Chap 0133

Chapter 14
Long-Term Liabilities
QUESTIONS
1. A bond is a liability of the issuing company. A share of stock represents an ownership

interest in the company.
2. Notes payable generally involve borrowing from a single creditor, whereas bonds
payable are usually sold to many different lenders (bondholders).
3. Bonds can allow a companys owners to increase their return on equity without investing
additional amounts. This result occurs as long as the rate of return on the assets
acquired from the borrowed cash is greater than the interest rate paid on the bonds.
Bonds also help the current owners remain in control of the company. There is also a tax
advantage with bonds when issued by corporations.
4. A trustee for bondholders has the responsibility of monitoring the issuers actions,
financial performance, and financial condition to ensure that the obligations in the bond
indenture are met.
5. A bond indenture is a legal contract between the issuing company and the bondholders
that identifies the obligations and rights of both parties. It specifies such items as the
par value of the bonds, the contract interest rate, the due dates for interest payments,
and the maturity date(s) of the bonds. It also may name a trustee, describe the bond
issue in detail, and provide for a sinking fund.
6. The contract rate (also known as the coupon rate, stated rate, or nominal rate) is the rate
that is identified in the bond indenture. It is applied to the par value to determine the size
of the cash interest payments. The market rate is the consensus rate that a company is
willing to pay and that investors are willing to accept for a specific bond.
7. In general, the supply of and demand for bonds affect market rates. The market rate for
a particular bond issue is also affected by risks unique to the issuer (e.g., financial
performance and condition) and the length of time until the bonds mature.
8.B The effective interest method creates a constant rate of interest over a bonds life
because the market rate at the time of issuance is multiplied by the beginning balance
for each period. The straight-line method produces either an increasing or decreasing
rate because it allocates the same amount of expense to each period, even if the liability
balance is growing (a discount) or decreasing (a premium).
9.C When issuing bonds between interest dates, a company collects accrued interest from
the purchasers to avoid keeping detailed records of bond purchasers and the dates
when bonds are purchased. If the company did not collect accrued interest, individual
checks would be needed to pay the correct amount of interest to each purchaser. By
collecting in advance, the issuer merely distributes the same amount per check to all
bondholders, regardless of when they purchased the bonds.
McGraw-Hill Companies, Inc., 2007

Solutions Manual, Chapter 14 53
10. The price of bonds can be computed by finding the present value of both the par value at
maturity and the periodic cash interest payments discounted at the market rate of
interest.
11. The issue price of a $2,000 bond sold at 98 is 98.25% of $2,000, or $1,965. The issue
price of a $6,000 bond priced at 101 is 101.5% of $6,000, or $6,090.
12. The debt-to-equity ratio is calculated by dividing total liabilities by total equity. The
higher a companys debt-to-equity ratio, the higher proportion of a companys assets
that are provided by creditors. If a company has a high debt-to-equity ratio, the company
may be at risk during poor economic times, because it must still pay off creditors even
though it may not be earning as much as it did in the past.
13. An entrepreneur (owner) must repay the bondholders the principal (par value) according
to the term of the bonds. He or she must also pay interest on the bonds per the amount
and frequency cited in the bond indenture, and must adhere to any stipulations
(covenants) specified in the bond contract.
14. Best Buy shows long-term both Long-term Liabilities and Long-Term Debt on its
balance sheet. To determine whether the long term debt is comprised of bonds or other
obligations we must read footnote 4 disclosing details of the Long-Term Debt of the
company. The footnote reports that its long-term debt is comprised of Convertible
debentures (bonds), Lease Obligations, and Mortgages.
15. Per Circuit Citys February 28, 2005, statement of cash flows (financing section), the
company repaid $28,008,000 for the fiscal year ended February 28, 2005.
16. The financing section of the statement of cash flows of Apple indicates that for the year
ended September 25, 2004, the company issued common stock totaling $427,000,000.
For that same period, the company repaid debt in the amount of $300,000,000.
17.D If a lease qualifies to be recorded as a capital lease, an asset account for the leased
asset will be debited with an amount equal to the present value of the future lease
payments. The corresponding credit will be to a lease liability account.
18.D An operating lease is a short-term or cancelable lease in which the lessor retains the
risks and rewards of ownership. The lessee expenses operating lease payments when
incurred and the lessee does not report the leased item(s) as an asset nor as a liability.
A capital lease is a long-term or noncancelable lease in which the lessor transfers
substantially all the risks and rewards of ownership to the lessee. The lessee records
the leased item as its own asset along with a lease liability at the start of the lease term
the amount recorded equals the present value of all lease payments.
19.D Pension plans can be designed as defined benefit plans or defined contribution plans. In
a defined benefit plan the employer estimates the contribution necessary to pay a pre-
defined benefit amount to its retirees. For example, an employees monthly pension
benefit may be set at $1,000 per month. The employer must contribute the amount
necessary to the pension plan to fund the $1,000 a month to the employee when the
employee retires. Alternatively, with a defined contribution plan, the pension
contribution is defined and the employer or employee contributes the amount specified
in the pension agreement. For example, a defined contribution plan might specify that
the employer will contribute 2% of an employees annual salary to the pension plan every
year.

54 International Edition: Fundamental Accounting Principles, 18 th Edition
QUICK STUDIES
Quick Study 14-1 (10 minutes)
1. B Debenture 5. G Sinking fund bond

2. D Bond Indenture 6. E Convertible bond
3. F Bearer bond 7. H Secured bond
4. A Registered bond 8. C Serial bond
1. Bonds cash proceeds: $350,000 x 0.875 = $306,250
2. Twenty semiannual interest payments of $14,000...... $280,000

Plus bond discount ($350,000 - $306,250)................... 43,750
Total bond interest expense.......................................... $323,750
3. Bond interest expense on first payment date:

$323,750 / 20 semiannual periods = $16,188
Quick Study 14-3B (10 minutes)
1. Bonds cash proceeds: $120,000 x 1.1725 = $140,700
2. Thirty semiannual interest payments of $6,000.......... $180,000

Less premium ($140,700 - $120,000)............................ (20,700)
Total bond interest expense.......................................... $159,300
3. Bond interest expense on first payment date:

$140,700 x 4% = $5,628

2005
Jan. 1 Cash.................................................................................
306,250
Discount on Bonds Payable.......................................... 43,750
Bonds Payable.......................................................... 350,000
To record issuing bonds at a discount.
Jan. 1 Cash.................................................................................
140,700
Bonds Payable.......................................................... 120,000
Premium on Bonds Payable.................................... 20,700
To record issuing bonds at a premium.
a. Using facts in QS 14-2, the bonds cash proceeds for the bond selling at
a discount are computed as follows
Cash Flow Table Value Present Value

$350,000 par (maturity) value................ 0.3769 $131,915
$14,000 interest payment....................... 12.4622 174,471
Price of Bond....................................... $306,386*
*
Agrees with $306,250 as given in QS 14-2, except for rounding difference.
(Instructor note: The price in QS 14-2 is rounded to 87.5 from 87.5388, yielding the $136 difference).
b. Using facts in QS 14-3, the bonds cash proceeds for the bond selling at
a premium are computed as
Cash Flow Table Value Present Value

$120,000 par (maturity) value................ 0.3083 $ 36,996
$ 6,000 interest payment...................... 17.2920 103,752
Price of Bond....................................... $140,748*
*
Agrees with $140,700 as given in QS 14-3, except for rounding difference.
2005
Mar. 1 Cash................................................................................
202,667
Interest payable*....................................................... 2,667
Bonds payable.......................................................... 200,000
Sold $200,000 of bonds with two months
accrued interest. *($200,000 x .08 x 2/12)

2005
July 1 Bonds Payable................................................................
200,000
Premium on Bonds Payable.......................................... 8,000
Gain on Retirement of Bonds*................................ 3,000
Cash........................................................................... 205,000
To record retirement of bonds before maturity.
*$3,000 = $208,000 - $205,000
2005
Jan. 1 Bonds Payable.................................................................
1,000,000
Common Stock*......................................................... 250,000
Contributed Capital in Excess of Par Value................ 750,000
To record retirement of bonds by stock
conversion. *500,000 shares x $0.50
Initial cash proceeds from note

Amount of annual payment = Table B.3 present value for 5 payments
a. 4%: Payment = $170,000 / 4.4518 = $38,187

b. 8%: Payment = $170,000 / 3.9927 = $42,578
c. 12%: Payment = $170,000 / 3.6048 = $47,159
Collins Industries is restricted in several ways by the creditor bank. They are
restricted from incurring certain types of additional indebtedness, from
making certain investments, from selling a substantial portion of their assets,
from making certain capital expenditures, and from granting substantial cash
dividends. In addition, the company must maintain the agreed upon level of
certain financial ratios and other measures of financial condition.

