1
Q
A business entity acquired a long-lived tangible asset on January 1, Year 4. On that date, it recorded a liability for an asset retirement obligation (ARO) and capitalized asset retirement cost (ARC). The estimated useful life of the long-lived tangible asset is 5 years, the credit-adjusted risk-free (CARF) rate used for initial measurement of the ARO is 10%, the initial fair value of the ARO liability based on an expected present value calculation is $250,000, and no changes occur in the undiscounted estimated cash flows used to calculate that fair value. If the entity settles the ARO on December 31, Year 8, for $420,000, what is the settlement gain or loss (rounded)?
A
(17,732)
The difference between the settlement amount of the ARO and its carrying amount is recognized in the income statement. In this case, the settlement loss is $17,372 ($420,000 settlement amount – $402,628 ARO balance at December 31, Year 8).
2
Q
On January 1, Evangel Company issued 9% bonds in the face amount of $100,000, which mature in 5 years. The bonds were issued for $96,207 to yield 10%, resulting in a bond discount of $3,793. Evangel uses the effective interest method of amortizing bond discount. Interest is payable annually on December 31.
What is the amount of interest expense that should be reported on Evangel’s income statement for the second year?
A
$9,683
An amortization schedule for the first 2 years of Evangel’s bonds can be prepared as follows:Year 1Beginning Carrying Amount: $96,207Times: Effective Rate: 10%Equals: Interest Expense: $9,621Minus: Cash Paid: $9,000Equals: Discount Amortized: $621Ending Carrying Amount: $96,828
Year 2Beginning Carrying Amount: $96,828Times: Effective Rate: 10%Equals: Interest Expense: $9,683Minus: Cash Paid: $9,000Equals: Discount Amortized: 683Ending Carrying Amount: $97,510
296,82810%9,6839,00068397,510
3
Q
On July 1, Year 1, Eagle Corp. issued 600 of its 10%, $1,000 bonds at 99 plus accrued interest. The bonds are dated April 1, Year 1, and mature on April 1, Year 11. Interest is payable semiannually on April 1 and October 1. What amount did Eagle receive from the bond issuance?
A
$609,000
A bond issued “at 99” is issued at a price equal to 99% of its face amount (600 bonds × $1,000 face amount × .99 = $594,000). Accrued interest for 3 months was $15,000 [$600,000 face amount × 10% coupon rate × (3 ÷ 12)]. The net cash received from the issuance of the bonds was therefore $609,000 ($594,000 bond proceeds + $15,000 accrued interest).
4
Q
On June 2, Year 1, Tory, Inc., issued $500,000 of 10%, 15-year bonds at par. Interest is payable semiannually on June 1 and December 1. Bond issue costs were $6,000, and Tory uses the straight-line method of amortizing bond issue costs. On June 2, Year 6, Tory retired half of the bonds at 98. What is the net carrying amount that Tory should use in computing the gain or loss on retirement of debt?
A
$248,000
The gain or loss on the retirement of debt is equal to the difference between the proceeds paid and the carrying amount of the debt. The carrying amount is equal to the face amount (1) plus any unamortized premium or minus any unamortized discount and (2) minus any unamortized debt issue costs. The amortization of the issue costs is $400 per year ($6,000 ÷ 15). Because accumulated amortization is $2,000 ($400 × 5), the unamortized issue costs are $4,000 ($6,000 – $2,000), of which 50% or $2,000 should be subtracted in determining the carrying amount of the bonds retired. Thus, the net carrying amount used in computing the gain or loss on this early extinguishment of debt is $248,000 ($250,000 face amount – $2,000 unamortized deferred bond issue costs).
5
Q
On December 30, Year 4, Fort, Inc., issued 1,000 of its 8%, 10-year, $1,000 face value bonds with detachable stock warrants at par. Each bond carried a detachable warrant for one share of Fort’s common stock at a specified option price of $25 per share. Immediately after issuance, the market value of the bonds without the warrants was $1,080,000, and the market value of the warrants was $120,000. In its December 31, Year 4, balance sheet, what amount should Fort report as bonds payable?
