Brief Exercises 467

ASSIGNMENT MATERIAL Discussion Questions

1. Define liabilities. Identify several characteristics that distin-
guish liabilities from owners’ equity.
2. Explain the relative priority of the claims of owners and of
creditors to the assets of a business. Do all creditors have
equal priority? Explain.
3. Define current liabilities and long-term liabilities. Under
what circumstances might a 10-year bond issue be classi-
fied as a current liability? Under what circumstances might
a note payable maturing 30 days after the balance sheet date
be classified as a long-term liability?
4. Explain why an employer’s “total cost” of a payroll may
exceed by a substantial amount the total wages and salaries
earned by employees.
5. A friend of yours has just purchased a house and has taken
out a $50,000, 11 percent mortgage, payable at $476.17
per month. After making the first monthly payment, he
received a receipt from the bank stating that only $17.84
of the $476.17 had been applied to reducing the principal
amount of the loan. Your friend computes that, at the rate of
$17.84 per month, it will take over 233 years to pay off the
$50,000 mortgage. Do you agree with your friend’s analy-
sis? Explain.
6. Briefly explain the income tax advantage of raising capital
by issuing bonds rather than by selling capital stock.
7. Seattle Boat Company pays federal income taxes at a rate
of 35 percent on taxable income. Compute the company’s
annual after-tax cost of borrowing on an 8 percent,
$5 million bond issue. Express this after-tax cost as a per-
centage of the borrowed $5 million.
8. Why do bond prices vary inversely with interest rates?
9. Some bonds now being bought and sold by investors on
organized securities exchanges were issued when inter-
est rates were much higher than they are today. Would you
expect these bonds to be trading at prices above or below
their face values? Explain.
10. There is a business saying that “You shouldn’t be in business
if your company doesn’t earn higher than bank rates.” This
means that if a company is to succeed, its return on assets
should be significantly higher than its cost of borrowing.
Why is this so important?
11. Identify two characteristics of estimated liabilities. Provide
at least two examples of estimated liabilities.
12. What is the meaning of the term loss contingency? Give
several examples. How are loss contingencies presented in
financial statements? Explain.
13. Explain how the lessee accounts for operating leases and
capital leases. Why is an operating lease sometimes called
off-balance sheet financing?
14. When are the costs of postretirement benefits recognized as
an expense? When are the related cash payments made?
15. What are deferred income tax liabilities? How are these
items presented in financial statements?

LO10-2
BRIEF EXERCISE 10.1
Cash Effects of Borrowing
Brief Exercises
Jansen Company borrowed $12,000 on a one-year, 8 percent note payable from the local bank on
April 1. Interest was paid quarterly, and the note was repaid one year from the time the money was
borrowed. Calculate the amount of cash payments Jansen was required to make in each of the two
calendar years that were affected by the note payable.

LO10-5
BRIEF EXERCISE 10.2
Effective Interest Rate
One of the advantages of borrowing is that interest is deductible for income tax purposes.
a. If a company pays 8 percent interest to borrow $500,000, but is in an income tax bracket that
requires it to pay 40 percent income tax, what is the actual net-of-tax interest cost that the com-
pany incurs?
b. What is the effective interest rate that is paid by the company?

LO10-6 Crosby, Inc., sells $1,000,000 general obligation bonds for 98. The interest rate on the bonds, paid
BRIEF EXERCISE 10.3 quarterly, is 6 percent. Calculate (a) the amount that the company will actually receive from the
Bonds Issued at a Discount sale of the bonds, and (b) the amount of both the quarterly and the total annual cash interest that
the company will be required to pay.

