AC 311 Exam 1
quality-assurance warranty
-a guarantee by the seller that the customer will be satisfied with the goods or services that the seller provided -there may be a future sacrifice of economic benefits due to an existing circumstance that depends on an uncertain future event -the criteria for accruing a contingent loss almost always are met for product warranties
in the balance sheet, long-term debt is reported as:
-a single amount, net f any discount or increased by any premium, rather than its face amount
Adams Corporation's balance sheet reports $100 million in bonds payable. Felix Company who purchased some of Adams' bonds will report the bonds as
-an investment
gain contingency
-an uncertain situation that might result in a gain. example: in a pending lawsuit, one side-the defendant-faces a loss contingency; the other side-the plantiff-has a gain contingency -gain contingencies are not accrued. recognizing gains should wait their realization -material gain contingencies are disclosed in notes to the financial statements
if a company retires shares repurchased for a higher price than what it was originally issued, the repurchase transaction will result in a:
-decrease in paid-in-capital and retained earnings
example of accrual of the contingent liability for warranties in the reporting period in which the product under warranty is sold: -Two-year warranty against defects. Estimates based on industry experience indicate warranty costs of 3% of sales during the first 12 months following the sale and 4% the next 12 months. During December 2021, its first month of availability, $2 million units sold
-during december: DR Cash for $2 million, CR Sales Revenue for $2 million -december 31, 2021 (adjusting entry): DR Warranty Expense for $140,000 =[(3%+4%)*$2 million] CR Warranty Liability for $140,000 when customer claims are made and costs are incurred to satisfy those claims, the liability is reduced (lets say $61,000 in 2022) DR Warranty Liability for $61,000, CR Cash for $61,000
Periodic interest expense on liabilities is calculated by multiplying the amount of debt outstanding during the period by the
-effective interest rate
effective interest method
-effective market rate of interest multiplied by the outstanding balance of debt -straightforward application of the accrual concept, whereby interest expense or revenue is accrued periodically at the effective rate -record that amount of interest expense or revenue accrued even though the cash interest is a different amount
subsequent events
-for a loss contingency to be accrued, the cause of the lawsuit must have occurred before the accounting period ended. It's not necessary that the lawsuit actually was filed during that reporting period. -any event occurring after the fiscal year-end but before the financial statements are issued that has a material effect on the company's financial position must be disclosed in a subsequent events disclosure note. Examples are an issuance of debt or equity securities, a business combination, and discontinued operations
if a company sells shares previously recorded as treasury stock at a price higher than their repurchase price, the resale transaction will result in a:
-increase in paid-in-capital and no impact on retained earnings
effective (or market) rate
-interest expense (issuer) & revenue (investor) are calculated on the outstanding debt balance
bonds sold at premium
-interest on bonds issued at premium is determined in precisely the same manner as bonds issued at discount -interest is the effective interest rate applied to the debt balance outstanding during each period, and the cash paid is the stated rate time the face face amount -the difference between the two is the amortization of the premium
extended warranties example: Brand name appliances sell major appliances that carry a one-year manufacture's warranty. Customers are offered the opportunity at the time of the purchase to also buy a three-year extended warranty for an additional charge. On January 3, 2021, Brand name sold a $60 extended warranty, covering years 2022, 2023, and 2024
-january 3, 2021 DR Cash (or AR) for $60, CR Deferred revenue-extended warranties for $60 -december 31, 2022, 2023, 2024 (adjusting entries) DR Deferred revenue-extended warranties for $20, CR Revenue-extended warranties for $20 =($60/3 years) -the costs incurred to satisfy customer claims under the extended warranties also will be recorded during the same three-year period. That way, net income in each year of the extended warranty will reflect both the warranty recognized and the costs associated with that revenue
debt issuance costs
-reduce the cash proceeds from the issuance of debt, they reflect a higher cost of borrowing -by reducing debt issuance costs, we lower the carrying value amount of the debt, which increases the interest rate on that debt -the net borrowed is less, but interest payments are the same, so the effective rate of borrowing is higher
callable bonds
-reedemable, allows the issuing company to buy back, or call, outstanding bonds from bondholders before their scheduled maturity date
unasserted claims and assessments
-sometimes companies are aware of a potential claim that has not yet been made. such unasserted claims may require accrual or disclosure of a contingent liability. a two-step process is involved in deciding how the unasserted claim should be reported: -1. is it probable that a claim will be asserted? if "no" then stop, no accrual or disclosure is necessary. If "yes" go on to step 2 -2. treat the claim as if the claim has been asserted. that requires evaluating (a) the likelihood of an unfavorable outcome and (b) whether the $ amount of loss can be estimated -an estimated loss and contingent liability would be accrued only if an unfavorable outcome is probable and the amount can be reasonably estimated. a disclosure note alone would be appropriate if an unfavorable settlement is only reasonably possible or if the settlement is probably but cannot be reasonably estimated.
as the premium is reduced by amortization
-the book value of the bonds declines toward face value -this is because the effective interest each period is less than the cash interest paid
when the effective interest each period is more than the cash paid when bonds are at discount..
