Question & Answer

What are the general rules for measuring and recognizing gain or loss by a debt extinguishment with modification?

What is the required method of amortizing discount and premium on bonds payable? Explain the procedures.

Wie Company has been operating for just 2 years, producing specialty golf equipment for women golfers.

To date, the company has been able to finance its successful operations with investments from its principal owner, Michelle Wie, and cash flows from operations. However, current expansion plans will require some borrowing to expand the company’s production line.

As part of the expansion plan, Wie will acquire some used equipment by signing a zero-interestbearing note. The note has a maturity value of $50,000 and matures in 5 years. A reliable fair value measure for the equipment is not available, given the age and specialty nature of the equipment. As a result, Wie’s accounting staff is unable to determine an established exchange price for recording the equipment (nor the interest rate to be used to record interest expense on the long-term note). They have asked you to conduct some accounting research on this topic.

Instructions

If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.

(a) Identify the authoritative literature that provides guidance on the zero-interest-bearing note. Use some of the examples to explain how the standard applies in this setting.

(b) How is present value determined when an established exchange price is not determinable and a note has no ready market? What is the resulting interest rate often called?

(c) Where should a discount or premium appear in the financial statements? What about issue costs?

The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www.

wiley.com/college/kieso.

Instructions

Refer to P&G’s 2011 financial statements and the accompanying notes to answer the following questions.

(a) What cash outflow obligations related to the repayment of long-term debt does P&G have over the next 5 years?

(b) P&G indicates that it believes that it has the ability to meet business requirements in the foreseeable future. Prepare an assessment of its liquidity, solvency, and financial flexibility using ratio analysis.

Donald Lennon is the president, founder, and majority owner of Wichita Medical Corporation, an emerging medical technology products company. Wichita is in dire need of additional capital to keep operating and to bring several promising products to final development, testing, and production.

Donald, as owner of 51% of the outstanding stock, manages the company’s operations. He places heavy emphasis on research and development and long-term growth. The other principal stockholder is Nina Friendly who, as a nonemployee investor, owns 40% of the stock. Nina would like to deemphasize the R & D functions and emphasize the marketing function to maximize short-run sales and profits from existing products. She believes this strategy would raise the market price of Wichita’s stock.

All of Donald’s personal capital and borrowing power is tied up in his 51% stock ownership. He knows that any offering of additional shares of stock will dilute his controlling interest because he won’t be able to participate in such an issuance. But, Nina has money and would likely buy enough shares to gain control of Wichita. She then would dictate the company’s future direction, even if it meant replacing Donald as president and CEO.

The company already has considerable debt. Raising additional debt will be costly, will adversely affect

Wichita’s credit rating, and will increase the company’s reported losses due to the growth in interest expense. Nina and the other minority stockholders express opposition to the assumption of additional debt, fearing the company will be pushed to the brink of bankruptcy. Wanting to maintain his control and to preserve the direction of “his” company, Donald is doing everything to avoid a stock issuance and is contemplating a large issuance of bonds, even if it means the bonds are issued with a high effective-interest rate.

Instructions

(a) Who are the stakeholders in this situation?

(b) What are the ethical issues in this case?

(c) What would you do if you were Donald?

Matt Ryan Corporation is interested in building its own soda can manufacturing plant adjacent to its existing plant in Partyville, Kansas. The objective would be to ensure a steady supply of cans at a stable price and to minimize transportation costs. However, the company has been experiencing some financial problems and has been reluctant to borrow any additional cash to fund the project. The company is not concerned with the cash flow problems of making payments, but rather with the impact of adding additional long-term debt to its balance sheet.

The president of Ryan, Andy Newlin, approached the president of the Aluminum Can Company (ACC), its major supplier, to see if some agreement could be reached. ACC was anxious to work out an arrangement, since it seemed inevitable that Ryan would begin its own can production. The Aluminum

Can Company could not afford to lose the account.

After some discussion, a two-part plan was worked out. First, ACC was to construct the plant on Ryan’s land adjacent to the existing plant. Second, Ryan would sign a 20-year purchase agreement. Under the purchase agreement, Ryan would express its intention to buy all of its cans from ACC, paying a unit price which at normal capacity would cover labor and material, an operating management fee, and the debt service requirements on the plant. The expected unit price, if transportation costs are taken into consideration, is lower than current market. If Ryan did not take enough production in any one year and if the excess cans could not be sold at a high enough price on the open market, Ryan agrees to make up any cash shortfall so that ACC could make the payments on its debt. The bank will be willing to make a 20-year loan for the plant, taking the plant and the purchase agreement as collateral. At the end of 20 years, the plant is to become the property of Ryan.

