financial accounting tools for business decision making solutions 7e chapter 10

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CHAPTER 10 REPORTING AND ANALYZING LIABILITIES

LEARNING OBJECTIVES

1 Account for current liabilities

2 Account for instalment notes payable

3 Identify the requirements for the financial statement presentation and analysis of

liabilities

4 Account for bonds payable (Appendix 10A)

SUMMARY OF QUESTIONS BY LEARNING OBJECTIVES

AND BLOOM’S TAXONOMY

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Time: Estimated time to prepare in minutes

AACSB Association to Advance Collegiate Schools of Business

Reflec Thinking Reflective Thinking

CPA CM CPA Canada Competency

cpa-e001 Ethics Professional and Ethical Behaviour

cpa-e002 PS and DM Problem-Solving and Decision-Making

cpa-e003 Comm Communication

cpa-e004 Self-Mgt Self-Management

cpa-e005 Team & Lead Teamwork and Leadership

cpa-t001 Reporting Financial Reporting

cpa-t002 Stat & Gov Strategy and Governance

cpa-t003 Mgt Accounting Management Accounting

cpa-t004 Audit Audit and Assurance

cpa-t005 Finance Finance

cpa-t006 Tax Taxation

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ANSWERS TO QUESTIONS

1 Accounts payable and short-term notes payable are both forms of credit

used by a business to acquire the items or services they need to operate

Both represent obligations of the business to repay amounts in the future

and are therefore considered to be liabilities However, an account payable

is normally for a shorter period of time (e.g., 30, 60, 90 days) than a note

payable A note payable usually provides for a longer period of time to

settle the amount owing

A note payable involves a more formal arrangement than an account

payable A note payable is an obligation in written form and will provide

documentation if legal action is required to collect the debt As well, a note

payable often requires the payment of interest because it is generally used

when credit is to be granted for a longer period of time than for an account

payable

LO 1 BT: K Difficulty: S Time: 5 min AACSB: None CPA: cpa-t001 CM: Reporting

2 An operating line of credit, or credit facility, is used by a business to

overcome short-term cash demands or temporary cash shortfalls that

invariably happen during the operating cycle It is not usually intended to be

a permanent type of financing and is generally used for operations When

needed, the funds are used and then repaid as the liquidity improves and

cash becomes available from operations Short-term bank loans are also

liabilities of the business and are often structured in such a way to deal with

short-term cash needs of the business Short-term bank loans could be

used to finance inventory and accounts receivable Bank loans are for

specific amounts that have structured terms for the repayment of the

principal

LO 1 BT: C Difficulty: M Time: 5 min AACSB: None CPA: cpa-t001 CM: Reporting

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authority It does not keep and report sales tax as revenue; it merely

forwards the amount paid by the customer to the government Therefore,

until it is remitted to the government, sales tax is reported as a current

liability on the statement of financial position

4 Unearned revenue should be recognized when sales of gift cards are made

to customers When a gift card is presented to pay for items or services

received by the customer, the unearned revenue is reduced and the sales

or service revenue increased If there is a legally permissible expiration

date on the gift card, once that date is reached, any unused balances on

gift cards should be recognized as revenue and the related unearned

revenue eliminated

5 When determining whether an uncertain liability should be accrued as a

provision, management must first assess the level of uncertainty

concerning the outcome of a future event that will confirm either the

existence of the liability or the amount payable or both Under IFRS, if the

outcome of a future event is probable and a reasonable estimate can be

made of the amount expected to be paid, the amount will appear as a

current liability on the statement of financial position Probable, in this case

means “more likely than not” which is normally interpreted to mean that

there is more than a 50% probability of occurring

The details of the reasons for the accrual will also be outlined in the

financial statement notes If the outcome is not probable or if the amount

cannot be reasonably estimated, the details of the uncertain liability will be

disclosed in the notes to the financial statements An uncertain liability that

is disclosed rather than recorded is known under IFRS as a contingent

liability On the other hand, if the company is reporting under ASPE, the

probability needs to be “likely” ASPE does not use the term “provision”

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Q 5 (continued)

