CHAPTER 10
REPORTING AND ANALYZING LIABILITIES
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
- Explain a current liability and identify the major types of current liabilities.
- Describe the accounting for notes payable.
- Explain the accounting for other current liabilities.
- Identify the types of bonds.
- Prepare the entries for the issuance of bonds and interest expense.
- Describe the entries when bonds are redeemed.
- Identify the requirements for the financial statement presentation and analysis of liabilities.
Feature Story
AND THEN THERE WERE TWO
Debt can help a company acquire the things it needs 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 unable to pay its bills, its creditors stepped in and took over. They hired a former General Motors (GM) 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. 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 argued that the United States could not afford to let Chrysler fail because of the loss of jobs. 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.
To compete in today's global vehicle market, you must be big—really big. So in 1998, Chrysler merged with German automaker Daimler-Benz to form DaimlerChrysler. For a time, this left just two U.S.-based auto manufacturers—GM and Ford. But in 2007, DaimlerChrysler sold 81% of Chrysler to Cerberus, an investment group, to provide much-needed cash infusions to the automaker. In 2009, Daimler turned over its remaining stake to Cerberus. Three days later, Chrysler filed for bankruptcy. But by 2010, it was beginning to show signs of a turnaround.
The car companies are giants. GM and Ford typically rank among the top five U.S. firms in total assets. But GM and Ford accumulated truckloads of debt on their way to getting big. Although debt made it possible to get so big, the Chrysler story, and GM's recent bankruptcy, make it clear that debt can also threaten a company's survival.
INSIDE CHAPTER 10…
- When Convertible Bonds Don't (p. 513)
- Debt Masking (p. 525)
- “Covenant-Lite” Debt (p. 527)
PREVIEW OF CHAPTER 10
The Feature Story suggests that General Motors (GM) and Ford accumulated tremendous amounts of debt in their pursuit of auto industry dominance. 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 companies incur? In this chapter, we address these issues.
The content and organization of the chapter are as follows.
Current Liabilities
WHAT IS A CURRENT LIABILITY?
LEARNING OBJECTIVE 1
Explain a current liability and identify the major types of current liabilities.
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 creation of other current liabilities, and (2) within one year or the operating cycle, 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 bankruptcy, a specific, predetermined order of payment to creditors exists. Thus, the amount and type of liabilities are of critical importance.
Helpful Hint In previous chapters, we explained the entries for accounts payable and the adjusting entries for some 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 the sections that follow, we discuss a few of the common 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 provide 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.
To illustrate the accounting for notes payable, assume that on September 1, 2014, Cole Williams Co. signs a $100,000, 12%, four-month note maturing on January 1 with First National Bank. 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.
Interest accrues over the life of the note, and the issuer must periodically record that accrual. (You may find it helpful to review the discussion of interest computations that was provided in Chapter 8, page 408, with regard to notes receivable.) If Cole Williams Co. prepares financial statements annually, it makes an adjusting entry at December 31 to recognize four months of interest expense and interest payable of $4,000 ($100,000 × 12% × 
):
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 expenses 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% × 
). It records payment of the note and accrued interest as follows.
Appendix 10C at the end of this chapter discusses the accounting for long-term installment notes payable.
SALES TAXES PAYABLE
LEARNING OBJECTIVE 3
Explain the accounting for other current liabilities.
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 Internet as well. Sales taxes are expressed as a percentage of the sales price. The 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. Collecting sales taxes is important. For example, the State of New York recently sued Sprint Nextel Corporation for $300 million for its alleged failure to collect sales taxes on phone calls.
Helpful Hint Check your sales receipts from local retailers to see whether the sales tax is computed separately.
Under most state laws, the selling company must enter 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 register readings to credit Sales Revenue 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 enter 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 enters 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%).
UNEARNED REVENUES
A magazine publisher such as Sports Illustrated collects cash when customers place orders for magazine subscriptions. An airline company such as American Airlines often receives cash when it sells tickets for future flights. Season tickets for concerts, 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 performed?
- When the company receives an advance, it increases (debits) Cash and increases (credits) a current liability account identifying the source of the unearned revenue.
- When the company recognizes revenue, it decreases (debits) the unearned revenue account and increases (credits) a revenue account.
As each game is completed, Superior records the recognition of revenue with the following entry.
The account Unearned Ticket Revenue represents unearned revenue, and Superior reports it as a current liability. As the school recognizes revenue, it reclassifies the amount from unearned revenue to Ticket Revenue. Unearned revenue is material for some companies. In the airline industry, tickets sold for future flights represent almost 50% of total current liabilities. At United Air Lines, unearned ticket revenue is its largest current liability, recently amounting to more than $1 billion.
Illustration 10-1 shows specific unearned revenue and revenue accounts used in selected types of businesses.
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, 2013. This note specifies that each January 1, starting January 1, 2014, Wendy should pay $5,000 of the note. When the company prepares financial statements on December 31, 2013, it should report $5,000 as a current liability and $20,000 as a long-term liability. (The $5,000 amount is the portion of the note that is due to be paid within the next 12 months.) Companies often identify current maturities of long-term debt on the balance sheet as long-term debt due within one year. In a recent year, General Motors had $724 million of such debt.
It is not necessary to prepare an adjusting entry to recognize the current maturity of long-term debt. At the balance sheet date, all obligations due within one year are classified as current, and all other obligations are long-term.
Do it!
CURRENT LIABILITIES
You and several classmates are studying for the next accounting examination. They ask you to answer the following questions.
- If cash is borrowed on a $50,000, 6-month, 12% note on September 1, how much interest expense would be incurred by December 31?
- How is the sales tax amount determined when the cash register total includes sales taxes?
- If $15,000 is collected in advance on November 1 for 3-months' rent, what amount of rent should be recognized by December 31?
Action Plan
- Use the interest formula: Face value of note × Annual interest rate × Time in terms of one year.
- Divide total receipts by 100% plus the tax rate to determine sales; then subtract sales from the total receipts.
- Determine what fraction of the total unearned rent should be recognized this year.
Solution
- $50,000 × 12% × 4/12 = $2,000
- First, divide the total cash register receipts by 100% plus the sales tax percentage to find the sales amount. Second, subtract the sales amount from the total cash register receipts to determine the sales taxes.
- $15,000 × 2/3 = $10,000
Related exercise material: BE10-2, BE10-3, BE10-4, 
10-1, E10-1, E10-2, E10-3, E10-4, E10-6, and E10-7.
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 taxes1 and for federal and state income taxes. If these withholdings total $100, Susan will receive a check for only $300. Illustration 10-2 summarizes the types of payroll deductions that normally occur for most companies.
As a result of these deductions, companies withhold from employee paychecks 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 below.
Cargo then records payment of this payroll on March 7 as follows.
In this case, Cargo reports $100,000 in salaries and wages expense. In addition, it reports liabilities for the salaries and wages payable as well as liabilities to governmental 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 incurs 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 federal 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.
Companies classify the payroll and payroll tax liability accounts as current liabilities because they must be paid to employees or remitted to taxing authorities periodically and in the near term. Taxing authorities impose substantial fines and penalties on employers if the withholding and payroll taxes are not computed correctly and paid on time.
ANATOMY OF A FRAUD
Art was a custodial supervisor for a large school district. The district was supposed to employ between 35 and 40 regular custodians, as well as 3 or 4 substitute custodians to fill in when regular custodians were missing. Instead, in addition to the regular custodians, Art “hired” 77 substitutes. In fact, almost none of these people worked for the district. Instead, Art submitted time cards for these people, collected their checks at the district office, and personally distributed the checks to the “employees.” If a substitute's check was for $1,200, that person would cash the check, keep $200, and pay Art $1,000.
Total take: $150,000
THE MISSING CONTROLS
Human Resource Controls. Thorough background checks should be performed. No employees should begin work until they have been approved by the Board of Education and entered into the payroll system. No employees should be entered into the payroll system until they have been approved by a supervisor. All paychecks should be distributed directly to employees at the official school locations by designated employees.
Independent internal verification. Budgets should be reviewed monthly to identify situations where actual costs significantly exceed budgeted amounts.
Source: Adapted from Wells, Fraud Casebook (2007), pp. 164–171.
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) salaries and wages expense and salaries 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 withholdings 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.
(b) Payroll taxes would be for the company's share of FICA, as well as for federal and state unemployment tax.
Related exercise material: BE10-5, BE10-6, 10-2, and E10-5.
Bonds: Long-Term Liabilities
LEARNING OBJECTIVE 4
Identify the types of bonds.
Long-term liabilities are obligations that a company expects to pay more than one year in the future. In this section, we explain the accounting for the principal types of obligations reported in the long-term liabilities section of the balance sheet. These obligations often are in the form of bonds or long-term notes.
Bonds are a form of interest-bearing note payable issued by corporations, universities, 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. When a corporation issues bonds, it is borrowing money. The person who buys the bonds (the bondholder) is investing in bonds.
TYPES OF BONDS
Bonds may have different features. In the following sections, we describe some commonly issued types of bonds.
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, at one time 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 redeem (buy back) 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 feature often gives bondholders an opportunity to benefit if the market price of the common stock increases substantially. Furthermore, until conversion, the bondholder receives interest 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 issued convertible bonds.
Accounting Across the Organization
When Convertible Bonds Don't
During the boom times of the late 1990s, many rapidly growing companies issued 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. When many of these massive bonds came due, companies were 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 assets ratios of these companies. Discuss how the perception of a high debt to assets ratio changed before and after the fall in stock prices. (See page 563.)
ISSUING PROCEDURES
Alternative Terminology The contractual rate is often referred to as the stated rate.
A bond certificate is issued to the investor to provide evidence of the investor's claim against the company. As Illustration 10-3 (page 514) shows, the bond certificate 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 contractual interest rate. The face value is the amount of principal 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 determine 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. (We use annual payments in our examples to simplify.)
DETERMINING THE MARKET PRICE 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 equivalent today, or its present value. In other words, you would want to determine the value today of the amount to be received in the future after taking into account current interest rates.
The current market price (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 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, 2014, issues $100,000 of 9% bonds, due in five years, with interest payable annually at yearend. 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.
The current market price 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%.
Tables are available to provide the present value numbers to be used, or these values can be determined mathematically or with financial calculators.2 Appendix D, near the end of the textbook, provides further discussion of the concepts and the mechanics of the time value of money computations.
Do it!
BOND TERMINOLOGY
State whether each of the following statements is true or false.
| _____ 1. | Secured bonds have specific assets of the issuer pledged as collateral. |
| _____ 2. | Callable bonds can be redeemed by the issuing company at a stated dollar amount prior to maturity. |
| _____ 3. | The contractual rate is the rate investors demand for loaning funds. |
| _____ 4. | The face value is the amount of principal the issuing company must pay at the maturity date. |
| _____ 5. | The market price of a bond is equal to its maturity value. |
Action Plan
- Review the types of bonds and the basic terms associated with bonds.
Solution
- True.
- True.
- False. The contractual interest rate is used to determine the amount of cash interest the borrower pays.
- True.
- False. The market price of a bond is equal to the present value of all the future cash payments promised by the bond.
Related exercise material: 10-3.
Accounting for Bond Issues
LEARNING OBJECTIVE 5
Prepare the entries for the issuance of bonds and interest expense.
A corporation records bond transactions when it issues (sells) or redeems (buys back) bonds and when bondholders convert bonds into common stock. If bond-holders sell their bond investments to other investors, the issuing firm receives no further money on the transaction, nor does the issuing corporation journalize the transaction (although it does keep records of the names of bondholders 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, 2014, at 100 (100% of face value). The entry to record the sale is:
Devor reports bonds payable in the long-term liabilities section of the balance sheet because the maturity date is January 1, 2019 (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% × 
) on December 31. At December 31, Devor recognizes the $10,000 of interest expense incurred with the following adjusting entry.
The company classifies interest payable as a current liability because it is scheduled for payment within the next year. When Devor pays the interest on January 1, 2015, it decreases (debits) Interest Payable and decreases (credits) Cash for $10,000. Devor records the payment on January 1 as follows.
