DMP3e CH09 Solutions 05.17.10 Revised

7/27/2019 DMP3e CH09 Solutions 05.17.10 Revised

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Chapter 9

Reporting and Analyzing Liabilities

Learning Objectives coverage by question

Mini-exercises

Exercises Problems Cases

LO1 Identify and account forcurrent operating liabilities.

18, 22, 30 36, 37, 38, 49 61

LO2 Describe and account forcurrent nonoperating (financial)liabilities.

18 49 61

LO3 Explain and illustrate the pricingof long-term nonoperating liabilities.

19, 28, 29,

31, 34, 35

40, 43, 44,

45, 46, 47,

48, 50

51, 52, 53,

54, 55, 56,

57, 58, 59, 60

62, 63

LO4 Analyze and account forfinancial statement effects of long-

term nonoperating liabilities.

17, 20, 21,

23, 24, 25,

26, 31, 33, 34

39, 42, 43,

44, 45, 47,

48, 49, 50

51, 52, 53,

54, 55, 56,

57, 58

61, 62, 63

LO5 Explain how solvency ratiosand debt ratings are determinedand how they impact the cost ofdebt.

20, 27, 32 41 51 62, 63

Cambridge Business Publishers, 2011

Solutions Manual, Chapter 9 9-1


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QUESTIONS

Q9-1. Current liabilities are obligations that require payment within the comingyear or operating cycle, whichever is longer.

Generally, current liabilities are normally settled with use of existing currentassets or operating cash flows.

Q9-2. An accrual is the recognition of an event in the financial statements eventhough no actual transaction has occurred. Accruals can involve bothliabilities (and expenses) and assets (and revenues).

Accruals are vital to the fair presentation of the financial condition of acompany as they impact both the recognition of revenue and thematching of expense.

Q9-3. The coupon rate is the rate specified on the face of the bond. It is used tocompute the amount of cash interest paid to the bond holder. The marketrate is the rate of return expected by investors that purchase the bonds.The market rate determines the market price of the bond. It incorporatesexpectations about the relative riskiness of the borrower and the rate ofinflation. In general, there is an inverse relation between the bondsmarket rate and the bonds market price.

Q9-4. Bonds sold at face (par) value earn an effective interest rate equal to thebonds coupon rate. Bonds are sold at a discount when the effectiveinterest rate is higher than the coupon rate. Bonds are sold at a premium

when the effective interest rate is lower than the coupon rate.

Q9-5. Bonds are reported at historical cost, that is, the face amount plus (minus)unamortized premium (discount). The market price of the bonds variesinversely with the level of interest rates and fluctuates continuously.Differences between the market price of a bond and its carrying amountrepresent unrealized gains and losses. These unrealized gains (losses) arenot reflected in the financial statements (although they are disclosed in thefootnotes). They must be recognized upon repurchase of the bonds, thepoint at which they become realized.

If the bonds are refunded (that is, replaced with new bonds reflectingcurrent market values and interest rates), the gain (or loss) that isrecognized in the current period will be offset by correspondingly higher(lower) interest payments in the future. The present value of the futureinterest payments, along with the present value of the difference betweenthe face amount of the new bond and the former face amount, exactly offsetthe reported gain (loss).


Financial Accounting, 3rd Edition9-2


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Q9-6. Debt ratings reflect the relative riskiness of the borrowing company. Thisriskiness relates to the probability of default (e.g., not repaying the principaland interest when due). Higher (greater quality) debt ratings result in highermarket prices for the bonds and a correspondingly lower effective interestrate for the issuer. Lower (lesser quality) debt ratings result in lower marketprices for the bonds and a correspondingly higher effective interest rate for

the issuer.

Q9-7. Reported gains or losses on bond redemption result from changes in themarket price of the bonds and the use of historical cost accounting.Because bonds are typically reported at historical cost, fluctuations in bondprices are not recognized until they are realized when the bonds areredeemed or refunded. If the bonds are refunded (new bonds are issued),the gain or loss is offset by the present value of lower (higher) futureinterest payments on the new bond issue.

Q9-8. (a) Term loan a loan that matures on a single, pre-specified date

(b) Bonds payable the liability account used to record the face value ofbonds issued by a company

(c) Serial bonds bonds that mature in installments rather than on one date

(d) Call provision the right for the bond issuer to repurchase the debt,before it matures, at a predetermined price.

(e) Convertible bonds bonds that can be converted into some other asset(typically common stock) at the option of the bondholder

(f) Face value the predetermined amount (typically $1,000) that must berepaid when a bond matures

(g) Nominal rate the rate specified on the face of the bond that determinesthe periodic interest (coupon) payment

(h) Bond discount the difference between the face value of the bond andthe market price when the price is lower than the face value; recorded as acontra-liability

(i) Bond premium the difference between the market price of a bond andthe face value when the market price is higher than the face value; recordedas an adjunct-liability

(j) Amortization of premium or discount the periodic reduction of thebalance in the premium or discount account recorded each time interestexpense is accrued; equal to the difference between the accrued interestand the coupon payment (or payable)




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Q9-9. The advantages of issuing bonds are (1) the interest payments are limitedto the predetermined amount specified on the bond; (2) the interest is taxdeductible; (3) bondholders do not have a vote when it comes to electingdirectors and managing the company; (4) the additional financial leveragecreated when bonds are issued increases profits in good years. Thedisadvantages of bonds include (1) bonds must be repaid while common

stock is issued with an indefinite life; (2) bondholders can imposerestrictive covenants in the loan indenture; (3) the additional financialleverage created when bonds are issued decreases profits in lean years.

Q9-10. $3,000,000 x [.98 + (.09 x 3/12)] = $3,007,500

Q9-11. The contract rate (or stated rate or coupon rate) determines the periodiccoupon payment. If this rate is not equal to the rate required by the market,the bond price is adjusted to the present value of the cash payments fromthe bond discounted at the applicable market rate of interest. If the marketrate is higher than the coupon rate, then the periodic coupon payments are

insufficient and the bond will be priced lower than the face value (adiscount). If the market rate is lower than the coupon rate, then the periodiccoupon payments will be higher than required by the market, and the bond

will sell for a premium.

Q9-12. When the bonds mature, the book value of the bonds will be equal to theface value. Over the life of the bonds, the change in the book value of thebonds will be equal to face value less the market value at the time that thebonds are issued.

Q9-13. When the effective interest method is used to amortize a bond discount or

premium, the effective rate is multiplied by the net balance in bondspayable (bonds payable plus/minus the premium or discount). If the bondis issued at a discount, the balance increases over the life of the bond; theinterest expense will increase as the balance increases. If the bond isissued at a premium, the balance decreases over the life of the bond; theinterest expense will decrease as the balance decreases.