If the liability is recorded it is referred to as a, contingent liability and there

is no special term for just having the contingency disclosed in a note to the

financial statements rather than recording it This is a higher level of

probability that the standard used in IFRS

LO 1 BT: C Difficulty: C Time: 10 min AACSB: None CPA: cpa-t001 CM: Reporting

6 Current liabilities include those payments that are going to be due for

payment in one year from the financial statement date Non-current

liabilities are to be paid beyond that period Included in current liabilities

would be the principal portion of any loans or debt that will be paid in the

next year Consequently, care must be taken to disaggregate balances of

such non-current loans or mortgages to ensure that the current portion of

the debt is properly classified as a current liability

LO 1,2 BT: C Difficulty: M Time: 5 min AACSB: None CPA: cpa-t001 CM: Reporting

7 Long-term instalment notes are similar to short-term notes in that they both

provide written documentation of a debtor’s obligation to the lender The

main difference between the two types of notes is that long-term instalment

notes have maturities that extend beyond one year and have principal

repayments included in the periodic payments required by the note

For both types of notes, interest expense is calculated by multiplying the

outstanding principal balance by the interest rate However, because a

portion of the principal balance is usually repaid periodically throughout the

term of a long-term instalment note, the outstanding principal balance will

change (decrease) In contrast, the principal balance does not change

throughout the term of a short-term note

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principal through fixed periodic payments relating to the principal along with

any interest that was due at that time Each time a payment is made, a

constant amount of principal repayment is deducted from the note The

total payment amount will decline over time as the interest expense portion

decreases due to reductions in the principal amount of the note

An instalment note with a blended principal and interest payment is

repayable in equal periodic amounts and results in changing amounts of

interest and principal being applied to the note The total payment remains

the same over the life of the note but the portion applied to the principal

increases over time as the interest portion decreases due to reductions in

the principal amount of the note

LO 2 BT: C Difficulty: S Time: 5 min AACSB: None CPA: cpa-t001 CM: Reporting

9 (a) A student choosing the floating rate loan will initially pay a lower

interest rate, but if the prime lending rate changes so does the interest rate that is charged on the balance of the loan Since the loan repayment typically takes several years, a floating interest rate reduces the risk to the financial institution and provides a market return

on their loan to the student With the fixed interest rate, the initial interest rate paid is higher, but the rate does not change over the term

of the loan

(b) If, in the view of the student, interest rates are expected to rise, the

fixed rate of interest is the better choice On the other hand, if interest rates are expected to remain steady or fall, the variable rate loan would

be the better choice

LO 2 BT: C Difficulty: C Time: 5 min AACSB: Analytic CPA: cpa-t001, cpa-t005

CM: Reporting and Finance

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10 Doug is incorrect because the amount of interest paid each month will

decrease as payments are made and the outstanding (remaining) principal

balance decreases The amount of interest is calculated as a percentage

of the outstanding principal amount Because the monthly cash payment

remains constant, over time, greater portions of the payment will be applied

to the principal thereby more rapidly reducing the balance of the mortgage

LO 2 BT: C Difficulty: M Time: 5 min AACSB: Analytic CPA: cpa-t001, cpa-t005

11 (a) Current liabilities should be presented in the statement of financial

position with each major type shown separately They are normally listed in order of maturity, although other listing orders are also possible The notes to the financial statements should indicate the terms, including interest rates, maturity dates, and other pertinent information such as assets pledged as collateral

(b) The nature and the amount of each non-current liability should be

presented in the statement of financial position or in schedules included in the accompanying notes to the statements The notes should also indicate the interest rates, maturity dates, conversion privileges, and assets pledged as collateral

12 Liquidity ratios measure the short-term ability of a company to repay its

maturing obligations Ratios such as the current ratio, receivables turnover,

and inventory turnover can be used to assess liquidity In all three ratios, an

increase in the ratio demonstrates an improvement

Solvency ratios measure the ability of a company to repay its total debt and

survive over a long period of time Ratios that are commonly used to

measure solvency include debt to total assets and times interest earned

ratios In the case of debt to total assets ratio, an increase in the ratio is

often interpreted as a deterioration in solvency, while for the times interest

earned ratio, an increase demonstrates an improvement

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overcome short-term cash demands that invariably happen during the