Instructions

(a) What are project financing arrangements using special-purpose entities?

(b) What are take-or-pay contracts?

(c) Should Ryan record the plant as an asset together with the related obligation?

(d) If not, should Ryan record an asset relating to the future commitment?

(e) What is meant by off-balance-sheet financing?

Part I: The appropriate method of amortizing a premium or discount on issuance of bonds is the effectiveinterest method.

Instructions

(a) What is the effective-interest method of amortization and how is it different from and similar to the straight-line method of amortization?

(b) How is amortization computed using the effective-interest method, and why and how do amounts obtained using the effective-interest method differ from amounts computed under the straight-line method?

Part II: Gains or losses from the early extinguishment of debt that is refunded can theoretically be accounted for in three ways:

1. Amortized over remaining life of old debt.

2. Amortized over the life of the new debt issue.

3. Recognized in the period of extinguishment.

Instructions

(a) Develop supporting arguments for each of the three theoretical methods of accounting for gains and losses from the early extinguishment of debt.

(b) Which of the methods above is generally accepted and how should the appropriate amount of gain

or loss be shown in a company’s financial statements?

On March 1, 2014, Sealy Company sold its 5-year, $1,000 face value, 9% bonds dated March 1, 2014, at an effective annual interest rate (yield) of 11%. Interest is payable semiannually, and the first interest payment date is September 1, 2014. Sealy uses the effective-interest method of amortization. Bond issue costs were incurred in preparing and selling the bond issue. The bonds can be called by Sealy at 101 at any time on or after March 1, 2015.

Instructions

(a) (1) How would the selling price of the bond be determined?

(2) Specify how all items related to the bonds would be presented in a balance sheet prepared immediately after the bond issue was sold.

(b) What items related to the bond issue would be included in Sealy’s 2014 income statement, and how would each be determined?

(c) Would the amount of bond discount amortization using the effective-interest method of amortization be lower in the second or third year of the life of the bond issue? Why?

(d) Assuming that the bonds were called in and redeemed on March 1, 2015, how should Sealy report the redemption of the bonds on the 2015 income statement?

On January 1, 2014, Nichols Company issued for $1,085,800 its 20-year, 11% bonds that have a maturity value of $1,000,000 and pay interest semiannually on January 1 and July 1. Bond issue costs were not material in amount. Below are three presentations of the long-term liability section of the balance sheet that might be used for these bonds at the issue date.

1. Bonds payable (maturing January 1, 2034) $1,000,000

Unamortized premium on bonds payable 85,800

Total bond liability $1,085,800

2. Bonds payable—principal (face value $1,000,000 maturing

January 1, 2034) $ 142,050a

Bonds payable—interest (semiannual payment $55,000) 943,750b

Total bond liability $1,085,800

3. Bonds payable—principal (maturing January 1, 2034) $1,000,000

Bonds payable—interest ($55,000 per period for 40 periods) 2,200,000

Total bond liability $3,200,000

aThe present value of $1,000,000 due at the end of 40 (6-month) periods at the yield rate of 5% per period.

bThe present value of $55,000 per period for 40 (6-month) periods at the yield rate of 5% per period.

Instructions

(a) Discuss the conceptual merit(s) of each of the date-of-issue balance sheet presentations shown above for these bonds.

(b) Explain why investors would pay $1,085,800 for bonds that have a maturity value of only $1,000,000.

(c) Assuming that a discount rate is needed to compute the carrying value of the obligations arising from a bond issue at any date during the life of the bonds, discuss the conceptual merit(s) of using for this purpose:

(1) The coupon or nominal rate.

(2) The effective or yield rate at date of issue.

(d) If the obligations arising from these bonds are to be carried at their present value computed by means of the current market rate of interest, how would the bond valuation at dates subsequent to the date of issue be affected by an increase or a decrease in the market rate of interest?

Crocker Corp. owes D. Yaeger Corp. a 10-year, 10% note in the amount of $330,000 plus $33,000 of accrued interest. The note is due today, December 31, 2014. Because Crocker Corp. is in financial trouble, D. Yaeger Corp. agrees to forgive the accrued interest, $30,000 of the principal, and to extend the maturity date to December 31, 2017. Interest at 10% of revised principal will continue to be due on 12/31 each year.

Assume the following present value factors for 3 periods.