Q9-14. Bonds payable is presented in the balance sheet net of any discount orplus any premium.

Q9-15. The loss is the difference between the retirement value and the book value

of the bond: 101% x $200,000 $197,600 = $4,400.

Q9-16. Each payment includes both interest on the outstanding balance andrepayment of the principal. As each payment is made, the principalbalance is reduced. As a consequence, the interest component of thepayment is smaller each period.




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MINI EXERCISES

M9-17 (10 minutes)

a. Interest expense (+E,-SE)... 24Interest payable (+L)... 24

b.- Interest Payable (L) + + Interest Expense (E) -

24 a. a. 24

c.

Balance Sheet Income Statement

Transaction CashAsset + NoncashAssets = Liabil-ities + Contrib.Capital + Earnedcapital Revenues - Expenses = NetIncomeAccrued $24 interest

on note payable =+24

InterestPayable

-24RetainedEarnings

-+24

InterestExpense

=-24

M9-18 (15 minutes)

a. Accounts Payable, $110,000 (current liability).

b. Not recorded as a liability; an accountable transaction has not yet occurred.

c. Estimated liability for product warranty, $2,200 (current liability).

d. Bonuses Payable, $30,000 (current liability)computed as $600,000 5%. Thisliability must be reported since its payment is probable and can beestimated.

M9-19 (10 minutes)

a. Boston Scientific is offering bonds with a coupon (stated) rate of 4.25% whenthe market rate (yield) is higher (4.349%). In order to obtain this expected rateof return, the bonds sell at a discount price of 99.476 (99.476% of par).

b. The first bond matures in 2011 while the second matures in 2017. There is,generally, a higher rate (yield) expected for a longer maturity.




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M9-20 (10 minutes)

Amount paid to retire bonds ($200,000 x 101%)......................................... $202,000Book value of retired bonds, net of $2,400 unamortized discount........... 197,600Loss on bond retirement.............................................................................. $ 4,400

M9-21 (10 minutes)

a. The $45 million indicates that BMY has bonds maturing that will requirepayment in the amount of $45 million in 2010.

b. BMY will need to pay off the bonds when they mature. This will result in a cashoutflow that must come from operating activities if the bonds cannot berefinanced prior to maturity. However, most of BMYs long-term debt maturesmore than 5 years after the financial statement date (December 31, 2008).

Thus, BMYs near-term cash needs for covering long-term debt should notplace a significant burden on the companys operations.

M9-22 (10 minutes)

a. Gain on Bond Retirement: In the other (nonoperating) revenues and expensessection unless it meets the tests for extraordinary treatment (e.g., unusual andinfrequent)

b. Discount on Bonds Payable: Deduction from Bonds Payable; thus, a (contra)

long-term liability in the balance sheet (e.g., it is netted in the presentation oflong-term liabilities).

c. Mortgage Notes Payable: Long-term liability in the balance sheet.

d. Bonds Payable: Long-term liability in the balance sheet.

e. Bond Interest Expense: In other (nonoperating) revenues and expenses sectionof income statement.

f. Bond Interest Payable: Current liability in the balance sheet.

g. Premium on Bonds Payable: Addition to Bonds Payable; thus, part of along-term liability in the balance sheet (e.g., it is included in the presentation oflong-term liabilities).

h. Loss on Bond Retirement: In the other (nonoperating) revenues and expensessection unless it meets the tests for extraordinary treatment (e.g., unusual andinfrequent)




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M9-23 (15 minutes)

a. Financial ratios used in bond covenants are typically designed to protect thebond holders against actions by management that they feel would bedetrimental to their interests. These might include restrictions against theimpairment of liquidity, restrictions on the amount of financial leverage the

company can employ, and restrictions on the payment of dividends. Inaddition, bond holders usually impose various covenants prohibiting theacquisition of other companies or the divestiture of business segments

without their consent. All of these covenants, by design, restrict managementin its actions.

b. Management, facing imminent default in one or more of its bond covenants,may be pressured into taking actions in order to avoid such default. Thesemay include, for example, operational actions, such as reduction of R&D oradvertising in order to improve profitability, or leaning on the trade orreduction of receivables (via early payment incentives) and inventories (by

marketing promotions or delaying restocking) in order to boost cash balances.Actions may also include fraudulent accounting measures, such as improperrecognition of revenues or delayed recognition of expenses.

c. Restricted assets, such as cash or securities, should not be considered asgeneral assets in an analysis of the firms liquidity or solvency because theyare not available to management for general corporate uses.




8/40

M9-24 (15 minutes)a.1/1/2004 Cash (+A) ..... 432,000

Bonds payable (+L) .. 400,000Bond premium (+L) .. 32,000

1/1/2009 Bonds payable (-L) .... 400,000Bond premium (-L) .... 27,809

Cash (-A) ..... 412,000Gain on retirement of bonds (+R, +SE) 15,809

b.+ Cash (A) - - Bonds Payable (L) +

1/1/04 432,000 400,000 1/1/04412,000 1/1/09 1/1/09 400,000

- Gain on Retirement of Bonds (R) + - Bond Premium (L) +

15,809 1/1/09 32,000 1/1/04

1/1/09 27,809

c.


Transaction CashAsset +

NoncashAssets =

Liabil-ities +

Contrib.Capital +

EarnedCapital Revenues - Expenses =

NetIncome

1/1/04 Issue bonds ata premium.

432,000Cash

=

+400,000Bonds

Payable

+32,000

BondsPayable,net

- =

1/1/09 Retired bondsissued on 1/1/04.

-412,000Cash

=

-400,000Bonds

Payable

-27,809Bonds

Payable,net

+15,809RetainedEarnings

+15,809Gain on

Retirementof Bonds

- =

+15,809




9/40

M9-25 (15 minutes)a.7/1/2003 Cash (+A) . 240,000

Bond discount (+XL, -L) ... 10,000Bonds payable (+L) .. 250,000

7/1/2009 Bonds payable (-L) 250,000Loss on retirement of bonds (+E, -SE) 9,314

Bond discount (-XL, +L) . 6,814Cash (-A) . 252,500


7/1/03 240,000 250,000 7/1/03252,500 7/1/09 7/1/09 250,000

+ Loss on Retirement of Bonds (E) - + Bond Discount (XL) -

7/1/09 9,314 7/1/03 10,0006,814 7/1/09

c.



