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Chapter 9
Liabilities
Short Exercises
(10 min.) S 9-1
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
July 31 Inventory…………………………………………… 11,000
Note Payable, Short-Term…………………… 11,000
Purchasedinventoryby issuinga
note payable.
2013
Apr. 30 Interest Expense($11,000× .12 × 9/12)……….. 990
Interest Payable……………………………….. 990Accruedinterest expense.
July 31 Note Payable, Short-Term………………............ 11,000
Interest Payable…………………………………… 990
Interest Expense($11,000× .12 × 3/12)……….. 330
Cash……………………………………………… 12,320
Paid note payableand interest at
maturity.
Balance Sheet on April 30, 2013:
Note payable, short-term $11,000
Interest payable 990
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Income Statement, April 30, 2013:
Interest Expense $990
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(5-10 min.) S 9-2
Req. 1
2012 2011
Accounts payable turnover:
COGS
Averageaccountspayable
$2,700,000 = 9
$300,000
$2,500,000 = 10
$250,000
Days payable outstanding:
365
Accountspayableturnover
365 = 41 days
9
365 = 37 days
10
Req. 2
The company’sliquidity positionhas deterioratedduring2012.
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(10 min.) S 9-3
Req. 1
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
Cash($564,000× .40)…………………..….. 225,600
Notes Receivable($564,000 $255,600)..− 338,400
Sales Revenue…………………………… 564,000
To recordsales on account.
WarrantyExpense($564,000× .05)……… 28,200
EstimatedWarrantyPayable……….…. 28,200
To accruewarrantyexpense.
EstimatedWarrantyPayable……………... 18,000
Cash…………………………………….…. 18,000
To pay warrantyclaims.
Req. 2
EstimatedWarrantyPayable
Bal. 13,00018,000 28,200
Bal. 23,200
(5-10 min.) S 9-4
Warrantyexpense= $28,200
Theexpense recognition principle addressesthis situation.
The warrantyexpensefor the year does not necessarily equal the year’s cash payments
for warranties. Cash paymentsfor warranties do not determinethe amount of warranty
expense for that year. Instead, the warranty expense is estimated and deducted from
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revenueduringthe periodof the sale, regardlessof whenthe companypays for warranty
claims.
Studentresponsesmayvary.
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(5-10 min.) S 9-5
1. These are contingent liabilities, because, at the time of the note, Tony Chase, Inc.,
was not liable for any of these productlosses.
2. In the United States, the contingencycan becomea real liability if a user of a Tony
Chaseproductsuffers a loss for whichthe companyis responsible.
Tony Chase must pay for all individual losses up to $3.8 million and all aggregate
losses above $26.3 million. The company is insured against losses between $3.8
million and $26.3 million.
3. Outsidethe United States, the contingencybecomesa real liability the sameway — if
a Tony Chaseuser suffers a loss for whichthe companyis responsible.
Outside the United States, Tony Chase must pay only for losses above $26.3 million
becausethe companyis insuredagainst lossesup to $26.3 million.
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(5-10 min.) S 9-6
a. $155,500 ($200,000× .7775)
b. $207,000 ($200,000× 1.0350)
c. $188,500 ($200,000× .9425)
d. $205,000 ($200,000× 1.0250)
(5 min.) S 9-7
a. Discount
b. Premium
c. Par (face) value
d. Discount
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(5-10 min.) S 9-8
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
a. July 1 Cash…………………………………………….. 125,000BondsPayable…………………………….. 125,000
To issue bondat par.
b. Dec. 31 Interest Expense($125,000× .08 × 6/12)……. 5,000
Interest Payable……………………………. 5,000
To accrueinterest expense.
2013
c. Jan. 1 Interest Payable……………………………….. 5,000
Cash…………………………………………. 5,000
To pay semiannualinterest on bonds.
2019
d. July 1 BondsPayable………………………………… 125,000
Cash………………………………………..... 125,000
To pay bondsat maturity.
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(10-15 min.) S 9-9
Req. 1 Amortization table
A B C D E
Semiannual
Interest
Date
Interest
Payment
(3% of
Maturity
Value)
InterestExpense
(4.5%of
Preceding
BondCarrying
Amount)
Discount
Amortization
(B - A)
Discount
Account
Balance
(Preceding
(D - C)
Bond
Carrying
Amount
($560,000
- D)
Mar. 31, 2012 $109,200 $450,800
Sept. 30, 2012 $16,800 $20,286 $3,486 105,714 454,286
Mar. 31, 2013 16,800 20,443 3,643 102,071 457,929
Sept. 30, 2013 16,800 20,607 3,807 98,264 461,736
Req. 2
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
Mar. 31 Cash($560,000× .805)…………… 450,800Discounton BondsPayable…….. 109,200
BondsPayable…………………. 560,000
Sept. 30 Interest Expense………………….. 20,286
Discounton BondsPayable… 3,486
Cash…………………………….. 16,800
(10 min.) S 9-10
Req. 1— Borrowed$450,800. Maturity value is $560,000.
Req. 2— Cashinterest is $16,800.
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Req. 3— Interest expenseSeptember30, 2012 is $20,286.
Interest expenseMarch31, 2013 is $20,443.
(10-15 min.) S 9-11
Req. 1— Borrowed$2,925,000:
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
July 1 Cash($3,000,000× .975)…………… 2,925,000
Discounton BondsPayable………. 75,000
BondsPayable…………………… 3,000,000
Req. 2— Pay back $3,000,000at maturity, July 1, 2022.
Req. 3— Cashinterest is $120,000($3,000,000× 8% × 6/12) each six months.
Req. 4— Interest expenseis $123,750[$120,000+ ($75,000/ 20)]
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
Dec. 31 Interest Expense.................................... 123,750
Discounton BondsPayable............... 3,750
Interest Payable................................ 120,000
2013
Jan. 1 Interest Payable..................................... 120,000
Cash............................................... 120,000
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(10-15 min.) S 9-12
Req. 1
Best Buy
Co.
Wal Mart
Stores
5 Leverage
ratio
$17,849/ $7,292 2.45 $180,663/ $71,247 2.53
6 Total debt $17,849- $7,292 $10,557 $180,663- $71,247 $109,416
7 Debt ratio $10,557/ $17,849 .59 $109,416/ $180,663 .60
8 Times
interestearned
$2,114/ $87 24.2 times $25,542/ $1,928 13.2 times
Req. 2
Both companies’debt-payingabilities are strong. Fromthe standpointof leverage(debt)
the companiesare about equal. However, Best Buy has a strongertimes-interest-earned
ratio (24.2 vs. 13.2).
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(5-10 min.) S 9-14
Req. 1
Leverage
ratio
$100.0 / $40.0 = 2.5
This meansthat Evensonhas $2.50 of assetsfor every dollar of
stockholders’equity.
Debt ratio $60.0 / $100.0 = .60
This meansthat Evensonhas $.60 in liabilities (debt) for every dollar of
assets.
Timesinterest earned
$4.1 / $1.1 = 3.73 times
This meansthat for every dollar of interest expenseEvensonhas
earned$3.73 of operatingincome.
Evenson’sdebt ratio is about averageand can cover its existinginterest
expense. I wouldbe willing to lend Evenson$1 million.
Chapter 9 Liabilities 9-13
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(10 min.) S 9-15
LIABILITIES
Current:
Accountspayable……………………….. $ 33,000
Current portionof bondspayable……. 56,000
Interest payable………………………….. 1,700
Total current liabilities………………. 90,700
Longterm:
Notes payable, long-term………………. 125,000Bondspayable…………………………… $375,000
Less: Discounton bondspayable……. (11,250) 363,750
Total liabilities………………………………. $579,450
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Exercises
(5-15 min.) E 9-16A
Req. 1
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
WarrantyExpense($111,000× .08)………… 8,880
EstimatedWarrantyPayable…………….. 8,880
EstimatedWarrantyPayable………………… 7,000
Cash………………………………………….. 7,000
Req. 2
INCOMESTATEMENT
Sales revenue……………………………………… $111,000
Warrantyexpense………………………………… 8,880
BALANCESHEETCurrent liabilities
Estimatedwarrantypayable
($5,000+ $8,880 $7,000)…………………− $ 6,880
Req. 3
Estimated warranty payable, a current liability, will cause a company’s current ratio to
decrease .
Chapter 9 Liabilities 9-15
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(10-15 min.) E 9-17A
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
Oct. 1 Cash………………………………………………… 2,616UnearnedSubscriptionRevenue…………... 2,400
Sales Tax Payable($2,400× .09)…………… 216
Nov. 15 Sales Tax Payable………………………………... 216
Cash…………………………………………….. 216
Dec. 31 UnearnedSubscriptionRevenue……………… 600
SubscriptionRevenue($2,400× 3/12)…….. 600
BALANCESHEET
Current liabilities:
Unearnedsubscriptionrevenue($2,400 $600)……− $1,800
(10 min.) E 9-18A
INCOMESTATEMENT
Expenses:
Payroll expense………………………………………. $150,000
Payroll tax expense($150,000× .08)……………… 12,000
BALANCESHEET
Current liabilities:
Salary payable………………………………………… $7,500
Payroll tax payable…………………………………... 700
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(5-10 min.) E 9-19A
Req. 1
Accruedinterest,
Dec. 31, 2012 = $85,000× .08 × 9/12 = $5,100
Req. 2
Final payment = $85,000+ ($85,000× .08) = $91,800
on April 1, 2013
Req. 3
Interest expensefor:
2012 = $85,000× .08 × 9/12 = $5,100
2013 = $85,000× .08 × 3/12 = $1,700
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(10-15 min.) E 9-20A
Olsen’sbalancesheet at December31, 2013, reported:
Incometax payable....................................................... $166,000*
Olsen’s2013 incomestatementreported:
Incometax expense($900,000× .29)............................... $261,000
_____ * Beginningincometax payable....................…………………….. $150,000
+ Incometax expense(and payable) for the year..............
$900,000× .29)................................................................... 261,000
−
Incometax paymentsduringthe year.................................... (245,000) = Endingincometax payable.................................................. $166,000
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(10-20 min.) E 9-21A
Req. 1
Accounts payable are amounts owed to suppliers for products or services that have
been purchasedon account.
Accrued expensesare expenses that the companyhas incurred but not yet paid. They
are liabilities for expensessuch as interest and incometaxes.
Employeecompensationand benefits are amounts owed to employeesfor salaries and
other payroll-relatedexpenses.
Current portion of long-term debt is next year’s payment on the company’s long-term
debt.