operating cycle It is not usually intended to be a permanent type of

financing and is generally used for operations When needed, the funds are

used and then repaid as the liquidity improves and cash becomes available

from operations This type of financing is extremely flexible because interest

charges are only incurred for the actual amount of cash borrowed for the

needed period of time when there is a cash shortfall from daily operations

As a consequence, the business does not incur the constant charge for

interest on a long-term bank debt or mortgages and can save on interest

costs The liquidity issues of a business can therefore be effectively dealt

with using an operating line of credit

14 A company’s debt to total asset ratio should be measured in terms of its

ability to manage its debt A company may have a high debt to total asset

ratio but still be able to meet its interest payments because of high income

Alternatively, a company with a low debt to total assets may find itself in

financial difficulty if it does not have sufficient net income to cover required

interest payments Therefore, it is important to interpret these two ratios in

conjunction with one another

15 A company with significant operating leases has obligations that are

reported in the notes to the financial statements rather than on the

statement of financial position This is referred to as off-balance sheet

financing The existence of these off-balance sheet forms of financing

highlights the importance of including the information contained in the notes

in any analysis of a company’s solvency These notes also help the financial

statement user forecast the amount of the future cash outflows that will

occur to satisfy these lease commitments

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*16 (a) A bond is a form of a long-term note payable They are similar in that

both have fixed maturity dates and pay interest The most significant difference between a note payable and a bond is that bonds are often traded on publicly whereas few notes are In addition, bonds tend to

be issued for much larger amounts than notes Because of these differences, generally only large companies use bonds as a form of debt financing

(b) When it comes to large sums of money, a business would consider

the issue of shares or bonds for obtaining the necessary cash Both would be traded publicly Bonds are classified as debt on the statement of financial position and common shares are classified as equity Bonds require principal and interest payments; common shares do not have to be repaid The board of directors may choose

to pay dividends to the common shareholders, however

*17 (a) When a bond is sold at a discount, the proceeds received are less

than the face value of the bond because the stated rate of interest that the bond offers is lower than the market interest rate This has made the bond less attractive to investors who will increase the return they get from the bond by paying less than its face value The bond discount is considered to be an additional cost of borrowing This additional cost of borrowing should be recorded as additional interest expense over the term of the bond through a process called amortization Initially, the discount is recorded by showing the Bond Payable at an amount lower than its face value, but over time this account is increased (credited) so that it will be equal to its face value

by the time it matures The offsetting debit is made to interest expense This is the additional interest expense incurred by the company for selling a bond at a discount When interest is actually paid, this amount is added to interest expense So interest expense will consist of a portion that is paid and a portion relating to the amortization of the discount thereby making it greater than the cash interest paid

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(b) When a bond is sold at a premium, the proceeds received are greater

than the face value of the bond because the stated rate of interest that the bond offers is higher than the market interest rate This has made the bond very attractive to investors who will be prepared to pay

a higher price for the bond than its face value The bond premium is considered to be a reduction in interest This benefit should be recorded through reductions to interest expense over the term of the bond through a process called amortization Initially, the premium is recorded by showing the Bond Payable at an amount higher than its face value, but over time this account is decreased (debited) so that

it will be equal to its face value by the time it matures The offsetting credit is made to interest expense This lowers interest expense to reflect the benefit of the premium When interest is actually paid, this amount is added to interest expense So interest expense will consist

of a portion that is paid minus a portion relating to the amortization of the premium thereby making it lower than the interest paid

LO 4 BT: C Difficulty: C Time: 10 min AACSB: Analytic CPA: cpa-t001 CM: Reporting

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SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 10-1

(a)

Oct 1 Cash ($6,000 + $780) 6,780

Sales 6,000 Sales Tax Payable ($6,000 × 13%) 780

(b)

Oct 1 Cash ($6,000 + $899) 6,899

Sales 6,000 Sales Tax Payable [($6,000 × 5%) +

($6,000 × 9.975%)] 899

LO 1 BT: AP Difficulty: S Time: 10 min AACSB: Analytic CPA: cpa-t001 CM: Reporting

BRIEF EXERCISE 10-2

(a)

Apr 30 Property Tax Expense ($36,000 ÷ 12 × 4) 12,000

Property Tax Payable 12,000

(b)

July 15 Property Tax Payable 12,000

Property Tax Expense ($36,000 ÷ 12 × 2.5) 7,500 Prepaid Property Tax ($36,000 ÷ 12 × 5.5) 16,500 Cash 36,000