21/4% 23/8% 21/2% 25/8% 23/4% 3%

Single sum .93543 .93201 .92859 .92521 .92184 .91514

Ordinary annuity of 1 2.86989 2.86295 2.85602 2.84913 2.84226 2.82861

Instructions

(a) Compute the new effective-interest rate for Crocker Corp. following restructure. (Hint: Find the interest rate that establishes approximately $363,000 as the present value of the total future cash flows.)

(b) Prepare a schedule of debt reduction and interest expense for the years 2014 through 2017.

(c) Compute the gain or loss for D. Yaeger Corp. and prepare a schedule of receivable reduction and interest revenue for the years 2014 through 2017.

(d) Prepare all the necessary journal entries on the books of Crocker Corp. for the years 2014, 2015, and

2016.

(e) Prepare all the necessary journal entries on the books of D. Yaeger Corp. for the years 2014, 2015, and 2016.

Halvor Corporation is having financial difficulty and therefore has asked Frontenac National Bank to restructure its $5 million note outstanding. The present note has 3 years remaining and pays a current rate of interest of 10%. The present market rate for a loan of this nature is 12%. The note was issued at its face value.

Instructions

Presented below and on the next page are four independent situations. Prepare the journal entry that

Halvor and Frontenac National Bank would make for each of these restructurings.

(a) Frontenac National Bank agrees to take an equity interest in Halvor by accepting common stock valued at $3,700,000 in exchange for relinquishing its claim on this note. The common stock has a par value of $1,700,000.

(b) Frontenac National Bank agrees to accept land in exchange for relinquishing its claim on this note.

The land has a book value of $3,250,000 and a fair value of $4,000,000.

(c) Frontenac National Bank agrees to modify the terms of the note, indicating that Halvor does not have to pay any interest on the note over the 3-year period.

(d) Frontenac National Bank agrees to reduce the principal balance due to $4,166,667 and require interest only in the second and third year at a rate of 10%.

Daniel Perkins is the sole shareholder of Perkins Inc., which is currently under protection of the U.S. bankruptcy court. As a “debtor in possession,” he has negotiated the following revised loan agreement with United Bank. Perkins Inc.’s $600,000, 12%, 10-year note was refinanced with a $600,000, 5%, 10-year note.

Instructions

(a) What is the accounting nature of this transaction?

(b) Prepare the journal entry to record this refinancing:

(1) On the books of Perkins Inc.

(2) On the books of United Bank.

(c) Discuss whether generally accepted accounting principles provide the proper information useful to managers and investors in this situation.

Samantha Cordelia, an intermediate accounting student, is having difficulty amortizing bond premiums and discounts using the effective-interest method. Furthermore, she cannot understand why GAAP requires that this method be used instead of the straight-line method. She has come to you with the following problem, looking for help.

On June 30, 2014, Hobart Company issued $2,000,000 face value of 11%, 20-year bonds at $2,171,600, a yield of 10%. Hobart Company uses the effective-interest method to amortize bond premiums or discounts.

The bonds pay semiannual interest on June 30 and December 31. Prepare an amortization schedule for four periods.

Instructions

Using the data above for illustrative purposes, write a short memo (1–1.5 pages double-spaced) to Samantha, explaining what the effective-interest method is, why it is preferable, and how it is computed. (Do not forget to include an amortization schedule, referring to it whenever necessary.)

Presented on the next page are four independent situations.

(a) On March 1, 2015, Wilke Co. issued at 103 plus accrued interest $4,000,000, 9% bonds. The bonds are dated January 1, 2015, and pay interest semiannually on July 1 and January 1. In addition, Wilke Co. incurred $27,000 of bond issuance costs. Compute the net amount of cash received by Wilke Co. as a result of the issuance of these bonds.

(b) On January 1, 2014, Langley Co. issued 9% bonds with a face value of $700,000 for $656,992 to yield 10%. The bonds are dated January 1, 2014, and pay interest annually. What amount is reported for interest expense in 2014 related to these bonds, assuming that Langley used the effective-interest method for amortizing bond premium and discount?

(c) Tweedie Building Co. has a number of long-term bonds outstanding at December 31, 2014. These long-term bonds have the following sinking fund requirements and maturities for the next 6 years.

Sinking Fund Maturities

2015 $300,000 $100,000

2016 100,000 250,000

2017 100,000 100,000

2018 200,000 —

2019 200,000 150,000

2020 200,000 100,000

Indicate how this information should be reported in the financial statements at December 31, 2014.