Long-term debt is the amount of long-term notes and bonds payable that the company
expectsto pay after the comingyear.
Postretirement benefits are the company’s liabilities for providing benefits — mainly
health care — to retirees.
The other liabilities are a catch-all group of liabilities that do not fit one of the more
specific categories. The other liabilities are long-term, as shownby the fact that they are
not listed amongthe current liabilities.
Chapter 9 Liabilities 9-19
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(continued) E 9-21A
Req. 2
Total assets = $3,714million, the sumof total liabilities and
stockholders’equity.
(in millions) 2012
Leverage
ratio=
Total assets ($3,714)
Total stockholders’ equity ($1,951)= 1.90
Debt ratio =Total liabilities ($3,714 $1,951)*−
= 0.47Total assets ($3,714)
For 2011, the leverageratio was 2.26 and the debt ratio was .56.
Both the leverageratio and debt ratio improvedin 2012. Therefore, the company
improved. ____
*Or, $259 + $1,394+ $102 + $8 = $1,763
Req. 3
2012 2011
Accounts
payable
turnover
Cost of goodssold $1,656
= 11.3
$1,790
= 9.6AverageAccounts
payable
$146 $186
*($110+ $182) / 2 **($182+ $190) / 2
Days payable
outstanding
365 365
= 32.3
365
= 38.0Accts. payable
turnover
11.3 9.6
Current
ratio
Current assets $661= 2.55
$600= 1.52
Current liabilities $259 $394
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The company’sability to cover accountspayableand current liabilities over the year
improved.
Chapter 9 Liabilities 9-21
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(5-10 min.) E 9-22A
Req. 1
Smith Security Systemsshouldreport this situationin a note to the financial statements.
The note shouldconveyessentially the samemessagegiven in Note 14.
Req. 2
Smith wouldreport:
INCOMESTATEMENT
Estimatedloss (or expense)……………… $3,000,000
BALANCESHEET
Estimatedliability…………………………… $3,000,000
The note disclosurewould be similar to Requirement1.
JournalDATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
EstimatedLoss fromDamageClaim 3,000,000
EstimatedLiability fromDamageClaim 3,000,000
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(15-20 min.) E 9-23A
Banff Electronics
BalanceSheet (partial)
March31, 2012
Current liabilities:a. Estimatedwarrantypayable
[$35,000+ ($2,400,000× .04) $57,000]− ............................... $ 74,000
b. Current portionof long-term note payable............................... 16,250
Interest payable($65,000× .07 × 1/12)..................................... 379
c. Unearnedsales revenue($100,000 $85,000)− .......................... 15,000
d. Employeewithheldincometax payable.................................. 30,900
FICAtax payable($320,000× .0765)…..................................... 24,480
Total current liabilities...................................................... $161,009
Long-term liabilities:
Note payable($65,000 $16,250)− ............................................ $ 48,750
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(10-15 min.) E 9-24A
Req. 1
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT2012
a. Jan. 31 Cash($8,000,000× 0.96)............................ 7,680,000
Discounton BondsPayable....................... 320,000
BondsPayable..................................... 8,000,000
To issue bondsat a discount.
b. July 31 Interest Expense...................................... 312,000
Cash($8,000,000× .07 × 6/12)................ 280,000
Discounton BondsPayable
($320,000/ 10).................................. 32,000
To pay interest and amortize bonds.
c. Dec. 31 Interest Expense...................................... 260,000
Interest Payable
($8,000,000× .07 × 5/12).................... 233,333
Discounton BondsPayable
($320,000/ 10 × 5/6).......................... 26,667To accrueinterest and amortizebonds.
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(10-15 min.) E 9-25A
1. Cashreceived= $100,000× 1.05 = $105,000
2. Principal……………………………………………………… $100,000Interest ($100,000× .07 × 20)…………………….............. 140,000
Total cash paid……………………………………………… $240,000
3. Total cash paid……………………………………………… $240,000
Less: Cashreceived…………………………………….... (105,000)
Difference= Total interest expense……………………... $135,000
4. Annualinterest expenseby the straight-line amortizationmethod:
$100,000× .07 $100,000× (1.05 1.00)−
20
$7,000 − $250 = $ 6,750
Cashinterest payment Premiumamortization
× 20 years
Total interest expenseover the life of the bonds $135,000
Chapter 9 Liabilities 9-25
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(15-20 min.) E 9-26A
Req. 1 (amortization table)
SEMIANNUAL
INTEREST
DATE
A
INTEREST
PAYMENT
(2 ½ % OF
MATURITY
VALUE)
B
INTEREST
EXPENSE
(3% OF
PRECEDING
BOND
CARRYING
AMOUNT)
C
DISCOUNT
AMORTIZATION
(B – A)
D
DISCOUNT
ACCOUNT
BALANCE
(PRECEDING
D – C)
E
BONDCARRYING
AMOUNT
($4,000,000– D)
Dec. 31, 2012 $297,550 $3,702,450
June 30, 2013 $100,000 $111,073 $ 11,073 286,477 3,713,524
Dec. 31, 2013 100,000 111,406 11,406 275,071 3,724,929June 30, 2014 100,000 111,748 11,748 263,323 3,736,677
Dec. 31, 2014 100,000 112,100 12,100 251,223 3,748,777
Req. 2
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
Dec. 31 Cash……………………………………… 3,702,450
Discounton BondsPayable…………. 297,550
BondsPayable……………………… 4,000,000
To issue bondsat a discount.
2013
June 30 Interest Expense........................................ 111,074
Cash.................................................... 100,000
Discounton BondsPayable.................... 11,074To pay semiannualinterest and
amortizebonds.
2013
Dec. 31 Interest Expense........................................ 111,406
Cash.................................................... 100,000
Discounton BondsPayable.................... 11,406
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To pay semiannualinterest and
amortizebonds.
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(15-20 min.) E 9-27A
Req. 1 (amortization table)
SEMIANNUAL
INTEREST
DATE
A
INTEREST
PAYMENT
(4½%OF
MATURITY
VALUE)
B
INTEREST
EXPENSE
(4% OF
PRECEDING
BOND
CARRYING
AMOUNT)
C
PREMIUM
AMORTIZATION
(A – B)
D
PREMIUM
ACCOUNT
BALANCE
(PRECEDING
D – C)
E
BONDCARRYING
AMOUNT
($4,000,000+ D)
June 30, 2012 $395,800 $4,395,8001
Dec. 31, 2012 $180,000 $175,832 $4,168 391,632 4,391,632
June 30, 2013 180,000 175,665 4,335 387,297 4,387,297Dec. 31, 2013 180,000 175,492 4,508 382,789 4,382,789
June 30, 2014 180,000 175,312 4,688 378,101 4,378,101
_____ 1$4,000,000× 1.09895= $4,395,800
Req. 2 (journal entries)
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
June 30 Cash($4,000,000× 1.09895)…………….. 4,395,800
BondsPayable……………………....... 4,000,000
Premiumon BondsPayable………… 395,800
To issue bondsat a premium.
Dec. 31 Interest Expense………………………….. 175,832
Premiumon BondsPayable……………. 4,168
Cash…………………………………….. 180,000
To pay semiannualinterest and amortizebonds.
2013
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June 30 Interest Expense…………………………. 175,665
Premiumon BondsPayable.………...... 4,335
Cash……………………………………. 180,000
To pay semiannualinterest and amortizebonds.
Chapter 9 Liabilities 9-29
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(15-20 min.) E 9-28A
A B C D E F
1 Bond
2 Interest Interest Discount Discount Carrying
3 Date Payment Expense Amortization Balance Amount4
5 Jan. 1, 2012 $21,071 $278,929
6 Dec. 31, 2012 $18,000 $19,525 $1,525 19,546 280,454
7 Dec. 31, 2013 18,000 19,632 1,632 17,914 282,086
8 Dec. 31, 2014 18,000 19,746 1,746 16,168 283,832
9 Dec. 31, 2015 18,000 19,868 1,868 14,300 285,700
10 Dec. 31, 2016 18,000 19,999 1,999 12,301 287,699
11 Dec. 31, 2017 18,000 20,139 2,139 10,162 289,838
12 Dec. 31, 2018 18,000 20,289 2,289 7,873 292,127
13 Dec. 31, 2019 18,000 20,449 2,449 5,424 294,576
14 Dec. 31, 2020 18,000 20,620 2,620 2,804 297,196
15 Dec. 31, 2021 18,000 20,804 2,804 0 300,000
Note : Computer-generatedsolutionsmay containslight roundingdifferences.
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(15-20 min.) E 9-29A
Req. 1
The company has the right to occupy space and operate out of leased stores for
several years to come. In return, the company is obligated to make payments
amountingto over $2.6 billion dollars to variouslandlords(lessors).
Req. 2
The rights and obligations discussedin Req. 1 are classified as operating leases and
are not reported on the balance sheet. Omitting them from the balance sheet improves
(lowers) the company’sdebt and leverageratios.
Req. 3
In the future, the FASB and IASB are proposing to eliminate most operating leases. If
this rule change occurs, companies like Abercrombie and Fitch Co. will have to
capitalize leased property as assets and also record the related lease obligations as
liabilities.
Chapter 9 Liabilities 9-31
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(20-25 min.) E 9-30A
Amounts in millions or billions
Company Company Company
Ratio B N V
Current =
Total current assets =
$429 ¥5,321 €144,720
ratio Total current liabilities $227 ¥2,217 € 72,000
= 1.89 = 2.40 = 2.01
B N V
Debt=== = Total liabilities* = $227 + $77 ¥2,217+ ¥2,277 €72,000+ €111,177ratio Total assets** $429 + $81 ¥5,321+ ¥592 €144,720+ €65,828
= 0.60 = 0.76 = 0.87
B N V
Leverage
ratio =
Total assets =
$510 ¥5,913 €210,548
Tot. stockholders’equity $206 ¥1,419 €27,371
= 2.48 = 4.17 = 7.69
B N V
Times-
interest- =
Operatingincome =
$295 ¥230 €5,646
earned Interest expense $41 ¥27 €655
ratio
= 7.2 times = 8.5 times = 8.6 times
_____
B N V
Assets $510 ¥5,913 €210,548
Liabilities $304 ¥4,494 €183,177
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Basedon these ratio values, CompanyN looks the least risky.