(c)

Dec 31 Property Tax Expense 16,500

Prepaid Property Tax 16,500

LO 1 BT: AP Difficulty: M Time: 10 min AACSB: Analytic CPA: cpa-t001 CM: Reporting

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(a) Aug 24 Salaries Expense 15,000

Employee Income Tax Payable 6,258

CPP Payable 743

EI Payable 282

Cash ($15,000 – $6,258 – $743 – $282) 7,717 (b) Aug 24 Employee Benefits Expense 1,138 CPP Payable 743

EI Payable 395

(c) Sept 3 Employee Income Tax Payable 6,258 CPP Payable ($743 + $743) 1,486 EI Payable ($282 + $395) 677

Cash ($6,258 + $1,486 + $677) 8,421 LO 1 BT: AP Difficulty: M Time: 10 min AACSB: Analytic CPA: cpa-t001 CM: Reporting BRIEF EXERCISE 10-4 (a) July 1 Cash 60,000 Bank Loan Payable 60,000 (b) (1) Aug 1 Interest Expense ($60,000 × 5% × 1/12) 250

Cash 250

(2) Aug 31 Interest Expense 250

Interest Payable 250

(3) Sept 1 Interest Payable 250

Cash 250

(4) Oct 1 Interest Expense 250

Cash 250

(c) Oct 1 Bank Loan Payable 60,000

Cash 60,000

LO 1 BT: AP Difficulty: M Time: 10 min AACSB: Analytic CPA: cpa-t001 CM: Reporting

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a) Record and disclose a provision Record and disclose a contingent

(likely is a higher level of probability than probable,

liability, which in turn, is more likely than not)

b) Not recorded, disclose only Not recorded, disclose only

c) Not recorded nor disclosed Not recorded nor disclosed

d) Not recorded, disclose only Not recorded, disclose only

e) Not recorded, disclose only Not recorded, disclose only

LO 1 BT: AN Difficulty: C Time: 10 min AACSB: None CPA: cpa-t001 CM: Reporting

a) The advantage of the fixed interest rate option is that the rate will not

change during the 10-year period, regardless of what happens to interest

rates in the future One could view this feature as a disadvantage in that a

decline in interest rates will not result in a reduction of interest costs In

order to lock in the interest rate for such a long period of time, the monthly

instalment payment and the amount of interest is higher

The disadvantage of the fixed interest rate option becomes the advantage

of the floating interest rate option When interest rates decline, the loan

interest and the monthly instalment payment are reduced The

disadvantage is that if interest rates increase, the opposite will occur

b) Students generally have limited income upon graduation and so the

additional risk of possible increases in instalment payments for student

loans should be avoided The fixed interest rate is recommended

Alternately, choosing the floating rate makes the initial monthly payments

smaller, during the time when earnings may be at their lowest As long as

rates do not increase too much, it could be the less expensive alternative

LO 2 BT: AN Difficulty: M Time: 15 min AACSB: None CPA: cpa-t001 CM: Reporting

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(a) [1] $50,000 × 7% = $3,500

[2] $13,500 – $3,500 = $10,000

[3] $12,800 – $2,800 = $10,000 or same as [2] as fixed principal reduction

[4] $40,000 – $10,000 = $30,000 (or $2,100 ÷ 7% = $30,000)

[5] $10,000 fixed principal reduction [6] + $2,100 = $12,100

[6] $10,000 fixed principal reduction

[7] $30,000 [4] – $10,000 [6] = $20,000

[8] $11,400 – $1,400 = $10,000 fixed principal reduction or $20,000 [7] – $10,000 [9] $10,700 – $700 = $10,000 fixed principal reduction

[10] $10,000 – $10,000 = $0

(b) The current portion of the note at the end of period 3 is the amount of

principal reduction in the next year (period 4), which is $10,000 This leaves

$10,000 ($20,000 less current portion of $10,000) as the non-current

portion of the debt

LO 2 BT: AP Difficulty: C Time: 15 min AACSB: Analytic CPA: cpa-t001 CM: Reporting

