Chapter 10 Solution of fundamental of financial accouting by EDMONDS (4th edition)

ANSWERS TO QUESTIONS - CHAPTER 10

1. Short-term notes mature within one year or one operating cycle, whichever is longer. Long-term notes payable are used to satisfy financing periods that range from two to five years; i.e., notes that do not mature within one year or one operating cycle, whichever is longer, are classified as long-term.

2.Principal Paymen

tInterest Reducti

on Period Bal. 1/1 12/31 Exp. 8% of Prin.1 $ 72,000 $16,246 $5,760 $10,4862 61,514 16,246 4,921 11,3253 50,189

Interest expense in year 1 and 2 is $5,760 and $4,921, respectively. The principal balance at the end of year 2 is $50,189.

3. A line of credit is a preapproved amount of credit that is available to a business to use as needed. It eliminates the need to get loan approval each time the company needs some additional cash. When using a line of credit, money can be borrowed one day and paid back the next or used for some prespecified period. A line of credit is generally used for short-term financing where it is not practical to issue bonds.

4. A business may need to borrow funds for a short period of time or a longer period. Most short-term financing is in the form of loans from financial institutions. However, when a business needs large sums of money, one financial institution may not be able to meet the needs of the business. A company can obtain long-term permanent financing through the issuance of bonds.

5. One of the primary advantages of bond financing is that the company can usually obtain larger amounts of money over a longer term. By going directly to the public, the

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company may also be able to obtain lower financing costs.

6. One of the primary disadvantages of a bond issue is the restrictions that may be placed on management. These restrictions are called debt covenants and may restrict some actions of management, e.g., there may be a restriction on the amount of dividends that can be paid.

7. One reason that a company may be able to borrow money more cheaply if bonds are issued rather than borrowing the money from a financial institution is the way financial institutions make their money. Banks receive money from customers through investments in checking or savings accounts for which the bank must pay these customers interest. The bank then uses these funds to make loans to other customers. The difference in the amount paid to depositors and the amount received from loan customers is called a spread. The spread is the amount the bank uses to pay operating expenses and then to make a profit. Bonds are sold directly to the public, thereby avoiding the spread. However, the risk to the bondholder is greater, so the interest rate that must be paid is generally higher than for savings accounts.

8. Tax rules seem to encourage borrowing (debt financing) over stockholder financing (equity financing) because interest paid on debt is deductible for tax purposes. Dividends paid to stockholders are not tax deductible. The fact that interest is deductible reduces the cost of borrowing by reducing the amount of tax that will be paid. However, this scenario is only applicable if the business is a for-profit business and has taxable income.

9. Financial leverage is the concept of acquiring additional funds through debt, then using these funds to invest in projects that yield a rate of return higher than the cost of the debt. Financial leverage is using debt to increase the earnings of a business.

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10. The secured bond will usually have the lower interest rate because the bondholder has less risk when the debt is backed by some real asset. The unsecured bond is issued based on the general credit of the company and is not secured by any particular company asset.

11. Restrictive covenants are limitations placed on a company that will help to reduce a bondholder's risk of default. Common covenants include restrictions on additional borrowing, payment of dividends to owners, and salaries of key employees.

12. Bearer bonds are unregistered bonds and payment is made to any individual who redeems the coupons or bond. No record is kept of the purchaser; this makes these bonds more susceptible to theft.

13. Term bonds mature on a specific date in the future. For example, a $1,000,000, 10-year term bond issued on Jan. 1, 1996 would mature Jan. 1, 2006.

Serial bonds mature at specified intervals over the life of the entire issue. For example, a $1,000,000 serial bond issued may mature at $100,000 each year over 10 years.

14. A sinking fund is a fund into which a company makes annual or periodic payments to assure the availability of cash for the payment of the principal amount at the maturity date of the bond.

15. Callable bonds allow the company to pay off the debt prior to the maturity date at a specified amount called the call price. The call price is usually higher than the face value of the bond. This call premium provides some protection to bondholders when the interest rate falls and the company pays off the bond earlier than the maturity date.

16. The issuance of $100,000, 5%, 10-year bonds at face will result in an increase to assets (cash + $100,000) and liabilities on the balance sheet. The income statement is not affected by the issuance of the bonds. The cash flows

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statement will show $100,000 cash inflows from financing activities.

Annual interest expense and interest payments will be $5,000 ($100,000 x 5%). Interest expense will reduce net income on the income statement. The interest payment is a cash outflow from operating activities on the statement of cash flows.

17. Bonds can be issued at a premium or discount (an amount above or below the face amount of the bond) to equate the stated interest rate with the market interest rate. The difference in cash proceeds from face value causes the “effective” interest rate to approximately equal the market rate.

18. When the effective interest rate is higher than the stated interest rate the bond will sell at a discount. The amount of the discount combined with the stated rate of interest will equal the effective interest rate or market interest rate.

19. The issuance of bonds by a company is an asset source transaction. Assets increase and liabilities increase.

20. The passage of time is usually the cause of the effective interest rate and the stated interest rate being different. When bonds are issued, the interest rate is set, usually at the market rate at that time. However, as time passes, the market rate of interest will continue to change. Bonds will sell at a discount or premium to equate the two interest rates and attract buyers for the bonds.

21. The cash received for the bond will be $975 (1,000 x .975).

22. The carrying value of a bond is the face value of the bond less any unamortized discount or plus any unamortized premium.

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23. The carrying value of the bonds is $19,800 ($25,000 face minus $5,200 discount).

The total liability to be paid at maturity is $25,000. That amount represents the $19,800 cash received plus $5,200 of discount (interest) subtracted at issue.

24. When the effective interest rate is higher than the stated interest rate, interest expense will be larger than the amount of interest paid. Interest paid is equal to the face value of the note times the stated interest rate. Interest expense is the amount of the interest paid plus the amortization of bond discount.

25. The issuer of a bond would prefer to pay interest annually rather than semiannually because of the timing of the cash outflow. Interest paid annually is paid only once a year, at the end of the year. Semiannual interest payments require part of the cash outflow to occur every six months. While the amount of interest paid is the same, paying interest semiannually transfers control of the funds (i.e., use of the funds) to the bondholder earlier in the period. This precludes the bond issuer from using that cash in operations.

26. The $2,850 loss, if material, is shown as an extraordinary item, below operating income on the income statement.

27. Debt financing has a tax advantage over equity financing because interest payments are tax deductible while dividend payments are not.

28. The after-tax cost of the debt is $7,000, computed as follows:

Interest Expense $10,000Reduction in Taxes ($10,000 x 30%) (3,000)After-Tax Cost $ 7,000

Note: A $10,000 dividend paid to stockholders is not deductible in calculating taxable income and, therefore,

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would not reduce the income tax liability as interest does.

29. Debt financing increases the risk factor of a business. This risk arises due to the definite liability to pay interest on the debt and repay the principal at maturity. There is no legal obligation to pay dividends to stockholders or to return their investment at a specific future date. A business should use a balance of debt and equity financing to effectively increase earnings while managing financial risk.

30. The times-interest-earned ratio (EBIT/Interest Expense) assesses the ability of a company to pay its interest expense and is a measure of financial risk from the use of leverage. Higher times-interest-earned ratios suggest lower levels of risk.

APPENDIX

31. Simple Interest is interest on the principal only and is calculated as: Principal x Rate x Time.

Compound interest means that interest earned is reinvested and interest in future periods is computed on both principal and prior interest earned. This compounding allows the investor to earn more over the same time period than simple interest.

32. The future value of an investment is the amount that an investment made today will grow to at some specific future date and specific rate of compound interest.

The future value of an investment can be calculated by multiplying the investment by a future value conversion factor. Conversion factors are available in mathematical tables for most common interest rates and time periods (Table I). The factors can also be manually calculated from the formula: (1 + i)n where i = the interest rate and n = the number of interest payment periods.

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33. The future value of $10,000 invested at 8% interest for 4 years is $13,605:

$10,000 x (1 + .08)4 = $10,000 x 1.3604890 = $13,604.890 $13,605

Alternatively, the factor can be found in Table I by moving down the column marked “n” to period 4 and across to the column marked 8%. The factor found here is 1.360489.

34. The present value of an investment is the worth today of an amount to be received at some specific date in the future at a specific interest rate.

Present value is calculated by multiplying the amount of the investment by a present value conversion factor. Conversion factors can be calculated as 1/(1 + i)n, where “i” is the interest rate and “n” is the number of interest payment periods. Present value factors can also be found in prepared tables (Table II).

35. Present value of $25,000 to be received in 3 years, discounted at 8% is $19,846:$25,000 x [1/(1 + .08)3] or;25,000 x .793832241 = $19,845.80603 $19,846Alternatively, the present value factor can be found in Table II by looking down the column marked “n” to 3 and across to the 8% column. The factor there is .793832.

36. The present value of a $4,000 annuity received for 4 years at 8% is $13,248:$4,000 x 3.312127 = $13,248.508 $13,249

37. The effective interest method applies a constant rate of interest (market rate) to the changing carrying value of the bond to calculate interest expense. The premium/discount amortization is the difference between interest expense and interest payment (stated rate).

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Straight-line amortization charges an equal amount of premium/discount to interest expense each year over the term of the bond.

The effective interest method is conceptually more correct than the straight-line method because interest expense changes as the carrying value of the liability changes. GAAP requires the effective interest method if it yields a materially different expense from that of straight-line.

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SOLUTIONS TO EXERCISES - SERIES A - CHAPTER 10

EXERCISE 10-1A

a. Year 1

Option 1 - annual interest only:$100,000 x 9% = $9,000

Option 2 - annual interest and $10,000 on principal:$100,000 x 9% = $9,000

Note: The amount of interest paid in year 1 is the same under both options because no payment was made on the principal until the end of the year under option two.

b. Year 2

Option 1 - annual interest only:$100,000 x 9% = $9,000

Option 2 - annual interest and $10,000 on principal:Original principal: $100,000Less, payment at end of year one (10,000 ) Balance of principal for year two$ 90,000

$90,000 x 9% = $8,100

Note: Under option two, less interest will be paid in year two and in future years because the amount subject to interest is less.

c. Under option one, only annual interest is paid. This is a desirable option if a company expects cash flow problems in the early years. More interest will be paid, but less cash is required in the short term. Option two is more advantageous if the business has enough cash to pay both principal and interest each year. This option is less costly.