LO10-6 Presley Company sells $1,000,000 general obligation bonds for 102. The interest rate on the bonds,
BRIEF EXERCISE 10.4 paid quarterly, is 5 percent. Calculate (a) the amount that the company will actually receive from
Bonds Issued at a Premium the sale of the bonds, and (b) the amount of both the quarterly and the total annual cash interest
that the company will be required to pay.
Exercises
LO10-5, LO10-6
EXERCISE 10.9
Accounting for Bonds
Issued at a Premium:
Issuance, Interest
Payments, and Retirement
LO10-5, LO10-6
EXERCISE 10.10
Accounting for Bonds
Issued at a Discount:
Issuance, Interest
Payments, and Retirement
LO10-9
EXERCISE 10.11
Safety of Creditors’ Claims
LO10-10
EXERCISE 10.12
Accounting for Leases
471
c. Prepare the adjusting entry at December 31, 2015, to record bond interest expense accrued since
September 30, 2015. (Assume that no monthly adjusting entries to accrue interest expense had
been made prior to December 31, 2015.)
d. Explain why the issuing corporation charged its bond investors for interest accrued in April
2015, prior to the issuance date (see part b above).
Xonic Corporation issued $8 million of 20-year, 8 percent bonds on April 1, 2015, at 102. Interest
is due on March 31 and September 30 of each year, and all of the bonds in the issue mature on
March 31, 2035. Xonic’s fiscal year ends on December 31. Prepare the following journal entries:
a. April 1, 2015, to record the issuance of the bonds.
b. September 30, 2015, to pay interest and to amortize the bond premium.
c. March 31, 2035, to pay interest, amortize the bond premium, and retire the bonds at maturity
(make two separate entries).
d. Briefly explain the effect of amortizing the bond premium on (1) annual net income and
(2) annual net cash flow from operating activities. (Ignore possible income tax effects.)
Mellilo Corporation issued $5 million of 20-year, 9.5 percent bonds on July 1, 2015, at 98. Interest
is due on June 30 and December 31 of each year, and all of the bonds in the issue mature on June
30, 2035. Mellilo’s fiscal year ends on December 31. Prepare the following journal entries:
a. July 1, 2015, to record the issuance of the bonds.
b. December 31, 2015, to pay interest and amortize the bond discount.
c. June 30, 2035, to pay interest, amortize the bond discount, and retire the bonds at maturity
(make two separate entries).
d. Briefly explain the effect of amortizing the bond discount upon (1) annual net income and
(2) annual net cash flow from operating activities. (Ignore possible income tax effects.)
Shown below are data from recent reports of two toy makers. Dollar amounts are stated in
thousands.
Toyco Pemco
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $615,132 $2,780,500
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349,792 1,105,735
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,026 39,588
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,028 304,672
a. Compute for each company (1) the debt ratio and (2) the interest coverage ratio. (Round the debt
ratio to the nearest percent and the interest coverage ratio to two decimal places.)
b. In your opinion, which of these companies would a long-term creditor probably view as the
safer investment? Explain.
On July 1, Pine Region Dairy leased equipment from Farm America for a period of three years.
The lease calls for monthly payments of $2,500 payable in advance on the first day of each month,
beginning July 1.
Prepare the journal entry needed to record this lease in the accounting records of Pine Region
Dairy on July 1 under each of the following independent assumptions:
a. The lease represents a simple rental arrangement.
b. At the end of three years, title to this equipment will be transferred to Pine Region Dairy at no
additional cost. The present value of the 36 monthly lease payments is $76,021, of which $2,500
is paid in cash on July 1. None of the initial $2,500 is allocated to interest expense.
c. Why is situation a, the operating lease, sometimes called off-balance sheet financing?
d. Would it be acceptable for a company to account for a capital lease as an operating lease to
report rent expense rather than a long-term liability?
Problem Set B 479

AMORTIZATION TABLE
(12%, 4-YEAR NOTE PAYABLE FOR $100,000;
PAYABLE IN 48 MONTHLY INSTALLMENTS OF $2,633)
Interest Payment Monthly Interest Principal Unpaid
Period Date Payment Expense Reduction Balance

Issue date Oct. 1, 2015 — — — $100,000

1 Nov. 1 $2,633 $1,000 $1,633 98,367
2 Dec. 1 2,633 984 1,649 96,718

Instructions
a. Explain whether the amounts of interest expense and the reductions in the unpaid principal are
likely to change in any predictable pattern from month to month.
b. Prepare journal entries to record the first two monthly payments on this note.
c. Complete this amortization table for two more monthly installments.
d. Will any amounts relating to this four-year note be classified as current liabilities in Jenco’s
December 31, 2015, balance sheet? Explain, but you need not compute any additional dollar
amounts.

LO10-5 Stevens Manufacturing Company obtained authorization to issue 10-year bonds with a face value
PROBLEM 10.5B of $5 million. The bonds are dated June 1, 2015, and have a contract rate of interest of 6 percent.
Bond Interest (Bonds They pay interest on December 1 and June 1. The bonds are issued on September 1, 2015, at 100
Issued at Face Value) plus three months’ accrued interest.

Instructions
Prepare the necessary journal entries in general journal form on:
a. September 1, 2015, to record the issuance of the bonds.
b. December 1, 2015, to record the first semiannual interest payment on the bond issue.
c. December 31, 2015, to record interest expense accrued through year-end.
d. June 1, 2016, to record the second semiannual interest payment.
e. What was the prevailing market rate of interest on the date that the bonds were issued?
Explain.

LO10-5, LO10-6 On September 1, 2011, Rodriguez Plumbing Company issued $5 million in 10-year, 12 percent
PROBLEM 10.6B bonds payable. Interest is payable semiannually on March 1 and September 1. Bond discounts and
Amortization of a Bond premiums are amortized at each interest payment date and at year-end. The company’s fiscal year
Discount and Premium ends at December 31.

Instructions
a. Make the necessary adjusting entries at December 31, 2015, and the journal entry to record
the payment of bond interest on March 1, 2016, under each of the following assumptions:
1. The bonds were issued at 98. (Round to the nearest dollar.)
2. The bonds were issued at 104. (Round to the nearest dollar.)
b. Compute the net bond liability at December 31, 2016, under assumptions 1 and 2 above.
(Round to the nearest dollar.)
c. Under which of the above assumptions, 1 or 2, would the investor’s effective rate of interest be
higher? Explain.