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(b) The current portion of the note at the end of period 3 is the amount of

principal reduction in the next year (period 4), which is $10,652 [8] This

leaves $11,394 ($22,046 [6] less current portion of $10,652) as the

non-current portion of the debt

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(a) Fixed principal payment

Monthly

Interest

Period

(A) Cash Payment (B) + (C)

(B) Interest Expense (D) × 4% ÷

12 months

(C) Reduction of Principal ($300,000 ÷ 120)

(D) Principal Balance (D) ̶ (C)

Dec 31, 2017 $3,500 $1,000 $2,500 297,500 Jan 31, 2018 3,492 992 2,500 295,000

2018

Jan 31 Interest Expense 992

Mortgage Payable 2,500 Cash 3,492

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BRIEF EXERCISE 10-9 (CONTINUED)

(b) Blended principal and interest payment

Monthly

Interest

Period

(A) Cash Payment

(B) Interest Expense (D) × 4% ÷

12 mos

(C) Reduction

of Principal (A) – (B)

(D) Principal Balance (D) – (C) Nov 30, 2017

Dec 31, 2017

Jan 31, 2018

$3,037 3,037

$1,000

993

$2,037 2,044

01476.73

$300,000 297,963 295,919

2018

Jan 31 Interest Expense 993

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a Non-current liability

b Current liability

c Current liability

d Neither – any unused portion is not a liability and no balance is outstanding

but line of credit limits should be disclosed in the notes to the financial

i Neither – current asset

j Current liability for the $5,000 due next year The remaining $70,000

balance is a non-current liability

k Neither – because the outcome has a remote probability, it is neither

recorded nor disclosed

LO 3 BT: AP Difficulty: S Time: 10 min AACSB: Analytic CPA: cpa-t001, cpa-t005

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(a) Debt to total assets Improvement

Times interest earned Deterioration

(b) Although Fromage’s debt to total assets ratio improved in 2018, its times

interest earned ratio deteriorated Fromage’s overall solvency appears to

have deteriorated because even though liabilities relative to assets has

fallen, the company is generating less income before income tax and

interest relative to its interest expense than it did in the prior year

LO 3 BT: AN Difficulty: M Time: 10 min AACSB: Analytic CPA: cpa-t001, cpa-t005

*BRIEF EXERCISE 10-13

(a) The proceeds received from the issue of the bonds = face value of the

bonds X price

$200,000 x 96 = $192,000

(b) Interest expense on the first semi-annual interest payment = bond carrying

amount x effective interest rate x 6/12

$192,000 x 7% x 6/12 = $6,720

(c) The semi-annual interest payment based on the coupon rate of 6% x face

value of the bonds x 6/12 = $200,000 x 6% x 6/12 = $6,000

The amortization of the bond discount is $6,720 less $6,000 or $720

The amortization of the bond discount is added to the bond carrying

amount of $192,000 making the carrying amount after the first interest

payment $192,720

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(a) The proceeds received from the issue of the bonds = face value of the

bonds X price

$100,000 x 109 = $109,000

(b) Interest expense on the first semi-annual interest payment = bond carrying

amount x effective interest rate x 6/12

$109,000 x 3% x 6/12 = $1,635

(c) The semi-annual interest payment based on the coupon rate of 5% x face

value of the bonds x 6/12 = $100,000 x 5% x 6/12 = $2,500

The amortization of the bond premium is $2,500 less $1,635 or $865

The amortization of the bond premium is deducted from the bond carrying

amount of $109,000 making the carrying amount after the first interest

payment $108,135

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*BRIEF EXERCISE 10-15

(a) Key inputs: Future value (FV) = $500,000

Market interest rate (i) = 2.5% (5% × 6/12)

Interest payment (PMT) = $15,000 ($500,000 × 6% × 6/12)

Number of semi-annual periods (n) = 10 (5 years × 2)

Present value of $500,000 received in 10 periods

($500,000 × 0.78120) (n = 10, i = 2.5%) $390,600 Present value of $15,000 received each of 10 periods

($500,000 × 3% × 8.75206) (n = 10, i = 2.5%) 131,281 Present value (issue price) of the bonds $521,881

(b) Key inputs: Future value (FV) = $500,000

Market interest rate (i) = 3% (6% × 6/12)

($500,000 × 0.74409) (n = 10, i = 3%) $372,045 Present value of $15,000 received each of 10 periods