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10-10

EXERCISE 10-2A

Wallace CompanyAmortization Schedule

$80,000, 4-Yr. Term Note, 9% Interest Rate

YearPrin. Bal. on Jan 1

Cash Pay. Dec. 31

Applied to

Interest

Applied to

Principal

Prin. Bal. End of Period

2004

$80,000 $24,693 $7,200 $17,493 $62,507

2005

62,507 24,693 5,626 19,067 43,440

2006

43,440 24,693 3,910 20,783 22,657

2007

22,657 24,693 2,036* 22,657 -0-

*Adjusted due to rounding.

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EXERCISE 10-3A

The first four years are provided for the use of the instructor:

Yang CompanyAmortization Schedule



Cash Pay. Dec. 31

Applied to

Interest

Applied to

Principal

Prin Bal. end of Period

2004

$100,000 $14,903 $8,000 $6,903 $93,097

2005

93,097 14,903 7,448 7,455 85,642

2006

85,642 14,903 6,851 8,052 77,590

2007

77,590 14,903 6,207 8,696 68,894

a.1. $8,0002. $6,903

b. $93,097

c.1. $7,4482. $7,455

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EXERCISE 10-4Aa. $13,500 $150,000 = .09b.

Effect of Transactions on Financial Statements

Balance Sheet Income Statement Statement of

No.

Assets = Liab. + S. Equity

Rev. Exp. = Net Inc.

Cash Flows

1. 150,000 = 150,000 + NA NA NA = NA 150,000 FA

2. (38,563)

= (25,063)

+ (13,500)

NA 13,500

= (13,500)

(25,063) FA

(13,500) OA

c. (1)

Revenue $100,000

ExpensesOperating

Expenses$50,000

Interest Expense 13,500Total Expenses 63,500

Net Income $ 36,500

c. (2)

Cash Flows From Operating Activities:

Inflow from Customers $100,000Outflow for Expenses (63,500)

Net Cash Flow from Operating Activities

$ 36,500

c. (3)

Cash Flows From Financing Activities:

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Inflow from Issue of Note $150,000Outflow to Repay Note (25,063)

Net Cash Flow from Financing Activities

$124,937

d. Principal 1/1/04: $97,618 ($124,937 $27,319)$97,618 x 9% = $8,785.62 or $8,786 rounded to nearest

dollar.

10-14

EXERCISE 10-5A

MonthAmount

Borrowed (Repaid)

Balance End of Month

Interest Rate

Interest

Expense

January $100,000 $100,000 .08/12 $667February

50,000 150,000 .07/12 875

March (60,000) 90,000 .075/12

563

April 10,000 100,000 .07/12 583

Date Account Titles Debit Credit

2004Jan. 1 Cash 100,000

Line of Credit Payable 100,000

Jan. 31 Interest Expense 667Cash 667

Feb. 1 Cash 50,000Line of Credit Payable 50,000

Feb. 28 Interest Expense 875Cash 875

March 1 Line of Credit Payable 60,000Cash 60,000

March 31

Interest Expense 563

Cash 563

April 1 Cash 10,000Line of Credit Payable 10,000

April 30 Interest Expense 583Cash 583

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10-16

EXERCISE 10-6A

a. $50,000 x 9% = $4,500

b. $50,000 x 9% x 6/12 = $2,250 on June 30$50,000 x 9% x 6/12 = $2,250 on December 31

or a total of $4,500 will be paid in 2004.

c. The total amount of interest paid each year will be the same regardless of whether it is paid annually or semiannually. Because of the time value of money, semiannual interest works to the advantage of the lender (bondholder) and the disadvantage of the issuer of the bonds. Huggins would prefer the annual interest; cash only has to be paid at the end of the year.

10-17

EXERCISE 10-7A

Face x Selling Price

Cash Proceeds

Discount or Premium

a. $100,000 x 101% $101,000 Premium

b. $150,000 x 98% 147,000 Discount

c. $200,000 x 102.25%

204,500 Premium

d. $40,000 x 97.5% 39,000 Discount

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EXERCISE 10-8A

a. Premium

b. Discount

c. Discount

d. Premium

e. Face

EXERCISE 10-9A

a. Discount (Stated rate is less than market rate.)

b. Discount (Stated rate is less than market rate.)

c. Premium (Stated rate is greater than market rate.)

EXERCISE 10-10A

a. $60,000 x 4% = $2,400; Premium

b. $90,000 x 1.5% = $1,350; Premium

c. $200,000 x 1.75% = $3,500; Discount

d. $150,000 x 4% = $6,000; Discount

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EXERCISE 10-11Aa.



No.



Cash Flows

1. + = + + NA NA NA = NA + FA2. NA = + + NA + = NA3. = NA + NA + = OA

b. Amortization of bond discount, 2004: $4,000 10 = $400 per year

Carrying Value, December 31, 2002:

Bonds Payable $200,000Less: Discount on Bonds Payable (3,600)Carrying Value, December 31, 2002$196,400

c. Interest Expense, 2002:

Stated Interest ($200,000 x 10%)$20,000Amortization of Bond Discount 400Interest Expense $20,400

d. Carrying Value, December 31, 2003:

Bonds Payable $200,000Less: Discount on Bonds Payable (3,200 ) Carrying Value, December 31, 2003$196,800

e. Interest Expense, 2003:

Stated Interest ($200,000 x 10%)$20,000Amortization of Bond Discount 400Interest Expense $20,400

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EXERCISE 10-12Aa.


Balance Sheet Income Statement Stmt. ofNo.



Cash Flows

1. + = + + NA NA NA = NA + FA2. NA = + + NA = + NA3. = NA + NA + = OA

b. Amortization of bond premium, 2002: $4,000 10 = $400 per year


Bonds Payable $200,000Plus: Premium on Bonds Payable ($4,000 $400) 3,600Carrying Value, December 31, 2002 $203,600


Stated Interest ($200,000 x 10%) $20,000Amortization of Bond Premium (400)Interest Expense $19,600





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EXERCISE 10-13Aa.

Home Supplies, Inc.General Journal


2003July 1 Cash1 95,000

Discount on Bonds Payable 5,000Bonds Payable 100,000

Dec. 31

Interest Expense 3,250

Discount on Bonds Payable2

250

Cash3 3,000

Dec. 31

Retained Earnings 3,250


2004June 30


Discount on Bonds Payable 250Cash 3,000

Dec. 31


Discount on Bonds Payable 250Cash 3,000

Dec. 31



1$100,000 x .95 = $95,0002$5,000 10 = $500; $500 x 6/12 = $2503$100,000 x 6% x 6/12 = $3,000

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EXERCISE 10-13A a.(cont.)

Home Supplies, Inc.T-accounts

Assets = Liabilities + Stockholders’ Equity

Cash Bonds Payable Retained Earnings2003 2003 20037/1 95,000 12/31

3,0007/1100,000 cl 3,250

Bal. 92,000 Bal.100,000

Bal. 3,250

2004 20046/30 3,000 cl 6,50012/313,000

Disc. on Bonds Pay. Bal. 9,750

Bal. 86,000 20037/1 5,000 12/31 250 Interest ExpenseBal. 4,750 20032004 12/313,250 cl 3,250

6/30 250 Bal. -0-12/31 250 2004

Bal. 4,250 6/30 3,25012/313,250 cl 6,500Bal. -0-

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EXERCISE 10-13A (cont.)b.

Home Supplies, Inc.Balance Sheet

Liabilities 2003 2004Bonds Payable $100,00

0$100,000

Discount on Bonds Payable

(4,750) (4,250)

Net Carrying Value of Bonds

95,250 95,750

Total Liabilities $95,250 $95,750

c. Interest Expense 2003 2004 $3,250 $6,500

d. Cash Outflow for Interest 2003 2004$3,000 $6,000

10-24

EXERCISE 10-14A

Hammond Corp.General Journal


2003Jan.1 Cash 200,000

Bonds Payable 200,000

Dec. 31

Interest Expense* 16,000

Cash 16,000

2004Dec. 31


Cash 16,000

*$200,000 x 8% = $16,000 interest expense per year

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EXERCISE 10-15A

Macy Co.General Journal


2004Jan. 1 Cash1 192,000


Dec. 31

Interest Expense2 1,600

Discount on Bonds Payable 1,600

Dec. 31


Cash 16,000

2005Dec. 31


Discount on Bonds Payable 1,600

Dec. 31


Cash 16,000

1$200,000 x .96 = $192,000 cash proceeds2$8,000 5 = $1,600 discount amortization per year3$200,000 x 8% = $16,000 interest payment per year

10-26

EXERCISE 10-16A

Bay Company General Journal


2004Jan. 1 Cash1 204,000

Premium on Bonds Payable 4,000Bonds Payable 200,000

Dec. 31

Premium on Bonds Payable2 800


Dec. 31


Cash 16,000

2005

Dec. 31

Premium on Bonds Payable 800


Dec. 31


Cash 16,000

1$200,000 x 1.02 = $204,000 cash proceeds2$4,000 5 = $800 premium amortization per year3$200,000 x 8% = $16,000 interest payment per year

10-27

EXERCISE 10-17Aa.

Goode CompanyGeneral Journal


2001Jan. 1 Cash 500,000


Jan. 1 Land 500,000Cash 500,000

Dec. 31

Cash 60,000

Lease Revenue 60,000

Dec. 31

Interest Expense ($500,000 x 8%)

40,000

Cash 40,000

Dec. 31


Interest Expense 40,000Retained Earnings 20,000

2002Dec. 31

Cash 60,000


Dec. 31


Cash 40,000

Dec. 31



10-28

EXERCISE 10-17A a. (cont.)

