STUDY STEPS

Understanding the Underlying Business Transactions

Bonds

Bonds are instruments used to raise long-term financing, usually when the amount of financing needed is too large for one lender to supply. Bonds are considered liabilities of the issuing company, as they generally require repayment of principal along with interest. Bonds usually have a face value (the value at which the bonds will be redeemed or repaid at maturity) and a stated interest rate (the interest rate written in the terms of the bond indenture and printed on the bond certificate). If the market interest rate (the current market interest rate for similar bonds with similar risk) is the same as the stated interest rate on the bond, the bond trades at face value. (For example, a bond with a face value of $100 and a stated interest rate of 10% will be bought and sold for $100 assuming that the current market interest rate for similar bonds with similar risk is 10%.)

If the market interest rate is lower than the stated interest rate, the bond becomes more valuable to investors, because the interest rate printed on the bond (stated interest rate) exceeds the interest rate that investors would be willing to accept (market interest rate). As a result, the bond would trade at a premium. (In the example above, the bond would sell at a price greater than $100.) Likewise, if the market interest rate is higher than the stated interest rate, the bond would trade at a discount. (In the example above, the bond would sell at a price lower than $100.)

Bond premium is the difference between the proceeds from the sale of the bonds and the face value (or maturity value) of the bonds, and arises if the bonds’ stated interest rate exceeded the bonds’ market interest rate at the time of issuance.

Bond discount is the difference between the face value of the bonds and proceeds from the sale of the bonds, and arises if the bonds’ market interest rate exceeded the bonds’ stated interest rate at the time of issuance.

The fair value of a bond varies with demand and market interest rate; it is therefore rare that a bond's fair value would be the same as either its face value or carrying value.

Derecognition of debt

Repayment of debt is often called extinguishment of debt. When debt is repaid or extinguished, it is derecognized from the financial statements. From a financial reporting perspective, debt is considered to be extinguished when either of the following occurs:

1. The debtor discharges the liability by paying the creditor.
2. The debtor is legally released from primary responsibility for the liability by law or by the creditor (for example, due to cancellation or expiry).

If debt is extinguished before its maturity date, on the date of repayment, a loss (or gain) is calculated as the reacquisition price less the updated net carrying amount of the bonds redeemed. (A gain would result if the updated net carrying amount of the bonds redeemed is greater than the reacquisition price.) Often, early repayment (before maturity date) is not an allowable option under the terms of the debt agreement, or there may be penalties for early repayment. As an alternative, an entity may enter into a trust or business arrangement called debt defeasance. In a defeasance arrangement, the entity puts the funds it would otherwise have used to extinguish the debt in low-risk or risk-free investments that are set aside to repay the principal and interest directly to the creditor. In a defeasance arrangement, the investment and return on investment are only used to make scheduled repayments on the related debt as they come due (according to the original debt agreement).

Legal defeasance occurs when the original debt's creditors agree to the arrangement, look to the trust for repayment, give up their claim on the entity, and release the entity from further liability. In legal defeasance arrangements, the creditor usually wants to ensure that the investment funds will be used only for repayment of the related debt, often requiring that the investment funds be held in trust. Because the entity no longer has an obligation to the creditor, both ASPE and IFRS allow derecognition of debt under legal defeasance arrangements.

In-substance defeasance occurs when the original debt's creditors do not agree to release the entity from the primary obligation or liability to settle the debt, or when the entity does not inform the creditor of the defeasance arrangement. Because the debtor entity still has an obligation to the creditor (that is, the creditor has not released the entity from the debt obligation), both ASPE and IFRS do not allow derecognition of debt under in-substance defeasance arrangements.

Troubled debt restructurings

A troubled debt restructuring occurs when the creditor grants a concession to the debtor entity as a result of the debtor entity's financial difficulties. Troubled debt restructuring may result in settlement (early repayment or refunding and derecognition) of the original debt. Or, it may result in continuation (revised terms and cash flows but no derecognition) of the original debt, but with a modification of its terms.

Settlement of debt may be done by a transfer of non-cash assets, share issue, or issue of new debt to another creditor, with the proceeds used to repay the original debt. Settlement of debt for less than its carrying amount results in derecognition of the related debt, and usually recognition of a gain on restructuring of debt.

