Chapters 13-15

Commercial Paper:

A line of credit allows a company to borrow cash without having to follow formal loan procedures and paperwork. Commercial paper refers to unsecured notes sold in minimum denominations of $25,000 with maturities ranging from 1 to 270 days (beyond 270 days the firm would be required to file a registration statement with the SEC). Interest often is discounted at the issuance of the note. Usually commercial paper is issued directly to the buyer (lender) and is backed by a line of credit with a bank. This allows the interest rate to be lower than in a bank loan

Under IFRS, liabilities payable within the coming year are classified as long-term liabilities only if refinancing is completed before the

BALANCE SHEET date.

Bonds that are retired as a consequence of bondholders choosing to convert them into shares of stock

Convertible bonds

Bonds that allow the issuing company to buy back outstanding bonds from the bondholders before their scheduled maturity date

Callable bonds

Capitalize or Expense? Hazard insurance

Capitalize in right-of-use asset

Problem: JE Dec 31

Debit: Interest Expense Credit: Interest payable Debit: Amortization expense Credit: Right-of-use asset

Patty's Bakery is a defendant in a lawsuit in which trademark infringement is claimed. Patty's attorney believes there is very little chance that the company will lose in court and no settlement offer has been made. If Patty's does lose, the damages could be as high as the $50,000 of damages claimed in the lawsuit. How should this loss contingency impact the balance sheet that is currently being prepared?

Do not accrue a loss contingency or disclose the lawsuit in a note. The loss is remote

Accounting Treatment: Sales-Type Lease that Includes a Selling Profit

Expensed in the period of "sale"

Lessee has, in substance, purchased the lease asset

Finance leases

A contingent liability must be accrued as a liability when the loss is:

Probable. Reasonably estimable.

Capitalize or Expense? Maintenance

Record as expense

Which of the following statements about the accounting for loss and gain contingencies are true?

The IFRS definition of "probable" includes a lower threshold than typically associated with "probable" in U.S. GAAP. If there is a range of equally likely outcomes, IFRS would use the midpoint of the range to measure the liability relating to a loss contingency, while U.S. GAAP requires use of the low end of the range.

Which of the following statements about the accounting for convertible bonds is true?

Under IFRS, convertible debt is divided into its liability and equity elements. If the fair value of the bonds cannot be determined, that value can be calculated as the present value of the bonds' cash flows, using the market rate of interest.

Bonds that are backed only by the "full faith and credit" of the issuing corporation

Debenture bonds

Problem: JE for Issuance Lessee

Debit: Right-of-use asset (Present value) Credit: Lease payable (Present value)

Which of the following statements about liabilities is true?

In part, liabilities are probable, future sacrifices of economic benefits that result from past transactions or events.

Capitalize or Expense? Service contract

Record as expense

On May 1, 2018, Fine Co. borrowed $10,000 and signed a two-year note bearing interest at 6% per annum compounded annually. Interest is payable in full at maturity on April 30, 2020. What amount should Fine report as a liability for accrued interest at December 31, 2019?

$1,024.

Both IFRS and GAAP _______ when realization is probable

disclose contingent gains

U.S. GAAP uses the two-model approach;

that is, leases are accounted for as (1) finance leases by lessees (sales-type leases for lessors) or (2) operating leases. Under international standards, all leases are accounted for as finance leases by the lessee (the one-model approach); only lessors apply the classification criteria to distinguish between finance and operating leases.

Fundamental rights and responsibilities of ownership are retained by the lessor and the lessee merely is using the asset temporarily

Operating lease

Bonds that must be redeemed on a prespecified year-by-year basis specified debt issues are satisfied

Sinking fund debentures

Which of the following statements about the classification and accounting for leases are true?

Under U.S. GAAP, lessees classify leases as either financing leases or operating leases. Under U.S. GAAP, lessors classify leases as either sales-type leases or operating leases.

