Debt – Practice Problems

Problem #1

A ___________debt covenant tells a borrower they should maintain certain financial ratios and/or provide
audited financial statements.

Problem #2

On January 1, 20X1, Textile Inc. issues $100,000, 6-year, 10 percent bonds when the market interest rate was 8
percent. Interest is paid semiannually.
The present value of the bond at issuance was $109,385.
In 20X1, what was the amount of Interest Expense recorded for the year?

Problem #3

1. Calculate the debt ratio using the following information. What does the debt ratio tell you?
2. Calculate net worth. What does the calculation tell you?
Current Assets $23,500
Other Assets 42,250
Current Liabilities 10,925
Long-term Liabilities 12,088
Problem #4

On January 1, 20X1, Anex Inc issued 10% semi-annual bonds with a face value of $100,000 that mature in 10
years. The market price of the bonds was 12%, which result in a bond issue price of 88,530.
At what amount will the bond be presented in the December 31, 20X1 balance sheet?

What is total interest expense for 20X1?

Problem #5

On July 1, 20X1, Jupiter Inc issued 10% semi-annual bonds with a face value of $100,000 that mature in 10
years. The market price of the bonds was 9%, which result in a bond issue price of 106,504.
At what amount will the bond be presented in the December 31, 20X1 balance sheet?

What is total interest expense for 20X1?

Problem #6

Utah Corp took out a 5% note for $500,000 on January 1, 20X4. The principal is to be paid back in installments
of $100,000 at the end of each year for the next 5 years.

How will this note be reflected on the balance sheet at December 31, 20X4?

What is interest expense for the year ended 20X4? 20X5?

Problem #7

Butte Mountain Inc repurchased bonds by exercising a call provision for $825,000. The bonds have a face
value of $800,000 and an unamortized premium of $20,000.

Determine the amount of any gain or loss on the repurchase.

Problem #8

Presented below are various account balances of Royale Corp. for Dec. 31, 2020
(a) Bonds payable of $12,000,000 maturing January 10, 2022.
(b) Notes payable due December 15, 2021.
(c) Amounts withheld from employees’ wages for FICA taxes.
(d) Debenture bonds payable (maturing in 2025).
(e) Discount on bonds payable.
(f) Mortgage payable (payable in equal amounts over next 3 years).
(g) Interest payable (credit balance).

Indicate whether each of the items above should be classified on December 31, 2020, as a current liability, a
long-term liability, or under some other classification. Consider each one independently from all others; that is,
do not assume that all of them relate to one particular business. If the classification of some of the items is
doubtful, explain why in each case.

Problem #9

McGee Company issued $400,000 of 8%, 20-year bonds on January 1, Year 4, at $492,460. Market rate is
currently at 6%. Interest is payable semiannually on July 1 and January 1.
What is the carrying value of the bond at 12/31/ Year 6?
Problem #10

On July 1, Year 4, Sugarland Company issued $2,000,000 face value of 10%, 10-year bonds at $1,770,602, a
yield of 12%. Sugarland uses the effective interest method to amortize bond premium or discount. The bonds
pay semiannual interest on June 30 and December 31.
(a) What is the CV of bonds payable on the December 31, Year 5, balance sheet?
(b) What amount of interest expense is reported for Year 5?
Conceptual Questions

1. A bond issue with a face amount of $900,000 bears interest at the rate of 8%. The current market rate of
interest is 10%. These bonds will sell at a price that is:
a. More than $900,000.
b. The answer cannot be determined.
c. Equal to $900,000
d. Less than $900,000.

2. A bond issue on June 1, Year 6, has interest payment dates of April 1 and October 1. Bond interest
expense for the year ended December 31, Year 6, is for a period of:
a. 3 months.
b. 4 months.
c. 6 months.
d. 7 months.

3. For a bond issue that sells for more than its face value, the market rate of interest is
a. Equal to the rate stated on the bond.
b. Dependent on the rate stated on the bond.
c. Higher than the rate stated on the bond.
d. Less than the rate stated on the bond.

