Chapter 7

Which of the following statements are true?

The more quickly an asset is converted to cash or consumed, the more liquid it is considered. Most businesses provide information about their bill-paying ability by classifying their assets and liabilities according to liquidity.

Simms Accountants charged a client $2,000 cash plus tax for services provided in a state where the service sales tax rate is 6%. As a result of this event, the ______.

cash account increases by $2,120 sales tax liability account increases by $120

A potential obligation arising from a past event is called a(n) _____ liability.

contingent

Loans that provide flexible borrowing and repayment options are called ______.

lines of credit

Bond obligations normally have ______ terms when compared to notes issued to bank.

longer

Assume that a $1,000 face value bond sells at a $200 discount. If the bond has a 6.2% stated rate of interest and a 20 year term to maturity, the effective rate of interest is approximately ______.

9.0% Reason: Total annual interest = ($1,000 × 6.2%) + ($200 ÷ 20) discount = $72. Effective interest rate = $72 annual interest ÷ $800 amount borrowed =.09 or 9%.

Which of the following statements regarding contingent liabilities is true?

For reporting purposes, contingent liabilities are sorted into three categories depending on the likelihood of their becoming actual liabilities. A contingent liability is a potential obligation arising from a past event. The amount or existence of a contingent liability depends on some future event.

On January 1, Year 1, Ocean Enterprises issued bonds with a face value of $60,000, a stated rate of interest of 8% and a five-year term. The effective interest rate at the time of issue was 9%, so the bonds sold for $57,666. Assuming Ocean Enterprises uses the effective interest rate method to amortize the bond discount, calculate the Year 1 discount amortization.

$390 Reason: $57,666 x 9%= $5,190 interest expense is based on effective interest rate × book value - $4,800 interest based on stated rate × face value = $390.

On January 1, Year 1, Hector Inc. issued bonds with a face value of $120,000, a stated rate of interest of 8% and a five-year term. The effective rate of interest at the time of issue was 7%, so the bonds sold for $124,920. Assuming Hector uses the effective interest rate method to amortize the bond premium, calculate the amount of interest expense recognized in Year 1.

$8,744 Reason: $124,920 carrying value × 7% effective interest = $8,744 interest expense.

Agreements that restrict additional borrowing, limit dividend payments, or restrict salary increases are examples of _____ covenants.

restrictive

Loans that require payments of principal and interest at regular intervals are called ______.

installment notes

A line of credit ______.

is normally renewable on a one year term normally has fluctuating interest rates.

A company experienced an event that caused assets, liabilities and cash flow from financing activities to increase, but had no affect on net income. This could be due to ______.

issuing a bond with a 20 year term

Bond interest rates are generally ______ than interest rates charged by bank.

lower

The carrying value of a bond issued at a premium is equal to that face value of the bond ______.

plus the premium

True or false: When a bond is issued, the stated interest rate is determined by current market conditions.

False

Warranty obligations ______.

are reported in financial statements have uncertain timing and amounts

Issuing a bond to borrow money is a(n) ______ transaction.

asset source

Issuing a note to borrow money affects the ______.

balance sheet statement of cash flows

When a bond discount is amortized using the effective interest rate method, the amount of interest expense recognized ______ as the carrying value of the bond liability increases.

increases

The seller of a bond is called the _____, while the buyer of a bond is called the _____.

issuer bondholder

The effective rate of interest investors are willing to accept for a particular bond equals the _____ rate of interest for other investments of similar risk.

market

When a company recognizes a cash revenue event that is subject to state sales tax, the balance in the Cash account increases by ______ the amount of revenue.

more than

The average time it takes a business to convert cash to inventory, inventory to accounts receivable, and accounts receivable back to cash is commonly called the _____ cycle.

operating

In practice, bonds normally pay interest ______.

semiannually

What type of interest rate fluctuates up or down during the loan period?

variable

An easy to understand, but inaccurate method for amortizing bond discounts and premiums is known as the ______ method.

straight-line

True or false: Bond prices are normally expressed as a percentage of the face value.

