Chapter Eleven Questions
1. Define the term long-term liabilities.
Long-term liabilities are liabilities that do not
have to be paid within one year of the date to which the balance sheet applies. For example, for the December 31, Year 1 balance sheet,
long-term liabilities would be those liabilities that would not have to be paid
before December 31, Year 2.
2. Give three examples of long-term liabilities.
Notes payable, bonds payable,
deferred taxes, obligations under capital leases.
3. What are bonds payable and notes payable?
Bonds payable and notes payable are written promises
to pay known dollar amounts, on specific dates, to the owners of the bonds and
notes.
4. Identify one difference between bonds payable and notes payable.
The common difference between bonds payable and
notes payable is that notes usually have shorter lives than bonds.
5. During the life of a bond, what two dollar amounts must be paid to the bond’s owner and when are the payments usually made?
A bond requires the payment of the bond principal
and interest. The principal is paid at the end of the
bond's life, while interest is often paid every six or twelve months.
6. State the formula for calculating interest on a bond payable.
Bond interest = principal x interest rate x time.
7. On which financial statement and in which section of the statement is interest expense reported?
Interest expense is reported on the income statement
as part of other revenues and expenses.
8. Why do companies use underwriters when they issue bonds?
Underwriters buy bonds from companies and sell them
to individuals and other companies. Companies use
underwriters when they issue bonds because the companies receive cash faster
and they do not have to find individuals and companies to buy the bonds.
9. Identify four choices that companies must make when they decide to issue bonds.
Bond principal, life, interest
rate, and interest payment dates.
10. Why can it take several weeks or months between when a company establishes a bond’s interest rate and the date that the company actually issues the bonds and receives cash?
Companies must comply with rules of regulatory
agencies such as the Securities and Exchange Commission. Complying
with these rules takes time.
11. What are deferred taxes and why do they exist?
Deferred taxes are long-term liabilities for dollar
amounts owed to governments for services provided by them. Deferred
taxes exist when companies report income taxes expenses on their income
statements that differ from the income taxes they report on their tax returns. A common cause of deferred taxes is the use of
straight-line depreciation for income statement purposes but accelerated
depreciation for tax purposes.
12. On which financial statement are long-term liabilities reported?
Long-term liabilities are reported in a separate
section of the balance sheet.
Chapter Eleven Exercises
Exercise 11.1: Bonds Payable Cash Payments
The Kokernak Corporation is considering issuing bonds. For each of the three bonds below, calculate the total cash that the Kokernak Corporation would pay out during the life of the bonds.
1. $5,000,000, 8%, 15-year bond.
Principal = $5,000,000
Interest = $5,000,000 x .08 x 15 = $6,000,000
Principal + interest = $11,000,000
2. $6,000,000, 9%, 20-year bond.
Principal = $6,000,000
Interest = $6,000,000 x .09 x 20 = $10,800,000
Principal + interest = $16,800,000
3. $8,000,000, 10%, 25-year bond.
Principal = $8,000,000
Interest = $8,000,000 x .10 x 25 = $20,000,000
Principal + interest = $28,000,000
Exercise 11.2: Bonds Payable: Cost of Borrowing
Over the last several years, the Keo Corporation issued bonds three different times. For each of the three bond issues, calculate the Keo Corporation’s cost of borrowing.
Issue one: $10,000,000 principal, 7% annual interest, 20-year life. Cash received by the Keo
Corporation was $10,000,000.
|
Cash received |
|
$10,000,000 |
|
Interest payments: $10,000,000 x .07 x 20 |
$14,000,000 |
|
|
Principal payment |
$10,000,000 |
$24,000,000 |
|
Cost of Borrowing |
|
$14,000,000 |
Issue two: $10,000,000 principal, 7.2% annual interest, 20-year life. Cash received by the Keo
Corporation was $10,800,000.
|
Cash received |
|
$10,800,000 |
|
Interest payments: $10,000,000 x .072 x 20 |
$14,400,000 |
|
|
Principal payment |
$10,000,000 |
$24,400,000 |
|
Cost of Borrowing |
|
$13,600,000 |
Issue three: $10,000,000 principal, 6.9% annual interest, 20-year life. Cash received by the Keo
Corporation was $9,700,000.
|
Cash received |
|
$9,700,000 |
|
Interest payments: $10,000,000 x .069 x 20 |
$13,800,000 |
|
|
Principal payment |
$10,000,000 |
$23,800,000 |
|
Cost of Borrowing |
|
$14,100,000 |
Exercise 11.3: Bond Transactions: Issued at Principal Amount
On July 1, the Andriolo Corporation issued $45,000,000, 8%, 20-year bonds and received $45,000,000. Interest on the bonds is to be paid every six months beginning on Jan. 1.
