 Interest expense from bonds

Income before income taxes Income tax expense (30%)

Net income $ $

Outstanding shares 700,000

Earnings per share $ $

BE10-6 Lazar Corporation issued 1,000 7%, 5-year, $1,000 bonds dated January 1, 2007, at face value. Interest is paid each January 1.

(a) Prepare the journal entry to record the sale of these bonds on January 1, 2007. (b) Prepare the adjusting journal entry on December 31, 2007, to record interest expense. (c) Prepare the journal entry on January 1, 2008, to record interest paid.

BE10-7 The balance sheet for Tiffany Company reports the following information on July 1, 2007.

Identify whether obligations are current liabilities. (SO 1)

Prepare entries for an interest-bearing note payable. (SO 2)

Compute and record sales taxes payable. (SO 3)

Prepare entries for unearned revenues. (SO 3)

Compare bond financing to stock financing. (SO 4)

BE10-1 Kananga Company has these obligations at December 31: (a) a note payable for $100,000 due in 2 years, (b) a 10-year mortgage payable of $200,000 payable in ten $20,000 annual payments, (c) interest payable of $15,000 on the mortgage, and (d) ac- counts payable of $60,000. For each obligation, indicate whether it should be classified as a current liability.

BE10-2 Popp Company borrows $70,000 on July 1 from the bank by signing a $70,000, 8%, 1-year note payable. Prepare the journal entries to record (a) the proceeds of the note and (b) accrued interest at December 31, assuming adjusting entries are made only at the end of the year.

BE10-3 Gold Supply does not segregate sales and sales taxes at the time of sale. The register total for March 16 is $10,388. All sales are subject to a 6% sales tax. Compute sales taxes payable and make the entry to record sales taxes payable and sales.

BE10-4 Denton University sells 3,800 season basketball tickets at $60 each for its 10-game home schedule. Give the entry to record (a) the sale of the season tickets and (b) the revenue earned by playing the first home game.

BE10-5 Domino Inc. is considering these two alternatives to finance its construction of a new $2 million plant:

(a) Issuance of 200,000 shares of common stock at the market price of $10 per share. (b) Issuance of $2 million, 6% bonds at face value.

Complete the table and indicate which alternative is preferable.

TIFFANY COMPANY Balance Sheet (partial)

Long-term liabilities Bonds payable $1,000,000 Less: Discount on bonds payable 30,000 $970,000

Tiffany decides to redeem these bonds at 102 after paying annual interest. Prepare the journal entry to record the redemption on July 1, 2007.

BE10-8 Presented here are long-term liability items for Carlton Inc. at December 31, 2007. Prepare the long-term liabilities section of the balance sheet for Carlton Inc.

Bonds payable, due 2011 $900,000 Notes payable, due 2009 80,000 Discount on bonds payable 21,000

Prepare journal entries for bonds issued at face value. (SO 5)

Prepare journal entry for redemption of bonds. (SO 6)

Prepare statement presentation of long-term liabilities. (SO 7)

mbebebeber 31111: (a)))) a nottte payabbbblllle

Brief Exercises 511

BE10-9 Presented here are liability items for Warner Inc. at December 31, 2007. Pre- pare the liabilities section of Warner’s balance sheet.

Accounts payable $135,000 Employee benefits payable $ 7,800 Bank note payable

(due May 1, 2008) 20,000 Interest payable 40,000 Bonds payable, due 2011 900,000 Notes payable, due 2009 80,000 Current portion of

long-term debt 240,000 Property tax payable 3,500 Discount on bonds payable 45,000 Sales taxes payable 1,400

BE10-10 The 2004 Reebok financial statements contain the following selected data (in millions).

Current assets $1,858 Interest expense $ 26 Total assets 2,441 Income taxes 68 Current liabilities 806 Net income 192 Total liabilities 1,221 Cash 565

Compute the following values and provide a brief interpretation of each. (a) Working capital. (c) Debt to total assets ratio. (b) Current ratio. (d) Times interest earned ratio.

BE10-11 The Canadian National Railway Company’s (CN) total assets in a recent year were $18,924 million and its total liabilities were $12,297 million. That year, CN reported operating lease commitments for its locomotives, freight cars, and equipment totalling $1,154 million. If these assets had been recorded as capital leases, assume that assets and liabilities would have risen by approximately $1,154 million.

(a) Calculate CN’s debt to total assets ratio, first using the figures reported, and then after increasing assets and liabilities for the unrecorded operating leases.

(b) Discuss the potential effect of these operating leases on your assessment of CN’s solvency.

*BE10-12 Vijay Company issues $2 million, 10-year, 6% bonds at 99, with interest payable on December 31. The straight-line method is used to amortize bond discount.

(a) Prepare the journal entry to record the sale of these bonds on January 1, 2007. (b) Prepare the journal entry to record interest expense and bond discount amortiza-

tion on December 31, 2007, assuming no previous accrual of interest.

*BE10-13 Sydor Inc. issues $5 million, 5-year, 8% bonds at 103, with interest payable on January 1. The straight-line method is used to amortize bond premium.

(a) Prepare the journal entry to record the sale of these bonds on January 1, 2007. (b) Prepare the journal entry to record interest expense and bond premium amortiza-

tion on December 31, 2007, assuming no previous accrual of interest.

*BE10-14 Presented below is the partial bond discount amortization schedule for Nuong Tu Corp., which uses the effective-interest method of amortization.

Interest Bond Interest Interest to Expense to Discount Unamortized Carrying Periods Be Paid Be Recorded Amortization Discount Value

Issue date $62,311 $937,689 1 $45,000 $46,884 $1,884 60,427 939,573 2 45,000 46,979 1,979 58,448 941,552

Instructions (a) Prepare the journal entry to record the payment of interest and the discount amor-

tization at the end of period 1. (b) Explain why interest expense is greater than interest paid. (c) Explain why interest expense will increase each period.

Analyze solvency. (SO 7)

Prepare liabilities section of balance sheet. (SO 7)

Analyze solvency. (SO 7)

Prepare journal entries for bonds issued at a discount. (SO 8)

Prepare journal entries for bonds issued at a premium. (SO 8)

Use effective-interest method of bond amortization. (SO 9)

2222000007. PPPPre

$ 7 888800

p balbababa ancancancance sheeeeeeeet.t.tt (SSO 7)7

512 CHAPTER 10 Reporting and Analyzing Liabilities

Exercises

E10-1 Rebecca Fleming and Carrie Platt borrowed $12,000 on a 7-month, 9% note from Gopher State Bank to open their business, RC’s Coffee House. The money was borrowed on June 1, 2007, and the note matures January 1, 2008.

Instructions (a) Prepare the entry to record the receipt of the funds from the loan. (b) Prepare the entry to accrue the interest on June 30. (c) Assuming adjusting entries are made at the end of each month, determine the bal-

ance in the interest payable account at December 31, 2007. (d) Prepare the entry required on January 1, 2008, when the loan is paid back.

E10-2 On May 15, Kiwi’s Outback Clothiers borrowed some money on a 4-month note to provide cash during the slow season of the year. The interest rate on the note was 8%. At the time the note was due, the amount of interest owed was $320.

Instructions (a) Determine the amount borrowed by Kiwi’s. (b) Assume the amount borrowed was $18,500. What was the interest rate if the amount

of interest owed was $740? (c) Prepare the entry for the initial borrowing and the repayment for the facts in part (a).

E10-3 On June 1, Avery Company Ltd. borrows $50,000 from First Bank on a 6-month, $50,000, 9% note. The note matures on December 1.

Instructions (a) Prepare the entry on June 1. (b) Prepare the adjusting entry on June 30. (c) Prepare the entry at maturity (December 1), assuming monthly adjusting entries have

been made through November 30. (d) What was the total financing cost (interest expense)?

E10-4 In providing accounting services to small businesses, you encounter the follow- ing situations pertaining to cash sales. 1. Mariella Company rings up sales and sales taxes separately on its cash register. On

April 10 the register totals are sales $25,000 and sales taxes $1,250. 2. Brent Company does not segregate sales and sales taxes. Its register total for April 15

is $11,660, which includes a 6% sales tax.

Instructions Prepare the entries to record the sales transactions and related taxes for (a) Mariella Company and (b) Brent Company.