If the debtor transfers non-cash assets to settle debt, both the asset and debt are removed from the debtor's books at carrying amount. The asset's carrying amount less fair value is recorded as a loss on asset disposal (or gain on asset disposal if the asset's carrying amount is less than its fair value). Then, the debt's carrying amount less the asset's fair value is recorded as a gain on restructuring of debt (or loss on restructuring of debt if the debt's carrying amount is less than the asset's fair value).

If the debtor issues shares to settle debt, the appropriate share capital account is credited for fair value of the shares, the debt is removed at carrying amount, and the debt's carrying amount less the fair value of the shares issued is recorded as a gain on restructuring of debt (or loss on restructuring of debt if the debt's carrying amount is less than the fair value of the shares issued).

Substantial modifications to a debt agreement exist when either:

1. The discounted cash flows of the debt under the new terms (discounted using the original effective interest rate) are at least 10% different from the discounted present value of the remaining cash flows under the original debt; or
2. There is a change in creditor and the original debt is legally discharged.

If there are substantial modifications to a debt agreement (that is, if either of the above two conditions is met), then the arrangement is accounted for as a settlement. This requires derecognition of the original debt, recognition of the new debt, and recognition of (usually) a gain on restructuring of debt.

If there are non-substantial modifications to a debt agreement (that is, if a debt agreement has been modified, but neither of the above two conditions is met), the original debt remains on the debtor's books as is, and a new effective interest rate is imputed by equating the carrying amount of the original debt with the present value of the revised cash flows. Going forward, at each interest payment date, interest expense is calculated as the carrying amount of the debt multiplied by the new effective interest rate, and the carrying amount of the debt is decreased by the difference between interest paid and interest expense.

Off–balance sheet financing

Off–balance sheet financing occurs when a company borrows money in a way that does not result in recording of debt on the statement of financial position. For example, a company could sell inventory for cash up front and agree to repurchase it over time under certain conditions, transfer receivables while retaining the risks and rewards of ownership, or finance an equipment purchase through a lease. There are many examples of off–balance sheet financing, some of which serve valid business objectives. However, financial statement users should be aware that a company's management may inappropriately enter into off–balance sheet financing arrangements in order to disguise risks (including business risk and solvency risk). For this reason, complex business arrangements that are entered into for the purpose of raising funds should be analyzed carefully, and properly disclosed in notes, to provide users with a faithfully representative view of the economic substance of the transactions.

Becoming Proficient with Related Calculations

In this chapter, two main areas require fairly complex calculations:

• Measurement and valuation of bonds and notes
• Troubled debt restructuring

Working through the illustrations and exercises in this chapter will help you achieve proficiency with the related calculations.

Ratio Analysis

To properly analyze ratios, a detailed understanding of GAAP and classification of financial statement items is required.

There are two key ratios that help determine whether a company has undue liquidity or solvency risk associated with debt:

Debt to total assets measures the percentage of assets financed by debt, which is a riskier source of financing than equity. Note that many companies do not necessarily use “total debt” when calculating this ratio; long-term debt may be substituted for total debt if long-term debt to total assets is a more important measure. A high ratio of debt to total assets is associated with a high risk of default. Care should be taken when comparing ratios between companies.

It should also be noted that total debt reported on the statement of financial position might not include all debt. For example, the effects of off–balance sheet financing would not be included in total debt; good analysis by a financial statement user would include adjustments for off–balance sheet debt.

Times interest earned focuses on the company's ability to meet interest payments as they come due. In general, the higher this ratio is, the better.

TIPS ON CHAPTER TOPICS

ILLUSTRATION 14-1

Calculation and Proof of Bond Issuance Price

On January 1, 2014, Gemple Company issued a five-year bond, with a January 1, 2019 maturity date and a stated interest rate of 6%. Market interest rate at the date of issuance is 5%, par value is $1,000, and interest is due annually on January 1.

The bond is a promise to pay $1,000 on January 1, 2019, and $60 (6% × $1,000) every January 1 beginning January 1, 2015, and ending January 1, 2019. The price of the bond is determined by calculating the present value of all future cash flows related to the bond, discounted at the market interest rate (5%):

Thus, the bond price would be $1,043.30. Theoretically, this is the sum that would be invested now at a 5% market interest rate compounded annually to allow for the periodic (in this case, annual) withdrawal of $60 (stated interest amount) at the end of each of five years and the withdrawal of $1,000 at the end of five years. The following is proof that $1,043.30 is the amount required.

