financial accounting tools for business decision making solutions 7e chapter 10

Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CHAPTER 10 REPORTING AND ANALYZING LIABILITIES LEARNING OBJECTIVES Account for current liabilities Account for instalment notes payable Identify the requirements for the financial statement presentation and analysis of liabilities Account for bonds payable (Appendix 10A) SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES AND BLOOM’S TAXONOMY Item LO BT Item LO BT Item LO BT Questions Item LO BT 1 K C C 13 C C 1,2 C 10 C 14 C C K 11 K 15 C C C 12 C 16 K AP 13 AP Item LO BT 17 C 17 AP Brief Exercises 1 AP AN 2 AP AN 10 K 14 AP AP AP 11 AP 15 AP AP AP 12 AN 16 AP 1 AN C AN 10 AN 13 AP AP AP AP 11 AN 14 AP AP AP AN 12 AP Exercises Problems: Set A and B 1,3 AP AP 2,3 AP AN AP 1,3 AP 2,3 AP 1,3 K AN 10 3,4 AP 1,3 AP 2,3 AP Accounting Cycle Review Cases AN 3 S S AN S AN Solutions Manual 10-1 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition Legend: The following abbreviations will appear throughout the solutions manual file LO Learning objective BT Bloom's Taxonomy K Knowledge C Comprehension AP Application AN Analysis S Synthesis E Evaluation Level of difficulty S Simple M Moderate C Complex Estimated time to prepare in minutes Difficulty: Time: AACSB CPA CM cpa-e001 cpa-e002 cpa-e003 cpa-e004 cpa-e005 cpa-t001 cpa-t002 cpa-t003 cpa-t004 cpa-t005 cpa-t006 Association to Advance Collegiate Schools of Business Communication Communication Ethics Ethics Analytic Analytic Technology Tech Diversity Diversity Reflective Thinking Reflec Thinking CPA Canada Competency Ethics Professional and Ethical Behaviour PS and DM Problem-Solving and Decision-Making Comm Communication Self-Mgt Self-Management Team & Lead Teamwork and Leadership Reporting Financial Reporting Stat & Gov Strategy and Governance Mgt Accounting Management Accounting Audit Audit and Assurance Finance Finance Tax Taxation Solutions Manual 10-2 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition ANSWERS TO QUESTIONS Accounts payable and short-term notes payable are both forms of credit used by a business to acquire the items or services they need to operate Both represent obligations of the business to repay amounts in the future and are therefore considered to be liabilities However, an account payable is normally for a shorter period of time (e.g., 30, 60, 90 days) than a note payable A note payable usually provides for a longer period of time to settle the amount owing A note payable involves a more formal arrangement than an account payable A note payable is an obligation in written form and will provide documentation if legal action is required to collect the debt As well, a note payable often requires the payment of interest because it is generally used when credit is to be granted for a longer period of time than for an account payable LO BT: K Difficulty: S Time: AACSB: None CPA: cpa-t001 CM: Reporting An operating line of credit, or credit facility, is used by a business to overcome short-term cash demands or temporary cash shortfalls that invariably happen during the operating cycle It is not usually intended to be a permanent type of financing and is generally used for operations When needed, the funds are used and then repaid as the liquidity improves and cash becomes available from operations Short-term bank loans are also liabilities of the business and are often structured in such a way to deal with short-term cash needs of the business Short-term bank loans could be used to finance inventory and accounts receivable Bank loans are for specific amounts that have structured terms for the repayment of the principal LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001 CM: Reporting Solutions Manual 10-3 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition Disagree The company only serves as a collection agent for the taxing authority It does not keep and report sales tax as revenue; it merely forwards the amount paid by the customer to the government Therefore, until it is remitted to the government, sales tax is reported as a current liability on the statement of financial position LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001 CM: Reporting Unearned revenue should be recognized when sales of gift cards are made to customers When a gift card is presented to pay for items or services received by the customer, the unearned revenue is reduced and the sales or service revenue increased If there is a legally permissible expiration date on the gift card, once that date is reached, any unused balances on gift cards should be recognized as revenue and the related unearned revenue eliminated LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001 CM: Reporting When determining whether an uncertain liability should be accrued as a provision, management must first assess the level of uncertainty concerning the outcome of a future