E10-5 During the month of March, Pouncer Company’s employees earned wages of $70,000. Withholdings related to these wages were $5,355 for Social Security (FICA), $7,500 for federal income tax, $3,100 for state income tax, and $400 for union dues. The company incurred no cost related to these earnings for federal unemployment tax, but incurred $700 for state unemployment tax.

Instructions (a) Prepare the necessary March 31 journal entry to record wages expense and wages

payable. Assume that wages earned during March will be paid during April. (b) Prepare the entry to record the company’s payroll tax expense.

E10-6 Season tickets for the Lame Ducks are priced at $230 and include 20 games. Rev- enue is recognized after each game is played. When the season began, the amount cred- ited to Unearned Season Ticket Revenue was $1,104,000. By the end of October, $772,800 of the Unearned Season Ticket Revenue had been recorded as earned.

Instructions (a) How many season tickets did the Lame Ducks sell? (b) How many home games had the Lame Ducks played by the end of October?

Prepare entries for interest- bearing notes. (SO 2)

Journalize sales and related taxes. (SO 3)

Journalize payroll entries. (SO 3)

Journalize unearned revenue transactions. (SO 3)

Exercises 513

(c) Prepare the entry for the initial recording of the Unearned Season Ticket Revenue. (d) Prepare the entry to recognize the revenue after the first home game had been played.

E10-7 Walter Company Ltd. publishes a monthly sports magazine, Fishing Preview. Sub- scriptions to the magazine cost $22 per year. During November 2007, Walter sells 6,000 subscriptions for cash, beginning with the December issue. Walter prepares financial statements quarterly and recognizes subscription revenue earned at the end of the quar- ter. The company uses the accounts Unearned Subscription Revenue and Subscription Revenue. The company has a December 31 year-end.

Instructions (a) Prepare the entry in November for the receipt of the subscriptions. (b) Prepare the adjusting entry at December 31, 2007, to record subscription revenue

earned in December 2007. (c) Prepare the adjusting entry at March 31, 2008, to record subscription revenue earned

in the first quarter of 2008.

E10-8 On September 1, 2007, Chardin Corporation issued $300,000, 8%, 10-year bonds at face value. Interest is payable annually on September 1. Chardin’s year-end is December 31.

Instructions Prepare journal entries to record the following events. (a) The issuance of the bonds. (b) The accrual of interest on December 31, 2007. (c) The payment of interest on September 1, 2008.

E10-9 On January 1 Stanhope Company issued $100,000, 7%, 10-year bonds at face value. Interest is payable annually on January 1.

Instructions Prepare journal entries to record the following events. (a) The issuance of the bonds. (b) The accrual of interest on December 31. (c) The payment of interest on January 1.

E10-10 Assume that the following are independent situations recently reported in the Wall Street Journal. 1. General Electric (GE) 7% bonds, maturing January 28, 2010, were issued at 111.12. 2. Boeing 7% bonds, maturing September 24, 2027, were issued at 99.08.

Instructions (a) Were GE and Boeing bonds issued at a premium or a discount? (b) Explain how bonds, both paying the same contractual interest rate, could be issued

at different prices. (c) Prepare the journal entry to record the issue of each of these two bonds, assuming

each company issued $500,000 of bonds in total.

E10-11 Boone Company issued $240,000 of 8%, 20-year bonds on January 1, 2007, at face value. Interest is payable annually on January 1.

Instructions Prepare the journal entries to record the following events. (a) The issuance of the bonds (b) The accrual of interest on December 31, 2007. (c) The payment of interest on January 1, 2008. (d) The redemption of the bonds at maturity, assuming interest for the last interest period

has been paid and recorded.

E10-12 The situations presented here are independent of each other.

Instructions For each situation prepare the appropriate journal entry for the redemption of the bonds. (a) Thunder Corporation retired $130,000 face value, 12% bonds on June 30, 2007, at

102. The carrying value of the bonds at the redemption date was $122,500. The bonds

Journalize unearned subscription revenue. (SO 3)

Prepare journal entries for issuance of bonds and payment of accrual of interest. (SO 5)

Prepare journal entries for issuance of bonds and payment and accrual of interest. (SO 5)

Prepare entries for issue of bonds. (SO 5)

Prepare journal entries to record issuance of bonds, payment of interest, and redemption at maturity. (SO 5, 6)

Prepare journal entries for redemption of bonds. (SO 6)

ReReReRevenunnn e... ennn n plppp ayayayayedededed..

viewwww. Suuuubbb-b JoJoJouJo rnarrnarnalizzlizlize ue ue ue uneaneanean rnernrnrn d

514 CHAPTER 10 Reporting and Analyzing Liabilities

pay annual interest, and the interest payment due on June 30, 2007, has been made and recorded.

(b) Lightning, Inc., retired $180,000 face value, 12.5% bonds on June 30, 2007, at 98. The carrying value of the bonds at the redemption date was $184,000. The bonds pay annual interest, and the interest payment due on June 30, 2007, has been made and recorded.

E10-13 Cyclone, Inc. reports the following liabilities (in thousands) on its January 31, 2007, balance sheet and notes to the financial statements.

Accounts payable $3,263.9 Notes payable—long-term $5,746.7 Accrued pension liability 1,215.2 Operating leases 1,641.7 Accrued liabilities 1,258.1 Loans payable—long-term 335.6 Bonds payable 1,961.2 Payroll-related liabilities 558.1 Current portion of Short-term borrowings 2,563.6

long-term debt 1,992.2 Unused operating line of credit 3,337.6 Income taxes payable 235.2 Warranty liability—current 1,417.3

Instructions (a) Identify which of the above liabilities are likely current and which are likely long-

term. Say if an item fits in neither category. Explain the reasoning for your selection. (b) Prepare the liabilities section of Cyclone’s balance sheet as at January 31, 2007.

E10-14 McDonald’s 2004 financial statements contain the following selected data (in millions).

Current assets $ 2,857.8 Interest expense $ 358.4 Total assets 27,837.5 Income taxes 923.9 Current liabilities 3,520.5 Net income 2,278.5 Total liabilities 13,636

Instructions (a) Compute the following values and provide a brief interpretation of each.

(1) Working capital. (3) Debt to total assets ratio. (2) Current ratio. (4) Times interest earned ratio.

(b) The notes to McDonald’s financial statements show that subsequent to 2004 the com- pany will have future minimum lease payments under operating leases of $11,442.6 million. If these assets had been purchased with debt, assets and liabilities would rise by approximately $10,500 million. Recompute the debt to total assets ratio after adjusting for this. Discuss your result.

E10-15 3M Company reported the following financial data for 2004 and 2003 ($ in millions).

Calculate liquidity and solvency ratios; discuss impact of unrecorded obligations on liquidity and solvency. (SO 7)

Calculate current ratio before and after paying accounts payable. (SO 7)

Prepare liabilities section of balance sheet. (SO 7)

Instructions (a) Calculate the current ratio for 3M for 2004 and 2003. (b) Suppose that at the end of 2004 3M management used $300 million cash to pay off

$300 million of accounts payable. How would its current ratio change?

3M COMPANY Balance Sheet (partial)

2004 2003

Current assets Cash and cash equivalents $2,757 $1,836 Accounts receivable, net 2,792 2,714 Inventories 1,897 1,816 Other current assets 1,274 1,354

Total current assets $8,720 $7,720

Current liabilities $6,071 $5,082

ununuunee e 30000,, ,, 200007070707, has been made

nds ss s oononon JJJJuunuu e 330, 22007, atattt 999988.8 was $$$184444 000000 Thehhehe bbbononondsddsds pppayyayay

Exercises 515

E10-16 Unique Boutique reported the following financial data for 2007 and 2006.

UNIQUE BOUTIQUE Balance Sheet (partial)

September 30 (in thousands)

2007 2006

Current assets Cash and short-term deposits $2,574 $1,021 Accounts receivable 2,347 1,575 Inventories 1,201 1,010 Other current assets 322 192

Total current assets $6,444 $3,798

Current liabilities $5,303 $4,008

Instructions (a) Calculate the current ratio for Unique Boutique for 2007 and 2006. (b) Suppose that at the end of 2007, the Unique Boutique used $1.5 million cash to pay

off $1.5 million of accounts payable. How would its current ratio change? (c) At September 30, the Unique Boutique has an undrawn operating line of credit of

$12.5 million. Would this affect any assessment that you might make of the Unique Boutique’s short-term liquidity? Explain.

