CHAPTER 15

Non-current liabilities

Summary of Questions by STUDY Objectives
and Bloom’s Taxonomy

Note: K = Knowledge C = Comprehension AP = Application

SUMMARY OF STUDY OBJECTIVES BY QUESTION TYPE

Note: TF = True-False MC = Multiple Choice Ma = Matching

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.

TRUE-FALSE STATEMENTS

1. Non-current liabilities such as bonds payable and instalment notes payable are financial liabilities because there is a contract between two or more parties to pay cash in the future.

2. Debt that is NOT current is non-current.

3. One of the main decisions of a company considering financing is whether to issue debt or equity.

4. When equity is issued, shareholder control is NOT affected.

5. When equity is issued instead of debt, the company will have an income tax savings.

6. When debt is issued instead of equity, earnings per share may be higher.

7. Return on equity is often higher under debt financing because shareholder’s equity is proportionately lower than profit.

8. Equity financing is riskier than debt financing because interest must be paid regularly and the principal must be paid on maturity.

9. Most companies choose to issue debt because earnings per share and return on equity may be higher.

10. Financial leverage refers to the practice of borrowing at one rate and investing at another.

11. Dividends are tax deductible by the company.

12. Debt financing will mean the company will pay less corporate income tax.

13. A bond issued by a corporation may be issued without the permission of the Board of Directors of the company.

14. Bond issuances are more common in the first quarter of a company’s fiscal year.

15. The face value of a bond is the amount of cash that the borrower receives at the start of the bond.

16. The contractual interest rate and the market interest rate on a bond will always be equal.

17. The contractual interest rate and the market interest rate on the bond will always be equal if the bond’s present value equals the face value of the bond.

18. The maturity date of the bond is the date that the first interest payment is due.

19. The market rate of interest is the rate that investors demand for lending their money.

20. The present value of a bond is the value at which the bond would sell in the marketplace.

21. The current market value of the bond is equal to the future value of all the present cash flows.

22. The present value of bonds always equals the face value of the bonds if the market interest rate equals the contractual interest rate at the time of the issuance of the bonds.

23. Unsecured bonds have specific assets of the issuer pledged as collateral for the bonds.

24. Bonds that mature in instalments are called term bonds.

25. Term bonds are bonds that mature at a single specified future date.

26. If a corporation issued bonds at an amount less than face value, it indicates that the corporation has a weak credit rating.

27. If bonds are issued at a discount, the issuing corporation will repay an amount less than the face amount of the bonds on the maturity date.

28. If $180,000, 9%, bonds are issued on January 1, and pay interest semi-annually, the amount of interest paid on July 1, will be $8,100.

29. If bonds sell at a premium, the interest expense recognized each year will be greater than the contractual rate of interest.

30. When a bond discount is allocated to interest expense over the life of the bond, this process is called amortizing the discount.

31. A gain on redemption is recorded when the cash paid is more than the amortized cost of the bond.

32. When a bond is retired, a gain is recorded when the cash paid is less than the amortized cost.

33. If $100,000 face value bonds with a carrying value of $95,200 are redeemed at 97, a loss on redemption will be recorded.

34. Under the effective interest method, the amount of premium or discount amortized is constant every period.

35. The effective-interest method of amortization results in varying amounts of amortization, and interest expense per period but a constant rate of interest.

36. A fixed interest rate means that the interest rate is constant for the entire length of the note payable.

37. Notes Payable are often traded on stock exchanges.

38. One of the differences between notes payable and bonds payable is that most notes are payable in a series of periodic payments, while bonds are normally repayable in full at maturity.

39. Instalment notes with blended payments are repayable in variable periodic amounts that include the principal and the interest.

40. Debt to Total Assets measures the percentage of total assets that is financed by creditors rather than shareholders.

41. Financing by creditors is less risky than financing provided by shareholders.

42. The debt to total assets is calculated by dividing total assets by total liabilities.

43. The Interest coverage ratio indicates the company’s ability to meet interest payments as they come due.

ANSWERS TO TRUE-FALSE STATEMENTS

MULTIPLE CHOICE QUESTIONS

44. From the standpoint of the issuing company, a disadvantage of using bonds as a means of long-term financing is that

a. bond interest is deductible for tax purposes.

b. interest must be paid on a periodic basis regardless of earnings.

c. income to shareholders may increase as a result of trading on the equity.

d. the bondholders do not have voting rights.