Goode Company


Cash Bonds Payable Retained Earnings2001 2001 2001

1/1 500,000 1/1 500,000 1/1 500,000 cl 20,00012/31 60,000 12/31 40,000 Bal. 500,000 Bal. 20,000Bal. 20,000 20022002 cl 20,00012/31 60,000 12/31 40,000 Bal. 40,000Bal. 40,000

Lease Revenue2001

Land cl 60,000 12/31 60,0002001 Bal. -0

1/1 500,000 2002Bal.500,000 cl 60,000 12/31 60,000

Bal. -0-

Interest Expense2001

12/31

40,000cl 40,000

Bal. -0-2002

12/31

40,000cl 40,000

Bal. -0-

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EXERCISE 10-17A (cont.) b. Goode Company Financial Statements

Income Statements 2001 2002

Lease Revenue $60,000 $60,000

Interest Expense (40,000) (40,000)

Net Income $20,000 $20,000

Balance SheetsAssets

Cash $ 20,000 $ 40,000Land 500,000 500,000

Total Assets $520,000 $540,000

LiabilitiesBonds Payable $500,000 $500,000

Stockholders’ EquityCommon Stock -0- -0-Retained Earnings 20,000 40,000

Total Stockholders’ Equity 20,000 40,000

Total Liab. and Stockholders’ Equity

$520,000 $540,000

Statements of Cash Flows


Inflow from Revenue $ 60,000 $ 60,000Outflow for Interest (40,000) (40,000)

Net Cash Flow from Operating Act.

20,000 20,000

Cash Flows From Investing Activities:

Outflow to Purchase Land (500,000) -0-


Inflow from Bond Issue 500,000 -0-

10-30

Net Change in Cash 20,000 20,000Plus: Beginning Cash Balance -0- 20,000Ending Cash Balance $ 20,000 $ 40,000

EXERCISE 10-18A

Boark Company


2004Jan. 1 Cash 400,000


2007Dec. 31

Loss on Bond Redemption 8,000

Bonds Payable 400,000Cash 408,000

10-31

EXERCISE 10-19Aa.

Ames Co. Cox Co. Douglas Co.

Bonds Payable $200,000 $500,000 $800,000Interest Rate 8% 7% 6%Before Tax Interest Cost

$ 16,000 $ 35,000 $ 48,000

b.Ames Co. Cox Co. Douglas

Co.Before Tax Interest Cost

$16,000 $35,000 $48,000

x (1 Tax Rate) 65% 80% 75%After Tax Interest Cost

$10,400 $28,000 $36,000

c. There are two ways to determine the after-tax interest cost as a percentage of the face value of the bonds.

1.Ames Co. Cox Co. Douglas Co.

After Tax Interest Cost $ 10,400 $ 28,000 $ 36,000 Bonds Payable $200,000 $500,000 $800,000= After Tax Interest Rate

5.2% 5.6% 4.5%

OR 2.Interest Rate x (1 Tax Rate)

.08 x ( 1.35)

.07 x (1 .2)

.06 x (1 .25)

= After Tax Interest Rate

= 5.2% = 5.6% = 4.5%

10-32

EXERCISE 10-20A

1. $25,000 x 1.628895 = $40,722 (Table I, 5%, 10 years)

2. $1,500 x 10.636628 = $15,955 (Table III, 8%, 8 years)

3. $100,000 x .747258 = $74,726 (Table II, 6%, 5 years)

4. Annual Payment x 7.02358 = $80,000; (Table IV, 7%, 10 years)

$80,000 7.023582 = $11,390 annual payment

EXERCISE 10-21A

a. Payment amount x 3.312127 = $25,000 (Table IV, 8%, 4 years)

$25,000 3.312127 = $7,548

b. $6,000 x 3.312127 = $19,873 (Table IV, 8%, 4 years)

EXERCISE 10-22A

a. Annual payment x 14.486562 = $225,000; (Table III, 8%, 10 years)

$225,000 14.486562 = $15,531.64

b. $225,000 x .463193 = $104,218 (Table II, 8%, 10 years)

10-33

EXERCISE 10-23A

a.Present Value of Principal

$50,000 x .508349 = $ 25,417

Present Value of Interest

$4,000 x 7.0235822

= 28,094

Selling Price $53,5111Table II, 7%, 10 years2Table IV, 7%, 10 years

b.Account Titles Debit Credit

Cash 53,511Premium on Bonds Payable 3,511Bonds Payable 50,000

c. Interest payment amount: $50,000 x .08 = $4,000

Interest expense: Carrying value x effective interest rate$53,511 x 7% = $3,745.77

Amortization of Premium: Interest Payment$4,000.00

Less: Interest Expense( 3,745 .77) Amortization $ 254 .23

Account Titles Debit Credit

Interest Expense 3,745.77

Premium on Bonds Payable 254.23Cash 4,000.00

10-34

EXERCISE 10-24A

The effective interest considers the time value of money. As the premium or discount is amortized, the carrying value of the bond changes. The effective interest method computes the amount of interest on the constantly changing carrying value of the bond liability while the straight-line method simply allocates the premium or discount ratably over the life of the bond. The effective interest method is theoretically the correct method.

10-35

SOLUTIONS TO PROBLEMS - SERIES A - CHAPTER 10

PROBLEM 10-25Aa.

Jones CompanyAmortization Schedule


YearPrin.

Bal. on Jan 1

Cash Pay. Dec.

31

Applied to

Interest

Applied to

Principal


2001

$80,000 $31,043 $6,400 $24,643 $55,357

2002

55,357 31,043 4,429 26,614 28,743

2003

28,743 31,043 2,300* 28,743 -0-

*Adjusted due to rounding

10-36

PROBLEM 10-25A (cont.)b. Provided for the use of the Instructor:

Cash Notes Payable Retained Earnings2001 2001 2001

1/1 80,000 1/1 80,000 1/1 80,000 cl 29,60012/31

36,00012/3131,043

12/31 24,643

Bal. 29,600

Bal. 4,957 Bal.55,357

2002

2002 2002 cl 31,57112/31

36,00012/3131,043

12/3126,614 Bal. 61,171

Bal. 9,914 Bal.28,743

2003

2003 2003 cl 33,70012/31

36,00012/3131,043

12/3128,743 Bal. 94,871

Bal.14,871 Bal. -0-Rent Revenue

Land 20012001 cl 36,000 12/31

36,0001/1 80,000 Bal. -0Bal. 80,000 2002

cl 36,000 12/3136,000Bal. -0

2003cl 36,000 12/31

36,000Bal. -0

Interest Expense200112/31 6,400 cl 6,400Bal. -0-200212/31 4,429 cl 4,429Bal. -0-200312/31 2,300 cl 2,300Bal. -0-

10-37

PROBLEM 10-25A (cont.)Jones Company

Financial Statements

Income Statements 2001 2002 2003

Rent Revenue $36,000

$36,000

$36,000

Interest Expense (6,400) (4,429) (2,300)

Net Income $29,600

$31,571

$33,700

Balance Sheets

AssetsCash $

4,957$

9,914$14,87

1Land 80,000 80,000 80,000

Total Assets $84,957

$89,914

$94,871

LiabilitiesNotes Payable $55,35

7$28,74

3$ -

0-

Stockholders’ EquityRetained Earnings 29,600 61,171 94,871


$84,957

$89,914

$94,871


Cash Flows From Operating Act.:

Inflow from Rental $36,000

$36,000

$36,000

Outflow for Interest (6,400) (4,429) (2,300)Net Cash Flow from Operating Act.

29,600 31,571 33,700

Cash Flow From Investing Act.:

Outflow to Purchase Land (80,000 -0- -0-

10-38

)

Cash Flow From Financing Act.:

Inflow from Loan 80,000 -0- -0-Outflow to Repay Loan (24,643

)(26,614

)(28,743

)Net Cash Flow from Financing Act.

55,357 (26,614)

(28,743)

Net Change in Cash 4,957 4,957 4,957Plus: Beginning Cash Balance -0- 4,957 9,914Ending Cash Balance $

4,957$

9,914$14,87

1

PROBLEM 10-25A (cont.)

c. Because the company is making both principal and interest payments on the loan each year, the amount paid on the principal reduces the balance of the loan and consequently the amount of interest paid on the loan each year. Even though the total amount of the payment is the same each year, the amount paid on the principal increases and the amount paid on the interest decreases. Consequently, the cash flow from financing activities increases and the cash flow from operating activities decreases.

10-39

PROBLEM 10-26A

Computation of Interest Expense

MonthAmount

Borrowed (Repaid)

End of Month

Balancex

Interest Rate per Month

=Interest Expens

e

January $80,000 $ 80,000 .07/12 $ 467February 50,000 130,000 .07/12 758March (30,000) 100,000 .08/12 667April -0- 100,000 .08/12 667May -0- 100,000 .08/12 667June -0- 100,000 .08/12 667July -0- 100,000 .08/12 667August -0- 100,000 .08/12 667September

-0- 100,000 .08/12 667

October -0- 100,000 .08/12 667November

(60,000) 40,000 .08/12 267

December

(40,000) -0- .07/12 -0-

Total $6,828

a.

Powell CompanyIncome Statement

For the Year Ended December 31, 2003

Service Revenue $18,000

ExpensesInterest Expense (6,828)

Net Income $11,172

10-40

PROBLEM 10-26A a. (cont.)