E10-17 Wal-Mart was sued nearly 5,000 times in a recent year—about once every two hours every day of the year. Wal-Mart has been sued for everything imaginable—ranging from falls on icy parking lots to injuries sustained in shoppers’ stampedes to a murder with a rifle purchased at Wal-Mart.

Wal-Mart does not adhere to the legal strategy many businesses use of “Settle quickly and cut your losses.” Instead, Wal-Mart aggressively fights lawsuits, even when it would be cheaper to settle. The company reported the following in the notes to its financial statements:

The Company and its subsidiaries are involved from time to time in claims, proceedings, and litigation arising from the operation of its business. The Company does not believe that any such claim, proceeding, or litigation, either alone or in the aggregate, will have a material adverse effect on the Company’s financial position or results of its operations.

Instructions (a) Explain why Wal-Mart does not have to record these contingent liabilities. (b) Comment on any implications for analysis of the financial statements.

*E10-18 Columbo Company issued $300,000, 7%, 20-year bonds on January 1, 2007, at 103. Interest is payable annually on January 1. Columbo uses straight-line amortization for bond premium or discount.

Instructions Prepare the journal entries to record the following events. (a) The issuance of the bonds. (b) The accrual of interest and the premium amortization on December 31, 2007. (c) The payment of interest on January 1, 2008. (d) The redemption of the bonds at maturity, assuming interest for the last interest pe-

riod has been paid and recorded.

*E10-19 Pierce Company issued $220,000, 8%, 10-year bonds on December 31, 2006, for $215,000. Interest is payable annually on December 31. Pierce uses the straight-line method to amortize bond premium or discount.

Instructions Prepare the journal entries to record the following events. (a) The issuance of the bonds. (b) The payment of interest and the discount amortization on December 31, 2007. (c) The redemption of the bonds at maturity, assuming interest for the last interest pe-

riod has been paid and recorded.

Calculate current ratio before and after paying accounts payable. (SO 7)

Discuss contingent liabilities. (SO 7)

Prepare journal entries to record issuance of bonds, payment of interest, amortization of premium using straight-line, and redemption at maturity. (SO 5, 6, 8)

Prepare journal entries to record issuance of bonds, payment of interest, amortization of discount using straight-line, and redemption at maturity. (SO 5, 6, 8)

22220000 6. f andandanand afafafafter paaaayinyinyiny g ag ag ag accoccoccoccountntttssss pppayablaab e. (SO(SO(SOSO 7)7)7)

516 CHAPTER 10 Reporting and Analyzing Liabilities

*E10-20 Midas Corporation issued $260,000, 7%, 10-year bonds on January 1, 2007, for $242,554. This price resulted in an effective interest rate of 8% on the bonds. Interest is payable annually on January 1. Midas uses the effective-interest method to amortize bond premium or discount.

Instructions Prepare the journal entries to record (round to the nearest dollar): (a) The issuance of the bonds. (b) The accrual of interest and the discount amortization on December 31, 2007. (c) The payment of interest on January 1, 2008.

*E10-21 Melina Company issued $180,000, 7%, 10-year bonds on January 1, 2007, for $193,248. This price resulted in an effective interest rate of 6% on the bonds. Interest is payable annually on January 1. Melina uses the effective-interest method to amortize bond premium or discount.

Instructions Prepare the journal entries (rounded to the nearest dollar) to record: (a) The issuance of the bonds. (b) The accrual of interest and the premium amortization on December 31, 2007. (c) The payment of interest on January 1, 2008.

*E10-22 Moore Co. receives $110,000 when it issues a $110,000, 8%, mortgage note payable to finance the construction of a building at December 31, 2007. The terms pro- vide for semiannual installment payments of $7,041 on June 30 and December 31.

Instructions Prepare the journal entries to record the mortgage loan and the first two installment payments.

Prepare journal entries for issuance of bonds, payment of interest, and amortization of discount using effective- interest method. (SO 5, 9)

Problems: Set A P10-1A On January 1, 2007, the ledger of Daniels Company contained these liability accounts.

Accounts Payable $42,500 Sales Taxes Payable 6,600 Unearned Service Revenue 19,000

During January the following selected transactions occurred.

Jan. 1 Borrowed $12,000 in cash from Midland Bank on a 4-month, 8%, $12,000 note.

5 Sold merchandise for cash totaling $6,510, which includes 5% sales taxes.

12 Provided services for customers who had made advance payments of $10,000. (Credit Service Revenue.)

14 Paid state treasurer’s department for sales taxes collected in December 2006, $6,600.

20 Sold 500 units of a new product on credit at $48 per unit, plus 5% sales tax.

During January the company’s employees earned wages of $60,000. Withholdings related to these wages were $4,590 for Social Security (FICA), $5,000 for federal income tax, and $1,500 for state income tax. The company owed no money related to these earnings for federal or state unemployment tax. Assume that wages earned during January will be paid during Feb- ruary. No entry had been recorded for wages or payroll tax expense as of January 31.

Instructions (a) Journalize the January transactions. (b) Journalize the adjusting entries at January 31 for the outstanding note payable and

for wages expense and payroll tax expense. (c) Prepare the current liabilities section of the balance sheet at January 31, 2007. As-

sume no change in Accounts Payable.

Prepare current liability entries, adjusting entries, and current liabilities section. (SO 1, 2, 3, 7)

Prepare journal entries for issuance of bonds, payment of interest, and amortization of premium using effective- interest method. (SO 5, 9)

Prepare journal entries to record mortgage note and installment payments. (SO 10)

GLS

ononono ddsd oooon Jaaannunn ary 1, 2007, for 8888%%% % onononon tttthehehehe bb b boonono dsdsdss.. Interererere tstst iiiissss estttt mmmmetttthohohohod too amommortizeee bobobob ndnnn

Problems: Set A 517

P10-2A On the Edge Corporation sells rock-climbing products and also operates an in- door climbing facility for climbing enthusiasts. During the last part of 2007, On the Edge had the following transactions related to notes payable.

Sept. 1 Issued a $9,000 note to Gibraltar to purchase inventory. The 3-month note payable bears interest of 8% and is due December 1.

Sept. 30 Recorded accrued interest for the Gibraltar note. Oct. 1 Issued a $18,000, 9%, 4-month note to Apex Bank to finance the pur-

chase of a new climbing wall for advanced climbers. The note is due February 1.

Oct. 31 Recorded accrued interest for the Gibraltar note and the Apex Bank note.

Nov. 1 Issued a $20,000 note and paid $8,000 cash to purchase a vehicle to transport clients to nearby climbing sites as part of a new series of climbing classes. This note bears interest of 6% and matures in 12 months.

Nov. 30 Recorded accrued interest for the Gibraltar note, the Apex Bank note, and the vehicle note.

Dec. 1 Paid principal and interest on the Gibraltar note. Dec. 31 Recorded accrued interest for the Apex Bank note and the vehicle note.

Instructions (a) Prepare journal entries for the transactions noted above. (b) Post the above entries to the Notes Payable, Interest Payable, and Interest Expense

accounts. (Use T accounts.) (c) Show the balance sheet presentation of notes payable and interest payable at

December 31. (d) How much interest expense relating to notes payable did On the Edge incur during

the year?

P10-3A The following section is taken from Majestic’s balance sheet at December 31, 2006.

Current liabilities Bond interest payable $ 24,000

Long-term liabilities Bonds payable, 8%, due January 1, 2013 300,000

Interest is payable annually on January 1. The bonds are callable on any annual interest date.

Instructions (a) Journalize the payment of the bond interest on January 1, 2007. (b) Assume that on January 1, 2007, after paying interest, Majestic calls bonds having a

face value of $50,000. The call price is 104. Record the redemption of the bonds. (c) Prepare the adjusting entry on December 31, 2007, to accrue the interest on the

remaining bonds.

P10-4A On October 1, 2006, Ferdinand Corp. issued $500,000, 7%, 10-year bonds at face value. The bonds were dated October 1, 2006, and pay interest annually on October 1. Financial statements are prepared annually on December 31.