(d) In the long-term debt structure of Beckford Inc., the following three bonds were reported: mortgage bonds payable $10,000,000; collateral trust bonds $5,000,000; bonds maturing in installments, secured by plant equipment $4,000,000. Determine the total amount, if any, of debenture bonds outstanding.

Sabonis Cosmetics Co. purchased machinery on December 31, 2013, paying $50,000 down and agreeing to pay the balance in four equal installments of $40,000 payable each December 31. An assumed interest of 8% is implicit in the purchase price.

Instructions

Prepare the journal entries that would be recorded for the purchase and for the payments and interest on the following dates. (Round answers to the nearest cent.)

(a) December 31, 2013. (d) December 31, 2016.

(b) December 31, 2014. (e) December 31, 2017.

(c) December 31, 2015.

On December 31, 2014, Faital Company acquired a computer from Plato Corporation by issuing a $600,000 zero-interest-bearing note, payable in full on December 31, 2018. Faital Company’s credit rating permits it to borrow funds from its several lines of credit at 10%.

The computer is expected to have a 5-year life and a $70,000 salvage value.

Instructions

(Round answers to the nearest cent.)

(a) Prepare the journal entry for the purchase on December 31, 2014.

(b) Prepare any necessary adjusting entries relative to depreciation (use straight-line) and amortization (use effective-interest method) on December 31, 2015.

(c) Prepare any necessary adjusting entries relative to depreciation and amortization on December 31,

2016.

On April 1, 2014, Seminole Company sold 15,000 of its 11%, 15-year, $1,000 face value bonds at 97. Interest payment dates are April 1 and October 1, and the company uses the straight-line method of bond discount amortization. On March 1, 2015, Seminole took advantage of favorable prices of its stock to extinguish 6,000 of the bonds by issuing 200,000 shares of its $10 par value common stock. At this time, the accrued interest was paid in cash. The company’s stock was selling for $31 per share on March 1, 2015.

Instructions

Prepare the journal entries needed on the books of Seminole Company to record the following.

(a) April 1, 2014: issuance of the bonds.

(b) October 1, 2014: payment of semiannual interest.

(c) December 31, 2014: accrual of interest expense.

(d) March 1, 2015: extinguishment of 6,000 bonds. (No reversing entries made.)

Presented below are selected transactions on the books of Simonson Corporation.

May 1, 2014 Bonds payable with a par value of $900,000, which are dated January 1, 2014, are sold at

106 plus accrued interest. They are coupon bonds, bear interest at 12% (payable annually at January 1), and mature January 1, 2024. (Use interest expense account for accrued interest.)

Dec. 31 Adjusting entries are made to record the accrued interest on the bonds, and the amortization of the proper amount of premium. (Use straight-line amortization.)

Jan. 1, 2015 Interest on the bonds is paid.

April 1 Bonds with par value of $360,000 are called at 102 plus accrued interest, and redeemed.

(Bond premium is to be amortized only at the end of each year.)

Dec. 31 Adjusting entries are made to record the accrued interest on the bonds, and the proper amount of premium amortized.

In each of the following independent cases the company closes its books on December 31.

1. Sanford Co. sells $500,000 of 10% bonds on March 1, 2014. The bonds pay interest on September 1 and March 1. The due date of the bonds is September 1, 2017. The bonds yield 12%. Give entries through December 31, 2015.

2. Titania Co. sells $400,000 of 12% bonds on June 1, 2014. The bonds pay interest on December 1 and

June 1. The due date of the bonds is June 1, 2018. The bonds yield 10%. On October 1, 2015, Titania buys back $120,000 worth of bonds for $126,000 (includes accrued interest). Give entries through

December 1, 2016.

3 4

Instructions

For the two cases prepare all of the relevant journal entries from the time of sale until the date indicated.

Use the effective-interest method for discount and premium amortization (construct amortization tables where applicable). Amortize premium or discount on interest dates and at year-end. (Assume that no reversing entries were made.)

Holiday Company issued its 9%, 25-year mortgage bonds in the principal amount of $3,000,000 on January 2, 2000, at a discount of $150,000, which it proceeded to amortize by charges to expense over the life of the issue on a straight-line basis. The indenture securing the issue provided that the bonds could be called for redemption in total but not in part at any time before maturity at 104% of the principal amount, but it did not provide for any sinking fund.

On December 18, 2014, the company issued its 11%, 20-year debenture bonds in the principal amount of $4,000,000 at 102, and the proceeds were used to redeem the 9%, 25-year mortgage bonds on January 2,

2015. The indenture securing the new issue did not provide for any sinking fund or for redemption before maturity.

Instructions

(a) Prepare journal entries to record the issuance of the 11% bonds and the redemption of the 9% bonds.