event that will confirm either the existence of the liability or the amount payable or both Under IFRS, if the outcome of a future event is probable and a reasonable estimate can be made of the amount expected to be paid, the amount will appear as a current liability on the statement of financial position Probable, in this case means “more likely than not” which is normally interpreted to mean that there is more than a 50% probability of occurring The details of the reasons for the accrual will also be outlined in the financial statement notes If the outcome is not probable or if the amount cannot be reasonably estimated, the details of the uncertain liability will be disclosed in the notes to the financial statements An uncertain liability that is disclosed rather than recorded is known under IFRS as a contingent liability On the other hand, if the company is reporting under ASPE, the probability needs to be “likely” ASPE does not use the term “provision” Solutions Manual 10-4 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition Q (continued) If the liability is recorded it is referred to as a, contingent liability and there is no special term for just having the contingency disclosed in a note to the financial statements rather than recording it This is a higher level of probability that the standard used in IFRS LO BT: C Difficulty: C Time: 10 AACSB: None CPA: cpa-t001 CM: Reporting Current liabilities include those payments that are going to be due for payment in one year from the financial statement date Non-current liabilities are to be paid beyond that period Included in current liabilities would be the principal portion of any loans or debt that will be paid in the next year Consequently, care must be taken to disaggregate balances of such non-current loans or mortgages to ensure that the current portion of the debt is properly classified as a current liability LO 1,2 BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001 CM: Reporting Long-term instalment notes are similar to short-term notes in that they both provide written documentation of a debtor’s obligation to the lender The main difference between the two types of notes is that long-term instalment notes have maturities that extend beyond one year and have principal repayments included in the periodic payments required by the note For both types of notes, interest expense is calculated by multiplying the outstanding principal balance by the interest rate However, because a portion of the principal balance is usually repaid periodically throughout the term of a long-term instalment note, the outstanding principal balance will change (decrease) In contrast, the principal balance does not change throughout the term of a short-term note LO BT: K Difficulty: S Time: AACSB: None CPA: cpa-t001 CM: Reporting Solutions Manual 10-5 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition Instalment notes usually require the borrower to pay down a portion of the principal through fixed periodic payments relating to the principal along with any interest that was due at that time Each time a payment is made, a constant amount of principal repayment is deducted from the note The total payment amount will decline over time as the interest expense portion decreases due to reductions in the principal amount of the note An instalment note with a blended principal and interest payment is repayable in equal periodic amounts and results in changing amounts of interest and principal being applied to the note The total payment remains the same over the life of the note but the portion applied to the principal increases over time as the interest portion decreases due to reductions in the principal amount of the note LO BT: C Difficulty: S Time: AACSB: None CPA: cpa-t001 CM: Reporting (a) A student choosing the floating rate loan will initially pay a lower interest rate, but if the prime lending rate changes so does the interest rate that is charged on the balance of the loan Since the loan repayment typically takes several years, a floating interest rate reduces the risk to the financial institution and provides a market return on their loan to the student With the fixed interest rate, the initial interest rate paid is higher, but the rate does not change over the term of the loan (b) If, in the view of the student, interest rates are expected to rise, the fixed rate of interest is the better choice On the other hand, if interest rates are expected to remain steady or fall, the variable rate loan would be the better choice LO BT: C Difficulty: C Time: AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 10-6 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley 10 Financial Accounting, Seventh Canadian Edition Doug is incorrect because the amount of interest paid each month will decrease as payments are made and the outstanding (remaining) principal balance decreases The amount of interest is