Chapter 14 Review Questions

The interest rate actually earned by a bondholder who buys the bond at a discount, as compared to the stated rate on the bond is: Higher / Lower A.Yes No B.Yes Yes C.No Yes D.No No

(A)When a bond is sold at a discount the effective rate of interest is higher than the stated rate on the bond. This is due to the fact that the amount paid for the bond is less than its face amount, yet the interest earned is the same as that earned if the bond had been sold at par.

The stated rate of interest on bonds is the rate set by the party issuing the bonds.

(T)

Bonds that are secured by stocks and bonds of other corporations are called: A.collateral trust bonds. B.registered bonds. C.serial bonds. D.treasury bonds.

(A)Bonds that are secured by stocks and bonds of other corporations are called collateral trust bonds.

A debt instrument with no ready market is exchanged for property whose fair market value is currently indeterminable. When such a transaction takes place: A.the present value of the debt instrument must be approximated using an imputed interest rate. B.it should not be recorded on the books of either party until the fair market value of the property becomes evident. C.the board of directors of the entity receiving the property should estimate a value for the property that will serve as a basis for the transaction. D.the directors of both entities involved in the transaction should negotiate a value to be assigned to the property.

(A)If the fair value of the property is not determinable and if the debt instrument has no ready market, the present value of the debt instrument must be estimated. The estimation involves approximating (imputing) an interest rate. The imputed interest rate is used to establish the present value of the debt instrument by discounting, at that rate, all future payments on the debt.

If bonds are issued initially at a premium and the effective interest method of amortization is used, interest expense in the earlier years will be: A.greater than if the straight-line method were used. B.greater than the amount of the interest payments. C.the same as if the straight-line method were used. D.less than if the straight line method were used.

(A)Interest expense is based on the carrying value of thebonds (face value plus unamortized premium). Early in the life of the bond issue, interest expense is higher under the effective interest method because the carrying amount of the bonds includes the total premium. Under the straight-line method, the bond premium is allocated equally to each bond interest period. Studying the bond premium amortization table in the text will help demonstrate this relationship.

When a zero-interest-bearing note is given for property, goods, or services, the present value of the note is best measured by: A.the fair value of the property, goods, or services or by an amount that reasonably approximates the fair value of the note. B.the prime interest rate unless that rate is not applicable to the entities involved in the transaction. C.the interest rate on similar notes being offered in the market place for similar property, goods, or services. D.a negotiated interest rate between the issuer of the note and the owner of the property, goods, or services.

(A)Present value is best measured in these circumstances by the fair value of the property, goods, or services involved in the transaction. The interest element is the difference between the face amount of the note and the fair value of the property, goods, or services.

Which of the following is not a characteristic of a project financing arrangement? A.Two or more entities form a new entity to construct an operating plant that will be used by all parties. B.The project must be one that neither entity could enter into on its own. C.The new entity borrows money to finance the project and repays the debt from the proceeds received from the project. D.Payment of the debt is guaranteed by the companies that formed the new entity.

(B)A project financing arrangement has nothing to do with the ability of either entity involved to enter into the project on their own. The other three alternatives (A, C, and D) are relevant characteristics.

If a corporation issues a debenture bond, it means the bond: A.is secured by stocks and bonds of other corporations. B.matures in installments. C.is unsecured. D.may be converted into other securities of the corporation for a specified time after issuance.

(C)A debenture bond is an unsecured bond that is issued on the good name of the company. Alternative A describes a collateral trust bond. Alternative B refers to a serial bond, and alternative D describes a convertible bond.

If bonds are outstanding to maturity any premium or discount as well as any bond issue costs: A.should be written off directly to a bond retirement account as the bond will be redeemed. B.are carried forward and written off in the same manner as that used prior to the maturity date. C.will be fully amortized as their amortization period is designed to coincide with the life of the bond issue. D.should be used to calculate the gain or loss resulting from the maturity of the bonds.

(C)At maturity date of the bonds any premium, discount, or issue costs will be fully amortized. As a result, the carrying amount will be equal to the maturity (face) value of the bond. As the maturity or face value is also equal to the bond's market value at that time, no gain or loss exists.

When debt is extinguished before its maturity date through a refunding transaction, any difference between the reacquisition price of outstanding debt and its net carrying amount per books should be: A.amortized over the remaining original life of the extinguished issue. B.amortized over the life of the new issue. C.recognized currently in income as a loss or gain. D.treated as a prior period adjustment.

(C)Gains or losses from extinguishment of debt should be reported in the income statement.