True

On January 1, Year 1, Ocean Enterprises issued bonds with a face value of $60,000, a stated rate of interest of 8% and a five-year term. The effective interest rate at the time of issue was 9%, so the bonds sold for $57,666. Assuming Ocean Enterprises uses the effective interest rate method to amortize the bond discount, calculate the Year 1 interest expense.

$5,190 Reason: $57,666 carrying value × 9% effective interest = $5,190 interest expense.

On January 1, Year 1, Ocean Enterprises issued bonds with a face value of $60,000, a stated rate of interest of 8% and a five-year term. The effective interest rate at the time of issue was 9%, so the bonds sold for $57,666. Assuming Ocean Enterprises uses the effective interest rate method to amortize the bond discount, what is the carrying value of the bond on January 1, Year 2?

$58,056 Reason: $57,666 carrying value January 1, Year 1 + $390 discount amortized in Year 1= $58,056

On January 1, Year 1, Hector Inc. issued bonds with a face value of $120,000, a stated rate of interest of 8% and a five-year term. The effective rate of interest at the time of issue was 7%, so the bonds sold for $124,920. Assuming Hector uses the effective interest rate method to amortize the bond premium, calculate the premium amortization for Year 1.

$856 Reason: $120,000 x 8%= $9,600 interest expense based on stated rate - $124,920 x 7%= $8,744 interest expense based on effective rate to interest $9,600 - $8,744= $856 in premium amortization.

A $10,000 face value bond that sells for 95 1/4 will yield cash proceeds of ______.

$9,525 Reason: $10,000 × 0.9525= $9,525.

On January 1, Year 1, Hector Inc. issued bonds with a face value of $120,000, a stated rate of interest of 8% and a five-year term. The effective rate of interest at the time of issue was 7%, so the bonds sold for $124,920. Assuming Hector uses the effective interest rate method to amortize the bond premium, calculate the amount of cash paid for interest in Year 1.

$9,600 Reason: $120,000 principal × 8% stated rate of interest = $9,600 cash interest

Assume that a $1,000 face value bond sells at a $100 discount. If the bond has a 7% stated rate of interest and a 5 year term to maturity, the effective rate of interest is approximately ______.

10% Reason: Total annual interest = ($1,000 x 7%) + ($100 ÷ 5) discount = $90. Effective interest rate = $90 annual interest ÷ $900 amount borrowed = 10%.

On January 1, Year 1, Dixon Company issued 10-year, 8% bonds with a $50,000 face value at 96. Immediately after the issue, the carrying value of the bond liability was $_____.

48,000

Which of the following statements are true?

Assets like accounts receivable, inventory, equipment, buildings, land may be pledged as collateral for business loans. Creditors may demand executives to pledge personal assets as well as business assets as security for loans.

Which of the following statements are true?

The amount due at bond maturity is called the face value of the bond. Cash interest payments are based on the stated interest rate. A bond certificate describes the company's obligation to repay the principal.

True or false: Bonds that do not pay high enough interest to attract buyers may be discounted in order to make them more attractive.

True

A company recorded an event that caused assets, liabilities and cash flow from financing activities to increase, but had no affect on net income. This event could have been due to ______.

borrowing money with a two year term to maturity

Borrowing money by issuing a bond increases ______.

cash bonds payable (cash flow from financing activities)

Arlin Company accepted $94,000 in exchange for a $100,000 bond. The $6,000 difference is called a bond _____.

discount

Bond premiums reduce the _____ interest rate.

effective

On January 1, Year 1, Dixon Company issued 10-year, 8% bonds with a $50,000 face value at 96. As a result on this, the statement of cash flows shows a cash flow from ______ activities of _______.

financing, $48,000 Reason: The carrying value of the bonds is equal to the $50,000 of Bonds Payable minus the $2,000 discount. The statement of cash flows would show a $48,000 cash inflow from financing activities.

What type of interest rate remains constant during the term of the loan?

fixed

Warranties normally _____.

guarantee repair or replacement are based on estimates cover a specific time period

Payments on installment loans ______.

include a payment for interest include a repayment of a portion of the principal balance

Semiannual interest means that interest is paid ______.

two times per year