1. Calculate the Andriolo Corporation’s
total 20-year cost of borrowing by issuing the bonds.
|
Cash received |
|
$45,000,000 |
|
Interest payments: $45,000,000 x .08 x 20 |
$72,000,000 |
|
|
Principal payment |
$45,000,000 |
$117,000,000 |
|
Cost of Borrowing |
|
$72,000,000 |
2. Calculate the Andriolo Corporation’s
monthly cost of borrowing by issuing the bonds.
$72,000,000 / 20 years / 12 months = $300,000.
3. Prepare journal entries to record the corporation’s
following transactions. Before you prepare each
journal entry, determine the transaction's effects on the company's resources
and sources of resources.
July 1: Bonds issued.
|
Total |
= |
Sources of |
+ |
Sources of |
+ |
Sources of |
|
Assets |
= |
Liabilities |
+ |
Stockholders' Equity |
||
|
+ $45,000,000 |
= |
+ $45,000,000 |
|
|
|
|
|
Date |
Description |
Post. |
Debits |
Credits |
|
July 1 |
Cash |
|
45,000,000 |
|
|
|
Bonds Payable |
|
|
45,000,000 |
|
|
8%, 20-year bonds issued |
|
|
|
July 31: Monthly interest.
|
Total |
= |
Sources of |
+ |
Sources of |
+ |
Sources of |
|
Assets |
= |
Liabilities |
+ |
Stockholders' Equity |
||
|
|
|
+ $300,000 |
|
|
+ |
- $300,000 |
|
Date |
Description |
Post. |
Debits |
Credits |
|
July 31 |
Interest Expense |
|
300,000 |
|
|
|
Interest Payable |
|
|
300,000 |
|
|
8%, 20-year bonds interest |
|
|
|
Jan. 1: Interest payment.
|
Total |
= |
Sources of |
+ |
Sources of |
+ |
Sources of |
|
Assets |
= |
Liabilities |
+ |
Stockholders' Equity |
||
|
- $1,800,000 |
= |
- $1,800,000 |
|
|
|
|
|
Date |
Description |
Post. |
Debits |
Credits |
|
Jan. 1 |
Interest Payable |
|
1,800,000 |
|
|
|
Cash |
|
|
1,800,000 |
|
|
8%, 20-year bonds interest paid |
|
|
|
June 30, at the end of 20 years: Bond retirement.
|
Total |
= |
Sources of |
+ |
Sources of |
+ |
Sources of |
|
Assets |
= |
Liabilities |
+ |
Stockholders' Equity |
||
|
- $45,000,000 |
= |
- $45,000,000 |
|
|
|
|
|
Date |
Description |
Post. |
Debits |
Credits |
|
June 30 |
Bonds Payable |
|
45,000,000 |
|
|
|
Cash |
|
|
45,000,000 |
|
|
8%, 20-year bonds retired |
|
|
|
4. Compare your answer in part 2 to the July 31 journal entry.
The monthly cost of borrowing ($300,000) = monthly
interest expense.
Exercise 11.4: Advantage of Borrowing: Bonds Issued at Principal Amount
The Campaigne Corporation is considering a plan in which it would increase the size of its operations. As a result of the increased operations, without considering the cost of borrowing, the company expects income before taxes to increase by $5,000,000 per year in years 1-3, $7,000,000 per year in years 4-8, $9,000,000 per year in years 9-15, and $6,000,000 per year in years 16-20. To increase its operations the company would issue $50,000,000, 12%, 20-year bonds. The company expects to be able to issue the bonds at their principal.