Ratio of pledged assets to secured liabilities
Xiang Co. Xu Co.

Pledged assets....................... $387,000 $172,000
Secured liabilities................... $163,000 $158,000
Ratio........................................ 2.37 to 1 1.09 to 1
Analysis and interpretation: Xus secured liabilities appear more risky as it

only has $1.09 in pledged assets for each $1 in secured liabilities. In
comparison, each $1 of Xiangs secured liabilities is covered by $2.37 in
pledged assets.
Quick Study 14-12C (10 minutes)
Rental Expense...............................................................350
Cash (or Payable)..................................................... 350
To record rental expense for car lease.
Quick Study 14-13C (10 minutes)
Leased AssetOffice Equipment................................. 20,859

Lease Liability........................................................... 20,859
To record capital lease of office equipment.

EXERCISES
Exercise 14-1 (15 minutes)
1. Semiannual cash interest payment = $1,700,000 x 9% x 1/2 = $76,500
2. Journal entries
2005
(a)
Jan. 1 Cash.................................................................................
1,700,000
Bonds Payable.......................................................... 1,700,000
Sold bonds at par.
(b)
June 30 Bond Interest Expense.................................................. 76,500
Cash........................................................................... 76,500
Paid semiannual interest on bonds.
(c)
Dec. 31 Bond Interest Expense.................................................. 76,500
Cash........................................................................... 76,500
Paid semiannual interest on bonds.
3.
2005
(a)
Jan. 1 Cash* 1,666,000
Discount on Bonds Payable..........................................
34,000
Bonds Payable.......................................................... 1,700,000
Sold bonds at 98. *($1,700,000 x 0.98)
(b)
Jan. 1 Cash* 1,734,000
Bonds Payable.......................................................... 1,700,000
Sold bonds at 102. *($1,700,000 x 1.02)

1. Discount = Par value - Issue price = $90,000 - $85,431 = $4,569
2. Total bond interest expense over the life of the bonds

Amount repaid
Six payments of $3,600................. $ 21,600
Par value at maturity..................... 90,000
Total repaid.................................... 111,600
Less amount borrowed.................... (85,431)
Total bond interest expense............ $ 26,169
or:
Six payments of $3,600.................... $ 21,600
Plus discount.................................... 4,569
3. Straight-line amortization table
Semiannual Unamortized Carrying

Period-End Discount Value
(0) 1/01/2005.........................$4,569 $85,431
(1) 6/30/2005......................... 3,807 86,193
(2) 12/31/2005......................... 3,045 86,955
(3) 6/30/2006......................... 2,283 87,717
(4) 12/31/2006......................... 1,521 88,479
(5) 6/30/2007......................... 759* 89,241
(6) 12/31/2007......................... 0 90,000
*Adjusted for rounding

Exercise 14-3B (30 minutes)
1. Discount = Par value - Issue price = $250,000 - $231,570 = $18,430

Amount repaid
Six payments of $11,250............... $ 67,500
Total repaid.................................... 317,500
or
Six payments of $11,250.................. $ 67,500
Plus discount.................................... 18,430
3. Effective interest amortization table
(A) (B) (C) (D) (E)

Semiannual Cash Interest Bond Interest Discount Unamortized Carrying
Interest Paid Expense Amortization Discount Value
Period-End [4.5% x $250,000] [6% x Prior (E)] [(B) - (A)] [Prior (D) - (C)] [$250,000 - (D)]
1/01/2005 $18,430 $231,570
6/30/2005 $11,250 $13,894 $ 2,644 15,786 234,214
12/31/2005 11,250 14,053 2,803 12,983 237,017
6/30/2006 11,250 14,221 2,971 10,012 239,988
12/31/2006 11,250 14,399 3,149 6,863 243,137
6/30/2007 11,250 14,588 3,338 3,525 246,475
12/31/2007 11,250 14,775 * 3,525 0 250,000
$67,500 $85,930 $18,430

*Adjusted for rounding.

1. Premium = Issue price - Par value = $819,700 - $800,000 = $19,700
Amount repaid
Six payments of $52,000............... $ 312,000
Total repaid.................................... 1,112,000
or
Six payments of $52,000.................. $ 312,000
Less premium................................... (19,700)
3. Straight-line amortization table: ($19,700/6 = $3,283)

Interest Period-End Premium Value
1/01/2005 $19,700 $819,700
6/30/2005 16,417 816,417
12/31/2005 13,134 813,134
6/30/2006 9,851 809,851
12/31/2006 6,568 806,568
6/30/2007 3,285 803,285
12/31/2007 0 800,000

Exercise 14-5B (30 minutes)
1. Premium = Issue price - Par value = $819,700 - $800,000 = $19,700
Amount repaid
Six payments of $52,000............... $ 312,000
Total repaid.................................... 1,112,000
or
Six payments of $52,000.................. $ 312,000
Less premium................................... (19,700)
3. Effective interest amortization table
(A) (B) (C) (D) (E)

Semiannual Cash Interest Bond Interest Premium Unamortized Carrying
Interest Paid Expense Amortization Premium Value
Period-End [6.5% x $800,000] [6% x Prior (E)] [(A) - (B)] [Prior (D) - (C)] [800,000 + (D)]
1/01/2005 $19,700 $819,700
6/30/2005 $ 52,000 $ 49,182 $ 2,818 16,882 816,882
12/31/2005 52,000 49,013 2,987 13,895 813,895
6/30/2006 52,000 48,834 3,166 10,729 810,729
12/31/2006 52,000 48,644 3,356 7,373 807,373
6/30/2007 52,000 48,442 3,558 3,815 803,815
12/31/2007 52,000 48,185* 3,815 0 800,000
$312,000 $292,300 $ 19,700


1. Semiannual cash interest payment = $600,000 x 6% x year = $18,000
2. Number of payments = 10 years x 2 per year = 20 semiannual payments
3. The 6% contract rate is less than the 8% market rate; therefore, the
bonds are issued at a discount.
4. Estimation of the market price at the issue date
Cash Flow Table Table Value* Amount Present Value

Par (maturity) value........B.1 0.4564 $600,000 $273,840
Interest (annuity).............B.3 13.5903 18,000 244,625
Price of bonds................. $518,465
* Table values are based on a discount rate of 4% (half the annual market rate) and
20 periods (semiannual payments).
5. Cash.................................................................................
518,465
Bonds Payable.......................................................... 600,000
Sold bonds at a discount on the stated issue date.
1. Semiannual cash interest payment = $75,000 x 10% x year = $3,750
2. Number of payments = 5 years x 2 per year = 10 semiannual payments
3. The 10% contract rate is greater than the 8% market rate; therefore, the
bonds are issued at a premium.
4. Estimation of the market price at the issue date

Par (maturity) value........B.1 0.6756 $75,000 $50,670
Interest (annuity).............B.3 8.1109 3,750 30,416
Price of bonds................. $81,086
5. Cash.................................................................................
81,086

Bonds Payable.......................................................... 75,000
Sold bonds at a premium on the stated issue date.

1. Cash proceeds from sale of bonds at issuance

$350,000 x 97.75% = $342,125
2. Discount at issuance
Par value................................................ $350,000
Cash issue price (from part 1)............. (342,125)
Discount at issuance............................ $ 7,875
3. Total amortization for first 6 years

The first six years (from 1/1/04 to 12/31/09) equals 40% of the bonds 15-
year life. Therefore, the total amortization equals 40% of the total
discount (since straight-line amortization is being used), which is
$7,875 x 40%, or $3,150.
4. Carrying value of the bonds at 12/31/2009

Discount at issuance (from part 2)...... $ 7,875
Less amortization (from part 3)........... (3,150)
Remaining discount.............................. $ 4,725
Entire Group Retired 20%

Par value................................................. $350,000 $70,000
Remaining discount............................... (4,725) (945)
Carrying value........................................ $345,275 $69,055
5. Cash purchase price

($350,000 x 20%) x 104.5% = $73,150
6. Loss on retirement
Cash paid (from part 5)....................... $ 73,150
Carrying value (from part 4)................ (69,055)
Loss on retirement.............................. $ 4,095
7. Journal entry at retirement for 20% of bonds

2010
Jan. 1 Bonds Payable................................................................
70,000
Loss on Retirement of Bonds Payable........................ 4,095
Discount on Bonds Payable.................................... 945
Cash........................................................................... 73,150
To record the retirement of bonds.