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(15-20 min.) E 9-31A
Req. 1
PLANA
BORROW
$600,000
AT 6%
PLANB
ISSUE
$600,000
OF COMMON
STOCK
Net incomebefore expansion………………… $300,000 $300,000
Project incomebefore interest and incometax $500,000 $500,000
Less interest expense($600,000× .06)………. 36,000 -0-
Project incomebefore incometax……………. 464,000 500,000
Less: incometax expense(25%)……………… (116,000) (125,000)
Project net income………………………………. 348,000 375,000
Total companynet income………………… $648,000 $675,000
Earningsper share includingnew project:
Plan A ($648,000/ 100,000shares)…….................. $6.48
Plan B ($675,000/ 225,000shares)........................ $3.00
Financial Accounting 9/e Solutions Manual9-34
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(continued) E 9-31A
Req. 2
MEMORANDUM
TO: Boardof Directorsof PrimeNationFinancial Services
FROM: StudentName
SUBJECT: Financingplan to expandoperations
Plan A (borrowing) results in much higher earnings per share. Plan A also allows the
existing stockholdersto retain control of the companybecausethe companyissues no
new stock. But Plan A also creates more financial risk becauseborrowingobligates the
companyto pay the interest and the principal of the debt. I prefer Plan A, assumingthe
company’slevel of debt is not alreadytoo high.
Students can defend either plan based on their preferencesfor control of the business,
avoidanceof risk, and higher earningsper share.
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(5-15 min.) E 9-32B
Req. 1
JournalDATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
WarrantyExpense($176,000× .09)………… 15,840
EstimatedWarrantyPayable…………….. 15,840
EstimatedWarrantyPayable………………… 9,000
Cash………………………………………….. 9,000
Req. 2
INCOMESTATEMENT
Sales revenue………………………………………… $176,000
Warrantyexpense…………………………………… 15,840
BALANCESHEETCurrent liabilities
Estimatedwarrantypayable
($2,000+ $15,840 $9,000)……………….....− $ 8,840
Req. 3
Estimated warranty payable, a current liability, will cause a company’s current ratio to
decrease .
Financial Accounting 9/e Solutions Manual9-36
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(10-15 min.) E 9-33B
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
Oct. 1 Cash………………………………………………… 2,247UnearnedSubscriptionRevenue…………... 2,100
Sales Tax Payable($2,100× .07)…………… 147
Nov. 15 Sales Tax Payable………………………………... 147
Cash…………………………………………….. 157
Dec. 31 UnearnedSubscriptionRevenue……………… 525
SubscriptionRevenue($2,100× 3/12)…….. 525
BALANCESHEET
Current liabilities:
Unearnedsubscriptionrevenue($2,100 $525)……− $1,575
(10 min.) E 9-34B
INCOMESTATEMENT
Expenses:
Payroll expense………………………………………. $190,000
Payroll tax expense($190,000× .08)……………… 15,200
BALANCESHEET
Current liabilities:
Salary payable………………………………………… $ 8,000
Payroll tax payable…………………………………... 750
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(5-10 min.) E 9-35B
Req. 1
Interest to
accrueat = $84,000× .07 × 3/12 = $1,470Dec. 31, 2012
Req. 2
Final payment= $84,000+ ($84,000× .07) = $89,880
on October1, 2013
Req. 3
Interest expensefor:
. = $84,000× .07 × 3/12 = $1,470
2013 = $84,000× .07 × 9/12 = $4,410
Financial Accounting 9/e Solutions Manual9-38
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(10-15 min.) E 9-36B
McKinley’sbalancesheet at December31, 2013 reported:
Incometax payable…………………………………... $436,000*
McKinley’s2013 incomestatementreported:
Incometax expense($1,600,000× .36)…………… $576,000
_____ * Beginningincometax payable…………………….. $210,000
+ Incometax expense(and payable) for the year
($1,600,000× .36)…………………………………… 576,000
−
Incometax paymentsduringthe year……………. (350,000) = Endingincometax payable………………………… $436,000
Chapter 9 Liabilities 9-39
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(10-20 min.) E 9-37B
Req. 1
Accounts payable are amounts owed to suppliers for products or services that have
been purchasedon account.
Accrued expenses are expensesthat the companyhas incurred but not paid. They are
liabilities for expensessuch as interest and incometaxes.
Employeecompensationand benefits are amounts owed to employeesfor salaries and
other payroll-relatedexpenses.
Current portion of long-term debt is next year’s payment on the company’s long-term
debt.
Long-term debt is the amount of long-term notes and bonds payable that the company
expectsto pay after the comingyear.
Postretirement benefits are the company’s liabilities for providing benefits — mainly
health care — to retirees.
The other liabilities are a catch-all group of liabilities that do not fit one of the more
specific categories. The other liabilities are long-term, as shownby the fact that they are
not listed amongthe current liabilities.
Financial Accounting 9/e Solutions Manual9-40
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(continued) E 9-37B
Req. 2
Total assets = $4,050million, the sumof total liabilities and
stockholders’equity.
(in millions) 2012
Leverage
ratio =
Total assets ($4,050)
Total stockholders’ equity ($2,027)= 2.0
Debt ratio =Total liabilities ($4,050 $2,027)*−
= 0.50Total assets ($4,050)
For 2011, the leverageratio was 2.23 and the debt ratio was .55.
Both the leverageratio and debt ratio improved. Therefore, the companyimproved.
____ *Or, $368 + $1,497+ $138 + $20 = $2,023
Req. 3
2012 2011
Accounts
payable
turnover
Cost of goodssold $1,885
= 11.8
$2,196
= 11.6Averageaccounts
payable
$159* $188**
*($137+ $181) / 2 **($181+ $195) / 2
Days payable
outstanding
365 365
= 30.9
365
= 31.5Accts. payable
turnover
11.8 11.6
Current
ratio
Current assets $643= 1.75
$610= 1.62
Current liabilities $368 $376
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The company’sability to cover accountspayableand current liabilities over the year
improved.
Financial Accounting 9/e Solutions Manual9-42
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(5-10 min.) E 9-38B
Req. 1
Clark Security Systemsshould report this situationin a note to the financial statements.
The note shouldconveyessentially the samemessagegiven in Note 14.
Req. 2
Clark wouldreport:
INCOMESTATEMENT
Estimatedloss (or expense)……………… $2,000,000
BALANCESHEET
Estimatedliability…………………………… $2,000,000
The note disclosurewould be similar to Requirement1.
JournalDATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
EstimatedLoss fromDamageClaim 2,000,000
EstimatedLiability fromDamageClaim 2,000,000
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(15-20 min.) E 9-39B
Jasper Electronics
BalanceSheet (partial)
June 30, 2012
Current liabilities:
a. Estimatedwarrantypayable
[$36,000+ ($2,100,000× .06) $51,000]………− $111,000
b. Current portionof long-term note payable……... 11,250
Interest payable($45,000× .07 × 1/12)…………… 263
c. Unearnedsales revenue($130,000 $75,000)….− 55,000
d. Employeewithheldincometax payable…………. 30,300
FICAtax payable($300,000× .0765)……………… 22,950
Total current liabilities………………………….. $230,763
Long-term liabilities:
Note payable($45,000 $11,250)……………........− $ 33,750
Financial Accounting 9/e Solutions Manual9-44
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(10-15 min.) E 9-40B
Req. 1
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
a. Jan. 31 Cash($9,000,000× 0.93)……………… 8,370,000
Discounton BondsPayable…………. 630,000
BondsPayable……………………... 9,000,000
To issue bondsat a discount.
b. July 31 Interest Expense....................................... 436,500
Cash($9,000,000× .09 × 6/12)................. 405,000
Discounton BondsPayable
($630,000/ 20)................................... 31,500
To pay interest and amortizebonds.
c. Dec. 31 Interest Expense....................................... 363,750
Interest Payable
($9,000,000× .09 × 5/12)..................... 337,500
Discounton BondsPayable
($31,500× 5/6)................................... 26,250To accrueinterest and amortize bonds.
Chapter 9 Liabilities 9-45
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(10-15 min.) E 9-41B
1. Cashreceived= $300,000× 1.01 = $303,000
2. Principal……………………………………………………… $300,000
Interest ($300,000× .06 × 20)…………………….............. 360,000
Total cash paid……………………………………………… $660,000
3. Total cash paid……………………………………………… $660,000
Less: Cashreceived……………………………………... (303,000)
Difference= Total interest expense……………………... $357,000
4. Annualinterest expenseby the straight-line amortizationmethod:
$300,000× .06 $300,000× (1.01 1.00)−
20
$18,000 − $150 = $ 17,850
Cashinterest payment Premiumamortization × 20 years
Total interest expenseover the life of the bonds $357,000
Financial Accounting 9/e Solutions Manual9-46
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(15-20 min.) E 9-42B
Req. 1 (amortization table)
SEMIANNUAL
INTEREST
DATE
A
INTEREST
PAYMENT
(6% OF
MATURITY
VALUE)
B
INTEREST
EXPENSE
(7% OF
PRECEDING
BOND
CARRYING
AMOUNT)
C
DISCOUNT
AMORTIZATION
(B – A)
D
DISCOUNT
ACCOUNT
BALANCE
(PRECEDING
D – C)
E
BONDCARRYING
AMOUNT
($3,200,000– D)
Dec. 31, 2012 $339,000 $2,861,000
June 30, 2013 $192,000 $200,270 $8,270 330,730 2,869,270
Dec. 31, 2013 192,000 200,849 8,849 321,881 2,878,119June 30, 2014 192,000 201,468 9,468 312,413 2,887,587
Dec. 31, 2014 192,000 202,131 10,131 302,282 2,897,718
Req. 2
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
Dec. 31 Cash........................................................... 2,861,000
Discounton BondsPayable........................... 339,000
BondsPayable........................................ 3,200,000
To issue bondsat a discount.
2013
June 30 Interest Expense.......................................... 200,270
Cash....................................................... 192,000
Discounton BondsPayable...................... 8,270To pay semiannualinterest and
amortizebonds.
2013
Dec. 31 Interest Expense.......................................... 200,849
Cash....................................................... 192,000
Discounton BondsPayable...................... 8,849
Chapter 9 Liabilities 9-47
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To pay semiannualinterest and
amortizebonds.