NoncashAssets =

Liabil-ities +

Contrib.Capital +


NetIncome

7/1/03 Issue bonds ata discount

+240,000Cash

=

+250,000Bonds

Payable

-10,000BondsPayable,

net

- =

7/1/09 Retired bondsissued on 7/1/03

-252,500Cash

=

-250,000Bonds

Payable

+6,814Bonds

Payable,net

-9,314RetainedEarnings

-

+9,314Loss on

retirement ofBonds

=

-9,314

M9-26 (10 minutes)

Nissim: $18,000 0.10 40/365 = $197.26

Klein: $14,000 0.09 18/365 = 62.14

Bildersee: $16,000 0.12 12/365 = 63.12$322.52




10/40

M9-27 (10 minutes)

a. The Debt-to-Equity ratio (D/E) will likely change, but the direction and amountis difficult to determine from the information given. The increase inoutstanding debt by $773.2 million ($946.6+$1,450.0-$1,623.4) along with thenet share repurchases of $1,336 million ($2,425.9-$1,089.4) and dividend

payments of $529.7 million will increase D/E. (The effect of the sharerepurchases on reported equity is not provided the $2,425.9 million is themarket value of the repurchased shares.)Times interest earned will decrease as additional interest cost on newborrowing is added to the denominator. How much of an effect this will havedepends on the size of the change in net income.

b. Generally, the higher (lower) the firm's solvency measures, the higher (lower)the firm's debt rating. In financial leverage terms, the higher (lower) the firm'sleverage the lower (higher) the firm's debt rating. Increasing the amount ofdebt while decreasing equity may harm General Mills debt ratings.

M9-28 (15 minutes)

a. Selling price of 9% bonds discounted at 8%

Present value of principal repayment ($500,000 0.45639) ....................$228,195Present value of interest payments ($22,500 13.59033) .................... 305,782Selling price of bonds.................................................................................$533,977

b. Selling price of 9% bonds discounted at 10%

Present value of principal repayment ($500,000 0.37689) ....................$188,445Present value of interest payments ($22,500 12.46221) .................... 280,400Selling price of bonds.................................................................................$468,845

M9-29 (15 minutes)

a. Selling price of zero-coupon bonds discounted at 8%:

Present value of principal repayment ($500,000 0.45639) $228,195

b. Selling price of zero coupon bonds discounted at 10%:Present value of principal repayment ($500,000 0.37689) $188,445

c. Based on the debt-to-equity ratio, financial leverage would increase from 2.0[=($3 - $1)/$1] to 2.19 [=($3 - $1 + $0.188)/$1)




11/40

M9-30 (15 minutes)a.1. Inventory (+A) . 300

Accounts payable (+L) 300

2. Accounts receivable (+A) 420

Sales revenue (+R, +SE) .... 420

3. Cost of goods sold (+E, -SE) . 300Inventory (-A) 300

4. Accounts payable (-L) . 300Cash (-A) 300

5. Cash (+A) 420Accounts receivable (-A) 300

b.+ Cash (A) - - Accounts Payable (L) +

300 4. 300 1.5. 420 4. 300

+ Accounts Receivable (A) - - Sales Revenue (R) +

2. 420 420 2.420 5.

+ Inventory (A) - + Cost of Goods Sold (E) -

1. 300 3. 300300 3.

c.



NoncashAssets =

Liabil-ities +

Contrib.Capital +


NetIncome

1. Purchase inventoryon account.

+300Inventory =

+300AccountsPayable

- =

2. Sell inventory oncredit.

+420Accts Rec =

+420RetainedEarnings

+420Sales - =

+420

3. Cost of sales from2.

-300Inventory =

-300RetainedEarnings

-+300

Cost ofGoods Sold

=-300

4. Paid cash forinventorypurchased in 1.

-300Cash =

-300AccountsPayable

- =

d. Receive cash onreceivable from 2.

420Cash

-420Accts Rec = - =




12/40

M9-31 (30 minutes)

a.

Data Inputs into Excel

1/1/2009 Settlement date

12/31/2018 Maturity date9.00% Percent semiannual coupon

8.00% Percent yield$100 Redemption value

2 Frequency is semiannual (see above)

1 actual/actual basis

Percent of Par Sale ProceedsPrice 106.7951632 $533,975.82

b.

Period Interest Cash PaidPremium

AmortizationPremiumBalance

CarryingAmount

0 33,975.82 533,975.82

1 21,359.03 22,500.00 1,140.97 32,834.85 532,834.85

2 21,313.39 22,500.00 1,186.61 31,648.24 531,648.24

3 21,265.93 22,500.00 1,234.07 30,414.17 530,414.17

4 21,216.57 22,500.00 1,283.43 29,130.74 529,130.74

5 21,165.23 22,500.00 1,334.77 27,795.97 527,795.97

6 21,111.84 22,500.00 1,388.16 26,407.81 526,407.81

7 21,056.31 22,500.00 1,443.69 24,964.12 524,964.128 20,998.56 22,500.00 1,501.44 23,462.68 523,462.68

9 20,938.51 22,500.00 1,561.49 21,901.19 521,901.19

10 20,876.05 22,500.00 1,623.95 20,277.24 520,277.24

11 20,811.09 22,500.00 1,688.91 18,588.33 518,588.33

12 20,743.53 22,500.00 1,756.47 16,831.86 516,831.86

13 20,673.27 22,500.00 1,826.73 15,005.14 515,005.14

14 20,600.21 22,500.00 1,899.79 13,105.34 513,105.34

15 20,524.21 22,500.00 1,975.79 11,129.56 511,129.56

16 20,445.18 22,500.00 2,054.82 9,074.74 509,074.74

17 20,362.99 22,500.00 2,137.01 6,937.73 506,937.73

18 20,277.51 22,500.00 2,222.49 4,715.24 504,715.24

19 20,188.61 22,500.00 2,311.39 2,403.85 502,403.85

20 20,096.15 22,500.00 2,403.85 0.00 500,000.00




13/40

M9-32 (15 minutes)

Verizons leverage as measured by its D/E ratio is higher than either Comcast orSprint (Quest has negative equity). On the other hand, Verizon is in better shapethan any of its competitors in terms of its ability to pay the interest on its debt asindicated by its greater TIE ratio. The comparison includes Sprint/Nextel which

has a negative operating income.

