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Solutions Manual

to accompany

Financial
Accounting:
Recording, Analysis
and Decision Making
Fifth Edition

Prepared by

Chrisann Palm

John Wiley & Sons Australia, Ltd 2016


Chapter 9: Reporting and analysing liabilities

CHAPTER 9 – REPORTING AND ANALYSING LIABILITIES

ASSIGNMENT CLASSIFICATION TABLE

Brief
Learning Objectives Questions Exercises Exercises Problems
1. Explain the differences 1
between current and non-
current liabilities.

2. Identify common types of 2 1, 2 1A, 2A, 1B,


current liabilities and explain 2B
how to account for them.

3. Identify common types of 7 3, 4 3A, 4A, 3B,


non-current liabilities, such 4B
as debentures and
unsecured notes, and
explain how to
account for them.

4. Prepare journal entries for 1, 3, 4 5, 6 5A, 6A, 11A,


loans payable by instalment 5B, 6B, 11B
and distinguish between
current and non-current
components of long-term
debt.

5. Identify the advantages of


leasing and explain the
difference between an
operating lease and a
finance lease.

6. Complete basic journal 11, 12, 13 12A, 12B


entries for accounting for
leases and explain how to
report leases.

7. Explain the differences 7


between provisions,
contingencies and other
types of liabilities.

8. Explain how to report 8, 9, 10


contingent liabilities.

9. Prepare entries to record 5, 6 7A, 8A, 7B,


provisions for warranties. 8B

10. Evaluate an entity’s liquidity 8, 9 9A, 10A, 9B,


and solvency. 10B

© John Wiley and Sons Australia Ltd, 2016 9.2


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

CHAPTER 9 – REPORTING AND ANALYSING LIABILITIES

ANSWERS TO QUESTIONS

1. While this is generally true, more precisely a current liability is a debt that can
reasonably be expected to be paid within one year or the operating cycle,
whichever is longer.

2. (a) The entry when the tickets are sold is:


Cash at Bank .............................................................. 250,000
Football Ticket Revenue Received in Advance .................... 250,000

(b) The entry after each game is:


Football Ticket Revenue Received in Advance ............. 50,000
Football Ticket Revenue........................................................ 50,000

3. No, Nikki is not right. The market price on any note is a function of three factors:
(1) the dollar amounts to be received by the investor (interest and principal), (2)
the length of time until the amounts are received (interest payment dates and
maturity date), and (3) the market interest rate.

4. $1000 ($50 000 x 8% x 3/12)

5. A provision is a liability for which the amount or timing of the future sacrifice is
uncertain (AASB 137 para 10). It requires estimation. For example, a provision
for long service leave requires estimation of the proportion of employees who will
stay with the entity long enough to receive long service leave entitlements. The
amount of the future sacrifice of other liabilities, such as trade creditors and
mortgages, is quantified by an invoice or contractual arrangement.

6. A provision is a liability for which the amount or timing of the future sacrifice is
uncertain (AASB 137 para 10). It requires estimation for recognition as a liability.
An example is a provision for warranty claims. A contingent liability is not
recognised because they are not probable or are unable to be measured reliably,
or both. A liability may be classified as a contingent liability because it is so
uncertain that it cannot be measured reliably, or because it does not satisfy the
probability criterion, or if it is dependent upon the occurrence of a future
uncertain event outside the control of the entity. An example of a contingent
liability is an unresolved lawsuit brought against the company. It is contingent
upon the outcome of the court case.

7. Ms Dwyer is incorrect. The obligation for a warranty arises when the sale is
made. The warranty contract commences at that point in time. The sacrifice of
economic benefits arises when the company honours the customer’s warranty
claim. This is similar to having an obligation to pay employees. The obligation
arises when the employee performs the service but the sacrifice of economic
benefits, that is, the payment, is usually made in the following week.

© John Wiley and Sons Australia Ltd, 2016 9.3


Chapter 9: Reporting and analysing liabilities

8. A mortgage loan is a secured liability, repayable in regular instalments over the


period of the loan. A mortgage liability should be reported as an interest-bearing
liability. The current and non-current components of the mortgage liability should
be reported separately. That is, the current portion of the mortgage liability
should be included in financial liabilities (also referred to as borrowings) that are
classified as current liabilities. The non-current portion of the mortgage liability
should be included in the financial liabilities that are classified as non-current
liabilities.