45. Which of the following is the exception to the category non-current liability?

a. Accounts Payable

b. Mortgage Payable

c. Bond Payable

d. Note payable (due in 5 years)

46. Which of the following are NOT affected by issuing equity?

a. Shareholder Control

b. Amount of Corporate Income Tax paid by a company

c. Earnings per Share

d. Return on Equity

47. Which is a major shortcoming of issuing debt instead of equity?

a. Shareholder control is not affected.

b. Income tax payable will be less.

c. Interest must be paid regularly.

d. Dividends are not tax deductible.

48. Shareholders of a company may be reluctant to finance expansion through issuing more equity because

a. leveraging with debt is always a better idea.

b. their earnings per share may decrease.

c. the price of the shares will automatically decrease.

d. dividends must be paid on a periodic basis.

49. Which of the following is a disadvantage of issuing bonds instead of common shares?

a. Shareholder control is not affected.

b. The principal of the debt must be repaid at maturity.

c. Income to common shareholders may increase.

d. Earnings per share will increase.

50. If a corporation issued $4,000,000 in bonds which pay 5% annual interest, what is the annual net cash cost of this borrowing if the income tax rate is 30%?

a. $2,000,000

b. $60,000

c. $200,000

d. $140,000

51. Common examples of non-current liabilities include all of the following EXCEPT

a. bonds payable.

b. instalment notes payable.

c. finance lease.

d. accounts payable.

52. Earnings per share is usually higher under debt financing because

a. more common shares are issued.

b. interest expense reduces profit.

c. no additional common shares are issued.

d. interest expense increases profit.

53. Even if it is riskier to issue debt, most companies still choose to do this because

a. money that is borrowed increases earnings per share.

b. it produces a higher return on equity.

c. it does not affect shareholder control.

d. all of the above are correct.

54. Which of the following statements are correct in regards to financial leverage?

a. Financial leverage is said to be ‘negative’ if the rate of return is higher than the borrowing rate.

b. Financial leverage is said to be ‘positive’ if the rate of return is lower than the rate of borrowing.

c. Financial leverage is borrowing at one rate and investing at a different rate.

d. Financial leverage can decrease the return on equity.

55. Junk bonds are bonds that

a. are of good quality and have a low credit risk.

b. are registered in the name of the owner.

c. are considered speculative and have a high risk of default.

d. are unsecured.

56. Bonds that can be retired by the issuer at a stated dollar amount before they mature are known as

a. term bonds.

b. redeemable bonds.

c. debentures.

d. AAA bonds.

57. Bonds that are issued against the general credit of the issuer are termed

a. market value bonds.

b. redeemable bonds.

c. debentures.

d. junk bonds.

58. Bonds that mature at a single specified future date are called

a. contractual bonds.

b. term bonds.

c. junk bonds.

d. debentures.

59. Within a corporation, formal approval is required before bonds can be issued by the

a. chief executive officer.

b. board of directors.

c. controller.

d. provincial government.

60. The contractual rate of interest is always stated as a(n)

a. monthly rate.

b. daily rate.

c. semi-annual rate.

d. annual rate.

61. When authorizing bonds to be issued, the board of directors does NOT specify the

a. total number of bonds authorized to be sold.

b. contractual interest rate.

c. selling price.

d. total face value of the bonds.

Use the following exhibit for questions 62–63.

Bonds Coupon Maturity Date Bid $ Yield %

Bombardier 7.350 Dec. 22/26 103.12 6.35

62. The contractual interest rate of the Bombardier bonds is

a. less than the market rate of interest.

b. greater than the market rate of interest.

c. equal to the market rate of interest.

d. not determinable.

63. On the day of trading referred to above,

a. the bond will mature on Dec. 22 or Dec. 26.

b. bonds with market prices of $7.35 were traded.

c. the bond is selling for 103.12% of face value.

d. the bond sold for $6.35.

64. The present value of a bond is also known as its

a. face value.

b. market price.

c. future value.

d. deferred value.

65. A $1,000 face value bond with a quoted price of 97 is selling for

a. $1,000.

b. $970.

c. $907.

d. $97.

66. If the market rate of interest is greater than the contractual rate of interest, bonds will sell

a. at a premium.

b. at face value.

c. at a discount.

d. only after the stated rate of interest is increased.