An amortization schedule can be constructed using the calculations above. It would appear as follows:

ILLUSTRATION 14-2

Common Calculations Involving Bonds Payable

1. Cash Interest per Period

   

2. Interest Expense with Straight-Line Amortization of Discount or Premium

   

3. Amortization per Period Using Straight-Line Amortization of Discount or Premium

   

4. Interest Expense with Effective Interest Amortization of Discount or Premium

   

5. Amortization Amount Using Effective Interest Amortization of Discount or Premium

   

6. Carrying Amount and Net Carrying Amount

   

7. Gain or Loss on Derecognition

   

EXERCISE 14-1

PURPOSE: This exercise will illustrate (1) the calculations and journal entries throughout a bond's life for a bond issued at a discount and (2) the journal entries required when bonds are called prior to their maturity date.

Howell Company issued bonds with the following details:

Instructions

Solution to Exercise 14-1

EXPLANATION: The issuance of a bond is recorded with a credit to the Bonds Payable account for par value less discount or plus premium, less issuance costs (as long as the instrument is not subsequently measured using fair value). In this case, the credit amounts to $100,000.00 − $7,460.05 = $92,539.95.

EXPLANATION: Stated interest is determined by multiplying the par value ($100,000) by the contract rate of interest (7%). Interest expense is calculated by multiplying the carrying amount at the beginning of the interest period by the bond's effective interest rate (10%). The amount of discount amortization for the period is the excess of interest expense over stated interest (cash interest) amount. The carrying amount at an interest payment date is the carrying amount at the beginning of the interest period plus the discount amortization for the period.

ILLUSTRATION 14-3

Graph to Depict Interest Patterns for Bonds

EXERCISE 14-2

PURPOSE: This exercise will provide an example of both issuance of bonds between interest payment dates and use of the straight-line method of amortization.

On May 1, 2014, Pan Tools Corporation issued bonds payable with a face value of $1.4 million at 104 plus accrued interest. They are registered bonds dated January 1, 2014, bearing interest at 9% payable semi-annually on January 1 and July 1, and maturing on January 1, 2024. The company uses the straight-line method of amortization.

Instructions

Solution to Exercise 14-2

APPROACH AND EXPLANATION: Prepare the journal entries to record issuance of the bonds, payment of interest, and amortization of premium on July 1, 2014, and year-end adjustment. Post the entries to the Interest Expense account and determine its balance at December 31, 2014.

EXERCISE 14-3

PURPOSE: This exercise will illustrate the calculation of bond price when interest is due semi-annually, the effective interest method of amortization, and the journal entries required when the end of the accounting period does not coincide with the end of an interest period.

Chase Company sells $500,000 of 10% bonds on November 1, 2014. The bonds yield 12% and pay interest on May 1 and November 1. The bonds are due on May 1, 2018. Bond premium or discount is amortized at interest dates and at year end. The accounting period is the calendar year and no reversing entries are made.

Instructions

Solution to Exercise 14-3

(a) Time diagram:

(b)

(c)

EXERCISE 14-4

PURPOSE: This exercise will help you identify data required to perform bonds payable calculations and apply terminology associated with bonds.

On January 1, 2014, Tuna Fishery sold $100,000 (face value) of bonds. The bonds are dated January 1, 2014, and will mature on January 1, 2019. Interest is to be paid annually on January 1. The following amortization schedule was prepared for the first two years of the bonds’ life:

Instructions

Based on the information above, answer the following questions (round your answers to the nearest cent or percent) and explain your answers and calculations.

Solution to Exercise 14-4

EXERCISE 14-5

PURPOSE: This exercise will illustrate how to account for redemption of bonds by cash payment prior to maturity.

The balance sheet for Sea Corporation reports the following information on December 31, 2014:

Long-term liabilities

9% Bonds payable, due December 31, 2018           $940,000

The bonds have a face value of $1 million and were issued on January 1, 2014. Interest is payable annually on December 31. The straight-line method is used for amortization of bond discount or premium. In general, interest rates have declined since the bonds were issued. Sea Corporation decides to borrow money from another source at a lower interest rate to lower its overall annual interest expense. On July 1, 2015, Sea redeems all of the old outstanding bonds at 102. (Recall that bond prices vary inversely with changes in the market interest rate.)

Instructions

Prepare the journal entry(ies) to record redemption (extinguishment) of these bonds on July 1, 2015.