9. Many financially healthy companies have current ratios below 2:0. In order to
reduce costs, many companies today keep low amounts of inventory on hand.
Consequently, liquidity ratios are generally lower than they used to be.
Another measure that could be checked is the quick ratio. This ratio is a measure
of a company’s immediate short-term liquidity and inventory is not included in this
calculation. Another measure of liquidity is working capital.

10. A finance lease is a lease in which substantially all the risks and rewards of
ownership of the leased assets are transferred from the lessor to the lessee in
exchange for a series of payments over the lease term. If substantially all the
risks and rewards of ownership are not transferred, the lease is classified as an
operating lease.

© John Wiley and Sons Australia Ltd, 2016 9.4


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 9.1


Alvin Ltd

(a) A note payable due in two years is a non-current liability.

(b) Part of the mortgage payable is a current maturity of long-term debt. This amount
should be reported as a current liability.

(c) Interest payable is a current liability, assuming it is due for payment within the next
12 months.

(d) Accounts payable is a current liability because it is due for payment within the next
12 months.

BRIEF EXERCISE 9.2


Admiralty Ltd

(a) July 1 Cash at Bank ................................................. $160,000


Notes Payable .................................................... $160,000

(b) Dec. 31 Interest Expense.............................................. $8,000


Interest Payable .................................................. $8,000
($160,000 X 10% X 6/12)

BRIEF EXERCISE 9.3

31 May 16 Interest Expense $ 902


Loan Payable $4,098
Cash at Bank $5,000
(To record the loan payment for May)

BRIEF EXERCISE 9.4

30 Sept. 16 Interest Expense $ 736


Loan Payable $4,264
Cash at Bank $5,000
(To record the loan payment for September)

© John Wiley and Sons Australia Ltd, 2016 9.5


Chapter 9: Reporting and analysing liabilities

BRIEF EXERCISE 9.5

Trish’s Toasters Pty Ltd

30 June Warranty Expense $36,000


Warranty Provision $36,000
(To adjust the liability for Warranty Provision account to total estimated liability for
contracts outstanding at balance date)

BRIEF EXERCISE 9.6


Mac’s Auto Repairs Pty Ltd

30 June Warranty Expense $9,300


Warranty Provision $9,300
(To adjust the liability for Warranty Provision account to total estimated liability for contracts
outstanding at balance date)

BRIEF EXERCISE 9.7


Eccencia Ltd

(a) Jan. 1 Cash at Bank ................................... $2,000,000


Debentures Payable ............................... $2,000,000
(2,000 X $1,000)

(b) July 1 Interest Expense.............................. $80,000


Cash at Bank .......................................... $80,000
($2,000,000 X 8% X 1/2)

(c) Dec. 31 Interest Expense.............................. $80,000


Interest Payable ...................................... $80,000
($2,000,000 X 8% X 1/2)

© John Wiley and Sons Australia Ltd, 2016 9.6


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

BRIEF EXERCISE 9.8

David Jones Ltd


($ in thousands) 2013
(a) Working capital
294 705301 830 = -7 125
Current assets  Current liabilities
(b) Current ratio
294 705
Current assets
301 830 = 0.98 :1
Current liabilities
(c) Quick ratio
13 877+941+19 092
Cash+ Marketable securities + Net receivables
301 830 = 0.11:1
Current liabilities
(d) Debt to total assets ratio
436 689
Total liabilities
1 237 785 = 0.35:1
Total assets

BRIEF EXERCISE 9.9


Fresh Flowers Ltd

30 June Delivery truck lease receivable $100


Delivery truck lease revenue $100

31 Aug Cash $300


Delivery truck lease receivable $100
Delivery truck lease revenue $200

© John Wiley and Sons Australia Ltd, 2016 9.7


Chapter 9: Reporting and analysing liabilities

SOLUTIONS TO EXERCISES

EXERCISE 9.1

(a) May 1 Cash at Bank.................................................... $12,000


Note Payable....................................................... $12,000

(b) May 31 Interest expense............................................... $100


($12,000 X .1 X 1/12)
Interest Payable .................................................. $100

(c) Interest payable accrued each month ........................ $100


Number of months from borrowing to year end .......... x 8
Balance in interest payable account .......................... $800