M9-33 (15 minutes)

a. Gain on bond retirement Reported in the income statement under other(nonoperating) income

b. Discount on bonds payable Contra-liability netted against bonds payableunder long-term liabilities in the balance

sheetc. Mortgage notes payable Long-term liability in the balance sheet; the

amount due within one year would bereported as a current liability

d. Bonds payable Long-term liability in the balance sheet; theamount due within one year would bereported as a current liability

e. Bond interest expense Nonoperating expense reported in the incomestatement

f. Bond interest payable A current liability in the balance sheetg. Premium on bonds payable Adjunct-liability added to bonds payable

under long-term liabilities in the balancesheet




14/40

M9-34 (15 minutes)a.12/31/10 Cash (+A) ..... 700,000

Mortgage note payable (+L) .. 700,000

6/30/11 Interest expense (+E, -SE) .. 42,000

Mortgage note payable (-L) . 8,854Cash (-A) . 50,854

12/31/11 Interest expense (+E, -SE) .. 41,469Mortgage note payable (-L) . 9,385

Cash (-A) . 50,854

* $41,469 = ($700,000 $8,854) x 12%/2.

b.+ Cash (A) - - Mortgage Note Payable (L) +

12/31/10 700,000 700,000 12/31/10

50,854 6/30/11 6/30/11 8,85450,854 12/31/11 12/31/11 9,385

+ Interest Expense (E) -6/30/11 42,000

12/31/11 41,469

c.


Transaction CashAsset + NoncashAssets = Liabil-ities + Contrib.Capital + EarnedCapital Revenues - Expenses = NetIncome12/31/10 Borrow

$700,000 on a 15-year mortgage notepayable.

+700,000Cash

=

+700,000Mortgage

NotePayable

- =

6/30/11 Interestpayment on note.

-50,854Cash =

-8,854Mortgage

NotePayable


-

+42,000InterestExpense

=

-42,000


-50,854Cash =

-9,385Mortgage

NotePayable


-


=

-41,469

M9-35 (5 minutes)

$900,000 x 0.55839 + (900,000 x 10%/2) x 7.36009 = $833,755.

$833,755 / $900,000 = 92.6% of par value.




15/40

EXERCISES

E9-36 (15 minutes)

a.

Total expected failures from units sold (69,000 0.02)................ 1,380Average cost per failure................................................................. $50Total expected future warranty costs............................................ $69,000

Current warranty liability................................................................ $10,000Additional warranty cost liability required.................................... $ 59,000

The product warranty liability must be increased by $59,000 to cover theexpected repair costs, (because the warranty is for a 60-day period, the $10,000remaining in the liability account represents unused amounts left from prioryears accruals). Warranty expense of $59,000 must be recorded in the income

statement when the liability account is increased.

b. The warranty liability should be equal, at all times, to the expected dollar costof repairs. Analysis issues relate to whether the warranty liability exists and, ifso, is it at the correct amount. Understating (overstating) the accrualoverstates (understates) current period income at the expense (benefit) offuture income.

c. The debt-to-equity ratio will increase and the operating cash flow to liabilitieswill decrease. The times-interest earned ratio will not be affected.

E9-37 (10 minutes)

Item Accounting Treatment

a. Neither record nor disclose (neither probable nor reasonably possible)

b. Record a current liability for the note, no liability for interest until incurred

c. Disclose in a footnote (at least reasonably possible)

d. Record warranty liability on balance sheet and recognize expense inincome statement (costs are probable and reasonably estimable).




16/40

E9-38 (15 minutes)

The company must accrue the $25,000 of wages that have been earned byemployees even though these wages will not be paid until the first of next month.The required accounting accrual will:

increase wages payable by $25,000 on the balance sheet increase wages expense by $25,000 in the income statement

Failure to make this accounting accrual (called adjusting entry) would understateliabilities, understate expenses, overstate income, and overstate stockholdersequity.

M9-39 (15 minutes)

a. Selling price of bonds:

Present value of principal repayment ($300,000

0.30832).............$ 92,496Present value of interest payments ($16,500 17.29203)................ 285,318Selling price of bonds $377,814

b.1/1/10 Cash (+A) .. 377,814

Bond premium (+L) 77,814Bonds payable (+L) ... 300,000

6/30/10 Interest expense (+E, -SE) 15,113

Bond premium (-L) ..... 1,387Cash (-A) .. 16,500

12/31/10 Interest expense (+E, -SE) 15,057Bond premium (-L) . 1,443

Cash (-A) .. 16,500

* $15,057 = ($377,814 $1,387) x 8%/2.

c.+ Cash (A) - - Bonds Payable (L) +

1/1/10 377,814 300,000 1/1/10

16,500 6/30/1016,500 12/31/10

+ Interest Expense (E) - - Bond Premium (L) +

77,814 1/1/106/30/10 15,113 6/30/10 1,387

12/31/10 15,057 12/31/10 1,443




17/40

d.



NoncashAssets =

Liabil-ities +

Contrib.Capital +


NetIncome


+377,814Cash

=

+300,000Bonds

Payable

+77,814Bonds

Payable,net

- =

6/30/10 Interestpayment on bonds.

-16,500Cash =

-1,387Bonds

Payable,net


-


=

-15,113


-16,500Cash =

-1,443Bonds

Payable,net


-


=

-15,057

E9-40 (10 minutes)

Selling price of bonds

Present value of principal repayment ($900,000 0.44230)................$398,070Present value of interest payments ($49,500 9.29498)...................... 460,102Selling price of bonds.............................................................................$858,172

E9-41 (15minutes)

a.

Warranty expense (+E, -SE) . 123.0Warranty liability (+L) 123.0

b.

- Accrued Warranty Liability (L) + + Warranty Expense (E) -60.5 07 bal.

08 cost 125.1 123.0 08 exp. 123.0

55.2 08 bal.

c. 2008: $123.0 / $6,086.1 = 2.0% 2007: $118.8 / $6563.2 = 1.8%.Warranty expense appears to have increased in 2008 as a percentage of salesrevenue.




18/40

E9-42 (15 minutes)a.5/1/10 Cash (+A) ... 500,000

Bonds payable (+L) 500,000

10/31/10 Interest expense (+E, -SE) 22,5001

Cash (-A) .. 22,500

11/1/11 Bonds payable (-L) . 300,000Loss on retirement of bonds (+E, -SE) . 3,000

Cash (-A) .. 303,0002

1 $500,000 x 0.09 x 1/2 = $22,500 interest expense. Because the bonds were sold at par,there is no discount or premium amortization.

2 Cash required to retire $300,000 of bonds at 101 = $300,000 x 1.01 = $303,000. The

difference between the cash paid and the carrying amount of the bonds is the gain orloss on the redemption. In this case, the loss is $3,000. This calculation assumes thatthe interest was paid on 10/31/11, so accrued interest is not recorded.


