To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 10 Reporting and Analyzing Long-Term Liabilities QUESTIONS A bond is a liability of the issuing company A share of stock represents an ownership interest in the company Notes payable generally involve borrowing from a single creditor, whereas bonds payable are usually sold to many different lenders (bondholders) Bonds can allow a company’s owners to increase their return on equity without investing additional amounts This result occurs as long as the rate of return on the assets acquired from the borrowed cash is greater than the interest rate paid on the bonds Bonds also help the current owners remain in control of the company There is also a tax advantage with bonds when issued by corporations A trustee for bondholders has the responsibility of monitoring the issuer’s actions, financial performance, and financial condition to ensure that the obligations in the bond indenture are met A bond indenture is a legal contract between the issuing company and the bondholders that identifies the obligations and rights of both parties It specifies such items as the par value of the bonds, the contract interest rate, the due dates for interest payments, and the maturity date(s) of the bonds It also may name a trustee, describe the bond issue in detail, and provide for a sinking fund The contract rate (also known as the coupon rate, stated rate, or nominal rate) is the rate that is identified in the bond indenture It is applied to the par value to determine the size of the cash interest payments The market rate is the consensus rate that a company is willing to pay and that investors are willing to accept for a specific bond In general, the supply of and demand for bonds affect market rates The market rate for a particular bond issue is also affected by risks unique to the issuer (e.g., financial performance and condition) and the length of time until the bonds mature 8.B The effective interest method creates a constant rate of interest over a bond’s life because the market rate at the time of issuance is multiplied by the beginning balance for each period The straight-line method produces either an increasing or decreasing rate because it allocates the same amount of expense to each period, even if the liability balance is growing (a discount) or decreasing (a premium) 9.C When issuing bonds between interest dates, a company collects accrued interest from the purchasers to avoid keeping detailed records of bond purchasers and the dates when bonds are purchased If the company did not collect accrued interest, individual checks would be needed to pay the correct amount of interest to each purchaser By ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 10 515 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com collecting in advance, the issuer merely distributes the same amount per check to all bondholders, regardless of when they purchased the bonds 10 The price of bonds can be computed by finding the present value of both the par value at maturity and the periodic cash interest payments discounted at the market rate of interest 11 The issue price of a $2,000 bond sold at 98 ¼ is 98.25% of $2,000, or $1,965 The issue price of a $6,000 bond priced at 101 ½ is 101.5% of $6,000, or $6,090 12 The debt-to-equity ratio is calculated by dividing total liabilities by total equity The higher a company’s debt-to-equity ratio, the higher proportion of a company’s assets that are provided by creditors If a company has a high debt-to-equity ratio, the company may be at risk during poor economic times, because it must still pay off creditors even though it may not be earning as much as it did in the past 13 An entrepreneur (owner) must repay the bondholders the principal (par value) according to the term of the bonds He or she must also pay interest on the bonds per the amount and frequency cited in the bond indenture, and must adhere to any stipulations (covenants) specified in the bond contract 14 Best Buy shows long-term both ―Long-term Liabilities‖ and ―Long-Term Debt‖ on its balance sheet To determine whether the long term debt is comprised of bonds or other obligations we must read footnote disclosing details of the Long-Term Debt of the company The footnote reports that its long-term debt is comprised of Convertible debentures (bonds), Lease Obligations, and Mortgages 15 Per Circuit City’s February 28, 2005, statement of cash flows (financing section), the company repaid $28,008,000 for the fiscal year ended February 28, 2005 16 The financing section of the statement of cash flows of Apple indicates that for the year ended September 25, 2004, the company issued common stock totaling $427,000,000 For that same