-the discount is reduced by amortization, the book value of the bonds increases towards the face value
stockholders equity is impacted by all of the following expect:
-the distribution of cash dividends
the disclosure note for debt includes:
-the nature of the company's liabilities, interest rates, maturity dates, call provisions, conversion options...
bond indenture
-the specific promises made to bondholders described in this document
product warranties
-the traditional way of measuring a warranty obligation is to report the "best estimate" of future cash flows, ignoring the time value of money on the basis of immateriality -However, when the warranty obligation spans more than one year we can associate probabilities with possible cash flow outcomes: This "expected cash flow approach" incorporates specific probabilities of cash flows into the analysis -A product warranty liability and warranty expense should be recorded at the time the product is sold, if it is probable that customers will be making claims under the warranty and the amount can be estimated -When the warranty liability is both probable and can be estimated, the accountant will accrue in the period of the sale a liability and an expense for the future warranty work. (This matching of warranty expense with the related sales revenue is reasonable, since the warranty could be as important in getting the sale as the product's advertising expense.)
A disclosure note is required for all material loss contingencies for which the probability of loss is reasonably possible
-true
debt issue costs of $14,000
DR Cash for $652,633 =($666,663 prices - $14,000 issuance costs, DR Discount and Debt issuance cost for $47,367 (difference), CR Bonds payable for $700,000 (face amount)
the fair value of financial instruments:
must be discloses either in the body of the financial statements or in disclosure notes
subordinated debenture
not entitled to receive any liquidation payments until the claims of other specified debt issues are satisfied
forces of supply and demand cause a bond issue to be..
priced to yield the market rate -an investor paying that price will earn an effective rate of return on the investment equal to the market rate
Daria Corp. reported an accumulated other comprehensive income of $62 million on their 12/31/31 Balance Sheet. On the statement of Comprehensive Income for the year ended 12/31/2021, Percy reported net income of $540 million and other comprehensive income of $29 million. what was the 12/31/20 balance of accumulated other comprehensive income?
-$33 million -two attributes of other comprehensive income are reported: 1) the components of comprehensive income created during the reporting period ($29 million in this instance) and 2) the comprehensive income accumulated over the current and prior periods ($62 million at the end of this year). -the $62 million represents the cumulative sum of changes in each component created during each reporting period throughout all prior years. Since this amount increased by $29 million, the balance sheet must have been $33 million last year
Houston Inc. became involved in a penalty dispute with a regulatory agency in June of 2022. At December 31, 2022, Houston's attorney indicated that an unfavorable outcome to the dispute was probable and the penalties were estimated to be $765,000 but could be as high as $1,165,000. After the year-end, but before the 2022 financial statements were issued, Houston and the regulatory agency reached a settlement of $890,000. What amount of liability should Houston report on its balance sheet as of December 31, 2022?
-$890,000
the debt issuance costs of $14,000 has the effect of increasing the effective rate from 7% semiannually to 7.4389%
-DR Interest expense for $48,549 =(652,633 x 7.439%) CR Discount and debt issuance costs for $6,549 (difference) CR Cash for $42,000 =($700,000 cash x 6% stated rate)
warranty expense example: Hanover grants a two-year warranty for each processing machine sold. Past experiences indicates that the costs of satisfying warranties are approximately 2% of sales. During 2021, sales of machines totaled $21,300,000. 2021 expenditures for warranty repair costs were $178,000 related to 2021 sales and $220,000 related to 2020 sales. The January 1, 2021, balance of the warranty liability account was $250,000
-DR warranty expense for $426,000 =(2%*21,300,000), CR Warranty Liability for $426,000 -DR Warranty Liability for $398,000 =($178,000 + $220,000), CR Cash for $398,000
On January 1, a company issued 2%, 10-year bonds with a face amount of $70 million for $58,553,901 to yield 4%. Interest is paid semiannually. What was the interest expense at the effective interest rate on the December 31 annual income statement?
-June 30 DR Interest expense (2% × $58,553,901) 1,171,078 CR Discount on bonds payable (difference) 471,078 CR Cash (1.0% × $70,000,000) 700,000 -Dec. 31 DR Interest expense (2% × [$58,553,901 +$471,078]) 1,180,500 CR Discount on bonds payable (difference) 480,500 CR Cash (1.0% × $70,000,000) 700,000
Generally, liabilities are valued at their
-PV
in a statement of cash flows, issuing bonds or notes are reported:
-as cash flows from financing activities from the issue and cash flows from investing activities by the investor
A company issued 8%, 3-year bonds with a face amount of $4 million for $4,106,571 on 1/1/21. The market rate at time of issuance was 7%. What is the impact to pre-tax income for the year ended 12/31/21?