1. Semiannual cash interest payment = $1,700,000 x 9% x year = $76,500

Amount accrued for four months = $76,500 x 4/6 = $51,000
2. Journal entries
2005
May 1 Cash.................................................................................
1,751,000
Interest Payable........................................................ 51,000
Bonds Payable.......................................................... 1,700,000
Sold bonds with 4 months accrued interest.
June 30 Interest Payable..............................................................

51,000
Bond Interest Expense.................................................. 25,500
Cash........................................................................... 76,500
Paid semiannual interest on the bonds.

Cash........................................................................... 76,500
Paid semiannual interest on the bonds.

1. Straight-line amortization table

6/01/2004..................... $2,026 $47,974
11/30/2004..................... 1,773 48,227
5/31/2005..................... 1,520 48,480
11/30/2005..................... 1,267 48,733
5/31/2006..................... 1,014 48,986
11/30/2006..................... 761 49,239
5/31/2007..................... 508 49,492
*
11/30/2007..................... 255 49,745
5/31/2008..................... 0 50,000
*
Rounding difference.

Supporting computations
Eight payments of $1,750........................ $ 14,000
Par value at maturity................................ 50,000
Total repaid............................................... 64,000
Less amount borrowed........................... (47,974)
Total bond interest expense.................... $ 16,026
or
Eight payments of $1,750........................ $ 14,000
Plus discount........................................... 2,026
Total bond interest expense.................... $ 16,026
Semiannual straight-line interest expense = $16,026 / 8 = $2,003 (rounded)

Semiannual bond discount amortization = $2,026 / 8 = $253 (rounded)

Exercise 14-10 (Concluded)
2.
2004
Nov. 30 Bond Interest Expense.................................................. 2,003
Cash........................................................................... 1,750
To record 6 months interest and discount amortization.
Dec. 31 Bond Interest Expense.................................................. 334

Interest Payable........................................................ 292
To record one month's accrued interest
($2,003 x 1/6) and amortization ($253 x 1/6).
2005
May 31 Interest Payable.............................................................. 292
Bond Interest Expense.................................................. 1,669
Cash........................................................................... 1,750
To record five months interest ($2,003 - $334)
and amortization ($253 - $42) and eliminate
the accrued interest liability.
1. Amount of principal in each payment = $25,000 / 4 years = $6,250
2. Amortization table for the loan
Payments
(A) (B) (C) (D) (E)
Debit Debit Credit
Period Beginning Interest Notes Ending
Ending Balance Expense + Payable = Cash Balance
Date [Prior (E)] [7% x (A)] [$25,000/4] [(B) + (C)] [(A) - (C)]
2005....... $25,000 $1,750 $ 6,250 $ 8,000 $18,750
2006....... 18,750 1,313 6,250 7,563 12,500
2007....... 12,500 875 6,250 7,125 6,250
2008....... 6,250 438 6,250 6,688 0

$4,376 $25,000 $29,376

2005
Jan. 1 Cash.................................................................................
25,000
Notes Payable........................................................... 25,000
Borrowed $25,000 by signing a 7%
installment note.
2005
Dec. 31 Interest Expense............................................................. 1,750
Notes Payable................................................................. 6,250
Cash........................................................................... 8,000
To record first installment payment.
2006
Notes Payable................................................................. 6,250
Cash........................................................................... 7,563
To record second installment payment.
2007
Dec. 31 Interest Expense............................................................. 875
Notes Payable................................................................. 6,250
Cash........................................................................... 7,125
To record third installment payment.
2008
Dec. 31 Interest Expense............................................................. 438
Notes Payable................................................................. 6,250
Cash........................................................................... 6,688
To record fourth installment payment.

1. Amount of each payment = Initial note balance / Table B.3 value

= $25,000 / 3.3872 = $7,381
2. Amortization table for the loan
Payments
(A) (B) (C) (D) (E)
Debit Debit Credit
Date [Prior (E)] [7% x (A)] [(D) - (B)] [computed] [(A) - (C)]
2005....... $25,000 $1,750 $ 5,631 $ 7,381 $19,369
2006....... 19,369 1,356 6,025 7,381 13,344
2007....... 13,344 934 6,447 7,381 6,897
2008....... 6,897 484* 6,897 7,381 0
$4,524 $25,000 $29,524

2005
Jan. 1 Cash.................................................................................
25,000
Notes Payable........................................................... 25,000
Borrowed $25,000 by signing a 7%
installment note.
2005
Notes Payable................................................................. 5,631
Cash........................................................................... 7,381
To record first installment payment.
2006
Notes Payable................................................................. 6,025
Cash........................................................................... 7,381
To record second installment payment.
2007
Dec. 31 Interest Expense.............................................................934
Notes Payable................................................................. 6,447
Cash........................................................................... 7,381
To record third installment payment.
2008
Dec. 31 Interest Expense.............................................................484
Notes Payable................................................................. 6,897
Cash........................................................................... 7,381
To record fourth installment payment.
The ratio of pledged assets to secured liabilities describes the pool of assets
that are committed to being available for paying the secured creditors if the
borrower should experience financial distress and be unable to make payment
on the secured liabilities. The increasing value of the ratio could arise from at
least two sets of activities.
First, the borrower could be significantly decreasing the amount of debt that is
secured by assets, but still keeping the assets pledged as collateral. These
activities would cause the ratios numerator to stay constant while the
denominator decreases.

Exercise 14-15 (concluded)
Second, the borrower might be keeping the amount of debt constant while
greatly increasing the amount of assets that have been pledged as security. A
higher ratio value would result from a larger numerator, while the denominator
stayed constant.
In either case, the increasing ratio could be alarming to the unsecured creditor
because it might reflect a growing concern by the secured creditors that the
values of the borrowers assets are not sufficient for paying the secured
debts. If so, the unsecured creditors are more vulnerable to losing their
balances if the company should be forced into bankruptcy. Of course, the
change could arise from a combination of both activities. In accordance with
a basic concept of financial analysis, the change in a ratio does not fully
explain what happened, but does point out areas where potential problems
might exist and where we might search for more complete answers.
Exercise 14-16C (10 minutes)
1. Operating 2. Capital 3. Capital
1. Leased AssetOffice Equipment................................. 82,000

Lease Liability........................................................... 82,000
2. Depreciation ExpenseOffice Equipment..................

16,400
Accum. DepreciationOffice Equipment.............. 16,400
To record depreciation ($82,000 / 5 years).
[Note: 12% / 12 months = 1% per month as the relevant interest rate.]
Option 1: $1,750 per month for 25 months = $1,750 x 22.0232 = $38,541
Option 2: $1,500 per month for 25 months + $5,000 =

($1,500 x 22.0232) + $5,000 = $38,035
Option 3: = $38,500

Analysis: Option 2 has the lowest present value at $38,035 and, thus, is the
best lease deal.