($500,000 × 3% × 8.53020) (n = 10, i = 3%) 127,953 Present value (issue price) of the bonds (rounded to $500,000) $500,000

This is rounded because we know that there would be no

discount or premium because the market and stated rate are equal

(c) Key inputs: Future value (FV) = $500,000

Market interest rate (i) = 3.5% (7% × 6/12)

($500,000 × 0 70892) (n = 10, i = 3.5%) $354,460 Present value of $15,000 received each of 10 periods

($500,000 × 3% × 8.31661) (n = 10, i = 3.5%) 124,749 Present value (issue price) of the bonds $479,209

Note to the instructor: Rounding discrepancies may arise depending on whether

present value tables, calculators, or spreadsheet programs are used to determine

the present value

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Bond Premium Amortization

(B) Interest Expense (5% × 6/12

= 2.5%)

(C) Premium Amor- tization (A) – (B)

(D) Unamor- tized Premium (D) – (C)

(E) Bond Carrying Amount ($500,000 + D)

July 1/18 $15,000 $13,047 $1,953 19,928 519,928 Jan 1/19 15,000 12,998 2,002 17,926 517,926

Interest Expense (6% × 6/12

= 3%)

Bond Carrying Amount ($500,000)

July 1/18 $15,000 $15,000 500,000

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BRIEF EXERCISE 10-16 (CONTINUED)

(B) Interest Expense (7% × 6/12

= 3.5%)

(C) Discount Amortization (A) – (B)

(D) Unamortized Discount (D) – (C)

(E) Bond Carrying Amount ($500,000 – D)

$16,772 16,834

$1,772 1,834

$20,791 19,019 17,185

$479,209 480,981 482,815

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Dec 31 Interest Expense 12,998

Bonds Payable 2,002 Interest Payable 15,000

Jan 1 Cash 479,209

Bonds Payable 479,209

July 1 Interest Expense 16,772

Bonds Payable 1,772 Cash 15,000

Dec 31 Interest Expense 16,834

Bonds Payable 1,834 Interest Payable 15,000

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SOLUTIONS TO EXERCISES EXERCISE 10-1

Assets Liabilities Shareholders’

Equity Revenues Expenses

Net Income

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(a)

Mar 17 Cash 56,000

Sales 50,000 Sales Tax Payable ($2,500 + $3,500) 6,000

May 1 Property Tax Expense ($52,800 ÷ 12 × 4) 17,600

Property Tax Payable 17,600

July 1 Property Tax Expense ($52,800 ÷ 12 × 2) 8,800

Prepaid Property Tax ($52,800 ÷ 12 × 6) 26,400 Property Tax Payable 17,600 Cash 52,800

Aug 15 Salaries Expense 81,000

CPP Payable 4,010

EI Payable 1,523

Employee Income Tax Payable 16,020 Pension Payable 6,400 Cash 53,047

15 Employee Benefits Expense 6,142

CPP Payable 4,010

EI Payable 2,132

22 CPP Payable ($4,010 + $4,010) 8,020

EI Payable ($1,523 + $2,132) 3,655 Employee Income Tax Payable 16,020 Cash 27,695

Oct 1 Cash 100,000

Bank Loan Payable 100,000

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EXERCISE 10-3 (CONTINUED)

(b)

Dec 31 Property Tax Expense 26,400

Prepaid Property Tax 26,400

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(a) Dougald Construction

(1) Oct 1, 2017 Cash 250,000

Bank Loan Payable 250,000

(2) Dec 31, 2017 Interest Expense 3,125

(1) Oct 1, 2017 Notes Receivable 250,000

Cash 250,000

(2) Dec 31, 2017 Interest Receivable 3,125

Interest Revenue 3,125 ($250,000 × 5% × 3/12)

(3) July 1, 2018 Interest Receivable ($250,000 × 5% × 6/12) 6,250

Interest Revenue 6,250

Cash 259,375 Interest Receivable ($3,125 + $6,250) 9,375 Notes Receivable 250,000

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EXERCISE 10-4

(a) Since the obligation for providing maintenance on the aircraft exists at the

time of signing the lease, the provision must be recorded at that time When the provision is established (by crediting that account), the offsetting

debit is recorded as an asset that is amortized over the period of the lease

(b) The provision for aircraft maintenance is based on estimates of the costs

that are expected to be incurred when the maintenance work will be

performed in the future Consequently, the amount estimated is subject to

change In the case of accounts payable, the amounts owed are fixed and

determinable

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(B) Interest Expense (D) × 5% × 6/12