A
$900,000
The issue price of the bonds is allocated between the bonds and the detachable stock warrants based on their relative fair values. The market price of bonds without the warrants is $1,080,000, which is 90% [$1,080,000 ÷ ($1,080,000 + $120,000)] of the total fair value. Consequently, 90% of the issue price should be allocated to the bonds, and they should be reported at $900,000 ($1,000,000 × 90%) in the balance sheet.
6
Q
If a premium on a bonds payable transaction is not amortized, what are the effects on interest expense and total stockholders’ equity?
Interest expense:
Total stockholder’s equity:
A
Overstated
Understated
Total interest expense and the carrying amount of the bonds decrease each period when amortizing a premium. Thus, if the premium is not amortized, the interest expense will be overstated. Overstating an expense will understate net income. As net income is ultimately closed to stockholders’ equity, not amortizing a premium will result in the understatement of stockholders’ equity.
7
Q
On January 1, Year 1, Boston Group issued $100,000 par value, 5% 5-year bonds when the market rate of interest was 8%. Interest is payable annually on December 31. The following present value information is available:
Present value of $1 (n = 5)5%: 0.783538%: 0.68058Present value of an ordinary annuity (n = 5)5%: 4.329488%: 3.99271
What amount is the value of net bonds payable at the end of Year 1?
A
$90,064
On January 1, Year 1, the bonds were issued at $88,022 [($5,000 annuity payment × 3.99271 present value of an 8% annuity) + ($100,000 bond repayment × .68058 present value of $1 at 8%)], which is at an $11,978 discount ($100,000 – $88,022). The interest expense in the first year is $7,042 ($88,022 × 8%), and the coupon payment is $5,000. This means $2,042 ($7,042 – $5,000) of the value of the discount is amortized in Year 1. Therefore, the value of the net bonds payable at the end of Year 1 is $90,064 ($88,022 + $2,042).
8
Q
Included in Lee Corp.’s liability account balances at December 31, Year 4, were the following:
14% note payable issued October 1, Year 4, maturing
September 30, Year 5: $125,000
16% note payable issued April 1, Year 2, payable in six equal annual installments of $50,000 beginning April 1, Year 3: 200,000
Lee’s December 31, Year 4, financial statements were issued on March 31, Year 5. On January 15, Year 5, the entire $200,000 balance of the 16% note was refinanced by issuance of a long-term obligation payable in a lump sum. In addition, on March 10, Year 5, Lee consummated a noncancelable agreement with the lender to refinance the 14%, $125,000 note on a long-term basis, on readily determinable terms that have not yet been implemented. Both parties are financially capable of honoring the agreement, and there have been no violations of the agreement’s provisions. On the December 31, Year 4, balance sheet, the amount of the notes payable that Lee should classify as short-term obligations is
A
$0
If an entity intends to refinance short-term obligations on a long-term basis and demonstrates an ability to consummate the refinancing, the obligation should be excluded from current liabilities and reclassified as noncurrent. The ability to consummate the refinancing may be demonstrated by a post-balance-sheet-date issuance of long-term obligations or equity securities. Thus, the 16% note payable should be classified as noncurrent. The ability to refinance may also be shown by entering into a financing agreement that meets the following criteria: (1) the agreement does not expire within the longer of 1 year or the operating cycle, (2) it is noncancelable by the lender, (3) no violation of the agreement exists at the balance sheet date, and (4) the lender is financially capable of honoring the agreement. For this reason, the 14% note payable is also excluded from short-term obligations. The amount of the notes payable classified as short-term is therefore $0.
9
Q
On December 31, Year 1, Taylor, Inc., signed a binding agreement with a bank for the refinancing of an existing note payable scheduled to mature in February Year 2. The terms of the refinancing included extending the maturity date of the note by 3 years. On January 15, Year 2, the note was refinanced. How should Taylor report the note payable in its December 31, Year 1, balance sheet?
A
A Long-term Liability.