Under IFRS gain contingencies are:

accrued if "virtually certain"

Accounting Treatment: Sales-Type Lease with No Selling Profit

Deferred and expensed over the lease term (by including in the lease receivable)

Accounting Treatment: Operating lease

Deferred and expensed over the lease term (generally on a straight-line basis)

Under GAAP gain contingencies are:

NEVER accrued

Nutramint Inc. had a balance of $175,000 in its warranty liability account as of December 31, 2018. In 2019, Nutramint's warranty expenditures were $125,000. Its warranty expense is calculated as 1% of sales, and Sales in 2019 were $10 million. What was the balance in the warranty liability account as of December 31, 2019?

$150,000.

Karla Salons leased equipment from Smith Co. on July 1, 2021, in a finance lease. The present value of the lease payments discounted at 6% was $81,900. Ten annual lease payments of $10,500 are due each year beginning July 1, 2021. Smith Co. had constructed the equipment recently for $71,500, and its retail fair value was $81,900. The total interest expense (pretax) in Karla's December 31, 2021, income statement would be (ignore taxes):

$2,142.

VanGuard Goods' fiscal year ends on December 31. At the end of the 2019 fiscal year, the company had notes payable of $12 million due on February 8, 2020. VanGuard issued 2 million shares of common stock on February 2, 2020 for $9 million. The proceeds from that issuance along with $3 million from the maturation of some 3-month CDs were used to pay the notes payable on February 8. Vanguard's financial statements were issued on February 23, 2020. What amount, if any, related to the notes payable described should VanGuard report among current liabilities on its December 31, 2018 balance sheet?

$3 million.

MSG Corporation has $1,000,000 of 10-year, 6% bonds outstanding on December 31, 2018. The bonds have 3 years remaining to maturity. Assume interest is paid at the end of each month. The unamortized premium remaining on these bonds was $60,000. MSG uses straight-line amortization, so the unamortized premium would be $40,000 on December 31, 2019, provided none of the bonds had been retired before that day. On May 1, 2019, $100,000 of the bonds were retired at 112. How much, and what type of gain or loss, results from the retirement?

$6,667 nonoperating loss

Zilch Inc. manufactures and leases computer systems. Zilch leases several computers to Five Star Company on January 1, 2021. The manufacturing cost of the computers was $6 million. This non-cancelable lease had the following terms (numbers made up): Lease payments: $1,300,000 semiannually; first payment at January 1, 2021; remaining payments at June 30 and December 31 each year through June 30, 2025. Lease term: five years (10 semiannual payments). No residual value; no purchase option. Economic life of equipment: five years. Implicit interest rate and lessee's incremental borrowing rate: 5% semiannually. Fair value of the computers at January 1, 2021: $10 million. What is the outstanding balance of the lease liability in Lone Star's June 30, 2021, balance sheet?

$7,835,000.

In May of 2019, Raymond Financial Services became involved in a tax dispute with the IRS. On December 31, 2019, the tax attorney for Raymond indicated that an unfavorable outcome to the dispute was probable. The additional taxes were estimated to be $770,000 but could be as high as $1,170,000. After the year-end, but before the 2019 financial statements were issued, Raymond accepted an IRS settlement offer of $900,000. Raymond should have reported the following accrued liability amount on its issued balance sheet dated December 31, 2019:

$900,000

I.D. Clair Co. recorded a right-of-use asset of $100,000 in a 10-year operating lease. Payments of $14,795 are made annually at January 1 of each year beginning January 1, 2021. The interest rate charged by the lessor was 10%. The balance in the right-of-use asset at December 31, 2021, will be: (Round your answer to the nearest whole dollar amount.)