PROBLEM SET A
Problem 14-1A (50 minutes)
Part 1
a.
Par value...................... B.1 0.4564 $20,000 $ 9,128
Interest (annuity)......... B.3 13.5903 1,000 13,590
Price of bonds............. $22,718
Bond premium............. $ 2,718
* Table values are based on a discount rate of 4% (half the annual market rate)
and 20 periods (semiannual payments).
b.
2005
Jan. 1 Cash.................................................................................
22,718
Bonds Payable.......................................................... 20,000
Sold bonds on stated issue date.
Part 2
a.
Par value...................... B.1 0.3769 $20,000 $ 7,538
Price of bonds............. $20,000
20 periods (semiannual payments). (Note: When the contract rate and market rate
are the same, the bonds sell at par and there is no discount or premium.)
b.
2005
Jan. 1 Cash.................................................................................
20,000
Bonds Payable.......................................................... 20,000

Problem 14-1A (Concluded)
Part 3
a.
Par value..................... B.1 0.3118 $20,000 $ 6,236
Interest (annuity)........ B.3 11.4699 1,000 11,470
Price of bonds............ $17,706
Bond discount............ $ 2,294
b.
2005
Jan. 1 Cash.................................................................................
17,706
Bonds Payable.......................................................... 20,000

Part 1
2004
Jan. 1 Cash.................................................................................
1,728,224
Bonds Payable.......................................................... 2,000,000
Part 2
[Note: The semiannual amounts for (a), (b), and (c) below are the same throughout the bonds
life because this company uses straight-line amortization.]
(a) Cash Payment = $2,000,000 x 6% x 6/12 year = $60,000
(b) Discount = $2,000,000 - $1,728,224 = $271,776
Straight-line discount amortization= $271,776 / 30 semiannual periods

= $9,059*
*rounded
(c) Bond interest expense = $60,000 + $9,059 = $69,059
Part 3
Thirty payments of $60,000 ............ $1,800,000

Par value at maturity........................ 2,000,000
Total repaid....................................... 3,800,000
Less amount borrowed.................... (1,728,224)
Total bond interest expense............ $2,071,776
or:
Thirty payments of $60,000.................. $1,800,000
Plus discount......................................... 271,776
Total bond interest expense................. $2,071,776
Part 4

1/01/2004..................... $271,776 $1,728,224
6/30/2004..................... 262,717 1,737,283
12/31/2004..................... 253,658 1,746,342

6/30/2005..................... 244,599 1,755,401
12/31/2005..................... 235,540 1,764,460

Problem 14-2A (Continued)
Part 5
2004
Discount on Bonds Payable.................................... 9,059
Cash........................................................................... 60,000
To record six months interest and
discount amortization.
2004
Cash........................................................................... 60,000
Part 6
[Note: Parts 1 through 5 are repeated assuming a bond premium.]
Requirement 1
2004
Jan. 1 Cash.................................................................................
2,447,990
Bonds Payable.......................................................... 2,000,000
Sold bonds on issue date at a premium.
Requirement 2
(a) Cash Payment = $2,000,000 x 6% x 6/12 = $60,000
(b) Premium = $2,447,990 - $2,000,000 = $447,990
Straight-line premium amortization = $447,990 / 30 semiannual periods

= $14,933
(c) Bond interest expense = $60,000 - $14,933 = $45,067
Requirement 3
Thirty payments of $60,000 ............ $1,800,000

Total repaid....................................... 3,800,000
or:
Thirty payments of $60,000.................. $1,800,000

Less premium........................................ (447,990)
Total bond interest expense................. $1,352,010

Requirement 4

Period-End Premium Value
1/01/2004..................... $447,990 $2,447,990
6/30/2004..................... 433,057 2,433,057
12/31/2004..................... 418,124 2,418,124
6/30/2005..................... 403,191 2,403,191
12/31/2005..................... 388,258 2,388,258
Requirement 5
2004
June 30 Bond Interest Expense..................................................
45,067
Cash........................................................................... 60,000
premium amortization.
2004
Dec. 31 Bond Interest Expense..................................................
45,067
Cash........................................................................... 60,000

Part 1
Ten payments of $16,250 ................ $ 162,500
Par value at maturity........................ 500,000
Total repaid....................................... 662,500
Total bond interest expense............ $151,834
or:
Ten payments of $16,250................. $162,500
Less premium................................... (10,666)
Part 2
Straight-line amortization table ($10,666/10 = $1,067*)
1/01/2004 $10,666 $510,666
6/30/2004 9,599 509,599
12/31/2004 8,532 508,532
6/30/2005 7,465 507,465
12/31/2005 6,398 506,398
6/30/2006 5,331 505,331
12/31/2006 4,264 504,264
6/30/2007 3,197 503,197
12/31/2007 2,130 502,130
6/30/2008 1,063** 501,063
12/31/2008 0 500,000
* Rounded to nearest dollar. ** Adjusted for rounding.

Part 3
2004
15,183
Cash........................................................................... 16,250
2004
15,183
Cash........................................................................... 16,250

Problem 14-4AB (45 minutes)
Part 1
Ten payments of $16,250 ................ $ 162,500
Total repaid....................................... 662,500
or:
Ten payments of $16,250................. $ 162,500
Less premium................................... (10,666)
Part 2
(A) (B) (C) (D) (E)
Period-End [3.25% x $500,000] [3% x Prior (E)] [(A) - (B)] [Prior (D) - (C)] [$500,000 + (D)]
1/01/2004 $10,666 $510,666
6/30/2004 $ 16,250 $ 15,320 $ 930 9,736 509,736
12/31/2004 16,250 15,292 95 8,778 508,778

8
6/30/2005 16,250 15,263 98 7,791 507,791

7
12/31/2005 16,250 15,234 1,016 6,775 506,775
6/30/2006 16,250 15,203 1,047 5,728 505,728
12/31/2006 16,250 15,172 1,078 4,650 504,650
6/30/2007 16,250 15,140 1,110 3,540 503,540
12/31/2007 16,250 15,106 1,144 2,396 502,396
6/30/2008 16,250 15,072 1,178 1,218 501,218
12/31/2008 16,250 15,032* 1,218 0 500,000
$162,500 $151,834 $10,666


Problem 14-4AB (Concluded)
Part 3
2004
15,320
Premium on Bonds Payable.......................................... 930
Cash........................................................................... 16,250
2004
15,292
Part 4
As of December 31, 2006
Par value...................... B.1 0.8885 $500,000 $444,250
Price of bonds............. $504,653
* Table values are based on a discount rate of 3% (half the annual original market
rate) and 4 periods (semiannual payments).
Comparison to Part 2 Table

Except for a small rounding difference, this present value ($504,653) equals
the carrying value of the bonds in column (E) of the amortization table
($504,650). This shows a general rule: The carrying value of bonds at any
point in time equals the present value of the remaining cash flows using
the market rate at the time of issuance.

Part 1
2004
Jan. 1 Cash.................................................................................
584,361
Bonds Payable.......................................................... 650,000
Part 2
Eight payments of $16,250* ................. $ 130,000
Par value at maturity............................. 650,000
Total repaid............................................ 780,000
Less amount borrowed........................ (584,361)
Total bond interest expense................ $ 195,639
or:
Eight payments of $16,250*.................. $ 130,000
Plus discount........................................ 65,639
*
Semiannual interest payment, computed as $650,000 x 5% x year.
Part 3 Straight-line amortization table ($65,639/8 =$8,205)

Interest Period-End Discount Value
1/01/2004 $65,639 $584,361
6/30/2004 57,434 592,566
12/31/2004 49,229 600,771
6/30/2005 41,024 608,976
12/31/2005 32,819 617,181

Part 4
2004
24,455
Cash........................................................................... 16,250
2004
24,455
Cash........................................................................... 16,250
Part 5
If the market interest rate on the issue date had been 4% instead of 8%, the
bonds would have sold at a premium because the contract rate of 5% would
have been greater than the market rate.
This change would affect the balance sheet because the bond liability would
be larger (par value plus a premium instead of par value minus a discount).
As the years passed, the bond liability would decrease with amortization of
the premium instead of increasing with amortization of the discount.
The income statement would show smaller amounts of bond interest expense
over the life of the bonds issued at a premium than it would show if the bonds
had been issued at a discount.
The statement of cash flows would show a larger amount of cash received
from borrowing. However, the cash flow statements presented over the life of
the bonds (after issuance) would report that the same amount of cash was
paid for interest. This cash amount is fixed as it is the product of the contract
rate and the par value of the bonds and is unaffected by the change in the
market rate.

