CHAPTER 15

non-current liabilities

Summary of Questions by STUDY Objectives
and Bloom’s Taxonomy

Note: AN = Analysis AP = Application

summary of questions by level of difficulty (lod)

Note: E = Easy M = Medium H=Hard

CHAPTER STUDY OBJECTIVES

1. Compare the impact of issuing debt instead of equity. Debt offers the following advantages over equity: (1) shareholder control is not affected, (2) income tax savings result, (3) earnings per share may be higher, and (4) return on equity may be higher.

2. Account for bonds payable. The market value of bonds is determined using present value factors to determine the present value of the interest and principal cash flows generated by the bond relative to the current market interest rate. When bonds are issued, the Bonds Payable account is credited for the bonds’ market value (present value). Bonds are issued at a discount if the market interest rate is higher than the contractual interest rate. Bonds are issued at a premium if the market interest rate is lower than the contractual interest rate.

Bond discounts and bond premiums are amortized to interest expense over the life of the bond using the effective- interest method of amortization. Amortization of the bond discount or premium is the difference between the interest paid and the interest expense. Interest paid is calculated by multiplying the face value of the bonds by the contractual interest rate. Interest expense is calculated by multiplying the amortized cost of the bonds at the beginning of the interest period by the market interest rate. The amortization of a bond discount increases interest expense. The amortization of a bond premium decreases interest expense.

When bonds are retired at maturity, Bonds Payable is debited and Cash is credited. There is no gain or loss at retirement. When bonds are redeemed before maturity, it is necessary to (1) pay and record any unrecorded interest, (2) eliminate the amortized cost of the bonds at the redemption date, (3) record the cash paid, and (4) recognize any gain or loss on redemption.

3. Account for instalment notes payable. Instalment notes payable are repayable in a series of instalments. Each payment consists of (1) interest on the unpaid balance of the note, and (2) a reduction of the principal balance. These payments can be either (1) fixed principal plus interest payments or (2) blended principal and interest payments. With fixed principal payments, the reduction in principal is constant but the cash payment and interest decrease each period (as the principal decreases). With blended payments, the cash payment is constant but the interest decreases and the principal reduction increases each period.

4. Explain and illustrate the methods for the presentation and analysis of non-current liabilities. The current portion of debt is the amount of the principal that must be paid within one year of the balance sheet date. This amount is reported as a current liability in the balance sheet, and the remaining portion of the principal is reported as a non-current liability. The nature of each liability should be described in the notes accompanying the financial statements. A company’s long-term solvency may be analyzed by calculating two ratios. Debt to total assets indicates the proportion of company assets that is financed by debt. Interest coverage measures a company’s ability to meet its interest payments as they come due.

Exercises

Exercise 1

The board of directors of Finley Corporation is considering two plans for financing the purchase of new plant equipment. Plan #1 would require the issue of $4,000,000, 6%, 20-year bonds at face value. Plan #2 would require the issue of 200,000 common shares for $20 per share. Finley Corporation currently has 100,000 common shares issued at a book value of $20 each and retained earnings of $750,000. The income tax rate is expected to be 30%. Assume that income before interest and income taxes is expected to be $800,000 if the new factory equipment is purchased. Assume that the debt or equity will be issued at the beginning of the year.

Instructions

a. Prepare a schedule which shows the expected profit, earnings per share, and return on equity under each of the plans that the board of directors is considering.

b. If the board of directors’ stated goal is to maximize the common shareholders’ return, which alternative is preferable? If the board’s stated goal is to maximize solvency, which alternative is preferable?

Exercise 2

United Health is considering two alternatives for the financing of some high technology medical equipment. These two alternatives are:

1. Issue 50,000 common shares at $50 per share.

2. Issue $2,500,000, 5%, 10-year bonds at face value.

It is estimated that the company will earn $900,000 before interest and taxes as a result of acquiring the medical equipment. The company has an estimated tax rate of 30% and has 100,000 common shares issued prior to the new financing.

Instructions

Determine the effect on profit and earnings per share for these two methods of financing.

Exercise 3

Three plans for financing a $20,000,000 corporation are under consideration by its organizers. The bonds will be issued at their face value and the income tax rate is estimated at 20%.

Plan 1 Plan 2 Plan 3

6% Bonds — — $10,000,000

$8 Preferred Shares, issued at $100 — $10,000,000 5,000,000

Common Shares, issued at $10 $20,000,000 10,000,000 5,000,000

Total $20,000,000 $20,000,000 $20,000,000

It is estimated that profit before interest and taxes will be $4,000,000.