$93,726. 10% × ($100,000 - 14,795) = $8,521. So, amortization will be $14,795 - 8,521 = $6,274. The year-end balance, then, will be $100,000 - 6,274 = $93,726

Short Term Obligations:

(including the callable obligations we discussed in the previous section) that are expected to be refinanced on a long-term basis can be reported as noncurrent, rather than current, liabilities only if two conditions are met: (1) The company must intend to refinance on a long-term basis, and (2) the company must actually have demonstrated the ability to refinance on a long-term basis. Ability to refinance on a long-term basis can be demonstrated by either an existing refinancing agreement or by actual financing prior to the issuance of the financial statements.

Barry Company has a calendar year-end. On December 15, Year 1, a customer was injured using a product manufactured by Barry. That customer files a lawsuit against Barry on January 15, Year 2. On February 15, Year 2, Barry's attorney advises Barry to settle the claim for $100,000 because a loss in that amount is probable and material. Barry has not yet distributed its Year 1 financial statements. What must Barry do with regards to those financial statements?

Accrue the loss as of December 31, and disclose the lawsuit in the notes to the financial statements. Even though the lawsuit was not filed until after year-end, the event giving rise to it happened during the year. In this case, since the loss is probable, it should be accrued and disclosed.

Which of the following descriptions about commercial paper are true?

Allows a company to borrow cash without having to follow formal loan procedures and paperwork. Interest is often discounted at issuance

Boyd Corp. issued $1,500,000 of 9% nonconvertible bonds at 107, due in 10 years. Each $1,000 bond was issued with 45 detachable stock warrants, each of which entitled the holder to purchase, for $70, one share of Boyd's $40 par common stock. The market price of each warrant was $7. How much of the proceeds should be allocated to the warrants issued?

Amount of proceeds allocated to the warrants issued: 472,500 Amount attributable to the warrants = $7 each × 45 warrants per bond = $315 × 1,500 bonds = $472,500.Fair value of warrants issued = Number of warrants issued × Fair value of each warrant Fair value of warrants issued = [($1,500,000 total face value ÷ $1,000 face value per bond) × 45 warrants per bond)] × $7 per warrant = $472,500

Reporting long-term debt:

Because both interest expense and interest revenue are components of the income statement, both parties to the transaction report interest among operating activities. In the balance sheet, long-term debt (liability for the debtor; asset for the creditor) typically is reported as a single amount, net of any discount or increased by any premium, rather than at its face amount accompanied by a separate valuation account for the discount or premium. In a statement of cash flows, issuing bonds or notes are reported as cash flows from financing activities by the issuer (borrower) and cash flows from investing activities by the investor (lender).The fair value of financial instruments must be disclosed either in the body of the financial statements or in disclosure notes.

Bond X and bond Y are issued by the same company on the same day. Each bond has a maturity value of $100,000 and each pays interest at 10%. The current market rate of interest is 10%. Bond X matures in 5 years while bond Y matures in 10 years. Which of the following is correct?

Both bonds will sell for the same amount.

Which of the following statements about financial statement disclosures appropriate to long-term debt are true?

Both interest expense and interest revenue are reported among operating activities on the statement of cash flows. The fair value of financial instruments must be disclosed either in the body of the financial statements or in disclosure notes.

Capitalize or Expense? Property taxes

Capitalize in right-of-use asset

Kelly Company issued $100,000 of 5%, 10-year bonds at 102 to a single investor. Each of the $1,000 bonds was convertible into 100 shares of no par common stock. The bonds were later converted when the remaining unamortized premium was $1,000. What is the amount that Kelly will credit to Common Stock when recording the conversion of the bonds?

Credit to common stock: 101,000 The conversion would be recorded with a debit to Convertible Bonds Payable for $100,000, a debit to Premium on Bonds Payable for $1,000, and a credit to Common Stock for $101,000.

Assume that a lessor applies the five criteria to a lease involving equipment and determines that a lease should be classified as a sales-type lease. The entry the lessor will record at the beginning of the lease will include a:

Debit to Lease receivable for the present value of the lease payments. The entry by the lessor at the beginning of a sales-type lease includes a debit to Lease receivable for the present value of the payments to be received and a credit to the Equipment account for the carrying amount of the equipment to remove the equipment being leased from its balance sheet.