-assuming semi-annual interest: Decrease of $286,891 as a result of interest expense =$143,730+143,161=$286,891 -assuming annual interest: Decrease of $287,460 =$4,106,571*.07=$287,460
mortgage bond
-backed by a lien on specified real estate owned by the issuer -less risky than debentures
an amortization schedule reasoning:
-because the balance of the debt changes each period, the dollar amount of interest (balance x rate) also will change each period. -to keep up with changing amounts, it usually is convenient to prepare a schedule that reflects the changes in the debt over its term to maturity
The mirror image a liability is an asset. The mirror image of investments in bonds is
-bond payable
the most common type of corporate debt is
-bonds
the effective interest (expense to the issue; revenue to the investor) is calculated each period as the effective rate x amount of the debt outstanding during the interest period
-borrowe DR Interest Expense for $46,664 =(effective rate x outstanding balance) CR Discount on Notes Payable for $4,664 (difference) CR Cash for $42,000 (stated rate x face amount)
how is price of a bond calculayed?
-calculated as the present value of all the cash flows required of the bonds, where the discount rate used in the present value calculation is the market rate -present value of the periodic cash payments (face amount x stated rate) + the present value of the principal payable at maturity, both discounted at the market rate
determining the selling price of bonds
-can be sold for more than face amount: premium; or less than face amount: discount -the reason the stated rate often differs from the market rate, resulting in a premium or discount, is the inevitable delay between the date the terms of the issue are established and the date the issue comes to market
A challenge with debt instruments is that the financial community continually develops increasingly ______ ways to write financial instruments to satisfy the evolving tastes of both debtors and creditors
-complex
reporting a contingent liability
-known and probable: liability accrued and disclosure note / known and reasonably possible: disclosure not only / Known and remote: no disclosure required -reasonably estimable and probable: liability accrued and disclosure note / reasonably estimable and reasonably possible: disclosure note only / reasonably estimable and remote: no disclosure required -not reasonably estimable and probable / not reasonably estimable and reasonably possible: disclosure note only / not reasonably estimable and remote: no disclosure required
When bonds are sold at a discount and the effective interest method is used, at each subsequent interest payment date, the cash paid is:
-less than interest expense
recording bonds at issuance: On January 1, 2021, Masterwear industries issued $700,000 of 12% bonds
-masterwear (issuer) DR Cash for $700,000, CR Bonds Payable for $700,000 -united (investor) DR Investment in Bonds for $700,000, CR Cash $700,000 -most bonds are issued on the day they are dated. On rare occasions, there may be a delay in issuing bonds that causes them to be issued between interest dates, in which case the interest that has accrued since the day they are dated is added to the price of the bonds
debeture bond
-most corporate bonds, backed by the "full faith and credit" of the issuing corporation
A company issued 6%, 20-year bonds with a face amount of $76 million. The market rate at time of issuance was 7% and the bonds pay interest semi-annually. How much did total liabilities increase as a result of the bond issuance?
-n=40 -i=3.5% -PV of annuity: (1-(1+i)^-n)/i (1-(1.035)^-40/.035 = 21.3351 -PV of 1: (1+i)^-n (1.035)^-40 = .2526 -Semi annual coupon interest: par value x semi annual coupon rate $76,000,000 x .03 = 2,280,000 -1-40: 2,280,000 x 21.3352 = $48,644,028 40: 76,000,000 x .2526 = $19,197,600 =$48,644,0428 + 19,197,600 = $67,841,628
bonds sold at discount - calculation of the price of bonds On January 1, 2021, Masterwear industries issued $700,000 of 12% bonds -interest of $42,000 is payable semiannually on June 30 & Dec. 31 -the bonds mature in three years -the market yield for bonds of similar risk and maturity is 14%
-n=6 (3 years, semi-annually -I=7% (14%/2) -PMT=42,000 -FV=700,000 =$666,633
what is a bond?
-obligate the issuing corporation to repay a stated amount (variously referred to as the principal, par value, face amount, or maturity value) at a specified maturity date -maturities for bonds typically range from 10 to 40 years -the company also agrees to pay interest to bondholders between the issue date and maturity. the periodic interest is stated percentage of the face amount (referred to as the stated rate, coupon rate, or nominal rate)
when a company declares and distributes a 15% stock dividend
-paid-in-capital increases and retained earnings decrease
the likelihood that future events will confirm the incurrence of the liability:
-probable: confirming that the event is likely to occur -reasonably possible: the chance the confirming event will occur is more than remote but less likely -remote: the chance the confirming event will occur is slight
extended warranty
-provides warranty protection beyond the manufacture's original warranty (computer, car, camera) -priced and sold separately from the warranted product -qualify for revenue recognition over the period of coverage -revenue is not recognized immediately but instead is recorded as a deferred revenue liability at the time of the sale and recognized as revenue over the contract period, typically straight-line basis.