Chapter 11 Test Questions & Answers Long-Term Liabilities

Chapter 11

Multiple Choice

1. A loss from early extinguishment of debt, if material, should be reported as a component of income
2. After cumulative effect of accounting changes and after discontinued operations of a segment of a business
3. After cumulative effect of accounting changes and before discontinued operations of a segment of a business
4. Income from continuing operations
5. Before cumulative effect of accounting changes and before discontinued operation s of a segment of a business
6. Unamortized bond discount should be reported on the balance sheet of the issuer as
7. A direct deduction from the face amount of the debt
8. A direct deduction from the present value of the debt
9. A deferred charge
10. Part of the issue costs
11. An example of an item that is not a liability is
12. Dividends payable in stock
13. Advances from customers on contracts
14. Accrued estimated warranty costs
15. The portion of long-term debt due within one year
16. If bonds are issued initially at a discount and the straight-line method of amortization is used for the discount, interest expense in the earlier years will be
17. Greater than if the compound interest method were used
18. The same as if the compound interest method were used
19. Less than if the compound interest method were used
20. Less than the amount of the interest payments
21. Cole Manufacturing Corporation issued bonds with a maturity amount of $200,000 and a maturity 10 years from date of issue. If the bonds were issued at a premium, this indicates that
22. The yield (effective or market) rate of interest exceeded the stated (coupon) rate
23. The stated rate of interest exceeded the yield rate
24. The yield and stated rates coincided
25. No necessary relationship exists between the two rates
26. Financial leverage refers to the

a. Amount of working capital

b. Amount of capital provided by owners

c. Use of borrowed money to increase the return to owners

d. Number of times interest is earned

1. Financial leverage is likely to be a good financial strategy for stockholders of companies having
2. Cyclical high and low amounts of reported earnings
3. Steady amounts of reported earnings
4. Volatile fluctuation in reported earnings over short periods of time
5. Steadily declining amounts of reported earnings
6. The covenants and other terms of the agreement between the issuer of bonds and the lender are set forth in the
   1. Registered bond
   2. Bond coupon
   3. Bond indenture
   4. Bond debenture
7. The term used for bonds that are secured only by the general credit of a company is
   1. Indebenture bonds
   2. Callable bonds
   3. Debenture bonds
   4. Mortgage bonds
8. The rate of interest actually earned by bondholders is called the
   1. Effective rate
   2. Stated rate
   3. Coupon rate
   4. Nominal rate
9. Theoretically, a bond payable should be reported at the present value of the interest discounted at
10. Stated interest rate for both principal and interest
11. Effective interest rate for both principal and interest
12. Stated interest rate for principal and effective interest rate for interest
13. Effective interest rate for principal and stated interest rate for interest
14. If a bond was sold at 97, the market rate of interest was:
    1. Equal to the coupon rate
    2. Greater than the stated rate
    3. Equal to the stated rate
    4. Less than the stated rate
15. A threat of expropriation of assets that is reasonably possible, and for which the amount of loss can be reasonably estimated, is an example of a (an)
16. Loss contingency that should be disclosed, but not accrued
17. Loss contingency that should be accrued and disclosed
18. Appropriation of retained earnings against which losses should be charged
19. General business risk which should not be accrued and need not be disclosed
20. When it is necessary to impute an interest rate in connection with a note payable, the rate should be
21. Two-thirds of the prime rate effective at the time the obligation is incurred
22. The same as that used in the GNP Implicit Price Deflator
23. At least equal to the rate at which the debtor can obtain financing of a similar nature from other sources at the date of the transaction
24. As near zero as can be justified
25. Taft Company sells Lee Company a machine, the usual cash price of which is $10,000, in exchange for an $11,800 non-interest-bearing note due three years from date. If Taft initially records the note at $10,000, the overall effect will be
26. A correct sales price and correct interest revenue
27. A correct sales price and understated interest revenue
28. An understated sales price and understated interest revenue
29. An overstated interest price and understated interest revenue
30. In the situation described in problem 15, if Lee records the asset and note at $11,800, the overall effect will be
31. A correct acquisition cost and correct interest expense
32. A correct acquisition cost and understated interest expense
33. An understated acquisition cost and understated interest expense
34. An overstated acquisition cost and understated interest expense
35. When a note payable is exchanged for property, goods, or services, the stated interest rate is presumed to be appropriate unless
    1. No interest rate is stated
    2. The stated interest rate is inappropriate.
    3. The stated face amount of the note is materially different from the current cash sales price for similar items or from current fair value of the note
36. If a debt instrument with no ready market is exchanged for property whose fair value is currently indeterminable.
    1. The board of directors of the entity receiving the property should estimate a value for the property that will serve as a basis for the transaction
    2. The present value of the debt instrument must be approximated using an imputed interest rate
    3. The directors of both entities involved in the transaction should negotiate a value to be assigned to the property
    4. It should not be recorded on the books of either party until the fair value of the property becomes evident
37. When bonds are issued at a discount, interest expense over the term of debt equals the cash interest paid
    1. Minus the discount
    2. Minus the discount minus the par value
    3. Plus the discount
    4. Plus the discount plus the par value
38. How would the amortization of premium on bonds payable affect each of the following?