The portion of debt scheduled to mature in the following fiscal year ordinarily should be classified as a current liability. However, if an entity intends to refinance short-term obligations on a long-term basis and demonstrates an ability to consummate the refinancing, the obligation should be excluded from current liabilities and classified as noncurrent. One method of demonstrating the ability to refinance is to issue long-term obligations or equity securities after the balance sheet date but before the financial statements are issued. Given that (1) refinancing occurred shortly after the balance sheet date and (2) the maturity date was extended by 3 years, the note should be classified as a long-term liability.
10
Q
Johnstone Company owns 10,000 shares of Breva Corporation’s stock; Breva currently has 40,000 shares outstanding. During the year, Breva had net income of $200,000 and paid $160,000 in dividends. At the beginning of the year, there was a balance of $150,000 in Johnstone’s equity method investment in Breva Corporation account. At the end of the year, the balance in this account should be
A
$160,000
Johnstone holds 25% (10,000 ÷ 40,000) of Breva’s voting common stock. Under the equity method, (1) an investor recognizes its share of the investee’s net income as an increase in the investment account:
Investment in Breva ($200,000 × 25%) $50,000
Income – equity-method investee $50,000
(2) a dividend from the investee is treated as a return of an investment:
Cash ($160,000 × 25%) $40,000
Investment in Breva $40,000
Thus, at the end of the year, the balance in the investment in Breva account is $160,000 ($150,000 + $50,000 – $40,000).
11
Q
On June 30, Year 1, Town Co. had outstanding 8%, $2 million face amount, 15-year bonds maturing on June 30, Year 11. Interest is payable on June 30 and December 31. The unamortized balances of bond discount and unamortized bonds issue costs on June 30, Year 1, were $70,000 and $20,000, respectively. On June 30, Year 1, Town acquired all of these bonds at 94 and retired them. What net carrying amount should be used in computing gain or loss on this early extinguishment of debt?
A
$1,910,000
The gain or loss on the retirement of debt is equal to the difference between the proceeds paid and the carrying amount of the debt. The carrying amount of the debt is equal to the face amount (1) plus any unamortized premium or minus any unamortized discount and (2) minus any unamortized debt issue costs. Consequently, the net carrying amount that should be used in computing the gain or loss on this early extinguishment of debt is equal to $1,910,000 ($2,000,000 face amount – $70,000 unamortized discount – $20,000 unamortized deferred issue costs).
12
Q
On January 31, Year 4, Beau Corp. issued $300,000 maturity value, 12% bonds for $300,000 cash. The bonds are dated December 31, Year 3, and mature on December 31, Year 13. Interest will be paid semiannually on June 30 and December 31. What amount of accrued interest payable should Beau report in its September 30, Year 4, balance sheet?
A
$9,000
Because interest is paid semiannually on June 30 and December 31, the amount of each payment is $18,000 [($300,000 face amount × 12% stated rate) × (6 ÷ 12)]. On June 30, $18,000 was paid (because the bonds were issued at par, periodic interest expense consists entirely of the cash interest payment). From July 1 to September 30, Year 4 (3 months), interest accrued for the December 31, Year 4, payment. Thus, $9,000 [$18,000 × (3 ÷ 6)] of accrued interest payable should be reported.
13
Q
On December 30 of the current year, Azrael, Inc., purchased a machine from Abiss Corp. in exchange for a noninterest-bearing note requiring 8 payments of $20,000. The first payment was made on December 30, and the others are due annually on December 30. At date of issuance, the prevailing rate of interest for this type of note was 11%. Present value factors are as follows:
Period 7:
Present Value of Ordinary Annuity of $1 at 11%: 4.712
Present Value of Annuity in Advance Period of $1 at 11%: 5.146
Period 8:
Present Value of Ordinary Annuity of $1 at 11%: 5.231
Present Value of Annuity in Advance Period of $1 at 11%: 5.712
On Azrael’s current year December 31 balance sheet, the note payable to Abiss was
A
$94,240
The payment terms of this purchase agreement provide for a $20,000 initial payment and seven equal payments of $20,000 to be received at the end of each of the next 7 years. The note payable, however, should reflect only the present value of the 7 future payments. The present value factor to be used is the present value of an ordinary annuity for 7 periods at 11%, or 4.712. The note payable should be recorded at $94,240 ($20,000 × 4.712).