Financial Accounting 9/e Solutions Manual9-48
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(15-20 min.) E 9-43B
Req. 1 (amortization table)
SEMIANNUAL
INTEREST
DATE
A
INTEREST
PAYMENT
(4% OF
MATURITY
VALUE)
B
INTEREST
EXPENSE
(3-1/2%OF
PRECEDING
BOND
CARRYING
AMOUNT)
C
PREMIUM
AMORTIZATION
(A – B)
D
PREMIUM
ACCOUNT
BALANCE
(PRECEDING
D – C)
E
BONDCARRYING
AMOUNT
($1,600,000+ D)
June 30, 2012 $188,000 $1,788,000
Dec. 31, 2012 $64,000 $62,580 $1,420 186,580 1,786,580
June 30, 2013 64,000 62,530 1,470 185,110 1,785,110Dec. 31, 2013 64,000 62,479 1,521 183,589 1,783,589
June 30, 2014 64,000 62,426 1,574 182,015 1,782,015
_____ 1$1,600,000× 1.1175= $1,788,000
Req. 2 (journal entries)
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
June 30 Cash($1,600,000× 1.1175)……….. 1,788,000
BondsPayable………………… 1,600,000
Premiumon BondsPayable… 188,000
To issue bondsat a premium.
Dec. 31 Interest Expense……………………. 62,580
Premiumon BondsPayable……… 1,420
Cash………………………………. 64,000
To pay semiannualinterest and amortizebonds.
2013
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June 30 Interest Expense……………………. 62,530
Premiumon BondsPayable.……... 1,470
Cash……………………………….. 64,000
To pay semiannualinterest and amortizebonds.
Financial Accounting 9/e Solutions Manual9-50
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(15-20 min.) E 9-44B
A B C D E F
1 Bond
2 Interest Interest Discount Discount Carrying
3 Date Payment Expense Amortization Balance Amount
4
5 Jan. 1, 2012 $33,120 $416,880
6 Dec. 31, 2012 $22,500 $25,013 $2,513 30,607 419,393
7 Dec. 31, 2013 22,500 25,164 2,664 27,943 422,057
8 Dec. 31, 2014 22,500 25,323 2,823 25,120 424,880
9 Dec. 31, 2015 22,500 25,493 2,993 22,127 427,87310 Dec. 31, 2016 22,500 25,672 3,172 18,955 431,045
11 Dec. 31, 2017 22,500 25,863 3,363 15,592 434,408
12 Dec. 31, 2018 22,500 26,064 3,564 12,028 437,972
13 Dec. 31, 2019 22,500 26,278 3,778 8,250 441,750
14 Dec. 31, 2020 22,500 26,505 4,005 4,245 445,755
15 Dec. 31, 2021 22,500 26,745 4,245 0* 450,000*
*Note : Computer-generatedsolutionsmay containslight roundingdifferences.
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(15-20 min.) E 9-45B
Req. 1
The company has the right to occupy space and operate out of leased stores for
several years to come. In return, the company is obligated to make payments
amountingto over $1 billion dollars to various landlords(lessors). A very small portion
of these paymentsmay be offset by receipts fromsub-leasesto other tenants.
Req. 2
The rights and obligations discussedin Req. 1 are classified as operating leases and
are not reported on the balance sheet. Omitting them from the balance sheet improves
(lowers) the company’sdebt and leverageratios.
Req. 3
In the future, the FASB and IASB are proposing to eliminate most operating leases. If
this rule change occurs, companies like Ann Taylor Stores Corporation will have to
capitalize leased property as assets and also record the related lease obligations as
liabilities.
Financial Accounting 9/e Solutions Manual9-52
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(20-25 min.) E 9-46B
Amounts in millions or billions
Company Compan
y Company
Ratio F K R
Current =
Total current assets =
$434 ¥5,383 €148,526
ratio Total current liabilities $207 ¥2,197 €72,100
= 2.10 = 2.45 = 2.06
F K R
Debt=
Total liabilities=
$207 + $107 ¥2,197+ ¥2,318 €72,100+ €110,107
ratio Total assets $434 + $96 ¥5,383+ ¥405 €148,526+ €49,525
= 0.59 = 0.78 = 0.92
F K R
Leverageratio
= Total assets = $530 ¥5,788 €198,051Tot. stockholders’equity $216 ¥1,273 €15,844
= 2.45 = 4.55 = 12.50
F K R
Times-
interest-
=
Operatingincome
=
$292 ¥224 €5,592
earned Interest expense $46 ¥33 €736ratio
= 6.4 times = 6.8 times = 7.6 times
_____
F K R
Assets $530 ¥5,788 €198,051
Chapter 9 Liabilities 9-53
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Liabilities $314 ¥4,515 €182,207
Basedon these ratio values, CompanyK looks the least risky.
Financial Accounting 9/e Solutions Manual9-54
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(15-20 min.) E 9-47B
Req. 1
PLANABORROW
$900,000
AT 10%
PLANB
ISSUE$900,000
OF COMMON
STOCK
Net incomebefore expansion…………………….. $600,000 $600,000
Project incomebefore interest and incometax.. $800,000 $800,000
Less: interest expense($900,000× .10)………… (90,000) -0-
Project incomebefore incometax………………. 710,000 800,000
Less: incometax expense(40%)………………… (284,000) (320,000)
Project net income………………………………….. 426,000 480,000
Total companynet income……………………. $1,026,000 $1,080,000
Earningsper share includingnew project:
Plan A ($1,026,000/ 200,000shares)………… $5.13
Plan B ($1,080,000/ 450,000shares)………... $2.40
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(continued) E 9-47B
Req. 2
MEMORANDUM
TO: Boardof Directorsof UnitedNationFinancial Services
FROM: StudentName
SUBJECT: Financingplan to expandoperations
Plan A (borrowing) results in much higher earnings per share. Plan A also allows the
existing stockholdersto retain control of the companybecausethe companyissues no
new stock. But Plan A also creates more financial risk becauseborrowingobligates the
companyto pay the interest and the principal of the debt. I prefer Plan A, assumingthe
company’slevel of debt is not alreadytoo high.
Students can defend either plan based on their preferencesfor control of the business,
avoidanceof risk, and higher earningsper share.
Financial Accounting 9/e Solutions Manual9-56
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Quiz
Q9-48 d
Q9-49 aQ9-50 d
Q9-51 c
Q9-52 a
Q9-53 b [($650,000+ $850,000)× .07] – $5,200 $42,500= $57,300−
Q9-54 d
Q9-55 a
Q9-56 f
Q9-57 b
Q9-58 c
Q9-59 b ($400,000× .13) + [($400,000 $388,000)/ 10] = $53,200−
Q9-60 Interest Expense………………………………….. 39,900
Discounton BondsPayable
($12,000/ 10 × 9/12)………………………… 900Interest Payable($400,000× .13 × 9/12)…... 39,000
Q9-61 Interest Payable……………………….................. 39,000
Interest Expense………………………………….. 13,300
Discounton BondsPayable
($12,000/ 10 × 3/12)…………………………. 300
Cash($400,000× .13)…………………........... 52,000
Q9-62 d ($295,000 x .07) = $20,650)
Q9-63 c
Q9-64 c
Q9-65 c
Q9-66 a
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Financial Accounting 9/e Solutions Manual9-58
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Problems
(15-20 min.) P 9-67A
a. Sales tax payable($150,000× .06)..................……………………………… $9,000
b. Note payable, short-term..................………………………………………… $81,000
Interest payable($81,000× .04 × 4/12)..................………………………… 1,080
c. Unearnedservice revenue($3,000× 4/6)..................……………………… $1, 000
d. Estimatedwarrantypayable
($11,300+ $32,000 $34,500)−
.................………………………………... $8,800
e. Portionof long-term note payabledue
within one year.................. …………………………………………………. $20,000
Interest payable($100,000× .06).................. ……………………………….. 6,000
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(30-40 min.) P 9-68A
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
Mar. 3 Inventory............................................................. 50,000 Note Payable, Short-term................................... 50,000
May 31 Cash................................................................... 85,000
Note Payable, Short-term................................... 17,000
Note Payable, Long-term................................... 68,000
Sept. 3 Note Payable, Short-term....................................... 50,000
Interest Expense($50,000× .08 × 6/12)…… 2,000
Cash............................................................... 52,000
Dec. 31 WarrantyExpense($196,000× .025)........................ 4,900
EstimatedWarrantyPayable.............................. 4,900
31 Interest Expense($85,000× .08 × 7/12) 3,967
Interest Payable............................................... 3,967
2013
May 31 Note Payable, Short-term....................................... 17,000Interest Payable................................................... 3,967
Interest Expense($85,000× .08 × 5/12)…… 2,833
Cash............................................................... 23,800
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(20-25 min.) P 9-69A
Req. 1
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT2012
a. May 31 Cash($7,000,000× 1/2)…………...... 3,500,000
BondsPayable……………………. 3,500,000
To issue bondsat par.
b. Nov. 30 Interest Expense…………………...... 157,500
Cash($3,500,000× .09 × 6/12)…. 157,500
To pay interest on bonds.
c. Dec. 31 Interest Expense
($3,500,000× .09 × 1/12)…………….. 26,250
Interest Payable………………...... 26,250
To accrueinterest.
2013
d. May 31 Interest Payable………………………. 26,250
Interest Expense($3,500,000× .09 × 5/12)…………….. 131,250
Cash($3,500,000× .09 × 6/12)….. 157,500
To pay interest on bonds.
Req. 2 (reporting the liabilities on the balance sheet at
December 31, 2012)
Current liabilities:
Interest payable..................................................... $ 26,250
Long-term liabilities:
Bondspayable...................................................... $3,500,000
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30-40 min.) P 9-70A
Req. 1
The 6% bondsissuedwhen the market interest rate is 5% will be priced at a premium .
They are relatively attractive in this market, so investorswill pay a price above par value
to acquire them.
Req. 2
The 6% bonds issuedwhen the market interest rate is 7% will be priced at a discount .
They are relatively unattractivein this market, so investorswill pay less than par value to
acquire them.
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(continued) P 9-70A
Req. 3
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
a. Feb. 28 Cash($900,000× .96)...................................... 864,000
Discounton BondsPayable............................. 36,000
BondsPayable........................................... 900,000
To issue bondsat a discount.
b. Aug. 31 Interest Expense............................................. 28,800
Cash($900,000× .06 × 6/12)......................... 27,000
Discounton BondsPayable
($36,000/ 20)........................................... 1,800To pay interest and amortizebonds.
c. Dec. 31 Interest Expense............................................. 19,200
Interest Payable($27,000× 4/6).................... 18,000
Discounton BondsPayable
($1,800× 4/6)........................................... 1,200
To accrueinterest and amortize bonds.