(C) Reduction

of Principal ($150,000 ÷ 20)

(D) Principal Balance (D) – (C) Dec 31, 2017

June 30, 2018

Dec 31, 2018

$11,250 11,063

01

$3,750

$7,500 7,500

01476.73

$150,000 142,500 135,000

22,000

Issue of Mortgage

2017 Dec 31 Cash 150,000

Mortgage Payable 150,000

First Instalment Payment

2018 June 30 Interest Expense ($150,000 × 5% × 6/12) 3,750

Second Instalment Payment

Dec 31 Interest Expense

[($150,000 – $7,500) × 5% × 6/12] 3,563 Mortgage Payable 7,500 Cash 11,063

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EXERCISE 10-5 (CONTINUED)

(a) and (b) (continued)

(2) Blended principal and interest payment

Semi-annual

Interest

Period

(A) Cash Payment

(B) Interest Expense (D) × 5% × 6/12

(C) Reduction

(D) Principal Balance (D) – (C) Dec 31, 2017

June 30, 2018

Dec 31, 2018

$9,622 9,622

01

$3,750 3,603

0

$5,872 6,019

01476.73

$150,000 144,128 138,109

22,000

Issue of Mortgage

2017 Dec 31 Cash 150,000

Mortgage Payable 150,000

First Instalment Payment

2018 June 30 Interest Expense

($150,000 × 5% × 6/12) 3,750 Mortgage Payable 5,872 Cash 9,622

Second Instalment Payment

Dec 31 Interest Expense [($150,000

– $5,872) × 5% × 6/12] 3,603 Mortgage Payable 6,019 Cash 9,622

(c) Interest expense for the six-month period ended June 30, 2018 is the same

amount of $3,750 whether the payment is blended or based on fixed principal payments because for this first period, the amount of the principal balance of the loan is the same, at the initial amount of $150,000 Once the six-month period is completed, the principal balance of the mortgage payable on which interest charges are applied changes by a different amount based on whether the principal payment is fixed or is blended with interest, based on the repayment terms of the loan Thereafter, the interest expense will differ under the two approaches

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(B) Interest Expense (D) × 4%

(C) Reduction

(D) Principal Balance (D) – (C) July 1, 2017

June 30, 2018

June 30, 2019

$7,953 7,953

$600

306

$7,353 7,647

$15,000 7,647

(c) On December 31, 2018 another accrual for interest expense would be made

as follows:

Dec 31 Interest Expense ($306 × 6/12) 153

Interest Payable 153

After making the above entry the company would have two current liabilities

relating to the note as follows:

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EXERCISE 10-7

(a) This is a blended principal and interest payment schedule, as the cash

payment is constant at $23,097.48 each year

(b) The interest rate is 5% ($5,000 ÷ $100,000)

(a) Current liabilities would likely include:

Accounts payable and accrued liabilities Current portion of long-term debt

Income taxes payable Dividends payable Deferred (unearned) tenant deposits

Non-current liabilities would likely include:

Long-term debt Deferred income taxes Finance lease obligations

Depending on when the liability will become due, some items listed above

under non-current could instead be current; an example: finance lease

obligations As well, some items listed above as current could be

non-current or portions of the balances could be non-non-current; an example:

deferred (unearned) tenant deposits

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(b)

DOLLARAMA INC

Statement of Financial Position (partial)

February 1, 2015 (in thousands)

Current liabilities

Accounts payable and accrued liabilities $ 175,739 Dividends payable 10,480 Income taxes payable 25,427 Deferred (unearned) tenant deposits 60,475 Current portion of long-term debt 3,846

Total current liabilities 275,967 Non-current liabilities

Long-term debt 560,641 Deferred income taxes 122,184 Finance lease obligations 1,566 Total non-current liabilities 684,391 Total liabilities $960,358

LO 3 BT: AP Difficulty: S Time: 20 min AACSB: Analytic CPA: cpa-t001 CM: Reporting

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(1) Based only on the current ratio, Fruition’s liquidity is improving in