5/1/010 500,000 500,000 5/1/10

22,500 10/31/10

303,000 11/1/11 11/1/11 300,000

+ Interest Expense (E) - + Loss on Retirement of Bonds (E) -10/31/10 22,500 11/1/11 3,000

c.


Transaction CashAsset +NoncashAssets =

Liabil-ities +

Contrib.Capital +


NetIncome

5/1/10 Issue bonds. +500,000Cash =

+500,000Bonds

Payable- =

10/31/10Interestpayment on bonds.

-22,500Cash =


-+22,500InterestExpense

=-22,500

11/1/11 Earlyretirement ofbonds.

-303,000Cash =

-300,000Bonds

Payable


-

+3,000Loss on

Retirementof Bonds

=

-3,000




19/40

E9-43 (25 minutes)

a. Selling price of bonds

Present value of principal repayment ($250,000 0.41552)................$103,880Present value of interest payments ($10,000 11.68959).................. 116,896

Selling price of bonds.............................................................................$220,776

b.1/1/10 Cash (+A) . 220,776

Bond discount (+XL, -L) 29,224Bonds payable (+L) .. 250,000

6/30/10 Interest expense (+E, -SE) 11,039Bond Discount (-XL, +L) .. 1,039Cash (-A) .. 10,000

$11,039 = $220,776 .05.

12/31/10 Interest expense (+E, -SE) . 11,091Bond Discount (-XL, +L) .. 1,091Cash (-A) .. 10,000

$11,091 = [$220,776 + $1,039] .05.


1/1/10 220,776 250,000 1/1/10

10,000 6/30/10

10,000 12/31/10

+ Interest Expense (E) - + Bond Discount (XL) -1/1/10 29,224

6/30/10 11,039 1,039 6/30/1012/31/10 11,091 1,091 12/31/10




20/40

E9-43continued.

d.



Liabil-ities +

Contrib.Capital +


NetIncome

1/1/10 Issue bonds ata discount. +220,776Cash

=

+250,000BondsPayable

-29,224Bonds

Payable,net

- =


-10,000Cash =

+1,039Bonds

Payable,net


-


=

-11,039


-10,000Cash =

+1,091Bonds

Payable,net


-


=

-11,091

E9-44 (25 minutes)

a. Selling price of bonds:

Present value of principal repayment ($800,000 0.20829)................$166,632Present value of interest payments ($36,000 19.79277).................... 712,540Selling price of bonds.............................................................................$879,172

b.1/1/10 Cash (+A) ... 879,172

Bond premium (+L) 79,172Bonds payable (+L) 800,000

6/30/10 Interest expense (+E,-SE) . 35,167Bond premium (-L) . 833

Cash (-A) .. 36,000$35, 167 = $879,172 x .04.

12/31/10 Interest expense (+E,-SE) . 35,134

Bond premium (-L) . 866Cash (-A) .. 36,000

$35,134 = ($879,171 - $833) x .04.




21/40

E9-44continued.


1/1/10 879,172 800,000 1/1/10

36,000 6/30/10

36,000 12/31/10


79,172 1/1/106/30/10 35,167 6/30/10 833

12/31/10 35,134 12/31/10 866

d.


TransactionCashAsset +

NoncashAssets =

Liabil-ities +

Contrib.Capital +


NetIncome


+879,172Cash

=

+800,000Bonds

Payable

+79,172Bonds

Payable,net

- =


-36,000Cash =

-833Bonds

Payable,net


-


=

-35,167


-36,000Cash =

-866Bonds

Payable,net

-35,134Retained

Earnings-

+35,134Interest

Expense

=

-35,134




22/40

E9-45 (20 minutes)

a. There is an inverse relation between interest rates and bond prices (examinethe increasing discount rates as the yield increases in present value tables).Since the bonds now trade at a premium and assuming that Deeres creditratings have not changed, we can conclude that interest rates have fallen

since the bonds were issued.

b. No, once the bond is initially recorded, neither the coupon rate nor the yieldused to compute interest expense is changed. Bonds are recorded athistorical cost (like most other balance sheet assets and liabilities). As aresult, changes in the general level of interest rates have no effect on interestexpense (or the interest payment) that is reflected in the financial statements.

c. Because the bonds trade at a premium in the market, Deere would be payingmore to retire the bonds than the amount at which they are carried on itsbalance sheet. This would result in a loss on the repurchase that would lower

current profitability.

d. The face amount of the bonds will be paid at maturity. As a result, the marketprice of the bonds must also equal their face amount ($200 million) at thattime.

E9-46A (20 minutes)

a. 1. $90,000 0.46319 = $41,6872. $90,000 0.45639 = $41,075

b. $1,000 5.33493 = $5,335

c. $600 17.29203 = $10,375

d. $500,000 0.38554 = $192,770

E9-47 (25 minutes)


Present value of principal repayment ($600,000 0.09722).................$ 58,332Present value of interest payments ($33,000 15.04630).................... 496,528Selling price of bonds.............................................................................$554,860




23/40

E9-47continued.

b.1/1/10 Cash (+A) .. 554,860

Bond discount (+XL, -L) .. 45,140Bonds payable (+L) .. 600,000

6/30/10 Interest expense (+E, -SE) 33,292Bond discount (-XL, +L) .. 292Cash (-A) . 33,000

$33,292 = $554,860 .06.

12/31/10 Interest expense (+E, -SE) 33,309Bond discount (-XL, +L) .. 309Cash (-A) .. 33,000

$33,309 = ($554,860 + $292) .06.

c. + Cash (A) - - Bonds Payable (L) +1/1/10 554,860 600,000 1/1/10

33,000 6/30/10

33,000 12/31/10


6/30/10 33,292 292 6/30/1012/31/10 33,309 309 12/31/10

d.Balance Sheet Income Statement


NoncashAssets =

Liabil-ities +

Contrib.Capital +


NetIncome

1/1/10 Issue bonds ata discount.

+554,860Cash

=

+600,000Bonds

payable

-45,140Bonds

Payable,net

- =


-33,000Cash

+292Bonds

Payable,

net


-


-33,292

12/31/10Interestpayment on bonds.

-33,000Cash =

+309Bonds

Payable,net


-


=

-33,309




24/40

E9-48 (25 minutes)


Present value of principal repayment ($400,000 0.61391)...................... $245,564Present value of interest payments ($26,000 7.72173)............................ 200,765

Selling price of bonds.................................................................................. $446,329

b.1/1/10 Cash (+A) ... 446,329

Bond premium (+L) 46,329Bonds payable (+L) 400,000

6/30/10 Interest expense (+E,-SE) . 22,316Bond premium (-L) . 3,684

Cash (-A) .. 26,000$22,316 = $446,329 .05.