Instructions (a) Prepare the journal entry to record the issuance of the bonds. (b) Prepare the adjusting entry to record the accrual of interest on December 31, 2006. (c) Show the balance sheet presentation of bonds payable and bond interest payable on

December 31, 2006. (d) Prepare the journal entry to record the payment of interest on October 1, 2007. (e) Prepare the adjusting entry to record the accrual of interest on December 31, 2007. (f) Assume that on January 1, 2008, Ferdinand pays the accrued bond interest and calls

the bonds. The call price is 102. Record the payment of interest and redemption of the bonds.

P10-5A Margaret Rose Company sold $4,000,000, 8%, 20-year bonds on January 1, 2007. The bonds were dated January 1, 2007, and pay interest on December 31. The bonds were sold at 98.

Journalize and post note transactions; show balance sheet presentation. (SO 2, 7)

(b) Interest Payable $605

Prepare journal entries to record interest payments and redemption of bonds. (SO 5, 6)

Prepare journal entries to record issuance of bonds, interest, balance sheet presentation, and bond redemption. (SO 5, 6, 7)

(f) Loss $10,000

Prepare journal entries to record issuance of bonds, show balance sheet presentation, and record bond redemption. (SO 5, 6, 7)

atataa eese an nnn in n ththththe EdEdEdEdgeeee

p tratrrr nsansansansactionsnsnss; s; s showhowowhow ba ba ba balannnncccc ssheet presennntatatatationioioio . (SO(SO(SOSO 2,2,2, 7) 7)7) 7)

518 CHAPTER 10 Reporting and Analyzing Liabilities

Instructions (a) Prepare the journal entry to record the issuance of the bonds on January 1, 2007. (b) At December 31, 2007, $4,000 of the bond discount had been amortized. Show the

balance sheet presentation of the bond liability at December 31, 2007. (Assume that interest has been paid.)

(c) At December 31, 2008, when the carrying value of the bonds was $3,928,000, the com- pany redeemed the bonds at 102. Record the redemption of the bonds assuming that interest for the year had already been paid.

P10-6A You have been presented with the following selected information taken from the financial statements of Southwest Airlines Co.

Calculate and comment on ratios. (SO 7)

SOUTHWEST AIRLINES CO. Balance Sheet (partial)

December 31 (in millions)

2004 2003

Total current assets $2,172 $2,313 Noncurrent assets 9,165 7,565

Total assets $11,337 $9,878

Note 8. Leases The majority of the Company’s terminal operations space, as well as 88 aircraft, were un- der operating leases at December 31, 2004. Future minimum lease payments under non- cancelable operating leases are as follows: 2005, $343,000; 2006, $279,000; 2007, $256,000; 2008, $226,000; 2009, $204,000; after 2009, $1,369,000.

Instructions (a) Calculate each of the following ratios for 2004 and 2003.

(1) Current ratio. (2) Free cash flow. (3) Debt to total assets. (4) Times interest earned ratio.

(b) Comment on the trend in ratios. (c) Read the company’s note on leases. If the operating leases had instead been accounted

for like a purchase, assets and liabilities would increase by approximately $1,500 mil- lion. Recalculate the debt to total assets ratio for 2004 in light of this information, and discuss the implictions for analysis.

*P10-7A The information on page 519 is taken from Simon Corp.’s balance sheet at December 31, 2007.

Current liabilities $2,142 $1,723 Long-term liabilities 3,671 3,103

Total liabilities 5,813 4,826 Shareholders’ equity 5,524 5,052

Total liabilities and shareholders’ equity $11,337 $9,878

Other information:

2004 2003

Net income (loss) $ 313 $ 442 Income tax expense 176 266 Interest expense 88 91 Cash provided by operations 1,157 1,336 Capital expenditures 1,775 1,238 Cash dividends 14 14

Prepare journal entries to record interest payments, straight-line discount amortization, and redemption of bonds. (SO 5, 6, 8)

e bobobobondndndndsss s onononon JJJJaaana uuuau rryrr 1, 202022007070707. d bebebebeeneneen a a a amommm rrrtizedd. Showowww ttt thehhh mbereee 31111 2000007777 (((AsAAsAssususumememem ttthahhatttt

Problems: Set A 519

Interest is payable annually on January 1. The bonds are callable on any annual inter- est date. Simon uses straight-line amortization for any bond premium or discount. From December 31, 2007, the bonds will be outstanding for an additional 10 years (120 months).

Instructions (Round all computations to the nearest dollar.) (a) Journalize the payment of bond interest on January 1, 2008. (b) Prepare the entry to amortize bond discount and to accrue the interest on December

31, 2008. (c) Assume on January 1, 2009, after paying interest, that Simon Corp. calls bonds hav-

ing a face value of $300,000. The call price is 103. Record the redemption of the bonds.

(d) Prepare the adjusting entry at December 31, 2009, to amortize bond discount and to accrue interest on the remaining bonds.

*P10-8A Peru Corporation sold $1,500,000, 6%, 10-year bonds on January 1, 2007. The bonds were dated January 1, 2007, and pay interest on January 1. Peru Corporation uses the straight-line method to amortize bond premium or discount.

Instructions (a) Prepare all the necessary journal entries to record the issuance of the bonds and bond

interest expense for 2007, assuming that the bonds sold at 103. (b) Prepare journal entries as in part (a) assuming that the bonds sold at 98. (c) Show the balance sheet presentation for the bond issue at December 31, 2007, using

(1) the 103 selling price, and then (2) the 98 selling price.

*P10-9A McGraw Co. sold $4,000,000, 9%, 5-year bonds on January 1, 2007. The bonds were dated January 1, 2007, and pay interest on January 1. The company uses straight- line amortization on bond premiums and discounts. Financial statements are prepared annually.

Instructions (a) Prepare the journal entries to record the issuance of the bonds assuming they sold at:

(1) 101. (2) 97.

(b) Prepare amortization tables for both assumed sales for the first three interest payments.

(d) Show the balance sheet presentation for both assumed sales at December 31, 2007.

*P10-10A On January 1, 2007, Lucy Corporation issued $1,200,000 face value, 7%, 10-year bonds at $1,119,479. This price resulted in an effective-interest rate of 8% on the bonds. Lucy uses the effective-interest method to amortize bond premium or dis- count. The bonds pay annual interest January 1.

Instructions (Round all computations to the nearest dollar.) (a) Prepare the journal entry to record the issuance of the bonds on January 1, 2007. (b) Prepare an amortization table through December 31, 2009 (three interest periods) for

this bond issue. (c) Prepare the journal entry to record the accrual of interest and the amortization of

the discount on December 31, 2007. (d) Prepare the journal entry to record the payment of interest on January 1, 2008. (e) Prepare the journal entry to record the accrual of interest and the amortization of

the discount on December 31, 2008.

Current liabilities Bond interest payable $ 192,000

Long-term liabilities Bonds payable, 8%, due January 1, 2018 $2,400,000 Less: Discount on bonds payable 42,000 2,358,000

Prepare journal entries to record issuance of bonds, interest, and straight-line amortization, and balance sheet presentation. (SO 5, 7, 8)

Prepare journal entries to record issuance of bonds, interest, and straight-line amortization, and balance sheet presentation. (SO 5, 6, 8)

Prepare journal entries to record issuance of bonds, payment of interest, and amortization of bond discount using effective- interest method. (SO 9)

,000000000

520 CHAPTER 10 Reporting and Analyzing Liabilities

*P10-11A On January 1, 2007, HiLo Company issued $2,000,000 face value, 8%, 10-year bonds at $2,294,403. This price resulted in a 6% effective-interest rate on the bonds. HiLo uses the effective-interest method to amortize bond premium or discount. The bonds pay annual interest on each January 1.

Instructions (a) Prepare the journal entries to record the following transactions.

(1) The issuance of the bonds on January 1, 2007. (2) Accrual of interest and amortization of the premium on December 31, 2007. (3) The payment of interest on January 1, 2008. (4) Accrual of interest and amortization of the premium on December 31, 2008.

(b) Show the proper balance sheet presentation for the liability for bonds payable on the December 31, 2008, balance sheet.

(c) Provide the answers to the following questions in narrative form. (1) What amount of interest expense is reported for 2008? (2) Would the bond interest expense reported in 2008 be the same as, greater than,

or less than the amount that would be reported if the straight-line method of amortization were used?