2018 There are proportionately more current assets to pay the current liabilities

(2) To make a proper assessment, information concerning the due dates

for the liabilities and the type of current assets that make up the remaining assets would need to be scrutinized For example, if current assets consisted mainly of cash rather than inventory, we would conclude that the company had greater liquidity Knowing the quality

of receivables and the turnover of the inventory would be useful

(b) Current ratio for 2018:

Paying off the $1 million improves Fruition’s current ratio from 1.6:1 to

1.9:1 This is because $1 million represents a greater percentage of the

denominator than it does the numerator The greater percentage decrease

to the denominator makes the ratio rise

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(c) Having access to an operating line of credit means that cash is available

on a short-term basis and therefore the assessment of the company’s

short-term liquidity is better than it first appeared Although the ability to

access cash improves the liquidity position, it does not necessarily mean

that drawing down the operating line of credit will improve the current ratio

If the unused line of credit were to be fully drawn down, Fruition’s current

assets would increase by the addition of $4 million of cash At the same

time, the current liabilities would increase by the addition of a $4 million

bank loan payable As is demonstrated in the calculation below, the current

ratio would deteriorate to 1.2:1

$4,744 + $4,000 = 1.2:1

$3,011 + $4,000

LO 3 BT: AN Difficulty: M Time: 15 min AACSB: Analytic CPA: cpa-t001, cpa-t005

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Open Text Corporation’s debt to total assets ratio deteriorated slightly in

2015, with the increase from 57.9% to 58.3% The company’s times

interest earned ratio decreased significantly from 10.9 times in 2014 to 5.8

times in 2015 This reveals a deterioration in Open Text’s solvency

(b) Having access to an operating line of credit means that cash is available

on a short-term basis None of the total line of credit available in the amount

of $300 million has been drawn down at the date of the financial

statements Since no liability exists at the end of the year, only a note

disclosure of the available operating line of credit will be needed

LO 3 BT: AN Difficulty: M Time: 15 min AACSB: Analytic CPA: cpa-t001 CM: Reporting

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(a) The Province of Manitoba bonds are trading at a discount

(b) The Loblaw Companies Limited bonds are trading at a premium

(c) Cash (0.999 × $100,000) 99,900

Cash (1.4409 × $100,000) 144,090

(d) When initially issued, both Loblaws and the Province of Manitoba would

have an understanding of the rate of interest demanded by the market, for

equivalent risk, and would consequently set the coupon rate of interest on

their bonds at a level that would be very close to the market interest rate at

that time When the market rate and the coupon rate are the same, the

bonds are issued at par or 100% of the face value of the bond When

issued at par, there are is no premiums or discounts to amortize

(e) The major reason for the change in the price of the bonds since they were

issued is the market rate changes that have occurred since the date of

issuance If the market rate (yield demanded by bondholders) increases,

the price of the bonds will fall and they will trade at a discount If the market

rate decreases, the price of the bonds will rise and they will trade at a

premium

LO 4 BT: AN Difficulty: C Time: 20 min AACSB: Analytic CPA: cpa-t001 CM: Reporting

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Bonds payable, due 2028 800,000

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(b) $1,000,000 face value ($925,613 carrying amount plus unamortized

discount $74,387 at issue date)

(c) The bonds were issued at a discount as the carrying amount of $925,613

is lower than the $1,000,000 face value of the bond at the issue date

(d) Coupon interest rate: Semi-annual payments are $25,000 × 2 divided by

the face value $1,000,000 = 5% per year

Market interest rate: Interest expense April 30 (item [1] of part (a) $27,768)

divided by carrying amount at issue date $925,613 × 2 = 3% × 2 = annual

rate of 6%

(e) The effective rate of interest of 6% is greater than the coupon rate Interest

expense is calculated using the market rate of interest and cash interest

paid is calculated using the coupon rate Therefore, interest expense is

greater than cash interest paid

(f) Interest expense is calculated by multiplying the carrying value of the

bonds by the market rate of interest With each semi-annual payment, the

carrying amount of the bonds increases, from the semi-annual amortization

of the discount, and consequently, the amount of interest expense

increases

(g) The carrying amount of the bonds will be equal to the face value of the

bonds of $1,000,000 as the entire amount of the discount will have been

amortized

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