Solution to Exercise 14-5

EXPLANATION: Break the required entry into three simple parts: payment of accrued interest, discount amortization, and bond extinguishment. The bondholder is entitled to interest for the months between the last interest payment date (December 31, 2014) and the redemption date (July 1, 2015), which is six months in this case. Discount amortization must be updated to arrive at the carrying amount of the bonds as at the redemption date. In this case, six months of amortization must be recorded. The discount is amortized straight-line, so the total $60,000 discount is amortized evenly over the remaining four years of the bond's term. Discount amortization for six months would, therefore, be one half of the $15,000 annual amount.

For the entry to record redemption, do the following. (1) Credit Cash to record payment of the redemption price, which is 102% of the bonds’ face value. (2) Remove the bonds’ carrying amount from the accounts by debiting Bonds Payable for their up-to-date carrying amount – the December 31, 2014 carrying amount ($940,000) plus the discount amortized from January 1, 2015 to July 1, 2015 ($7,500). (3) Record the difference between redemption (retirement) price and the bonds’ carrying amount as a gain or loss on redemption of bonds. An excess of carrying amount over redemption price results in a gain. In this case, the redemption price ($1,020,000) exceeds the bonds’ carrying amount ($947,500), resulting in a loss on redemption of $72,500.

EXERCISE 14-6

PURPOSE: This exercise will illustrate issuance of a note payable to acquire land when the note payable bears interest at a rate that is unreasonably low relative to the market interest rate.

On December 31, 2014, Weiss, Inc. purchased land by paying $40,000 in cash plus a $500,000 face value note bearing interest at 3%. There was no established exchange price for the land, and no ready market for the note payable. The note is due on December 31, 2018. Interest is payable each December 31. Weiss's incremental borrowing rate is 10%.

Instructions

Solution to Exercise 14-6

EXERCISE 14-7

PURPOSE: This exercise will illustrate the journal entries for a long-term note payable.

The Feelgood Clinic issued a $400,000, 10%, 10-year mortgage note on December 31, 2014. The terms require semi-annual instalment payments of $32,097.03 on June 30 and December 31. The note, along with $80,000 cash, was given in exchange for a new building. The accounting period is the calendar year.

Instructions

Prepare the journal entries to record:

Solution to Exercise 14-7

EXPLANATION TO PART (A): The cost of the building is determined by the fair value of the consideration given, which was $80,000 cash plus the $400,000 present value of the mortgage payable.

EXPLANATION TO PARTS (B) AND (C): The mortgage payable is recorded initially at face value ($400,000), which is often referred to as the note's beginning principal. Each instalment payment reduces the outstanding principal amount. Instalment payments are in equal amounts; however, the portion of each instalment payment going toward interest and reduction in principal varies each period. In this exercise, instalment payments are due semi-annually; thus, the length of an interest period is six months and the annual interest rate (10%) must be expressed on a semiannual basis (5%) in order to calculate interest each period. Interest is a function of outstanding balance, interest rate, and time. Thus, interest incurred in the first six months is determined by the mortgage payable's initial carrying amount (face value of $400,000), the annual interest rate of 10%, and the six-month time period. Interest incurred in the second six months is calculated based on the outstanding principal balance remaining after deduction of the principal portion of the first instalment payment. Although this exercise does not require a complete mortgage amortization schedule for this note, one is presented below for your observation and study. Notice that as subsequent instalment payments are made, a decreasing portion of each payment goes toward interest and an increasing portion of each payment goes toward reduction of the principal balance. This is because interest is calculated by multiplying a constant interest rate (5% each interest period) by a decreasing principal balance (carrying amount).

EXERCISE 14-8

PURPOSE: This exercise will illustrate how an instalment note payable, such as a mortgage note, affects financial statements.

A mortgage note is a commonly used debt instrument to finance the acquisition of long-lived tangible assets. A mortgage note usually requires the borrower to repay the loan by equal periodic payments over the life of the loan. Each payment goes partly toward interest expense accrued during the period and partly toward reduction of the principal balance.