14
Q
On May 1, Kreal Corp. issued $2 million of 20-year, 10% bonds for $2,120,000. Each $1,000 bond had a detachable warrant eligible for the purchase of one share of Kreal’s $50 par common stock for $60. Immediately after the bonds were issued, Kreal’s securities had the following market values:
10% bond without warrant: $1,040
Warrant: 20
Common stock, $50 par: 56
What amount should Kreal credit to premium on bonds payable?
A
$80,000
The proceeds must be allocated based on the relative fair values of the bonds and warrants at the date of issuance, if known. A total of 2,000 ($2,000,000 ÷ $1,000) bonds was issued, each with one detachable warrant. The fair value of the 2,000 bonds was $2,080,000 (2,000 bonds × $1,040 fair value). The fair value of the warrants was $40,000 (2,000 warrants × $20 fair value). Thus, the cash proceeds of $2,120,000 equaled the aggregate fair value of the bonds and warrants ($2,080,000 + $40,000). The fair values of both the debt securities and the warrants are known, and the sum of the fair values equals the proceeds. Accordingly, the carrying amount of the bonds should be their fair value of $2,080,000, that is, a credit to bonds payable of $2 million and a credit to bond premium of $80,000.
15
Q
On June 30, Year 4, Huff Corp. issued 1,000 of its 8%, $1,000 bonds at 99. The bonds were issued through an underwriter to whom Huff paid bond issue costs of $35,000. On June 30, Year 4, Huff should report the bond liability at
A
$955,000
A bond issued at 99 is issued at a price equal to 99% of its face amount (1,000 bonds × $1,000 face amount × .99 = $990,000). Debt issue costs must be reported in the balance sheet as a direct deduction from the face amount of the debt. Thus, the net bond liability is reported at $955,000 ($1,000,000 face amount – $10,000 discount on bond – $35,000 bond issue costs).
16
Q
On December 30, Year 4, Hale Corp. paid $400,000 cash and issued 80,000 shares of its $1 par value common stock to its unsecured creditors on a pro rata basis pursuant to a reorganization plan under Chapter 11 of the bankruptcy statutes. Hale owed these unsecured creditors a total of $1.2 million. Hale’s common stock was trading at $1.25 per share on December 30, Year 4. As a result of this transaction, Hale’s total equity had a net increase of
A
$800,000
A debtor that grants an equity interest in full settlement of a payable should account for the equity interest at fair value. The difference between the fair value of the equity interest and the carrying amount of the payable is a gain. The appropriate accounting for this troubled debt restructuring is to debit liabilities for $1,200,000 and to credit cash for $400,000, common stock at its par value of $80,000 (80,000 shares × $1), additional paid-in capital for $20,000 [80,000 shares × ($1.25 fair value per share – $1 par)], and a gain for $700,000. Accordingly, the net increase in total equity is $800,000 ($80,000 + $20,000 + $700,000).
17
Q
Dixon Co. incurred costs of $3,300 when it issued, on August 31, Year 1, 5-year debenture bonds dated April 1, Year 1. What amount of issue expense should Dixon report in its income statement for the year ended December 31, Year 1?
A
$240
Debt issue costs are reported as a direct deduction from the face amount of the debt. Subsequent to their initial recognition, debt issue costs are amortized over the term of the debt. The bonds will be outstanding for 55 months (5 years – the period from April 1, Year 1, to August 31, Year 1). Hence, straight-line amortization is $240 [$3,300 × ( 4 ÷ 55 months)]. The interest method is theoretically superior, but the straight-line method may be applied if the results are not materially different.