*P10-12A Fowler purchased a new piece of equipment to be used in its new facility. The $550,000 piece of equipment was purchased with a $50,000 down payment and with cash received through the issuance of a $500,000, 8%, 4-year mortgage note payable is- sued on October 1, 2007. The terms provide for quarterly installment payments of $36,825 on December 31, March 31, June 30, and September 30.

Instructions (Round all computations to the nearest dollar.) (a) Prepare an installment payments schedule for the first five payments of the notes

payable. (b) Prepare all journal entries related to the notes payable for December 31, 2007. (c) Show the balance sheet presentation for this obligation for December 31, 2007. (Hint:

Be sure to distinguish between the current and long-term portions of the note.)

*P10-13A Cindy Davito has just approached a venture capitalist for financing for her new business venture, the development of a local ski hill. On July 1, 2007, Cindy was loaned $100,000 at an annual interest rate of 7%. The loan is repayable over 5 years in annual installments of $24,389, principal and interest, due each June 30. The first pay- ment is due June 30, 2008. Cindy uses the effective-interest method for amortizing debt. Her ski hill company’s year-end will be June 30.

Instructions (a) Prepare an amortization schedule for the 5 years, 2007–2012. Round all calculations

to the nearest dollar. (b) Prepare all journal entries for Cindy Davito for the first 2 fiscal years ended June 30,

2008, and June 30, 2009. Round all calculations to the nearest dollar. (c) Show the balance sheet presentation of the note payable as of June 30, 2009. (Hint:

Be sure to distinguish between the current and long-term portions of the note.)

Prepare journal entries to record issuance of bonds, payment of interest, and effective-interest amortization, and balance sheet presentation. (SO 5, 7, 9) (a) (4) Interest

Expense $136,324

Prepare installment payments schedule, journal entries, and balance sheet presentation for a mortgage note payable. (SO 7, 10)

Prepare journal entries to record payments for long- term note payable, and balance sheet presentation. (SO 7, 10)

(b) 6/30/08 Interest Expense $7,000

Prepare current liability entries, adjusting entries, and current liabilities section. (SO 1, 2, 3, 7)

Problems: Set B P10-1B On January 1, 2007, the ledger of Cramer Company contained the following li- ability accounts.

Accounts Payable $52,000 Sales Taxes Payable 8,500 Unearned Service Revenue 11,000

During January the following selected transactions occurred.

Jan. 1 Borrowed $18,000 from TriCounty Bank on a 3-month, 6%, $18,000 note. 5 Sold merchandise for cash totaling $17,172, which includes 6% sales

taxes. 12 Provided services for customers who had made advance payments of

$8,000. (Credit Service Revenue.)

GLS

0000,00,000 fffface e e vvavv lue, 8%, 10 year errrresesesest rarararatettt oooon ththhhe bobobobonds. H H H HiLiLiLLoooo

m orororor d d d disssscocococounttt. Thehhe bondsdsdss p paayaa

Problems: Set B 521

14 Paid state revenue department for sales taxes collected in December 2006 ($8,500).

20 Sold 500 units of a new product on credit at $50 per unit, plus 6% sales tax.

During January the company’s employees earned wages of $40,000. Withholdings related to these wages were $3,060 for Social Security (FICA), $3,800 for federal income tax, and $1,100 for state income tax. The company owed no money related to these earnings for federal or state unemployment tax. Assume that wages earned during January will be paid during February. No entry had been recorded for wages or payroll tax expense as of January 31.

Instructions (a) Journalize the January transactions. (b) Journalize the adjusting entries at January 31 for the outstanding notes payable and

for wages expense and payroll tax expense. (c) Prepare the current liabilities section of the balance sheet at January 31, 2007. As-

sume no change in accounts payable.

P10-2B Cougar Mountain Bikes markets mountain-bike tours to clients vacationing in various locations in the mountains of Colorado. In preparation for the upcoming sum- mer biking season, Cougar entered into the following transactions related to notes payable.

Mar. 1 Purchased Puma bikes for use as rentals by issuing an $8,000, 3-month, 6% note payable that is due June 1.

Mar. 31 Recorded accrued interest for the Puma note. Apr. 1 Issued a $24,000 9-month note for the purchase of mountain property

on which to build bike trails. The note bears 8% interest and is due January 1.

Apr. 30 Recorded accrued interest for the Puma note and the land note. May 1 Issued a 4-month note to Rocky National Bank for $20,000 at 6%. The

funds will be used for working capital for the beginning of the season; the note is due September 1.

May 31 Recorded accrued interest for all three notes. June 1 Paid principal and interest on the Puma note. June 30 Recorded accrued interest for the land note and the Rocky Bank note.

Instructions (a) Prepare journal entries for the transactions noted above. (b) Post the above entries to the Notes Payable, Interest Payable, and Interest Expense

accounts. (Use T accounts.) (c) Assuming that Cougar’s year-end is June 30, show the balance sheet presentation of

notes payable and interest payable at that date. (d) How much interest expense relating to notes payable did Cougar incur during the

year?

P10-3B The following section is taken from Barnaby Corp.’s balance sheet at Decem- ber 31, 2006.

Current liabilities Bond interest payable $ 128,000

Long-term liabilities Bonds payable, 8%, due January 1, 2011 1,600,000

Interest is payable annually on January 1. The bonds are callable on any annual interest date.

Instructions (a) Journalize the payment of the bond interest on January 1, 2007. (b) Assume that on January 1, 2007, after paying interest, Barnaby Corp. calls bonds hav-

ing a face value of $400,000. The call price is 105. Record the redemption of the bonds. (c) Prepare the adjusting entry on December 31, 2007, to accrue the interest on the

remaining bonds.

Journalize and post note transactions; show balance sheet presentation. (SO 2, 7)

(b) Loss $20,000

Prepare journal entries to record interest payments and redemption of bonds. (SO 5, 6)

(b) Interest Payable $680

mmmmbebeber 20222 0666

salalaaleseseses ttttaxaxaxax.

522 CHAPTER 10 Reporting and Analyzing Liabilities

P10-4B On April 1, 2006, ERV Corp. issued $800,000, 7%, 5-year bonds at face value. The bonds were dated April 1, 2006, and pay interest annually on April 1. Financial state- ments are prepared annually on December 31.

December 31, 2006. (d) Prepare the journal entry to record the payment of interest on April 1, 2007. (e) Prepare the adjusting entry to record the accrual of interest on December 31, 2007. (f) Assume that on January 1, 2008, ERV pays the accrued bond interest and calls the

bonds. The call price is 102. Record the payment of interest and redemption of the bonds.

P10-5B Buzz Electric sold $3,000,000, 9%, 20-year bonds on January 1, 2007. The bonds were dated January 1 and pay interest on January 1. The bonds were sold at 103.

Instructions (a) Prepare the journal entry to record the issuance of the bonds on January 1, 2007. (b) At December 31, 2007, $4,500 of the bond premium had been amortized. Show the

balance sheet presentation of the bond liability at December 31, 2007. (Assume that interest has been paid.)

(c) At December 31, 2008, when the carrying value of the bonds was $3,081,000, the com- pany redeemed the bonds at 104. Record the redemption of the bonds assuming that interest for the year had already been paid.

P10-6B The following selected information was taken from the financial statements of Krispy Kreme Doughnuts, Inc.

Prepare journal entries to record issuance of bonds, interest, balance sheet presentation, and bond redemption. (SO 5, 6, 7)

(f) Loss 16,000

Prepare journal entries to record issuance of bonds, show balance sheet presentation, and record bond redemption. (SO 5, 6, 7)

KRISPY KREME DOUGHNUTS, INC. Balance Sheet (partial)

(in thousands)

Feb. 1, 2004 Feb. 2, 2003

Total current assets $138,644 $141,128 Capital assets and other long-term assets 522,020 269,359

$660,664 $410,487

Current liabilities $ 53,493 $ 59,687 Long-term liabilities 154,964 77,448

Total liabilities 208,457 137,135 Shareholders’ equity 452,207 273,352

Total liabilities and shareholders’ equity $660,664 $410,487

Other information: 2004 2003

Interest expense $ 4,409 $ 1,781 Tax expense 37,590 21,295 Net income 33,478 57,087 Cash provided by operations 95,553 51,036 Capital expenditures 79,649 83,196 Cash dividends -0- -0-

Note 8. Lease Commitments The Company conducts some of its operations from leased facilities and, additionally, leases certain equipment under operating leases. Generally, these have initial terms of 3 to 20 years and contain provisions for renewal options of 5 to 10 years.