Barrington Corporation paid $26,000 to have bond certificates printed and engraved, $100,000 in legal fees, and $8,000 to a CPA for registration information. Barrington sold the bonds to an underwriter. The spread between the price the underwriter paid and the resale price was $230,000. What is the amount of debt issue costs?

Debt issue Cost: 364,000 Debt issue costs = Printing costs + Legal fees + CPA fees + Underwriting fees Debt issue costs = $26,000 + $100,000 + $8,000 + $230,000 = $364,000

On February 1, Armstrong, Inc., borrowed $200,000 cash from First Bank under a noncommitted short-term line of credit arrangement and issued a three-month, 12% promissory note. Prepare the appropriate journal entry dated May 1 for the payment of principal and interest made at maturity.

Debt: Notes payable 200,000 Debit: Interest Expense 6,000 Credit: Cash 206,000 Interest = $200,000 × 12% × 3/12 = $6,000

Equinox is a local boutique that sells gift cards especially before holidays. At November 30, the company's Deferred gift card revenue account had a balance of $400. During December, the company sold additional gift cards in the amount of $5,000, customers redeemed $1,000 of gift cards, and unused gift cards in the amount of $300 expired. What is the balance of Deferred gift card revenue that will be reported at December 31?

Deferred Gift Revenue: 4,100 Ending balance = Beginning balance of $400 + Gift cards sold of $5,000 − Gift cards redeemed of $1,000 − Gift cards expired of $300 = $4,100

Payson Company filed a lawsuit against Leer Company for $1 million. While the financial statements for Payson are being prepared, the company's attorney advises Payson's management that a settlement in the amount of $500,000 is probable in the case. The potential settlement is material to Payson's financial position. How should Payson reflect this situation in its financial statements?

Even if the receipt of the settlement is not probable, disclosure should be made. However, no accrual should be recorded.

Touché, Inc. issued 9%, $1,300,000 bonds for $1,600,000. Touché reacquired these bonds for $1,365,000 when their book value was $1,436,500. What was the gain or loss on the early extinguishment of this debt?

Gain of $71,500 When the debt is retired for less than book value, the debtor records a gain. Gain on early extinguishment of debt = Book value of debt − Reacquisition price Gain on early extinguishment of debt = $1,436,500 − $1,365,000 = $71,500

IFRS vs GAAP loss/gain contingency differences:

IFRS defines "probable" as "more likely than not" (greater than 50%), which is a lower threshold than typically associated with "probable" in U.S. GAAP. If a liability is accrued, IFRS measures the liability as the best estimate of the expenditure required to settle the present obligation. If there is a range of equally likely outcomes, IFRS would use the midpoint of the range, while U.S. GAAP requires use of the low end of the range.

Kent Company has a calendar year-end. On December 15, Year 1, a customer was injured using a product manufactured by Kent. That customer has not yet filed a lawsuit or made a claim. Kent has not yet distributed its Year 1 financial statements. What must Kent do with regards to those financial statements?

If it is probable that a claim will be asserted, it should be treated as if the claim had been asserted.

On January 1, Year 1, Willette Company sold $240,000 of 6% ten-year bonds. Interest is payable semiannually on June 30 and December 31. The bonds were sold for $180,181, priced to yield 10%. Using the straight-line method, what is the amount of interest expense that Willette will report for the six months ended June 30, Year 1?

Interest Expense: 10,191 Semiannual interest payment = Face amount × (Stated rate ÷ 2)Semiannual interest payment = $240,000 × (6% ÷ 2) = $7,200 Allocation of discount = (Face amount of bonds − Issue price) ÷ Number of interest payments Allocation of discount = ($240,000 - $180,181) ÷ (10 years × 2 payments per year) = $59,819 ÷ 20 = $2,991 Interest expense recorded each interest period = Interest payment + Allocation of discount Interest expense recorded each interest period = $7,200 + $2,991 = $10,191

On January 1, Year 1, Chaco Company sold $300,000 of 10% twenty-year bonds. Interest is payable semiannually on June 30 and December 31. The bonds were issued for $359,378, priced to yield 8%. What is the amount of effective interest expense that Chaco will record for the six months ended June 30, Year 1?