Powell CompanyFinancial Statements

Balance Sheet As of December 31, 2003

AssetsCash $11,172


Liabilities $ -0-

Stockholders’ EquityCommon Stock $ -0-Retained Earnings 11,172

Total Stockholders’ Equity 11,172

Total Liabilities and Stockholders’ Equity

$11,172

Statement of Cash FlowsFor the Year Ended December 31, 2003


Inflow from Revenue $18,000Outflow for Interest (6,828)


$11,172


-0-


Inflow from Loan 130,000Outflow to Repay Loan (130,000

)Net Cash Flow from Financing -0-

10-41

Activities

Net Change in Cash 11,172Plus: Beginning Cash Balance -0-Ending Cash Balance $11,17

2

10-42


b. When a business has an established line of credit, the business can access funds without having to apply for a loan and wait for approval to receive the cash. It can save time and expense for the business.

10-43

PROBLEM 10-27A

Provided for the instructor’s use:

Transactions:1. Issued bonds at 105. Cash proceeds = $157,500; Premium = $7,500.2. Purchased land for $157,500.3. Land rental, $17,500 per year, 2004, 2005, 2006.4. Interest payments per year, $15,000, 2004, 2005, 2006.5. Amortized premium per year, $500.6. Sold the land for $160,000, 1/1/07.7. Paid off bonds at 106, cash payment of $159,000.

10-44

PROBLEM 10-27A (cont.) T-Accounts Provided for Instructor’s Use:


1. 157,500 2.157,500 1. 150,000 cl 3,0003. 17,500 4. 15,000 Bal.

150,000Bal. 3,000

Bal. 2,500 2007 20052005 7.

150,000cl. 3,000

3. 17,500 4. 15,000 Bal. -0- Bal. 6,000Bal. 5,000 20062006 Premium on Bonds

Pay.cl. 3,000

3. 17,500 4. 15,000 2004 Bal. 9,000Bal. 7,500 5. 500 1. 7,500 20072007 Bal. 7,000 cl 5006. 160,000 7.159,000 2005 Bal. 8,500Bal. 8,500 5. 500

Bal. 6,500 Rental IncomeLand 2006 2004

2004 5. 500 cl 17,500 3. 17,5002. 157,500 Bal. 6,000 2005Bal.157,500 2007 cl 17,500 3. 17,5002007 7. 6,000 2006

6.157,500 Bal. -0- 17,500 3. 17,500Bal. -0- Bal. -0-

Interest Expense20044. 15,000 5. 500

cl 14,50020054. 15,000 5. 500

cl 14,50020064. 15,000 5. 500

cl 14,500Bal. -0-

Gain on Sale of Land2007cl 2,500 6. 2,500

Bal. -0-

Loss on Bond Redempt.

10-45

20077. 3,000 cl 3,000Bal. -0-

10-46

PROBLEM 10-27A (cont.)Maywood Company

Financial Statements

Income Statements 2004 2005 2006 2007


$17,500

$17,500

$ -0-

Interest Expense (14,500)

(14,500)

(14,500)

-0-

Operating Income 3,000 3,000 3,000 -0-

Non-Operating Inc./Expense

Gain on Sale of Land -0- -0- -0- 2,500Loss on Bond

Redemption-0- -0- -0- (3,000)

Net Income $ 3,000

$ 3,000

$ 3,000

$ (500)

Statement of Changes in Stockholders’ Equity

Common Stock $ -0-

$ -0- $ -0-

$ -0-

Beginning Retained Earnings

-0- 3,000 6,000 $9,000

Plus Net Income (Loss) 3,000 3,000 3,000 (500)Ending Retained Earnings

3,000 6,000 9,000 8,500

Total Stockholders’ Equity

$3,000 $6,000 $9,000 $8,500

10-47


Maywood Company Financial Statements

Balance Sheets 2004 2005 2006 2007

AssetsCash $ 2,500 $

5,000$ 7,500 $8,500

Land 157,500 157,500 157,500 -0-Total Assets $160,000 $162,50

0$165,000 $8,500

LiabilitiesBonds Payable $150,000 $150,00

0$150,000 $ -0-

Premium on Bonds Pay. 7,000 6,500 6,000 -0-Total Liabilities 157,000 156,500 156,000 -0-

Stockholders’ EquityRetained Earnings 3,000 6,000 9,000 8,500

Total Liab. and Stk. Equity

$160,000 $162,500

$165,000 $8,500


Cash Flow From Oper. Act.:

Inflow from Rental $ 17,500 $17,500 $17,500 $ -0-Outflow for Interest (15,000) (15,000) (15,000) -0-

Net Cash Flow Oper. Act. 2,500 2,500 2,500 -0-

Cash Flow From Inv. Act.:Inflow from Sale of

Land-0- -0- -0- 160,000

Outflow to Purchase Land

(157,500) -0- -0- -0-

Net Cash Flow from Inv. Act.

(157,500) -0- -0- 160,000

Cash Flow Financing Act.Inflow from Bond Issue 157,500 -0- -0- -0-Outflow to Repay Bond -0- -0- -0- (159,000)

Net Cash Flow Fin. Act. 157,500 -0- -0- (159,000)

Net Change in Cash 2,500 2,500 2,500 1,000Plus Beginning Cash Bal. -0- 2,500 5,000 7,500

10-48

Ending Cash Balance $ 2,500 $ 5,000 $ 7,500 $ 8,500

10-49

PROBLEM 10-28A

a. The market rate of interest was greater than the stated rate of interest. Consequently, the bonds sold at a discount. If the bonds had sold at face value, Adams would have received $50,000.

b.General Journal


2002Mar. 1 Cash 48,000


Sept. 1

Interest Expense ($50,000 x 9% x ½)

2,250

Cash 2,250

Dec. 31

Interest Expense ($50,000 x 9% x 4/12)

1,500

Interest Payable 1,500

Dec. 31

Interest Expense ($2,000 8 x 10/12)

208

Discount on Bonds Payable 208

Dec. 31



2003Mar. 1 Interest Expense 750

Interest Payable 1,500Cash 2,250

Sept. 1


Cash 2,250

Dec. 31


Interest Payable 1,500

10-50

Dec. 31



Dec. 31




c.2002 2003

LiabilitiesInterest Payable $ 1,500 $ 1,500Bonds Payable 50,000 50,000Less: Discount on Bonds

Payable(1,792) (1,542)

Carrying Value of Bonds Payable

48,208 48,458

Total Liabilities $49,708 $49,958

d.

2002 2003

Interest Expense Reported on Income Statement

$3,958

$4,750

e.

2002 2003

Interest Paid in Cash to Bondholders $2,250

$4,500

10-51

PROBLEM 10-29A

Western Land Co.

Event No.

Type of

EventAssets = Liabilitie

s+

Common Stock +

Retained

Earnings

Net Income Cash

Flow

1. AS + = NA + + + NA NA + FA2. AS + = + + NA + NA NA + FA3. AE + = NA + NA + NA NA IA4. AS + = NA + NA + + + + OA5. CE NA = + NA + + + NA6. AU = NA + NA + OA7. Closin

gNA = NA + NA + +/ NA NA

8. Closing

NA = NA + NA + +/ NA NA

9. AS + = NA + NA + + + + OA10. CE NA = + NA + + + NA11. AU = NA + NA + OA12. Closin


13. Closing

NA = NA + NA + +/ NA NA

14. AS/AE + = NA + NA + + + + IA15. AU = + NA + NA NA FA

10-52

PROBLEM 10-30A

a.Effect of Transactions on Financial Statements

No.


Rev.

Gain

Exp./ Loss = Net

Inc.Cash Flows

1 100,000 = 100,000 + NA NA NA = NA 100,000 FA

2. (10,000) = NA + (10,000)

NA 10,000

= (10,000)

(10,000) OA

3. (101,500)

= (100,000)

+ (1,500) NA 1,500 = (1,500) (101,500) FA

b.


1. Cash 100,000Bonds Payable 100,000

2. Interest Expense1 10,000Cash 10,000

3. Bonds Payable 100,000Loss on Redemption of Bonds 1,500

Cash2 101,500

1$100,000 x 10% = $10,0002$100,000 x 101.5% = $101,500

10-53

PROBLEM 10-31A


No.


Rev./

Gain

Exp./Loss = Net

Inc.Cash Flows

a. + = + + NA NA NA = NA + FAb. = NA + NA + = OAc. = + NA + = FA/OAd. + = + + NA NA NA = NA + FAe. = NA + NA + = OAf. + = + + NA NA NA = NA + FAg. = + + NA + = OAh. NA = + + NA + = NAi. + = + + NA NA NA = NA + FAj. = NA + NA + = OAk. NA = + + NA = + NA

10-54

PROBLEM 10-32A (APPENDIX)

a. Computation of Selling Price:Amount Table Factor Present Value

Principal Amount $200,000 x .508349 = $101,670Interest Payments 16,000 x 7.023582 = 112,377

Selling Price $214,047

b.

Date Account Title Debit Credit

1/1/02 Cash 214,047Premium on Bonds Payable 14,047Bonds Payable 200,000

c. Calculation of Interest Expense and Premium Amortization:

Date Bond Pay.Unamortz.Premium

Bond Carrying

Value

Interest Exp.

(CV x 7%)Interest Paid

(BP x 8%)

Premium Amortized

(Exp - Paid)

2002 $200,000 $14,047 $214,047 $14,983 $16,000 $1,0172003 200,000 13,030 213,030 14,912 16,000 1,0882004 200,000 11,942 211,942 14,836 16,000 1,1642005 200,000 10,778 210,778 14,754 16,000 1,246

Date Account Title Debit Credit

12/1/04 Interest Expense 14,836Premium on Bonds Payable 1,164Cash 16,000

d. See schedule above: $14,754.

10-55

SOLUTIONS TO EXERCISES - SERIES B - CHAPTER 10

EXERCISE 10-1B

Points that should be noted:

a. The carrying value of the amortized note (option 2) will be reduced by the amount of the principal payments for each period. However, the carrying value of the note with all principal due at maturity (option 1) will not change until the liability is paid off.

b. The amount of annual interest on the amortized loan (option 2) will decrease each year as the amount of the liability (carrying value) decreases. Interest on the lump sum payment note (option 1) will remain constant because the amount borrowed remains constant.

c. The total amount of interest paid will be greater under the lump sum payment note (option 1) because the liability was greater over the life of the loan.

d. The amortized loan (option 2) will have a greater amount of cash outflow each year except the year of maturity. Cash outflow is being made on both principal and interest, while cash is being paid only for interest on the term loan (option 1). However, in the year of maturity, the lump sum loan (option 1) will require the greater cash outlay.