Calculate and comment on ratios. (SO 7)

,,,, 55 5 yeaaaar booonndnn s at face value. ly yyy ooono AAAApprprprilililil 1... FiFFF nanananancial l stssttatattateee-e

Problems: Set B 523

Rental expense, net of rental income, totaled $10,576,000 in fiscal 2002, $13,169,000 in fiscal 2003 and $19,574,000 in fiscal 2004.

Instructions (a) Calculate each of the following ratios for 2004 and 2003.

(1) Current ratio. (2) Free cash flow. (3) Debt to total assets ratio. (4) Times interest earned ratio.

(b) Comment on Krispy Kreme’s liquidity and solvency. (c) Read the company’s note on leases (Note 8). If the operating leases had instead been

accounted for like a purchase, assets and liabilities would have increased by approximately $110,000,000. Recalculate the debt to total assets ratio for 2004 and discuss the implications for analysis.

*P10-7B The following section is taken from Clampette Oil Company’s balance sheet at December 31, 2007.

Amount Fiscal Year Ending in (in thousands)

2005 $ 21,119 2006 18,560 2007 15,657 2008 13,099 2009 11,692 Thereafter 75,599

$155,726

Prepare journal entries to record interest payments, straight-line premium amortization, and redemption of bonds (SO 5, 6, 8)Current liabilities

Bond interest payable $ 342,000 Long-term liabilities

Bonds payable, 9% due January 1, 2018 $3,800,000 Add: Premium on bonds payable 200,000 4,000,000

Interest is payable annually on January 1. The bonds are callable on any annual inter- est date. Clampette uses straight-line amortization for any bond premium or discount. From December 31, 2007, the bonds will be outstanding for an additional 10 years (120 months).

Instructions (Round all computations to the nearest dollar.) (a) Journalize the payment of bond interest on January 1, 2008. (b) Prepare the entry to amortize bond premium and to accrue interest due on December

31, 2008. (c) Assume on January 1, 2009, after paying interest, that Clampette Company calls bonds

having a face value of $1,900,000. The call price is 102. Record the redemption of the bonds.

(d) Prepare the adjusting entry at December 31, 2009, to amortize bond premium and to accrue interest on the remaining bonds.

*P10-8B Smudge Company sold $1,500,000, 10%, 10-year bonds on January 1, 2007. The bonds were dated January 1, 2007, and pay interest on January 1. Smudge Com- pany uses the straight-line method to amortize bond premium or discount.

Prepare journal entries to record issuance of bonds, interest, and straight-line amortization, and balance sheet presentation. (SO 5, 7, 8)

At February 1, 2004, future minimum annual rental commitments, gross, under non- cancelable operating leases, including lease commitments on consolidated joint ventures, are as follows:

nnnndded r nonnn n vvvveeene tutututurrrer s,s,s,s,

524 CHAPTER 10 Reporting and Analyzing Liabilities

Instructions (a) Prepare all the necessary journal entries to record the issuance of the bonds and bond

interest expense for 2007, assuming that the bonds sold at 102. (b) Prepare journal entries as in part (a) assuming that the bonds sold at 96. (c) Show the balance sheet presentation for the bond issue at December 31, 2007, using

(1) the 102 selling price, and then (2) the 96 selling price.

*P10-9B Zorin Corporation sold $3,500,000, 7%, 20-year bonds on December 31, 2006. The bonds were dated December 31, 2006, and pay interest on December 31. The com- pany uses straight-line amortization for premiums and discounts. Financial statements are prepared annually.

Instructions (a) Prepare the journal entry to record the issuance of the bonds assuming they sold at:

(1) 971⁄2. (2) 104.

(b) Prepare amortization tables for both of the assumed sales for the first three interest payments.

(d) Show the balance sheet presentation for both assumed sales at December 31, 2007.

*P10-10B On January 1, 2007, Stavlund Corporation issued $1,400,000 face value, 12%, 10-year bonds at $1,572,048. This price resulted in an effective-interest rate of 10% on the bonds. Stavlund uses the effective-interest method to amortize bond premium or dis- count. The bonds pay annual interest January 1.

this bond issue. (c) Prepare the journal entry to record the accrual of interest and the amortization of

the premium on December 31, 2007. (d) Prepare the journal entry to record the payment of interest on January 1, 2008. (e) Prepare the journal entry to record the accrual of interest and the amortization of

the premium on December 31, 2008.

*P10-11B On January 1, 2007, Gelber Company issued $2,200,000 face value, 10%, 15-year bonds at $1,900,322. This price resulted in an effective interest rate of 12% on the bonds. Gelber uses the effective-interest method to amortize bond premium or discount. The bonds pay annual interest January 1.

Instructions (a) Prepare the journal entries to record the following transactions.

(1) The issuance of the bonds on January 1, 2007. (2) The accrual of interest and the amortization of the discount on December 31, 2007. (3) The payment of interest on January 1, 2008. (4) The accrual of interest and the amortization of the discount on December 31, 2008.

(b) Show the proper balance sheet presentation for the liability for bonds payable on the December 31, 2008, balance sheet.

or less than the amount that would be reported if the straight-line method of amortization were used?

(3) Determine the total cost of borrowing over the life of the bond. (4) Would the total bond interest expense be greater than, the same as, or less than

the total interest expense that would be reported if the straight-line method of amortization were used?

*P10-12B Angela Corporation purchased a new piece of equipment to be used in its new facility. The $750,000 piece of equipment was purchased with a $50,000 down payment

Prepare journal entries to record issuance of bonds, interest, and straight-line amortization, and balance sheet presentation. (SO 5, 7, 8)

Prepare journal entries to record issuance of bonds, payment of interest, and amortization of bond premium using effective- interest method. (SO 5, 9)

Prepare journal entries to record issuance of bonds, payment of interest, and effective-interest amortization, and balance sheet presentation. (SO 5, 7, 9)

Prepare installment payments schedule, journal entries for a mortgage note payable, and balance sheet presentation. (SO 7, 10)

uuuananananceeee o o o of ththththe bobobobondndndnds and ddd bobobob ndndndnd atattt 111102020202. bonnnnds ssssold atatatat 96666

Comprehensive Problem 525

and with cash received through the issuance of a $700,000, 8%, 4-year mortgage note payable issued on October 1, 2007. The terms provide for quarterly installment payments of $51,555 on December 31, March 31, June 30, and September 30.

Instructions (Round all computations to the nearest dollar.) (a) Prepare an installment payments schedule for the first five payments of the notes

payable. (b) Prepare all necessary journal entries related to the notes payable for December 31,

2007. (c) Show the balance sheet presentation for these obligations for December 31, 2007.

(Hint: Be sure to distinguish between the current and long-term portions of the note.)

*P10-13B James Clark has just approached a venture capitalist for financing for his sail- ing school. The venture capitalist is willing to loan James $70,000 at a high-risk annual interest rate of 24%. The loan is payable over 3 years in monthly installments of $2,746. Each payment includes principal and interest, calculated using the effective-interest method for amortizing debt. James receives the loan on May 1, 2007, which is the first day of his fiscal year. James makes the first payment on May 31, 2007.

Instructions (a) Prepare an amortization schedule for the period from May 1, 2007, to August 31,

2007. Round all calculations to the nearest dollar. (b) Prepare all journal entries for James Clark for the period beginning May 1, 2007, and

ending July 31, 2007. Round all calculations to the nearest dollar.

Problems: Set C Visit the book’s website at www.wiley.com/college/kimmel and choose the Student Com- panion site to access Problem Set C.

Comprehensive Problem CP10 Crow Corporation’s balance sheet at December 31, 2006, is presented below.