4. Which of the following is a reason that a lender would desire a loan contract that includes a debt
covenant?
I. To protect themselves from borrower default.
II. To lower the interest rate.
III. To lower the risk.

a. I, III
b. II, III
c. I, II
d. I, II, III

ANSWERS
Problem #1

A ___________debt covenant tells a borrower they should maintain certain financial ratios and/or provide
audited financial statements.
positive

Problem #2

On January 1, 20X1, Textile Inc. issues $100,000, 6-year, 10 percent bonds when the market interest rate was 8
percent. Interest is paid semiannually.
The present value of the bond at issuance was $109,385.
In 20X1, what was the amount of Interest Expense recorded for the year?
Interest Cash Amort CV
109,385
1 4,375 5,000 625 108,760
2 4,350 5,000 650 108,111
8,725

Problem #3

1. Calculate the debt ratio using the following information. What does the debt ratio tell you?
2. Calculate net worth. What does the calculation tell you?

Current Assets $23,500

Other Assets 42,250
Current Liabilities 10,925
Long-term Liabilities 12,088

Total Liabilities = 10,925 + 12,088 = 23,013

Total Assets = 23,500 + 42,250 = 65,750

=35%
Borrowed 35% to buy your assets. Benchmark is usually around 50% (differs based on industry).

Total Assets = 65,750 – Total Liabilities = 23,013

Book value (net assets) of the company is $42,737. Company is able to cover all liabilities with its assets
and there would be leftovers for stockholders. Note that the market cap differs from net worth. Can
differ greatly depending on industry.

Problem #4
On January 1, 20X1, Anex Inc issued 10% semi-annual bonds with a face value of $100,000 that mature in 10
years. The market price of the bonds was 12%, which result in a bond issue price of 88,530.
At what amount will the bond be presented in the December 31, 20X1 balance sheet?
$89,172

Interest Cash Amort CV

88,530
1 5,312 5,000 312 88,842
2 5,331 5,000 331 89,172

What is total interest expense for 20X1?

$5,312 + 5,331 = 10,643

Problem #5

On July 1, 20X1, Jupiter Inc issued 10% semi-annual bonds with a face value of $100,000 that mature in 10
years. The market price of the bonds was 9%, which result in a bond issue price of 106,504.
At what amount will the bond be presented in the December 31, 20X1 balance sheet?
$106,297

Interest Cash Amort CV

106,504
1 4,793 5,000 207 106,297
2 4,783 5,000 217 106,080

What is total interest expense for 20X1?

$4,793

Problem #6
Utah Corp took out a 5% note for $500,000 on January 1, 20X4. The principal is to be paid back in installments
of $100,000 at the end of each year for the next 5 years.
How will this note be reflected on the balance sheet at December 31, 20X4?
$100,000 will be included in Current Liabilities
$300,000 will be included in Long-term Liabilities
What is interest expense for the year ended 20X4? 20X5?
$500,000 x 5% = 25,000
$400,000 x 5% = 20,000

Problem #7

Butte Mountain Inc repurchased bonds by exercising a call provision for $825,000. The bonds have a face
value of $800,000 and an unamortized premium of $20,000.

Determine the amount of any gain or loss on the repurchase.

Carrying value of the bond = 800,000 + 20,000 = 820,000
Cash paid = 825,000
Difference = 5,000 Loss on retirement

Problem #8

Presented below are various account balances of Royale Corp.

(a) Bonds payable of $12,000,000 maturing January 10, 2022.
(b) Notes payable due December 15, 2021.
(c) Amounts withheld from employees’ wages for FICA taxes.
(d) Debenture bonds payable (maturing in 2025).
(e) Discount on bonds payable.
(f) Mortgage payable (payable in equal amounts over next 3 years).
(g) Interest payable (credit balance).