10-56

EXERCISE 10-2B

Baco CompanyAmortization Schedule



Cash Pay. Dec. 31

Applied to

Interest

Applied to

Principal


2006

$120,000 $30,055 $9,600 $20,455 $99,545

2007

99,545 30,055 7,964 22,091 77,454

2008

77,454 30,055 6,196 23,859 53,595

2009

53,595 30,055 4,288 25,767 27,828

2010

27,828 30,055 2,227* 27,828 -0-

*Adjusted $1 due to rounding.

10-57

EXERCISE 10-3B

Provided for the use of the Instructor:

Amer CompanyAmortization Schedule



Cash Pay. Dec. 31

Applied to

Interest

Applied to

Principal

Prin Bal. end of Period

2004

$80,000 $21,104 $8,000 $13,104 $66,896

2005

66,896 21,104 6,690 14,414 52,482

2006

52,482 21,104 5,248 15,856 36,626

2007

36,626 21,104 3,663 17,441 19,185

2008

19,185 21,104 1,919* 19,185 -0-

*Adjusted due to rounding

a.1. $8,0002. $13,104

b. $66,896

c.1. $6,6902. $14,414

10-58

EXERCISE 10-4Ba.



No.



Cash Flows

1. 200,000 = 200,000 + NA NA NA = NA 200,000 FA

2. (32,549)

= (12,549)

+ (20,000)

NA 20,000

= (20,000)

(12,549) FA

(20,000) OA

b. (1)

Revenue $100,000

ExpensesOperating

Expenses$50,000

Interest Expense 20,000Total Expenses 70,000

Net Income $ 30,000

b. (2)


Inflow from Customers $100,000Outflow for Expenses (70,000)


$ 30,000

b. (3)


Inflow from Issue of Note $200,000

10-59

Outflow to Repay Note (12,549)Net Cash Flow from Financing Activities

$187,451

c. Principal 1/1/04: $158,463 ($173,647 $15,184)Interest Rate: $20,000 $200,000 = 10%$158,463 x 10% = $15,846 interest expense

10-60

EXERCISE 10-5B

MonthAmount

Borrowed (Repaid)

Balance End of Month

Interest Rate

Interest

Expense

January $50,000 $50,000 .05/12 $208February

30,000 80,000 .06/12 400

March (40,000) 40,000 .065/12

217


2007Jan. 1 Cash 50,000

Line of Credit Payable 50,000

Jan. 31 Interest Expense 208Cash 208

Feb. 1 Cash 30,000Line of Credit Payable 30,000

Feb. 28 Interest Expense 400Cash 400

March 1 Line of Credit Payable 40,000Cash 40,000

March 31


Cash 217

10-61

EXERCISE 10-6B

The total amount of interest paid each year will be the same regardless of whether it is paid annually or semiannually. If the interest is paid annually, the company will make one payment of $800 ($10,000 x 8%) on December 31. If the interest is paid semiannually, the company will make two payments of $400 each ($10,000 x 8% x 6/12). One payment would be made on June 30; the other payment would be made on December 31. However, due to the time value of money, semiannual interest works to the advantage of the lender of the money and to the disadvantage of the borrower.

10-62

EXERCISE 10-7B

Face x Selling Price

Cash Proceeds

Discount or Premium

a. $200,000 x 103% $206,000 Premium

b. $80,000 x 95.5% 76,400 Discount

c. $100,000 x 101.75%

101,750 Premium

d. $50,000 x 98% 49,000 Discount

10-63

EXERCISE 10-8B

a. Face

b. Premium

c. Discount

d. Premium

e. Discount

EXERCISE 10-9B

a. Premium (Stated rate is greater than market rate.)

b. Discount (Stated rate is less than market rate.)

c. Discount (Stated rate is less than market rate.)

EXERCISE 10-10B

a. $80,000 x 2% = $1,600; Premium

b. $50,000 x 2% = $1,000; Discount

c. $100,000 x 2.25% = $2,250; Premium

d. $500,000 x 1.75% = $8,750; Discount

10-64

EXERCISE 10-11Ba.



No.



Cash Flows

1. + = + + NA NA NA = NA + FA2. NA = + + NA + = NA3. = NA + NA + = OA

b. Amortization of bond discount, 2004: $4,000 5 = $800 per year


Bonds Payable $100,000Less: Discount on Bonds Payable (3,200)Carrying Value, December 31, 2004$ 96,800


Stated Interest ($100,000 x 8%) $8,000Amortization of Bond Discount 800Interest Expense $8,800


Bonds Payable $100,000Less: Discount on Bonds Payable (2,400 ) Carrying Value, December 31, 2005$ 97,600


Stated Interest ($100,000 x 8%) $8,000Amortization of Bond Discount 800Interest Expense $8,800

10-65

EXERCISE 10-12Ba.


Balance Sheet Income Statement Stmt. ofNo.



Cash Flows

1. + = + + NA NA NA = NA + FA2. NA = + + NA = + NA3. = NA + NA + = OA

b. Amortization of bond premium, 2004: $2,000 5 = $400 per year









10-66

EXERCISE 10-13Ba.

Farm Supplies, Inc.General Journal


2003July 1 Cash1 208,000


Dec. 31


Premium on Bonds Payable2 400Cash3 6,000

Dec. 31



2004June 30


Premium on Bonds Payable 400Cash 6,000

Dec. 31


Premium on Bonds Payable 400Cash 6,000

Dec. 31



1$200,000 x 1.04 = $208,0002$8,000 10 = $800; $800 x 6/12 = $4003$200,000 x 6% x 6/12 = $6,000

10-67

EXERCISE 10-13B a.(cont.)

Farm Supplies, Inc.T-accounts


Cash Bonds Payable Retained Earnings2003 2003 20037/1208,000 12/31

6,0007/1200,000 cl 5,600

Bal.202,000

Bal.200,000

Bal. 5,600

2004 20046/30 6,000 cl 11,20012/316,000

Premium on Bonds Pay.

Bal. 16,800

Bal.190,000

2003

12/31 400 7/1 8,000 Interest ExpenseBal. 7,600 2003

2004 12/31 5,600 cl 5,6006/30 400 Bal. -0-12/31 400 2004

Bal. 6,800 6/30 5,60012/31 5,600 cl 11,200Bal. -0-

10-68

EXERCISE 10-13B (cont.)b.

Farm Supplies, Inc.Balance Sheet

Liabilities 2003 2004Bonds Payable $200,00

0$200,000

Premium on Bonds Payable

7,600 6,800

Net Carrying Value of Bonds

207,600 206,800

Total Liabilities $207,600

$206,800

c. Interest Expense 2003 2004 $5,600 $11,200

d. Cash Outflow for Interest 2003 2004$6,000 $12,000

10-69

EXERCISE 10-14B

Miller Corp.General Journal


2001Jan.1 Cash 100,000


Dec. 31

Interest Expense* 9,000

Cash 9,000

2002Dec. 31


Cash 9,000

*$100,000 x 9% = $9,000 interest expense per year

10-70

EXERCISE 10-15B

Creason Co.General Journal


2005Jan. 1 Cash1 97,500


Dec. 31

Interest Expense2 500


Dec. 31


Cash 8,000

2006Dec. 31



Dec. 31


Cash 8,000

1$100,000 x .975 = $97,500 cash proceeds2$2,500 5 = $500 discount amortization per year3$100,000 x 8% = $8,000 interest payment per year

10-71

EXERCISE 10-16B

Vickers CompanyGeneral Journal


2006Jan. 1 Cash1 206,000


June 30

Premium on Bonds Payable2 600


June 30


Cash 12,000

Dec. 31



Dec. 31


Cash 12,000

2007June 30



June 30


Cash 12,000

Dec. 31



Dec. 31


Cash 12,000

10-72

1$200,000 x 1.03 = $206,000 cash proceeds2$6,000 5 = $1,200; $1,200 x 6/12 = $600 premium amortization per year

3$200,000 x 12% = $24,000; $24,000 x 6/12 = $12,000 interest payment per year

10-73

EXERCISE 10-17Ba.

Upton CompanyGeneral Journal


2004Jan. 1 Cash 1,000,000

Bonds Payable 1,000,000

Jan. 1 Land 1,000,000Cash 1,000,000

Dec. 31

Cash 140,000


Dec. 31

Interest Expense ($1,000,000 x 10%)

100,000

Cash 100,000

Dec. 31



2005Dec. 31

Cash 140,000


Dec. 31


Cash 100,000

Dec. 31



10-74

EXERCISE 10-17B a. (cont.)

Upton Company



1/1

1,000,0001/1 1,000,000 1/1

1,000,000cl 40,000

12/31

140,00012/31 100,000 Bal.

1,000,000Bal. 40,000

Bal. 40,000 20052005 cl 40,00012/31

140,00012/31

100,000Bal. 80,000

Bal. 80,000Lease Revenue

2004Land cl 140,000 12/31

140,0002004 Bal. -0

1/1

1,000,0002005

Bal.1,000,000

cl 140,000 12/31

140,000Bal. -0-

Interest Expense2004

12/31

100,000cl 100,000

Bal. -0-2005

12/31

100,000cl 100,000

Bal. -0-

10-75

EXERCISE 10-17B (cont.) b. Upton Company Financial Statements

Income Statements 2004 2005

Lease Revenue $140,000 $140,000

Interest Expense (100,000) (100,000)

Net Income $ 40,000 $ 40,000

Balance SheetsAssets

Cash $ 40,000 $ 80,000

Land 1,000,000 1,000,000Total Assets $1,040,00

0$1,080,00

0

LiabilitiesBonds Payable $1,000,00

0$1,000,00

0

Stockholders’ EquityCommon Stock -0- -0-Retained Earnings 40,000 80,000

Total Stockholders’ Equity 40,000 80,000


$1,040,000

$1,080,000



Inflow from Revenue $ 140,000 $ 140,000Outflow for Interest (100,000) (100,000)

Net Cash Flow from Operating Act.