2013
d. Feb. 28 Interest Payable(fromDec. 31)…………. 18,000
Interest Expense............................................. 9,600
Cash($900,000× .06 × 6/12)......................... 27,000
Discounton BondsPayable
($1,800× 2/6)........................................... 600
To pay interest and amortizebonds.
Req. 4 (reporting the liabilities on the balance sheet at December 31, 2012)
Current liabilities:
Interest payable……………………………. $ 18,000
Long-term liabilities:
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Bondspayable……………………………... $900,000
Less: Discounton bondspayable
($36,000 $1,800- $1,200)……..− (33,000) 867,000
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(30-40 min.) P 9-71A
Req. 1
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT2012
Jan. 1 Cash($4,000,000× .95)...................................... 3,800,000
Discounton BondsPayable............................... 200,000
BondsPayable…………………………... 4,000,000
To issue bondsat a discount.
July 1 Interest Expense.............................................. 130,000
Cash($4,000,000× .06 × 6/12)........................ 120,000
Discounton BondsPayable
($200,000/ 20)........................................... 10,000
To pay interest and amortize bonds.
Dec. 31 Interest Expense.............................................. 130,000
Interest Payable
($4,000,000× .06 × 6/12).............................. 120,000
Discounton BondsPayable………….............. 10,000
To accrueinterest and amortizebonds.2013
Jan. 1 Interest Payable............................................... 120,000
Cash........................................................... 120,000
To pay interest.
2022
Jan. 1 BondsPayable................................................. 4,000,000
Cash........................................................... 4,000,000
To pay bondsat maturity.
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(continued) P 9-71A
Req. 2
Carrying amount at December 31, 2012.
Bondspayable, net
($4,000,000 $200,000+ $10,000+ $10,000)………− $3,820,000
Req. 3
a. Interest expense = $130,000
b. Cashinterest paid = $120,000
Interest expenseexceedscash interest paid becausethe companyissuedthe bondsat a
discountand must pay back the full face value of the bondsat maturity. Amortizationof
the bond discount causes the interest expense on the bonds to exceed the amount of
cash interest paid.
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(30-45 min.) P 9-72A
Req. 1
a. Maturity value is $5,000,000
b. Annualcash interest paymentis $300,000
($5,000,000× .06)
c. Carryingamountis $4,479,360
Req. 2 (amortization table)
ANNUAL
INTEREST
DATE
A
INTEREST
PAYMENT
(6% OF
MATURITY
VALUE)
B INTEREST
EXPENSE
(8% OF
PRECEDING
BOND
CARRYING
AMOUNT)
C
DISCOUNT
AMORTIZATION
(B – A)
D
DISCOUNT
ACCOUNT
BALANCE
(PRECEDIN
G
D – C)
E
BOND
CARRYING
AMOUNT
($5,000,000–D)
Dec. 31, Yr. 1 $520,640 $4,479,360
Dec. 31, Yr. 2 $300,000 $358,349 $58,349 462,291 4,537,709
Dec. 31, Yr. 3 300,000 363,017 63,017 399,274 4,600,726
Dec. 31, Yr. 4 300,000 368,058 68,058 331,216 4,668,784
Interest expensefor the year endedDecember31, Year 4, is $368,058.
Req. 3 (reporting the liabilities at December 31, Year 4)
Current liabilities:
Current installmentof notes payable…….. $ 55,000
Long-term liabilities:
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Bondspayable………………………………... $5,000,000
Less: Discounton bondspayable………. (331,216) 4,668,784
Notes payable………………………………… 275,000
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(40-50 min.) P 9-73A
Req. 1 (amortization table)
SEMIANNUAL
INTEREST
DATE
A
INTEREST
PAYMENT
(5.5%OF
MATURITY
VALUE)
B
INTERESTEXPENSE
(6% OF
PRECEDING
BOND
CARRYING
AMOUNT)
C
DISCOUNT
AMORTIZATION
(B – A)
D
DISCOUNT
ACCOUNT
BALANCE
(PRECEDING
D – C)
E
BONDCARRYING
AMOUNT
($4,000,000– D)
12-31-12 $229,400 $3,770,600*
6-30-13 $220,000 $226,236 $6,236 223,164 3,776,836
12-31-13 220,000 226,610 6,610 216,554 3,783,4466-30-14 220,000 227,007 7,007 209,547 3,790,453
12-31-14 220,000 227,427 7,427 202,120 3,797,880
_____ *$4,000,000× .94265= $3,770,600
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(continued) P 9-73A
Req. 2
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT2012
a. Dec. 31 Cash($4,000,000× .94265)........................... 3,770,600
Discounton BondsPayable......................... 229,400
ConvertibleBondsPayable...................... 4,000,000
To issue bondsat a discount.
2013
b. June 30 Interest Expense......................................... 226,236
Cash..................................................... 220,000
Discounton BondsPayable..................... 6,236
To pay interest and amortizebonds.
c. Dec. 31 Interest Expense......................................... 226,610
Cash..................................................... 220,000
Discounton BondsPayable..................... 6,610
To pay interest and amortizebonds.
2014
d. July 1 ConvertibleBondsPayable.......................... 1,600,000 Discounton BondsPayable
($209,547× 2/5)................................... 83,819
CommonStock (90,000× $1).................... 90,000
Paid-in Capital in Excessof
Par — Common.................................. 1,426,181
To recordconversionof bonds.
Req. 3 (balance sheet presentation of bonds payable at
December 31, 2014)
Convertiblebondspayable
($4,000,000 $1,600,000)− ..................................... $2,400,000
Less: Discounton bondspayable
($202,120× 3/5*)................................................. (121,272) 2,278,728
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_____
*3/5 of the bondsare outstanding,so 3/5 of the discount
remains.
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(20-30 min.) P 9-74A
Req. 1
TO: Managementof Tony SportingGoods
FROM: StudentName
SUBJECT:Advantagesand disadvantagesof borrowing
versusissuingstock to raise cash for expansion
Raising money by borrowinghas at least two advantagesover issuing commonstock.
Borrowing does not change the present ownership of the business. It enables the
present owners to keep their proportionate interests in the business and to carry out
their plans without interference from a new group of stockholders. Under normal
conditions, borrowingresults in a higher earningsper share of commonstock, because
the interest expenseon the debt is tax-deductible. And higher earningsper share usually
lead to higher stock prices for companyowners.
The main disadvantageof borrowingis that the debt increases the financial risk of the
company. The principal and the related interest expense must be paid whether the
companyis earning a profit or not. If times get sufficiently bad, the debt burden could
threatenthe ability of the businessto continueas a goingconcern.
The main advantageof issuingstock is that ownersavoid the burdenof makinginterest
and principal paymentson the debt. Issuing stock creates no liability to pay anythingto
the owners. If the directors consider it necessary, they can refuse to pay dividends in
order to conservecash. Therefore, it is safer to issue stock.
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(continued) P 9-74A
One disadvantage of issuing stock is dilution of the ownership interests of existing
stockholders if the purchasers of new stock are outsiders. The new stockholders may
have different ideas about how to managethe businessand that may pose difficulties for
the original stockholder group. Another disadvantageof issuing stock is that earnings
per share are usually lower because of (1) the greater number of shares of stock
outstanding,and (2) the non-tax-deductibility of dividendspaid on the stock.
There is insufficient information available upon which to make a decision. Tony’s
managementmust preparebudgetswhich indicate the impact of the new stores in terms
of net incomeand cash flow. Managementmust also estimatethe cost of borrowingthe
funds.
Studentresponsesmay vary.
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(20-30 min.) P 9-75A
Req. 1
BrightonFoods, Inc.
Partial BalanceSheetDecember31, 2012
Property, plant, and
equipment: Current liabilities:*
Equipment................... $744,000 Mortgagenote
Accumulated payable, current.................... $ 92,000
depreciation.............. (166,000) Bondspayable,
578,000 current portion..................... 500,000
Interest payable...................... 75,000
Total current liabilities................ 667,000
Long-termliabilities:
Mortgagenote
payable................................ $ 318,000
Bondspayable….$200,000
Discounton
bondspayable…. (25,000)* 175,000
Pensionliability...................... 30,000 **
Total long-termliabilities............ 523,000
Notes:
* The order of listing current liabilities and long-termliabilities is optional. However, Discount onBondsPayableshouldcomeimmediatelyafter Bonds Payable. Also, it is customaryto report Interest
Payable after the related liability accounts, Mortgage Note Payable and Bonds Payable, Current
Portion.
** Computationof pensionliability:
Accumulatedpensionbenefit obligation…………….……............ $450,000
Less: Pensionplan assets, at marketvalue………………............ (420,000)
Pensionliability to be reportedon the balancesheet…………... $ 30,000
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(continued) P 9-75A
Req. 2
a. Carryingamountof bondspayable:
Current portion…………………………………. $ 500,000
Long-term portion($200,000 $25,000)…….−
175,000Carryingamount……………………………….. $675,000
b. Interest payable is the amountof interest that Brightonowes at year end. Interest
expenseis the company’scost of borrowingfor the full year.
Req. 3
Times-interest-earnedratio = Operatingincome = $370,000Interest expense $229,000
= 1.62 times
Req. 4
Leverage
ratio=
Total assets ($4,500,000)
Total stockholders’ equity ($3,310,000)= 1.36
Debt ratio = Total liabilities [$1,190,000= $667,000+ $523,000] = 0.26Total assets ($4,500,000)
The company’s debt ratio and leverage ratios are low, and operating income covers
interest paymentsby 1.62 times. With this limited information, the companyappears to
be low risk from a leverage point of view. Additional information from prior years and
competitorswouldalso be helpful.
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(continued) P 9-75A
Req. 5
Leverage
ratio=
Total assets ($7,500,000)
Total stockholders’ equity ($3,310,000)= 2.26
Debt ratio = Total liabilities ($4,190,000) = 0.56
Total assets ($7,500,000)
The leverageratio and debt ratio wouldincrease. The companywouldstill be
consideredhealthy(averagerisk) froma leveragepoint of view.