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 demand for loaning funds to the corporation. When the contractual interest rate and the market interest rate are the same, bonds sell at face value.
However, market interest rates change daily. The type of bond issued, the state of the economy, current industry conditions, and the company's individual 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. When a bond is sold for less than its face value, the difference between the face value of a bond and its selling price is called 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.
Helpful Hint Bond prices vary inversely with changes in the market interest rate. As market interest rates decline, bond prices increase. When a bond is issued, if the market interest rate is below the contractual rate, the bond price is higher than the face value.
Conversely, if the market rate of interest is lower than the contractual interest 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 price on the bonds will be bid up. When a bond is sold for more than its face value, the difference between the face value and its selling price is called a premium. Illustration 10-6 shows these relationships graphically.
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.
Issuance of bonds at an amount different from face value is quite common. 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, 2014, 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:
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.
Helpful Hint The carrying value (book value) of bonds issued at a discount is determined by subtracting the balance of the discount account from the balance of the Bonds Payable account.
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 borrowing 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 interest expense over the life of the bonds. The total cost of borrowing $98,000 for Candlestick Inc. is $52,000, computed as shown in Illustration 10-8.
Alternatively, we can compute the total cost of borrowing as shown in Illustration 10-9.
To follow the expense recognition principle, companies allocate bond discount to expense 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 carrying 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. Appendices 10A and 10B at the end of this chapter discuss procedures for amortizing bond discount.
ISSUING BONDS AT A PREMIUM
We can illustrate the issuance of bonds at a premium by now assuming the Candlestick Inc. bonds described above sell at 102 (102% of face value) rather than at 98. The entry to record the sale is:
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 considered 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 Candlestick Inc. is $48,000, computed as in Illustration 10-12.
Alternatively, we can compute the cost of borrowing as shown in Illustration 10-13.
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 contractual amount. As shown in Illustration 10-12, for the bonds issued by Candlestick 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. Appendices 10A and 10B at the end of this chapter discuss procedures for amortizing bond premium.
Do it!
BOND ISSUANCE
Giant Corporation issues $200,000 of bonds for $189,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the balance sheet at the date of issuance.
Action Plan
- Record cash received, bonds payable at face value, and the difference as a discount or premium.
- Report discount as a deduction from bonds payable and premium as an addition to bonds payable.
Solution
Related exercise material: BE10-8, BE10-9, BE10-10, 10-4, E10-8, E10-9, and E10-10.
Accounting for Bond Redemptions
LEARNING OBJECTIVE 6
Describe the entries when bonds are redeemed.
Bonds are redeemed when the issuing corporation buys them back. 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 separately the interest for the last interest period, Candlestick records the redemption of its bonds at maturity as:
REDEEMING BONDS BEFORE MATURITY
Bonds may be redeemed before maturity. A company may decide to redeem bonds before maturity in order to reduce interest cost and remove debt from its balance sheet. A company should redeem debt early only if it has sufficient cash resources.
When bonds are redeemed 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., having sold its bonds at a premium, redeems the $100,000 face value bonds at 103 after paying the annual interest. Assume that the carrying value of the bonds at the redemption date is $100,400 (principal $100,000 and premium $400). Candlestick records the redemption at the end of the fourth interest period (January 1, 2018) as:
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.
Do it!
BOND REDEMPTION
R & B Inc. issued $500,000, 10-year bonds at a discount. Prior to maturity, when the carrying value of the bonds is $496,000, the company redeems the bonds at 98. Prepare the entry to record the redemption of the bonds.
Action Plan
- Determine and eliminate the carrying value of the bonds.
- Record the cash paid.
- Compute and record the gain or loss (the difference between the first two items).
Solution
There is a loss on redemption. The cash paid, $490,000 ($500,000 × 98%), is less than the carrying value of $496,000. The entry is:
Related exercise material: BE10-11, 10-5, E10-13, and E10-14.
Financial Statement Presentation and Analysis
BALANCE SHEET PRESENTATION
LEARNING OBJECTIVE 7
Identify the requirements for the financial statement presentation and analysis of liabilities.
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 often list notes payable first, followed by accounts payable.
Companies report long-term liabilities in a separate section of the balance sheet immediately following “Current liabilities.” Illustration 10-15 shows an example.
Ethics Note Some companies try to minimize the amount of debt reported on their balance sheet by not reporting certain types of commitments as liabilities. This subject is of intense interest in the financial community.
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 privileges, 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.
KEEPING AN EYE ON CASH
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.
The statement of cash flows shown below presents the cash flows from financing activities for General Motors Company (Automotive Division). From this we learn that the company issued new debt of $476 million and repaid debt of $1,471 million.
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 the nonfinancial services division (primarily the Automotive Division) of Toyota Motor Corporation to illustrate the analysis of a company's liquidity and solvency.
Liquidity
Liquidity ratios measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash. A commonly used measure of liquidity is the current ratio (presented in Chapter 2). The current ratio is calculated as current assets divided by current liabilities. Illustration 10-17 presents the current ratio for the Automotive Division of Toyota along with the industry average.
Toyota's current ratio declined from 1.49:1 to 1.30:1 from 2010 to 2011. Although Toyota's ratio declined, it still exceeds the industry average current ratio for manufacturers of autos and trucks of 1.00:1.
Toyota's current ratio, like the industry average, is quite low. Many companies today minimize their liquid assets (such as accounts receivable and inventory) in order to improve profitability measures, such as return on assets. This is particularly true of large companies such as Ford, GM, and Toyota. Companies that keep fewer liquid assets on hand must rely on other sources of liquidity. 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. For example, a recent disclosure regarding debt in Toyota's financial statements states that it has $23.5 billion of unused lines of credit. This represents a substantial amount of available cash.
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 three 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, some U.S. automobile manufacturers took two precautionary steps while they enjoyed strong profits. First, they built up large balances of cash and cash equivalents to avoid a cash crisis. Second, they were reluctant to build new plants or hire new workers to meet their production needs. Instead, they asked workers to put in overtime, or they “outsourced” work to other companies. In this way, when the economic downturn occurred, they hoped to avoid having to make debt payments on idle production plants and to minimize layoffs. As a result, when the crisis first hit, Ford had cash of $29 billion, about double the amount of cash it would expect to use over a two-year period.
In Chapter 2, you learned that one measure of a company's solvency is the debt to assets ratio. This is calculated as total liabilities (debt) divided by total assets. This ratio indicates the extent to which a company's assets are financed with debt.
Another useful solvency measure is the times interest earned. It 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 523 and the additional information below to calculate solvency ratios for the Automotive Division of Toyota.
The debt to assets ratios and times interest earned for the Automotive Division of Toyota and averages for the industry are shown in Illustration 10-18.
Toyota's debt to assets ratio was 42%. The industry average for manufacturers of autos and trucks is 62%. Thus, Toyota is less reliant on debt financing than the average firm in the auto and truck industry.
Toyota's times interest earned increased from 3.4 times in 2010 to 13.6 in 2011. This means that in 2011 Toyota had earnings before interest and taxes that were more than 13 times the amount needed to pay interest. The higher the multiple, the lower the likelihood that the company will default on interest payments. Because many of the companies in this industry were still recovering from the recent recession, the industry average was only 3.2. This suggests that while Toyota's ability to meet interest payments was high, the average company in the industry had a lower ability to meet interest payments in 2011.
Investor Insight
Debt Masking
In the wake of the financial crisis, many financial institutions are wary of reporting too much debt on their financial statements, for fear that investors will consider them too risky. The Securities and Exchange Commission (SEC) is concerned that some companies engage in “debt masking” to make it appear that they use less debt than they actually do. These companies enter into transactions at the end of the accounting period that essentially remove debt from their books. Shortly after the end of the period, they reverse the transaction and the debt goes back on their books. The Wall Street Journal reported that 18 large banks “had consistently lowered one type of debt at the end of each of the past five quarters, reducing it on average by 42% from quarterly peaks.”
Source: Tom McGinty, Kate Kelly, and Kara Scannell, “Debt ‘Masking’ Under Fire,” Wall Street Journal Online (April 21, 2010).
What implications does debt masking have for an investor that is using the debt to assets ratio to evaluate a company's solvency? (See page 563.)
DECISION TOOLKIT
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, demonstrated 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 intentional effort by a company to structure its financing arrangements so as to avoid showing liabilities on its balance sheet. Two common types of off-balance-sheet financing result from unreported contingencies and lease transactions.
Contingencies
One reason a company's balance sheet might not fully reflect its potential obligations is due to contingencies. Contingencies are events with uncertain outcomes that may represent potential liabilities. 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 cleanup obligations. For example, in a recent year, Novartis AG began offering a money-back guarantee on its blood-pressure medications. This guarantee would necessitate an accrual for the estimated claims that will result from returns.
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 determine 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 discloses 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 increases 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 debt-financed purchase—increasing both assets and liabilities. As a result, many companies structure their lease agreements to avoid meeting the criteria of a capital lease.
Ethics Note Accounting standard-setters are attempting to rewrite rules on lease accounting because of concerns that abuse of the current standards is reducing the usefulness of financial statements.
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 $2.3 billion. Illustration 10-19 presents Southwest Airlines' debt to assets ratio for a recent year using the numbers presented in its balance sheet. It also shows the ratio after adjusting for the off-balance-sheet leases. After those adjustments, Southwest has a ratio of 62% versus 67% before. This means that of every dollar of assets, 67 cents was funded by debt. This would be of interest to analysts evaluating Southwest's solvency.
International Note GAAP accounting for leases is more “rules-based” than IFRS. GAAP relies on precisely defined cut-offs to determine whether an item is treated as a capital or operating lease. This rules-based approach may enable companies to structure leases “around the rules.” Creating a jointly prepared leasing standard is a top priority for the IASB and FASB.
Critics of off-balance-sheet financing contend that many leases represent unavoidable obligations that meet the definition of a liability. Therefore, companies should report them as liabilities on the balance sheet. To reduce these concerns, companies are required to report their operating lease obligations for subsequent years in a note. 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.
Investor Insight
“Covenant-Lite” Debt
In many corporate loans and bond issuances, the lending agreement specifies debt covenants. These covenants typically are specific financial measures, such as minimum levels of retained earnings, cash flows, times interest earned, or other measures that a company must maintain during the life of the loan. If the company violates a covenant, it is considered to have violated the loan agreement. The creditors can then demand immediate repayment, or they can renegotiate the loan's terms. Covenants protect lenders because they enable lenders to step in and try to get their money back before the borrower gets too deep into trouble.
During the 1990s, most traditional loans specified between three to six covenants or “triggers.” In more recent years, however, when there was lots of cash available, lenders began reducing or completely eliminating covenants from loan agreements in order to be more competitive with other lenders. When the economy declined, these lenders lost big money when companies defaulted.
Source: Cynthia Koons, “Risky Business: Growth of ‘Covenant-Lite’ Debt,” Wall Street Journal (June 18, 2007), p. C2.
How can financial ratios such as those covered in this chapter provide protection for creditors? (See page 564.)
Summary of Learning Objectives
- 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 existing current assets or through the creation of other current liabilities, and (b) within one year or the operating 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.
- Describe the accounting for notes payable. When a note payable 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.
- Explain the accounting for other current liabilities. Companies record sales taxes payable at the time the related sales occur. The company serves as a collection agent for the taxing authority. Sales taxes are not an expense to the company. Companies hold employee withholding taxes, and credit them to appropriate liability accounts, until they remit these taxes to the governmental taxing authorities. Unearned revenues are initially recorded in an unearned revenue account. As a company recognizes revenue, a transfer from unearned revenue to revenue occurs. Companies report the current maturities of long-term debt as a current liability in the balance sheet.
- Identify the types of bonds. The following different types of bonds may be issued: secured and unsecured bonds, and convertible and callable bonds.
- Prepare the entries for the issuance of bonds and interest 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, which increases or decreases interest expense, respectively.
- 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 maturity, 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.
- Identify the requirements for the financial statement presentation and analysis of liabilities. Current liabilities 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 assets ratio and the times interest earned. Other factors to consider are contingent liabilities and lease obligations.