12/31/10 Interest expense (+E,-SE) . 22,132Bond premium (-L) . 3,868

Cash (-A) .. 26,000$22,132 = ($446,329 - $3,684) .05.


1/1/10 446,329 400,000 1/1/10

26,000 6/30/10

26,000 12/31/10


46,329 1/1/106/30/10 22,316 6/30/10 3,684

12/31/10 22,132 12/31/10 3,868




25/40

E9-48continued.

d.



Liabil-ities +

Contrib.Capital +


NetIncome

1/1/10 Issue bonds ata premium. +446,329Cash

=

+400,000BondsPayable

+46,329Bonds

Payable,net

- =


-26,000Cash =

-3,684Bonds

Payable,net


-


=

-22,316


-26,000Cash

=

-3,868Bonds

Payable,net

-22,132RetainedEarnings -

+22,132InterestExpense =

-22,132

E9-49 (10 minutes)

Current liabilities:Bond interest payable $ 25,000Current maturities of long-term debt:10% bonds payable due 2011, including $15,000 premium 515,000

Total current liabilities $540,000

Long-term debt:9% bonds payable due 2012, net of $19,000 discount $581,000Zero coupon bonds payable due 2013 170,5008% bonds payable due 2015 100,000

Total long-term debt $851,500




26/40

E9-50 (20 minutes)a.12/31/10 Cash (+A) 500,000

Mortgage note payable (+L) . 500,000

3/31/11 Interest expense (+E, -SE) . 10,000

Mortgage note payable (-L) ... 8,278Cash (-A) 18,278

6/30/11 Interest expense (+E, -SE) . 9,834Mortgage note payable (-L) ... 8,444

Cash (-A) 18,278

$9,834 = ($500,000 $8,278) x 8%/4.

b.+ Cash (A) - - Mortgage Note Payable (L) +

12/31/10 500,000 500,000 12/31/10

18,278 3/31/11 3/31/11 8,27818,278 6/30/11 6/30/11 8,444

+ Interest Expense (E) -3/31/11 10,0006/30/11 9,834

c.



NoncashAssets =

Liabil-ities +

Contrib.Capital +


NetIncome

12/31/10 Borrow$500,000 on a 10-year mortgage notepayable.

+500,000Cash

=

+500,000Mortgage

NotePayable

- =


-18,278Cash =

-8,278Mortgage

NotePayable


-


=

-10,000


-18,278Cash

=

-8,444Mortgage

NotePayable


+9,834InterestExpense =

-9,834




27/40

PROBLEMS

P9-51 (20 minutes)

a.Hewlett-Packard Dell Inc.

- Accrued Warranty Liability (L) + - Accrued Warranty Liability (L) +

2,376 07 bal. 929 07 bal.3,244 08 exp. 1,180 08 exp.

3,006 1,0742,614 08 bal. 1,035 08 bal.

Hewlwtt-Packard incurred $3,006 million in warranty repair costs and settlementsin 2008 while Dell, Inc. incurred costs of $1,074 million.

b. HPs ratio of warranty expense to sales was 3.5% in 2008 ($3,244/$91,697) upfrom 3.1% in 2007 ($2,604/$84,229). Dells ratio was 1.9% both years($1,180/$61,101 in 2008 and $1,176/$61,133 in 2007). Dells warranty expenseis lower and more stable relative to sales revenue than that of HP. Possiblereasons for this include the following: (1) perhaps Dell products are higher-quality and require fewer repairs than HP products or (2) HP may have a moregenerous warranty policy than Dell, resulting in more warranty repairs, even ifthe quality is the same. The increase in HPs warranty expense as a percent ofsales indicates that either (1) warranty costs have gone up, (2) the companyunderestimated warranty costs in the past and needed to record larger than

normal accruals in 2008 to correct the underestimation; or (3) HP is buildingup a cookie-jar reserve by increasing its warranty liability this year.




28/40

P9-52 (20 minutes)

a. Cash (+A) .. 518,750Accrued interest payable (+L) 18,750Bonds payable (+L) .. 500,000

$18,750 = $500,000 x .09 x 5/12

b. Interest expense (+E, -SE). 3,750Accrued interest payable (-L) .. 18,750

Cash (-A) .. 22,500$22,500 = $500,000 x 9%/2

c. Interest expense (+E, -SE) 7,500Accrued interest payable (+L) 7,500

$7,500 = $500,000 x 9% x 2/12

d. Interest expense (+E, -SE) 15,000Accrued interest payable (-L) .. 7,500

Cash (-A) .. 22,500

e. Bonds payable (-L) . 300,000Loss on retirement of bonds (+E, -SE) . 3,000

Cash (-A) .. 303,000

+ Cash (A) - - Bonds payable (L) +

a. 518,750 500,000 a.22,500 b.22,500 d.

303,000 e. e. 300,000

+ Interest expense (E) - - Accrued Interest Payable (L) +

18,750 a.b. 3,750 b. 18,750c. 7,500 7,500 c.

d. 15,000 d. 7,500+ Loss on Retirement of Bonds (E) -

e. 3,000




29/40



Liabil-ities +

Contrib.Capital +

Earnedcapital Revenues - Expenses =

NetIncome

a. (10/1/10) Issuebonds.

+518,750Cash

=

+500,000Bonds

Payable

+18,750InterestPayable

- =

b. (11/1/10 Interestpayment on bonds.

-22,500Cash =

-18,750InterestPayable



=-3,750

c. (12/31/10) Accruedinterest on bonds. =




=-7,500

d. (5/1/11) Interestpayment on bonds.

-22,500Cash =




=-15,000

e. 5/1/15 Earlyretirement ofbonds.

-303,000Cash

=

-300,000Bonds

Payable


+3,000Loss on

Retirement

of Bonds

=

-3,000

P9-53 (15 minutes)

a. CVS reports interest expense of $529.8 million on average long-term debtof $8,203.45 million ([$8,057.2 million + $8,349.7 million]/2) for an average rate

of 6.5%. Using interest paid ($573.7 million) instead of interest expense yields7.0%. See the answer to c below.

b. CVS reports coupon rates of 4.0% to 8.52% so, the average rate seemsreasonable given the information disclosed in the long-term debt footnote.

c. Interest paid can differ from interest expense if bonds are sold at apremium or a discount. It can also differ because of capitalized interest. CVSreported capitalized interest of $27.8 million in 2008 (information not providedin the problem).