Instructions

Using the amortization schedule from Exercise 14-7, answer the following questions:

Solution to Exercise 14-8

ILLUSTRATION 14-4

Summary of Accounting for Troubled Debt Restructuring

Event	Accounting Procedure
1.  Settlement of debt; debt may be settled by: (a) transfer of non-cash assets, (b) issuance of shares, or (c) issuance of new debt to another creditor in order to repay the original debt.	Creditor: Record assets or shares received (at fair value); derecognize loan receivable; record loss on loan impairment (or debit allowance for doubtful accounts if loss on loan impairment was previously recognized). Debtor: Derecognize assets given up (at carrying value) or record shares given up (at fair value); derecognize loan payable; record gain or loss on disposal of assets (if applicable); record gain on restructuring of debt.
2.  Continuation of debt with substantial modification of terms; considered substantial if at least one of the following applies: (a) Discounted present value of cash flows under the new terms (discounted using the original effective interest rate) is at least 10% different from discounted present value of cash flows under the original debt, or (b) There is a change in creditor and the original debt is legally discharged.	Creditor: Reduce loan receivable to amount of net cash flows receivable (under modified terms) discounted at historical effective interest rate inherent in the loan; record loss based on reduction of loan receivable (similar to accounting for an impaired loan). Debtor: Derecognize original loan payable; record new loan payable at present value of new cash flows discounted at market interest rate at time of modification; record gain on restructuring of debt as the difference between these two amounts.
3.  Continuation of debt with non-substantial modification of terms (if neither of the two conditions for substantial modification of terms applies).	Creditor: Reduce loan receivable to amount of net cash flows receivable (under modified terms) discounted at historical effective interest rate inherent in the loan; record loss based on reduction of loan receivable (similar to accounting for an impaired loan). Debtor: No entry at date of restructuring; impute new effective interest rate by equating carrying amount of original debt with present value of revised cash flows.

EXERCISE 14-9

PURPOSE: This exercise will illustrate the journal entries to record the transfer of non-cash assets to settle debt in a troubled debt restructuring.

Naples Co. owes $194,400 to Morgan Trust Co. The debt is a 10-year, 8% note. Because Naples Co. is in financial trouble, Morgan agrees to accept a piece of equipment in exchange for cancelling the entire debt. The equipment's original cost was $150,000. The equipment's accumulated depreciation to date is $80,000, and its fair value is $110,000.

Instructions

Solution to Exercise 14-9

EXPLANATION: (1) Remove the carrying amount of the receivable from the accounts with a credit to Notes Receivable for $194,400. (2) Record acquisition of the asset with a debit to Equipment for its fair value of $110,000. (3) Record loss on loan impairment or settlement of $84,400 with a debit to Loss on Impairment or Allowance for Doubtful Accounts (if a loss on loan impairment was previously recorded). (4) Double-check the entry to make sure it balances.

The creditor calculates the excess of the carrying amount of the receivable over the fair value of the assets received, and reports the difference as a loss on loan impairment or a decrease in allowance for doubtful accounts (if a loss on loan impairment was previously recorded). A loss on loan impairment is classified under other expenses and losses on the creditor's income statement.

ANALYSIS OF MULTIPLE-CHOICE QUESTIONS

Question

1.  Bonds for which the owners’ names are not registered with the issuing corporation are called:

1. bearer bonds.
2. term bonds.
3. debenture bonds.
4. secured bonds.

APPROACH AND EXPLANATION: Briefly define each answer selection. Bearer (or coupon) bonds are bonds that are not recorded or registered in the owner's name by the issuer. Bearer bondholders are required to send in coupons in order to receive interest payments, and the bonds may be transferred directly to another party. Registered bonds are bonds registered in the name of the owner. Term bonds are bonds that mature (become due for payment) on a single specified future date. Debenture bonds are unsecured bonds. Secured bonds are bonds backed by a pledge of some sort of collateral. (Solution = a.)

Question

2.  Periodic amortization of a premium on bonds payable will:

1. cause the carrying amount of the bonds to increase each period.
2. cause the carrying amount of the bonds to decrease each period.
3. have no effect on the carrying amount of the bonds.
4. always cause the carrying amount to be less than the face value of the bonds.

EXPLANATION: Think about how a premium is recorded, how a premium is amortized, and how it affects the bonds’ carrying amount. A premium is a bond price adjustment required in order for the bond to yield the effective interest rate, if the stated interest rate is higher than the effective interest rate at the time of issuance. A premium is credited to Bonds Payable initially. Therefore, the entry to amortize the premium involves a debit to Bonds Payable and a credit to Interest Expense. As a result, the carrying amount of bonds payable issued at a premium will decrease each period until the maturity date (at which time the carrying amount will equal the face value). (Solution = b.)