40,000 40,000


Outflow to Purchase Land (1,000,000)

-0-

10-76


Inflow from Bond Issue 1,000,000 -0-

Net Change in Cash 40,000 40,000Plus: Beginning Cash Balance -0- 40,000Ending Cash Balance $ 40,000 $ 80,000

EXERCISE 10-18B

Han Company


2005Jan. 1 Cash 500,000


2009Dec. 31

Loss on Bond Redemption 20,000

Bonds Payable 500,000Cash 520,000

10-77

EXERCISE 10-19Ba.

Pace Co. Pile Co. Park Co.Bonds Payable $300,000 $600,000 $500,000Interest Rate 10% 9% 8%Before Tax Interest Cost

$ 30,000 $ 54,000 $ 40,000

b.Pace Co. Pile Co. Park Co.

Before Tax Interest Cost

$30,000 $54,000 $40,000

x (1 Tax Rate) 60% 70% 65%After Tax Interest Cost

$18,000 $37,800 $26,000

c. There are two ways to determine the after-tax interest cost as a percentage of the face value of the bonds.

1.Pace Co. Pile Co. Park Co.

After Tax Interest Cost $ 18,000 $ 37,800 $ 26,000 Bonds Payable $300,000 $600,000 $500,000= After Tax Interest Rate

6.0% 6.3% 5.2%

OR 2.Interest Rate x (1 Tax Rate)

.10 x ( 1.4) .09 x (1 .3)

.08 x (1 .35)

= After Tax Interest Rate

= 6.0% = 6.3% = 5.2%

10-78

EXERCISE 10-20B

1. $10,000 x 1.262477 = $12,625 (Table I, 6%, 4 years)

2. $2,000 x 6.105100 = $12,210 (Table III, 10%, 5 years)

3. $200,000 x .422411 = $84,482 (Table II, 9%, 10 years)

4. Annual Payment x 3.992710 = $100,000; (Table IV, 8%, 5 years)

$100,000 3.992710 = $25,045.65 annual payment

EXERCISE 10-21B

a. Payment amount x 3.790787 = $30,000 (Table IV, 10%, 5 years)

$30,000 3.790787 = $7,913.92

b. $4,000 x 3.790787 = $15,163 (Table IV, 10%, 5 years)

EXERCISE 10-22B

a. Annual payment x 37.450244 = $500,000; (Table III, 8%, 18 years)

$500,000 37.450244 = $13,351.05

b. $500,000 x .250249 = $125,125 (Table II, 8%, 18 years)

10-79

EXERCISE 10-23B

a.Present Value of Principal

$100,000

x .422411 = $ 42,241

Present Value of Interest

$10,000 x 6.4176582

= 64,177


1Table II, 9%, 10 years2Table IV, 9%, 10 years

b.Account Titles Debit Credit

Cash 106,418


c. Interest payment amount: $100,000 x .10 = $10,000

Interest expense: Carrying value x effective interest rate$106,418 x 9% = $9,577.62

Amortization of Premium: Interest Payment$10,000.00

Less, Interest Expense( 9,577 .62) Amortization $ 422 .38

Account Titles Debit Credit

Interest Expense 9,577.62

Premium on Bonds Payable 422.38Cash 10,000.0

0

10-80

10-81

EXERCISE 10-24B

An investor would rather collect semiannual interest as opposed to annual interest because of the time value of money. When interest is paid every six months, half of the interest payment amount will be received six months earlier than the total payment when interest is paid only annually. The investor can invest that six months of interest so that it can be earning interest. The effective interest rate is greater when the interest is paid semiannually.

10-82

SOLUTIONS TO PROBLEMS - SERIES B CHAPTER 10

PROBLEM 10-25B

a.Mixon Company

Amortization Schedule$100,000, 4-Yr. Term Note, 10% Interest Rate

YearPrin.

Bal. on Jan 1

Cash Pay. Dec.

31

Applied to

Interest

Applied to

Principal


2001

$100,000

$31,547 $10,000 $21,547 $78,453

2002

78,453 31,547 7,845 23,702 54,751

2003

54,751 31,547 5,475 26,072 28,679

2004

28,679 31,547 2,868 28,679 -0-

10-83

PROBLEM 10-25B (cont.)b. Provided for the use of the Instructor:

Cash Notes Payable Retained Earnings2001 2001 20011/1 100,000 1/1 100,000 1/1100,000 cl 30,00012/3140,000 12/31 31,547 12/3121,547 Bal. 30,000Bal. 8,453 Bal. 78,453 20022002 2002 cl 32,15512/3140,000 12/31 31,547 12/3123,702 Bal. 62,155Bal. 16,906 Bal. 54,751 20032003 2003 cl 34,52512/3140,000 12/31 31,547 12/3126,072 Bal. 96,680Bal. 25,359 Bal. 28,679 20042004 2004 cl 37,13212/3140,000 12/31 31,547 12/3128,679 Bal.133,812Bal. 33,812 Bal. -0-

Rent RevenueLand 2001

2001 cl 40,000 12/3140,0001/1100,000 Bal. -0-Bal.100,000 2002

cl 40,000 12/3140,000Bal. -0-

2003cl 40,000 12/3140,000

Bal. -0-2004cl 40,000 12/3140,000

Bal. -0-

Interest Expense200112/3110,000 cl 10,000Bal. -0-200212/31 7,845 cl 7,845Bal. -0-200312/31 5,475 cl 5,475Bal. -0-200412/31 2,868 cl 2,868Bal. -0-

10-84

PROBLEM 10-25B b. (cont.)Mixon Company Financial Statements


Rent Revenue $40,000 $40,000 $40,000 $40,000

Interest Expense (10,000) (7,845) (5,475) (2,868)

Net Income $30,000 $32,155 $34,525 $37,132

Balance Sheets

AssetsCash $

8,453$

16,906$

25,359$ 33,812

Land 100,000 100,000 100,000 100,000 Total Assets $108,45

3$116,90

6$125,35

9$133,81

2

LiabilitiesNotes Payable $

78,453$

54,751$

28,679$ -0-



$108,453

$116,906

$125,359

$133,812


Cash Flows From Oper. Act.:

Inflow from Rental $40,000 $40,000 $40,000 $40,000Outflow for Interest (10,000) (7,845) (5,475) (2,868)

Net Cash Flow fm. Op. Act.:

30,000 32,155 34,525 37,132

Cash Flows From Inv. Act.:


(100,000)

-0- -0- -0-

Cash Flows From Fin. Act.:

10-85

Inflow from Loan 100,000 -0- -0- -0-Outflow to Repay Loan (21,547) (23,702) (26,072) (28,679)

Net Cash Flow from Fin. Act.

78,453 (23,702 (26,072) (28,679)

Net Change in Cash 8,453 8,453 8,453 8,453 Plus: Beginning Cash Balance

-0- 8,453 16,906 25,359

Ending Cash Balance $ 8,453 $16,906 $25,359 $33,812

PROBLEM 10-25B (cont.)

c. Because the company is making both principal and interest payments on the loan each year, the amount paid on the principal reduces the balance of the loan and consequently the amount of interest paid on the loan each year. Even though the total amount of the payment is the same each year, the amount paid on the principal increases and the amount paid on the interest decreases.

10-86

PROBLEM 10-26B

Computation of Interest Expense

MonthAmount

Borrowed (Repaid)

End of Month

Balancex

Interest Rate per Month

=Interest Expens

e

January $100,000 $100,000 .07/12 $ 583February 50,000 150,000 .08/12 1,000March (40,000) 110,000 .09/12 825April -0- 110,000 .09/12 825May -0- 110,000 .09/12 825June -0- 110,000 .09/12 825July -0- 110,000 .09/12 825August -0- 110,000 .09/12 825September

-0- 110,000 .09/12 825

October -0- 110,000 .09/12 825November

(80,000) 30,000 .08/12 200

December

(20,000) 10,000 .07/12 58

Total $8,441

a.

Libby CompanyIncome Statement

For the Year Ended December 31, 2006

Service Revenue $30,000

ExpensesInterest Expense (8,441)

Net Income $21,559

10-87

PROBLEM 10-26B a. (cont.)

Libby CompanyFinancial Statements

Balance Sheet As of December 31, 2006

AssetsCash ($10,000 + $21,559) $31,559


Liabilities $10,000

Stockholders’ EquityCommon Stock $ -0-Retained Earnings 21,559

Total Stockholders’ Equity 21,559

Total Liabilities and Stockholders’ Equity

$31,559

Statement of Cash FlowsFor the Year Ended December 31, 2006


Inflow from Revenue $30,000Outflow for Interest (8,441)


$21,559

Cash Flows From Investing Activities

-0-


Inflow from Loan 150,000Outflow to Repay Loan (140,000

)

10-88

Net Cash Flow from Financing Activities

10,000

Net Change in Cash 31,559Plus: Beginning Cash Balance -0-Ending Cash Balance $31,55

9

10-89


b. Libby used debt financing instead of equity financing. Libby borrowed the cash to operate the business. The difference in the revenue generated and the interest expense incurred amounts to the net income. When the revenue produced by borrowing exceeds the cost of the borrowing, retained earnings (profits) will increase.

10-90

PROBLEM 10-27B

Provided for the instructor’s use:

Transactions:1. Issued bonds at 96. Cash proceeds = $384,000; Discount = $16,000.2. Purchased land for $384,000.3. Land rental, $50,000 per year, 2005, 2006, 2007.4. Interest payments per year, $32,000, 2005, 2006, 2007.5. Amortized discount per year, $800.6. Sold the land for $400,000, 1/1/08.7. Paid off bonds at 98, Cash payment of $392,000.