1. Calculate the Campaigne Corporation’s
total expected 20-year increase in income before taxes without considering the
cost of borrowing.
|
Year |
Increase in Income Before Taxes |
|
Years 1-3 |
$15,000,000 |
|
Years 4-8 |
35,000,000 |
|
Years 9-15 |
63,000,000 |
|
Years 16-20 |
30,000,000 |
|
Total |
$143,000,000 |
2. Calculate the Campaigne Corporation’s
total expected 20-year cost of borrowing.
|
Cash received |
|
$50,000,000 |
|
Interest payments: $50,000,000 x .12 x 20 |
$120,000,000 |
|
|
Principal payment |
$50,000,000 |
$170,000,000 |
|
Cost of Borrowing |
|
$120,000,000 |
3. Calculate the Campaigne Corporation’s
total expected 20-year increase in income before taxes after considering the
cost of borrowing.
|
Increase in income before taxes before borrowing |
$143,000,000 |
|
Less: Cost of Borrowing |
$120,000,000 |
|
Increase in income before taxes after borrowing |
$23,000,000 |
4. Assuming a 35% effective income tax rate, calculate the Campaigne
Corporation’s total expected 20-year increase in
resources if it issues the bonds and increases its operations.
|
Increase in income before taxes after borrowing |
$23,000,000 |
|
Less: Income taxes expense (35%) |
$8,050,000 |
|
Increase in income after taxes after borrowing |
$14,950,000 |
Exercise 11.5: Early Retirement of Bonds Issued at Principal Amount
Due to recent declines in interest rates, the Hughes Corporation is considering retiring one of its bond issues on March 1. The bonds are $20,000,000, 8%, 15-year bonds, issued at par on September 1, almost 13 years ago.
1. Calculate the gain or loss the company would recognize if it retired the
bonds for $21,500,000. Assume appropriate interest
payments will be made on the bonds before they are retired.
|
Cash paid on bond retirement |
$21,500,000 |
|
Bonds payable |
$20,000,000 |
|
Loss on retirement of bonds |
$1,500,000 |
2. Prepare the journal entry to record the bond retirement. Before
you prepare the journal entry, determine the transaction's effects on the
company's resources and sources of resources.
|
Total |
= |
Sources of |
+ |
Sources of |
+ |
Sources of |
|
Assets |
= |
Liabilities |
+ |
Stockholders' Equity |
||
|
- $21,500,000 |
= |
- $20,000,000 |
|
|
+ |
- $1,500,000 |
|
Date |
Description |
Post. |
Debits |
Credits |
|
March 1 |
Bonds Payable |
|
20,000,000 |
|
|
|
Loss on Early Retirement of Bonds Payable |
|
1,500,000 |
|
|
|
Cash |
|
|
21,500,000 |
|
|
8%, 15-year bonds retired |
|
|
|
Exercise 11.6: Deferred Income Taxes
There are several differences between the accounting methods the Baetz Corporation uses in the preparation of its financial statements and in the preparation of its federal income taxes return. For the year ended December 31, the company’s taxable income on its income statement was $200,000,000, while it was $180,000,000 for income taxes purposes. For simplification, assume that the income taxes rate is 35%.
1. Calculate the income taxes expense the company would report on its income statement.
$200,000,000 x .35 = $70,000,000.
2. Calculate the income taxes expense the company would report on its income
taxes return.
$180,000,000 x .35 = $63,000,000.
3. Prepare the journal entry to record the corporation’s
income taxes. Before you prepare the entry, determine
the transaction's effects on the company's resources and sources of resources.
|
Total |
= |
Sources of |
+ |
Sources of |
+ |
Sources of |
|
Assets |
= |
Liabilities |
+ |
Stockholders' Equity |
||
|
|
|
+ $63,000,000 |
|
|
+ |
- $70,000,000 |
|
Date |
Description |
Post. |
Debits |
Credits |
|
|
Income Taxes Expense |
|
70,000,000 |
|
|
|
Income Taxes Payable |
|
|
63,000,000 |
|
|
Deferred Income Taxes Payable |
|
|
7,000,000 |
|
|
Income taxes |
|
|
|