(b) Indicate the income statement treatment of the gain or loss from redemption and the note disclosure required.

Good-Deal Inc. developed a new sales gimmick to help sell its inventory of new automobiles. Because many new car buyers need financing, Good-Deal offered a low downpayment and low car payments for the first year after purchase. It believes that this promotion will bring in some new buyers.

On January 1, 2014, a customer purchased a new $33,000 automobile, making a downpayment of $1,000. The customer signed a note indicating that the annual rate of interest would be 8% and that quarterly payments would be made over 3 years. For the first year, Good-Deal required a $400 quarterly payment to be made on April 1, July 1, October 1, and January 1, 2015. After this one-year period, the customer was required to make regular quarterly payments that would pay off the loan as of January 1, 2017.

Instructions

(a) Prepare a note amortization schedule for the first year.

(b) Indicate the amount the customer owes on the contract at the end of the first year.

(c) Compute the amount of the new quarterly payments.

(d) Prepare a note amortization schedule for these new payments for the next 2 years.

(e) What do you think of the new sales promotion used by Good-Deal?

Venezuela Co. is building a new hockey arena at a cost of $2,500,000. It received a downpayment of $500,000 from local businesses to support the project, and now needs to borrow $2,000,000 to complete the project. It therefore decides to issue $2,000,000 of 10.5%, 10-year bonds. These bonds were issued on January 1, 2013, and pay interest annually on each January 1. The bonds yield 10%. Venezuela paid $50,000 in bond issue costs related to the bond sale.

Instructions

(a) Prepare the journal entry to record the issuance of the bonds and the related bond issue costs incurred on January 1, 2013.

(b) Prepare a bond amortization schedule up to and including January 1, 2017, using the effectiveinterest method.

(c) Assume that on July 1, 2016, Venezuela Co. redeems half of the bonds at a cost of $1,065,000 plus accrued interest. Prepare the journal entry to record this redemption.

The following amortization and interest schedule reflects the issuance of 10-year bonds by Capulet Corporation on January 1, 2008, and the subsequent interest payments and charges. The company’s year-end is December 31, and financial statements are prepared once yearly.BLEMS

Amortization Schedule

Amount Carrying

Year Cash Interest Unamortized Value

1/1/2008 $5,651 $ 94,349

2008 $11,000 $11,322 5,329 94,671

2009 11,000 11,361 4,968 95,032

2010 11,000 11,404 4,564 95,436

2011 11,000 11,452 4,112 95,888

2012 11,000 11,507 3,605 96,395

2013 11,000 11,567 3,038 96,962

2014 11,000 11,635 2,403 97,597

2015 11,000 11,712 1,691 98,309

2016 11,000 11,797 894 99,106

2017 11,000 11,894 100,000

Instructions

(a) Indicate whether the bonds were issued at a premium or a discount and how you can determine this fact from the schedule.

(b) Indicate whether the amortization schedule is based on the straight-line method or the effectiveinterest method, and how you can determine which method is used.

(c) Determine the stated interest rate and the effective-interest rate.

(d) On the basis of the schedule above, prepare the journal entry to record the issuance of the bonds on

January 1, 2008.

(e) On the basis of the schedule above, prepare the journal entry or entries to reflect the bond transactions and accruals for 2008. (Interest is paid January 1.)

(f) On the basis of the schedule above, prepare the journal entry or entries to reflect the bond transactions and accruals for 2015. Capulet Corporation does not use reversing entries.

Vargo Corp. owes $270,000 to First Trust. The debt is a 10-year, 12% note due December 31, 2014. Because Vargo Corp. is in financial trouble, First Trust agrees to extend the maturity date to December 31, 2016, reduce the principal to $220,000, and reduce the interest rate to 5%, payable annually on December 31.

Instructions

(a) Prepare the journal entries on Vargo’s books on December 31, 2014, 2015, 2016.

(b) Prepare the journal entries on First Trust’s books on December 31, 2014, 2015, 2016.

Gottlieb Co. owes $199,800 to Ceballos Inc. The debt is a 10-year, 11% note. Because Gottlieb Co. is in financial trouble, Ceballos Inc. agrees to accept some property and cancel the entire debt. The property has a book value of $90,000 and a fair value of $140,000.

Instructions

(a) Prepare the journal entry on Gottlieb’s books for debt restructure.

(b) Prepare the journal entry on Ceballos’s books for debt restructure.