Prepare journal entries to record payments for long- term note payable. (SO 10)

(b) 6/30 Interest Expense $1,373

(b) Interest Expense $14,000

CROW CORPORATION Balance Sheet

December 31, 2006

Cash $30,500 Inventory 25,750 Prepaid insurance 5,600 Equipment 38,000

$99,850

Accounts payable $13,750 Bond interest payable 3,000 Bonds payable 50,000 Common stock 20,000

Retained earnings $13,100

$99,850

During 2007, the following transactions occurred. 1. Crow paid $3,000 interest on the bonds on January 1, 2007. 2. Crow purchased $241,100 of inventory on account. 3. Crow sold for $400,000 cash inventory which cost $240,000. Crow also collected

$24,000 sales taxes. 4. Crow paid $230,000 on accounts payable. 5. Crow paid $3,000 interest on the bonds on July 1, 2007. 6. The prepaid insurance ($5,600) expired on July 31. 7. On August 1, Crow paid $10,800 for insurance coverage from August 1, 2007, through

July 31, 2008. 8. Crow paid $17,000 sales taxes to the state. 9. Paid other operating expenses, $91,000.

10. Retired the bonds on December 31, 2007, by paying $48,000 plus $3,000 interest. 11. Issued $70,000 of 8% bonds on December 31, 2007, at 104. The bonds pay interest

every June 30 and December 31.

w w

.wiley.co

m /c

o ll

eg e/

kimmel

gagagagage nnnnoteee ppppayayayaymememementntntntssss

� B R O A D E N I N G Y O U R P E R S P E C T I V E

526 CHAPTER 10 Reporting and Analyzing Liabilities

Adjustment data: 1. Recorded the insurance expired from item 7. 2. The equipment was acquired on December 31, 2006, and will be depreciated on a

straight-line basis over 5 years with a $3,000 salvage value. 3. The income tax rate is 30%. (Hint: Prepare the income statement up to income be-

fore taxes and multiply by 30% to compute the amount.)

Instructions (You may want to set up T accounts to determine ending balances.) (a) Prepare journal entries for the transactions listed above and adjusting entries. (b) Prepare an adjusted trial balance at December 31, 2007. (c) Prepare an income statement and a retained earnings statement for the year ending

December 31, 2007, and a classified balance sheet as of December 31, 2007.

Continuing Cookie Chronicle (Note: This is a continuation of the Cookie Chronicle from Chapters 1 through 9.)

CCC10 Natalie is thinking of repaying all amounts outstanding to her grandmother. Re- call that Cookie Creations borrowed $2,000 on November 16, 2006, from Natalie’s grand- mother. Interest on the note is 6% per year, and the note plus interest was to be repaid in 24 months. Recall that a monthly adjusting journal entry was prepared for the months of November 2006 (1/2 month), December 2006, and January 2007.

Instructions (a) Calculate the interest payable that was accrued and recorded to January 31, 2007. (b) Calculate the total interest expense and interest payable to August 31, 2007. Pre-

pare the journal entry at August 31, 2007, to bring the accounting records up to date.

(c) Natalie repays her grandmother on September 15, 2007—10 months after her grand- mother extended the loan to Cookie Creations. Prepare the journal entry for the loan repayment.

Financial Reporting and Analysis FINANCIAL REPORTING PROBLEM: Tootsie Roll Industries BYP10-1 Refer to the financial statements of Tootsie Roll Industries and the Notes to Consolidated Financial Statements in Appendix A.

Instructions Answer the following questions. (a) What were Tootsie Roll’s total current liabilities at December 31, 2004? What was the

increase/decrease in Tootsie Roll’s total current liabilities from the prior year? (b) How much were the accounts payable at December 31, 2004? (c) What were the components of total current liabilities on December 31, 2004 (other

than accounts payable already discussed above)?

COMPARATIVE ANALYSIS PROBLEM: Tootsie Roll vs. Hershey Foods BYP10-2 The financial statements of Hershey Foods are presented in Appendix B, fol- lowing the financial statements for Tootsie Roll Industries in Appendix A.

Instructions (a) Based on the information contained in these financial statements, compute the cur-

rent ratio for 2004 for each company.

ndddd wwwwilllll lll bebbb dddeepreeecciateddd oooonnnn a lue

Broadening Your Perspective 527

What conclusions concerning the companies’ liquidity can be drawn from these ratios? (b) Based on the information contained in these financial statements, compute the fol-

lowing 2004 ratios for each company.

(1) Debt to total assets. (2) Times interest earned. (Hershey’s total interest expense for 2004 was $67,919,000.)

What conclusions about the companies’ long-run solvency can be drawn from the ratios?

RESEARCH CASE BYP10-3 The July 2, 2004, edition of the Wall Street Journal contains an article by Ken Brown and Mark Heinzl titled “Nortel Board Finds Accounting Tricks Behind ’03 Profits.”

Instructions Read the article and answer the following questions. (a) Describe the process of “cookie jar” accounting. Include the example used in the

article. (b) What motivation did Nortel’s executives have to engage in the practice of “cookie jar”

accounting? (c) What actions did Nortel’s board of directors take once the improper accounting was

revealed?

INTERPRETING FINANCIAL STATEMENTS BYP10-4 Hechinger Co. and Home Depot are two home improvement retailers. Com- pared to Hechinger, founded in the early 1900s, Home Depot is a relative newcomer. But, in recent years, while Home Depot was reporting large increases in net income, Hechinger was reporting increasingly large net losses. Finally, largely due to competition from Home Depot, Hechinger was forced to file for bankruptcy. Here are financial data for both com- panies (in millions).

Hechinger Home Depot

Cash $ 21 $ 62 Receivables 0 469 Total current assets 1,153 4,933 Beginning total assets 1,668 11,229 Ending total assets 1,577 13,465 Beginning current liabilities 935 2,456 Ending current liabilities 938 2,857 Beginning total liabilities 1,392 4,015 Ending total liabilities 1,339 4,716 Interest expense 67 37 Income tax expense 3 1,040 Cash provided (used) by operations (257) 1,917 Net income (93) 1,614 Net sales 3,444 30,219

Instructions Using the data, perform the following analysis. (a) Calculate working capital and the current ratio for each company. Discuss their rel-

ative liquidity. (b) Calculate the debt to total assets ratio and times interest earned for each company.

Discuss their relative solvency.

te ththththeee e fofofofol-l-l-l-

528 CHAPTER 10 Reporting and Analyzing Liabilities

(c) Calculate the return on assets ratio and profit margin ratio for each company. Com- ment on their relative profitability.

(d) The notes to Home Depot’s financial statements indicate that it leases many of its fa- cilities using operating leases. If these assets had instead been purchased with debt, assets and liabilities would have increased by approximately $2,347 million. Calcu- late the company’s debt to total assets ratio employing this adjustment. Discuss the implications.

BYP10-5 Many multinational companies find it beneficial to have their shares listed on stock exchanges in foreign countries. In order to do this, they must comply with the securities laws of those countries. Some of these laws relate to the form of financial disclosure the company must provide, including disclosures related to contingent lia- bilities. This exercise investigates the Tokyo Stock Exchange, the largest stock exchange in Japan.

Address: www.tse.or.jp/english/index.shtml (or go to www.wiley.com/college/kimmel)

Steps

1. Choose About TSE. 2. Choose History. Answer questions (a) and (b). 3. Choose Listed Companies. 4. Choose Disclosure. Answer questions (c) and (d).

Instructions Answer the following questions. (a) When was the first stock exchange opened in Japan? How many exchanges does Japan

have today? (b) What event caused trading to stop for a period of time in Japan? (c) What are four examples of decisions by corporations that must be disclosed at the

time of their occurrence? (d) What are four examples of “occurrence of material fact” that must be disclosed at

the time of their occurrence?

FINANCIAL ANALYSIS ON THE WEB BYP10-6 Purpose: Bond or debt securities pay a stated rate of interest. This rate of interest is dependent on the risk associated with the investment. Moody’s Investment Service provides ratings for companies that issue debt securities.

Address: www.moodys.com/ (or go to www.wiley.com/college/kimmel)

Steps: From Moody’s homepage, choose About Moody’s.

Instructions Answer the following questions. (a) In what year did Moody’s introduce the first bond rating? (See Moody’s History.) (b) What is the total amount of debt securities that Moody’s analysts “track”? (See An

Introduction.) (c) What characteristics must debt ratings have in order to be useful to the capital

markets? (See Understand Risk: The Truth About Credit Ratings.)

BYP10-7 Purpose: To illustrate the usefulness of financial calculators on the Web.