Question

3.  A large department store issues bonds with a maturity date that is 20 years after the issuance date. If the bonds are issued at a discount, at the date of issuance, the:

1. nominal rate and the stated rate are equal.
2. nominal rate exceeds the yield rate.
3. effective yield rate exceeds the stated rate.
4. stated rate exceeds the effective rate.

EXPLANATION: Before reading the answer selections, write down the relationship that causes a bond to be issued at a discount: market interest rate exceeds stated interest rate. Then list the synonymous terms for (1) market interest rate and (2) stated interest rate, which are: (1) market rate, yield rate, effective yield rate, and effective rate; and (2) stated rate, nominal rate, coupon rate, and contract rate. Selection a. is incorrect because the nominal rate and the stated rate are just different names for the same thing. Selections b. and d. are incorrect because an excess of nominal rate (stated rate) over yield rate (effective rate) will result in a premium, not a discount. Selection c. is correct because when the effective yield rate (market rate) exceeds the coupon rate (stated rate), an issuance discount will result. (Solution = c.)

Question

4.  Assume the face value of a bond is $1,000. If the bond's current price is quoted at 102¾, the bond price is:

1. $1,000.00.
2. $1,002.75.
3. $1,020.75.
4. $1,027.50.

EXPLANATION: Convert the fraction (¾) to a decimal (0.75). Now take 102.75% of the bond's face value to determine its current price of $1,027.50. (Solution = d.)

Question

5.  The amount of cash to be paid for interest on bonds payable for any given year is calculated by multiplying:

1. face value by the stated interest rate.
2. face value by the market interest rate at the date of issuance.
3. carrying value at the beginning of the year by market interest rate at the date of issuance.
4. carrying value at the beginning of the year by stated interest rate.

EXPLANATION: The amount of cash interest to be paid is the amount promised by the bond contract (indenture), which is the (contractual) stated interest rate multiplied by the face value of the bond. (Solution = a.)

Question

6.  Amortization of a discount on bonds payable results in reporting an amount of interest expense for the period that:

1. exceeds the amount of cash interest for the period.
2. equals the amount of cash interest for the period.
3. is less than the amount of cash interest for the period.
4. has no relationship with the amount of cash interest for the period.

EXPLANATION: Think about the process of amortizing a discount on bonds payable and how it affects interest expense. A discount is a bond price adjustment required in order for the bond to yield the effective interest rate, if the effective interest rate is higher than the stated interest rate at the time of issuance. A discount is debited to Bonds Payable initially. Therefore, the entry to amortize the discount involves a credit to Bonds Payable and a debit to Interest Expense. Interest expense consists of the amount to be paid in cash for interest for the period plus the amount of discount amortization for the period. A discount is an additional amount of interest to be paid at maturity but is recognized (charged to expense) over the periods benefited (which would be the periods when the bonds are outstanding). (Solution = a.)

Question

7.  If bonds are initially sold at a discount and the straight-line method of amortization is used, interest expense in the earlier years of the bond's life will:

1. be less than the amount of interest actually paid.
2. be less than the amount of interest expense in the later years of the bond's life.
3. be the same as what it would have been if the effective interest method of amortization was used.
4. exceed what it would have been if the effective interest method of amortization was used.

EXPLANATION: Quickly sketch the graph that shows the relationships between interest paid, interest expense using the straight-line method, and interest expense using the effective interest method. The graph appears in Illustration 14-3. Treat each of the possible answer selections as a true-false question.

Selection a. is false because interest expense for a bond issued at a discount will be greater than interest actually paid throughout the bond's entire life, regardless of the amortization method used. Selection b. is false because interest expense is a constant amount each period when the straight-line method is used; hence interest expense will be the same amount in the later years as it is in the earlier years. Selection c. is false because for a bond issued at a discount, interest expense calculated using the straight-line method is greater than interest expense calculated using the effective interest method in the earlier years of life. Selection d. is true. Interest expense will increase over a bond's life if the bond is issued at a discount and the effective interest method of amortization is used. In the earlier years of life, interest expense using the effective interest method is less than interest expense using the straight-line method; in the later years of life, interest expense using the effective interest method is more than interest expense using the straight-line method. (Solution = d)

Question

8.  At the beginning of 2014, LaRochelle Corporation is sued 10% bonds with a face value of $400,000. The bonds mature in five years, and interest is paid semi-annually on June 30 and December 31. The bonds were sold for $370,560 to yield 12%. LaRochelle uses a calendar-year reporting period. Using the effective interest method of amortization, what amount of interest expense should be reported for 2014? (Round your answer to the nearest dollar.)