Part 1
2004
Jan. 1 Cash.................................................................................
584,361
Bonds Payable.......................................................... 650,000
Part 2
Eight payments of $16,250* ................. $ 130,000
Par value at maturity............................. 650,000
Total repaid............................................ 780,000
Less amount borrowed........................ (584,361)
or:
Eight payments of $16,250*.................. $ 130,000
Plus discount........................................ 65,639
*
Part 3
(A) (B) (C) (D) (E)

Period-End [2.5% x $650,000] [4% x Prior (E)] [(B) - (A)] [Prior (D) - (C)] [$650,000 - (D)]
1/01/2004 $65,639 $584,361
6/30/2004 $16,250 $23,374 $7,124 58,515 591,485
12/31/2004 16,250 23,659 7,409 51,106 598,894
6/30/2005 16,250 23,956 7,706 43,400 606,600
12/31/2005 16,250 24,264 8,014 35,386 614,614

Part 4
2004
23,374
Cash........................................................................... 16,250
2004
23,659
Cash........................................................................... 16,250

Part 1
2004
Jan. 1 Cash.................................................................................
92,283
Bonds Payable.......................................................... 90,000
Part 2
Six payments of $4,950 ................... $ 29,700
Total repaid....................................... 119,700
or:
Six payments of $4,950.................... $ 29,700
Less premium................................... (2,283)
Part 3
(A) (B) (C) (D) (E)

1/01/2004 $2,283 $92,283
6/30/2004 $4,950 $4,614 $336 1,947 91,947
12/31/2004 4,950 4,597 353 1,594 91,594
6/30/2005 4,950 4,580 370 1,224 91,224
12/31/2005 4,950 4,561 389 835 90,835

Part 4
2004
Cash........................................................................... 4,950
2004
Cash........................................................................... 4,950
Part 5
2006
Jan. 1 Bonds Payable ...............................................................
90,000
Cash*......................................................................... 88,200
Gain on Retirement of Bonds.................................. 2,635
*($90,000 x 98%)
Part 6
If the market rate on the issue date had been 12% instead of 10%, the bonds
would have sold at a discount because the contract rate of 11% would have been
lower than the market rate.
This change would affect the balance sheet because the bond liability would be
smaller (par value minus a discount instead of par value plus a premium). As the
years passed, the bond liability would increase with amortization of the discount
instead of decreasing with amortization of the premium.
The income statement would show larger amounts of bond interest expense over
the life of the bonds issued at a discount than it would show if the bonds had
been issued at a premium.
The statement of cash flows would show a smaller amount of cash received from
borrowing. However, the cash flow statements presented over the life of the
bonds (after issuance) would report the same total amount of cash paid for
interest. This amount is fixed as it is the product of the contract rate and the par
value of the bonds and is unaffected by the change in the market rate.

Part 1 Amount of Payment
Note balance...................................................................
$400,000
Number of periods......................................................... 5
Interest rate.....................................................................
8%
Value from Table B.3......................................................
3.9927
Payment ($400,000 / 3.9927)..........................................
$100,183
Part 2
Payments
(A) (B) (C) (D) (E)
Debit Debit Credit
10/31/2005.............
$400,000 $ 32,000 $ 68,183 $100,183 $331,817
10/31/2006.............
331,817 26,545 73,638 100,183 258,179
10/31/2007.............
258,179 20,654 79,529 100,183 178,650
10/31/2008.............
178,650 14,292 85,891 100,183 92,759
10/31/2009.............
92,759 7,424* 92,759 100,183 0
$100,915 $400,000 $500,915
* Adjusted for rounding
Part 3
2004
Dec. 31 Interest Expense.............................................................
5,333
Accrued interest on the installment
note payable ($32,000 x 2/12).
2005
Oct. 31 Interest Expense............................................................. 26,667
Interest Payable.............................................................. 5,333
Notes Payable.................................................................68,183
Cash........................................................................... 100,183
Record first payment on installment note
(interest expense = $32,000 - $5,333).

Part 4
Payments
(A) (B) (C) (D) (E)
Debit Debit Notes Credit
Period Beginning Interest Payable Ending
Ending Balance Expense + [$400,000/5] = Cash Balance
Date [Prior (E)] [8% x (A)] [(B) + (C)] [(A) - (C)]
10/31/2005.............
$400,000 $32,000 $ 80,000 $112,000 $320,000
10/31/2006.............
320,000 25,600 80,000 105,600 240,000
10/31/2007.............
240,000 19,200 80,000 99,200 160,000
10/31/2008.............
160,000 12,800 80,000 92,800 80,000
10/31/2009.............80,000 6,400 80,000 86,400 0
$96,000 $400,000 $496,000
2004
5,333
2005
Oct. 31 Interest Expense............................................................. 26,667
Notes Payable.................................................................80,000
Cash........................................................................... 112,000

Part 1
Wildcat Company
Pledged assets [($900,000 x 43%) + $225,000]...........................$612,000
Secured liabilities ($210,000 + $135,000)....................................$345,000
Ratio ($612,000 / $345,000)...........................................................1.77 to 1
Athens Company
Pledged assets [($450,000 x 54%) + $150,000]...........................$393,000
Secured liabilities ($75,000 + $60,000)........................................$135,000
Ratio ($393,000 / $135,000)..........................................................2.91 to 1
Part 2
Athens's ratio of pledged assets to secured liabilities is higher than

Wildcat's, so the Athens bonds appear less risky. Before deciding to buy
Athens's bonds, however, it might be helpful to estimate the liquidation
value of both companies assets that are pledged as collateral. It also is
important to evaluate the ability of each company to meet its obligations
from operating cash flows.

Problem 14-10AC (35 minutes)
Part 1
Present Value of the Lease Payments
$20,000 x 3.9927 (from Table B.3) = $79,854
Part 2
Lease Liability........................................................... 79,854
Part 3
Capital Lease Liability Payment (Amortization) Schedule
Beginning Interest on Ending

Period Balance of Lease Reduction Cash Balance of
Ending Lease Liability of Lease Lease Lease
Date Liability (8%) Liability Payment Liability
Year 1 $79,854 $ 6,388* $13,612 $ 20,000 $66,242
Year 2 66,242 5,299 14,701 20,000 51,541
Year 3 51,541 4,123 15,877 20,000 35,664
Year 4 35,664 2,853 17,147 20,000 18,517
Year 5 18,517 1,483** 18,517 20,000 0
$20,146 $79,854 $100,000
* Rounded to nearest dollar.

** Difference due to rounding.
Part 4
Depreciation ExpenseOffice Equipment..................
15,971

PROBLEM SET B
Problem 14-1B (50 minutes)
Part 1
a.
Par value................. B.1 0.6139 $45,000 $27,626
Interest (annuity).... B.3 7.7217 2,700 20,849
Price of bonds........ $48,475
Bond Premium........ $ 3,475
b.
2005
Jan. 1 Cash.................................................................................
48,475
Bonds Payable.......................................................... 45,000
Part 2
a.
Par value................. B.1 0.5584 $45,000 $25,128
Price of bonds........ $45,000**
10 periods (semiannual payments). (Note: When the contract rate and market
rate are the same, the bonds sell at par and there is no discount or premium.)
**Adjusted for rounding.
b.
2005
Jan. 1 Cash.................................................................................
45,000
Bonds Payable.......................................................... 45,000

Problem 14-1B (Concluded)
Part 3
a.
Par value................. B.1 0.5083 $45,000 $22,874
Price of bonds........ $41,838
Bond discount........ $ 3,162
b.
2005
Jan. 1 Cash.................................................................................
41,838
Bonds Payable.......................................................... 45,000

Part 1
2004
Jan. 1 Cash.................................................................................
1,505,001
Bonds Payable.......................................................... 1,700,000
Part 2
[Note: The semiannual amounts for (a), (b), and (c) below are the same throughout
the bonds life because the company uses straight-line amortization.]