Interest Expense: 14,375 Interest expense = Effective semiannual interest rate × Outstanding balance Interest expense = (8% ÷ 2) × $359,378 = $14,375

On January 1, Year 1, Maverick Company sold bonds that pay interest semiannually on June 30 and December 31. Maverick has a fiscal year-end of February 28. The amortization schedule for these bonds shows a cash payment of interest of $7,200 and effective interest of $9,009 relating to the interest payment that will be made on June 30, Year 1. What is the amount of interest expense that should be accrued by Maverick in an adjusting entry dated February 28, Year 1?

Interest Expense: 3,003 Interest expense = Effective interest for first interest period × Period of time covered by adjusting entry Interest expense = $9,009 × 2/6 = $3,003

On January 1, Year 1, Willette Company sold $240,000 of 6% ten-year bonds. Interest is payable semiannually on June 30 and December 31. The bonds were issued for $180,181, priced to yield 10%. What is the amount of effective interest expense that should be recorded for the six months ended June 30, Year 1?

Interest Expense: 9,009 Interest expense = Effective semiannual interest rate × Outstanding balance Interest expense = (10% ÷ 2) × $180,181 = $9,009

On January 1, Year 1, Savor Corporation leased equipment to Spree Company. The lease term is 9 years. The first payment of $698,000 was made on January 1, 2018. The present value of the lease payments is $4,561,300. The lease is appropriately classified as an operating lease. Assuming the interest rate for this lease is 9%, how much interest revenue will Savor record in Year 1 on this lease?

Interest Revenue: 0 When a lease is classified as an operating lease, the lessor will report lease revenue rather than interest revenue (which it would have reported if this had been a sales-type lease). In other words, the lessor does not report any interest revenue for an operating lease.

On January 1, 2018, Savor Corporation leased equipment to Spree Company. The lease term is 9 years. The first payment of $698,000 was made on January 1, 2018. The present value of the lease payments is $4,561,300. The lease is appropriately classified as a sales-type lease. Assuming the interest rate for this lease is 9%, how much interest revenue will Savor record in 2018 on this lease?

Interest revenue: 347,697 Interest = Outstanding balance × 9%Interest = ($4,561,300 − $698,000) × 9% = $347,697

Which of the following statements about why companies frequently choose to lease assets are true?

Leasing offers flexibility when disposing of the asset. Leasing reduces the upfront cash needed to use an asset. Leasing MIGHT offer protection against the risk of declining asset values. SOMETIMES leasing offers tax savings over outright purchases.

On February 1, 2015, Pat Weaver Inc. (PWI) issued 10%, $1,000,000 bonds for $1,116,000. PWI retired all of these bonds on January 1, 2016, at 102. Unamortized bond premium on that date was $92,800. How much gain or loss should be recognized on this bond retirement?

Paid at redemption: $1,000,000 × 102% = $1,020,000 Book value: $1,000,000 + $92,800= 1,092,800 Gain on bond retirement $72,800

Lessor transfers control of lease asset to lessee, with or without a selling profit on the sale of the asset

Sales-type lease

Which of the following statements about short-term obligations that are expected to be refinanced is true?

Short-term obligations that are expected to be refinanced on a long-term basis can be reported as noncurrent liabilities only if the company intends to refinance on a long-term basis and the company has actually demonstrated the ability to refinance on a long-term basis.