Address: www.centura.com/tools (or go to www.wiley.com/college/kimmel)

Steps: Go to the site shown above.

Instructions Choose one of the many financial decisions listed at the site. Fill in inputs based on two different sets of assumptions. Print out your results, and then write up a short de- scription of the decision model for your instructor. Describe the inputs and assump- tions the model uses. Also try to identify the strengths and weaknesses of the site.

p y

thhhhatatatat ii iit t t t leleleleaseees manaany of itstststs ffffaa-a d bbbbeeeee n puppp rchahahahaseeeedddd wiiwiwithththth dddebbebebtttt

Broadening Your Perspective 529

Critical Thinking DECISION MAKING ACROSS THE ORGANIZATION BYP10-8 On January 1, 2005, Troy Corporation issued $1,200,000 of 5-year, 8% bonds at 97. The bonds pay interest annually on January 1. By January 1, 2007, the market rate of interest for bonds of risk similar to those of Troy Corporation had risen. As a result the market value of these bonds was $1,000,000 on January 1, 2007—below their carry- ing value of $1,178,400.

Troy Athens, president of the company, suggests repurchasing all of these bonds in the open market at the $1,000,000 price. But to do so the company will have to issue $1,000,000 (face value) of new 10-year, 12% bonds at par. The president asks you, as con- troller, “What is the feasibility of my proposed repurchase plan?”

Instructions With the class divided into groups, answer the following. (a) Prepare the journal entry to retire the 5-year bonds on January 1, 2007. Prepare the

journal entry to issue the new 10-year bonds. (b) Prepare a short memo to the president in response to his request for advice. List

the economic factors that you believe should be considered for his repurchase proposal.

COMMUNICATION ACTIVITY BYP10-9 Adam Merritt, president of Good to Go, is considering the issuance of bonds to finance an expansion of his business. He has asked you to do the following: (1) discuss the advantages of bonds over common stock financing, (2) indicate the types of bonds he might issue, and (3) explain the issuing procedures used in bond transactions.

Instructions Write a memorandum to the president, answering his request.

ETHICS CASE BYP10-10 The July 1998 issue of Inc. magazine includes an article by Jeffrey L. Seglin entitled “Would You Lie to Save Your Company?” It recounts the following true situation:

“A Chief Executive Officer (CEO) of a $20-million company that repairs aircraft engines received notice from a number of its customers that engines that it had recently repaired had failed, and that the company’s parts were to blame. The CEO had not yet determined whether his company’s parts were, in fact, the cause of the problem. The Federal Avia- tion Administration (FAA) had been notified and was investigating the matter.

What complicated the situation was that the company was in the midst of its year- end audit. As part of the audit, the CEO was required to sign a letter saying that he was not aware of any significant outstanding circumstances that could negatively impact the company—in accounting terms, of any contingent liabilities. The auditor was not aware of the customer complaints or the FAA investigation.

The company relied heavily on short-term loans from eight banks. The CEO feared that if these lenders learned of the situation, they would pull their loans. The loss of these loans would force the company into bankruptcy, leaving hundreds of people without jobs. Prior to this problem, the company had a stellar performance record.”

Instructions Answer the following questions. (a) Who are the stakeholders in this situation? (b) What are the CEO’s possible courses of action? What are the potential results of each

course of action? (Take into account the two alternative outcomes: the FAA deter- mines the company (1) was not at fault, and (2) was at fault.)

530 CHAPTER 10 Reporting and Analyzing Liabilities

(d) Suppose the CEO decides to conceal the situation, and that during the next year the company is found to be at fault and is forced into bankruptcy. What losses are incurred by the stakeholders in this situation? Do you think the CEO should suffer legal con- sequences if he decides to conceal the situation?

BYP10-11 During the summer of 2002 the financial press reported that Citigroup was being investigated for allegations that it had arranged transactions for Enron so as to intentionally misrepresent the nature of the transactions and consequently achieve favorable balance sheet treatment. Essentially, the deals were structured to make it appear that money was coming into Enron from trading activities, rather than from loans.

A July 23, 2002, New York Times article by Richard Oppel and Kurt Eichenwald en- titled “Citigroup Said to Mold Deal to Help Enron Skirt Rules” suggested that Citigroup intentionally kept certain parts of a secret oral agreement out of the written record for fear that it would change the accounting treatment. Critics contend that this had the effect of significantly understating Enron’s liabilities, thus misleading investors and creditors. Citigroup maintains that, as a lender, it has no obligation to ensure that its clients account for transactions properly. The proper accounting, Citigroup insists, is the responsibility of the client and its auditor.

Instructions Answer the following questions.

(a) Who are the stakeholders in this situation? (b) Do you think that a lender, in general, in arranging so called “structured fi-

nancing” has a responsibility to ensure that its clients account for the financing in an appropriate fashion, or is this the responsibility of the client and its auditor?

(c) What effect did the fact that the written record did not disclose all characteristics of the transaction probably have on the auditor’s ability to evaluate the accounting treatment of this transaction?

(d) The New York Times article noted that in one presentation made to sell this kind of deal to Enron and other energy companies, Citigroup stated that using such an arrangement “eliminates the need for capital markets disclosure, keeping structure mechanics private.” Why might a company wish to conceal the terms of a financing arrangement from the capital markets (investors and creditors)? Is this appropriate? Do you think it is ethical for a lender to market deals in this way?

(e) Why was this deal more potentially harmful to shareholders than other off-balance- sheet transactions (for example, lease financing)?

Answers to Business Insight and Accounting across the Organization Questions p. 479 Q: Based on this story, what is a good general rule to use in choosing between short-term

and long-term financing? A: In general, it is best to finance short-term assets with short-term liabilities and long-

term assets with long-term liabilities in order to reduce the likelihood of a liquidity crunch such as this.

p. 481 Q: The drop in stock prices did not change the debt to total assets ratios of these compa-

nies. Discuss how the perception of a high debt to total assets ratio changed before and after the fall in stock prices.

A: When stock prices fell, the debt to total assets of these companies was unchanged: The debt was outstanding before the fall, and it was outstanding after the fall. However, before the fall, many investors did not worry if a company had a high debt to total assets ratio; they assumed that the debt would be converted to stock and so would never have to be repaid with cash. After the fall it became clear that the debt would not be converted to stock; suddenly, a high debt to total assets ratio was a real concern.

gggg y ptctctctcyyy.y WWWWhhhah t t t t llollosssssssses arrrer inccccuruururrereeredddd CEEEEO O O O shshshshouououould suuffeeerr legaall cocooconn-nn

Broadening Your Perspective 531

p. 494 Q: Explain how the sale of plant assets could improve the company’s solvency. A: A common measure of solvency is the debt to total assets ratio. By selling some of its

fixed assets and using the cash to pay off debt, the company would reduce its reliance on debt financing and improve its debt to assets ratio.

Answer to Tootsie Roll Review It Question 5, p. 480 The liabilities that Tootsie Roll has identified as current are: Bank loan, Accounts payable, Dividends payable, Accrued liabilities, and Income taxes payable.

Answers to Self-Study Questions 1. a 2. d 3. b 4. b 5. a 6. c 7. a 8. c 9. b 10. c 11. c 12. a 13. b 14. c

REMEMBER TO GO BACK TO THE NAVIGATOR BOX ON THE CHAPTER-OPENING PAGE AND CHECK OFF YOUR COMPLETED WORK.●❍✔✔

ommmme eee offff i i i itstststs ts reeeelianccec

boom:

title: Financial Accounting 4e Ch10
subtitle:
abstract:
text:

instructions: This is a Protected PDF document. Please enter your user name and password to unlock the text.

form:

username_label: User Name:
response:

username:
docid: 1000-0001-4AF4-0010AF37

pwd_label: Password:
neversend:

pwd:

unlocked:

rememberme: Yes
rememberme_label: Remember my user name and password.

help: If you are experiencing problems unlocking this document or you have questions regarding Protectedpdf files please contact a Technical Support representative: In the United States: 1-877-832-4867 In Canada: 1-800-859-3682 Outside the U.S. and Canada: 1-602-387-2222 Email: [email protected].
protectedpdf_version: 2012-4-13 (Version 2.6.0 Build 2.0.7.36)
version: 2013-01-25
logo:
info_publisher: This document is published by: Apollo Group, Inc.
info: