CHAPTER 10 Long-Term Liabilities

OVERVIEW OF EXERCISES PRO!LE"S A#$ CASES

Learning O&t'omes E(er'ises Estimate% Time in "in&tes Le)el

1* Identify the components of the long-term liability category of the balance sheet. +* Define the important characteristics of bonds payable. ,* Determine the issue price of a bond using compound interest techniques. -* !ho" that you understand the effect on the balance sheet of the issuance of bonds. 1 2 3 # 15$ 1%$ 1&$ 15$ 1%$ 1&$ 5 % & * + 10 11 12 13 1# 10 15 25 10 15 20 20 15 20 20 10 10 10 10 20 5 20 10 5 10 Easy Easy od od od od od od od od od od od od od Easy od od Easy Easy

.* 'ind the amorti(ation of premium or discount using the effecti)e interest method. /* 'ind the gain or loss on retirement of bonds. 0* Determine "hether or not a lease agreement must be reported as a liability on the balance sheet. 1* E,plain the effects that transactions in)ol)ing long-term liabilities ha)e on the statement of cash flo"s. 2* E,plain deferred ta,es and calculate the deferred ta, liability -.ppendi,/. $E,ercise0 problem0 or case co)ers t"o or more learning outcomes 1e)el 2 Difficulty le)els3 Easy4 oderate - od/4 Difficult -Diff/

10-1

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Learning O&t'omes

Problems an% Alternates

Estimate% Time in "in&tes

Le)el

1* Identify the components of the long-term liability category of the balance sheet. +* Define the important characteristics of bonds payable. ,* Determine the issue price of a bond using compound interest techniques. -* !ho" that you understand the effect on the balance sheet of the issuance of bonds. .* 'ind the amorti(ation of premium or discount using the effecti)e interest method. /* 'ind the gain or loss on retirement of bonds. 0* Determine "hether or not a lease agreement must be reported as a liability on the balance sheet. 1* E,plain the effects that transactions in)ol)ing long-term liabilities ha)e on the statement of cash flo"s. 2* E,plain deferred ta,es and calculate the deferred ta, liability -.ppendi,/.

+$

20

od

1 *$ 2 3 *$ # *; 5

15 20 25 25 20 15 20 35

od od od od od od od Diff

% & +$

15 30 20

od Diff od

$E,ercise0 problem0 or case co)ers t"o or more learning outcomes ;.lternate problem only 1e)el 2 Difficulty le)els3 Easy4 oderate - od/4 Difficult -Diff/

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10-,

Learning O&t'omes

Cases

Estimate% Time in "in&tes

Le)el

1* Identify the components of the long-term liability category of the balance sheet. +* Define the important characteristics of bonds payable. ,* Determine the issue price of a bond using compound interest techniques. -* !ho" that you understand the effect on the balance sheet of the issuance of bonds. .* 'ind the amorti(ation of premium or discount using the effecti)e interest method. /* 'ind the gain or loss on retirement of bonds. 0* Determine "hether or not a lease agreement must be reported as a liability on the balance sheet. 1* E,plain the effects that transactions in)ol)ing long-term liabilities ha)e on the statement of cash flo"s. 2* E,plain deferred ta,es and calculate the deferred ta, liability -.ppendi,/. $E,ercise0 problem0 or case co)ers t"o or more learning outcomes 1e)el 2 Difficulty le)els3 Easy4 oderate - od/4 Difficult -Diff/

1$ #

#0 25

od od

5 1$ % 2 3$ 3$

15 25 30 #0 25 25

od od od od od od

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34ESTIO#S 1* 9he issue price of a bond should al"ays be calculated using the marAet rate of interest. 9he face rate determines the dollar amount of interest0 but the marAet rate is used to calculate the present )alue that represents the issue price. +* 9he ta, ad)antage for bonds is the fact that interest paid on bonds is an e,pense that is deductible for ta, purposes0 "hereas di)idends paid on stocA are not deductible. ,* Bhen bonds are issued at a premium0 it is an indication that the face rate is higher than the marAet rate. -* @y basing each periodCs interest e,pense on a decreasing or increasing amount0 the amount of interest e,pense is different each period0 but the rate of interest remains the same. .* .morti(ation affects interest e,pense because premium or discount is amorti(ed to the Interest E,pense account. .morti(ation of premium decreases interest e,pense. .morti(ation of discount increases interest e,pense. /* .morti(ation of premium decreases the bond carrying )alue because it decreases the =remium on @onds =ayable account. !ince Discount on @onds =ayable is a contra liability account0 amorti(ation of discount increases the bond carrying )alue. 0* :ain or loss on bond redemption "ill almost al"ays occur "hen bonds are redeemed or retired before their scheduled due date. 9he gain or loss is computed as the difference bet"een the bond carrying )alue at the redemption date and the reacquisition price. 1* 1eases are not all accounted for in the same manner because of the )ariety of pro)isions that can be found in lease agreements. !ome leases are only short-term rental arrangements to use the asset0 and others are actually purchases of the asset o)er a long time period. It may be possible to de)elop an accounting rule to treat all leases similarly. <o"e)er0 the rule must also be fle,ible enough to co)er the "ide )ariety of financial arrangements that are all called leases. 2* Off-balance-sheet financing refers to transactions "hereby a party obtains the use of an asset but is not required to record the related liability on the balance sheet. 'irms may fa)or off-balance-sheet arrangements because they belie)e there are benefits in not recording an obligation as a liability. @enefits may include the maintenance of borro"ing capacity and fle,ibility in meeting debtDequity or similar requirements in e,isting loan contracts. 10* .n operating lease is not recorded on the balance sheet of the lessee0 and the only e,pense on the income statement is the rental payments. . capital lease is sho"n as an asset and a liability by the lessee. E,pense on the income statement includes interest on the liability and depreciation on the asset.

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10-.

11* Depreciation should be recorded on leased assets treated as capital leases. :enerally0 depreciation should be recorded o)er the time period benefited by the asset0 "hich normally is the term of the lease. 1+* Deferred 9a, is an account that reconciles the differences bet"een the accounting for ta, purposes and the accounting for the financial statement prepared for stocAholders. If the Deferred 9a, account has a credit balance0 it represents a liability. If the account has a debit balance0 it should be presented as an asset on the balance sheet. 1,* . permanent difference affects only booA accounting but not ta, accounting0 or )ice )ersa0 ta, accounting but not booA accounting. 9emporary differences affect both booA and ta, accounting but in different time periods. 1-* 9he amount of ta, e,pense on the income statement does not represent the amount of ta, actually paid to the I>!. 9a, e,pense represents the e,pense computed using the accounting methods adopted for financial statement purposes. It does not reflect the accounting methods actually used for ta, accounting purposes. 1.* .ccounting liabilities are not necessarily legal liabilities. .ccounting taAes a broader )ie" and considers some items as liabilities that are not legally enforceable claims. E,amples include accrued liabilities0 some unearned income amounts0 and deferred ta,.

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EXERCISES 17 2
EXERCISE 10-1 RELATIO#SHIPS

1* +*

Cas5 Interest 6 6

Interest E(7ense I D

Amort* $is'*8Prem* I I

Carr6ing Val&e I D

17 3

EXERCISE 10-+ ISS4E PRICE

1* a* E5000000 b* E5000000 '* E5000000 +* a* E5000000 F *G F 1D2 year 2 E200000 b* E5000000 F *G F 1D2 year 2 E200000 '* E5000000 F *G F 1D2 year 2 E200000 ,* a* E 200000 F 13.5+0 E5000000 F 0.#5% Issue price -9able +-#0 n 2 200 i 2 #G/ 2 -9able +-20 n 2 200 i 2 #G/ 2 E2&10*00 22*0000 E#++0*00$

$!hould equal E50000004 the difference is due to rounding in present )alue factors. b* E 200000 F 1#.*&& E5000000 F 0.55# Issue price '* E 200000 F 12.#%2 E5000000 F 0.3&& Issue price -9able +-#0 n 2 200 i 2 3G/ 2 -9able +-20 n 2 200 i 2 3G/ 2 -9able +-#0 n 2 200 i 2 5G/ 2 -9able +-20 n 2 200 i 2 5G/ 2 E2+&05#0 2&&0000 E5&#05#0 E2#+02#0 1**0500 E#3&0&#0

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10-0

17 3

EXERCISE 10-, ISS4E PRICE

a* E5000000 E #00000$

F F

0.%21 -n 2 50 i 2 10G/ 2 3.&+1 -n 2 50 i 2 10G/ 2

E 3100500 1510%#0 E #%201#0 E 30&0000 15#0##0 E #%10##0 E 3010%00 3+*0&*# E &0003*# E 2310000 +220320 E101530320

$500 bonds F E10000 par F *G 2 E#00000. b* E5000000 E 200000$ F F 0.%1# -n 2 100 i 2 5G/ 2 &.&22 -n 2 100 i 2 5G/ 2

$500 bonds F E10000 par F *G F %D12 2 E200000. '* E*000000 E 320000$ F 0.3&& -n 2 200 i 2 5G/ 2 F 12.#%2 -n 2 200 i 2 5G/ 2

$*00 bonds F E10000 par F *G F %D12 2 E320000. %* E100000000 F 0.231 -n 2 300 i 2 5G/ 2 E %00000$ F 15.3&2 -n 2 300 i 2 5G/ 2 $20000 bonds F E500 par F 12G F %D12 2 E%00000.

17 #

EXERCISE 10-- I"PACT OF TWO !O#$ ALTER#ATIVES

1* If the company issues bonds "ith a face rate of *G "hen the marAet rate is +G0 the bonds "ill be issued at a discount. 9he real interest cost the company incurs is the marAet rate of interest of +G. 9hus0 the company cannot Hsa)e moneyI by issuing bonds at a discount. +* If the company issues bonds "ith a face rate of 10G "hen the marAet rate is +G0 the bonds "ill be issued at a premium. 9he company "ill recei)e an amount in e,cess of the par )alue of the bonds0 but that amount is offset by the fact that the company must then pay interest at 10G. 9he result is that the company incurs a real interest cost of +G0 "hich is the marAet rate of interest. 9hus0 the company does not HbenefitI by issuing bonds at 10G.

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17 %

EXERCISE 10-. RE$E"PTIO# OF !O#$S

1* >edemption price3 E&50000 F 1.03 2 6arrying )alue3 E&50000 J E10&50 2

E&&0250 &30250 E -#0000/ loss

+* 9he gain or loss on bond redemption should be presented on the income statement. In most cases0 the gain or loss on bond redemption should not be considered unusual or infrequent and therefore should not be presented in the section of the statement "here e,traordinary items are presented.

17 %

EXERCISE 10-/ RE$E"PTIO# OF A !O#$ AT "AT4RIT9

!ince the bonds are fully matured0 the carrying )alue equals the face )alue and there "ill be no gain or loss on the redemption of the bonds. 9he effect on the accounting equation of the redemption of the bonds is as follo"s3
!ALA#CE SHEET
Assets 6ash -2500000/ : Liabilities ; @onds =ayable -2500000/
I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses

17 &

EXERCISE 10-0 LEASE$ ASSET

1* =ayment F 9able factor ord. annuity 2 =K min. lease payments E*0000 F %.#1* -9able +-#0 n 2 100 i 2 +G/ 2 E5103## +* E*00000 is not a correct amount to record because it does not recogni(e the time )alue of money. !ince the payments "ill e,tend o)er 10 years0 the lease must be recorded at the present )alue of the payments.

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10-2

17 &

EXERCISE 10-1 FI#A#CIAL STATE"E#T I"PACT OF A LEASE

1* =ayment F 9able factor ord. annuity 2 =K min. lease payment =ayment F #.355 -9able +-#0 n 2 %0 i 2 10G/ 2 E1300%5 =ayment 2 E1300%5D#.355 2 E30000 per year +* E+050*.%5 $ate 1D01D0& 12D31D0& 12D31D0* Lease Pa6ment E30000 30000 Interest E(7ense E1030%.50 1013&.15 Re%&'tion o@ Obligation E10%+3.50 10*%2.*5 Lease Obligation E1300%5.00 1103&1.50 +050*.%5

17 &

EXERCISE 10-2 LEASE$ ASSETS

1* a* 9he )alue of the forAlift "ill not appear on the balance sheet. b* 9he lease payments "ill appear on the income statement as 1ease E,pense. +* a* 9he effect on the accounting equation "hen the lease is signed is as follo"s3

!ALA#CE SHEET
Assets 1eased .sset 50001$ : Liabilities 1ease 1iability ; 50001

I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses

$E10510 F 3.312 -9able +-#0 n 2 #0 i 2 *G/ 2 E50001 9he leased asset should be reported at the present )alue of the payments "hich is E500010 not at E%00#0. b* 9he effect on the accounting equation of the first lease payment0 on December 310 200&0 is as follo"s3

!ALA#CE SHEET
Assets 6ash -10510/ : Liabilities ; -10110/ 1ease 1iability

I#CO"E

STATE"E#T
-#00/$

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Interest E,pense

$E50001 F *G 2 E#00 '* Depreciation e,pense 2 E50001D# years 2 E10250.

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EXERCISE 10-2 ACon'l&%e%B

%* 6urrent liabilities3 1ease liability -current portion/ $-E50001 J E10110/ F *G 2 E311. E10510 J E311 2 E101++. 1ong-term liabilities3 1ease liability $$E50001 J E10110 J E101++ 2 E20%+2

E101++$

E20%+2$$

17 *

EXERCISE 10-10 I"PACT OF TRA#SACTIO#S I#VOLVI#C !O#$S O# STATE"E#T OF CASH FLOWS

'L=roceeds from issuance of bonds payable 7LInterest e,pense 'L>edemption of bonds payable at maturity

17 *

EXERCISE 10-11 I"PACT OF TRA#SACTIO#S I#VOLVI#C CAPITAL LEASES O# STATE"E#T OF CASH FLOWS

1* :arnett obtained the equipment by signing a lease4 no cash changed hands. .s a result0 this transaction "ould be reported as a noncash in)esting and financing transaction on the statement of cash flo"s. +* 'L>eduction of lease obligation -principal portion of lease payment/ 7LInterest e,pense 7LDepreciation e,penseLleased assets

17 *

EXERCISE 10-1+ I"PACT OF TRA#SACTIO#S I#VOLVI#C TAX LIA!ILITIES O# STATE"E#T OF CASH FLOWS

7 -deduct from net income/LDecrease in ta,es payable 7 -add to net income/LIncrease in deferred ta,es

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17 +

EXERCISE 10-1, TE"PORAR9 A#$ PER"A#E#T $IFFERE#CES AA77en%i(B

1* =ermanent +* =ermanent ,* 9emporary 17 +

-* 9emporary .* 9emporary /* =ermanent

EXERCISE 10-1- $EFERRE$ TAX AA77en%i(B

!alan'e o@ %e@erre% ta( a''o&ntD +000 9a, depreciation @ooA depreciation Difference F 9a, rate Entry to deferred ta, @alance of account +001 9a, depreciation @ooA depreciation Difference F 9a, rate Entry to deferred ta, @alance of account +002 9a, depreciation @ooA depreciation Difference F 9a, rate Entry to deferred ta, @alance of account +010 9a, depreciation @ooA depreciation Difference F 9a, rate Entry to deferred ta, @alance of account +011 9a, depreciation @ooA depreciation Difference F 9a, rate Entry to deferred ta, @alance of account

2 2 2

E100%%& %0#00 E #02%& F 0.#0 2 E10&0& credit 2 E10&0& credit

2 2 2

E100%%& %0#00 E #02%& F 0.#0 2 E10&0& credit 2 E30#1# credit

2 2 2

E100%%% %0#00 E #02%% F 0.#0 2 E10&0% credit 2 E50120 credit

2 2 2

0 %0#00 E -%0#00/ F 0.#0 2 E205%0 debit 2 E205%0 credit

2 2 2

0 %0#00 E -%0#00/ F 0.#0 2 E205%0 debit 2 E 0

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"4LTI-CO#CEPT EXERCISES 17 #05

EXERCISE 10-1. ISS4A#CE OF A !O#$ AT FACE VAL4E

1* E3000000$ F 0.%1# E 150000$$ F &.&22 Issuance price

-9able +-20 n 2 100 i 2 5G/ 2 -9able +-#0 n 2 100 i 2 5G/ 2

E1*#0200 1150*30 E3000030$$$

$300 F E10000 2 E3000000. $$E3000000 F 10G F 1D2 year 2 E150000. $$$!hould equal E30000004 difference due to rounding in present )alue factors. +* If the marAet rate of interest had been higher than 10G0 the issue price "ould ha)e been less than the face )alue of the bonds. 9he bonds "ould ha)e been issued at a discount. ,* 9he effect on the accounting equation of the payment of interest on Muly 10 200&0 is as follo"s3
!ALA#CE SHEET
Assets 6ash -150000/ : Liabilities ;

I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Interest E,pense -150000/

-* 9he amount of interest to be accrued on December 310 200&0 is calculated as follo"s3 E3000000 F 10G F 1D2 year 2 E150000.

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17 #05

EXERCISE 10-1/ I"PACT OF A $ISCO4#T

1* 9he effect on the accounting equation of the Manuary 10 200&0 sale of bonds is as follo"s3
!ALA#CE SHEET
Assets 6ash +1052% : Liabilities ; @onds =ayable 1000000 Discount on @onds =ayable -*0#&#/
I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses

@onds payable 1ess3 Discount on bonds payable

E1000000 *0#&# E +1052%

+* 9he effect on the accounting equation of the payment of interest on December 310 200&0 is as follo"s3
!ALA#CE SHEET
Assets 6ash -+0000/$ : Liabilities Discount on @onds =ayable ; 153
I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Interest E,pense -+0153/$$

$E1000000 F +G F 1 year 2 E+0000 $$E+1052% F 10G F 1 year 2 E+0153 @onds payable 1ess3 Discount on bonds payable $E*0#&# J E153 2 E*0321 ,* 9he marAet rate of interest "as greater than the interest rate that @erol 6orporation is paying. 9herefore0 the issuance price0 discounted at 10G0 the marAet rate0 "ill be less than face )alue. E 1000000 *0321$ E +10%&+

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17 #05

EXERCISE 10-10 I"PACT OF A PRE"I4"

1* 9he effect on the accounting equation of the sale of bonds on Manuary 10 200&0 is as follo"s3
!ALA#CE SHEET
Assets 6ash 10+0*%2 : Liabilities ; @onds =ayable 1000000 =remium on @onds =ayable +0*%2
I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses

@onds payable =lus3 =remium on bonds payable

E1000000 +0*%2 E10+0*%2

+* 9he effect on the accounting equation of the payment of interest on December 310 200&0 is as follo"s3
!ALA#CE SHEET
Assets 6ash : Liabilities ; -211/ -+0000/$ =remium on @onds =ayable
I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Interest E,pense -*0&*+/$$

$E1000000 F +G F 1 year 2 E+0000 $$E10+0*%2 F *G F 1 year 2 E*0&*+ @onds payable =lus3 =remium on bonds payable $E+0*%2 J E211 2 E+0%51 ,* 9he marAet rate of *G is lo"er than the interest rate @erol is paying. 9herefore0 in)estors "ill be "illing to pay more on the basis of the future cash flo"s discounted at the marAet rate. E 1000000 +0%51$ E 10+0%51

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10-1.

PRO!LE"S 17 3
PRO!LE" 10-1 FACTORS THAT AFFECT THE !O#$ ISS4E PRICE

1* a* 9he bonds "ould be issued at par0 since the face or coupon rate is equal to the marAet rate of interest. b* 9he bonds "ould be issued at a discount in this situation because in)estors "ould demand a &G return on their in)estment. !ince the cash flo"s are fi,ed0 the in)estment must be decreased to increase the effecti)e interest rate. +* a* E1000000 F 0.55# E 30000$ F 1#.*&& 9otal present )alue 2 -9able +-20 n 2 200 i 2 3G/ 2 -9able +-#0 n 2 200 i 2 3G/ 2 E 550#00 ##0%31 E1000031$$

$E1000000 F %G F %D12 2 E30000 $$!hould be E10000004 difference due to rounding. b* E1000000 F 0.50* E %0000$ F &.02# 9otal present )alue 2 $E1000000 F %G 2 E%0000. -9able +-20 n 2 100 i 2 &G/ 2 -9able +-#0 n 2 100 i 2 &G/ 2 E 500*00 #201## E +20+##

17 5 1*

PRO!LE" 10-+ A"ORTIEATIO# OF $ISCO4#T

$is'o&nt AmortiFation E@@e'ti)e Interest "et5o% o@ AmortiFation Col* 1 Cas5 Interest 10G L E10000 10000 10000 10000 10000 E50000 Col* + Interest E(7ense 1+G L E10113 1012& 101#2 1015+ 101*#$ E50&25 Col* , $is'o&nt AmortiFe% Col* + ? Col* 1 L E113 12& 1#2 15+ 1*# E&25 Col* Carr6ing Val&e E +02&5 +03** +0515 +0%5& +0*1% 100000

$ate 1D01D0& 12D31D0& 12D31D0* 12D31D0+ 12D31D10 12D31D11 9otals

$.mount needed to bring carrying )alue to face )alue.

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PRO!LE" 10-+ ACon'l&%e%B

+* Interest e,pense 2 6ash interest payment 2 Discount amorti(ed 2

E50&25 50000 E &25

,* 9he effect on the accounting equation of the payment of interest and amorti(ation of discount on December 310 200+0 is as follo"s3
!ALA#CE SHEET
Assets 6ash -10000/ : Liabilities Discount on @onds =ayable ; 1#2
I#CO"E

STATE"E#T
-101#2/

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Interest E,pense

@onds payable 1ess3 Discount on bonds payable

E100000 3#3 E +0%5&

17 5 1*

PRO!LE" 10-, A"ORTIEATIO# OF PRE"I4"

Premi&m AmortiFation E@@e'ti)e Interest "et5o% o@ AmortiFation Col* 1 Cas5 Interest 10G L E10000 10000 10000 10000 10000 E50000 Col* + Interest E(7ense 1G L E *%# *53 *#2 *2+ *0+$ E#01+& Col* , Premi&m AmortiFe% Col* + ? Col* 1 L E13% 1#& 15* 1&1 1+1 E*03 Col* Carr6ing Val&e E100*03 100%%& 100520 1003%2 1001+1 100000

$ate 1D01D0& 12D31D0& 12D31D0* 12D31D0+ 12D31D10 12D31D11 9otals

$.mount needed to bring carrying )alue to face )alue. +* Interest e,pense 2 6ash interest payment 2 =remium amorti(ed 2 E#01+& 50000 E *03

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10-10

PRO!LE" 10-, ACon'l&%e%B

,* 9he effect on the accounting equation of the payment of interest and the amorti(ation of premium on December 310 200+0 is as follo"s3
!ALA#CE SHEET
Assets 6ash -10000/ : Liabilities ; -15*/ =remium on @onds =ayable
I#CO"E

STATE"E#T
-*#2/

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Interest E,pense

@onds payable =lus3 =remium on bonds payable

E100000 3%2 E1003%2

17 %

PRO!LE" 10-- RE$E"PTIO# OF !O#$S

1* >edemption price 6arrying )alue :ain on redemption +* >edemption price 6arrying )alue 1oss on redemption

E2000000 F 1.01 2 E2000000 N -E#0500 J E10000/ 2 E2000000 F 1.03 2 E2000000 N E30500 2

E2020000 2030500 E 10500 E20%0000 2030500 E 20500

,* 9he gain or loss on bond redemption should be presented on the income statement. In most cases0 the gain or loss on bond redemption should not be considered unusual or infrequent and therefore should not be presented in the section of the statement "here e,traordinary items are presented. -* @onds are redeemed early only if it is ad)antageous to the issuing firm. <o"e)er0 early redemption is usually not fa)orable to the in)estor because it usually means the in)estor can no longer benefit from a fa)orable interest rate. 9o compensate the in)estor for foregone interest0 as "ell as for the costs and incon)enience in)ol)ed0 the call price is normally set at an amount higher than 100.

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17 & 1*

PRO!LE" 10-. FI#A#CIAL STATE"E#T I"PACT OF A LEASE

Col* 1 Lease Pa6ment $ate 1D01D0& 12D31D0& 12D31D0* 12D31D0+ 12D31D10 12D31D11 L E2*0300 2*0300 2*0300 2*0300 2*0300

Col* + Interest E(7ense 1G L E+00#0 &0#++ 50*35 #003* 200**

Col* , Re%&'tion o@ Obligation Col* 1 ? Col* + L E1+02%0 200*01 220#%5 2#02%2 2%0212$

Col* Lease Obligation E1130000 +30&#0 &20+3+ 500#&# 2%0212 0

$.mount needed to pay off lease obligation. +* 9he effect on the accounting equation of the lease transaction on Manuary 10 200&0 is as follo"s3
!ALA#CE SHEET
Assets 1eased 9rucA : Liabilities ; 1130000 1130000 1ease 1iability
I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses

,* 9he effect on the accounting equation of the annual payment and interest e,pense on December 310 200*0 is as follo"s3
!ALA#CE SHEET
Assets 6ash -2*0300/ : Liabilities 1ease 1iability ; -200*01/
I#CO"E

STATE"E#T
-&0#++/

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Interest E,pense

9he effect on the accounting equation of the depreciation e,pense for the second year of the lease is as follo"s3
!ALA#CE SHEET
Assets : Liabilities ; .ccumulated DepreciationL 1eased 9rucA -220%00/$
I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Depreciation E,penseL 1eased 9rucA -220%00/

$E1130000D5 years 2 E220%00

6<.=9E> 10 ? 175:-9E>

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10-12

PRO!LE" 10-. ACon'l&%e%B

-* 1ong-term assets3 1eased trucA 1ess3 .ccumulated depreciation $E220%00 F 2 years 2 E#50200. 6urrent liabilities3 1ease liability 1ong-term liabilities3 1ease liability

E1130000 #50200$ E %&0*00

E 220#%5 E 500#&#

17 +

PRO!LE" 10-/ $EFERRE$ TAX AA77en%i(B

1* 9he effect on the accounting equation for income ta, e,pense0 deferred ta,0 and income ta, payable for 200& is as follo"s3
!ALA#CE SHEET
Assets : Liabilities Income 9a, =ayable Deferred 9a, ; 120 *0

I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Income 9a, E,pense -200/

+* 9he Deferred 9a, account e,ists to reconcile the difference bet"een the accounting done for ta, purposes and that done for reporting to stocAholders0 also referred to as booA purposes. 9he balance of the Deferred 9a, account represents all temporary differences bet"een booA and ta, accounting reflected at the corporate ta, rate. 9he amount of the temporary differences is entered into the Deferred 9a, account "hen it originates. In theory0 the items "ill be remo)ed from the account "hen they re)erse0 and the balance of the account "ill be reduced at that time. 9he current pro)ision for ta, of E120 represents the amount paid or payable to the go)ernment for 200& ta,es. 9he deferred portion of E*0 represents the increase in the balance of the Deferred 9a, account. 9he deferred amount of E*0 in the note represents the entry to deferred ta, during the current year. 9he amount of E1*0 in the liability category of the balance sheet represents the year-end balance of the account.

10-+0

'I5.56I.1 .667859I5: !7189I75!

.58.1

17 + 1* +00.

PRO!LE" 10-0 $EFERRE$ TAX CALC4LATIO#S AA77en%i(B

Income before ta,es 1ess3 E,cess of ta, depreciation o)er booA depreciation -E500000 J E2%0%%&$/ 9a,able income 9a, paid or payable -35G/ $-E**0000 J E*0000/D3 years 2 E2%0%%&. Income before ta,es =lus3 E,cess of booA depreciation o)er ta, depreciation -E2%0%%& J E200000/ 9a,able income 9a, paid or payable -35G/ Income before ta,es =lus3 E,cess of booA depreciation o)er ta, depreciation -E2%0%%& J E100000/ 9a,able income 9a, paid or payable -35G/ Income before ta,es Income ta, e,pense -35G/ Income before ta,es Income ta, e,pense -35G/ Income before ta,es Income ta, e,pense -35G/ Col* 1 In'ome Ta( E(7ense E&30500 *#0000 +*0000 Col* + In'ome Ta( Pa6able E %50333 *%0333 1030*33 Col* , Col* 1 ? Col* + E *01%& J20333 J50*3#$

E2100000 -230333/ E1*%0%%& E %50333 E2#00000 %0%%& E2#%0%%& E *%0333 E2*00000 1%0%%& E2+%0%%& E1030*33 E2100000 E &30500 E2#00000 E *#0000 E2*00000 E +*0000 Col* $e@erre% Ta( A''o&nt E*01%& credit 50*3# credit 0

+00/

+000

+* +00. +00/ +000

,* 9ear 2005 200% 200&

$Difference due to rounding.

6<.=9E> 10 ? 175:-9E>

1I.@I1I9IE!

10-+1

"4LTI-CO#CEPT PRO!LE"S 17 #05

PRO!LE" 10-1 !O#$ TRA#SACTIO#S

1* 9he effect on the accounting equation of the .pril 10 200&0 issuance of the bonds is as follo"s3

!ALA#CE SHEET
Assets 6ash 100000000 : Liabilities ; @onds =ayable

I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses

100000000

+* 9he effect on the accounting equation of the 7ctober 10 200&0 interest payment is as follo"s3

!ALA#CE SHEET
Assets 6ash -%00000/ : Liabilities ;

I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Interest E,pense -%00000/$

$E100000000 12G %D12 2 E%00000 ,* .dditional interest must be recorded on December 31 to accrue interest for the time period of 7ctober 1JDecember 31. 9he interest should be recorded as an e,pense "hen it is incurred under the accrual accounting process. 9he accrual does not affect the amount of interest paid on .pril 10 200*. . full semiannual payment of E%00000 should occur on that date. -* 9otal cash inflo" to @rand 9otal cash outflo"3 Interest E%00000 F 1% payments =rincipal 9otal outflo" Difference E100000000 E +%00000 100000000 10+%00000 E +%00000

10-++

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.58.1

17 10+

PRO!LE" 10-2 PARTIAL CLASSIFIE$ !ALA#CE SHEET FOR WALCREE#S

1* 9he follo"ing is the liabilities section of the consolidated balance sheet of Balgreens at .ugust 310 200#. -.ll amounts are in millions./ C&rrent Liabilities 9rade accounts payable .ccrued e,penses and other liabilities Income ta,es payable 9otal current liabilities Deferred income ta, 7ther noncurrent liabilities 9otal long-term liabilities E20%#1.5 103&0.5 %5.+ E#00&&.+ E 2&#.1 *50.# E1012#.5

Long-Term Liabilities

+* 6omputation of debt-to-equity ratios3 20033 200#3 E#053+.0DE&011&.* 2 0.%# E50202.#DE*013+.& 2 0.%#

BalgreensC debt-to-equity ratio has stayed the same from 2003 to 200#. 9his means that the company has maintained a stable financing pattern from year to year. ost in)estors "ould prefer a decrease rather than an increase in this ratio o)er time. Debt has fi,ed repayment terms0 and its repayment must include interest. Equity ne)er has to be repaid0 and di)idend payments are optional. .lso0 the debt represents a claim on the companyCs assets. In the e)ent of liquidation0 this claim "ould need to be repaid before any assets are distributed to stocAholders. <o"e)er0 o)erall Balgreens is a )ery safe company "ith a lo" le)el of debt compared to most other companies. ,* BalgreensC lenders "ant to be sure that the company can repay the principal and pay the interest on the loan. 9hey "ould be interested in BalgreensC times interest earned and debt ser)ice co)erage ratios. @oth ratios measure the degree to "hich a company can maAe its debt payments out of current cash flo"s.

6<.=9E> 10 ? 175:-9E>

1I.@I1I9IE!

10-+,

AL TE R # AT E P R O! LE " S 17 3
PRO!LE" 10-1A FACTORS THAT AFFECT THE !O#$ ISS4E PRICE

1* a* 9he bonds "ould be issued at par0 since the face or coupon rate is equal to the marAet rate of interest. b* 9he bonds "ould be issued at a premium in this situation because in)estors "ould bid the price up"ard on a bond "ith a 5G return. !ince the cash flo"s are fi,ed0 the in)estment must be increased to decrease the effecti)e interest rate. +* a* E5000000 E 120500$ 9otal F F 0.%10 15.5++ -n 2 200 i 2 2 1D2G/ 2 -n 2 200 i 2 2 1D2G/ 2 E3050000 1+#0+** E#++0+**$$

$E5000000 F 5G F %D12 2 E120500. $$!hould be E50000004 difference is due to rounding. #oteD 9he tables pro)ided "ith the te,t do not gi)e )alues for 2 1D2G. !tudents must find the )alues by using a calculator or by interpolating the )alues in the e,isting tables. b* E5000000 E 250000$ 9otal F F 0.%&% *.111 -n 2100 i 2 #G/ 2 -n 2100 i 2 #G/ 2 E33*0000 2020&&5 E5#00&&5

$E5000000 F 5G 2 E250000.

10-+-

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.58.1

17 5 1*

PRO!LE" 10-+A A"ORTIEATIO# OF $ISCO4#T

$is'o&nt AmortiFation E@@e'ti)e Interest "et5o% o@ AmortiFation Col* 1 Cas5 Interest .G L E 20500 20500 20500 20500 20500 E120500 Col* + Interest E(7ense 1G L E 30521 30%03 30%+1 30&*% 30***$ E1*0#*+ Col* , $is'o&nt AmortiFe% Col* + ? Col* 1 L E10021 10103 101+1 102*% 103** E50+*+ Col* Carr6ing Val&e E##0011 #50032 #%0135 #&032% #*0%12 500000

$ate 1D01D0& 12D31D0& 12D31D0* 12D31D0+ 12D31D0& 12D31D11 9otals

$.mount needed to bring carrying )alue to face )alue. +* Interest e,pense 2 6ash interest payment 2 Discount amorti(ed 2 E1*0#*+ 120500 E 50+*+

,* 9he effect of on the accounting equation of the payment of interest on December 310 200+0 is as follo"s3
!ALA#CE SHEET
Assets 6ash -20500/ Interest E,pense -30%+1/ @onds =ayable 101+1 : Liabilities ;
I#CO"E

STATE"E#T
on

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Discount

@onds payable 1ess3 Discount on bonds payable

E500000 20%&# E#&032%

6<.=9E> 10 ? 175:-9E>

1I.@I1I9IE!

10-+.

17 5 1*

PRO!LE" 10-,A A"ORTIEATIO# OF PRE"I4"

Premi&m AmortiFation E@@e'ti)e Interest "et5o% o@ AmortiFation Col* 1 Cas5 Interest .G L E 20500 20500 20500 20500 20500 E120500 Col* + Interest E(7ense -G L E 200*+ 200&3 2005% 2003* 2001#$ E1002&0 Col* , Premi&m AmortiFe% Col* 1 ? Col* + L E #11 #2& ### #%2 #*% E20230 Col* Carr6ing Val&e E520230 510*1+ 5103+2 500+#* 500#*% 500000

$ate 1D01D0& 12D31D0& 12D31D0* 12D31D0+ 12D31D10 12D31D11 9otals

$.mount needed to bring carrying )alue to face )alue. +* Interest e,pense 2 6ash interest payment 2 =remium amorti(ed 2 E1002&0 120500 E 20230

,* 9he effect on the accounting equation of the payment of interest on December 310 200+0 is as follo"s3
!ALA#CE SHEET
Assets 6ash -20500/ Interest E,pense -2005%/ @onds =ayable -###/ : Liabilities ;
I#CO"E

STATE"E#T
on

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses =remium

@onds payable .dd3 =remium on bonds payable

E500000 +#* E500+#*

10-+/

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.58.1

17 %

PRO!LE" 10--A RE$E"PTIO# OF !O#$S

1* >edemption price E1000000 F 1.01 2 6arrying )alue E1000000 N -E50500 J E20000/ 2 :ain on redemption +* >edemption price E1000000 F 1.0# 2 6arrying )alue E1000000 N E30500 2 1oss on redemption

E1010000 1030500 E 20500 E10#0000 1030500 E 500

,* 9he gain or loss on bond redemption should be presented on the income statement. In most cases0 the gain or loss on bond redemption should not be considered unusual or infrequent and therefore should not be presented in the section of the statement "here e,traordinary items are presented. -* @onds are redeemed early only if it is ad)antageous to the issuing firm. <o"e)er0 early redemption is usually not fa)orable to the in)estor because it usually means the in)estor can no longer benefit from a fa)orable interest rate. 9o compensate the in)estor for foregone interest0 as "ell as for the costs and incon)enience in)ol)ed0 the call price is normally set at an amount higher than 100.

17 & 1*

PRO!LE" 10-.A FI#A#CIAL STATE"E#T I"PACT OF A LEASE

Col* 1 Lease Pa6ment $ate 1D01D0& 12D31D0& 12D31D0* 12D31D0+ 12D31D10 12D31D11 12D31D12 L E210+*0 210+*0 210+*0 210+*0 210+*0 210+*0

Col* + Interest E(7ense 2G L E*0*&# &0%+# %0#0+ 5000& 30#*0 10*1%

Col* , Re%&'tion o@ Obligation Col* 1 ? Col* + L E13010% 1#02*% 1505&1 1%0+&3 1*0500 2001%#$

Col* Lease Obligation E+*0%00 *50#+# &1020* 550%3& 3*0%%# 2001%# 0

$>ounded to bring carrying )alue to (ero. +* 9he effect on the accounting equation of the lease transaction on Manuary 10 200&0 is as follo"s3
!ALA#CE SHEET
Assets 1eased achine +*0%00 : Liabilities 1ease 1iability ; +*0%00
I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses

6<.=9E> 10 ? 175:-9E>

1I.@I1I9IE!

10-+0

PRO!LE" 10-.A ACon'l&%e%B

,* 9he effect on the accounting equation of the December 310 200*0 annual payment and interest e,pense is as follo"s3
!ALA#CE SHEET
Assets 6ash -210+*0/ : Liabilities 1ease 1iability ; -1#02*%/

I#CO"E

STATE"E#T
-&0%+#/

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Interest E,pense

9he effect on the accounting equation of the December 310 200*0 depreciation e,pense is as follo"s3
!ALA#CE SHEET
Assets : Liabilities ; .ccumulated DepreciationL 1eased achine -1%0#33/
I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Depreciation E,penseL 1eased achine

-1%0#33/

-* 1ong-term assets3 1eased machine 1ess3 .ccumulated depreciation $E1%0#33 F 2 years 2 E320*%%. 6urrent liabilities3 1ease liabilityLcurrent portion 1ong-term liabilities3 1ease liability

E+*0%00 320*%%$ E%50&3#

E1505&1 E550%3&

10-+1

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.58.1

17 +

PRO!LE" 10-/A $EFERRE$ TAX AA77en%i(B

1* 9he effect on the accounting equation of the December 310 200&0 income ta, e,pense0 deferred ta,0 and income ta, payable is as follo"s3
!ALA#CE SHEET
Assets : Liabilities Income 9a, =ayable Deferred 9a, ; 120 -20/
I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Income 9a, E,pense -100/

+* 9he Deferred 9a, account e,ists to reconcile the difference bet"een the accounting done for ta, purposes and that done for reporting to stocAholders0 also referred to as booA purposes. 9he balance of the Deferred 9a, account represents all temporary differences bet"een booA and ta, accounting reflected at the corporate ta, rate. 9he amount of the temporary differences is entered into the Deferred 9a, account "hen it originates. In theory0 the items "ill be remo)ed from the account "hen they re)erse and the balance of the account "ill be reduced at that time.

17 + 1* 9ear 1

PRO!LE" 10-0A $EFERRE$ TAX CALC4LATIO#S AA77en%i(B

Income before ta,es 1ess3 9a,-e,empt income 1ess3 E,cess of ta, depreciation o)er booA depreciation -E300000 J E200000/ 9a,able income 9a,es paid or payable -#0G/ Income before ta,es 1ess3 9a,-e,empt income =lus3 E,cess of booA depreciation o)er ta, depreciation -E200000 J E200000/ 9a,able income 9a,es paid or payable -#0G/ Income before ta,es 1ess3 9a,-e,empt income =lus3 E,cess of booA depreciation o)er ta, depreciation -E200000 J E100000/ 9a,able income 9a,es paid or payable -#0G/

E 1200000 -50000/ -100000/ E 1050000 E #20000 E 1200000 -50000/ 0 E 1150000 E #%0000 E 1200000 -50000/ 100000 E 1250000 E 500000

9ear +

9ear ,

6<.=9E> 10 ? 175:-9E>

1I.@I1I9IE!

10-+2

PRO!LE" 10-0A ACon'l&%e%B

+* 9he Deferred 9a, account for Oears 1J3 "ould contain the follo"ing information3 9ear 1 entr6D 9a, e,pense greater than ta, payable E100000 F #0G 2 E#0000 credit 9ear 1 balan'e 2 E#0000 credit0 a liability 20 2 E#0000 credit0 a liability

9ear + entr6D 9ear + balan'e 9ear , entr6D

9a, payable greater than ta, e,pense E100000 F #0G 2 E#0000 debit 9ear , balan'e 20

9he account "ould not appear on the balance sheet at the end of Oear 3. AL TE R # ATE " 4 LTI- C O# C E P T PR O! LE " S 17 #0%
PRO!LE" 10-1A FI#A#CIAL STATE"E#T I"PACT OF A !O#$

1* 9he effect on the accounting equation of the Muly 10 200&0 issuance of the bonds is as follo"s3

!ALA#CE SHEET
Assets 6ash +1%0200 : Liabilities ; @onds =ayable 100000000 Discount on @onds =ayable -*30*00/

I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses

E500000$ *.3*# -9able +-#0 n 2 120 i 2 %G/ 2 E100000000 0.#+& -9able +-20 n 2 120 i 2 %G/ 2 $E100000000 10G %D12 2 E500000

E #1+0200 #+&0000 E +1%0200

10-,0

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.58.1

PRO!LE" 10-1A ACon'l&%e%B

+* 9he effect on the accounting equation of the December 310 200&0 accrual of interest is as follo"s3
!ALA#CE SHEET
Assets : Liabilities ; 500000 #0+&2$$ Interest =ayable Discount on @onds =ayable
I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses Interest E,pense -5#0+&2/$

$E+1%0200 %G 2 E5#0+&2 $$Discount amorti(ed 2 E5#0+&2 J E500000 2 E#0+&2 ,* 9he effect on the accounting equation of the Manuary 10 200*0 interest payment is as follo"s3
!ALA#CE SHEET
Assets 6ash -500000/ : Liabilities Interest =ayable ;
I#CO"E

STATE"E#T

Sto'<5ol%ers= E>&it6 ; Re)en&es ? E(7enses

-500000/

-* 7n the maturity date0 Muly 10 20130 the balance in Discount on @onds =ayable "ill ha)e been reduced to (ero. 9he only remaining amount to be paid is the principal on the bond as sho"n in the @onds =ayable account0 E100000000. 17 10+
PRO!LE" 10-2A PARTIAL CLASSIFIE$ !ALA#CE SHEET FOR !OEI#C

1* 9he follo"ing is the liabilities section of the consolidated balance sheet of @oeing Inc. at December 310 200#. -.ll amounts are in millions./ Liabilities 6urrent liabilities3 .ccounts payable and other liabilities Income ta, payable !hort-term debt and current portion of long-term debt .d)ances in e,cess of related costs 9otal current liabilities 1ong-term debt .ccrued retiree healthcare Deferred income ta,es Deferred lease income

E1#0*%+ 522 10321 #0123 E200*35 E100*&+ 50+5+ 100+0 &#5

6<.=9E> 10 ? 175:-9E>

1I.@I1I9IE!

10-,1

PRO!LE" 10-2A ACon'l&%e%B

+* 6omputation of debt-to-equity ratios3 +00, E##0*#&DE*013+ 2 5.51 to 1 +00-E200*35 N E100*&+ N E50+5+ N E100+0 N E&#5/DE1102*% 2 E3+050*DE1102*% 2 3.50 to 1 @oeingCs debt-to-equity ratio has decreased some"hat during 200#. 9his means that @oeing has less debt for each dollar of equity3 E5.51 of debt per E1 of equity in 2003 compared "ith E3.50 of debt per E1 of equity in 200#. ost in)estors "ould prefer a decrease rather than an increase in this ratio. Debt has fi,ed repayment terms0 and its repayment must include interest. Equity ne)er has to be repaid0 and di)idend payments are optional. .lso0 the debt represents a claim on the companyCs assets. In the e)ent of liquidation0 this claim "ould need to be repaid before any assets are distributed to stocAholders. 7)erall0 the debt-to-equity ratio is fairly high and indicates the company has a high le)el of debt. ,* @oeingCs lenders "ant to be sure that the company can repay the principal and pay the interest on the loan. 9hey "ould be interested in @oeingCs times interest earned and debt ser)ice co)erage ratios. @oth ratios measure the degree to "hich a company can maAe its debt payments out of current cash flo"s.