Carrying value of

Bond Net Income

1. Increase Decrease
2. Increase Increase
3. Decrease Decrease
4. Decrease Increase
5. For a trouble debt restructuring involving only modification of terms, it is appropriate for a debtor to recognize a gain when the carrying amount of the debt
   1. Exceeds the total future cash payments specified by the new terms
   2. Is less than the total future cash payments specified by the new terms
   3. Exceeds the present value specified by the new terms
   4. Is less than the present value specified by the new terms
6. How should the value of warrants attached to a debt security be account for?
7. No value assigned
8. A separate portion of paid-in capital
9. An appropriation of retained earnings
10. A liability
11. For the issuer of a 10-year term bond, the amount of amortization using the interest method would increase each year if the bond was sold at a

Discount Premium

1. No No
2. Yes Yes
3. No Yes
4. Yes No
5. Gain contingencies are usually recognized in the income statement when
   1. Realized
   2. Occurrence is reasonably possible, and the amount can be reasonably estimated
   3. Occurrence is probable and the amount can be reasonably estimated
   4. The amount can be reasonably estimated
6. An estimated loss from a loss contingency should be accrued when
7. It is probable at the date of the financial statements that a loss has been incurred and the amount of the loss can be reasonably estimated
8. The loss has been incurred by the date of the financial statements and the amount of the loss may be material
9. It is probable at the date of the financial statements that a loss has been incurred and the amount of the loss may be material
10. It is probable that a loss will be incurred in a future period and the amount of the loss can be reasonably estimated
11. A two-year note was issued in an arm’s-length transaction at face value solely for cash at the beginning of the year. There were no other rights or privileges exchanged. The interest rate is specified at 10 percent per year. Principal and interest are payable at maturity. The prevailing rate of interest for a loan of this type is 15 percent per year. What annual interest rate should be used to record interest expense for this year and next year?

This year Next Year

1. 10 percent 15 percent
2. 10 percent 10 percent
3. 15 percent 10 percent
4. 15 percent 15 percent

27. The interest rate used to calculate the cash interest payments by the issuer of bonds is

a. The market rate of interest

b. The effective interest rate

c. The stated interest rate

d. Equal to the actual interest expense rate

1. Ace Corporation has a debt to total assets ratio of 65%. This tells the user of Ace’s financial statements
2. Ace is getting a 35% return on its assets
3. There is a risk Ace cannot pay its debts as they come due
4. 65% of the assets are financed by the stockholders
5. Ace should issue more debt to reduce its risk
6. The current accounting treatment for convertible debt is to treat it as straight debt. This treatment can be defended on what basis?
7. Convertible debt is a complex financial instrument.
8. Convertible debt comprises two financial instruments – a debt instrument and the option to convert.
9. The debt instrument and the option to convert are not separable.
10. The option to convert is equity.
11. A zero-coupon bond is different from a typical bond issue because
12. The investor can clip the coupons and get paid for the periodic interest on the bond while a typical bond does not have coupons.
13. It is reported in the balance sheet net of the discount on the bond.
14. The zero-coupon bond’s deep discount is reported as an asset and a typical bond that is issued at a discount is reported net of the discount.
15. It does not pay any periodic interest while the typical bond does.
16. An unearned revenue is an example of a(an)
17. Deferred credit.
18. Accrued liability.
19. Customer billing that takes place before a job is finished.
20. Accounts receivable.