1. $44,333
2. $44,467
3. $44,601
4. $45,888

APPROACH AND EXPLANATION: Write down the formula for calculating interest using the effective interest method of amortization. Use the data in the question to work through the formula.

Question

9.  As at December 31, 2014, Malloy Corporation has the following information regarding bonds payable:

If the bonds are retired on January 1, 2015, at 102, what will Malloy report as a loss on extinguishment?

1. $92,500
2. $80,000
3. $67,500
4. $50,000

EXPLANATION: Write down the format for the calculation of gain or loss on repayment of debt and plug in the amounts from this question.

Question

10. “In-substance defeasance” refers to an arrangement whereby:

1. a company gets a third party to cover its payments due on long-term debt.
2. a government body issues debt instruments to corporations.
3. a company provides for future repayment of a long-term debt by placing funds in an irrevocable trust.
4. a company legally extinguishes debt before its due date.

EXPLANATION: In-substance defeasance is an arrangement whereby a company provides for future repayment of one or more of its long-term debt issues by placing funds in an irrevocable trust. Within the trust, the funds are invested in securities, the principal and interest of which are pledged to pay off the principal and interest of the company's own debt instruments as they mature. The company, however, is not legally released from being the primary obligor of the debt that is still outstanding. (Solution = c.)

Question

11. On December 31, 2014, Sugar Products Company borrows $100,000 from Candy Factory Company and gives Candy Factory a five-year, non-interest-bearing note with a face value of $100,000. The conditions of the note provide that Candy Factory can purchase $400,000 of products from Sugar Products at less than regular market price over the next five years. Sugar Products normally has to pay an interest rate of 10% when it borrows money from a bank to finance purchases of raw materials. Which of the following is true?

1. Sugar Products should report the note payable at a carrying amount of $100,000 on its statement of financial position at December 31, 2014.
2. Sugar Products should record no interest expense over the next five years in connection with this loan.
3. At inception, Sugar Products should record a debit to Cash for the present value of the note using a 10% interest rate for discounting purposes.
4. At inception, Sugar Products should record unearned revenue for the excess of the note's face value over its present value.

EXPLANATION: Record Sugar Products’ journal entry at the inception of the note. The difference between present value of the note and cash received should be recorded both as a discount on the note and as unearned revenue. The journal entry would be as follows:

The discount on the note will be amortized to interest expense over the five-year term using the effective interest method. The unearned revenue will be recognized as revenue as products are sold, based on each period's sales to the lender-customer relative to total sales to that customer for the term of the note. Thus, in this situation, amortization of the discount and recognition of revenue occur at different rates. (Solution = d.)

Question

12. Bandy Rentals borrowed money from a bank to build new mini-warehouses. Bandy gave a 20-year mortgage note in the amount of $100,000 with a stated rate of 10.75%. The lender charged $4,000 to close the financing. Based on this information:

1. To record the $4,000 charge at the date the money is borrowed, Bandy should debit Interest Expense.
2. Bandy's effective interest rate is now less than the 10.75% stated rate.
3. Bandy should record the Mortgage Payable for only $96,000 since only $96,000 cash was received.
4. Bandy should amortize the $4,000 to interest expense over the life of the loan.

EXPLANATION: Bandy will receive $96,000 cash but will have to repay $100,000 plus interest at 10.75%. Thus, the $4,000 charge raises the effective interest rate above the stated rate and should be accounted for as interest expense over the life of the loan. (Solution = d.)

Question

13. Kilinski Corporation borrowed money from a bank to build a building. The long-term note signed by the corporation is secured by a mortgage that pledges title to the building as security for the loan. Kilinski is to pay the bank $80,000 each year for 10 years to repay the loan. Which of the following statements applies to this situation?

1. The balance of mortgage payable at any given statement of financial position date will be reported as a long-term liability.
2. The balance of mortgage payable will remain a constant amount over the 10-year period.
3. The amount of interest expense will decrease each period the loan is outstanding, while the portion of the annual payment applied to the loan principal will increase each period.
4. The amount of interest expense will remain constant over the 10-year period.