(b) Discount = $1,700,000 - $1,505,001 = $194,999
Straight-line discount amortization= $194,999 / 20 semiannual periods
= $9,750
(c) Bond interest expense = $85,000 + $9,750 = $94,750

Problem 14-2B (Continued)
Part 3
Twenty payments of $85,000........... $1,700,000
Total repaid....................................... 3,400,000
or:
Twenty payments of $85,000 .......... $1,700,000
Plus discount.................................... 194,999
Part 4
1/01/2004..................... $194,999 $1,505,001
6/30/2004..................... 185,249 1,514,751
12/31/2004..................... 175,499 1,524,501
6/30/2005..................... 165,749 1,534,251
12/31/2005..................... 155,999 1,544,001
Part 5
2004
June 30 Bond Interest Expense..................................................94,750
Cash........................................................................... 85,000
2004
Dec. 31 Bond Interest Expense..................................................94,750
Cash........................................................................... 85,000

Problem 14-2B (Continued)
Part 6. [Requirements 1 through 5 are repeated assuming a bond premium.]
Requirement 1
2004
Jan. 1 Cash.................................................................................
2,096,466
Bonds Payable.......................................................... 1,700,000
Sold bonds on issue date at a premium.
Requirement 2

(b) Premium = $2,096,466 - $1,700,000 = $396,466
Straight-line premium amortization= $396,466/20 semiannual periods
= $19,823*
*rounded
(c) Bond interest expense = $85,000 - $19,823 = $65,177
Requirement 3

Total repaid....................................... 3,400,000
or:
Less premium................................... (396,466)

Requirement 4

Period-End Premium Value
1/01/2004..................... $396,466 $2,096,466
6/30/2004..................... 376,643 2,076,643
12/31/2004..................... 356,820 2,056,820
6/30/2005..................... 336,997 2,036,997
12/31/2005..................... 317,174 2,017,174
Requirement 5
2004
65,177
Cash........................................................................... 85,000
2004
65,177
Cash........................................................................... 85,000

Part 1
Ten payments of $7,200 .................. $ 72,000
Total repaid....................................... 232,000
or:
Ten payments of $7,200 .................. $ 72,000
Less premium................................... (6,494)
Part 2
Straight-line amortization table ($6,494/10 = $649)
1/01/2004 $6,494 $166,494
6/30/2004 5,845 165,845
12/31/2004 5,196 165,196
6/30/2005 4,547 164,547
12/31/2005 3,898 163,898
6/30/2006 3,249 163,249
12/31/2006 2,600 162,600
6/30/2007 1,951 161,951
12/31/2007 1,302 161,302
6/30/2008 653* 160,653
12/31/2008 0 160,000
* Adjusted for rounding.

Part 3
2004
Cash........................................................................... 7,200
2004
6,551

Problem 14-4BB (45 minutes)
Part 1
Ten payments of $7,200 .................. $ 72,000
Total repaid....................................... 232,000
or:
Ten payments of $7,200 .................. $ 72,000
Less premium................................... (6,494)
Part 2
(A) (B) (C) (D) (E)
1/01/2004 $6,494 $166,494
6/30/2004 $ 7,200 $ 6,660 $ 540 5,954 165,954
12/31/2004 7,200 6,638 562 5,392 165,392
6/30/2005 7,200 6,616 584 4,808 164,808
12/31/2005 7,200 6,592 608 4,200 164,200
6/30/2006 7,200 6,568 632 3,568 163,568
12/31/2006 7,200 6,543 657 2,911 162,911
6/30/2007 7,200 6,516 684 2,227 162,227
12/31/2007 7,200 6,489 711 1,516 161,516
6/30/2008 7,200 6,461 739 777 160,777
12/31/2008 7,200 6,423* 777 0 160,000

$72,000 $65,506 $6,494

Problem 14-4BB (Concluded)
Part 3
2004
Cash........................................................................... 7,200
2004
6,638
Part 4
As of December 31, 2006
Par value................. B.1 0.8548 $160,000 $136,768
Price of bonds........ $162,903
* Table values are based on a discount rate of 4% (half the annual original market
rate) and 4 periods (semiannual payments).
Comparison to Part 2 Table

Except for a small rounding difference, this present value ($162,903) equals
the carrying value of the bonds in column (E) of the amortization table
($162,911). This reveals a general rule: The carrying value of bonds at any
point in time equals the present value of the remaining cash flows using
the market rate at the time of issuance.

Part 1
2004
Jan. 1 Cash.................................................................................
99,247
Bonds Payable.......................................................... 120,000
Part 2
Thirty payments of $3,600* ............. $108,000
Total repaid....................................... 228,000
or:
Plus discount.................................... 20,753
*
Part 3 Straight-line amortization table ($20,753/30= $692)

Interest Period-End Discount Value
1/01/2004 $20,753 $ 99,247
6/30/2004 20,061 99,939
12/31/2004 19,369 100,631
6/30/2005 18,677 101,323
12/31/2005 17,985 102,015

Part 4
2004
Cash........................................................................... 3,600
2004
Cash........................................................................... 3,600

Part 1
2004
Jan. 1 Cash.................................................................................
99,247
Bonds Payable.......................................................... 120,000
Part 2
Total repaid....................................... 228,000
or:
Plus discount.................................... 20,753
*
Part 3
(A) (B) (C) (D) (E)

Period-End [3% x $120,000] [4% x Prior (E)] [(B) - (A)] [Prior (D) - (C)] [$120,000 - (D)]
1/01/2004 $20,753 $ 99,247
6/30/2004 $3,600 $3,970 $370 20,383 99,617
12/31/2004 3,600 3,985 385 19,998 100,002
6/30/2005 3,600 4,000 400 19,598 100,402
12/31/2005 3,600 4,016 416 19,182 100,818

Part 4
2004
Cash........................................................................... 3,600
2004
Cash........................................................................... 3,600

Part 1
2004
Jan. 1 Cash.................................................................................
987,217
Bonds Payable.......................................................... 900,000
Part 2
Eight payments of $58,500 ............. $ 468,000
Total repaid....................................... 1,368,000
or:
Eight payments of $58,500 ............. $ 468,000
Less premium................................... (87,217)
Part 3
(A) (B) (C) (D) (E)

1/01/2004 $87,217 $987,217
6/30/2004 $58,500 $49,361 $ 9,139 78,078 978,078
12/31/2004 58,500 48,904 9,596 68,482 968,482
6/30/2005 58,500 48,424 10,076 58,406 958,406
12/31/2005 58,500 47,920 10,580 47,826 947,826

Part 4
2004
49,361
Cash........................................................................... 58,500
2004
48,904
Cash........................................................................... 58,500
Part 5
2006
Jan. 1 Bonds Payable ...............................................................
900,000
Loss on Retirement of Bonds....................................... 6,174
Cash*......................................................................... 954,000
*($900,000 x 106%)
Part 6
If the market rate on the issue date had been 14% instead of 10%, the bonds
would have sold at a discount because the contract rate of 13% would have been
lower than the market rate.
This change would affect the balance sheet because the bond liability would be
smaller (par value minus a discount instead of par value plus a premium). As the
years passed, the bond liability would increase with amortization of the discount
instead of decreasing with amortization of the premium.
The income statement would show larger amounts of bond interest expense over
the life of the bonds issued at a discount than it would show if the bonds had
been issued at a premium.
The statement of cash flows would show a smaller amount of cash received from
borrowing. However, the cash flow statements presented over the life of the
bonds (after issuance) would report the same total amount of cash paid for
interest. This amount is fixed as it is the product of the contract rate and the par
value of the bonds and is unaffected by the change in the market rate.

Part 1 Amount of Payment
Note balance...................................................................
$300,000
Number of periods......................................................... 3
Interest rate.....................................................................
10%
Value from Table B.3......................................................
2.4869
Payment ($300,000 / 2.4869)..........................................
$120,632
Part 2
Payments
(A) (B) (C) (D) (E)
Debit Debit Credit
9/30/2005...............
$300,000 $30,000 $ 90,632 $120,632 $209,368
9/30/2006...............
209,368 20,937 99,695 120,632 109,673
9/30/2007...............
109,673 10,959* 109,673 120,632 0
$61,896 $300,000 $361,896

Part 3
2004
7,500
2005
Sept. 30 Interest Expense.............................................................22,500
Notes Payable.................................................................
90,632
Cash........................................................................... 120,632

Part 4
Payments
(A) (B) (C) (D) (E)
Debit Debit Credit
Date [Prior (E)] [10% x (A)] [$300,000/ 3] [(B) + (C)] [(A) - (C)]
9/30/2005...............
$300,000 $30,000 $100,000 $130,000 $200,000
9/30/2006...............
200,000 20,000 100,000 120,000 100,000
9/30/2007...............
100,000 10,000 100,000 110,000 0
$60,000 $300,000 $360,000
2004
7,500
note payable ($300,000 x .10 x 3/12).
2005
Sept. 30 Interest Expense............................................................. 22,500
Notes Payable.................................................................
100,000
Cash........................................................................... 130,000

Part 1
Hunt Company
Pledged assets [($180,000 x 32%) + $120,000]...........................$177,600

Secured liabilities ($39,000 + $45,000)........................................$ 84,000
Ratio ($177,600 / $84,000).............................................................2.11 to 1
Hound Company
Pledged assets [($750,000 x 10%) + $225,000]...........................$300,000

Secured liabilities ($57,000 + $150,000)......................................$207,000
Ratio ($300,000 / $207,000)...........................................................1.45 to 1
Part 2
Hunt's ratio of pledged assets to secured liabilities is higher than Hound's,

so the Hunt bonds appear less risky to bondholders. Before deciding to
buy Hunts bonds, however, it might be helpful to know the liquidation
value of both companies assets that are pledged as collateral. It also is
important to evaluate the ability of each company to meet its obligations
from operating cash flows.