1. A deferred credit meets the definition of a liability because
2. It is a probable future sacrifice of assets as the result of a past transaction or event.
3. It is a present obligation to transfer assets to another entity.
4. It is an accrual representing an obligation to pay money in the future.
5. It is a present obligation to provide services to another entity.
6. ABC Company has a note payable that is due six months after its year end. Under which of the following conditions will ABC be able to classify the note as a long-term debt.
7. ABC cannot classify the note as long term because it is due within the current operating cycle or one year, whichever is longer.
8. ABC can classify the note as long term because it is due next year.
9. ABC can classify the note as long term because management intends to refinance it with long term debt and has an agreement to do so with a qualified creditor.
10. ABC can classify the note as long term because it is a 10 year note and management intends to pay the maturity value at the end of the 10-year period.
11. Current accounting treatment for gain contingencies is different from the accounting treatment for loss contingencies. Which accounting concept is this differential concept consistent with?
12. Conservatism
13. Materiality
14. Full disclosure
15. Revenue recognition
16. In general, derivative instruments are
17. Not reported in a company’s balance sheet because their impact on the company is not yet known.
18. Reported in the balance sheet at fair value and changes in their fair value are reported in earnings.
19. Reported in the balance sheet at historical cost and changes in their fair value are reported in earnings.
20. Reported in the balance sheet at fair value and changes in their fair value are reported in other comprehensive income.
21. A debtor and a creditor have negotiated new terms on a note. How can you determine whether the restructuring is a troubled debt restructure?
    1. If the interest rate as stated in the restructuring agreement has been reduced relative to the original loan agreement
    2. If the present value of the restructured flows using the original interest rate is less than the market value of the original debt at the date of the restructure
    3. If the present value of the restructured flows using the original interest rate is less than the book value of the debt at the date of the restructure
    4. If the interest rate that equates (1) the book value of the debt at the date of the restructure and (2) the present value of restructured cash flows, exceeds the original interest rate
22. In a troubled debt restructuring in which the debt is continued with modified terms and the carrying amount of the debt is less than the total future cash flows,
    1. A gain should be recognized by the debtor
    2. No interest expense or revenue should be recognized in the future
    3. A loss should be recognized by the debtor
    4. A new effective-interest rate must be computed
23. Under a troubled debt restructuring that results in a modification of terms the debtor will report interest expense when
24. The debtor reports a gain on restructuring.
25. The future cash flows under the restructuring agreement are less than the company’s obligation at the date the restructuring takes place.
26. Always because the troubled debtor has a new agreement that obligates the company to make payments in the future.
27. The debtor reports no gain on restructuring.

39. The times interest earned ratio is computed by dividing

a. Income before income taxes and interest expense by interest expense

b. Income before taxes by interest expense

c. Net income by interest expense.

d. Net income and interest expense by interest expense

1. The following data pertain to Mahler Company’s operations for the year ended December 31, 2017:

Operating income $800,000

Interest expense 100,000

Income before income tax 700,000

Income tax expense 210,000

Net income $490,000

The times interest earned ratio is

• 1. 4.9 to 1
  2. 5.6 to 1
  3. 7.0 to 1
  4. 8.0 to 1

1. The long-term debt to assets ratio is computed by dividing
   1. Long-term debt by total assets
   2. Total assets by total liabilities
   3. Total liabilities by total assets
   4. Current liabilities by total assets

Essay

1. List and discuss five factors that may be employed to determine if a particular financial instrument is a debt or equity security.
2. Discuss the definition and the proper accounting for mandatorily redeemable preferred stock.
3. Discuss the four basic reasons why a corporation may wish to issue debt rather than equity securities.

• Bonds may be the only available source of funds. Many small and medium-size companies may appear too risky for investors to make a permanent investment.
• Debt financing has a lower cost. Since bonds have lower investment risk than stock, they traditionally have paid relatively low rates of interest. Investors acquiring equity securities generally expect a greater return to compensate for higher investment risk.
• Debt financing offers a tax advantage. Interest payments to debt holders are deductible for income tax purposes, whereas dividends paid on equity securities are not.
• The voting privilege is not shared. Stockholders wishing to maintain their present percentage of ownership in a corporation must purchase the current ownership proportion of each new common stock issue. Debt issues do not carry ownership or voting rights; consequently, they do not dilute voting power. Where the proportion of ownership is small and holdings are widespread, this consideration is probably not very important.