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(15-20 min.) P 9-76B
a. Sales tax payable($130,000× .07)................................................... $9,100
b. Note payable, short-term............................................................... $80,000
Interest payable($80,000× .06 × 4/12)............................................. 1,600
c. Unearnedservice revenue($3,000× 2/6).......................................... $1,000
d. Estimatedwarrantypayable
($11,800+ $34,000 $34,800)− .................................................... $11,000
e. Portionof long-term note payabledue
within one year........................................................................ $30,000
Interest payable($90,000× .06)...................................................... 5,400
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(30-40 min.) P 9-77B
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
Mar. 3 Inventory…………………………………… 70,000 Note Payable, Short-term……………. 70,000
May 31 Cash…………………………………………. 70,000
Note Payable, Short-term……………. 14,000
Note Payable, Long-term…………….. 56,000
Sept. 3 Note Payable, Short-term………………... 70,000
Interest Expense($70,000× .06 × 6/12).. 2,100
Cash……………………………………... 72,100
Dec. 31 WarrantyExpense($194,000× .02)……. 3,880
EstimatedWarrantyPayable………... 3,880
Dec. 31 Interest Expense
($70,000× .05 × 7/12)…………………….. 2,042
Interest Payable……………………….. 2,042
2013
May 31 Note Payable, Short-term……………….. 14,000
Interest Payable…………………………… 2,042
Interest Expense($70,000× 0.05 × 5/12) 1,458
Cash[$14,000+ ($70,000× .05)] …... 17,500
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(20-25 min.) P 9-78B
Req. 1
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT2012
a. May 31 Cash...................................................... 4,000,000
BondsPayable.................................... 4,000,000
To issue bondsat par.
b. Nov. 30 Interest Expense……………….......... 120,000
Cash($4,000,000× .06 × 6/12)….. 120,000
To pay interest on bonds.
c. Dec. 31 Interest Expense
($4,000,000× .06 × 1/12)............................ 20,000
Interest Payable.................................. 20,000
To accrueinterest.
2013
d. May 31 Interest Payable....................................... 20,000
Interest Expense($4,000,000× .06 × 5/12)............................ 100,000
Cash……………………………….. 120,000
To pay interest on bonds.
Req. 2 (reporting the liabilities on the balance sheet at
December 31, 2012)
Current liabilities:
Interest payable……………………………. $ 20,000
Long-term liabilities:
Bondspayable……………………………... $4,000,000
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(30-40 min.) P 9-79B
Req. 1
The 10% notes issuedwhen the market interest rate is 9% will be priced at a premium .
They are relatively attractive in this market, so investorswill pay a price above par value
to acquire them.
Req. 2
The 10%notes issuedwhenthe market interest rate is 11%will be pricedat a discount .
They are relatively unattractivein this market, so investorswill pay less than par value to
acquire them.
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(continued) P 9-79B
Req. 3
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT2012
a. Feb. 28 Cash($1,200,000× 0.96)……………………… 1,152,000
Discounton BondsPayable…………………. 48,000
BondsPayable……………………………… 1,200,000
To issue bondspayableat a discount.
b. Aug. 31 Interest Expense……………………………….. 64,800
Discounton BondsPayable($48,000/ 10) 4,800
Cash($1,200,000× .05 × 6/12)……………. 60,000To pay interest and amortizebondspayable.
c. Dec. 31 Interest Expense……………………………….. 43,200
Discounton BondsPayable($4,800× 4/6) 3,200
Interest Payable($60,000 4/6)………….. 40,000
To accrueinterest and amortizebondspayable.
2022
d. Feb. 28 Interest Payable(fromDec. 31)……………… 40,000
Interest Expense……………………………….. 21,600
Discounton BondsPayable($4,800× 2/6) 1,600
Cash($1,200,000× .10 × 6/12)…………… 60,000
To pay interest and amortizebondspayable.
Req. 4 (reporting the liabilities on the balance sheet at
December 31, 2012)
Current liabilities:
Interest payable................................................... $ 40,000
Long-term liabilities:
Bondspayable..................................................... $1,200,000
Less: Discounton bondspayable
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($48,000 $4,800 $3,200)− − .................................. (40,000) 1,160,000
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(30-40 min.) P 9-80B
Req. 1
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT
2012
Jan. 1 Cash($3,000,000× .94)........................................ 2,820,000
Discounton BondsPayable.................................. 180,000
BondsPayable................................................ 3,000,000
To issue bondsat a discount.
July 1 Interest Expense................................................. 129,000
Cash($3,000,000× .08 × 6/12)........................... 120,000 Discounton BondsPayable
($180,000/ 20).............................................. 9,000
To pay interest and amortizebonds.
Dec. 31 Interest Expense................................................. 129,000
Interest Payable($3,000,000× .08 × 6/12) 120,000
Discounton BondsPayable
($180,000/ 20)…………………………… 9,000
To accrueinterest and amortize bonds.2013
Jan. 1 Interest Payable………………………………. 120,000
Cash………………………………………… 120,000
To pay interest.
2022
Jan. 1 BondsPayable………………………………… 3,000,000
Cash…………………………………………. 3,000,000
To pay off bondsat maturity.
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(continued) P 9-80B
Req. 2
Carrying amount at December 31, 2012:
Bondspayable, net
($3,000,000 $180,000+ $9,000+ $9,000) = $2,838,000−
Req. 3
a. Interest expense = $129,000
b. Cashinterest paid = $120,000
Interest expenseexceedscash interest paid becausethe companyissuedthe bondsat a
discountand must pay back the full face value of the bondsat maturity. Amortizationof
the bonds causes the interest expense on the bonds to exceed the amount of cash
interest paid.
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(30-45 min.) P 9-81B
Req. 1
a. Maturity value is $4,000,000.
b. Annualcash interest paymentis $200,000($4,000,000× .05).
c. Carryingamountis $3,568,850.
Req. 2 (amortization table)
ANNUAL
INTEREST
DATE
A
INTEREST
PAYMENT
(5% OF
MATURITY
VALUE)
B
INTEREST
EXPENSE
(7% OF
PRECEDING
BOND
CARRYING
AMOUNT)
C
DISCOUNT
AMORTIZATION
(B – A)
D
DISCOUNT
ACCOUNT
BALANCE
(PRECEDING
D – C)
E
BONDCARRYING
AMOUNT
($4,000,000– D)
Dec. 31, Yr. 1 $431,150 $3,568,850
Dec. 31, Yr. 2 $200,000 $249,820 $49,820 381,331 3,618,670
Dec. 31, Yr. 3 200,000 253,307 53,307 328,024 3,671,976
Dec. 31, Yr.4 200,000 257,038 57,038 270,985 3,729,015
Interest expensefor the year endedDecember31, Year 4 is $257,038.
Req. 3 (reporting the liabilities at December 31, Year 4)
Current liabilities:
Current portionof notes payable............................ $ 40,000
Long-term liabilities:
Bondspayable..................................................... $4,000,000
Less: Discounton bondspayable……….. (270,985) 3,729,015
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Notes payable
($360,000 $60,000)− ........................................... 200,000
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(40-50 min.) P 9-82B
Req. 1 (amortization table)
SEMIANNUAL
INTEREST
DATE
A
INTEREST
PAYMENT
(2-1/2%OF
MATURITY
VALUE)
B
INTEREST
EXPENSE
(3% OF
PRECEDING
BOND
CARRYING
AMOUNT)
C
DISCOUNT
AMORTIZATION
(B – A)
D
DISCOUNT
ACCOUNT
BALANCE
(PRECEDING
D – C)
E
BONDCARRYING
AMOUNT
($5,000,000- D)
12-31-12 $372,000 $4,628,000*
6-30-13 $125,000 $138,840 $13,840 358,160 4,641,840
12-31-13 125,000 139,255 14,255 343,905 4,656,095 6-30-14 125,000 139,683 14,683 329,222 4,670,778
12-31-14 125,000 140,123 15,123 314,099 4,685,901
_____ *$5,000,000× .9256 = $4,628,000
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(continued) P 9-82B
Req. 2
Journal
DATE ACCOUNTTITLESANDEXPLANATION DEBIT CREDIT2012
a. Dec. 31 Cash($5,000,000× .9256)................................. 4,628,000
Discounton BondsPayable……………… 372,00
ConvertibleBondsPayable........................... 5,000,000
To issue bondsat a discount.
2013
b. June 30 Interest Expense............................................. 138,840
Cash......................................................... 125,000 Discounton BondsPayable......................... 13,840
To pay interest and amortizebonds.
c. Dec. 31 Interest Expense............................................. 139,255
Cash.......................................................... 125,000
Discounton BondsPayable.......................... 14,255
To pay interest and amortizebonds.
2014d. July 1 Convertible BondsPayable............................... 2,000,000
Discounton BondsPayable
($329,222× 2/5)......................................... 131,689
CommonStock(90,000× $1)......................... 90,000
Paid-in Capital in Excessof
Par — Common........................................ 1,778,311
To recordconversionof bonds.
Req. 3 (balance sheet presentation of bonds payable at
December 31, 2014)
Convertiblebondspayable
($5,000,000 $2,000,000)− ............................................ $3,000,000
Less: Discounton bondspayable
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($314,099 × 3/5)*……………………………….…. (188,459) $2,811,541
_____
*3/5 of the bondsare outstanding,so 3/5 of the discountremains.
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(15-30 min.) P 9-83B
TO: Managementof Marco’sSportingGoods
FROM: StudentName
SUBJECT:Advantagesand disadvantagesof borrowing
versusissuingstock to raise cash for expansion
Raising money by borrowinghas at least two advantagesover issuing commonstock.
Borrowing does not change the present ownership of the business. It enables the
present owners to keep their proportionate interests in the business and to carry out
their plans without interference from a new group of stockholders. Under normal
conditions, borrowingresults in a higher earningsper share of commonstock, because
the interest expenseon the debt is tax-deductible. And higher earningsper share usually
lead to higher stock prices for companyowners.
The main disadvantageof borrowingis that the debt increases the financial risk of the
company. The principal and the related interest expense must be paid whether the
companyis earning a profit or not. If times get sufficiently bad, the debt burden could
threatenthe ability of the businessto continueas a goingconcern.
The main advantageof issuingstock is that ownersavoid the burdenof makinginterest
and principal paymentson the debt. Issuing stock creates no liability to pay anythingto
the owners. If the directors consider it necessary, they can refuse to pay dividends in
order to conservecash. Therefore, it is safer to issue stock.
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(continued) P 9-83B
One disadvantage of issuing stock is dilution of the ownership interests of existing
stockholders if the purchasers of new stock are outsiders. The new stockholders may
have different ideas about how to managethe businessand that may pose difficulties for
the original stockholder group. Another disadvantageof issuing stock is that earnings
per share are usually lower because of (1) the greater number of shares of stock
outstanding,and (2) the non-tax-deductibility of dividendspaid on the stock.
There is insufficient information available upon which to make a decision. Marco’s
managementmust preparebudgetswhich indicate the impact of the new stores in terms
of net incomeand cash flow. Managementmust also estimatethe cost of borrowingthe
funds.