Bonds for which the holder is not entitled to receive any liquidation payments until the claims of other specified debt issues are satisfied

Subordinated debentures

The amortization of a right-of-use asset over the lease term is computed by:

Subtracting the amount needed for interest from the straight-line lease payment. The lessee records interest the normal way (that is, as it would under a finance lease) and then "plugs" the right-of-use asset amortization at whatever amount is needed for interest plus amortization to equal the straight-line lease payment. In other words: Annual amortization = Lease payment − Interest expense.

On January 1, Leveler Corporation leased equipment to Messy Company. The present value of the lease payments is $200,000 and Leveler's cost of the equipment was $125,000. The lease is properly classified as a sales-type lease. In comparison to the entries that would have been made if this lease did not include a selling profit, how are the entries affected because this lease includes a selling profit?

The entries made by Messy (lessee) are not affected. The entry made by Leveler(lessor) to record the receipt of the first lease payment also will include the sales revenue and cost of goods sold.

Assume that the five classification criteria are applied to a lease involving equipment and, because none of the criteria is met, it is determined that a lease should be classified as an operating lease. At the beginning of the lease, the lessee:

The entry by the lessee to record an operating lease includes a debit to Right-of-use asset and a credit to Lease payable for the present value of the lease payments. The lessor does not record a lease receivable and does not remove the equipment from its books.

The lessee reports lease expense on a straight-line basis and the lessor reports lease revenue on a straight-line basis over the lease term.

The lease term (including any options to renew or extend) is twelve months or less. The lease does not contain a purchase option that the lessee is reasonably certain to exercise, which would extend the term beyond twelve months.

Under an operating lease:

The lessee reports a single amount of lease expense, which is equal to interest expense plus amortization expense, in its income statement. The lessee reports lease expense on a straight-line basis and the lessor reports lease revenue on a straight-line basis over the lease term.

Assume that Levier Corporation elected the fair value option for reporting bonds and the bonds decreased in fair value during the year. Which of the following statements is correct?

The portion of that that gain that is a result of a change in general interest rates is reported as part of net income, while any portion of that gain that is a result of a change in the "credit risk" of the debt is reported as other comprehensive income (OCI).

Which of the following statements about the classification of obligations expected to be refinanced?

Under IFRS, liabilities payable within the coming year are classified as long-term liabilities only if refinancing is completed before the BALANCE SHEET date. Under U.S. GAAP, liabilities payable within the coming year are classified as long-term liabilities if refinancing is completed before the date of issuance of the FINANCIAL STATEMENTS

Accounting for convertible bonds IFRS VS GAAP

Under IFRS, unlike U.S. GAAP, convertible debt is divided into its liability and equity elements. If the fair value of the bonds cannot be determined from an active trading market, that value can be calculated as the present value of the bonds' cash flows, using the market rate of interest. The currently acceptable practice under U.S. GAAP is to record the entire issue price as debt. Under IFRS, convertible debt is divided into its liability and equity elements.

Manor Inc. sells washing machines that include a two-year warranty covering parts. Experience shows that warranty expense averages about 2% of the selling price of each machine during the first 12 months following the sale and 1% during the next 12 months. Net sales totaled $400,000 during Year 1, the company's first year of operations. Actual warranty costs incurred totaled $7,900 during Year 2 and $4,000 during Year 3. What is the amount of warranty expense that should be reported on the income statement for Year 1?

Warranty expense: 12,000 Warranty expense = (2% + 1%) × $400,000 = $12,000

US GAAP and IFRS differ on when and how a loss contingency should be accrued. Which of the following statement is most correct?

When a contingent loss is probable and a range has been identified with all amounts having equal probability, then in all instances IFRS requires that the average of the range be accrued in the financial statements.

Amortization of a right-of-use asset over the lease term is recorded by the:

lessee amortizes its right-of-use asset over the lease term with a debit to Amortization Expense and a credit to Right-of-use asset.

Under U.S. GAAP, liabilities payable within the coming year are classified as long-term liabilities if refinancing is completed before

the date of issuance of the FINANCIAL STATEMENTS