period, the company repaid debt in the amount of $300,000,000 17.D If a lease qualifies to be recorded as a capital lease, an asset account for the leased asset will be debited with an amount equal to the present value of the future lease payments The corresponding credit will be to a lease liability account 18.D An operating lease is a short-term or cancelable lease in which the lessor retains the risks and rewards of ownership The lessee expenses operating lease payments when incurred and the lessee does not report the leased item(s) as an asset nor as a liability A capital lease is a long-term or noncancelable lease in which the lessor transfers substantially all the risks and rewards of ownership to the lessee The lessee records the leased item as its own asset along with a lease liability at the start of the lease term— the amount recorded equals the present value of all lease payments 19.D Pension plans can be designed as defined benefit plans or defined contribution plans In a defined benefit plan the employer estimates the contribution necessary to pay a predefined benefit amount to its retirees For example, an employee’s monthly pension benefit may be set at $1,000 per month The employer must contribute the amount necessary to the pension plan to fund the $1,000 a month to the employee when the employee retires Alternatively, with a defined contribution plan, the pension contribution is defined and the employer or employee contributes the amount specified in the pension agreement For example, a defined contribution plan might specify that the employer will contribute 2% of an employee’s annual salary to the pension plan every year ©McGraw-Hill Companies, 2008 516 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com QUICK STUDIES Quick Study 10-1 (10 minutes) Bond’s cash proceeds: $250,000 x 0.875 = $218,750 Twenty semiannual interest payments of $10,000* Plus bond discount ($250,000 - $218,750) Total bond interest expense *$250,000 x 0.08 x ½ = $10,000 Bond interest expense on first payment date: $231,250 / 20 semiannual periods = $11,563 $200,000 31,250 $231,250 Quick Study 10-2B (10 minutes) Bond’s cash proceeds: $240,000 x 1.1725 = $281,400 Thirty semiannual interest payments of $12,000* Less premium ($281,400 - $240,000) Total bond interest expense *$240,000 x 0.10 x ½ = $12,000 Bond interest expense on first payment date: $281,400 x 4% = $11,256 $360,000 (41,400) $318,600 Quick Study 10-3 (10 minutes) 2008 Jan Cash 218,750 Discount on Bonds Payable 31,250 Bonds Payable 250,000 To record issuing bonds at a discount Jan Cash 281,400 Bonds Payable 240,000 Premium on Bonds Payable 41,400 To record issuing bonds at a premium ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 10 517 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Quick Study 10-4 (10 minutes) a Using facts in QS 10-1, the bond’s cash proceeds for the bond selling at a discount are computed as follows Cash Flow Table Value $250,000 par (maturity) value 0.3769 $10,000 interest payment 12.4622 Price of Bond * Present Value $ 94,225 124,622 $218,847* Agrees with $218,750 as given in QS 10-1, except for rounding difference (Instructor note: The price in QS 10-1 is rounded to 87.5 from 87.5388, yielding the $97 difference.) b Using facts in QS 10-2, the bond’s cash proceeds for the bond selling at a premium are computed as Cash Flow Table Value $240,000 par (maturity) value 0.3083 $ 12,000 interest payment 17.2920 Price of Bond Present Value $ 73,992 207,504 $281,496* * Agrees with $281,400 as given in QS 10-2, except for rounding difference (Instructor note: The price in QS 10-2 is rounded to 117.5 from 117.29, yielding the $96 difference.) Quick Study 10-5 (10 minutes) 2008 July Bonds Payable 400,000 Premium on Bonds Payable 16,000 Gain on Retirement of Bonds* Cash 8,000 408,000 To record retirement of bonds before maturity *$8,000 = $416,000 - $408,000 Quick Study 10-6 (10 minutes) 2008 Jan Bonds Payable 2,000,000 Common Stock* Paid-In Capital in Excess of Par Value 1,000,000 1,000,000 To record retirement of bonds by stock conversion *1,000,000 shares x $1.00 ©McGraw-Hill Companies, 2008 518 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Quick Study 10-7 (10 minutes) Initial cash proceeds from note Amount of annual payment = Table B.3 present value for payments a 4%: Payment = $340,000 / 4.4518 = $76,374 b 8%: Payment = $340,000 / 3.9927 = $85,155 c 12%: Payment = $340,000 / 3.6048 = $94,319 Quick Study 10-8 (10 minutes) A C H F Registered bond Serial bond Secured bond Bearer bond E D G B Convertible bond Bond Indenture Sinking fund bond Debenture Quick Study 10-9 (10 minutes) Ratio of debt to equity Atlanta Company Spokane Company Total liabilities $429,000 $ 548,000 