Studentresponsesmay vary.
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(20-30 min.) P 9-84B
Req. 1
BraintreeFoods, Inc.
Partial BalanceSheet
December31, 2012
Property, plant, and
equipment: Current liabilities:*
Equipment……. $745,000 Bondspayable,
Accumulated current portion………….. $ 420,000
depreciation… (162,000) Mortgagenote payable,
583,000 current portion…………. 97,000 Interest payable…………… 74,000
Total current liabilities……... 591,000
Long-termliabilities:
Mortgagenote
payable…………………… $ 314,000
Bondspayable…$1,680,000
Less: Discounton
bondspayable.. (22,000)* 1,658,000
Pensionliability…………… 45,000 **
Total long-termliabilities…... 2,017,000
_____ Notes :
* The order of listing long-termliabilities is optional. However, Discounton Bonds Payable
shouldcomeimmediatelyafter BondsPayable. Also, it is customary to report InterestPayableafter the relatedliability accounts.
** Computationof pensionliability:
Accumulatedpensionbenefit obligation…………………….. $470,000
Less: Pensionplan assets, at market value…………………. (425,000)
Pensionliability to be reportedon the balancesheet…...... $ 45,000
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(continued) P 9-87B
Req. 2
a. Carryingamountof bondspayable:
Current portion..................................................................... $ 420,000Long-term portion................................................................ 1,658,000
Carryingamount................................................................... $2,078,000
b. Interest payable is the amount of interest that Braintree owes at year-end. Interest
expenseis the company’scost of borrowingfor the full year.
Req. 3
Times-interest-earnedratio =Operatingincome
= $390,000
Interest expense $227,000
= 1.72 times
Req. 4
Leverage
ratio =
Total assets ($4,200,000)
Total stockholders’ equity ($1,592,000)= 2.63
Debt ratio = Total liabilities [$2,608,000= $591,000+ $2,017,000] = 0.62
Total assets ($4,200,000)
The company’sdebt ratio and leverageratios are average, and operatingincomecovers
interest paymentsby 1.72 times. With this limited information,the companyappearsto
be averagerisk froma leveragepoint of view. Additional informationfromprior years
and competitorswouldalso be helpful.
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(continued) P 9-84B
Req. 5
Leverage
ratio
Total assets ($7,200,000)
Total stockholders’ equity ($1,592,000)= 4.52
Debt ratio = Total liabilities ($5,608,000) = 0.78
Total assets ($7,200,000)
The leverageratio and debt ratio wouldincrease. The companywouldbe considered
higher risk froma leveragepoint of view.
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ChallengeExercisesand Problem
(10-15 min.) E 9-85
Current ratio = Total current assets
=$324,500- X
= 2.00Total current liabilities $173,800- X
Let X = amount of current liabilities to pay in order to achieve a current ratio of 2.25.
Marquis Marketing Services should pay off $23,100* of current liabilities. Then the
current ratio will be:
$324,500 $23,100*− = $301,400 = 2.00
$173,800 $23,100*− $150,700
_____
*Computation: $324,500 X− = 2.00
$173,800 X−
$324,500 X− = 2.00 ($173,800 X)−
−
X = $347,600 2.00X $324,500− −
X = $23,100
Req. 2
Leverage
ratio=
Total assets ($1,423,000)
Total stockholders’ equity ($1,001,700)= 4.52
Debt ratio = Total liabilities ($421,300) = .30 Total assets ($1,423,000)
The leverageratio and debt ratio are low. The debt positionis low. Other helpful
informationwouldbe the leverageand debt ratios fromprior years and comparative
ratios fromcompetitors.
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(20-25 min.) E 9-86
Req. 1
Millions
BondsPayable, 5 ¼ %................................................ 160
BondsPayable, 13%........................................ 80Cash .......................................................... 17
Gain on Retirementof BondsPayable................ 63
Req. 2 (Dollar amounts in millions)
Old Bonds New Bonds
Annual interest expense…..$160 × .0525 $80 × .13
= $8.40 = $10.40
Req. 3
Possible reasonsfor the debt refinancing:
1. To decreaseannual interest expense: NO, becauseannual interest expenseon the
old bondsis less ($2,000,000)than interest expenseon the new bonds.2. To increase net income: YES, because the gain on retirement of bonds payable
added$63 million to net income.
3. To decreasethe leverageratio: YES, as follows:
Before After
(Dollar amounts in millions) Refinancing Refinancing
Leverage=
Total assets=
$503 $503 $17−
ratio Total stockholders’ $144 $144 + $63
equity = 3.49 = 2.35
4. To decreasethe debt ratio: YES, as follows:
(Dollar amounts in millions) BeforeRefinancing After Refinancing
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Debt=
Total liabilities=
$359 $359 $160 + $80−
ratio Total assets $503 $503 $17−
= 0.71 = 0.57
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(20-30 min.) P 9-87
Req. 1
a. Current ratio
2010 2009
Currentratio
Current assets $21,579 = 1.17 $17,551 1.28Current liabilities $18,508 $13,721
b. Debt ratio
2010 2009
Debt
ratio
Total
liabilities $72,921- $31,317 =.571 $48,671– $25,346 =.479
Total assets $72,921 $48,671
Req. 2
a. Current ratio
Current
ratio
Current assets $21,579 = 1.07
Current liabilities $18,508+ $1,590
b. Debt ratio
Debt
ratio
Total liabilities $41,604+ $1,590- $1,590 = .571
Total assets $72,921
Req. 3
Current
ratio
Current assets $21,579 = 1.15
Current liabilities $18,508+ $205
b. Debt ratio
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Debt
ratio
Total liabilities $41,604+ $965 = .584
Total assets $72,921
DecisionCases
(15-20 min.) DecisionCase 1
Req. 1
As
Reported
Debt ratio =Total liabilities
=$54,033
Total assets $65,503
= 0.82
Returnon
Assets=
Net income=
$979
(ROA) Total assets $65,503
= 1.5%
Req.2
Leverage
=
Total assets
=
$65,503
ratio Total
stockholders’
$11,470
equity
= 5.71
Returnon
ROAx LeverageratioEquity (ROE) = = 1.5%x 5.71 = 8.5%
The ROE is greater than the ROA becausethe leverageratio is extremely high which
magnifies the ROA. The debt ratio is also extremely high and indicates that 82% of
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the assets were financed with debt. The high leverage ratio and debt ratio should
have madeinvestorsquestionthe soundnessof Enron.
(continued)DecisionCase 1
Req. 3 After Includingthe
Special-PurposeEntities
Debt ratio =Total liabilities
=$54,033+ $6,900
Total assets $65,503 + $500*
= 0.92*The SPEs originally reportedassets of $7,000 million when those assets were only worth $500 but
actually had liabilitiesof $6,900.
Returnon
Assets=
Net income $979 + $0*
Total assets $100,789+ $500
= .1%
*The SPEs’ incomewas nearly wipedout due to the restatementmeaningthat the SPEdid not earn a
net incomebut did have assetswith a market value of $500.
As After IncludingtheReported Special-PurposeEntities
Operating
Times-interest- = Income = $1,953 $1,953+ ($300)earnedratio Interest $838 $838 + ($6,900× .10)
expense
= 2.3 times = 1.1 times
Req. 4
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It appears that Enron excluded the special-purpose-entities (SPEs) from its financial
statementsin order to hide their debt fromEnron’s investorsand creditors. The purpose
was to understate Enron’s liabilities. We would view Enron as much more risky after
including the SPEs in Enron’s financial statements. So did their banks, which is why
they stoppedlendingmoneyto them, causingthemto have to file for bankruptcy.
(30-40 min.) DecisionCase 2
Req. 1 (Analysis of financing plans)
PLANA PLANB PLANC
BORROW
AT 6%
ISSUE
COMMON
STOCK
ISSUE$3.75NONVOTING
PREFERRED
STOCK
Net incomebefore expansion $3,500,000 $3,500,000 $3,500,000
Project incomebefore interest
and incometax $1,500,000 $1,500,000 $1,500,000
Less interest expense ($5,000,000× .06) 300,000 -0- -0-
Project incomebefore incometax 1,200,000 1,500,000 1,500,000
Less incometax expense(35%) 420,000 525,000 525,000
Project net income 780,000 975,000 975,000
Less preferreddividends
(100,000× $3.75) -0- -0- 375,000
Additional net incomeavailable
to commonstockholders 780,000 975,000 600,000
Total companynet income $4,280,000 $4,475,000 $4,100,000
Earningsper share includingnew
project:
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Plan A
($4,280,000/ 1,000,000shares) $ 4.28
Plan B
($4,475,000/ 1,100,000shares) $ 4.07
Plan C
($4,100,000/ 1,000,000shares) $ 4.10
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(continued) DecisionCase 2
Req. 2 (Recommendation)
The best choiceappearsto be Plan A — borrowingat 6% — because:
(1) Borrowingallowsthe family to maintaincontrol of the business;
(2) EPS is higher under borrowingthan under issuingpreferred stock (which would
also maintainfamily control); and
(3) EPS under borrowingis higher than it wouldbe if commonstock were issued. Also,
cash flow under Plan A (borrowing) may be almost as good as under Plan B
(issuingcommonstock) after consideringstockholders’demandsfor dividends.
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Ethical Issue 1
Req. 1
A company would prefer not to disclose its contingent liabilities because they cast a
shadowon the businessand create a negativeimpression.
Req. 2 and 3
The potential parties and economic consequences of the decision not to disclose
contingentliabilities are:
1. The bank and its shareholders: With misleading information, they might extend
additional funds to the borrower assuming a better ability to pay back the funds than
actually exists. A contingent liability creates risk for a company. If the contingent
liability is not reported, the bank may view the companyas low-risk. This may lead the
bank to loan moneyat low interest rates and with easy paymentterms. With knowledge
of the contingent liability, the bank might not have made the loan at all. Or the bank
might have required a higher interest rate or more stringent payment terms. Making
loans on too-easy termsrobs the bank’s ownersof their money.
2. The companyseekingthe loan: Might becomeoverextendedin its borrowingand risk
default on debt in the future.
Req. 3 Legal and ethical consequences
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Banks have legal requirements to keep certain ratios of assets and liabilities on their
booksor risk default. Failure of a companyto report
(continued)Ethical Issue 1
its contingent liabilities to a bank requestingthis disclosurecould subject the company
to a lawsuit later on.