When a business enterprise enters into what is referred to as off-balance-sheet financing, the company: A.is attempting to conceal the debt from shareholders by having no information about the debt included in the balance sheet. B.wishes to confine all information related to the debt to the income statement and the statement of cash flows. C.can enhance the quality of its balance sheet and perhaps permit credit to be obtained more readily and at less cost. D.is in violation of generally accepted accounting principles.

(C)Many companies enter into off-balance-sheet financing arrangements to enhance their balance sheet and potentially allow future credit to be obtained more readily from potential lenders. There are many off-balance-sheet financing arrangements that companies enter into which are acceptable. However, these arrangements normally have to be disclosed in the footnotes to the financial statements so investors and creditors are not completely void of information on the kinds of arrangements an entity has entered into.

Garcia Company recently has experienced declining profits, liquidity problems, and an unfavorable trend in its debt to equity relationship. The company completed its negotiations in 2019for a creditor to accept 50,000 shares of Garcia common stock in settlement of a note payable for $300,000. Market value of the shares was $200,000. In accounting for this troubled debt restructuring, the appropriate treatment for Garcia is to: A.reduce liabilities by $300,000, increase paid-in capital by $200,000, and increase retained earnings directly for $100,000. B.reduce liabilities by $300,000 and create a separate paid-in capital section entitled "equity of former creditors-$300,000." C.reduce liabilities by $300,000, increase paid-in capital by $200,000, and recognize a gain of $100,000. D.reduce liabilities and increase paid-in capital by $300,000.

(C)When a transfer of noncash assets or the issuance of the debtor's stock can be used to settle a debt obligation in a troubled debt restructuring, the noncash assets or equity interest given should be accounted for at their fair market value. The excess of the carrying amount of the payable over the fair market value of the assets or equity interest transferred should be accounted for as a gain. When equity is issued by the debtor, it is recorded in the normal manner.

Bonds that pay no interest unless the issuing company is profitable are called: A.collateral trust bonds. B.debenture bonds. C.revenue bonds. D.income bonds.

(D)Bonds that pay no interest unless the issuing company is profitable are called income bonds.

Which of the following statements correctly depicts the nature of discounts or premiums as applied to a bond issue? A.When bonds are issued at a discount, the seller has an advantage in that interest payments are based upon an amount less than face value. B.The terms "discount" and "premium" are the same as loss and gain, respectively, to both buyer and seller. C.The difference between the effective rate of interest and the market rate of interest is the reason discounts and premiums arise. D.The net cash outflow (ignoring bond issue costs) to the seller of bonds issued at a premium will be less than the maturity value of the bonds plus total interest payments.

(D)For a $100,000, 10%, 5-year bond issued at a $12,000 premium, the following cash flow applies: Bond Proceeds...$112,000 Interest Expense (5 years at $10,000)......$ 50,000 Maturity Value.........100,000 150,000 Net Cash Outflow......$ 38,000

Long-term debt that matures within one year and is to be converted into stock should be: A.reported as a current liability. B.reported in a special section between liabilities and stockholders' equity. C.reported as noncurrent. D.reported as noncurrent and accompanied with a note explaining the method to be used in its liquidation.

(D)Long-term debt that matures within one year and is to be refinanced, converted into stock, or is to be retired from a bond retirement fund, should be reported as noncurrent and accompanied with a note explaining the method to be used in its liquidation.

A bond premium should be reported in the balance sheet: A.at the present value of the future reduction in bond interest expense due to the premium. B.as a deferred credit. C.along with other premium accounts such as those resulting from stock transactions. D.as a direct addition to the face amount of the bond.

(D)Premiums and discounts on bonds are liability valuation accounts. The accounting profession requires that discounts be shown as deductions from the face value of bonds and premiums must be added to the face value.

Hendrix Corporation exchanged land with a fair market value of $150,000 for Gaye Company's $226,000, zero-interest-bearing, 4-year note. If the $150,000 amount represents the present value of the note at an appropriate rate of interest, Hendrix Corporation should record the difference ($76,000) as: A.gain on the sale of land. B.premium on the sale of land. C.premium on notes receivable. D.discount on notes receivable.

(D)The difference between the fair market value of the land and the face value of this zero-interest-bearing note is considered a discount on the notes. The discount should be amortized over the life of the note.

An imputed interest rate used to determine the present value of a debt instrument may change during the life of the debt if a change occurs in the prevailing interest rate.

(F)An imputed interest rate is determined at the time a debt instrument is issued. Any subsequent changes in prevailing interest rates are ignored.

Any excess of the net carrying amount over the reacquisition price is a loss from extinguishment.