30/40

P9-54 (25 minutes)

a. 6/1/10 Cash (+A) . 824,000Accrued interest payable (+L) . 24,000Bonds payable (+L) 800,000

$24,000 = $800,000 x .09 x 4/12

b. 9/1/10 Interest expense (+E, -SE) .. 12,000Accrued interest payable (-L) . 24,000

Cash (-A) 36,000$36,000 = $800,000 x 9%/2

c. 12/31/10 Interest expense (+E, -SE) 24,000Accrued interest payable (+L) . 24,000

d. 3/1/11 Interest expense (+E) 12,000Accrued interest payable (-L) . 24,000

Cash (-A) 36,000

e. 3/1/11 Bonds payable (-L) 200,000Loss on retirement of bonds (+E, -SE) 2,000

Cash (-A) .. 202,000

+ Cash (A) - - Bonds Payable (L) +

a. 824,000 36,000 b. 800,000 a.36,000 d.

202,000 e. e. 200,000

+ Interest Expense (E) - - Accrued Interest Payable (L) +

b. 12,000 b. 24,000 24,000 a.c. 24,000 d. 24,000 24,000 c.d. 12,000

+ Loss on Retirement of Bonds (E) -

e. 2,000




31/40



NoncashAssets =

Liabil-ities +

Contrib.Capital +


NetIncome

a. (7/1/10) Issuebonds.

+824,000Cash

=

+800,000Bonds

Payable


- =

b. (9/1/10) Interestpayment on bonds.

-36,000Cash =




=-12,000

c. (12/31/10) Accruedinterest on bonds. =




=-24,000

d. (3/1/11) Interestpayment on bonds.

-36,000Cash =




=-12,000

e. 3/1/11 Earlyretirement of

bonds.

-202,000Cash =

-200,000Bonds

Payable

-2,000Retained

Earnings -

+2,000Loss on

Retirementof bonds

=

-2,000

P9-55 (20 minutes)a.

PeriodInterestexpense

Cashinterest

paid

Discountamortizatio

nDiscountbalance

Bondpayable net

0 $41,292 $678,7081 $40,722 $39,600 $1,122 $40,170 $679,8302 $40,790 $39,600 $1,190 $38,980 $681,020

$40,722 = $678,708 x 12%/2.$40,790 = $679,830 x 12%/2.

b.12/31/10 Cash (+A) .. 678,708

Bond discount (+XL) . 41,292Bonds payable (+L) .. 720,000

6/30/11 Interest expense (+E,-SE) . 40,722Bond discount (-XL) .. 1,122Cash (-A) .. 39,600

12/31/11 Interest expense (+E,-SE) . 40,790Bond discount (-XL) .. 1,190Cash (-A) .. 39,600




32/40


12/31/10 678,708 720,000 12/31/10

39,600 6/30/11

39,600 12/31/11


6/30/11 40,722 1,122 6/30/1112/31/11 40,790 1,190 12/31/11

d.



NoncashAssets =

Liabil-ities +

Contrib.Capital +

RetainedEarnings

Revenues - Expenses = NetIncome

12/31/10 Issue bondsat a discount.

+678,708Cash

=

+720,000Bonds

Payable

-41,292Bonds

Payable,net

- =


-39,600Cash =

+1,122Bonds

Payable,net


-


=

-40,722


-39,600Cash =

+1,190Bonds

Payable,net


-


=

-40,790




33/40

P9-56 (20 minutes)

a.

PeriodInterestexpense

Cashinterest

paid

Discountamortizatio

nDiscountbalance

Bondpayable net

0 $43,230 $206,7701 $8,271 $7,500 $771 $42,459 $207,5412 $8,302 $7,500 $802 $41,657 $208,343

$8,271= $206,770 x 8%/2.$8,302 = $207,541 x 8%/2.

b.4/30/10 Cash (+A) .... 206,770

Bond discount (+XL, -L) . 43,230Bonds payable (+L) . 250,000

10/31/10 Interest expense (+E, -SE) ..... 8,271Bond discount (-XL, +L) . 771Cash(-A) .. 7,500

12/31/10 Interest expense (+E, -SE) ..... 2,767Bond discount (-XL, +L) . 267Accrued interest payable (+L) .. 2,500

4/30/11 Interest expense (+E, -SE) ..... 5,535Accrued interest payable (-L) .... 2,500

Bond discount (-XL, +L) . 535

Cash(-A) .. 7,500


4/30/10 206,770 250,000 4/30/10

7,500 10/31/10

7,500 4/30/11


10/31/10 8,271 771 10/31/1012/31/10 2,767 267 12/31/104/30/11 5,535 535 4/30/11

- Accrued Interest Payable (L) +

2,500 12/31/104/30/11 2,500




34/40

d.



NoncashAssets =

Liabil-ities +

Contrib.Capital +


NetIncome

4/30/10 Issue bonds ata discount.

+206,770Cash

=

+250,000Bonds

Payable

-43,230Bonds

Payable,net

- =


-7,500Cash =

+771Bonds

Payable,net


-


=

-8,271

12/31/10 Accruedinterest on bonds.

=

+267Bonds

Payable,net

+2,500AccruedInterestPayable


-


=

-2,767


-7,500Cash

=

+535Bonds

Payable,net

-2,500AccruedInterestPayable


-


=

-5,535




35/40

P9-57 (20 minutes)

a. Payment x 12.46221 = $500,000; Payment = $500,000/12.46221 = $40,121.

b.12/31/10 Cash (+A) .. 500,000

Mortgage note payable (+L) 500,0006/30/11 Interest expense (+E, -SE) 25,000

Mortgage note payable (-L) . 15,121Cash (-A) .. 40,121

* $25,000 = $500,000 x 10%/2

12/31/11 Interest expense (+E, -SE) . 24,244Mortgage note payable (-L) .. 15,877

Cash (-A) .. 40,121

$24,244 = ($500,000 $15,121) x 10%/2.

c.+ Cash (A) - - Mortgage Note Payable (L) +

12/31/10 500,000 500,000 12/31/10

40,121 6/30/11 6/30/11 15,12140,121 12/31/11 12/31/11 15,877

+ Interest Expense (E) -

6/30/11 25,00012/31/11 24,244

d.



Liabil-ities +

Contrib.Capital +


NetIncome

12/31/10 Borrow$500,000 on a 10-year mortgage note

payable.