calculated as a percentage of the outstanding principal amount Because the monthly cash payment remains constant, over time, greater portions of the payment will be applied to the principal thereby more rapidly reducing the balance of the mortgage LO BT: C Difficulty: M Time: AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance 11 (a) Current liabilities should be presented in the statement of financial position with each major type shown separately They are normally listed in order of maturity, although other listing orders are also possible The notes to the financial statements should indicate the terms, including interest rates, maturity dates, and other pertinent information such as assets pledged as collateral (b) The nature and the amount of each non-current liability should be presented in the statement of financial position or in schedules included in the accompanying notes to the statements The notes should also indicate the interest rates, maturity dates, conversion privileges, and assets pledged as collateral LO BT: K Difficulty: S Time: AACSB: None CPA: cpa-t001 CM: Reporting 12 Liquidity ratios measure the short-term ability of a company to repay its maturing obligations Ratios such as the current ratio, receivables turnover, and inventory turnover can be used to assess liquidity In all three ratios, an increase in the ratio demonstrates an improvement Solvency ratios measure the ability of a company to repay its total debt and survive over a long period of time Ratios that are commonly used to measure solvency include debt to total assets and times interest earned ratios In the case of debt to total assets ratio, an increase in the ratio is often interpreted as a deterioration in solvency, while for the times interest earned ratio, an increase demonstrates an improvement LO BT: C Difficulty: M Time: AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 10-7 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley 13 Financial Accounting, Seventh Canadian Edition An operating line of credit, or credit facility, is used by a business to overcome short-term cash demands that invariably happen during the operating cycle It is not usually intended to be a permanent type of financing and is generally used for operations When needed, the funds are used and then repaid as the liquidity improves and cash becomes available from operations This type of financing is extremely flexible because interest charges are only incurred for the actual amount of cash borrowed for the needed period of time when there is a cash shortfall from daily operations As a consequence, the business does not incur the constant charge for interest on a long-term bank debt or mortgages and can save on interest costs The liquidity issues of a business can therefore be effectively dealt with using an operating line of credit LO BT: C Difficulty: M Time: AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance 14 A company’s debt to total asset ratio should be measured in terms of its ability to manage its debt A company may have a high debt to total asset ratio but still be able to meet its interest payments because of high income Alternatively, a company with a low debt to total assets may find itself in financial difficulty if it does not have sufficient net income to cover required interest payments Therefore, it is important to interpret these two ratios in conjunction with one another LO BT: C Difficulty: M Time: AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance 15 A company with significant operating leases has obligations that are reported in the notes to the financial statements rather than on the statement of financial position This is referred to as off-balance sheet financing The existence of these off-balance sheet forms of financing highlights the importance of including the information contained in the notes in any analysis of a company’s solvency These notes also help the financial statement user forecast the amount of the future cash outflows that will occur to satisfy these lease commitments LO BT: C Difficulty: M Time: AACSB: None CPA: cpa-t001 CM: Reporting Solutions Manual 10-8 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley *16 Financial Accounting, Seventh Canadian Edition (a) A bond is a form of a long-term note payable They are similar in that both have fixed maturity dates and pay interest The most significant difference between a note payable and a bond is that bonds are often traded on publicly whereas few notes are In addition, bonds tend to be issued for much larger amounts than notes Because of these differences, generally only large companies use bonds as a form of debt financing (b) When it comes to large sums of money, a business would consider the issue of shares or bonds for obtaining the necessary cash Both would be traded publicly Bonds are classified as debt on the statement of financial position and common shares