(F)Any excess of the net carrying amount over the reacquisition price is a gain from extinguishment.

When bonds are issued by a corporation, the AICPA requires that the issue be placed with an independent underwriter.

(F)Companies issuing bonds may choose to place privately a bond issue by selling bonds directly to a large institution, financial or otherwise, without the aid of an underwriter. The AICPA has no rules about initial bond placements.

If bonds are sold at a premium, the effective rate of interest is greater than the stated rate of interest.

(F)If bonds sell for more than face value, they are said to have sold at a premium. Thus, the effective rate of interest is less than the stated rate of interest.

Generally, long-term debt, in whatever form, is issued subject to various covenants or restrictions for the protection of corporate stockholders.

(F)Long-term debt is subject to various covenants or restrictions. However, these covenants and restrictions are for the protection of the lenders and the borrowers.

Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations are recorded in the retained earnings statement.

(F)Off-balance-sheet financing is an attempt to borrow monies in such a way that the obligations are not recorded.

In a project financing arrangement, a single company sets up a second company for the purpose of financing a specific project that has a maximum life of five years.

(F)Project financing arrangements arise when (a) two or more entities form another entity to construct an operating plant that will be used by all parties; (b) the new entity borrows funds to construct the project and repays the debt from the proceeds received from the project; and (c) payment of the debt is guaranteed by the entities that formed the new company.

Revenue bonds are bonds whose interest rate is a function of the revenue earned by the company issuing the bonds.

(F)Revenue bonds are bonds whose interest is paid from specified revenue sources. Such bonds are usually issued by airports, school districts, counties, tollroad authorities, and other governmental bodies.

Under the effective interest method semiannual interest expense is computed by multiplying the effective interest rate times a constant carrying value of the bonds.

(F)Under the effective interest method, the interest expense for each interest period is computed by multiplying the effective interest rate times the carrying amount of the bonds at the start of the period. The carrying amount of the bonds either increases (for bonds issued at a discount) or decreases (for bonds issued at a premium) each period by the amount of the amortized discount or premium.

When bonds are issued between interest dates, the purchaser pays for interest accrued since the date the bonds were originally issued.

(F)When bonds are issued between interest dates, the purchaser pays for interest accrued from the last interest payment date to the date of the purchase. Thus, the maximum amount of accrued interest a purchaser can be required to pay is 6 months (assuming semiannual interest).

Bond discount should be reported in the balance sheet as a direct deduction from the face amount of the bond.

(T)

Bonds issued by a corporation represent a means of borrowing funds from the general public or institutional investors on a long-term basis.

(T)

Commodity-backed bonds are redeemable in measures of a commodity such as barrels of oil, tons of coal, or ounces of a rare metal.

(T)

Disclosure is required of future payments for sinking fund requirements and maturity amounts of long-term debt during each of the next 5 years.

(T)

In a troubled debt restructuring the noncash assets or equity interest given should be accounted for at their fair value.

(T)

Long-term debt is ordinarily used by an enterprise as a more or less permanent means of financing to increase the earnings available to stockholders.

(T)

Long-term debt that matures within one year should be reported as a current liability, unless retirement is to be accomplished with other than current assets.

(T)

Mortgage "points" raise the effective interest rate above the rate specified in the note.

(T)

The amortization of a bond discount increases the amount of bond interest expense recorded each period.

(T)

The times interest earned ratio indicates the company's ability to meet interest payments as they come due.

(T)

Two reasons often cited for off-balance sheet financing are: (a) keeping debt off the balance sheet enhances the quality of the balance sheet and permits credit to be obtained more easily and (b) loan covenants often impose a limitation on the amount of debt a company may have.

(T)

When a debtor's serious short-run cash flow problems leads to a modification of terms, the creditor's loss is based on expected cash flows discounted at the historical effective rate of the loan.

(T)

When a zero-interest-bearing note is given in return for property, the present value of the note is measured by the fair value of the property or by an amount that reasonably approximates the market value of the note.

(T)

For a troubled debt restructuring involving only a modification of terms, the gain recorded by the debtor is: A.the excess amount of the total restructured future cash flows over the pre-restructured carrying amount. B.the excess amount of the present value of restructured future cash flows over the pre-restructured carrying amount. C.the excess amount of the pre-restructured carrying amount over the total restructured future cash flows. D.the excess amount of the pre-restructured carrying amount over the present value of restructured future cash flows.

C)Answers (A) and (B) would result in losses to the debtor. Answer (D) is how the creditor would account for its loss, and answer (C) is how the debtor would account for its gain.