Indicate whether each of the items above should be classified on December 31, 2020, as a current liability, a
long-term liability, or under some other classification. Consider each one independently from all others; that is,
do not assume that all of them relate to one particular business. If the classification of some of the items is
doubtful, explain why in each case.
(a) Long-term liability as amount is due more than 1 year out.
(b) Current liability, due within one year.
(c) Current liability.
(d) Long-term liability on balance sheet.
(e) Discount on Bonds Payable—Classify as contra account to bonds payable on balance sheet.
(f) Mortgage payable—Classify one-third as current liability and the remainder as long-term liability on
balance sheet.
(g) Current liability.

Problem #9
McGee Company issued $400,000 of 8%, 20-year bonds on January 1, Year 4, at $492,460. Market rate is
currently at 6%. Interest is payable semiannually on July 1 and January 1.
What is the carrying value of the bond at 12/31/ Year 6?
CV at 12/31/ Year 6 = $484,528

3% 4%
Period Interest Expense Cash Payment Amort CV
492,460
7/1/ Yr. 4 14,774 16,000 1,226 491,234
12/31/ Yr.
4 14,737 16,000 1,263 489,971
7/1/ Yr. 5 14,699 16,000 1,301 488,670
12/31/ Yr.
5 14,660 16,000 1,340 487,330
7/1/ Yr. 6 14,620 16,000 1,380 485,950
12/31/ Yr.
6 14,578 16,000 1,422 484,528

Note: these journal entries may be helpful to think through…

Cash $492,460
Bonds Payable $400,000
Premium on BP $92,640

Bond Interest Expense $14,774

Premium on BP $1,226
Cash $16,000

Bond Interest Expense $14,737

Premium on BP $1,263
Interest Payable $16,000
Problem #10

On July 1, Year 4, Sugarland Company issued $2,000,000 face value of 10%, 10-year bonds at $1,770,602, a
yield of 12%. Sugarland uses the effective interest method to amortize bond premium or discount. The bonds
pay semiannual interest on June 30 and December 31.
(a) What is the CV of bonds payable on the December 31, Year 5, balance sheet.
(b) What amount of interest expense is reported for Year 5?

(a) $1,790,455
(b) (106,610 + 107,007) = $213,617

6% 5%
Period Interest Expense Cash Payment Amort CV
7/1/ Yr. 4 1,770,602
12/31/ Yr.
4 106,236 100,000 6,236 1,776,838

7/30/ Yr. 5 106,610 100,000 6,610 1,783,448

12/31/ Yr.
5 107,007 100,000 7,007 1,790,455

7/30/ Yr. 6 107,427 100,000 7,427 1,797,883

12/31/ Yr.
6 107,873 100,000 7,873 1,805,756

Note: these journal entries may be helpful to think through…

Cash $1,770,602
Discount on BP $229,398
Bonds Payable $2,000,000

Bond Interest Expense $106,236

Discount on BP $6,236
Cash $100,000

Bond Interest Expense $106,610

Discount on BP $6,610
Cash $100,000
Conceptual Questions

1. A bond issue with a face amount of $900,000 bears interest at the rate of 8%. The current market rate of
interest is 10%. These bonds will sell at a price that is:
a. More than $900,000.
b. The answer cannot be determined.
c. Equal to $900,000
d. Less than $900,000.
When the market rate of interest is higher than the bonds' stated rate, the bonds will sell at a discount.
2. A bond issue on June 1, Year 6, has interest payment dates of April 1 and October 1. Bond interest
expense for the year ended December 31, Year 6, is for a period of:

a. 3 months.
b. 4 months.
c. 6 months.
d. 7 months.
The interest expense is for the time the bonds were outstanding during the reporting period—seven months in
this case.

3. For a bond issue that sells for more than its face value, the market rate of interest is
a. Equal to the rate stated on the bond.
b. Dependent on the rate stated on the bond.
c. Higher than the rate stated on the bond.
d. Less than the rate stated on the bond.
A bond issued at a premium reflects that the market rate is less than the contract rate.

4. Which of the following is a reason that a lender would desire a loan contract that includes a debt
covenant?
I. To protect themselves from borrower default.
II. To lower the interest rate.
III. To lower the risk.

a. I, III
b. II, III
c. I, II
d. I, II, III