are classified as equity Bonds require principal and interest payments; common shares not have to be repaid The board of directors may choose to pay dividends to the common shareholders, however LO BT: K Difficulty: S Time: AACSB: None CPA: cpa-t001 CM: Reporting *17 (a) When a bond is sold at a discount, the proceeds received are less than the face value of the bond because the stated rate of interest that the bond offers is lower than the market interest rate This has made the bond less attractive to investors who will increase the return they get from the bond by paying less than its face value The bond discount is considered to be an additional cost of borrowing This additional cost of borrowing should be recorded as additional interest expense over the term of the bond through a process called amortization Initially, the discount is recorded by showing the Bond Payable at an amount lower than its face value, but over time this account is increased (credited) so that it will be equal to its face value by the time it matures The offsetting debit is made to interest expense This is the additional interest expense incurred by the company for selling a bond at a discount When interest is actually paid, this amount is added to interest expense So interest expense will consist of a portion that is paid and a portion relating to the amortization of the discount thereby making it greater than the cash interest paid Solutions Manual 10-9 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition Q 17 (continued) (b) When a bond is sold at a premium, the proceeds received are greater than the face value of the bond because the stated rate of interest that the bond offers is higher than the market interest rate This has made the bond very attractive to investors who will be prepared to pay a higher price for the bond than its face value The bond premium is considered to be a reduction in interest This benefit should be recorded through reductions to interest expense over the term of the bond through a process called amortization Initially, the premium is recorded by showing the Bond Payable at an amount higher than its face value, but over time this account is decreased (debited) so that it will be equal to its face value by the time it matures The offsetting credit is made to interest expense This lowers interest expense to reflect the benefit of the premium When interest is actually paid, this amount is added to interest expense So interest expense will consist of a portion that is paid minus a portion relating to the amortization of the premium thereby making it lower than the interest paid LO BT: C Difficulty: C Time: 10 AACSB: Analytic CPA: cpa-t001 CM: Reporting Solutions Manual 10-10 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley CT10-2 Financial Accounting, Seventh Canadian Edition FINANCIAL REPORTING CASE (a) Ratios Current ratio Receivables turnover Inventory turnover Debt to total assets Times interest earned North West ($ in thousands) $335,581 $155,501 = 2.2:1 $1,796,035 = 23.7 times $79,373 + $72,506 $1,273,421 = 6.1 times $211,736 + $204,812 $436,183 $793,795 = 54.9% Sobeys ($ in millions) $2,581.4 $2,707.4 $24,618.8 $489.4 + $499.7 = 1.0:1 = 49.8 times $18,661.2 = 14.7 times $1,287.3 + $1,260.3 $5,230.9 $7,960.6 = 65.7% $69,779 + $31,332 + $(2,119.2) + $(463.4) Not $6,210 + $134.6 = 17.3 times = Applicable $6,210 $134.6 Solutions Manual 10-91 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT10-2 (CONTINUED) (b) Liquidity: Based on the current ratio, North West is more liquid than Sobeys As for receivable and inventory turnovers, Sobey’s is far ahead of North West North West must be offering terms on some of their sales, which is not the case for Sobeys This may in part be due to higher amounts of accounts receivable for North West as indicated by its lower receivables turnover On the other hand, North West’s inventory turnover is much lower than Sobeys Compared to the industry average, North West has a higher current ratio while Sobeys is lower than the industry average The opposite is true for both the receivables turnover and inventory turnover ratios, where Sobey’s ratios are higher than the industry while North West’s are lower All of the ratios are important for the assessment Solvency: The higher a company’s percentage of debt to total assets is, the greater the risk that this company may be unable to meet its maturing obligations North West’s debt to total assets ratio of 54.9% is higher (worse) than that of the industry average of 47.1%, but Sobey’s is even higher at 65.7% North West has a times interest earned ratio that is much higher than the industry average which means that the company is very able to make its interest payments Sobeys on the other hand, has a negative (not measureable) ratio due to the loss it reported Both ratios are important, but the high level of Sobey’s debt is most alarming LO BT: AN Difficulty: M Time: 25 AACSB: Analytic and Communication CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 10-92 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley CT10-3 Financial Accounting, Seventh Canadian Edition FINANCIAL ANALYSIS CASE Note to instructors: All of the material supplementing this group activity, including a suggested solution, can be found in the Collaborative Learning section of the Instructor Resource site accompanying this textbook as well as in the Prepare and Present section of WileyPLUS (a) Current Assets: Cash Accounts receivable Inventory 2018 2,000 20,000 30,000 52,000 2017 $10,000 5,000 7,500 22,500 Property, plant and equipment, net Total assets 60,000 $112,000 50,000 $72,500 Current liabilities: Accounts payable Non-current liabilities Total liabilities $ 30,930 40,000 $ 70,930 $16,550 30,000 $46,550 Income before taxes and interest (1) $100,000 – $50,000 – $26,000 (2) $50,000 – $20,000 – $10,000 $ $24,000 (1) Average $6,000 12,500 18,750 37,250 $20,000 (2) Solutions Manual 10-93 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT10-3 (CONTINUED) (a) (continued) Please note that when calculating turnover ratios, amounts from the current year statement of financial position are used as given in the instructions 2018 in thousands 2017 Current ratio $52,000 $30,930 Receivables turnover $100,000 $20,000 Inventory turnover $50,000 $30,000 = 1.7 times Debt to total assets $70,930 $112,000 = 63.3% Times interest earned $24,000 $2,400 (b) = 1.7:1 = 5.0 times = 10.0 times $22,500 $16,550 $50,000 $5,000 $20,000 $7,500 $46,550 $72,500 $20,000 $1,500 = 1.4:1 = 10.0 times = 2.7 times = 64.2% = 13.3 times Although Jim might conclude that profitability and liquidity has improved, a closer scrutiny of all ratios reveals issues with the liquidity and solvency of Atlas Limited The current ratio has increased from 1.4:1 to 1.7:1 in 2018 but this was due to the high levels of accounts receivable and inventory The receivables turnover has deteriorated substantially from 10 times in 2017 to only times in 2018 The inventory turnover has also deteriorated, from 2.7 times to 1.7 times Atlas needs to improve its collection of receivables and its inventory turnover Furthermore, Jim needs to keep in mind that some cash has been retained by negotiating an interest-only loan that will end in 2020 This advantage will not continue forever Solutions Manual 10-94 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT10-3 (CONTINUED) (b) (continued) From a solvency point of view, Atlas has a very similar debt to total assets ratio in both years but the ratio remains rather high given that more than 60% of the company’s assets have been purchased with debt financing In addition, Atlas’ times interest earned ratio had diminished from 13.3 times in 2017 to 10 times in 2018, indicating a strong, but reduced, capability to pay the interest on the loan Furthermore, it is likely that the existing loan is secured by the plant and equipment The loan now represents 67% of the plant and equipment balance, up from 60% of the year before This increase arises because the carrying value of plant and equipment is declining (c) Some of the underlying causes for the slowdown in the turnover of accounts receivable might be that Atlas has given its customers too generous terms for payment, possibly to improve sales or there has been a lack of attention paid to delinquent accounts In looking at the income statement, the banker will notice that gross profit did not rise as much as sales This is due in part to the fact that cost of goods sold is now 50% of sales in 2018 compared to 40% of sales in 2017 Also, although sales have doubled, operating expenses more than doubled and lastly, it appears that the interest rate on the loan has risen to 6% from 5% These factors that have decreased profitability will concern the banker A final area of concern for the banker will be the future settlement of the contingent liability stemming from the lawsuit launched against Atlas Although no amount could be accrued for this contingency as no reasonable estimate could be arrived at, the mere mention of this looming potential obligation will rightly bring doubt as to Atlas’ ability to deal with any related payments in the near future LO BT: S Difficulty: C Time: 40 AACSB: Analytic and Communication CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 10-95 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley CT10-4 Financial Accounting, Seventh Canadian Edition FINANCIAL ANALYSIS CASE (a) The likely explanation why shareholders’ equity increased in spite of a loss incurred during the year is the issuance of shares (b) Before the issuance of shares, debt was used to finance the expansion Once shares were issued, the cash was used in part to retire debt (c) When a company expands through the use of debt, interest is charged on that debt It is therefore critical for such a company to earn