67. The interest expense recorded on an interest payment date is increased

a. by the amortization of premium on bonds payable.

b. by the amortization of discount on bonds payable.

c. only if the bonds were sold at face value.

d. only if the market rate of interest is less than the stated rate of interest on that date.

68. If the market rate of interest is 5%, a $10,000, 6%, 10-year bond that pays interest semi-annually would sell at an amount

a. less than face value.

b. equal to the face value.

c. greater than face value.

d. that cannot be determined.

69. The present value of a $10,000, 5-year bond, will be less than $10,000 if the

a. contractual rate of interest is less than the market rate of interest.

b. contractual rate of interest is greater than the market rate of interest.

c. bond is redeemable.

d. contractual rate of interest is equal to the market rate of interest.

70. $5 million, 5%, 10-year bonds are issued at face value. Interest will be paid semi-annually. When calculating the market price of the bond, the present value of

a. $500,000 received for 10 periods must be calculated.

b. $5 million received in 10 periods must be calculated.

c. $5 million received in 20 periods must be calculated.

d. $250,000 received for 10 periods must be calculated.

71. Torrez Corporation issues 1,000, 10-year, 8%, $1,000 bonds dated January 1, 2013, at 97. The journal entry to record the issue will show a

a. debit to Cash for $1,000,000.

b. credit to Discount on Bonds Payable for $30,000.

c. credit to Bonds Payable for $1,000,000.

d. debit to Cash for $970,000.

72. The market rate of interest is often called the

a. stated rate.

b. effective rate.

c. coupon rate.

d. contractual rate.

73. If bonds are issued at a discount, it means that the

a. financial strength of the issuer is suspect.

b. market interest rate is higher than the contractual interest rate.

c. market interest rate is lower than the contractual interest rate.

d. bondholder will receive effectively less interest than the contractual rate of interest.

74. The carrying value (amortized cost) of bonds will equal the market price

a. at the close of every trading day.

b. at the end of the fiscal period.

c. on the date of issue.

d. every six months on the date interest is paid.

75. The sale of bonds above face value

a. is a rare occurrence.

b. will cause the total cost of borrowing to be less than the bond interest paid.

c. will cause the total cost of borrowing to be more than the bond interest paid.

d. will have no net effect on Interest Expense by the time the bonds mature.

76. If bonds have been issued at a discount, over the life of the bonds, the

a. amortized cost of the bonds will decrease.

b. amortized cost of the bonds will increase.

c. interest expense will decrease, if the discount is being amortized on a effective interest basis.

d. unamortized discount will increase.

77. When recording a retirement of bonds, a company must account for all of the following EXCEPT

a. the payment of cash to the bondholders.

b. the removal of the bond from the company’s accounting records.

c. the recognition of any gain or loss on redemption.

d. the receipt of cash from the bondholders.

78. If there is a loss on bonds redeemed before maturity, it is

a. debited directly to Retained Earnings.

b. reported as "Other Expenses" on the income statement.

c. reported as a reduction in interest revenue on the income statement.

d. debited to Interest Expense, as a cost of financing.

79. A company should retire bonds early only if

a. interest rates have risen significantly.

b. it has sufficient cash.

c. shareholders agree to the retirement.

d. the bonds were initially sold at a discount.

80. If bonds with a face value of $20,000 are redeemed before maturity when the amortized cost of the bonds is $18,000, the entry to record the redemption will include a debit to

a. Bonds Payable for $20,000.

b. Bonds Payable for $18,000.

c. Interest Payable for $2,000.

d. Bonds Payable equal to the market price of the bonds on the date of conversion.

81. The amortized cost of a bond sold at a discount equals

a. the face value of the bond less the loss on redemption.

b. the face value of the bond.

c. the face value of the bond less the unamortized discount.

d. the market value of the bond.

82. A $300,000 bond was retired at 98 when the amortized cost of the bond was $296,000. The entry to record the retirement would include a

a. gain on bond redemption of $4,000.

b. loss on bond redemption of $2,000.

c. loss on bond redemption of $4,000.

d. gain on bond redemption of $2,000.

83. Ten $1,000 bonds with an amortized cost of $12,800 are retired at 105 after paying semi-annual interest. The entry to record the redemption is

a. Bonds Payable 12,800

Gain on Bond Redemption 2,300

Cash 10,500

b. Bonds Payable 10,500

Gain on Bond Redemption 500

Cash 10,000

c. Bonds Payable 10,000

Loss on Bond Redemption 500

Cash 10,500

d. Bonds Payable 12,800

Cash 12,800

84. On January 1, 2013, $1,000,000, 5-year, 5% bonds, were issued for $957,349. The interest rate in effect when the bonds were issued was 6%. Interest is paid semi-annually on January 1 and July 1. What would be the amount of discount amortized on July 1, 2013?

a. $2,000

b. $3,720

c. $9,400

d. $2,350

85. On January 1, 2013, $1,000,000, 5-year, 5% bonds, were issued for $957,349. The interest rate in effect when the bonds were issued was 6%. Interest is paid semi-annually on January 1 and July 1. What would be the amount of discount amortized on January 1, 2014?

a. $2,000

b. $4,700

c. $3,832

d. $7,710

86. On January 1, 2013, $1,000,000, 5-year, 5% bonds, were issued for $957,349. The interest rate in effect when the bonds were issued was 6%. Interest is paid semi-annually on January 1 and July 1. What would be the amortized cost of the bonds on January 1, 2014?

a. $1,000,000

b. $957,345

c. $961,069

d. $961,845

87. On January 1, 2013, $1,000,000, 5-year, 5% bonds, were issued for $957,349. The interest rate in effect when the bonds were issued was 6%. Interest is paid semi-annually on January 1 and July 1. How much interest is paid at each interest payment date?

a. $25,000

b. $50,000

c. $30,000

d. $60,000

88. A corporation issued $200,000, 10%, 5-year bonds on January 1, 2013 for $216,222 which reflects an effective interest rate of 8%. Interest is paid semi-annually on January 1 and July 1. The amount of bond interest expense to be recognized on July 1, 2013, is

a. $10,000.

b. $8,000.

c. $10,811.

d. $8,649.

89. When bonds are issued at a discount, the

a. applicable interest rate used to calculate interest expense is the prevailing market interest rate on the date of each interest payment date.

b. amortized cost of the bonds will decrease each period.

c. interest expense will not be a constant dollar amount over the life of the bond.

d. interest paid to bondholders will be a function of the effective interest rate on the date the bonds are issued.

90. When bonds are issued at a premium, the

a. amount of premium amortized will get larger with successive amortization.

b. amortized cost of the bonds will increase with successive amortization.

c. interest paid to bondholders will increase after each interest payment date.

d. interest rate used to calculate interest expense will be the contractual rate.

91. When the discount on bonds is amortized, the annual interest expense will

a. remain the same over all interest periods.

b. increase each interest period.

c. decrease each interest period.

d. fluctuate depending on the market rate of interest.

92. Bonds are usually sold in small denominations; as a result,

a. bonds will not attract investors.

b. bonds must be sold in one transaction.

c. bonds attract many investors.

d. only one investor may purchase all the bonds.

93. The highest quality bonds are graded as

a. superior quality.

b. AAA bonds.

c. A+ bonds.

d. below BBB.

94. If the contractual interest rate on a bond is 9% and interest is paid semi-annually, the interest paid semi annually is

a. 9%.

b. 18%.

c. 4.5%.

d. 0%.

95. The market value depends on three factors. Which of the following is NOT a factor affecting the market value of bonds?

a. credit rating of the bond issuers

b. dollar value to be received in the future

c. length of time until amounts are received

d. market interest rates

96. The sale of bonds at a premium indicates

a. investors want to purchase the bonds because of the issuing company’s financial strength.

b. the contractual rate of interest is less than the market rate of interest.

c. the bond issuer requires more cash.

d. the contractual rate is higher than the stated market interest rate.

97. There are three steps required to calculate amortization using the effective interest method. Which one of the following is NOT a required step?

a. Calculate interest expense on the carrying amount of the bonds.

b. Calculate interest expense on the fair value of the bonds.

c. Calculate bond interest paid.

d. Calculate the amortization amount.

98. Bonds reported at amortized cost are reported at

a. the face value of the bond plus the unamortized premium or minus the unamortized discount.

b. the face value of the bond minus the unamortized premium or plus the unamortized premium.

c. the face value.

d. the price at which they were issued.

99. The effective interest method is required for

a. companies reporting under IFRS.

b. companies reporting under ASPE.

c. both IFRS and ASPE.

d. private companies.

100. If bonds are redeemable, the company will pay the bondholders an amount that was specified at the date of issue which is known as

a. the maturity value.

b. the contractual rate.

c. the redemption price.

d. the issue price.