DECISION TOOLKIT A SUMMARY
Appendix 10A
Straight-Line Amortization
AMORTIZING BOND DISCOUNT
To follow the expense recognition 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.
In the Candlestick Inc. example (page 517), the company sold $100,000, five-year, 10% bonds on January 1, 2014, 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 December 31 as follows.
Alternative Terminology The amount in the Discount on Bonds Payable account is often referred to as Unamortized Discount on Bonds Payable.
Over the term of the bonds, the balance in Discount on Bonds Payable will decrease 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 period 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.
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.
Continuing our example, assume Candlestick Inc., sells the bonds described above for $102,000, rather than $98,000 (see page 519). This results in a bond premium of $2,000 ($102,000 − $100,000). The premium amortization for each interest period is $400 ($2,000 ÷ 5). Candlestick records the first accrual of interest on December 31 as follows.
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.
Summary of Learning Objective for Appendix 10A
8. Apply the straight-line method of amortizing bond discount and bond premium. The straight-line method of amortization results in a constant amount of amortization and interest expense per period.
Appendix 10B
Effective-Interest Amortization
LEARNING OBJECTIVE 9
Apply the effective-interest method of amortizing bond discount and bond premium.
To follow the expense recognition principle, companies allocate bond discount to expense in each period in which the bonds are outstanding. However, to completely comply with the expense recognition principle, interest expense as a percentage of carrying value should not change over the life of the bonds.
This percentage, 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 percentage of the carrying value of the bonds. The effective-interest method results in varying amounts of amortization and interest expense per period but a constant percentage rate. In contrast, the straight-line method results in constant amounts of amortization and interest expense per period but a varying percentage rate.
Companies follow three steps under the effective-interest method:
- 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.
- Compute the bond interest paid (or accrued) by multiplying the face value of the bonds by the contractual interest rate.
- Compute the amortization amount by determining the difference between the amounts computed in steps (1) and (2).
Illustration 10B-1 depicts these steps.
Both the straight-line and effective-interest methods of amortization result 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.
AMORTIZING BOND DISCOUNT
Helpful Hint Note that the amount of periodic interest expense 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.
In the Candlestick Inc. example (page 517), the company sold $100,000, five-year, 10% bonds on January 1, 2014, for $98,000. This resulted in a $2,000 bond discount ($100,000 − $98,000). This discount results in an effective-interest rate of approximately 10.53%. (The effective-interest rate can be computed using the techniques shown in Appendix D at the end of this book.)
Preparing a bond discount amortization schedule as shown in Illustration 10B-2 (page 534) facilitates the recording of interest expense and the discount amortization. Note that interest expense as a percentage of carrying value remains constant at 10.53%.
For the first interest period, the computations of bond interest expense and the bond discount amortization are as follows.
As a result, Candlestick Inc. records the accrual of interest and amortization of bond discount on December 31 as follows.
For the second interest period, bond interest expense will be $10,353 ($98,319 × 10.53%), and the discount amortization will be $353. At December 31, Candlestick makes the following adjusting entry.
AMORTIZING BOND PREMIUM
Continuing our example, assume Candlestick Inc. sells the bonds described above for $102,000 rather than $98,000 (see page 519). This would result in a bond premium of $2,000 ($102,000 − $100,000). This premium results in an effective-interest rate of approximately 9.48%. (The effective-interest rate can be solved for using the techniques shown in Appendix D at the end of this book.) Illustration 10B-4 shows the bond premium amortization schedule.
For the first interest period, the computations of bond interest expense and the bond premium amortization are:
The entry Candlestick makes on December 31 is:
For the second interest period, interest expense will be $9,638, and the premium amortization will be $362. 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 Learning 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 percentage rate of interest. When the difference between the straight-line and effective-interest method is material, GAAP requires use of the effective-interest method.
Appendix 10C
Accounting for Long-Term Notes Payable
LEARNING OBJECTIVE 10
Describe the 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 except 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 market rate for comparable loans. Examples are the 8.03% adjustable rate notes issued by General Motors (GM) 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 McDonald's long-term debt related to mortgage notes on land, buildings, and improvements.
Helpful Hint Computer spreadsheet programs can create a schedule of installment loan payments. This allows you to put in the data for your own mortgage loan and get an illustration that really hits home.
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 borrower to make equal installment payments over the term of the loan. Each payment consists of (1) interest on the unpaid balance of the loan and (2) a reduction of loan principal. While the total amount paid remains constant, the interest decreases each period and the portion applied to the loan principal increases.
Companies initially record mortgage notes payable at face value, and subsequently 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, 2014, to obtain needed financing for the construction of a new research laboratory. The terms provide for semiannual installment payments of $33,231 (not including real estate taxes and insurance). The installment payment schedule for the first two years is as follows.
Porter Technology records the mortgage loan on December 31, 2014, as follows.
On June 30, 2015, Porter records the first installment payment as follows.
In the balance sheet, the company reports the reduction in principal for the next year as a current liability, and classifies the remaining unpaid principal balance as a long-term liability. At December 31, 2015 (the end of semiannual period 2), the total liability 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 Learning Objective for Appendix 10C
10. Describe the accounting for long-term notes payable. Each payment consists of (1) interest on the unpaid balance of the loan, and (2) a reduction of loan principal. The interest decreases each period, while the portion applied to the loan principal increases each period.
Glossary
Bond certificate (p. 513) A legal document that indicates the name of the issuer, the face value of the bonds, and other data such as the contractual interest rate and the maturity date of the bonds.
Bonds (p. 512) A form of interest-bearing notes payable issued by corporations, universities, and governmental entities.
Callable bonds (p. 512) Bonds that the issuing company can redeem (buy back) at a stated dollar amount prior to maturity.
Capital lease (p. 526) A contractual agreement allowing one party (the lessee) to use the assets of another party (the lessor); accounted for like a debt-financed purchase by the lessee.
Contingencies (p. 526) Events with uncertain outcomes that may represent potential liabilities.
Contractual (stated) interest rate (p. 513) Rate used to determine the amount of interest the borrower pays and the investor receives.
Convertible bonds (p. 512) Bonds that can be converted into common stock at the bondholder's option.
Current liability (p. 506) 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.
Discount (on a bond) (p. 516) The difference between the face value of a bond and its selling price when a bond is sold for less than its face value.
Effective-interest method of amortization (p. 533) A method of amortizing bond discount or bond premium that results in periodic interest expense equal to a constant percentage of the carrying value of the bonds.
Effective-interest rate (p. 533) Rate established when bonds are issued that maintains a constant value for interest expense as a percentage of bond carrying value in each interest period.
Face value (p. 513) Amount of principal due at the maturity date of the bond.
Long-term liabilities (p. 512) Obligations that a company expects to pay more than one year in the future.
Market interest rate (p. 514) The rate investors demand for loaning funds to the corporation.
Maturity date (p. 513) The date on which the final payment on a bond is due from the bond issuer to the investor.
Mortgage note payable (p. 536) A long-term note secured by a mortgage that pledges title to specific assets as security for the loan.
Notes payable (p. 507) An obligation in the form of a written note.
Off-balance-sheet financing (p. 525) The intentional effort by a company to structure its financing arrangements so as to avoid showing liabilities on its balance sheet.
Operating lease (p. 526) A contractual agreement allowing one party (the lessee) to use the asset of another party (the lessor); accounted for as a rental.
Premium (on a bond) (p. 517) The difference between the selling price and the face value of a bond when a bond is sold for more than its face value.
Present value (p. 514) The value today of an amount to be received at some date in the future after taking into account current interest rates.
Secured bonds (p. 512) Bonds that have specific assets of the issuer pledged as collateral.
Straight-line method of amortization (p. 530) A method of amortizing bond discount or bond premium that allocates the same amount to interest expense in each interest period.
Times interest earned (p. 524) A measure of a company's solvency, calculated by dividing income before interest expense and taxes by interest expense.
Time value of money (p. 513) The relationship between time and money. A dollar received today is worth more than a dollar promised at some time in the future.
Unsecured bonds (p. 512) Bonds issued against the general credit of the borrower.
Comprehensive Do it!
Snyder Software Inc. successfully developed a new spreadsheet program. However, to produce and market the program, the company needed additional financing. On January 1, 2013, Snyder borrowed money as follows.
- Snyder issued $500,000, 11%, 10-year bonds. The bonds sold at face value and pay interest on January 1.
- 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, 2013.
(2) Accrue interest expense on December 31, 2013.
(3) The payment of interest on January 1, 2014.
(b) For the 10-year, 10% bonds:
(1) Journalize the issuance of the bonds on January 1, 2013.
(2) Prepare the entry for the redemption of the bonds at 101 on January 1, 2016, after paying the interest due on this date. The carrying value of the bonds at the redemption date was $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.
Self-Test, Brief Exercises, Exercises, Problem Set A, and many more resources are available for practice in WileyPLUS.
*Note: All Questions, Exercises, and Problems marked with an asterisk relate to material in the appendices to the chapter.
Self-Test Questions
Answers are on page 564.
(LO 1)
1. The time period for classifying a liability as current is one year or the operating cycle, whichever is:
(a) longer.
(b) shorter.
(c) probable.
(d) possible.
(LO 1)
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).
(LO 2)
3. Ottman Company borrows $88,500 on September 1, 2014, from Farley State Bank by signing an $88,500, 12%, one-year note. What is the accrued interest at December 31, 2014?
(a) $2,655.
(b) $3,540.
(c) $4,425.
(d) $10,620.
(LO 2)
4. JD Company borrowed $70,000 on December 1 on a 6-month, 12% note. At December 31:
(a) neither the note payable nor the interest payable is a current liability.
(b) the note payable is a current liability but the interest payable is not.
(c) the interest payable is a current liability but the note payable is not.
(d) both the note payable and the interest payable are current liabilities.
5. Alexis 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 Revenue?
(a) $4,000.
(b) $4,300.
(c) $4,289.25.
(d) The correct answer is not given.
(LO 3)
6. When recording payroll:
(a) gross earnings are recorded as salaries and wages payable.
(b) net pay is recorded as salaries and wages expense.
(c) payroll deductions are recorded as liabilities.
(d) More than one of the above.
(LO 3)
7. No Fault Insurance Company collected a premium of $18,000 for a 1-year insurance policy on April 1. What amount should No Fault report as a current liability for Unearned Insurance Premiums at December 31?
(a) $0.
(b) $4,500.
(c) $13,500.
(d) $18,000.
(LO 4)
8. 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.
(LO 4)
9. The market interest rate:
(a) is the contractual interest rate used to determine the amount of cash interest paid by the borrower.
(b) is listed in the bond indenture.
(c) is the rate investors demand for loaning funds.
(d) More than one of the above is true.
(LO 5)
10. Laurel 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.
(LO 5)
11. On January 1, 2014, Kelly 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 Interest Expense of $14,000.
(LO 5)
12. Prescher Corporation issued bonds that pay interest every July 1 and January 1. The entry to accrue bond interest at December 31 includes a:
(a) debit to Interest Payable.
(b) credit to Cash.
(c) credit to Interest Expense.
(d) credit to Interest Payable.
(LO 6)
13. Goethe Corporation redeems its $100,000 face value bonds at 105 on January 1, following the payment 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.
(LO 7)
14. 
In a recent year, Derek Corporation had net income of $150,000, interest expense of $30,000, and income tax expense of $20,000. What was Derek Corporation's times interest earned for the year?
(a) 5.00.
(b) 4.00.
(c) 6.67.
(d) 7.50.
(LO 7)
15. Which of the following is not a measure of liquidity?
(a) Debt to assets ratio.
(b) Working capital.
(c) Current ratio.
(d) Current cash debt coverage.
(LO 8)
*16. On January 1, Xiang 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.
(LO 8)
*17. For the bonds issued in Question 16, what is the carrying value of the bonds at the end of the third interest period?
(a) $492,000.
(b) $488,000.
(c) $472,000.
(d) $464,000.
(LO 9)
*18. On January 1, Holly Ester Inc. issued $1,000,000, 10-year, 9% bonds for $938,554. The market rate of interest for these bonds is 10%. Interest is payable annually on December 31. Holly Ester uses the effective-interest method of amortizing bond discount. At the end of the first year, Holly Ester should report unamortized bond discount of:
(a) $54,900.