Problem 14-10BC (35 minutes)
Part 1
Present Value of the Lease Payments
$10,000 x 3.7908 (from Table B.3) = $37,908.
Part 2
Lease Liability........................................................... 37,908
Part 3
Capital Lease Liability Payment (Amortization) Schedule
Beginning Interest on Ending

Period Balance of Lease Reduction Cash Balance of
Ending Lease Liability of Lease Lease Lease
Date Liability (10%) Liability Payment Liability
Year 1 $37,908 $ 3,791* $ 6,209 $10,000 $31,699
Year 2 31,699 3,170 6,830 10,000 24,869
Year 3 24,869 2,487 7,513 10,000 17,356
Year 4 17,356 1,736 8,264 10,000 9,092
Year 5 9,092 908** 9,092 10,000 0
$12,092 $37,908 $50,000
* Rounded to nearest dollar.

** Difference due to rounding.
Part 4
Depreciation ExpenseOffice Equipment..................7,582

SERIAL PROBLEM
Serial Problem, Success Systems (75 minutes)
Part 1
Pledged Assets Balances at 3/31/05

Accounts Receivable........................................... $22,720
Merchandise inventory........................................ 704
Net Plant Assets................................................... 24,700
Total Pledged Assets........................................... $48,124
Maximum Loan Allowed....................................... ?
Pledged assets to secured loan ratio................. 6
Maximum loan allowed $48,124 / [?] = 6 $8,020
Part 2
Assume the secured loan is taken, then the percent of assets financed by:
a. Debt
($875 + $8,020) / ($129,909 + $8,020) = 6.4%
b. Equity
$129,034 / ($129,909 + $8,020) = 93.6%

Reporting in Action BTN 14-1
1. Best Buys Long-Term Debt consists of:

Convertible subordinated debentures, due 2022,
initial interest rate 2.25%.............................................................
$402,000,000
Master lease obligations, due 2006, interest rate 5.9%..................
55,000,000
Capital lease obligations, due 2005, interest rates
ranging from 5.5% to 8.0%..........................................................
13,000,000
Financing lease obligations, due 2008 to 2022,
interest rates ranging from 5.6% to 6.0%..................................
107,000,000
Mortgage and other debt, interest rates ranging from
1.8% to 8.9%.................................................................................
23,000,000
Total debt............................................................................................
$600,000,000
Less current portion..........................................................................
(72,000,000)
Total long-term debt...........................................................................
$528,000,000
2. The interest that Best Buy must pay on the 2.25% convertible
subordinated debentures is: $402,000,000 x .0225 = $9,045,000.
3. During the year ended February 26, 2005, Best Buy did not issue any
long-term debt that provided cash. (They did, however, pay off
$371,000,000 in long-term debt.)
4. Answer depends on the financial statement information obtained.

Comparative Analysis BTN 14-2
1. Best Buys current year debt-to-equity ratio = $5,845 / $4,449 = 1.3

Best Buys prior year debt-to-equity ratio = $5,230 / $3,422 = 1.5
Circuit Citys current year debt-to-equity ratio = $1,702/ $2,087 = 0.8

Circuit Citys prior year debt-to-equity ratio = $1,507/ $2,224 = 0.7
2. For both years, Best Buys debt-to-equity ratio is above the industry
average of 1.1. This implies that Best Buys debt level is slightly riskier
than that of its competitors.
Circuit Citys debt-to-equity ratio is below the industry average for both
years, implying that its debt level is less risky than the industry average
at least on this dimension.
Ethics Challenge BTN 14-3
1. The ethics of the Brevard County officials are questionable. The

financial impact of the leasing arrangement is the same as bond
financing in that the county has a debt obligation requiring the
repayment of principal and interest over time. Taxes may need to be
raised to repay the lease just as they would have if bonds were issued.
Yet, the voters had no say in the financing arrangement the officials
agreed to.
In reality, the taxpayers of Brevard County, Florida, reacted very
negatively to the actions of the county officials when they learned of the
leasing arrangement. The taxpayers felt that their voice was taken out
of the governing process. Brevard County officials responded to the
outrage of their constituents by floating the idea of holding a
referendum on whether to stop the lease payments on the building. Of
course, such talk angered the municipal bond industry and the
investors.
2. Since the lease requires payments of a non-binding nature, investors

who purchased the tax-exempt securities from the bank are holding an
investment that is more risky than the conventional municipal bonds of
Brevard County.

Communicating in Practice BTN 14-4
MEMORANDUM
TO:
FROM:
SUBJECT:
The body of the memorandum should make the following points:

The associate is confused about the concept of a bond premium. Bonds
that sell at a premium provide the issuing company more cash than they
are required to pay the bondholders at their maturity date. When a bond is
issued at a premium, the face amount is less than the amount the associate
will invest to acquire the bond. As a result, the investment will yield the
investor (and cost the issuing corporation) less than the contract rate of
interest. This means that selling/buying at a premium incurs/yields an
effective rate of interest equivalent to the market rate for the risk assessed
for that bond at the time of issuance. In addition, this market rate of
interest is lower than the contract rate of interest for premium bonds.
The bottom line is that the market prices the bonds according to their
perceived risks and returns. What your associate needs to focus on is the
level of risk she is willing to accept and then invest accordingly.
A cordial closing that indicates willingness to discuss the issue further

would be appropriate.

Taking It to the Net BTN 14-5
1. Home Depots long-term liabilities include:

Long-Term Debt, excluding current installments............ $2,148 million
Other Long-Term Liabilities............................................... 763 million
Deferred Income Taxes....................................................... 1,309 million
2a. Home Depots notes offer a 3 % interest rate. If the interest rate for
similar notes at similar interest were 3 %, then Home Depot would
have offered these notes at their par value of $1 billion. However,
since the notes were issued at a discount, the interest rate for similar
notes at similar risk must have been greater than 3 %, causing the
notes to have been issued at a discount.
2b. Cash interest that must be paid:
$1,000,000,000 x 0.0375 x year = $18,750,000

Teamwork in Action BTN 14-6
Parts 1 and 2
Effective Interest Amortization of Bond Premium
(A) (B) (C) (D) (E)
Semi- Cash Bond
annual Interest Interest Premium Unamortized Carrying
Period-end Paid Expense Amortization Premium Value
1/01/2008 $ 4,100 $ 104,100
6/30/2008 $ 4,500 $ 4,164 $ 336 3,764 103,764
12/31/2008 4,500 4,151 349 3,415 103,415
6/30/2009 4,500 4,137 363 3,052 103,052
12/31/2009 4,500 4,122 378 2,674 102,674
6/30/2010 4,500 4,107 393 2,281 102,281
Since teams generally have 4 or 5 members, the team solution will likely end about
here. The remainder of the table is shown for help in answering part 3.
12/31/2010 4,500 4,091 409 1,872 101,872

6/30/2011 4,500 4,075 425 1,447 101,447
12/31/2011 4,500 4,058 442 1,005 101,005
6/30/2012 4,500 4,040 460 545 100,545
12/31/2012 4,500 3,955* 545 0 100,000
$45,000 $40,900 $4,100
*Discrepancy due to rounding.
The following computations should be articulated by team members as

each line is explained and prepared:
Column (A) Cash Interest Paid = Bonds' par value ($100,000) x Semiannual
contract rate (4.5%).
Column (B) Bond interest expense = Bonds prior period carrying value x
Semiannual market rate (4%).
Column (C) Premium Amortization = difference between cash interest paid and
bond interest expense, or [(A) - (B)].
Column (D) Unamortized Premium = prior periods unamortized premium less
the current periods premium amortization, or [(D) - (C)].
Column (E) Bonds Carrying Value = Bonds par value plus unamortized
premium, or [$100,000 + (D)] or Previous book value - Periods amortization.