sufficient income from the projects that were financed with this debt in order to pay the interest on this debt However, when oil prices began to fall, the company realized that it would be difficult to pay interest on its loans, so to decrease that burden on the company’s cash flows, it needed to pay down its debt quickly in order to reduce interest payments The best way to that was to issue shares to obtain cash to pay down that debt (d) It would have been difficult for Baytex to be successful in issuing additional shares after the downturn in the oil prices It is more likely that the issue occurred before the downturn Following the drop in oil prices and related losses, the stock would have dropped in value as shareholders exited their investment in Baytex LO BT: S Difficulty: C Time: 15 AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 10-96 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley CT10-5 Financial Accounting, Seventh Canadian Edition FINANCIAL ANALYSIS CASE (a) Debt to total assets Times Interest earned $45,000 $100,000 $120,000 $20,000 = 45% = times (b) Error Error description Accounts affected Direction Interest not accrued Interest Expense Interest Payable Understated Understated $2,500 2,500 Posting of interest payment Interest Expense Bank Loan Payable Understated Understated 1,800 1,800 Sale of gift cards Sales Unearned Revenue Overstated Understated 2,700 2,700 (c) Amount Effect of error on income before taxes (net) Overstatement of Sales $2,700 Understatement of Interest Expense 2,500 Understatement of Interest Expense 1,800 Total overstatement of income before taxes 7,000 Income taxes at 30% 2,100 Net income effect $(4,900) Income Tax Expense overstated by Income Tax Payable overstated by 2,100 2,100 Solutions Manual 10-97 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT10-5 (CONTINUED) (d) All of the errors identified above will affect the calculation of debt but none of the errors affect assets Therefore, the revised debt is: As originally determined Correct error #1 – interest not accrued Correct error #2 – loan payment not allocated to interest Correct error #3 – unearned revenue understated Correct error #4 – overstatement of income tax Corrected balance $45,000 2,500 1,800 2,700 (2,100) $49,900 Only error #3 will affect the numerator (net income before interest and income tax) of the times interest earned ratio because this ratio excludes interest and income tax from the numerator and errors #1, #2, and #4 affect interest or income tax Therefore, the revised numerator is $120,000 – the effect of error #3 of $2,700 = $117,300 Interest expense (the denominator in the times interest earned ratio) will be revised as follows: As originally determined Correct error #1 – interest not accrued Correct error #2 – loan payment not allocated to interest Corrected balance Debt to total assets Times Interest earned (e) $20,000 2,500 1,800 $24,300 $49,900 = 49.9% $100,000 $120,000 - $2,700 $20,000 + $2,500 + $1,800 = 4.8 times Based on the revised calculations, ABC is close to breaching the covenant pertaining to debt to total assets, and below the requirement for times interest earned Solutions Manual 10-98 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT10-5 (CONTINUED) (f) Although all the errors affected the elements in the two ratios in adverse ways, it is unlikely that the errors were intentional An indication of this conclusion is that the errors were soon detected by Jennifer Woo LO BT: S Difficulty: C Time: 10 AACSB: Analytic and Communication CPA: cpa-t001, cpa-t005 CM: Reporting and Finance Solutions Manual 10-99 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley CT10-6 Financial Accounting, Seventh Canadian Edition ETHICS CASE (a) The stakeholders in this situation include: Shareholders The bank and other creditors Employees Management (b) Currently, operating lease payments are treated as rent expense The details of the amount of the future payments under the lease contract are reported in the notes to the financial statements On the other hand, a finance lease is treated as a means of financing the acquisition of the asset and so the asset being leased is added to the assets and the total obligations under the lease appear in the liabilities section of the statement of financial position Payments on finance lease obligations are treated as part interest expense and part debt repayment A finance lease causes increased interest expense and debt on the financial statements and so the debt to total assets ratio and the times interest earned ratio are adversely affected (c) There are many ways to structure a lease so that it is accounted for as an operating lease Many of these ways are legitimate while other ways can be unethical For example, if a lease is structured to last for 360 days, it will most likely be accounted for as an operating lease and doing so is completely appropriate If an option