(b) $57,591.
(c) $51,610.
(d) $51,000.
(LO 9)
*19. On January 1, Nicholas 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, using the effective-interest method, the debit entry to Interest Expense is for:
(a) $120,000.
(b) $125,581.
(c) $128,652.
(d) $140,000.
(LO 10)
*20. Sampson Corp. purchased a piece of equipment by issuing a $20,000, 6% installment note payable. Quarterly payments on the note are $1,165. What will be the reduction in the principal portion of the note payable that results from the first payment?
(a) $1,165.
(b) $300.
(c) $865.
(d) $1,200.
Go to the book's companion website, www.wiley.com/college/kimmel, to access additional Self-Test Questions.
Questions
1. Peggy Jantzen believes a current liability is a debt that can be expected to be paid in one year. Is Peggy correct? Explain.
2. Trayer Company obtains $20,000 in cash by signing a 9%, 6-month, $20,000 note payable to First Bank on July 1. Trayer's fiscal year ends on September 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.
(b) Amanda's Cafe has cash proceeds from sales of $8,550. This amount includes $550 of sales taxes. Give the entry to record the proceeds.
4. Dakota University sold 9,000 season football tickets at $100 each for its five-game home schedule. What entries should be made (a) when the tickets are sold and (b) after each game?
5. Identify three taxes commonly withheld by the employer from an employee's gross pay.
6.
(a) Identify three taxes commonly paid by employers on employees' salaries and wages.
(b) Where in the financial statements does the employer report taxes withheld from employees' pay?
7. 
Identify the liabilities classified by Tootsie Roll as current.
8.
(a) What are long-term liabilities? Give two examples.
(b) What is a bond?
9. Contrast these types of bonds:
(a) Secured and unsecured.
(b) Convertible and callable.
10. Explain each of these important terms in issuing bonds:
(a) Face value.
(b) Contractual interest rate.
(c) Bond certificate.
11.
(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.
12. Describe the two major obligations incurred by a company when bonds are issued.
13. Assume that Ziegler 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.
14. Jack and Lance are discussing how the market price of a bond is determined. Jack 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 he right? Discuss.
15. If a 6%, 10-year, $800,000 bond is issued at face value and interest is paid annually, what is the amount of the interest payment at the end of the first period?
16. If the Bonds Payable account has a balance of $700,000 and the Discount on Bonds Payable account has a balance of $36,000, what is the carrying value of the bonds?
17. Which accounts are debited and which are credited if a bond issue originally sold at a premium is redeemed before maturity at 97 immediately following the payment of interest?
18. Natalie Pendlay, the chief financial officer of Mullins Inc., is considering the options available 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 discuss the issues that Natalie should consider.
19.
(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?
20. Samuel Engels says that liquidity and solvency are the same thing. Is he correct? If not, how do they differ?
21. The management of Hinrichs Corporation 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 quality. Discuss the business as well as accounting implications of this move.
22. Matt Higgins 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 solvency ratios look bad. What options does he have other than purchasing the trucks, and how will these options affect his financial statements?
23. Norman Corporation has a current ratio of 1.1. Tim has always been told that a corporation's current ratio should exceed 2.0. The company maintains that its ratio is low because it has a minimal amount of inventory on hand so as to reduce operating costs. Norman also has significant available lines of credit. Is Tim still correct? What do some companies do to compensate for having fewer liquid assets?
24. What are the implications for analysis if a company has significant operating leases?
25. What criteria must be met before a contingency must be recorded as a liability? How should the contingency be disclosed if the criteria are not met?
*26. Explain the straight-line method of amortizing discount and premium on bonds payable.
*27. Knobler Corporation issues $200,000 of 6%, 5-year bonds on January 1, 2014, at 103. Assuming that the straight-line method is used to amortize the premium, what is the total amount of interest expense for 2014?
*28. Glenda Hope is discussing the advantages of the effective-interest method of bond amortization with her accounting staff. What do you think Glenda is saying?
*29. Whitson Corporation issues $400,000 of 9%, 5-year bonds on January 1, 2014, at 104. If Whitson uses the effective-interest method in amortizing the premium, will the annual interest expense increase or decrease over the life of the bonds? Explain.
*30. Your friend just received a car loan. It is a 7-year installment note. He does not understand the mechanics of how the loan works. Explain the important aspects of the installment note.
*31. Roy Toth, a friend of yours, has recently purchased a home for $125,000, paying $25,000 down and the remainder financed by a 6.5%, 20-year mortgage, payable at $745.57 per month. At the end of the first month, Roy receives a statement from the bank indicating that only $203.90 of principal was paid during the month. At this rate, he calculates that it will take over 40 years to pay off the mortgage. Is he right? Discuss.
Brief Exercises
Identify whether obligations are current liabilities.
(LO 1), C
BE10-1 Linton 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) accounts payable of $60,000. For each obligation, indicate whether it should be classified as a current liability.
Prepare entries for an interest-bearing note payable.
(LO 2), AP
BE10-2 Graves Company borrows $90,000 on July 1 from the bank by signing a $90,000, 7%, 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.
Compute and record sales taxes payable.
(LO 3), AP
BE10-3 Bluestem 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.
Prepare entries for unearned revenues.
(LO 3), AP
BE10-4 Washburn University sells 3,500 season basketball tickets at $80 each for its 10-game home schedule. Give the entry to record (a) the sale of the season tickets and (b) the revenue recognized after playing the first home game.
Compute gross earnings and net pay.
(LO 3), AP
BE10-5 Susan Braun's regular hourly wage rate is $16, and she receives an hourly rate of $24 for work in excess of 40 hours. During a January pay period, Susan works 47 hours. Susan's federal income tax withholding is $95, and she has no voluntary deductions. Compute Susan Braun's gross earnings and net pay for the pay period. Assume that the FICA tax rate is 7.65%.
Record a payroll and the payment of wages.
(LO 3), AP
BE10-6 Data for Susan Braun are presented in BE10-5. Prepare the employer's journal entries to record (a) Susan's pay for the period and (b) the payment of Susan's wages. Use January 15 for the end of the pay period and the payment date.
Prepare entries for payroll taxes.
(LO 3), AP
BE10-7 Data for Susan Braun are presented in BE10-5. Prepare the employer's journal entry to record payroll taxes for the period. Ignore unemployment taxes.
Prepare entries for issuance of bonds.
(LO 5), AP
BE10-8 Saddle Inc. issues $300,000, 10-year, 8% bonds at 98. Prepare the journal entry to record the sale of these bonds on March 1, 2014.
Prepare entries for issuance of bonds.
(LO 5), AP
BE10-9 Range Company issues $400,000, 20-year, 7% bonds at 101. Prepare the journal entry to record the sale of these bonds on June 1, 2014.
Prepare journal entries for bonds issued at face value.
(LO 5), AP
BE10-10 Rooney Corporation issued 3,000 7%, 5-year, $1,000 bonds dated January 1, 2014, at face value. Interest is paid each January 1.
(a) Prepare the journal entry to record the sale of these bonds on January 1, 2014.
(b) Prepare the adjusting journal entry on December 31, 2014, to record interest expense.
(c) Prepare the journal entry on January 1, 2015, to record interest paid.
BE10-11 The balance sheet for Fogelberg Company reports the following information on July 1, 2014.
Fogelberg decides to redeem these bonds at 102 after paying annual interest. Prepare the journal entry to record the redemption on July 1, 2014.
Prepare statement presentation of long-term liabilities.
(LO 7), AP
BE10-12 Presented here are long-term liability items for Evenson Inc. at December 31, 2014. Prepare the long-term liabilities section of the balance sheet for Evenson Inc.
Prepare liabilities section of balance sheet.
(LO 7), AP
BE10-13 Presented here are liability items for Desmond Inc. at December 31, 2014. Prepare the liabilities section of Desmond's balance sheet.
Analyze solvency.
(LO 7), AP
BE10-14 Suppose the 2014 adidas financial statements contain the following selected data (in millions).
Compute the following values and provide a brief interpretation of each.
(a) Working capital.
(b) Current ratio.
(c) Debt to assets ratio.
(d) Times interest earned.
Analyze solvency.
(LO 7), AN
BE10-15 Suppose the Canadian National Railway Company's (CN) total assets in a recent year were $24,004 million and its total liabilities were $14,180 million. That year, CN reported operating lease commitments for its locomotives, freight cars, and equipment totaling $740 million. If these assets had been recorded as capital leases, assume that assets and liabilities would have risen by approximately $740 million.
(a) Calculate CN's debt to 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.
Prepare journal entries for bonds issued at a discount.
(LO 8), AP
*BE10-16 Verlin Company issues $2 million, 10-year, 7% 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, 2014.
(b) Prepare the journal entry to record interest expense and bond discount amortization on December 31, 2014, assuming no previous accrual of interest.
Prepare journal entries for bonds issued at a premium.
(LO 8), AP
*BE10-17 Oxford Inc. issues $4 million, 5-year, 8% bonds at 102, 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, 2014.
(b) Prepare the journal entry to record interest expense and bond premium amortization on December 31, 2014, assuming no previous accrual of interest.
*BE10-18 Presented below is the partial bond discount amortization schedule for Pape Corp., which uses the effective-interest method of amortization.
Instructions
(a) Prepare the journal entry to record the payment of interest and the discount amortization 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.
Prepare entries for long-term notes payable.
(LO 10), AP
BE10-19 Leihsing Inc. issues a $600,000, 10%, 10-year mortgage note on December 31, 2013, to obtain financing for a new building. The terms provide for semiannual installment payments of $48,145. Prepare the entry to record the mortgage loan on December 31, 2013, and the first installment payment.
Do it! Review
Answer questions about current liabilities.
(LO 2, 3), C
10-1 You and several classmates are studying for the next accounting examination. They ask you to answer the following questions:
- If cash is borrowed on a $60,000, 9-month, 10% note on August 1, how much interest expense would be incurred by December 31?
- The cash register total including sales taxes is $42,000, and the sales tax rate is 5%. What is the sales taxes payable?
- If $42,000 is collected in advance on November 1 for 6-month magazine subscriptions, what amount of subscription revenue should be recognized on December 31?
Prepare entries for payroll and payroll taxes.
(LO 3), AP
10-2 During the month of February, Morrisey Corporation's employees earned wages of $74,000. Withholdings related to these wages were $5,661 for Social Security (FICA), $7,100 for federal income tax, and $1,900 for state income tax. Costs incurred for unemployment taxes were $110 for federal and $160 for state.
Prepare the February 28 journal entries for (a) salaries and wages expense and salaries and wages payable assuming that all February wages will be paid in March and (b) the company's payroll tax expense.
Evaluate statements about bonds.
(LO 4), C
10-3 State whether each of the following statements is true or false.
| _______ 1. | Convertible bonds are also known as callable bonds. |
| _______ 2. | The market rate is the rate investors demand for loaning funds. |
| _______ 3. | Semiannual interest on bonds is equal to the face value times the stated rate times 6/12. |
| _______ 4. | The present value of a bond is the value at which it should sell in the market. |
Prepare journal entry for bond issuance and show balance sheet presentation.
(LO 5), AP
10-4 Dilley Corporation issues $300,000 of bonds for $315,000. (a) Prepare the journal entry to record the issuance of the bonds, and (b) show how the bonds would be reported on the balance sheet at the date of issuance.
Prepare entry for bond redemption.
(LO 6), AP
10-5 Loveland Corporation issued $400,000 of 10-year bonds at a discount. Prior to maturity, when the carrying value of the bonds was $388,000, the company redeemed the bonds at 99. Prepare the entry to record the redemption of the bonds.
Prepare entries for interest-bearing notes.
(LO 2), AP
E10-1 Jenny Kane and Cindy Travis borrowed $15,000 on a 7-month, 8% note from Golden State Bank to open their business, KT's Coffee House. The money was borrowed on June 1, 2014, and the note matures January 1, 2015.
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 balance in the interest payable account at December 31, 2014.