10-91

PROBLEM 10-27B (cont.) T-Accounts Provided for Instructor’s Use:

Cash Bonds Payable Retained Earnings2005 2005 20051. 384,000 2. 384,000 1. 400,000 cl 17,2003. 50,000 4. 32,000 Bal.

400,000Bal. 17,200

Bal. 18,000 2008 20062006 7.

400,000cl. 17,200

3. 50,000 4. 32,000 Bal. -0- Bal. 34,400Bal. 36,000 20072007 Discount on Bonds

Pay.cl. 17,200

3. 50,000 4. 32,000 2005 Bal. 51,600Bal. 54,000 1. 16,000 5. 800 20082008 Bal.

15,200cl 10,400

6. 400,000 7. 392,000 2006 Bal. 62,000Bal. 62,000 5. 800

Bal.14,400

Rental Income

Land 2007 20052005 5. 800 cl 50,000 3. 50,0002. 384,000 Bal.13,600 2006Bal.

384,0002008 cl 50,000 3. 50,000

2008 7. 13,600 20076.384,000 Bal. -0- 50,000 3. 50,000

Bal. -0- Bal. -0-

Interest Expense20054. 32,0005. 800 cl 32,80020064. 32,0005. 800 cl 32,80020074. 32,0005. 800 cl 32,800Bal. -0-

Gain on Sale of Land2008cl 16,000 6. 16,000

10-92

Bal. -0-

Loss on Bond Redempt.

20087. 5,600 cl 5,600Bal. -0-

10-93


Box CompanyFinancial Statements



$50,000

$50,000

$ -0-

Interest Expense (32,800)

(32,800)

(32,800)

-0-

Operating Income 17,200 17,200 17,200 -0-

Non-Operating Income/Expense

Gain on Sale of Land -0- -0- -0- 16,000Loss on Bond Redemption -0- -0- -0- (5,600)

Net Income $17,200

$17,200

$17,200

$10,400

Statement of Changes in Stockholders’ Equity 2005 2006 2007 2008

Common Stock $ -0-

$ -0-

$ -0-

$ -0-

Beginning Retained Earnings

-0- 17,200 34,400 51,600

Plus: Net Income 17,200 17,200 17,200 10,400 Ending Retained Earnings 17,200 34,400 51,600 62,000

Total Stockholders’ Equity $17,200

$34,400

$51,600

$62,000

10-94


Box Company Financial Statements

Balance Sheets 2005 2006 2007 2008

AssetsCash $ 18,000 $

36,000$

54,000$62,000

Land 384,000 384,000 384,000 -0- Total Assets $402,000 $420,00

0$438,00

0$62,000

LiabilitiesBonds Payable $400,00

0$400,00

0$400,00

0$ -0-

Discount on Bonds Payable

(15,200) (14,400) (13,600) -0-

Total Liabilities 384,800 385,600 386,400 -0-



$402,000 $420,000

$438,000

$62,000


Cash Flows From Oper. Act.:

Inflow from Rental $50,000 $50,000 $50,000 $ -0-Outflow for Interest (32,000) (32,000) (32,000) -0-

Net Cash Flow from Opr. Act.

18,000 18,000 18,000 -0-

Cash Flows From Inv. Act.:

Inflow from Sale of Land

-0- -0- -0- 400,000


(384,000) -0- -0- -0-

Net Cash Flow from Inv. Act.

(384,000)

-0- -0- 400,000

Cash Flows From Fin.

10-95

Act.:Inflow from Bond Issue 384,000 -0- -0- -0-Outflow to Repay Bond -0- -0- -0- (392,000

) Net Cash Flow from Fin. Act.

384,000 -0- -0- (392,000)

Net Change in Cash 18,000 18,000 36,000 8,000 Plus: Beginning Cash Balance

-0- 18,000 18,000 54,000

Ending Cash Balance $ 18,000

$36,000 $54,000 $62,000

10-96

PROBLEM 10-28B

a. The bonds sold for less than the face amount; therefore, the bonds were sold at a discount. This means that the stated rate of interest is less than the market rate of interest. The amount of the discount acts to equate the two interest rates. If the bonds had been sold at the face amount, Joy would have received $100,000 in cash.

b.Date Account Titles Debit Credit

2006Jan. 1 Cash 96,000


Dec. 31


Cash 10,000

Dec. 31

Interest Expense2 400


Dec. 31



2007Dec. 31


Cash 10,000

Dec. 31



Dec. 31



10-97

1$100,000 x 10% = $10,0002$4,000 10 = $400

10-98

PROBLEM 10-28B (cont.)c.

2006 2007

LiabilitiesBonds Payable $100,000 $100,000Less: Discount on Bonds

Payable(3,600) (3,200)


$ 96,400 $ 96,800

2006 2007d.

Interest Expense Reported on Income Statement:

$10,400

$10,400

2006 2007e.

Interest Paid in Cash to Bondholders: $10,000

$10,000

10-99

PROBLEM 10-29B

Stafford Co.

Event No.

Type of

EventAssets = Liabilitie

s+

Common Stock +

Retained

Earnings

Net Income Cash

Flow

1. AS + = NA + + + NA NA + FA2. AS + = + + NA + NA NA + FA3. AE + = NA + NA + NA NA IA4. AS + = NA + NA + + + + OA5. CE NA = + + NA + NA6. AU = NA + NA + OA7. Closin


8. Closing

NA = NA + NA + /+ NA NA

9. AS + = NA + NA + + + + OA10. CE NA = + + NA + NA11. AU = NA + NA + OA12. Closin


13. Closing

NA = NA + NA + /+ NA NA

14. AS/AE + = NA + NA + + + + IA15. AU = + NA + NA NA FA

10-100

PROBLEM 10-30B

a.Effect of Transactions on Financial Statements

No. Assets = Liab. + S. Equity

Rev./Gain

Exp./Loss =Net Inc. Cash Flows

1. 300,000 =300,000 + NA NA NA = NA 300,000 FA2. (30,000) = NA +(30,000

)NA 30,00

0=(30,000

)(30,000) OA

3. (315,000)

=(300,000)

+(15,000)

NA 15,000

=(15,000)

(315,000) FA

b.

General Journal


1. Cash 300,000Bonds Payable 300,000

2. Interest Expense1 30,000Cash 30,000

3. Bonds Payable 300,000Loss on Redemption of Bonds 15,000

Cash2 315,000

1$300,000 x 10% = $30,0002$300,000 x 105% = $315,000

10-101

PROBLEM 10-31B

a.Bond Issued at Face Value


No.



Cash Flows

1. + = + + NA NA NA = NA + FA2. = NA + NA + = OA3. = + NA NA NA = NA FA

b.Bond Issued at a Discount


No.



Cash Flows

1. + = + + NA NA NA = NA + FA2a.

= NA + NA + = OA

2b.

NA = + + NA + = NA

3. = + NA NA NA = NA FA

c.Bond Issued at a Premium


No.



Cash Flows

1. + = + + NA NA NA = NA + FA2a.

= NA + NA + = OA

2b.

NA = + + + NA = + NA

3. = + NA NA NA = NA FA

10-102

PROBLEM 10-32B

a. Computation of Selling Price:Amount Table Factor Present Value

Principal Amount $500,000 x .422411 = $211,206Interest Payments 40,000 x 6.417658 = 256,706


b.


1/1/04 Cash 467,912Discount on Bonds Payable 32,088Bonds Payable 500,000

c.Calculation of Interest Expense and Discount Amortization:

DateBond

PayableUnamort.Discount

Bond Carrying

Value

Interest Exp.

(CV x 9%)Interest Paid

(BP x 8%)

Discount Amortized

(Exp. Paid)

2004 $500,000 32,088 $467,912 $42,112 $40,000 $2,1122005 500,000 29,976 470,024 42,302 40,000 2,302


12/31/04 Interest Expense 42,112Discount on Bonds Payable 2,112

Cash 40,000

d. See schedule above: $42,302

ATC 10-1

10-103

a. Dell’s balance sheet lists “Long-term debt” of $509 million and “Other” noncurrent debt of $761 million. The “Long-term Debt and Interest Rate Risk Management” note on page 36 indicates that $200 million of this is for notes payable due in 2008, and $300 million is for debentures due in 2028. The “Other” noncurrent liabilities of $761 million are described on page 42 as consisting of $306 million for “Deferred income,” and $455 million for “Other”.

b. The debt with the longest maturity are the debentures that mature in 2028.

c. $250 million. See “Financing Arrangements” on page 36 of the annual report.

10-104

ATC 10-2a.(1)(a)

Lot, Inc.: $100,000 x 102.25% = $102,250Max, Inc.: $100,000 x 98% = $98,000Par, Inc.: $100,000 x 104% = $104,000

(1)(b)Interest Expense = Interest paid +/ amortized discount/premium.

Amortization of premium or discount:Lot, Inc.: Premium amortization = $2,250 5 = $450 per year.Max, Inc.: Discount amortization = $2,000 5 = $400 per year.Par, Inc.: Premium amortization = $4,000 5 = $800 per year.

Interest Expense:Lot, Inc.: $8,000 $450 = $7,550 per year.Max, Inc.: $8,000 + $400 = $8,400 per year.Par, Inc.: $8,000 $800 = $7,200 per year.

(1)(c )Interest Paid:Lot, Inc.: Interest paid = $100,000 x 8% = $8,000 per year.Max, Inc.: Interest paid = $100,000 x 8% = $8,000 per year.Par, Inc.: Interest paid = $100,000 x 8% = $8,000 per year.