EXPLANATION: Mortgages payable are initially recorded at face value, and entries are subsequently recorded for each instalment payment. Each payment is partially allocated to (1) interest on the unpaid principal balance of the loan, and (2) reduction of loan principal. Because a portion of each payment is applied to the principal, the principal balance decreases each period. Interest for a period is calculated by multiplying the stated (contract) interest rate by the principal balance outstanding at the beginning of the period. Thus, the amount of each payment allocated to interest decreases while the portion of each payment allocated to payment of loan principal increases each period. (Solution = c.)

Question

14. The debt to total assets ratio measures the:

1. relationship between interest expense and income.
2. percentage of total assets financed through creditor sources.
3. portion of debt used to acquire assets.
4. relationship between debt and interest expense.

EXPLANATION: Write down the ratio for debt to total assets and consider its components. The debt to total assets ratio is calculated by dividing total debt by total assets. This ratio measures the percentage of total assets provided by creditors. The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations. (Solution = b.)

Question

15. The times interest earned ratio measures the:

1. company's ability to meet interest payments as they become due.
2. relationship between current liabilities and current assets.
3. percentage of total assets financed by debt.
4. relationship between debt and interest expense.

EXPLANATION: Write down the ratio for times interest earned and consider its components. The times interest earned ratio is calculated by dividing income before income taxes and interest expense by interest expense. This ratio measures the company's ability to meet interest payments as they come due. (Solution = a.)

Question

16. In a troubled debt restructuring, a debtor settles a debt by a transfer of land with a fair value that is less than the carrying amount of the debt but more than the book value of the land. Should a gain or loss on restructuring of debt be recognized? Should a gain or loss on the disposal of assets be recognized?

EXPLANATION: Assign amounts to (1) carrying amount of the debt, (2) book value of the land, and (3) fair value of the land. Be sure your assigned amounts maintain the relationships stated in the question. Then use a journal entry approach to solve. For instance, fair value of land, $100,000; book value of land, $65,000; and carrying amount of debt, $127,000 would maintain the relationships stated in the question. For the journal entry, debit the debt account(s) for $127,000; credit Land for $65,000; credit Gain on Disposal of Land for $35,000 (excess of fair value of land over book value of land). The rest of the entry is due to gain or loss on restructuring of debt. A $27,000 credit is needed for the entry to balance; hence, there is a gain on restructuring of debt. If a company is able to settle a debt by giving an asset with a fair value that is less than the carrying amount of the debt, the company's settlement of debt is advantageous; hence a gain on restructuring of debt is recognized.

17. Due to its serious cash flow problems, Unitech Company was able to negotiate a modification of the terms of an outstanding note payable with the creditor of the note. Unitech negotiated a reduction of the note's stated interest rate and reduction of the note's face value. Discounted present value of the note under the new terms (discounted using the original effective interest rate) is 8% different from discounted present value of the remaining cash flows under the original note. Which of the following statements applies to this situation?

1. Unitech should derecognize the original note and record issuance of the new note.
2. Unitech should record a loss on restructuring of debt.
3. Unitech should not record a journal entry as a result of this modification of terms.
4. None of the above.

EXPLANATION: In a troubled debt restructuring, a debtor may be able to negotiate one or more of the following modifications to the terms of an existing debt agreement: (1) reduction of the stated interest rate; (2) extension of the maturity date of the debt's face amount; (3) reduction of the debt's face amount; (4) reduction or deferral of any accrued interest; or (5) change in currency. However, modifications are only considered substantial if one of the following two criteria applies:

1. Discounted present value under the new terms (discounted using the original effective interest rate) is at least 10% different from the discounted present value of the remaining cash flows under the original debt.
2. There is a change in creditor and the original debt is legally discharged.

In a situation of substantial modification of terms, the original debt is derecognized and the new debt is recorded, along with a gain on restructuring of debt (measured as the difference between the current present value of the revised cash flows and the carrying amount of the original debt). In this case, however, neither of the two criteria for substantial modification of terms applies; therefore this is considered a non-substantial modification of terms. For a non-substantial modification of terms, the original debt remains on the books and no entry is recorded at the time of modification of terms. Instead, a new effective interest rate is imputed by equating the carrying amount of the original debt with the present value of the revised cash flows.

(Solution = c.)