(d) Prepare the entry required on January 1, 2015, when the loan is paid back.
Prepare entries for interest-bearing notes.
(LO 2), AP
E10-2 On May 15, Criqui 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 $480.
Instructions
(a) Determine the amount borrowed by Criqui.
(b) Assume the amount borrowed was $18,500. What was the interest rate if the amount of interest owed was $555?
(c) Prepare the entry for the initial borrowing and the repayment for the facts in part (a).
Prepare entries for interest-bearing notes.
(LO 2), AP
E10-3 On June 1, Fancher Company Ltd. borrows $60,000 from First Bank on a 6-month, $60,000, 8% 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)?
Journalize sales and related taxes.
(LO 3), AP
E10-4 In providing accounting services to small businesses, you encounter the following situations pertaining to cash sales.
- Furcal Company enters sales and sales taxes separately on its cash register. On April 10, the register totals are sales $22,000 and sales taxes $1,100.
- Crystal Company does not segregate sales and sales taxes. Its register total for April 15 is $13,780, which includes a 6% sales tax.
Instructions
Prepare the entries to record the sales transactions and related taxes for (a) Furcal Company and (b) Crystal Company.
Journalize payroll entries.
(LO 3), AP
E10-5 During the month of March, Olinger Company's employees earned wages of $64,000. Withholdings related to these wages were $4,896 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 salaries and wages expense and salaries 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.
Journalize unearned revenue transactions.
(LO 3), AP
E10-6 Season tickets for the Wildcats are priced at $320 and include 16 games. Revenue is recognized after each game is played. When the season began, the amount credited to Unearned Ticket Revenue was $1,728,000. By the end of October, $1,188,000 of the Unearned Ticket Revenue had been recognized as revenue.
Instructions
(a) How many season tickets did the Wildcats sell?
(b) How many home games had the Wildcats played by the end of October?
(c) Prepare the entry for the initial recording of the Unearned Ticket Revenue.
(d) Prepare the entry to recognize the revenue after the first home game had been played.
E10-7 Valenti Company Ltd. publishes a monthly sports magazine, Fishing Preview. Subscriptions to the magazine cost $28 per year. During November 2014, Valenti sells 6,300 subscriptions for cash, beginning with the December issue. Valenti prepares financial statements quarterly and recognizes subscription revenue at the end of the quarter. 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, 2014, to record subscription revenue in December 2014.
(c) Prepare the adjusting entry at March 31, 2015, to record subscription revenue in the first quarter of 2015.
Prepare journal entries for issuance of bonds and payment and accrual of interest.
(LO 5), AP
E10-8 On August 1, 2014, Ortega Corporation issued $600,000, 7%, 10-year bonds at face value. Interest is payable annually on August 1. Ortega'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, 2014.
(c) The payment of interest on August 1, 2015.
Prepare journal entries for issuance of bonds and payment and accrual of interest.
(LO 5), AP
E10-9 On January 1, Newkirk Company issued $300,000, 8%, 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.
Prepare entries for issuance of bonds, balance sheet presentation, and cause of deviations from face value.
(LO 5), AP
E10-10 Canyon Company issued $600,000, 10-year, 6% bonds at 103.
Instructions
(a) Prepare the journal entry to record the sale of these bonds on January 1, 2014.
(b) Suppose the remaining Premium on Bonds Payable was $10,800 on December 31, 2017. Show the balance sheet presentation on this date.
(c) Explain why the bonds sold at a price above the face amount.
Prepare entries for issuance of bonds, balance sheet presentation, and cause of deviations from face value.
(LO 5), AP
E10-11 Riot Company issued $500,000, 15-year, 7% bonds at 96.
Instructions
(a) Prepare the journal entry to record the sale of these bonds on January 1, 2014.
(b) Suppose the remaining Discount on Bonds Payable was $12,000 on December 31, 2019. Show the balance sheet presentation on this date.
(c) Explain why the bonds sold at a price below the face amount.
Prepare entries for issue of bonds.
(LO 5), AN
E10-12 Assume that the following are independent situations recently reported in the Wall Street Journal.
- General Electric (GE) 7% bonds, maturing January 28, 2015, were issued at 111.12.
- Boeing 7% bonds, maturing September 24, 2029, 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 $800,000 of bonds in total.
Prepare journal entries to record issuance of bonds, payment of interest, and redemption at maturity.
(LO 5, 6), AP
E10-13 Romine Company issued $350,000 of 8%, 20-year bonds on January 1, 2014, 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, 2014.
(c) The payment of interest on January 1, 2015.
(d) The redemption of the bonds at maturity, assuming interest for the last interest period has been paid and recorded.
Prepare journal entries for redemption of bonds.
(LO 6), AP
E10-14 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) Pelfer Corporation redeemed $140,000 face value, 9% bonds on April 30, 2014, at 101. The carrying value of the bonds at the redemption date was $126,500. The bonds pay annual interest, and the interest payment due on April 30, 2014, has been made and recorded.
(b) Youngman, Inc., redeemed $170,000 face value, 12.5% bonds on June 30, 2014, 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, 2014, has been made and recorded.
Prepare liabilities section of balance sheet.
(LO 7), AP
E10-15 Santana, Inc. reports the following liabilities (in thousands) on its January 31, 2014, balance sheet and notes to the financial statements.
Instructions
(a) Identify which of the above liabilities are likely current and which are likely long-term. List any items that do not fit in either category. Explain the reasoning for your selection.
(b) Prepare the liabilities section of Santana's balance sheet as at January 31, 2014.
Calculate liquidity and solvency ratios; discuss impact of unrecorded obligations on liquidity and solvency.
(LO 7), AP
E10-16 Suppose McDonald's 2014 financial statements contain the following selected data (in millions).
Instructions
(a) Compute the following values and provide a brief interpretation of each.
(1) Working capital.
(2) Current ratio.
(3) Debt to assets ratio.
(4) Times interest earned.
(b) Suppose the notes to McDonald's financial statements show that subsequent to 2014 the company will have future minimum lease payments under operating leases of $10,717.5 million. If these assets had been purchased with debt, assets and liabilities would rise by approximately $8,800 million. Recompute the debt to assets ratio after adjusting for this. Discuss your result.
Calculate current ratio before and after paying accounts payable.
(LO 7), AN
E10-17 Suppose 3M Company reported the following financial data for 2014 and 2013 (in millions).
(a) Calculate the current ratio for 3M for 2014 and 2013.
(b) Suppose that at the end of 2014, 3M management used $300 million cash to pay off $300 million of accounts payable. How would its current ratio change?
Calculate current ratio before and after paying accounts payable.
(LO 7), AN
E10-18 Sedgewick Boutique reported the following financial data for 2014 and 2013.
Instructions
(a) Calculate the current ratio for Sedgewick Boutique for 2014 and 2013.
(b) Suppose that at the end of 2014, Sedgewick 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, Sedgewick Boutique has an undrawn operating line of credit of $12.5 million. Would this affect any assessment that you might make of Sedgewick Boutique's short-term liquidity? Explain.
Discuss contingent liabilities.
(LO 7), C
E10-19 A large retailer was sued nearly 5,000 times in a recent year—about once every two hours every day of the year. It 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 one of its stores. 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 the company does not have to record these contingent liabilities.
(b) Comment on any implications for analysis of the financial statements.
Prepare journal entries to record issuance of bonds, payment of interest, amortization of premium using straight-line, and redemption at maturity.
(LO 5, 6, 8), AP
*E10-20 Prophet Company issued $500,000, 6%, 30-year bonds on January 1, 2014, at 103. Interest is payable annually on January 1. Prophet 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, 2014.
(c) The payment of interest on January 1, 2015.
(d) The redemption of the bonds at maturity, assuming interest for the last interest period has been paid and recorded.
Prepare journal entries to record issuance of bonds, payment of interest, amortization of discount using straight-line, and redemption at maturity.
(LO 5, 6, 8), AP
*E10-21 Dailey Company issued $300,000, 8%, 15-year bonds on December 31, 2013, for $288,000. Interest is payable annually on December 31. Dailey 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, 2014.
(c) The redemption of the bonds at maturity, assuming interest for the last interest period has been paid and recorded.
Prepare journal entries for issuance of bonds, payment of interest, and amortization of discount using effective-interest method.
(LO 5, 9), AP
*E10-22 Cole Corporation issued $400,000, 7%, 20-year bonds on January 1, 2014, for $360,727. This price resulted in an effective-interest rate of 8% on the bonds. Interest is payable annually on January 1. Cole 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, 2014.
(c) The payment of interest on January 1, 2015.
Prepare journal entries for issuance of bonds, payment of interest, and amortization of premium using effective-interest method.
(LO 5, 9), AP
*E10-23 Gomez Company issued $380,000, 7%, 10-year bonds on January 1, 2014, for $407,968. This price resulted in an effective-interest rate of 6% on the bonds. Interest is payable annually on January 1. Gomez 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, 2014.
(c) The payment of interest on January 1, 2015.
Prepare journal entries to record mortgage note and installment payments.
(LO 10), AP
*E10-24 Nance Co. receives $280,000 when it issues a $280,000, 6%, mortgage note payable to finance the construction of a building at December 31, 2014. The terms provide for semiannual installment payments of $14,285 on June 30 and December 31.
Instructions
Prepare the journal entries to record the mortgage loan and the first two installment payments.
Balance sheet presentation of installment note payable.
(LO 10), AP
*E10-25 Goins Corporation issued a $50,000, 10%, 10-year installment note payable on January 1, 2014. Payments of $8,137 are made each January 1, beginning January 1, 2015.
Instructions
(a) What amounts should be reported under current liabilities related to the note on December 31, 2014?
(b) What should be reported under long-term liabilities?
Exercises: Set B and Challenge Exercises
Visit the book's companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercise Set B and Challenge Exercises.
Problems: Set A
Prepare current liability entries, adjusting entries, and current liabilities section.
(LO 1, 2, 3, 7), AP
P10-1A On January 1, 2014, the ledger of Hiatt Company contained these liability accounts.
During January, the following selected transactions occurred.
| Jan. 1 | Borrowed $18,000 in cash from Premier Bank on a 4-month, 5%, $18,000 note. |
| 5 | Sold merchandise for cash totaling $6,254, which includes 6% sales taxes. |
| 12 | Performed 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 2013, $6,600. |
| 20 | Sold 500 units of a new product on credit at $48 per unit, plus 6% sales tax. |
During January, the company's employees earned wages of $70,000. Withholdings related to these wages were $5,355 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 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 note payable and for salaries and wages expense and payroll tax expense.
(c) Prepare the current liabilities section of the balance sheet at January 31, 2014. Assume no change in Accounts Payable.
Journalize and post note transactions; show balance sheet presentation.
(LO 2, 7), AP
P10-2A Ermlar Corporation sells rock-climbing products and also operates an indoor climbing facility for climbing enthusiasts. During the last part of 2014, Ermlar had the following transactions related to notes payable.
| Sept. 1 | Issued a $12,000 note to Lippert to purchase inventory. The 3-month note payable bears interest of 6% and is due December 1. (Ermlar uses a perpetual inventory system.) |
| Sept. 30 | Recorded accrued interest for the Lippert note. |
| Oct. 1 | Issued a $16,500, 8%, 4-month note to Shanee Bank to finance the purchase of a new climbing wall for advanced climbers. The note is due February 1. |
| Oct. 31 | Recorded accrued interest for the Lippert note and the Shanee Bank note. |
| Nov. 1 | Issued a $26,000 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 Lippert note, the Shanee Bank note, and the vehicle note. |
| Dec. 1 | Paid principal and interest on the Lippert note. |
| Dec. 31 | Recorded accrued interest for the Shanee 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 Ermlar incur during the year?
Prepare journal entries to record interest payments and redemption of bonds.
(LO 5, 6), AP
P10-3A The following section is taken from Mareska's balance sheet at December 31, 2013.
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, 2014.
(b) Assume that on January 1, 2014, after paying interest, Mareska calls bonds having a face value of $200,000. The call price is 103. Record the redemption of the bonds.
(c) Prepare the adjusting entry on December 31, 2014, to accrue the interest on the remaining bonds.