Instructions

For each plan, determine the expected profit and the earnings per share. Prior to obtaining financing there are no common shares outstanding.

Exercise 4

Kelsey Holdings Inc. requires $5,000,000 in new financing in order to expand its operations. The management team is in discussion about the best way to finance the expansion and has asked you, their accountant, for assistance. In order to provide them with the information they need, you analyze the following two options:

1. Issue 1,000,000 common shares at $5 which is the current market price of Kelsey’s 2,000,000 issued common shares.

2. Issue $5,000,000 of 10-year, 4% bonds at 101. Kelsey currently has no bonds payable issued.

The financing would be required at the beginning of the next fiscal year. Kelsey’s tax rate is 30%. The management team projects profit of $1,750,000 before financing costs and taxes. They are interested in comparing the net income after tax, the earnings per share, and the return on equity under each alternative. The management team’s goal is to maximize return on equity in the first year. Kelsey’s shareholder equity other than share capital includes retained earnings and accumulated other comprehensive income totaling $17,500,000.

Instructions

Calculate the amounts requested by the management team and present the two alternatives in comparative format. Recommend which alternative should be chosen.

Exercise 5

Southern Merchandising Inc. is considering new financing to pay out $2,500,000 of existing 10% bonds payable at the beginning of the next fiscal year. The company wants to maximize ROE in the new year. They are considering two alternative ways of financing the payout:

1. Do not pay out existing bonds;
2. Issue a 5% bond payable at face value, or issue 250,000 common shares at $10.

Other information about Southern:

• Southern’s tax rate is 25%.
• Southern currently has $4,000,000 in shareholder equity prior to any new share issue.
• Southern’s average profit before financing costs and taxes is $800,000.
• A one-time penalty of $150,000 will be incurred to pay out the 10% bonds early, which is fully tax deductible.

Instructions

Calculate the following amounts for Southern, compare the two alternatives to the current bonds payable, and make a recommendation on refinancing, assuming the goal is to maximize return on equity for the next year.

Exercise 6

On February 1, 2014, the Happy Valley Corporation issued $100,000, 5%, 5-year bonds. Interest is payable semi-annually on August 1 and February 1.

Instructions

a. Prepare the journal entries that Happy Valley would make on February 1 if it issued the bonds at (1) 100, (2) 98, and (3) 102.

b. How much interest would Happy Valley Corporation pay on August 1, 2014 under each of the three issue prices listed in a.?

Exercise 7

On January 1, 2014, Edwards Corporation issued $300,000, 5%, 10-year bonds dated January 1, 2014, to yield 4%. The bonds pay semi-annual interest on January 1 and July 1.

Instructions

Calculate the selling price of the bond and prepare the journal entry to record the issue of the bond.

Exercise 8

On January 1, 2013, Andrews Corporation issued $900,000, 8%, 5-year bonds dated January 1, 2013, to yield 9%. The bonds pay semi-annual interest on January 1 and July 1. The company has a December 31 year end.

Instructions

a. Calculate the selling price of the bond (round final answer to the nearest $1,000).

b. Prepare all the journal entries that Andrews Corporation would make related to this bond issue from issue date through to January 1, 2014.

Exercise 9

On January 1, 2013, Callahan Corporation issued $600,000, 9%, 5-year bonds, dated January 1, 2013, at 104. The bonds pay interest semi-annually on January 1 and July 1. The company has a December 31 year end. Assume amortization of $1,700 and $2,100 respectively for the first two semi-annual interest periods.

Instructions

Prepare the journal entries that Callahan Corporation would make related to the bond issue on the dates indicated below:

January 1, 2013 July 1, 2013 December 31, 2013 January 1, 2014

Exercise 10

On January 1, 2014, LeDrew Corporation issued $900,000, 8%, 10-year bonds at face value. Interest is payable semi-annually on July 1 and January 1. LeDrew Corporation has a calendar year end.

Instructions

Prepare all entries related to the bond issue for 2014.

Exercise 11

Stead, Inc. issued $600,000, 6%, 20-year bonds on January 1, 2014, at 102. Interest is payable semi-annually on July 1 and January 1. Stead has a December 31 year end. Assume amortization of $250 and $260 respectively for the first two semi-annual interest periods.

Instructions

Prepare all journal entries made in 2014 related to the bond issue.

Exercise 12

Kirby Limited issued $200,000, 6%, 10-year bonds on December 31, 2013, for $190,000. Interest is payable semi-annually on June 30 and December 31. Kirby has a December 31 year end. Amortization for the first semi-annual interest period is $360.

Instructions

Prepare the appropriate journal entries on

a. December 31, 2013.

b. June 30, 2014.