Teamwork in Action (Concluded)
Part 3
Without completing the table, team members should be able to project the
final number in the first column and for each of the columns (A), (D), and
(E). Specifically:
(Col. 1) Last interest period date is 12/31/2012 because this is a five-year
bond, issued 1/1/2008, with semiannual interest payments made
on 6/30 and 12/31 of each year.
(Col. A) Interest paid of $4,500 (every interest period has the same amount
of interest paid).
(Col. D) Zero unamortized premium (by the last interest period the
premium must be fully amortized).
(Col. E) Ending carrying value is $100,000 (the carrying value always
equals the par value at the maturity date, after all amortization is
completed).
Part 4
Total Bond interest expense = Interest Paid - Premium
= ($4,500 x 10 periods) - $4,100
= $45,000 - $4,100 = $40,900
Part 5 List likely includes:

Similarities Differences
a. Table column headings a. Column (C) will be Discount Amortization and
for the period and for Column (D) will be Unamortized Discount.
columns (A), (B), and (E).
b. Dates in the period b. Bond interest expense is higher (lower) than the
column and interest paid in interest paid and will increase (decrease) as we
column (A). amortize a discount (premium).
c. Computations in c. Carrying value will increase (decrease) as we

Columns (A), (B), and (D) amortize a discount (premium).
will follow the same format.
d. Ending unamortized d. Discount (premium) amortization will decrease
premium and discount will (increase) each period.
both be zero.
e. Carrying value at e. Computation of Column (C) will be (B) - (A),
12/31/2012 will be $100,000 and not (A) - (B).
in both cases.
f. Computation of Column (E) will be previous Column
(E) plus discount amortization whereas with a
premium we subtract to find the new carrying value.

Business Week Activity BTN 14-7
1. An interest-only mortgage is one in which the borrowers monthly

payment covers only the interest on the unpaid balance, and does not
reduce the principle amount. The unpaid loan amount never changes.
A conventional mortgage payment pays off interest on the unpaid
balance, as well as a part of the unpaid loan balance. In this way, the
loan amount eventually goes to zero.
Borrowers would seek an interest-only loan so that they can afford a
larger mortgage (and hence a more expensive home) than they could
with a conventional mortgage.
2. The interest-only monthly loan payment would always stay at:

$400,000 x .04875 x 1/12 = $1,625
Since the payment of $1,625 payment only covers interest, the loan
balance stays at $400,000.
3. If the borrower had a conventional mortgage, the first payment of

$2,120 would cover $1,625 in interest (part 2) and $495 on the $400,000
loan balance. The second months payment of $2,120 would cover
$1,623 in interest [($400,000 - $495) x .04875 x 1/12] and $497 on the
loan balance. The loan balance after the second month would be
$399,008 ($400,000 - $495 - $497).
4. There are several risks of interest-only mortgages, including:

If the buyer wishes to sell the home before the principle payments
come due, they might lose money if their property value does not
rise.
Since most of these loans require that principle payments begin at
some time, once these payments begin, the monthly payment may
increase by as much as 50% or more.

Entrepreneurial Decision BTN 14-8
Part 1
The table below reveals how the five alternative interest-bearing notes
affect Melton Franchise Systems interest expense, net income, equity, and
return on equity (net income/equity):
Alternative Notes for Expansion

Current 10% Note 15% Note 16% Note 17% Note 20% Note
Income before
interest..............$ 40,000 $ 56,000 $ 56,000 $ 56,000 $ 56,000 $ 56,000
Interest expense.... 10,000 20,000 25,000 26,000 27,000 30,000
Net income.............$ 30,000 $ 36,000 $ 31,000 $ 30,000 $ 29,000 $ 26,000
Equity.....................$250,000 $250,000 $250,000 $250,000 $250,000 $250,000

Return on equity. . . 12% 14.4% 12.4% 12% 11.6% 10.4%
Part 2
The analysis in Part 1 illustrates the general rule (called financial

leverage or trading on the equity): When a company earns a higher
return with borrowed funds than it is paying in interest, it increases its
return on equity. In the case of Meltons franchise, it is predicting a return
of 16% on its investment, computed as its expected $16,000 additional
annual income before interest divided by its $100,000 investment. This
means that for it to pursue the investment, the interest on the borrowed
funds must be less than 16%.
The table in Part 1 shows this result, where those notes with interest
expense below 16% are profitable (that is, yield a return greater than the
current ROE of 12%), while those above 16% are not (that is, yield a return
less than the current ROE of 12%). Also, Melton should take into account
any potential variability in its income predictions because any downturn in
income that results in return on equity lower than the interest rate paid on
the notes would be unprofitable.

Hitting the Road BTN 14-9
Students answers will depend on the municipality and time period chosen
for analysis. Students often find this assignment interesting as it
reinforces the relevance of their accounting studies.
Global Decision BTN 14-10
1. Dixons current year debt-to-equity ratio = 2,406 / 1,468 = 1.6
Dixons prior year debt-to-equity ratio = 2,782 / 1,376 = 2.0
2. Dixons debt-to-equity ratio declined from the prior year to the current
year. However, for both years, Dixons debt-to-equity ratio is higher
than both Best Buy and Circuit City, indicating a higher debt risk (at
least on this dimension).


Chap 0133

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chap 0133

Uploaded by

Copyright:

Available Formats

Chapter 14

1. A bond is a liability of the issuing company. A share of stock represents an ownership

McGraw-Hill Companies, Inc., 2007

McGraw-Hill Companies, Inc., 2007

Quick Study 14-1 (10 minutes)

1. B Debenture 5. G Sinking fund bond

Quick Study 14-2 (10 minutes)

1. Bonds cash proceeds: $350,000 x 0.875 = $306,250

2. Twenty semiannual interest payments of $14,000...... $280,000

3. Bond interest expense on first payment date:

Quick Study 14-3B (10 minutes)

1. Bonds cash proceeds: $120,000 x 1.1725 = $140,700

2. Thirty semiannual interest payments of $6,000.......... $180,000

3. Bond interest expense on first payment date:

McGraw-Hill Companies, Inc., 2007

Quick Study 14-5 (10 minutes)

Cash Flow Table Value Present Value

Cash Flow Table Value Present Value

Quick Study 14-6 (10 minutes)

McGraw-Hill Companies, Inc., 2007

Quick Study 14-8 (10 minutes)

Quick Study 14-9 (10 minutes)

Initial cash proceeds from note

a. 4%: Payment = $170,000 / 4.4518 = $38,187

Quick Study 14-10 (10 minutes)

McGraw-Hill Companies, Inc., 2007

Ratio of pledged assets to secured liabilities

Xiang Co. Xu Co.

Analysis and interpretation: Xus secured liabilities appear more risky as it

Quick Study 14-12C (10 minutes)

Quick Study 14-13C (10 minutes)

Leased AssetOffice Equipment................................. 20,859

McGraw-Hill Companies, Inc., 2007

Exercise 14-1 (15 minutes)

1. Semiannual cash interest payment = $1,700,000 x 9% x 1/2 = $76,500

McGraw-Hill Companies, Inc., 2007

1. Discount = Par value - Issue price = $90,000 - $85,431 = $4,569

2. Total bond interest expense over the life of the bonds

3. Straight-line amortization table

Semiannual Unamortized Carrying

McGraw-Hill Companies, Inc., 2007

1. Discount = Par value - Issue price = $250,000 - $231,570 = $18,430

2. Total bond interest expense over the life of the bonds

3. Effective interest amortization table

(A) (B) (C) (D) (E)

6/30/2005 $11,250 $13,894 $ 2,644 15,786 234,214

12/31/2005 11,250 14,053 2,803 12,983 237,017

6/30/2006 11,250 14,221 2,971 10,012 239,988

12/31/2006 11,250 14,399 3,149 6,863 243,137

6/30/2007 11,250 14,588 3,338 3,525 246,475

12/31/2007 11,250 14,775 * 3,525 0 250,000

$67,500 $85,930 $18,430

McGraw-Hill Companies, Inc., 2007

1. Premium = Issue price - Par value = $819,700 - $800,000 = $19,700

2. Total bond interest expense over the life of the bonds

3. Straight-line amortization table: ($19,700/6 = $3,283)

Semiannual Unamortized Carrying

6/30/2005 16,417 816,417

12/31/2005 13,134 813,134

6/30/2006 9,851 809,851

12/31/2006 6,568 806,568

6/30/2007 3,285 803,285

McGraw-Hill Companies, Inc., 2007

1. Premium = Issue price - Par value = $819,700 - $800,000 = $19,700