Prepare journal entries to record issuance of bonds, interest, balance sheet presentation, and bond redemption.
(LO 5, 6, 7), AP
P10-4A On October 1, 2013, Koppa Corp. issued $700,000, 5%, 10-year bonds at face value. The bonds were dated October 1, 2013, 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, 2013.
(c) Show the balance sheet presentation of bonds payable and bond interest payable on December 31, 2013.
(d) Prepare the journal entry to record the payment of interest on October 1, 2014.
(e) Prepare the adjusting entry to record the accrual of interest on December 31, 2014.
(f) Assume that on January 1, 2015, Koppa pays the accrued bond interest and calls the bonds. The call price is 104. Record the payment of interest and redemption of the bonds.
Prepare journal entries to record issuance of bonds, show balance sheet presentation, and record bond redemption.
(LO 5, 6, 7), AP
P10-5A Slocombe Company sold $6,000,000, 7%, 15-year bonds on January 1, 2014. The bonds were dated January 1, 2014, and pay interest on December 31. The bonds were sold at 98.
Instructions
(a) Prepare the journal entry to record the issuance of the bonds on January 1, 2014.
(b) At December 31, 2014, $8,000 of the bond discount had been amortized. Show the long-term liability balance sheet presentation of the bond liability at December 31, 2014.
(c) At January 1, 2016, when the carrying value of the bonds was $5,896,000, the company redeemed the bonds at 102. Record the redemption of the bonds assuming that interest for the year had already been paid.
Calculate and comment on ratios.
(LO 7), AN
P10-6A Suppose you have been presented with selected information taken from the financial statements of Southwest Airlines Co., shown below.
Instructions
(a) Calculate each of the following ratios for 2014 and 2013.
(1) Current ratio.
(2) Free cash flow.
(3) Debt to assets ratio.
(4) Times interest earned.
(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 $1,600 million. Recalculate the debt to assets ratio for 2014 in light of this information, and discuss the implications for analysis.
Prepare journal entries to record interest payments, straight-line discount amortization, and redemption of bonds.
(LO 5, 6, 8), AP
*P10-7A The following information is taken from Oler Corp.'s balance sheet at December 31, 2013.
Interest is payable annually on January 1. The bonds are callable on any annual interest date. Oler uses straight-line amortization for any bond premium or discount. From December 31, 2013, 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, 2014.
(b) Prepare the entry to amortize bond discount and to accrue the interest on December 31, 2014.
(c) Assume on January 1, 2015, after paying interest, that Oler Corp. calls bonds having a face value of $400,000. The call price is 102. Record the redemption of the bonds.
(d) Prepare the adjusting entry at December 31, 2015, to amortize bond discount and to accrue interest on the remaining bonds.
Prepare journal entries to record issuance of bonds, interest, and straight-line amortization, and balance sheet presentation.
(LO 5, 7, 8), AP 
*P10-8A Yung Corporation sold $2,000,000, 7%, 5-year bonds on January 1, 2014. The bonds were dated January 1, 2014, and pay interest on January 1. Yung 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 2014, assuming that the bonds sold at 102.
(b) Prepare journal entries as in part (a) assuming that the bonds sold at 97.
(c) Show the balance sheet presentation for the bond issue at December 31, 2014, using (1) the 102 selling price, and then (2) the 97 selling price.
Prepare journal entries to record issuance of bonds, interest, and straight-line amortization, and balance sheet presentation.
(LO 5, 7, 8), AP
*P10-9A Wempe Co. sold $3,000,000, 8%, 10-year bonds on January 1, 2014. The bonds were dated January 1, 2014, 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) 103.
(2) 98.
(b) Prepare amortization tables for both assumed sales for the first three interest payments.
(c) Prepare the journal entries to record interest expense for 2014 under both of the bond issuances assumed in part (a).
(d) Show the long-term liabilities balance sheet presentation for both of the bond issuances assumed in part (a) at December 31, 2014.
Prepare journal entries to record issuance of bonds, payment of interest, and amortization of bond discount using effective-interest method.
(LO 5, 9), AP
*P10-10A On January 1, 2014, Lock Corporation issued $1,800,000 face value, 5%, 10-year bonds at $1,667,518. This price resulted in an effective-interest rate of 6% on the bonds. Lock uses the effective-interest method to amortize bond premium or discount. 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, 2014.
(b) Prepare an amortization table through December 31, 2016 (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, 2014.
(d) Prepare the journal entry to record the payment of interest on January 1, 2015.
(e) Prepare the journal entry to record the accrual of interest and the amortization of the discount on December 31, 2015.
Prepare journal entries to record issuance of bonds, payment of interest, and effective-interest amortization, and balance sheet presentation.
(LO 5, 7, 9), AP
*P10-11A On January 1, 2014, Jade Company issued $2,000,000 face value, 7%, 10-year bonds at $2,147,202. This price resulted in a 6% effective-interest rate on the bonds. Jade 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, 2014.
(2) Accrual of interest and amortization of the premium on December 31, 2014.
(3) The payment of interest on January 1, 2015.
(4) Accrual of interest and amortization of the premium on December 31, 2015.
(b) Show the proper long-term liabilities balance sheet presentation for the liability for bonds payable at December 31, 2015.
(c) Provide the answers to the following questions in narrative form.
(1) What amount of interest expense is reported for 2015?
(2) Would the bond interest expense reported in 2015 be the same as, greater than, or less than the amount that would be reported if the straight-line method of amortization were used?
Prepare installment payments schedule, journal entries, and balance sheet presentation for a mortgage note payable.
(LO 7, 10), AP
*P10-12A Frevert purchased a new piece of equipment to be used in its new facility. The $370,000 piece of equipment was purchased with a $50,000 down payment and with cash received through the issuance of a $320,000, 8%, 3-year mortgage note payable issued on October 1, 2014. The terms provide for quarterly installment payments of $30,259 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 the journal entry related to the notes payable for December 31, 2014.
(c) Show the balance sheet presentation for this obligation for December 31, 2014. (Hint: Be sure to distinguish between the current and long-term portions of the note.)
Prepare journal entries to record payments for long-term note payable, and balance sheet presentation.
(LO 7, 10), AP
*P10-13A Grace Herron has just approached a venture capitalist for financing for her new business venture, the development of a local ski hill. On July 1, 2013, Grace was loaned $150,000 at an annual interest rate of 7%. The loan is repayable over 5 years in annual installments of $36,584, principal and interest, due each June 30. The first payment is due June 30, 2014. Grace 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, 2013–2018. (Round all calculations to the nearest dollar.)
(b) Prepare all journal entries for Grace Herron for the first 2 fiscal years ended June 30, 2014, and June 30, 2015. (Round all calculations to the nearest dollar.)
(c) Show the balance sheet presentation of the note payable as of June 30, 2015. (Hint: Be sure to distinguish between the current and long-term portions of the note.)
Problems: Set B
Prepare current liability entries, adjusting entries, and current liabilities section.
(LO 1, 2, 3, 7), AP
P10-1B On January 1, 2014, the ledger of Flaming Company contained the following liability accounts.
During January, the following selected transactions occurred.
| Jan. 1 | Borrowed $18,000 from TriCounty Bank on a 3-month, 8%, $18,000 note. |
| 5 | Sold merchandise for cash totaling $18,480, which includes 6.25% sales taxes. |
| 12 | Performed services for customers who had made advance payments of $8,000. (Credit Service Revenue.) |
| 14 | Paid state revenue department for sales taxes collected in December 2013 ($8,200). |
| 20 | Sold 500 units of a new product on credit at $50 per unit, plus 6.25% sales tax. |
During January, the company's employees earned wages of $54,000. Withholdings related to these wages were $4,131 for Social Security (FICA), $3,900 for federal income tax, and $1,200 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 salaries and wages expense and payroll tax expense.
(c) Prepare the current liabilities section of the balance sheet at January 31, 2014. Assume no change in accounts payable.
Journalize and post note transactions; show balance sheet presentation.
(LO 2, 7), AP
P10-2B Skate City Corporation sells skateboard products and also operates an indoor skating facility. During the last part of 2014, Skate City had the following transactions related to notes payable.
| Aug. 1 | Issued a $6,000 note to Wheeler to purchase inventory. The 3-month note payable bears interest of 9% and is due November 1. |
| Aug. 31 | Recorded accrued interest for the Wheeler note. |
| Sept. 1 | Issued a $15,000, 8%, 6-month note to Commerce Bank to finance the purchase of a new ramp for advanced boarders. The note is due March 1. |
| Sept. 30 | Recorded accrued interest for the Wheeler note and the Commerce Bank note. |
| Oct. 1 | Issued a $40,000 note and paid $10,000 cash to repair and improve its building. This note bears interest of 8% and matures in 12 months. |
| Oct. 31 | Recorded accrued interest for the Wheeler note, the Commerce Bank note, and the improvement note. |
| Nov. 1 | Paid principal and interest on the Wheeler note. |
| Nov. 30 | Recorded accrued interest for the Commerce Bank note and the improvement note. |
| Dec. 31 | Recorded accrued interest for the Commerce Bank note and the improvement 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 Skate City incur during the year?
Prepare journal entries to record interest payments and redemption of bonds.
(LO 5, 6), AP
P10-3B The following section is taken from Lyons Corp.'s balance sheet at December 31, 2013.
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, 2014.
(b) Assume that on January 1, 2014, after paying interest, Lyons Corp. calls bonds having a face value of $300,000. The call price is 108. Record the redemption of the bonds.
(c) Prepare the adjusting entry on December 31, 2014, to accrue the interest on the remaining bonds.
Prepare journal entries to record issuance of bonds, interest, balance sheet presentation, and bond redemption.
(LO 5, 6, 7), AP
P10-4B On April 1, 2013, CMV Corp. issued $600,000, 5%, 5-year bonds at face value. The bonds were dated April 1, 2013, and pay interest annually on April 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, 2013.
(c) Show the balance sheet presentation of bonds payable and bond interest payable on December 31, 2013.
(d) Prepare the journal entry to record the payment of interest on April 1, 2014.
(e) Prepare the adjusting entry to record the accrual of interest on December 31, 2014.
(f) Assume that on January 1, 2016, CMV pays the accrued bond interest and calls the bonds. The call price is 102.5. Record the payment of interest and redemption of the bonds.
Prepare journal entries to record issuance of bonds, show balance sheet presentation, and record bond redemption.
(LO 5, 6, 7), AP
P10-5B Union Electric sold $5,000,000, 5%, 10-year bonds on January 1, 2014. 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, 2014.
(b) At December 31, 2014, $15,000 of the bond premium had been amortized. Show the long-term liability balance sheet presentation of the bond liability at December 31, 2014.
(c) At January 1, 2016, when the carrying value of the bonds was $5,120,000, the company redeemed the bonds at 104. Record the redemption of the bonds assuming that interest for the year had already been paid.
Calculate and comment on ratios.
(LO 7), AN
P10-6B Suppose you have been presented with the following selected information taken from the financial statements of Kellogg Company.
Instructions
(a) Calculate each of the following ratios for 2014 and 2013.
(1) Current ratio.
(2) Free cash flow.
(3) Debt to assets ratio.
(4) Times interest earned.
(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 $584 million. Recalculate the debt to assets ratio for 2014 in light of this information, and discuss the implications for analysis.
Prepare journal entries to record interest payments, straight-line premium amortization, and redemption of bonds
(LO 5, 6, 8), AP
*P10-7B The following section is taken from Zenith Oil Company's balance sheet at December 31, 2013.
Interest is payable annually on January 1. The bonds are callable on any annual interest date. Zenith uses straight-line amortization for any bond premium or discount. From December 31, 2013, 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, 2014.
(b) Prepare the entry to amortize bond premium and to accrue interest due on December 31, 2014.
(c) Assume on January 1, 2015, after paying interest, that Zenith Company calls bonds having a face value of $1,800,000. The call price is 102. Record the redemption of the bonds.
(d) Prepare the adjusting entry at December 31, 2015, to amortize bond premium and to accrue interest on the remaining bonds.