exists in the lease agreement for the lessee to purchase the asset at the end of the lease at a “bargain price, the lease should not be accounted for as an operating lease But if management has negotiated such an option in a document separate from the lease agreement but claims that such an option does not exist thereby allowing the company to account for the lease as an operating lease, this would be unethical Such behaviour could be construed as a type of financial engineering which is designed to deceive others and remove obligations that occur as a result of a transaction In this case, management must meet some specific financial conditions with respect to its debt covenants with the bank Following through with the plan might put the bank at a disadvantage in obtaining recourse under its loan agreement with Crown Point Inc Solutions Manual 10-100 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT10-6 (CONTINUED) (d) Analysts are not fooled by financial engineering involving leases Notwithstanding the application of the current rules surrounding the capitalization of leases, analysts will make the necessary adjustments to the financial results to interpret the impact of the treatment of operating versus finance leases LO BT: AN Difficulty: M Time: 20 AACSB: Analytic and Ethics CPA: cpa-t001, cpa-e001 CM: Reporting and Ethics Solutions Manual 10-101 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT10-7 (a) SERIAL CASE The balance of the mortgage payable at November 25, 2018 is $46,718 as calculated below (B) (b) Interest (C) (D) (A) Expense Reduction Principal Monthly Cash (D) × 5% of Principal Balance Interest Period Payment × 1/12 (A) – (B) (D) – (C) June 25, 2018 Balance $49,050 July 25, 2018 $667 $204 $463 48,587 Aug 25, 2018 667 202 465 48,122 Sept 25, 2018 667 201 466 47,656 Oct 25, 2018 667 199 468 47,188 Nov 25, 2018 667 197 470 46,718 The $46,718 balance of the mortgage payable at November 25, 2018 will increase by $25,000 to a total of $71,718 after the mortgage is renegotiated Nov 25, 2018 Cash Mortgage Payable 25,000 25,000 Solutions Manual 10-102 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT10-7 (CONTINUED) (c) (B) Interest (C) (D) (A) Expense Reduction Principal Monthly Cash (D) × 4% of Principal Balance Interest Period Payment × 1/12 (A) – (B) (D) – (C) Nov 25, 2018 Balance $71,718 Dec 25, 2018 $1,320 $239 $1,081 70,637 Jan 25, 2019 1,320 235 1,085 69,552 Feb 25, 2019 1,320 232 1,088 68,464 Mar 25, 2019 1,320 228 1,092 67,372 Apr 25, 2019 1,320 225 1,095 66,277 May 25, 2019 1,320 221 1,099 65,178 June 25, 2019 1,320 217 1,103 64,075 July 25, 2019 1,320 214 1,106 62,969 Aug 25, 2019 1,320 210 1,110 61,859 Sept 25, 2019 1,320 206 1,114 60,745 Oct 25, 2019 1,320 202 1,118 59,627 Nov 25, 2019 1,320 199 1,121 58,506 Dec 25, 2019 1,320 195 1,125 57,381 Jan 25, 2020 1,320 191 1,129 56,252 Feb 25, 2020 1,320 188 1,132 55,120 Mar 25, 2020 1,320 184 1,136 53,984 Apr 25, 2020 1,320 180 1,140 52,844 May 25, 2020 1,320 176 1,144 51,700 June 25, 2020 1,320 172 1,148 50,552 Solutions Manual 10-103 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition CT10-7 (CONTINUED) (d) First Instalment Payment 2018 Dec 25 Interest Expense Mortgage Payable Cash 239 1,081 1,320 Second Instalment Payment 2019 (e) Jan 25 Interest Expense Mortgage Payable Cash 235 1,085 1,320 ANTHONY BUSINESS COMPANY LTD Statement of Financial Position (Partial) June 30, 2019 Liabilities Current liabilities Current portion of 4% mortgage payable ($64,075 – $50,552) Non-current liabilities Mortgage payable, 4%, due in 2023 Total liabilities $13,523 50,552 64,075 LO 2,3 BT: AP Difficulty: M Time: 40 AACSB: Analytic and Communication CPA: cpa-t001 CM: Reporting Solutions Manual 10-104 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited Kimmel, Weygandt, Kieso, Trenholm, Irvine, Burnley Financial Accounting, Seventh Canadian Edition Legal Notice Copyright © 2017 by John Wiley & Sons Canada, Ltd or related companies All rights reserved The data contained in these files are protected by copyright This manual is furnished under licence and may be used only in accordance with the terms of such licence The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd (MMXVI xi FI) Solutions Manual 10-105 Chapter 10 Copyright © 2017 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited ... of $109 ,000 making the carrying amount after the first interest payment $108 ,135 LO BT: AP Difficulty: M Time: 10 AACSB: Analytic CPA: cpa-t001 CM: Reporting Solutions Manual 10- 20 Chapter 10. .. reduction $40,000 – $10, 000 = $30,000 (or $2 ,100 ÷ 7% = $30,000) $10, 000 fixed principal reduction [6] + $2 ,100 = $12 ,100 $10, 000 fixed principal reduction $30,000 [4] – $10, 000 [6] = $20,000... of the premium thereby making it lower than the interest paid LO BT: C Difficulty: C Time: 10 AACSB: Analytic CPA: cpa-t001 CM: Reporting Solutions Manual 10- 10 Chapter 10 Copyright © 2017 John