Total equity $572,000 $1,827,000 Debt-to-equity ratio 0.75 0.30 Analysis and interpretation: Atlanta Company’s debt-to-equity ratio of 0.75 implies a riskier financing structure than Spokane Company’s 0.30 debt-toequity ratio Quick Study 10-10C (10 minutes) 2008 Mar Cash 405,333 Interest payable* 5,333 Bonds payable 400,000 Sold $400,000 of bonds with two months’ accrued interest *($400,000 x 08 x 2/12) ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 10 519 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Quick Study 10-11C (10 minutes) Rental Expense 250 Cash (or Payable) 250 To record rental expense for car lease Quick Study 10-12C (10 minutes) Leased Asset—Office Equipment 15,499 Lease Liability 15,499 To record capital lease of office equipment ©McGraw-Hill Companies, 2008 520 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com EXERCISES Exercise 10-1 (15 minutes) Semiannual cash interest payment = $3,400,000 x 9% x 1/2 = $153,000 Journal entries 2008 (a) Jan Cash 3,400,000 Bonds Payable 3,400,000 Sold bonds at par (b) June 30 Bond Interest Expense 153,000 Cash 153,000 Paid semiannual interest on bonds (c) Dec 31 Bond Interest Expense 153,000 Cash 153,000 Paid semiannual interest on bonds 2008 (a) Jan Cash* 3,332,000 Discount on Bonds Payable 68,000 Bonds Payable 3,400,000 Sold bonds at 98 *($3,400,000 x 0.98) (b) Jan Cash* 3,468,000 Premium on Bonds Payable Bonds Payable 68,000 3,400,000 Sold bonds at 102 *($3,400,000 x 1.02) ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 10 521 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 10-2 (30 minutes) Discount = Par value - Issue price = $180,000 - $170,862 = $9,138 Total bond interest expense over the life of the bonds Amount repaid Six payments of $7,200* Par value at maturity Total repaid Less amount borrowed Total bond interest expense $ 43,200 180,000 223,200 (170,862) $ 52,338 *180,000 x 0.08 x ½ = $7,200 or: Six payments of $7,200 $ 43,200 Plus discount 9,138 Total bond interest expense $ 52,338 Straight-line amortization table ($9,138/6 = $1,523) Semiannual Period-End Unamortized Discount Carrying Value (0) 1/01/2008 $9,138 $170,862 (1) 6/30/2008 7,615 172,385 (2) 12/31/2008 6,092 173,908 (3) 6/30/2009 4,569 175,431 (4) 12/31/2009 3,046 176,954 (5) 178,477 6/30/2010 1,523 (6) 12/31/2010 180,000 ©McGraw-Hill Companies, 2008 522 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 10-3B (30 minutes) Discount = Par value - Issue price = $500,000 - $463,140 = $36,860 Total bond interest expense over the life of the bonds Amount repaid Six payments of $22,500* $135,000 Par value at maturity 500,000 Total repaid 635,000 Less amount borrowed (463,140) Total bond interest expense $171,860 *$500,000 x 0.09 x ½ = $22,500 or Six payments of $22,500 $135,000 Plus discount 36,860 Total bond interest expense $171,860 Effective interest amortization table Semiannual Interest Period-End (A) Cash Interest Paid (B) Bond Interest Expense [4.5% x $500,000] [6% x Prior (E)] (C) (D) Discount Unamortized Amortization Discount [(B) - (A)] 1/01/2008 (E) Carrying Value [Prior (D) - (C)] [$500,000 - (D)] $36,860 $463,140 6/30/2008 $ 22,500 $ 27,788 $ 5,288 31,572 468,428 12/31/2008 22,500 28,106 5,606 25,966 474,034 6/30/2009 22,500 28,442 5,942 20,024 479,976 12/31/2009 22,500 28,799 6,299 13,725 486,275 6/30/2010 22,500 29,176 6,676 7,049 492,951 12/31/2010 22,500 29,549 * 7,049 500,000 $135,000 $171,860 $36,860 *Adjusted for rounding ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 10 523 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 10-4 (30 minutes) Premium = Issue price - Par value = $409,850 - $400,000 = $9,850 Total bond interest expense over the life of the bonds Amount repaid Six payments of $26,000* Par value at maturity Total repaid Less amount borrowed Total bond interest expense $156,000 400,000 556,000 (409,850) $146,150 *$400,000 x 0.13 x ½ = $26,000 or Six payments of $26,000 Less premium Total bond interest expense $156,000 (9,850) $146,150 Straight-line amortization table ($9,850/6 = $1,642) Semiannual Interest Period-End Unamortized Premium Carrying Value 1/01/2008 $9,850 $409,850 6/30/2008 8,208 408,208 12/31/2008 6,566 406,566 6/30/2009 4,924 404,924 12/31/2009 3,282 403,282 6/30/2010 1,640* 401,640 12/31/2010 400,000 *Adjusted for rounding ©McGraw-Hill Companies, 2008 524 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 10-7BB (70 minutes) Part 2004 Jan Cash 493,608 Premium on Bonds Payable Bonds Payable 43,608 450,000 Sold bonds on stated issue date Part Eight payments of $29,250* $ 234,000 Par value at maturity 450,000 Total repaid 684,000 Less amount borrowed (493,608) Total bond interest expense $ 190,392 *$450,000 x 0.13 x ½ = $29,250 or: Eight payments of $29,250 $ 234,000 Less premium (43,608) Total bond interest expense $ 190,392 Part Semiannual Interest Period-End (A) Cash Interest Paid (B) Bond Interest Expense [6.5% x $450,000] [5% x Prior (E)] (C) (D) Premium Unamortized Amortization Premium [(A) - (B)] 1/01/2007 (E) Carrying Value [Prior (D) - (C)] [$450,000 + (D)] $43,608 $493,608 6/30/2007 $29,250 $24,680 $4,570 39,038 489,038 12/31/2007 29,250 24,452 4,798 34,240 484,240 6/30/2008 29,250 24,212 5,038 29,202 479,202 12/31/2008 29,250 23,960 5,290 23,912 473,912 ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 10 565 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 10-7BB (Concluded) Part 2007 June 30 Bond Interest Expense 24,680 Premium on Bonds Payable 4,570 Cash 29,250 To record six months’ interest and premium amortization 2007 Dec 31 Bond Interest Expense 24,452 Premium on Bonds Payable 4,798 Cash 29,250 To record six months’ interest and premium amortization Part 2009 Jan Bonds Payable 450,000 Premium on Bonds Payable 23,912 Loss on Retirement of Bonds 3,088 Cash* 477,000 To record the retirement of bonds *($450,000 x 106%) Part If the market rate on the issue date had been 14% instead of 10%, the bonds would have sold at a discount because the contract rate of 13% would have been lower than the market rate This change would affect the balance sheet because the bond liability would be smaller (par value minus a discount instead of par value plus a premium) As the years passed, the bond liability would increase with amortization of the discount instead of decreasing with amortization of the premium The income statement would show larger amounts of bond interest expense over the life of the bonds issued at a discount than it would show if the bonds had been issued at a premium The statement of cash flows would show a smaller amount of cash received from borrowing However, the cash flow statements presented over the life of the bonds (after issuance) would report the same total amount of cash paid for interest This amount is fixed as it is the product of the contract rate and the par value of the bonds and is unaffected by the change in the market rate ©McGraw-Hill Companies, 2008 566 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 10-8B (30 minutes) Part Amount of Payment Note balance $150,000 Number of periods Interest rate 10% Value from Table B.3 2.4869 Payment ($150,000 / 2.4869) $ 60,316 Part (A) Beginning Balance (B) Debit Interest Expense [Prior (E)] [10% x (A)] 9/30/2008 $150,000 $15,000 9/30/2009 104,684 9/30/2010 .54,836 Period Ending Date Payments (C) Debit Notes Payable = (D) Credit (E) Cash Ending Balance [computed] [(A) - (C)] $ 45,316 $ 60,316 $104,684 10,468 49,848 60,316 54,836 5,480* 54,836 60,316 $30,948 $150,000 $180,948 + [(D) - (B)] *Adjusted for rounding Part 2007 Dec 31 Interest Expense 3,750 Interest Payable 3,750 Accrued interest on the installment note payable ($15,000 x 3/12) 2008 Sept 30 Interest Expense 11,250 Interest Payable 3,750 Notes Payable 45,316 Cash 60,316 Record first payment on installment note (interest expense = $15,000 - $3,750) ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 10 567 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 10-9B (30 minutes) Part Atlas Company Debt-to-equity ratio = $81,000 / $99,000 = 0.82 Bryan Company Debt-to-equity ratio = $562,500 / $187,500 = 3.00 Part Bryan’s debt-to-equity ratio is much higher than that for Atlas This implies that Bryan has a more risky financing structure Before concluding that either company’s debt-to-equity ratio is too high (or too low), it is important to evaluate the ability of each company to meet its obligations from operating cash flows and to assess the return on those borrowed funds ©McGraw-Hill Companies, 2008 568 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 10-10BD (35 minutes) Part Present Value of the Lease Payments $20,000 x 3.7908 (from Table B.3) = $75,816 Part Leased Asset—Office Equipment 75,816 Lease Liability 75,816 To record capital lease of office equipment Part Capital Lease Liability Payment (Amortization) Schedule Period Ending Date Beginning Balance of Lease Liability Interest on Lease Liability (10%) Reduction of Lease Liability Year $75,816 $ 7,582* $12,418 $ 20,000 $63,398 Year 63,398 6,340 13,660 20,000 49,738 Year 49,738 4,974 15,026 20,000 34,712 Year 34,712 3,471 16,529 20,000 18,183 Year 18,183 1,817** 18,183 20,000 $75,816 $100,000 $24,184 * ** Cash Lease Payment Ending Balance of Lease Liability Rounded to nearest dollar Adjusted for prior period rounding errors Part Depreciation Expense—Office Equipment 15,163 Accum Depreciation—Office Equipment 15,163 To record depreciation ($75,816 / years) ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 