+500,000Cash

=

+500,000Mortgage

NotePayable

- =


-40,121Cash =

-15,121Mortgage

NotePayable


-


=

-25,000


-40,121Cash =

-15,877Mortgage

NotePayable


-


=

-24,244




36/40

P9-58 (20 minutes)

a. Payment x 16.35143 = $950,000; Payment = $950,000/16.35143 = $58,099.b.12/31/10 Cash (+A) .. 950,000

Mortgage note payable (+L) 950,000

3/31/11 Interest expense (+E, -SE) 19,000*Mortgage note payable (-L) . 39,099

Cash (-A) .. 58,099

* $19,000 = $950,000 x 8%/4

6/30/11 Interest expense (+E, -SE) 18,218*Mortgage note payable (-L) . 39,881

Cash (-A) .. 58,099

* $18,218 = ($950,000 $39,099) x 8%/4.

c.+ Cash (A) - - Mortgage Note Payable (L) +

12/31/10 950,000 950,000 12/31/10

58,099 3/31/11 3/31/11 39,09958,099 6/30/11 6/30/11 39,881

+ Interest Expense (E) -

3/31/11 19,0006/30/11 18,218

d.



NoncashAssets =

Liabil-ities +

Contrib.Capital +


NetIncome

12/31/10 Borrow$950,000 on a 5-year mortgage notepayable.

+950,000Cash

=

+950,000Mortgage

NotePayable

- =

3/31/11 Payment on

note.

-58,099

Cash =

-39,099

MortgageNotePayable

-19,000

RetainedEarnings -

+19,000

InterestExpense = -19,000

6/30/11 Payment onnote.

-58,099Cash =

-39,881Mortgage

NotePayable


-


= -18,218




37/40

P9-59 (20 minutes)

a. 1. $90,000 x 0.54703 = $49,233

2. $90,000 x 0.53997* = $48,597 (*0.53997 = 1.045-14)

3. $90,000 x 0.53632** = $48,269 (**0.5632 = 1.0225-28)

b. $1,000 x 4.21236 = $4,212

c. $2,400 x 15.24696 = $36,593

d. $500,000 x 0.38554 = $192,770

e. $2,500 x 11.46992 + $85,000 x 0.31180 = $55,178

P9-60 (20 minutes)

a. $7,000 x 4.17725 = $29,241.

b. $7,000 x 4.32194 = $30,254.

c. $29,241 x 0.23939 = $7,000.

d. $6,000 x 1.69005 = $10,140.

e. $500 x 21.24339 = $10,622.




38/40

CASES

C9-61 (50 minutes)

a. The $1,300 million reported in short-term liabilities means that this face

amount will come due in 2009 and needs to be paid or refunded with new debt.The amount of debt needed to be either paid or refunded with a new issue isimportant because it implies required uses of cash unless refunding isavailable. The note reveals that, in October 2008, PBG issued $1,300 millionof 6.95% senior notes due in 2014 and the proceeds were used to pay off the7% notes due in February 2009. At the end of 2008, both debt issues appearedon PBGs balance sheet.

b. The 98.919 price indicates that each $1,000 bond would sell for $989.19. Each$1,000 bond still returns $70 of interest per year. The result is that theinvestor's return is increased. The lower bond price reflects an increase inmarket interest rates.

c. The first covenant indicates an upper limit on borrowing. The debt to EBITDAratio is an additional constraint on the level of debt. The third covenantrestricts new borrowing secured by the pledge of specific assets of the firm.All of these covenants restrict the firm's freedom to borrow.

d. Bond discount arises when a bond is sold at less than par. Sale below paroccurs when the market interest rate exceeds the coupon rate for the issue.The result is that the issuer receives less money but the interest paymentremains at the coupon rate. The amortization of the bond discount results inan increase in the firm's interest expense. The initial discount is reported as adebit contra account to the outstanding bond's face value. The discount isamortized over time reflected by a credit to it and a debit to interest expense.




39/40

C9-62 (50 minutes)

a. From the firm's view, it is useful to know the maturity dates in order tocomplete the firm's cash budget and to be able to plan for any refunding oradditional cash needs if refunding is not an option. This information is alsouseful to analysts as that they consider the firms solvency and debt capacity

as indicators of the firm's health and ability to implement its strategy.

b. Several factors can cause a difference between interest expense and interestpaid. Some of a firm's accrued interest may have been capitalized to assetsunder construction. In addition, bonds issued at a discount will result ininterest expense that is greater than interest paid, while bonds issued at apremium will lead to interest expense that is less than cash interest paid.

c. Several ratios discussed in this chapter may be useful in assessing a firmsriskiness include the firm's debt-to-equity ratio and its time interest earned.Credit rating companies look for the amount of indebtedness in relation to the

operating cash flow and asset size of the company. This is because cashserves as the primary source of debt repayment and assets serve as a backupsource, in the event of default. Other factors such as profitability measures, anexamination of the firm's closeness to its debt covenants, the state of thefirm's sales and industry health should also be considered.

d. $374.57 million. If the notes originally sold at par, the difference between the$385 million issue price and the current $374.57 million value would not bereflected in the firm's current financial statements. (The firm could report themarket value in a note if it wished.) Repurchase of the issue at the currentmarket price would eliminate the debt of $385 million for a cash payment of

$374.57 million and a gain on redemption equal to the difference. The 97.29price tells us that market rate of interest for the risk level associated with thisdebt issue has increased. An alternative explanation would be thatSouthwest's credit rating has declined since the notes were issued.

e. Cash (+A) ....... 297Bond discount (+XL) ................ 3

5% Notes payable, due 2016 (+L) .... 300




40/40

C9-63 (20 minutes)

a. The gain results from the difference between the book value of the debt($3,000,000) and the current redemption (market) value ($1,900,000). The gain

would be reported in the income statement under other (nonoperating)income. The source of the gain should be adequately disclosed in the notes.

b. Currently, Foster is paying 8% interest on the $3,000,000 of long-term debt, or$240,000 per year. Under the proposed refinancing, Foster would pay 16%, or$480,000. The refinancing would generate an additional $1,100,000 in cash.However, because interest costs are increasing by $240,000 per year ($480,000- $240,000), Foster is effectively borrowing the additional $1,100,000 at a rateof almost 22% ($240,000 / $1,100,000). As such, Foster would be paying in thefuture (in the form of higher interest costs) for a one-time boost in currentearnings.

c. The potential ethical conflict exists because Fosters president is concerned

that his job might be dependent on producing short-term earnings. Becauseof this, he might be tempted to accept this proposal and boost currentearnings at the cost of lower earnings in future years. This thinking ismisguided because, given adequate disclosure, analysts and investors wouldbe able to identify and discount the source of the earnings boost. The mostserious unethical act would be to try to hide (or obfuscate) the bondrefinancing with inadequate disclosure.

Date post:	14-Apr-2018
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DMP3e CH09 Solutions 05.17.10 Revised

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