(2)December 31, 2006

Lot Max Par

LiabilitiesBonds Payable $100,00

0$100,00

0$100,00

0Less: Discount on Bonds

Payable(1,600)

Plus: Premium on Bonds Payable

1,800 3,200


$101,800

$ 98,400

$103,200

Lot, Inc. $2,250 $450 = $1,800; Par, Inc. $4,000 $800 = $3,200

10-105

Max, Inc. $2,000 $400 = $1,600

10-106

ATC 10-2 (cont.)

c. The amount of interest expense is different for each of the three companies because the issue price was different; consequently the amount of premium or discount amortized is different for each company.

d. The amount of interest paid is the same for each of the companies because the face amount of the bond and the interest rate is the same for all three.

e. The amount of liabilities is different for each of the companies because the amount of premium or discount is different for each making the carrying value of the bonds different.

10-107

ATC 10-3

The credit ratings and the company to which each relates are as follows:

A = AlltelBB = Barnes & Noble (B&N)

CCC+ = AmerikingD = Carmike

Students will probably identify the companies with the two lowest ratings as Ameriking and Carmike, since both had net losses during 1998 and 1999. Upon closer examination, they can probably identify Carmike as the company with the D rating, since is the only company with a negative return-on-assets ratio, and it has a lower current ratios and a higher debt-to-assets ratios than Ameriking. The information presented in the textbook intentionally omitted disclosing that Carmike was in Chapter 11 proceedings at the time this case was written.

Students may have more trouble deciding whether Alltel or B&N is the company with the A versus the BB rating. B&N has the advantage in that its current ratios and times-interest-earned ratios are higher than Alltel’s, and its debt-to-assets ratios are lower. Conversely, Alltel had better return-on-assets ratios in 1998 and 1999 than did B&N. Also, though most students will not think to compute it, Alltel had a higher ratio of cash flows from operations to net earnings than did B&N, as computed below.

Cash flow from Operating Net Income forCompany Activities for 1998 + 1999 ÷ 1998 + 1999 = Ratio

Alltel $2,905,877 ÷ $1,386,761 = 2.10

B&N $ 364,999 ÷ $ 216,874 = 1.68

10-108

There is also the fact that Alltel is a larger company than B&N, and it is in an industry with more growth potential than is B&N.

Obviously the analysts at Standard & Poor’s had a lot more information to use than is presented in the textbook, but after considering all the factors, they gave Alltel a rating of A, and B&N a rating of BB.

10-109

ATC 10-4a. First, compute the EBIT for each company:

Quality Landscaping

Super Lawn Care

Net Income $ 46,500 $ 51,000Interest Expense 27,500 20,000Tax Expense 31,000 34,000EBIT $105,000 $105,000

Debt-to-assets:

Quality Landscaping: $300,000 ÷ $350,000 = 85.7%Super Lawn Care: $220,000 ÷ $350,000 = 62.9%

Current ratio:

Quality Landscaping: $20,000 ÷ $35,000 = .57 to 1.00Super Lawn Care: $20,000 ÷ $25,000 = .80 to 1.00

Times interest earned:

Quality Landscaping: $105,000 ÷ $27,500 = 3.82 timesSuper Lawn Care: : $105,000 ÷ $20,000 = 5.25 times

Quality Landscaping appears to have a greater financial risk because it has:a higher debt-to-assets ratio.a lower current ratio.a lower times interest earned ratio.

b. Return-on-equity:


Return-on-assets:


10-110

ATC 10-4 b.(cont.)

Even though the return-on-assets ratios of Quality Landscaping and Super Lawn Care are equal, Quality Landscaping generated a much higher return-on-equity than Super Lawn Care through the use of financial leverage. The ratios in part a. show that Quality Landscaping is using debt to a greater extent than Super Lawn Care.

10-111

ATC 10-5

a. Note to Instructor: Students may be able to solve this problem more easily if they first prepare a table showing the balances in current assets, total assets, current liabilities, and total liabilities for each situation. Then, they can more easily compute the new ratios and determine the effects of each transaction on each ratio.

Current Total Current TotalSituation Assets Assets Liabilities Liabilities Currently $100,000$325,000 $65,000$225,000Using bonds 200,000 425,000 65,000 325,000Using stock 200,000 425,000 65,000 225,000

If Bonds If Stock Currently Are Issued Is IssuedCurrent ratio 1.54/1 (1) 3.08/1 (2)

3.08/1 (2)Debt to assets ratio 69.2% (3) 76.5% (4)

52.9% (5)

(1) $100,000 ÷ $ 65,000 = 1.54 to 1.00(2) $200,000 ÷ $ 65,000 = 3.08 to 1.00(3) $225,000 ÷ $325,000 =69.2%(4) $325,000 ÷ $425,000 =76.5%(5) $225,000 ÷ $425,000 =52.9%

b. Bonds Stock EBIT $50,000 $50,000Interest expense 10,000 -0-

10-112

Pretax earnings 40,000 50,000Tax expense (30%) 12,000 15,000Net earnings 28,000 35,000Dividends -0 - 10,000Additional retained earnings $28,000 $25,000

10-113

ATC 10-6

a.Mack Company

Selected Financial Statements for 2003

Type of FinancingDebt Equity

Income Statement for 2003

Rental Revenue ($50,000 x .15) $7,500 $7,500

Interest Expense (5,000) -0-

Net Income Before Tax 2,500 7,500Income Tax Expense (30%) (750) (2,250)Net Income After Tax $1,750 $5,250

Statement of Cash Flows for 2003

Cash Flows From Operating ActivitiesInflow from Revenue $7,500 $7,500Outflow for Interest Expense (5,000) -0-Outflow for Tax Expense (750) (2,250)Net Cash Flow from Operating Activities

1,750 5,250

Cash Flows from Investing Activities -0- -0-

Cash Flows From Financing ActivitiesIssue of Bonds 50,000 -0-Issue of Stock -0- 50,000Payment of Dividends -0- (5,000)Net Cash Flow from Financing Activities

50,000 45,000

Net Change in Cash 51,750 50,250Add, Beginning Cash Balance -0- -0-Ending Cash Balance $51,750 $50,250

10-114

10-115

ATC 10-6 (cont.)

b. The students should explain that the net income will be higher under the equity alternative, because interest is a deductible expense with debt financing. However, the students should also note that the net cash inflow will be greater when debt financing is used. The difference is caused by the amount of tax paid under the two alternatives.

10-116

ATC 10-7

a. Forecast Statements

Financial StatementsForecast

1Forecast

2Forecast

3

Income Statements

Revenue $120,000 $160,000 $160,000Operating Expenses (70,000) (77,000) (77,000)Income Before Interest and Taxes 50,000 83,000 83,000Interest Expense -0- -0- (11,620)Income Tax Expense (30%) (15,000) (24,900) (21,414)Net Income $ 35,000 $ 58,100 $ 49,966

Statements of Changes in Stockholders’ EquityBeginning Retained Earnings $15,000 $15,000 $15,000Plus: Net Income 35,000 58,100 49,966Less: Dividend to Watson -0- (11,620) -0-Ending Retained Earnings $50,000 $61,480 $64,966

Balance SheetsAssets (see Note 1 below) $400,000 $511,480 $514,966

Liabilities $ -0- $ -0- $100,000

Stockholders’ EquityCommon Stock 350,000 450,000 350,000Retained Earnings 50,000 61,480 64,966Total Liab. And Stockholders’ Equity $400,000 $511,480 $514,966

Note 1: The asset balance for the current period is computed as the beginning balance of $365,000 plus net income of $35,000. The balance for the forecasted statements is computed as the beginning balance of $365,000, plus the $100,000 cash investment, plus net income of $58,100, less the $11,620 dividend. Alternatively, total assets can be computed by determining the amount of total claims (.i.e., Total Assets = Total Claims).

10-117

ATC 10-7 (cont.)

b. The difference in retained earning between forecast 2 and 3 is:

Forecast 3 Forecast 2 =Differenc

eRet. Earnings

$64,966 $61,480 = $3,486

c. Harbert’s proposal violates the tax law. The personal checks provide evidence of an intentional scheme to evade taxes. Entering into the agreement constitutes activity that is subject to criminal prosecution. Accordingly, Watson should reject Harbert’s proposal.

d. As indicated above, misrepresenting the truth on a tax return constitutes a fraudulent activity that is not only unethical but illegal as well. Further, it would behoove Watson to consider the fact that if Harbert is willing to defraud the IRS, she is likely to be willing to defraud her business associates as well. Watson’s safest course of action is to disassociate himself from not only the proposed transaction but from any and all business ventures associated with Harbert.

10-118

ATC 10-8 Using the EDGAR Database

NOTE: This solution was accurate as of January 3, 2002. However, the EDGAR database is subject to update at any time, so this solution will likely be “dated” at the time you assign this case to your students.

These data are from the December 31, 2000 financial statements and dollar amounts are in millions.

a. Total assets were $21,931 and total debt was $16,588 (Total debt was not stated; it must be determined by subtracting equity from assets.)

The debt-to-assets ratio was 75.6%

b. Delta’s net interest expense in 2000 was $271.

c. Delta had capital leases totaling $139 ($40 + $99) and total liabilities of $16,588. Thus, capital leases comprises less than 1% of liabilities.

(The balance sheet for Delta shows capital leases of $99 in the long-term debt section, and $40 under current liabilities.

d. Long-term debt totaled $10,251 at the end of 2000. Thus, debt arising from capital leases was slightly less than 1% of long term debt. ($99 ÷ $10,251)

e. Capital leases cause a company’s liabilities (and assets) to be higher. By avoiding capital leases, a company’s liabilities (and assets) will be lower, resulting in “better” ratios, such as the debt-to-assets and return-on-assets ratios. Consider that as of December 31, 2000, Delta had committed to make future payments of $171 for capital leases. The $139 present-value of these future payments showed up on its balance sheet as liabilities.

10-119

However, as of that same date, Delta had committed to make future payment of $15,120(!) for operating leases, of which none showed up on the balance sheet as liabilities.

10-120

Documents

Chapter 10 Solution of fundamental of financial accouting by EDMONDS (4th edition)