10 569 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com SERIAL PROBLEM — SP 10 Serial Problem — SP 10, Success Systems (75 minutes) Part Total equity = $146,479, so total liabilities can be no more than 0.8 x total equity, or $146,479 x 0.8 = $117,183 Max total liabilities – Present liability balance = Max that can be borrowed $117,183 – $1,050 = $116,133 Part Assume the secured loan is taken, then the percent of assets financed by: a Debt ($1,050 + $116,133) / ($147,529 + $116,133) = 44.4% b Equity $146,479 / ($147,529 + $116,133) = 55.6% Part Adriana should understand the risks she is taking by borrowing funds from the bank She currently has no interest-bearing debt, but the loan will require her to pay interest The interest is a fixed cost that must be paid, no matter what her profits are She must also consider what she will with the borrowed funds She needs to make sure she can earn a reasonable return on the assets acquired with the borrowed funds to make the debt worthwhile In addition, and probably more important, Adriana should understand the terms of the loan and have the ability to pay the loan back when it is due ©McGraw-Hill Companies, 2008 570 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Reporting in Action — BTN 10-1 Best Buy’s Long-Term Debt consists of: Convertible subordinated debentures, due 2022, initial interest rate 2.25% $402,000,000 Master lease obligations, due 2006, interest rate 5.9% 55,000,000 Capital lease obligations, due 2005, interest rates ranging from 5.5% to 8.0% 13,000,000 Financing lease obligations, due 2008 to 2022, interest rates ranging from 5.6% to 6.0% 107,000,000 Mortgage and other debt, interest rates ranging from 1.8% to 8.9% 23,000,000 Total debt $600,000,000 Less current portion (72,000,000) Total long-term debt $528,000,000 The interest that Best Buy must pay on the 2.25% convertible subordinated debentures is: $402,000,000 x 0225 = $9,045,000 During the year ended February 26, 2005, Best Buy did not issue any long-term debt that provided cash (They did, however, pay off $371,000,000 in long-term debt.) Answer depends on the financial statement information obtained ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 10 571 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Comparative Analysis — BTN 10-2 Best Buy’s current year debt-to-equity ratio = $5,845 / $4,449 = 1.3 Best Buy’s prior year debt-to-equity ratio = $5,230 / $3,422 = 1.5 Circuit City’s current year debt-to-equity ratio = $1,702/ $2,087 = 0.8 Circuit City’s prior year debt-to-equity ratio = $1,507/ $2,224 = 0.7 For both years, Best Buy’s debt-to-equity ratio is above the industry average of 1.1 This implies that Best Buy’s debt level is slightly riskier than that of its competitors Circuit City’s debt-to-equity ratio is below the industry average for both years, implying that its debt level is less risky than the industry average—at least on this dimension Ethics Challenge — BTN 10-3 The ethics of the Brevard County officials are questionable The financial impact of the leasing arrangement is the same as bond financing in that the county has a debt obligation requiring the repayment of principal and interest over time Taxes may need to be raised to repay the lease just as they would have if bonds were issued Yet, the voters had no say in the financing arrangement the officials agreed to In reality, the taxpayers of Brevard County, Florida, reacted very negatively to the actions of the county officials when they learned of the leasing arrangement The taxpayers felt that their voice was taken out of the governing process Brevard County officials responded to the outrage of their constituents by floating the idea of holding a referendum on whether to stop the lease payments on the building Of course, such talk angered the municipal bond industry and the investors Since the lease requires payments of a non-binding nature, investors who purchased the tax-exempt securities from the bank are holding an investment that is more risky than the conventional municipal bonds of Brevard County ©McGraw-Hill Companies, 2008 572 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Communicating in Practice — BTN 10-4 MEMORANDUM TO: FROM: SUBJECT: The body of the memorandum should make the following points: The associate is confused about the concept of a bond premium Bonds that sell at a premium provide the issuing company more cash than they are required to pay the bondholders at their maturity date When a bond is issued at a premium, the face amount is less than the amount the associate will invest to acquire the bond As a result, the investment will yield the investor (and cost the issuing corporation) less than the contract