10-,+

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.58.1

$ E C IS IO# C AS E S

REA$I#C A#$ I#TERPRETI#C FI#A#CIAL STATE"E#TS 17 10&

$ECISIO# CASE 10-1 EVAL4ATI#C THE LIA!ILITIES OF FOOT LOCHER

1* 'oot 1ocAer has the follo"ing long-term liabilities3 1ong-term debt and obligations under capital leasesLdecreased from 200# to 2005 7ther 1iabilitiesLdecreased from 200# to 2005 +* Debt-to-equity ratio for 200#3 E10#0&DE10*30 2 0.&& Debt-to-equity ratio for 20053 E102*5DE2002& 2 0.%# 9imes interest earned for 200#3 E#2&DE15 2 2*.#& times 9imes interest earned for 20053 E#1%DE10 2 #1.%0 times 9he company made impro)ements in its capital structure from 200# to 2005. 9he debt-to-equity ratio decreased marAedly0 indicating the company has less debt and more equity. 9he times interest earned ratio increased from 200# to 20050 indicating the company has a greater ability to maAe its interest payments on its e,isting debt. 9he company has lo" le)els of debt so the times interest earned ratio is quite good in both years.

17 *

$ECISIO# CASE 10-+ REA$I#C FI#ISH LI#E=S A#$ FOOT LOCHER=S STATE"E#T OF CASH FLOWS

1* 9he maPor source of cash in the financing acti)ities category for 'oot 1ocAer "as the issuance of common stocA. 9he maPor source for 'inish 1ine "as also the issuance of common stocA. +* . negati)e amount related to debt in the cash flo" statement indicates that 'oot 1ocAer used cash to pay off or redeem debt during the year. 9he maPor use of cash in the financing acti)ities category for 'oot 1ocAer "as the payment of di)idends. 9he maPor use of cash in the financing acti)ities category for 'inish 1ine "as the purchase of treasury stocA. ,* 'inish 1ine did not use any cash to retire or redeem debt during the year.

6<.=9E> 10 ? 175:-9E>

1I.@I1I9IE!

10-,,

17 *0+

$ECISIO# CASE 10-, REA$I#C PEPSICO=S STATE"E#T OF CASH FLOWS

1* =roceeds from debt is a positi)e amount on the cash flo"s statement because it indicates that the company has incurred a loan and recei)ed cash. =ayment of debt is a negati)e amount because it indicates that the company has used cash to repay a loan or other form of debt. +* Bhen interest rates decline0 companies often pay off loans that carry interest at a rate that is higher than the current rate. It maAes good economic sense to pay off loans that ha)e a high rate of interest because money borro"ed at the current rate of interest "ill be less than the rate on debt that "as incurred pre)iously. ,* Bhen a company has a Deferred Income 9a, account0 an increase in the account should be presented as a negati)e on the cash flo"s statement because it indicates that the amount of ta,es actually paid "as more than the amount reflected in the net income amount presented in the 7perating .cti)ities section of the balance sheet. 6hanges in the Deferred Income 9a, account should be presented in the 7perating .cti)ities section of the cash flo"s statement because it is related to operating acti)ities and affects the net income amount.

"AHI#C FI#A#CIAL $ECISIO#S 17 1

$ECISIO# CASE 10-- "AHI#C A LOA# $ECISIO#

1* 9he banACs policy is that a 2-to-1 ratio of assets to debt must be maintained. 9he note in olitorCs annual report indicates that generally accepted accounting principles do not require the item to be recorded. 9his is an e,ample of an offbalance-sheet financial arrangement. . strict interpretation of the policy and the accounting principle does not require the item to be recorded0 and the ratio is E%%00000DE3000000 2 2.2. If the amount is included0 the ratio is E*%00000DE5000000 2 1.&. +* 9he banA should adopt a more fle,ible policy to consider those financing techniques that are off-balance-sheet. <o"e)er0 it is )ery difficult to de)elop a policy that accommodates the "ide )ariety of financial arrangements that fall into this category. !ome are0 in substance0 liabilities and should be considered as such. 7thers are not liabilities and are more appropriately e,cluded from the banACs policy.

10-,-

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.58.1

17 % 973 >E3

$ECISIO# CASE 10-. !O#$ RE$E"PTIO# $ECISIO#

6ontroller >etirement of 7utstanding @onds

'>7 3 !tudent 5ame 9he outstanding bonds ha)e increased in )alue because they pay 10G in a marAet that requires only a #G return. 9he holders of these instruments "ould sell them for E1#*0&10 -E1000000 F 0.%&%/ N -E1000000 F 10G F *.111/. 9he company is required to pay this amount for the bonds in order to purchase them from the bondholders. If the company issues bonds at #G0 the ne" issuance "ill yield the company E1000000. 9he company "ould be required to use E#*0&10 of "orAing capital to reissue the bonds at the lo"er rate. 9he benefit to the company is that in the future 10 years0 the company is required to pay only E#0000 each year rather than E100000 in annual interest. Discounting the sa)ings of E%0000 per year yields a net benefit to the company of E#*0&10 -E%0000 F *.111 rounded/. I recommend that the company retire the outstanding bonds and reissue the bonds at the lo"er rate in order to reduce future cash outflo". It should be noted that if the company had issued the original bonds "ith a call price of less than 1#*.&10 the company "ould be able to call the bonds at lo"er than marAet. ACCO4#TI#C A#$ ETHICSD WHAT WO4L$ 9O4 $OI 17 &
$ECISIO# CASE 10-/ $ETER"I#ATIO# OF ASSET LIFE

1* 9he purpose of the case is to illustrate the Pudgment necessary in recording leases. E)en though criteria e,ist that go)ern lease accounting0 significant Pudgment is necessary in the application of the criteria. If Men belie)es that the first source of information is )alid0 she should record the lease as a capital lease. If the trade publication is more )alid0 she should record the lease as an operating lease. Men should gather additional information and consult other e,perts or opinions in forming her decision. <o"e)er0 in the final analysis0 she must maAe an informed decision that represents her best professional Pudgment. +* In this case0 either Pudgment can be supported pro)ided that it represents MenCs best professional Pudgment using all a)ailable information. If0 ho"e)er0 Men decides the issue because <aleCs does not "ant the lease recorded as a capital lease0 then probably she is acting unethically. .ccounting decisions should be based on the substance of the transaction and should not be based on a desire to achie)e a certain obPecti)e0 such as a desire to HhideI information or a desire to please oneCs boss.

6<.=9E> 10 ? 175:-9E>

1I.@I1I9IE!

10-,.

REAL WORL$ PRACTICE 10*1 1ong-9erm Debt decreased0 "hile Deferred Income 9a,es and 7ther 1iabilities increased.

REAL WORL$ PRACTICE 10*+ Debt to equity ratio for 200#3 E1*+00#*DE3*50+&1 2 0.#+ Debt to equity ratio for 20053 E1++02&# DE#2*05#2 2 0.#& 9he ratio decreased slightly0 indicating an impro)ed le)el of sol)ency for the company. 7)erall0 the companyCs le)el of debt is fairly lo".