101. Which is one of the main differences between a note payable and a bond payable?

a. a fixed maturity date

b. interest payments

c. security

d. not usually traded on a public stock exchange

102. Which of the following statements pertaining to fixed-rate non-current Instalment Notes Payable is correct?

a. Blended payments result in the same amount of principal being paid at every payment date.

b. When blended payments are made, a progressively larger portion of the payment goes toward the principal while a progressively smaller portion of the payment goes toward the interest.

c. When blended payments are made, a progressively smaller portion of the payment goes toward the principal while a progressively larger portion of the payment goes toward the interest.

d. Blended payments do not apply to non-current Instalment Notes Payable.

103. A mortgage note payable with a fixed interest rate requires the borrower to make blended principal and interest payments over the term of the loan. Each instalment payment includes interest on the unpaid balance of the loan and a payment on the principal. With each instalment payment, indicate the effect on the portion allocated to interest expense and the portion allocated to principal.

Portion Allocated to Interest Expense Portion Allocated to Principal

a. Increases Increases

b. Increases Decreases

c. Decreases Decreases

d. Decreases Increases

104. The entry to record an instalment payment on a non-current note payable is

a. Mortgage Notes Payable

Cash

b. Interest Expense

Cash

c. Mortgage Notes Payable

Interest Expense

Cash

d. Bonds Payable

Cash

Use the following information for questions 105–106.

On January 1, 2012, Coté Limited issues a $27,232, 5% 3-year note payable. The note calls for three annual payments of $10,000, blended principal and interest. The first payment is to be made on December 31, 2012.

105. On December 31, 2013, Coté will report interest expense of

a. $1,000.

b. $1,350.

c. $917.50.

d. $10,000.

106. The total amount of interest that will be paid over the term of the loan is

a. $2,767.

b. $929.69.

c. $10,000.

d. $2,291.29.

107. Prime is the interest rate that

a. a bank charges their least creditworthy customers.

b. a bank charges their most creditworthy customers.

c. a constant for the entire time of the note.

d. is applied only to non-current instalment notes payable and no other forms of debt.

108. With both types of instalment notes payable, the reduction in principal for the next year must be reported as

a. a non- current liability.

b. a non-current asset.

c. a current liability.

d. a current asset.

109. The ratio that measures the percentage of total assets provided by creditors is the

a. interest coverage ratio.

b. debt to total assets ratio.

c. return on assets ratio.

d. receivables turnover ratio.

110. The interest coverage ratio measures the ability of the company to

a. meet interest payments as they are due.

b. turn over inventory.

c. collect overdue accounts.

d. earn a profit.

111. An increase in the interest coverage ratio indicates primarily that the corporation’s

a. solvency has improved.

b. solvency has deteriorated.

c. liquidity has deteriorated.

d. liquidity has improved.

ANSWERS TO MULTIPLE CHOICE QUESTIONS

MATCHING QUESTION

112. Match the items below by entering the appropriate code letter in the space provided.

A. Term bonds G. Blended Payments

B. Debenture bonds H. Bonds

C. Financial Leverage I. Contractual rate

D. Premium on bonds payable J. Finance lease

E. Discount on bonds payable

F. Effective-interest method of amortization K. Redeemable bonds

L. Interest Coverage

____ 1. Borrowing at one rate and investing at a different rate.

____ 2. Bonds that mature at a single specified future date

____ 3. Bonds that can be retired by the company before they mature

____ 4. A debt security that is traded on organized exchanges

____ 5. Occurs when the contractual rate of interest is greater than the market rate of interest.

____ 6. Unsecured bonds issued against the general credit of the borrower

____ 7. Used to determine the amount of interest the borrower pays and the investor receives.

____ 8 Occurs when the contractual rate of interest is less than the market rate of interest.

____ 9. Fixed debt payments resulting in an increasingly larger portion of each payment being credited toward principal and a smaller portion toward interest over time.

____ 10. A contractual arrangement that transfers the risks and rewards of ownership to the lessee.

____ 11. Produces a periodic interest expense equal to a constant percentage of the amortized cost of the bonds.

_____ 12. Indicates the company’s ability to meet interest payments as they come due.

ANSWERS TO MATCHING QUESTION

1. C

2. A

3. L

4. H

5. D

6. B

7. I

8. E

9. G

10. J

11. F

12. L

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