rate of interest This means that selling/buying at a premium incurs/yields an effective rate of interest equivalent to the market rate for the risk assessed for that bond at the time of issuance In addition, this market rate of interest is lower than the contract rate of interest for premium bonds The bottom line is that the market prices the bonds according to their perceived risks and returns What your associate needs to focus on is the level of risk she is willing to accept and then invest accordingly A cordial closing that indicates willingness to discuss the issue further would be appropriate ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 10 573 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Taking It to the Net — BTN 10-5 Home Depot’s long-term liabilities include: Long-Term Debt, excluding current installments $2,148 million Other Long-Term Liabilities 763 million Deferred Income Taxes 1,309 million 2a Home Depot’s notes offer a ¾% interest rate If the interest rate for similar notes at similar interest were ¾%, then Home Depot would have offered these notes at their par value of $1 billion However, since the notes were issued at a discount, the interest rate for similar notes at similar risk must have been greater than ¾%, causing the notes to have been issued at a discount 2b Cash interest that must be paid: $1,000,000,000 x 0.0375 x ½ year = $18,750,000 ©McGraw-Hill Companies, 2008 574 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Teamwork in Action — BTN 10-6 Parts and Effective Interest Amortization of Bond Premium Semiannual Period-end (A) Cash Interest Paid (B) Bond Interest Expense (C) (D) (E) Premium Amortization Unamortized Premium Carrying Value 1/01/2008 $ 4,100 $ 104,100 6/30/2008 $ 4,500 $ 4,164 $ 336 3,764 103,764 12/31/2008 4,500 4,151 349 3,415 103,415 6/30/2009 4,500 4,137 363 3,052 103,052 12/31/2009 4,500 4,122 378 2,674 102,674 6/30/2010 4,500 4,107 393 2,281 102,281 Since teams generally have or members, the team solution will likely end about here The remainder of the table is shown for help in answering part 12/31/2010 6/30/2011 12/31/2011 6/30/2012 12/31/2012 4,500 4,500 4,500 4,500 4,500 $45,000 4,091 4,075 4,058 4,040 3,955* $40,900 409 425 442 460 545 $4,100 1,872 1,447 1,005 545 101,872 101,447 101,005 100,545 100,000 *Discrepancy due to rounding The following computations should be articulated by team members as each line is explained and prepared: Column (A) Cash Interest Paid = Bonds' par value ($100,000) x Semiannual contract rate (4.5%) Column (B) Bond interest expense = Bonds’ prior period carrying value x Semiannual market rate (4%) Column (C) Premium Amortization = difference between cash interest paid and bond interest expense, or [(A) - (B)] Column (D) Unamortized Premium = prior period’s unamortized premium less the current period’s premium amortization, or [(D) - (C)] Column (E) Bonds’ Carrying Value = Bonds’ par value plus unamortized premium, or [$100,000 + (D)] or Previous book value - Period’s amortization ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 10 575 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Teamwork in Action (Concluded) Part Without completing the table, team members should be able to project the final number in the first column and for each of the columns (A), (D), and (E) Specifically: (Col 1) Last interest period date is 12/31/2012 because this is a five-year bond, issued 1/1/2008, with semiannual interest payments made on 6/30 and 12/31 of each year (Col A) Interest paid of $4,500 (every interest period has the same amount of interest paid) (Col D) Zero unamortized premium (by the last interest period the premium must be fully amortized) (Col E) Ending carrying value is $100,000 (the carrying value always equals the par value at the maturity date, after all amortization is completed) Part Total Bond interest expense = Interest Paid - Premium = ($4,500 x 10 periods) - $4,100 = $45,000 - $4,100 = $40,900 Part List likely includes: Similarities a Table column headings for the period and for columns (A), (B), and (E) Differences a Column (C) will be Discount Amortization and Column (D) will be Unamortized Discount b Dates in the period column and interest paid in column (A) b Bond interest expense is higher (lower) than the interest paid and will increase (decrease) as we amortize a discount (premium) c Computations in Columns (A), (B), and (D) will follow the same format c Carrying value will increase (decrease) as we amortize a discount (premium) d Ending unamortized premium and discount will both be zero d Discount (premium) amortization will decrease (increase) each period e Carrying value at 12/31/2012 will be $100,000 in both cases e Computation of Column (C) will be (B) - (A), and not (A) - (B) f Computation of Column (E) will be previous Column (E) plus discount amortization whereas with a premium we subtract to find the new carrying value ©McGraw-Hill Companies, 2008 576 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Business Week Activity — BTN 10-7 An interest-only mortgage is one in which the borrower’s monthly payment covers only the interest on the unpaid balance, and does not reduce the principle amount The unpaid loan amount never changes A conventional mortgage payment pays off interest on the unpaid balance, as well as a part of the unpaid loan balance In this way, the loan amount eventually goes to zero Borrowers would seek an interest-only loan so that they can afford a larger mortgage (and hence a more expensive home) than they could with a conventional mortgage The interest-only monthly loan payment would always stay at: $400,000 x 04875 x 1/12 = $1,625 Since the payment of $1,625 payment only covers interest, the loan balance stays at $400,000 If the borrower had a conventional mortgage, the first payment of $2,120 would cover $1,625 in interest (part 2) and $495 on the $400,000 loan balance The second month’s payment of $2,120 would cover $1,623 in interest [($400,000 - $495) x 04875 x 1/12] and $497 on the loan balance The loan balance after the second month would be $399,008 ($400,000 - $495 - $497) There are several risks of interest-only mortgages, including: If the buyer wishes to sell the home before the principle payments come due, they might lose money if their property value does not rise Since most of these loans require that principle payments begin at some time, once these payments begin, the monthly payment may increase by as much as 50% or more ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 10 577 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Entrepreneurial Decision — BTN 10-8 Part The table below reveals how the five alternative interest-bearing notes would affect Rap Snacks’s interest expense, net income, equity, and return on equity (net income/equity): Current Income before interest Interest expense Alternative Notes for Expansion 10% Note 15% Note 16% Note 17% Note 20% Note $ 40,000 $ 56,000 $ 56,000 $ 56,000 $ 56,000 $ 56,000 10,000 20,000 25,000 26,000 27,000 30,000 Net income $ 30,000 $ 36,000 $ 31,000 $ 30,000 $ 29,000 $ 26,000 Equity $250,000 $250,000 $250,000 $250,000 $250,000 $250,000 Return on equity 12% 14.4% 12.4% 12% 11.6% 10.4% Part The analysis in Part illustrates the general rule (called ―financial leverage‖ or ―trading on the equity‖): When a company earns a higher return with borrowed funds than it is paying in interest, it increases its return on equity In the case of Rap Snacks, it is predicting a return of 16% on its investment, computed as its expected $16,000 additional annual income before interest divided by its $100,000 investment This means that for it to pursue the investment, the interest on the borrowed funds must be less than 16% The table in Part shows this result, where those notes with interest expense below 16% are profitable (that is, yield a return greater than the current ROE of 12%), while those above 16% are not (that is, yield a return less than the current ROE of 12%) Also, the company should take into account any potential variability in its income predictions because any downturn in income that results in return on equity lower than the interest rate paid on the notes would be unprofitable ©McGraw-Hill Companies, 2008 578 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Hitting the Road — BTN 10-9 Students’ answers will depend on the municipality and time period chosen for analysis Students often find this assignment interesting as it reinforces the relevance of their accounting studies Global Decision — BTN 10-10 Dixons’ current year debt-to-equity ratio = £2,406 / £1,468 = 1.6 Dixons’ prior year debt-to-equity ratio = £2,782 / £1,376 = 2.0 Dixons’ debt-to-equity ratio declined from the prior year to the current year However, for both years, Dixons’ debt-to-equity ratio is higher than both Best Buy and Circuit City, indicating a higher debt risk (at least on this dimension) ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 10 579 ... record retirement of bonds by stock conversion *1,000,000 shares x $1.00 ©McGraw-Hill Companies, 2008 518 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank,... of the bonds and is unaffected by the change in the market rate ©McGraw-Hill Companies, 2008 544 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit... record issuing bonds at a premium ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 10 517 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com