Exercise 13

Presented below are two independent situations:

a. Hillman Corporation redeemed $150,000 of its bonds on June 30, 2014, at 102. The amortized cost of the bonds on the retirement date was $137,700. The bonds pay semi-annual interest and the interest payment due on June 30, 2014, has been made and recorded.

b. Dalton Inc. redeemed $200,000 of its bonds at 96 on June 30, 2014. The amortized cost of the bonds on the retirement date was $196,500. The bonds pay semi-annual interest and the interest payment due on June 30, 2014, has been made and recorded.

Instructions

For each of the independent situations, prepare the journal entries to record the retirement or conversion of the bonds.

Exercise 14

Presented below are two independent situations:

a. On December 31, 2014, Legault Corporation had $1,000,000, 8% bonds payable issued. The bonds pay interest on January 1 and June 1 of each year, and mature on January 1, 2018. On January 2, 2015, Legault redeemed 60% of these bonds at 101 The amortized cost of the entire bond issue on the retirement date was $1,026,000. The interest payment due on January 1, 2015, has been made and recorded.

b. Antonio Inc. redeemed $500,000 of its bonds at 98 on December 31, 2014. The amortized cost of the bonds on the retirement date was $497,500. The bonds pay semi-annual interest and the interest payment due on December 31, 2014, has been made and recorded.

Instructions

For each of the independent situations, prepare the journal entries to record the retirement of the bonds.

Exercise 15

On January 1, 2014, Sark Wholesale Ltd. issued $500,000 of 10-year, 6% bonds payable at 99. Interest is payable semi-annually on June 30 and December 31. Semi-annual amortization for this bond is $250.

Instructions

a. Record all entries required for this bond during 2014.

b. Show how the bonds would be reported on Sark’s December 31, 2014 balance sheet.

Exercise 16

On January 1, 2014, Kramer International Inc. issued $200,000, 9%, 5-year bonds for $192,278. The bonds were sold to yield an effective interest rate of 10%. Interest is paid semi-annually on June 30 and December 31. The company uses the effective-interest method of amortization.

Instructions

a. Prepare a bond discount amortization schedule which shows the amortization of discount for the first two interest payment dates. (Round to the nearest dollar.)

b. Prepare the journal entries that Kramer International would make on January 1, June 30, and December 31, 2014, related to the bond issue.

Exercise 17

On June 30, 2013, Layton, Inc. sold $1,200,000 (face value) of bonds. The bonds are dated June 30, 2013, pay interest semi-annually on December 31 and June 30, and will mature on June 30, 2016. The following schedule was prepared by the accountant for 2013:

Semi-annual Interest to Interest Unamortized Bond

Interest Period be Paid Expense Amortization Amount Amortized cost

$62,906 $1,137,094

Dec 31, 2013 $36,000 $45,484 $9,484 53,422 1,146,578

Instructions

On the basis of the above information, answer the following questions. (Round your answer to the nearest dollar or percent.)

a. What is the contractual rate of interest for this bond issue?

b. What is the market rate of interest for this bond issue?

c. What was the selling price of the bonds as a percentage of the face value?

d. Prepare the journal entry to record the sale of the bond issue on June 30, 2013.

e. Prepare the journal entry to record the payment of interest and amortization on December 31, 2013.

Exercise 18

Butler Holdings Inc. issued $400,000 of 20-year, 5% bonds payable on July 1, 2014 providing an effective interest rate of 4.75%, for proceeds of $412,820. Interest is payable semi-annually on December 31 and June 30. Butler’s year end is June 30 and the effective-interest method is used in accounting for bonds payable.

Instructions

a. Record the issuing of the bonds on July 1, 2014.

b. Prepare an amortization table for the first year (two payments).

c. Record the payments on December 31, 2014 and June 30, 2015.

d. Show how the bond payable would be presented on Butler’s June 30, 2015 balance sheet.

Exercise 19

Prairie Corporation issued $100,000 of 10 year, 6% bonds payable on January 1, 2014 for $92,900, at a time when market interest rates were 7%. Interest is payable semi-annually on June 30 and December 31. On January 1, 2015, 20% of the bonds were redeemed at 101. Prairie has a December 31 year end and uses the effective-interest method in accounting for bonds payable.

Instructions

a. Record the issue of the bonds on January 1, 2014.

b. Record the payment of interest on June 30 and December 31, 2014.

c. Show how the bonds would be reported on Prairie’s December 31, 2014 balance sheet.

d. Record the redemption of the bonds on January 1, 2015.