18
Q
On December 30, Chang Co. sold a machine to Door Co. in exchange for a noninterest-bearing note requiring 10 annual payments of $10,000. Door made the first payment on December 30. The market interest rate for similar notes at date of issuance was 8%. Information on present value factors is as follows:
Period 9:
Present value of $1 at 8%: .50
Present value of ordinary annuity at 8%: 6.25
Period 10:
Present value of $1 at 8%: .46
Present value of ordinary annuity at 8%: 6.71
In its December 31 balance sheet, what amount should Chang report as note receivable?
A
$62,500
The purchase agreement calls for a $10,000 initial payment and equal payments of $10,000 to be received at the end of each of the next 9 years. The amount reported for the receivable should consist of the present value of the nine future payments. The present value factor to be used is the present value of an ordinary annuity for nine periods at 8%, or 6.25. The note receivable should be recorded at $62,500 ($10,000 × 6.25).
19
Q
Ace Corp. entered into a troubled debt restructuring agreement with National Bank. National agreed to accept land with a carrying amount of $75,000 and a fair value of $100,000 in exchange for a note with a carrying amount and fair value of $150,000. Disregarding income taxes, what amount should Ace report as a gain in its income statement?
A
$75,000
The debtor must recognize a gain as a result of the extinguishment of debt because the carrying amount of the debt is greater than the carrying amount of the asset given. Accordingly, Ace should recognize a total gain of $75,000 equal to the sum of (1) the $25,000 gain on appreciation of the land recognized on its disposal ($100,000 fair value –$75,000 carrying amount) and (2) the $50,000 gain on restructuring for the excess of the carrying amount of the debt over the fair value of the land ($150,000 – $100,000).
20
Q
On January 1, Year 2, Oak Co. issued 400 of its 8%, $1,000 bonds at 97 plus accrued interest. The bonds are dated October 1, Year 1, and mature on October 1, Year 11. Interest is payable semiannually on April 1 and October 1. Accrued interest for the period October 1, Year 1, to January 1, Year 2, amounted to $8,000. On January 1, Year 2, what amount should Oak report as bonds payable, net of discount?
A
$388,000
A bond issued “at 97” is issued at a price equal to 97% of its face amount (400 bonds × $1,000 face amount × .97 = $388,000). At the issue date, no time has passed, so no amortization has occurred, and the accrued interest is credited to either interest payable or interest expense. The reported amount is therefore $388,000 ($400,000 – $12,000).
21
Q
On January 1, 10 years ago, Andrew Co. created a subsidiary for the purpose of buying an oil tanker depot at a cost of $1,500,000. Andrew expected to operate the depot for 10 years, at which time it is legally required to dismantle the depot and remove underground storage tanks. It was estimated that it would cost $150,000 to dismantle the depot and remove the tanks at the end of the depot’s useful life. However, the actual cost to demolish and dismantle the depot and remove the tanks in the 10th year is $155,000. What amount of loss should Andrew recognize in its financial statements in Year 10?
A
$5,000
The asset retirement obligation (ARO) is recognized at fair value when incurred. An expected present value technique ordinarily is used to estimate the fair value. An amount equal to the ARO is the associated asset retirement cost (ARC). It is debited to the long-lived asset when the ARO is credited. The ARC is allocated to expense using the straight-line method over the life of the underlying asset (debit depreciation expense, credit accumulated depreciation). Furthermore, the entity recognizes accretion expense as an allocation of the difference between the maturity amount and the carrying amount of the ARO. Accretion expense for a period equals the beginning carrying amount of the ARO times the credit-adjusted risk-free interest rate. This amount is debited to accretion expense and credited to the ARO. At the end of the useful life of the underlying asset (the depot), the ARO should equal its maturity amount ($150,000). Moreover, the carrying amount of the ARC is zero. The total credits to accumulated depreciation equal the initial debit to record the ARC. Accordingly, given that the ARO liability after 10 years is $150,000, and the settlement cost is $155,000, the entry to record the settlement is to debit the ARO for $150,000, debit a loss for $5,000, and credit cash (or other accounts) for $155,000.