Prepare journal entries to record issuance of bonds, interest, and straight-line amortization, and balance sheet presentation.
(LO 5, 7, 8), AP
*P10-8B Holmes Corporation sold $2,200,000, 8%, 5-year bonds on January 1, 2014. The bonds were dated January 1, 2014, and pay interest on January 1. Holmes 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 2014, assuming that the bonds sold at 102.
(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, 2014, using (1) the 102 selling price, and then (2) the 98 selling price.
Prepare journal entries to record issuance of bonds, interest, and straight-line amortization, and balance sheet presentation.
(LO 5, 7, 8), AP
*P10-9B Wentworth Co. sold $3,000,000, 7%, 8-year bonds on January 1, 2014. The bonds were dated January 1, 2014, 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) 103.
(2) 99.
(b) Prepare amortization tables for both assumed sales for the first three interest payments.
(c) Prepare the journal entries to record interest expense for 2014 under both assumed sales.
(d) Show the balance sheet presentation for both assumed sales at December 31, 2014.
Prepare journal entries to record issuance of bonds, payment of interest, and amortization of bond premium using effective-interest method.
(LO 5, 9), AP
*P10-10B On January 1, 2014, Imelda Corporation issued $2,000,000 face value, 6%, 10-year bonds at $2,154,434. This price resulted in an effective-interest rate of 5% on the bonds. Imelda uses the effective-interest method to amortize bond premium or discount. 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, 2014.
(b) Prepare an amortization table through December 31, 2016 (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, 2014.
(d) Prepare the journal entry to record the payment of interest on January 1, 2015.
(e) Prepare the journal entry to record the accrual of interest and the amortization of the discount on December 31, 2015.
Prepare journal entries to record issuance of bonds, payment of interest, and effective-interest amortization, and balance sheet presentation.
(LO 5, 7, 9), AP
*P10-11B On January 1, 2014, Murphy Company issued $1,600,000 face value, 7%, 10-year bonds at $1,717,761. This price resulted in a 6% effective-interest rate on the bonds. Murphy 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, 2014.
(2) Accrual of interest and amortization of the premium on December 31, 2014.
(3) The payment of interest on January 1, 2015.
(4) Accrual of interest and amortization of the premium on December 31, 2015.
(b) Show the proper balance sheet presentation for the liability for bonds payable on the December 31, 2015, balance sheet.
(c) Provide the answers to the following questions in narrative form.
(1) What amount of interest expense is reported for 2015?
(2) Would the bond interest expense reported in 2015 be the same as, greater than, or less than the amount that would be reported if the straight-line method of amortization were used?
Prepare installment payments schedule, journal entries, and balance sheet presentation for a mortgage note payable.
(LO 7, 10), AP
*P10-12B Lyman purchased a new piece of equipment to be used in its new facility. The $380,000 piece of equipment was purchased with a $40,000 down payment and with cash received through the issuance of a $340,000, 8%, 5-year mortgage note payable issued on October 1, 2014. The terms provide for quarterly installment payments of $20,792 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 the journal entry related to the notes payable for December 31, 2014.
(c) Show the balance sheet presentation for this obligation for December 31, 2014. (Hint: Be sure to distinguish between the current and long-term portions of the note.)
Prepare journal entries to record payments for long-term note payable, and balance sheet presentation.
(LO 7, 10), AP
*P10-13B Ronald Allerton has just approached a venture capitalist for financing for a new business venture, the development of a local ski hill. On July 1, 2013, Ronald was loaned $140,000 at an annual interest rate of 8%. The loan is repayable over 5 years in annual installments of $35,064, principal and interest, due each June 30. The first payment is due June 30, 2014. Ronald uses the effective-interest method for amortizing debt. The ski hill company's year-end will be June 30.
Instructions
(a) Prepare an amortization schedule for the 5 years, 2013–2018. (Round all calculations to the nearest dollar.)
(b) Prepare all journal entries for Ronald Allerton for the first 2 fiscal years ended June 30, 2014, and June 30, 2015. (Round all calculations to the nearest dollar.)
(c) Show the balance sheet presentation of the note payable as of June 30, 2015. (Hint: Be sure to distinguish between the current and long-term portions of the note.)
Problems: Set C
Visit the book's companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problem Set C.
Comprehensive Problem
CP10 Trevor Corporation's balance sheet at December 31, 2013, is presented below.
During 2014, the following transactions occurred.
- Trevor paid $2,500 interest on the bonds on January 1, 2014.
- Trevor purchased $241,100 of inventory on account.
- Trevor sold for $480,000 cash inventory which cost $265,000. Trevor also collected $28,800 sales taxes.
- Trevor paid $230,000 on accounts payable.
- Trevor paid $2,500 interest on the bonds on July 1, 2014.
- The prepaid insurance ($5,600) expired on July 31.
- On August 1, Trevor paid $10,200 for insurance coverage from August 1, 2014, through July 31, 2015.
- Trevor paid $17,000 sales taxes to the state.
- Paid other operating expenses, $91,000.
- Redeemed the bonds on December 31, 2014, by paying $48,000 plus $2,500 interest.
- Issued $90,000 of 8% bonds on December 31, 2014, at 103. The bonds pay interest every June 30 and December 31.
Adjustment data:
- Recorded the insurance expired from item 7.
- The equipment was acquired on December 31, 2013, and will be depreciated on a straight-line basis over 5 years with a $3,000 salvage value.
- The income tax rate is 30%. (Hint: Prepare the income statement up to income before 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, 2014.
(c) Prepare an income statement and a retained earnings statement for the year ending December 31, 2014, and a classified balance sheet as of December 31, 2014.
Continuing Cookie Chronicle
(Note: This is a continuation of the Cookie Chronicle from Chapters 1 through 9.)
CCC10 Recall that Cookie Creations borrowed $2,000 from Natalie's grandmother. Natalie now is thinking of repaying all amounts outstanding on that loan. She needs to know the amounts of interest payable and interest expense to make the correct journal entries for repayment of the loan.
Go to the book's companion website, at www.wiley.com/college/kimmel, to see the completion of this problem.
Broadening Your Perspective
Financial Reporting and Analysis
FINANCIAL REPORTING PROBLEM: Tootsie Roll Industries, Inc.
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, 2011? 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, 2011?
(c) What were the components of total current liabilities on December 31, 2011 (other than accounts payable already discussed above)?
COMPARATIVE ANALYSIS PROBLEM: Tootsie Roll vs. Hershey
BYP10-2 The financial statements of The Hershey Company are presented in Appendix B, following the financial statements for Tootsie Roll Industries in Appendix A.
Instructions
(a) Based on the information contained in these financial statements, compute the current ratio for 2011 for each company. What conclusions concerning the companies' liquidity can be drawn from these ratios?
(b) Based on the information contained in these financial statements, compute the following 2011 ratios for each company.
(1) Debt to assets ratio.
(2) Times interest earned. (Hershey's total interest expense for 2011 was $94,780,000. See Tootsie Roll's Note 6 for its interest expense.)
What conclusions about the companies' long-run solvency can be drawn from the ratios?
RESEARCH CASE
BYP10-3 The September 1, 2009, edition of CFO.com contains an article by Marie Leone and Tim Reason entitled “Dirty Secrets.” You can access this article at www.cfo.com/article.cfm/14292477?f=singlepage.
Instructions
Read the article and answer the following questions.
(a) Summarize the accounting for contingent items that is provided in this textbook.
(b) The authors of the article suggest that many companies are basically accounting for contingencies on a cash basis. Is this consistent with the approach you described in part (a)?
(c) The article suggests that many companies report one set of liability estimates to insurers and a different (lower) set of numbers in their financial statements. How is this possible, and what are the implications for investors?
(d) How do international accounting standards differ in terms of the amounts reported in these types of situations?
INTERPRETING FINANCIAL STATEMENTS
BYP10-4 Hechinger Co. and Home Depot are two home improvement retailers. Compared 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 companies (in millions).
Instructions
Using the data provided, perform the following analysis.
(a) Calculate working capital and the current ratio for each company. Discuss their relative liquidity.
(b) Calculate the debt to assets ratio and times interest earned for each company. Discuss their relative solvency.
(c) Calculate the return on assets and profit margin for each company. Comment on their relative profitability.
(d) The notes to Home Depot's financial statements indicate that it leases many of its facilities using operating leases. If these assets had instead been purchased with debt, assets and liabilities would have increased by approximately $2,347 million. Calculate the company's debt to assets ratio employing this adjustment. Discuss the implications.
BYP10-5 For many years, Borders Group and Barnes and Noble were the dominant booksellers in the United States. They experienced rapid growth, and in the process they forced many small, independent bookstores out of business. Recently, Borders filed for bankruptcy. It was the victim of its inability to change with the times. It did not develop a viable business plan for dealing with digital books and online sales. Below is financial information (in millions) for the two companies, taken from the annual reports of each company one year before Borders filed for bankruptcy.
Instructions
(a) Compute the current ratio for each company.
(b) Compute the debt to assets ratio and times interest earned for each company. (Hint: A tax benefit means that rather than pay taxes, the company was due a refund because of its losses. For ratio purposes, a tax benefit is treated the opposite of tax expense.)
(c) Discuss the relative liquidity and solvency of each company. Did the bankruptcy of Borders seem likely?
REAL-WORLD FOCUS
BYP10-6 Bond or debt securities pay a stated rate of interest. This rate of interest is dependent on the risk associated with the investment. Also, bond prices change when the risks associated with those bonds change. Standard & Poor's provides ratings for companies that issue debt securities.
Address: www.standardandpoors.com/ratings/definitions-and-faqs/en/us, or go to www.wiley.com/college/kimmel
Instructions
Go to the website shown and answer the following questions.
(a) Explain the meaning of an “A” rating. Explain the meaning of a “C” rating.
(b) What types of things can cause a change in a company's credit rating?
(c) Explain the relationship between a company's credit rating and the merit of an investment in that company's bonds.
Critical Thinking
DECISION-MAKING ACROSS THE ORGANIZATION
BYP10-7 On January 1, 2012, Kenard Corporation issued $3,000,000, 5-year, 8% bonds at 97. The bonds pay interest annually on January 1. By January 1, 2014, the market rate of interest for bonds of risk similar to those of Kenard Corporation had risen. As a result, the market price of these bonds was $2,500,000 on January 1, 2014—below their carrying value of $2,946,000.
Mel Garner, president of the company, suggests repurchasing all of these bonds in the open market at the $2,500,000 price. But to do so the company will have to issue $2,500,000 (face value) of new 10-year, 12% bonds at par. The president asks you, as controller, “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 redeem the 5-year bonds on January 1, 2014. 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
BYP10-8 Harry Jackman, president of Weast, Inc., 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 CASES
BYP10-9 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 Aviation 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 determines the company (1) was not at fault, and (2) was at fault.)
(c) What would you do, and why?
(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 consequences if he decides to conceal the situation?
BYP10-10 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 entitled “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 financing” 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)?
ALL ABOUT YOU
BYP10-11 For most U.S. families, medical costs are substantial and rising. But will medical costs be your most substantial expense over your lifetime? Not likely. Will it be housing or food? Again, not likely. The answer: Taxes are likely to be your biggest expense. On average, Americans work 74 days to afford their federal taxes. Companies, too, have large tax burdens. They look very hard at tax issues in deciding where to build their plants and where to locate their administrative headquarters.
Instructions
(a) Determine what your state income taxes are if your taxable income is $60,000 and you file as a single taxpayer in the state in which you live.
(b) Assume that you own a home worth $200,000 in your community and the tax rate is 2.1%. Compute the property taxes you would pay.
(c) Assume that the total gasoline bill for your automobile is $1,200 a year (300 gallons at $4 per gallon). What are the amounts of state and federal taxes that you pay on the $1,200?
(d) Assume that your purchases for the year total $9,000. Of this amount, $5,000 was for food and prescription drugs. What is the amount of sales tax you would pay on these purchases? (Note: Many states do not have a sales tax for food or prescription drug purchases. Does yours?)
(e) Determine what your Social Security taxes are if your income is $60,000.
(f) Determine what your federal income taxes are if your taxable income is $60,000 and you file as a single taxpayer.