Exercise 20

Asgar Corporation issues a $350,000, 4%, 20-year mortgage note payable on December 31, 2014, to obtain needed financing for the construction of a building addition. The terms provide for semi-annual blended payments of $12,795 on June 30 and December 31.

Instructions

a. Prepare the journal entries to record the mortgage loan on December 31, 2014, and the first instalment payment.

b. Will the amount of principal reduction in the second instalment payment be more or less than with the first instalment payment?

Exercise 21

Hanna Manufacturing Limited receives $240,000 on January 1, 2013 when it issues a 6%, 3-year note payable to finance the purchase of equipment. The terms provide for annual payments each December 31. The first payment is due December 31, 2013.

Instructions

Prepare the journal entries to record the note and the first two instalment payments assuming:

a. the payment is a fixed principal payment of $80,000.

b. the payment is a blended payment of $89,786.76.

Exercise 22

Roblin Manufacturing Inc. intends to finance the acquisition of new manufacturing equipment that costs $150,000 by issuing a 5-year, 3.5% note payable. The note would be issued on January 1, 2014. Roblin’s year end is December and would require annual payments on December 31. The finance company has given Roblin the choice of making blended payments of $33,222, or making fixed payments of $30,000 plus interest.

Instructions

a. Assuming the blended payment option is selected; prepare the amortization table for the first two years of the note payable. Record the issue of the note and the December 31, 2014 payment under this alternative.

b. Assuming the fixed principal payment option is selected; prepare the amortization table for the first two years of the note payable. Record the December 31, 2014 payment under this alternative.

Exercise 23

On July 1, 2014, Jasper Distributors Inc. finances the purchase of a new pickup truck by making a cash down payment of $5,000 and issuing a $30,000 two year, 10% note payable for the balance. The note is payable in four equal semi-annual blended payments of $8,460 due on December 31, and June 30 of each year.

Instructions

a. Record the purchase of the truck.

b. Prepare the amortization table for the note payable.

c. Record the first and last payments made on the note.

Exercise 24

The adjusted trial balance for Raines Corporation at the end of the 2014 fiscal year contained the following accounts:

Bonds payable, 5% $460,000

Bond interest payable 20,000

Mortgage notes payable, 6%, due 2030 80,000

Accounts payable 120,000

Other information: The mortgage note is payable in monthly payments of $700 principal plus interest.

Instructions

a. Prepare the non-current liabilities section of the balance sheet.

b. Indicate the proper balance sheet classification for the accounts listed above that do not belong in the non-current liabilities section.

Exercise 25

Excerpts from Chung Corporation’s Income Statement and Balance Sheet for 2014 are presented below:

2014 Income Statement Detail 2014 Balance Sheet Detail

Sales $110,000 Cash $ 10,000

Cost of Goods Sold 50,000 Accounts Receivable 100,000

Gross Profit 60,000 Inventories 90,000

Interest Expense 10,000 Accounts Payable 20,000

Profit Before Taxes 50,000 Loan Payable 30,000

Income Tax 15,000 Shareholders’ Equity 150,000

Profit $ 35,000

Instructions

a. Calculate the interest coverage ratio.

b. Calculate the debt to total assets ratio.

c. What do the two ratios tell you?

Exercise 26

Company A has a high debt to total assets ratio and a high interest coverage ratio. Company B has a low debt to total assets ratio and a high interest coverage ratio. Company C has a high debt to total assets ratio and a low interest coverage ratio. Company D has a low debt to total assets ratio and a low interest coverage ratio.

Instructions

Based solely on the information provided above, which company or companies would you consider loaning money to? Explain your reasoning.

Exercise 27

The following is a summarized balance sheet of Falcon Corporation at December 31, 2013. All amounts are in $000’s.

Current assets $ 1,000

Property, plant and equipment 15,000

Total assets 16,000

Current liabilities $ 650

Long term debt 9,500

Total liabilities 10,150

Shareholders' equity

Common shares 4,000

Retained earnings 1,850

Total shareholders' equity 5,850

Total liabilities and equity $ 16,000

Falcon requires additional financing of $5,000,000 to finance an expansion of its business. The two choices are:

Alternative 1: Issue a 20-year, $5,000,000 5% bond payable at face value.

Alternative 2: Issue 250,000 common shares at $20 each.

In Falcon’s industry, a safe debt to total assets ratio is considered to be between 50% and 60%. Falcon’s board of directors is risk adverse. Assume that the financing is made at the beginning of the year.

Instructions

a. Calculate the debt to total assets ratio under the two proposed financing methods.

b. Make a recommendation to Falcon on the better financing alternative and explain your choice.