Froman ethical standpoint, reporting a contingent liability requires a delicate balancing
act. Ethics require that outsiders’ interests be protected. The company must disclose
enoughinformationto give outsiders a reasonablebasis for makinginformeddecisions
about the company. At the same time, the companyshould avoid giving away secrets
that could damageits owners’ investmentin the business. This dilemmais clear whena
defendant fears losing an important lawsuit. Fortunately for accountants, most
companies settle out of court those lawsuits that they expect to lose. In such cases,
there are no contingentliabilities to disclose.
Req. 4
As discussedin the chapter, changesare being discussedbetweenthe FASBand IASB
about a new standard for reporting contingencies. It is likely that, in the future, more
losses resulting from lawsuits and other contingenciesare likely to be disclosedin the
body and the footnotesof financial statements.
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Ethical Issue 2
1. The ethical issue is whetherto structurethis lease to avoid its havingto be disclosed
as a capital lease. The companywill do that if it is possible. It appearsthat Gocker and
Moranhave someflexibility in setting the life of the lease (4-6 years). If they set the term
of the lease at 4 years, it will be only 66 2/3 percent of the economiclife of the asset (6
years). Thus, the lease will fail all of the mechanical tests for the lease to be treatedas a
capital lease, and by default, it will be treated as an operating lease, and Gocker can
avoid capitalizingthe asset and includingthe liability on her financial statements. If they
set the term of the lease at 5 or 6 years, it will exceed 75% of the economic life of the
asset, and thus the lease will have to be capitalized.
2. The stakeholdersare Gocker, the lessee; Morgan, the lessor; and Last National Bank,
Gocker’spresentcreditor. The potential consequencesto the stakeholdersare:
a. economic: If the lease is structuredas a capital lease, Gockerwill violate its
long-term loan covenant with Last National Bank. As a result, the bank might demand
immediate payment of their loan. This may damage Gocker’s credit rating and create
difficulty getting future bank loans. Alternatively, Last National Bank may waive the loan
covenantin exchangefor a higher interest rate or more stringentrepaymentterms. This
too could cause Gocker financial difficulties. Morgan is not affected economically,
becauseMorganwill receive its paymentson the leased property regardlessof how the
transactionis disclosed.
(continued)Ethical Issue 2
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b. legal: If we assume that GAAP substitutes for legal requirements, if Gocker is
careful to structurethe lease termsso that it avoids the requirementsfor a capital lease,
there shouldbe no problemstatingthat the lease agreementcomplieswith GAAP.
c. ethical: The substanceof a capital lease is one that transfersthe risks and rewards
of ownershipto the lessee. If in fact, the substanceof the termsof this lease do that, the
equipmentshould be capitalizedby the lessee regardlessof the form of the lease terms.
To use mechanical rules to avoid recognizing assets and liabilities hardly seems like a
truthful way to do business. Nevertheless,U.S. GAAPpresentlyallowit!
3. Studentresponseswill vary on this question. Somewill say that, if the rules allow it,
then why not engineer the transaction in such as way as to benefit Gocker by keeping
the asset, and the lease obligation, off the books. After all, this is perfectly legal, and
perfectly in accordancewith existing U.S. GAAP(FAS 13). In the view of the authors,
Gocker should evaluate whether, in fact, she obtains the rights and rewards associated
with ownership of the machine. If so, she could so structure the lease that it fits the
economic substance of the transaction, which is what should also be disclosed in the
financial statements. If it turns out that the equipmentand the related lease obligation
will have to be addedto assets and liabilities in the balancesheet, thus causingGocker
to default on the loan covenant, she should attempt to obtain a waiver of the covenant.
This option is going to prove costly for Gocker, so she’s to have to be convincedthat
she did the right thing in order to be motivatedto followthis courseof action.
(continued)Ethical Issue 2
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4. The FASBand IASB are workingon a proposednew lease standardthat removesthe
mechanical criteria for lease capitalizationdiscussedin the chapter in favor of the more
theoretically and substantively correct, but also more subjective, “risks and rewards”
approach. As a result, more companies will be faced with making the judgment as to
whether their lease agreementsactually transfer risks and rewardsto lessees. This will
not remove the temptation to deliberately twist the facts. Under a “principles” based
standard, there will exist the opportunity for “strategic non-compliance”(that is, simply
decide that risks and rewards are not transferred and thus achieve the same result as
the “financial engineering” allowed by current GAAP. More judgment requires better
ethics. What do you think will happen?(Studentresponseswill vary on this question).
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Focuson Financials: Amazon.com,Inc.
(20 min.)
Req. 1
Amazon.com, Inc.’s accounts payable increased from $5,605 million in 2009 to $8,051million in 2010, an increase of about 43.6 percent. Accordingly, Account Payable
Turnoveris:
OperatingExpenses
Avg. Accts. Pay.
$32,798
($8,051+$5,605)/2 = 4.80
It takes Amazon.com,Inc. an average of (365/4.80) 76 days to pay its accounts payable.
This length overall is fairly long given that typical credit termsare closer to 30 days.
Req. 2
Provisionfor incometaxes $352 million
Incometaxes paid 75 million
These amounts differ because tax and accounting rules differ resulting in a different
incometax on the incomestatement(provisionfor incometaxes) than on the tax return
(incometax paid).
Req. 3
Refer to Note 5—LongTerm Debt. Based on this information, the company’slong term
debt (after current maturities) increased from $109 in 2009 to $184 in 2010. From this
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increase, you can tell that Amazon.com. Inc. borrowedmore than they paid off during
2010.
(continued)Amazon
Req. 4
Refer to Note 6—Commitmentsand Contingencies.
The footnotesdisclosecommitmentsof $3,799 million. Someof these commitmentswill
already be reported as liabilities, such as obligations for debt principal and interest,
capital leases, and financing leases. However, the commitments for operating leases
wouldnot be reportedin liabilities.
The footnotes also include a discussion of various legal proceedings against Amazon.
These legal proceedings are of the nature of “disclosed” loss contingencies, as
discussed in the chapter, therefore, are not included in the financial statements. The
criteria for disclosure of these contingent liabilities is that it is reasonablypossible that
the companywill have an obligationfromthe lawsuit companyin the future.
Req. 5
Ratio 2010 2009Debt ratio $10,372+ $1,561= 63.5%
$18,797
$7,364+ $1,192= 61.9%
$13,813
Timesinterest
earned
$1,406
$39 = 36.1 times
$1,129
$34 = 33.2 times
Current ratio $13,747 $9,797
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$10,372 = 1.33 $7,364 = 1.33
(continued)Amazon
Amazon.com,Inc.’s leverageincreasedslightly during 2010, as reflectedin the increase
of its debt to total asset ratios from2009 to 2010. Becauseof strongearnings, the times
interest earned (operating income/interest expense) ratios improved. The current ratio
has remainedrelatively stable.
Cash provided by operating activities on the Consolidated Statements of Cash Flows
increasedfrom$3,293 million in 2009 to $3,495 in 2010. On this basis, Amazon.com,Inc.
appears to be experiencinggrowth. They appear to be positionedwell for more growth,
profitability and improvedliquidity and leveragepositionsin the future.
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Focuson Financials: RadioShack,Corp.
(20 min.)
Req. 1
• Current Maturities of Long-TermDebt—theamountof principal that is payable
within one year.
• AccountsPayable—theamountowedfor productsor servicespurchasedon
account.
• AccruedExpenses—theamountof expensesincurredbut not yet paid.
• IncomeTaxesPayable—theamountof incometax incurredbut not yet paid.
Req. 2
• Payroll and Bonuses– an accrual for wagesfor pay earnedby employeesbut not
yet paid to employees.
• Insurance– an accrual for insuranceexpenseincurredbut not yet paid.
• Sales and Payroll Taxes– liability for amountowedto the governmentfor sales
and payroll taxes.
• Rent – an accrual for rent expenseincurredbut not yet paid.
• Advertising– an accrual for advertisingexpenseincurredbut not yet paid.
• Gift Card DeferredRevenue– liability for the amountof goodsand servicesowed
to customerswho have gift card balances.
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• Other – all other liabilities that will be paid with current assets that do not meet
the definitionsof the categoriesabove.
(continued)RadioShackCorp.
Req. 3
AP
Turnover
COGS
Avg. Accts.Pay.
$2,462.1
($272.4+$262.9)/2 9.20
Days in AP 365
AP Turnover
365
9.20
39.7
Current
Ratio
Current assets
Current liabilities
$1,778.7
$908.1
1.96
Quick Ratio Cash+ ST Inv. + Rec.
Current Liabilities
$569.4+$377.5+$108.1
$908.1
1.16
Days in AR 365
(Sales/Avg.AR)
365
($4,472.7/ $350)
28.6
Average
AR
Beg. AR+ End. AR
2
($377.5+$322.5)
2
$350
Inv.
Turnover
COGS
Avg. Inventory
$2,462.1
(($723.7+$670.6)/2)
3.53
Days in Inv. 365
InventoryTurnover
365
3.53
103
• The companyis currently able to pay its accounts within an average of about 40
days whichis slightly longer than optimal.
• The companyhas a strongCurrent Ratio close to 2 and a Quick Ratio still greater
than 1 meaning that it has the current assets necessary to pay for its current
liabilities.
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• The inventoryturnoverratio is quite disturbingin that RadioShackis only turning
over its inventory every 103 days on average. This meansthat RadioShackmust
wait at least 103 days after purchasinginventoryto sell it.
(continued)RadioShackCorp.
• It takes RadioShackalmost92 days (103 +28.6 – 39.7) to turn inventorypurchases
back into cash via sales and collections. A comparisonto previousyears would
indicateif this is trendingfavorableor unfavorable.
Overall, it wouldappearthat RadioShack,Corp. has the ability to pay its liabilities.
Req. 4
Five-year 2.5%unsecuredconvertiblenotes ($375 million)
Ten-year 7.375%unsecurednotes ($307 million)
The related interest is recordedin interest expenseon the IncomeStatement. The ten-
year notes are classified as current because they are due in 2011. The remaining five-
year notes are due in 2013.
Req. 5
Refer to Note 13—Commitments and Contingencies. RadioShack leases most of its
facilities and disclosesthese commitmentsin Note 13. The leases are operating leases
and thereforeno liability is reportedon the balancesheet.
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In this same note, RadioShack disclosed facts about litigation. Since RadioShack
considers the outcome of this lawsuit to be uncertain, the contingent liability is
disclosedin the notes to the financial statementsrather than accrued.
GroupProjects
Studentresponseswill vary.