(g) Determine your total taxes paid based on the above calculations, and determine the percentage of income that you would pay in taxes based on the following formula: Total taxes paid ÷ Total income.
BYP10-12 Some employees are encouraging and setting up preventive healthcare programs. Here are the percentages for five unhealthy behaviors for individuals with some college education: current cigarette smoker (22.9%), five or more alcoholic drinks at one sitting at least once in the past year (30%), physically inactive (30%), obese (25.2%), or sleep less than 6 hours per day (30.3%).
Suppose you own a business. About a quarter of your employees smoke, and an even higher percentage are overweight. You decide to implement a mandatory health program that requires employees to quit smoking and to exercise regularly, with regular monitoring. If employees do not participate in the program, they will have to pay their own insurance premiums. Is this fair?
YES: It is the responsibility of management to try to maximize a company's profit. Employees with unhealthy habits drive up the cost of health insurance because they require more frequent and more costly medical attention.
NO: What people do on their own time is their own business. This represents an invasion of privacy, and is a form of discrimination.
Instructions
Write a response indicating your position regarding the situation. Provide support for your view.
FASB CODIFICATION ACTIVITY
BYP10-13 If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following.
(a) What is the definition of current liabilities?
(b) What is the definition of long-term obligations?
(c) What guidance does the Codification provide for the disclosure of long-term obligations?
CONSIDERING PEOPLE, PLANET, AND PROFIT
BYP10-14 The December 10, 2011, edition of The Economist contains an article entitled “Helping the Poor to Save: Small Wonder.” This article discusses how many of the world's poorest people benefit from borrowing small amounts of money.
Instructions
Read the article and answer the following questions. (The article can be accessed by doing an Internet search that includes the title of the article and magazine.)
(a) What monthly rate of interest do people pay on the loans they borrow from the microfinance organizations described in the article? What would these rates be on an annualized basis?
(b) The rates described in your answer to part (a) are very high. Explain how somebody can pay such high rates and yet still benefit from borrowing.
(c) Describe the structure of the typical village savings and loan organization.
Answers to Insight and Accounting Across the Organization Questions
p. 513 When Convertible Bonds Don't Q: The drop in stock prices did not change the debt to assets ratios of these companies. Discuss how the perception of a high debt to assets ratio changed before and after the fall in stock prices. A: When stock prices fell, the debt to 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 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 assets ratio was a real concern.
p. 525 Debt Masking Q: What implications does debt masking have for an investor that is using the debt to assets ratio to evaluate a company's solvency? A: Since the debt to assets ratio is calculated using financial statement numbers from the end of the accounting period, debt masking could result in investors making incorrect assumptions about a company's solvency. By engaging in debt masking, a company is misleading investors because what it is disclosing at the end of the period does not reflect what its normal financial position was during most of the accounting period.
p. 527 “Covenant-Lite” Debt Q: How can financial ratios such as those covered in this chapter provide protection for creditors? A: Financial ratios such as the current ratio, debt to assets ratio, and the times interest earned provide indications of a company's liquidity and solvency. By specifying minimum levels of liquidity and solvency, as measured by these ratios, a creditor creates triggers that enable it to step in before a company's financial situation becomes too dire.
Answers to Self-Test Questions
- a
- d
- b ($88,500 × .12 ×
) - d
- b ($4,515 ÷ 1.05)
- c
- b ($18,000 ×
) - c
- c
- a
- c
- d
- b ($103,745 − $100,000)
- c ($150,000 + $30,000 + $20,000) ÷ $30,000
- a
- *c (($500,000 × .04) ÷ 5)
- *a ($500,000 − ($20,000 − (3 × $4,000)))
- *b (($938,554 × .10) − ($1,000,000 × .09)) = $3,855; ($1,000,000 − $938,554) − $3,855
- *c ($1,072,096 × .12)
- *c ($1,165 − ($20,000 ×.015))
A Look at IFRS
LEARNING OBJECTIVE 11
Compare the accounting procedures for liabilities under GAAP and IFRS.
IFRS and GAAP have similar definitions of liabilities. IFRSs related to reporting and recognition of liabilities are found in IAS 1 (revised) (“Presentation of Financial Statements”) and IAS 37 (“Provisions, Contingent Liabilities, and Contingent Assets”). The general recording procedures for payroll are similar although differences occur depending on the types of benefits that are provided in different countries.
KEY POINTS
- The basic definition of a liability under GAAP and IFRS is very similar. In a more technical way, liabilities are defined by the IASB as a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Liabilities may be legally enforceable via a contract or law but need not be. That is, they can arise due to normal business practices or customs.
- IFRS requires that companies classify liabilities as current or non-current on the face of the statement of financial position (balance sheet) except in industries where a presentation based on liquidity would be considered to provide more useful information (such as financial institutions). When current liabilities (also called short-term liabilities) are presented, they are generally presented in order of liquidity.
- Under IFRS, liabilities are classified as current if they are expected to be paid within 12 months.
- Similar to GAAP, items are normally reported in order of liquidity. Companies sometimes show liabilities before assets. Also, they will sometimes show non-current (long-term) liabilities before current liabilities.
- Under both GAAP and IFRS, preferred stock that is required to be redeemed at a specific point in time in the future must be reported as debt, rather than being presented as either equity or in a “mezzanine” area between debt and equity.
- Under IFRS, companies sometimes will net current liabilities against current assets to show working capital on the face of the statement of financial position. (This is evident in the Zetar financial statements in Appendix C.)
- IFRS requires use of the effective-interest method for amortization of bond discounts and premiums. GAAP allows use of the straight-line method where the difference is not material. Under IFRS, companies do not use a premium or discount account but instead show the bond at its net amount. For example, if a $100,000 bond was issued at 97, under IFRS a company would record:
- The accounting for convertible bonds differs across IFRS and GAAP. Unlike GAAP, IFRS splits the proceeds from the convertible bond between an equity component and a debt component. The equity conversion rights are reported in equity.
To illustrate, assume that Harris Corp. issues convertible 7% bonds with a face value of $1,000,000 and receives $1,000,000. Comparable bonds without a conversion feature would have required a 9% rate of interest. To determine how much of the proceeds would be allocated to debt and how much to equity, the promised payments of the bond obligation would be discounted at the market rate of 9%. Suppose that this results in a present value of $850,000. The entry to record the issuance would be:
- The IFRS leasing standard is IAS 17. Both Boards share the same objective of recording leases by lessees and lessors according to their economic substance—that is, according to the definitions of assets and liabilities. However, GAAP for leases is much more “rules-based,” with specific bright-line criteria (such as the “90% of fair value” test) to determine if a lease arrangement transfers the risks and rewards of ownership. IFRS is more conceptual in its provisions. Rather than a 90% cut-off, it asks whether the agreement transfers substantially all of the risks and rewards associated with ownership.
- Under GAAP, some contingent liabilities are recorded in the financial statements, others are disclosed, and in some cases no disclosure is required. Unlike GAAP, IFRS reserves the use of the term contingent liability to refer only to possible obligations that are not recognized in the financial statements but may be disclosed if certain criteria are met. Contingent liabilities are defined in IAS 37 as being:
- A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or
- A present obligation that arises from past events but is not recognized because:
- It is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or
- The amount of the obligation cannot be measured with sufficient reliability.
- For those items that GAAP would treat as recordable contingent liabilities, IFRS instead uses the term provisions. Provisions are defined as liabilities of uncertain timing or amount. Examples of provisions would be provisions for warranties, employee vacation pay, or anticipated losses. Under IFRS, the measurement of a provision related to an uncertain obligation is based on the best estimate of the expenditure required to settle the obligation.
LOOKING TO THE FUTURE
The FASB and IASB are currently involved in two projects, each of which has implications for the accounting for liabilities. One project is investigating approaches to differentiate between debt and equity instruments. The other project, the elements phase of the conceptual framework project, will evaluate the definitions of the fundamental building blocks of accounting. The results of these projects could change the classification of many debt and equity securities.
In addition to these projects, the FASB and IASB have also identified leasing as one of the most problematic areas of accounting. A joint project will initially focus primarily on lessee accounting. One of the first areas to be studied is, “What are the assets and liabilities to be recognized related to a lease contract?” Should the focus remain on the leased item or the right to use the leased item? This question is tied to the Boards' joint project on the conceptual framework—defining an “asset” and a “liability.”
IFRS PRACTICE
IFRS SELF-TEST QUESTIONS
- Which of the following is false?
(a) Under IFRS, current liabilities must always be presented before non-current liabilities.
(b) Under IFRS, an item is a current liability if it will be paid within the next 12 months.
(c) Under IFRS, current liabilities are shown in order of liquidity.
(d) Under IFRS, a liability is only recognized if it is a present obligation.
- Under IFRS, a contingent liability is:
(a) disclosed in the notes if certain criteria are met.
(b) reported on the face of the financial statements if certain criteria are met.
(c) the same as a provision.
(d) not addressed by IFRS.
- Stevens Corporation issued 5% convertible bonds with a total face value of $3,000,000 for $3,000,000. If the bonds had not had a conversion feature, they would have sold for $2,600,000. Under IFRS, the entry to record the transaction would require a credit to:
(a) Bonds Payable for $3,000,000.
(b) Bonds Payable for $400,000.
(c) Equity Conversion Rights for $400,000.
(d) Discount on Bonds Payable for $400,000.
- Under IFRS, if preference shares (preferred stock) have a requirement to be redeemed at a specific point in time in the future, they are treated:
(a) as a type of asset account.
(b) as ordinary shares (common stock).
(c) in the same fashion as other types of preference shares.
(d) as a liability.
- The joint projects of the FASB and IASB could potentially:
(a) change the definition of liabilities.
(b) change the definition of equity.
(c) change the definition of assets.
(d) All of the above.
IFRS CONCEPTS AND APPLICATION
IFRS10-1 Explain how IFRS defines a provision and give an example.
IFRS10-2 Explain how IFRS defines a contingent liability and give an example.
IFRS10-3 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to the accounting for liabilities.
IFRS10-4 Ratzlaff Company issues €2 million, 10-year, 8% bonds at 97, with interest payable on July 1 and January 1.
Instructions
(a) Prepare the journal entry to record the sale of these bonds on January 1, 2014.
(b) Assuming instead that the above bonds sold for 104, prepare the journal entry to record the sale of these bonds on January 1, 2014.
IFRS10-5 Many multinational companies find it beneficial to have their shares listed on securities 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 liabilities. This exercise investigates the Tokyo Stock Exchange, the largest securities exchange in Japan.
Address: www.tse.or.jp/english/, or go to www.wiley.com/college/kimmel
Steps
- Choose About TSE.
- Choose History of TSE. Answer questions (a) and (b).
- Choose Listed Company information.
- Choose Disclosure. Answer questions (c) and (d).
- Answer the following questions.
(a) When was the first securities 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?
INTERNATIONAL FINANCIAL STATEMENT ANALYSIS: Zetar plc
IFRS10-6 The financial statements of Zetar plc are presented in Appendix C. The company's complete annual report, including the notes to its financial statements, is available in the Investors section at www.zetarplc.com.
Instructions
Use the company's annual report to answer the following questions.
(a) According to the notes to the financial statements, what types of transactions do trade payables relate to? What was the average amount of time it took the company to pay its payables?
(b) Note 4.2 discusses provisions that the company records for certain types of activities. What do the provisions relate to, what are the estimates based on, and what could cause those estimates to change in subsequent periods?
(c) What was the average interest rate paid on bank loans and overdrafts?
Answers to IFRS Self-Test Questions
- a
- a
- c
- d
- d
Remember to go back to The Navigator box on the chapter opening page and check off your completed work.
1Social Security taxes are commonly called FICA taxes. In 1937, Congress enacted the Federal Insurance Contribution Act (FICA). As can be seen in the journal entry and the payroll tax journal entry on the next page, the employee and employer must make equal contributions to Social Security. The Social Security rate in 2012 was 7.65% for each except employees received a 2% reduction of the rate for 2012. Our examples and homework use 7.65% for both.
2For those knowledgeable 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).