1. Define the following terms:
   1. Mortgage bonds
   2. Debenture bonds
2. Explain how the selling price of a bond is determined.
3. How are bond issue costs recorded and reported on corporate financial statements?
4. What is a zero-coupon bond? Discuss accounting for zero-coupon bonds.
5. Discuss the difference between the straight-line and the effective interest methods of bond premium or discount amortizations.
6. List the three methods of accounting for bonds refunding. Under current GAAP, how are bond refundings recorded?

• Make a direct write-off of the gain or loss in the year of the transaction.
• Amortize the gain or loss over the remaining life of the original issue.
• Amortize the gain or loss over the life of the new issue.

1. Discuss the factors that might motivate corporate management to decide to issue convertible debt.
2. Avoid the downward price pressures on the firm's stock that placing a large new issue of common stock on the market would cause.
3. Avoid dilution of earnings and increased dividend requirements while an expansion program is getting under way.
4. Avoid the direct sale of common stock when the corporation believes that its stock is currently undervalued in the market.
5. Penetrate that segment of the capital market that is unwilling or unable to participate in a direct common stock issue.
6. Minimize the flotation cost (costs associated with selling securities).
7. Discuss accounting for long-term notes payable as originally described in APB Opinion No. 21.
8. Notes exchanged solely for cash are assumed to have a present value equal to the cash exchanged.
9. Notes exchanged for property, goods, and services are presumed to have an appropriate rate of interest.
10. If no interest is stated or the amount of interest is clearly inappropriate on notes exchanged for property, goods, and services, the present value of the note should be determined by (whichever is more clearly determinable):
11. If neither 3a nor 3b is determinable, the present value of the note should be determined by discounting all future payments to the present at an imputed rate of interest. The imputed rate should approximate the rate of similar independent borrowers and lenders in arm's-length transactions. In this case, the imputed rate should approximate the rate that the borrower would have to pay to obtain additional funds. So, it is often referred to as the incremental borrowing rate.
12. What is off-balance sheet financing and why do companies engage in off-balance sheet financing?
    1. Removing debt enhances the quality of the balance sheet and permits credit to be obtained more readily and at less cost.
    2. Loan covenants are less likely to be violated.
    3. The asset side of the balance sheet is understated because fair value is not used for many assets. As a result, not reporting certain debt transactions offsets the nonrecognition of fair values on certain assets.
13. Discuss accounting for contingencies
14. pending lawsuits
15. income tax disputes
16. notes receivable discounted
17. accommodation endorsements
18. Probable. The future event is likely to occur.
19. Reasonably possible. The chance of occurrence is more than remote but less than likely.
20. Remote. The chance of occurrence is slight.
    1. Information available prior to the issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements.
    2. The amount of the loss can be reasonably estimated.
21. What is a derivative? Describe the accounting treatment for fair value and cash flow hedges required by SFAS No. 133.
22. Define the following terms:
    1. Forward
    2. Future
    3. Option
    4. Swap
    5. Hybrid
23. What is a troubled debt restructuring? How is a troubled debt restructuring accomplished?
24. Obtain the financial statements of a company and ask the students to compute the:
    1. Long-term debt to assets ratio
    2. Interest coverage ratio
    3. Debt service coverage ratio
25. How are compound financial instruments accounted for under IAS No. 32?
26. What are the general rules for the initial and subsequent measurement of financial liabilities under IFRS No. 9?
    • • 1. Fair value through profit or loss (FVTPL) and
        2. Amortized cost.

Financial liabilities held for trading, derivatives, and financial liabilities designated are measured at FVTPL, and all other financial liabilities are measured at amortized cost unless the fair value option is applied. IFRS No. 9 provides an option to measure a financial liability at FVTPL if doing so eliminates or significantly reduces a measurement or recognition inconsistency (sometimes referred to as an accounting mismatch) or when doing so results in more relevant information.