(d) Jan. 1 Note Payable.................................................... $12,000


Interest Payable ................................................. 800
Cash at Bank....................................................... $12,800

EXERCISE 9.2
Transfield Pty Ltd

June 30 Salaries and Wages Expense ................. $105,000


General Health Fund ...................................... $6,750
PAYG Withheld Tax Payable .......................... 11,250
Superannuation Payable ................................ 9,450
Union Fees Payable ....................................... 2,000
Salaries and Wages Payable .......................... 75,550

EXERCISE 9.3
Fairy Wren Ltd

(a) Jan. 1 Cash at Bank ............................................. $100,000


Unsecured Notes Payable .............................. $100,000

(b) July 1 Interest Expense........................................ $5,000


Cash at Bank ($100,000 X 10% X 1/2)………………. $5,000
(c) Dec. 31 Interest Expense............................................ $5,000
Interest Payable .............................................. $5,000

© John Wiley and Sons Australia Ltd, 2016 9.8


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

EXERCISE 9.4

(a) June 30 Debentures Payable .................................. $130,000


Loss on Redemption of Debentures ................ 2,600
Cash at Bank ($130,000 X 102%).................. $132,600*

(b) June 30 Debentures Payable $180,000


Gain on Redemption of Debentures ....... $3,600
Cash at Bank ($180,000 X 98%)............ 176,400

EXERCISE 9.5

(a) 30 June Interest Expense $861


Loan Payable 4,139
Cash at Bank $5,000
(To record the loan payment for June)
.

(b) The current portion of the mortgage liability is $53,014 ($81,994 - $28,980).

(c) The non-current portion is $28,980. This is the loan balance at 30 June 2017.

(d) It is important to classify liabilities as current or non-current because readers of


the financial statements use this information to assess a company’s liquidity. A
liquidity analysis focuses on current liabilities, often comparing them to current
assets, for example. The inability to meet obligations as they become due
could lead to bankruptcy. Examples of current liabilities are accounts payable,
unearned revenues, wages and salaries, provisions and interest.

EXERCISE 9.6

(a) 30 June Interest Expense $2,202


Loan Payable 7,798
Cash at Bank $10,000
(To record the loan payment for June)

(b) The carrying amount of the mortgage liability after the above entry is $212,434.

(c) The current portion of the mortgage liability is $99,884 ($212,434 - $112,550)

(d) The non-current portion is $112,550.

© John Wiley and Sons Australia Ltd, 2016 9.9


Chapter 9: Reporting and analysing liabilities

EXERCISE 9.7
a. An unquantifiable liability for restoring a polluted river - Contingent
liabilities
b. Accounts payable – Other liabilities
c. Wages payable – Other liabilities
d. Obligation for unexpired warranty costs - Provisions
e. Trade creditors – Other liabilities
f. Obligations for employees’ long service leave - Provisions
g. Accrued interest liability – Other liabilities
h. Mortgage loan – Other liabilities
i. Guarantee for another’s loan, which will be payable if the other party
defaults – Contingent liabilities unless, at end of reporting period, it is
probable that the other party will default. If so, the guarantee should be
recognised as a provision (settlement date is uncertain).

EXERCISE 9.8
Olden Motor vehicles Ltd
(a)
Summary entry for claims during the year ended 30 June 2013
Warranty Provision $65,000
Inventory $30,000
Wages Payable 35,000
(To record motor vehicle repairs under warranty)

30 June Warranty Expense $70,000


Warranty Provision $70,000
(To adjust the liability for Warranty Provision account to total estimated liability for contracts
outstanding at balance date $75,000 estimate less $5,000 credit balance at 30/06/13.)

(b) Entities offer warranties because there is a statutory obligation to ensure that the
goods or services are of a satisfactory standard. In order to gain consumer
confidence and satisfaction and perhaps to increase sales, entities often offer a
warranty period greater than that required by law.

EXERCISE 9.9
Benson Builder Pty Ltd

Summary entry for claims during the year ended 31 December, 2016
Warranty Provision $85,000
Wages Payable $85,000
(To record work performed under warranty)

31 Dec Warranty Expense $75,000


Warranty Provision $75,000
(To adjust the liability for Warranty Provision account to the total estimated liability for
contracts outstanding at balance date--.01 X $7,000,000 = $70,000 plus the $5,000 debit
balance.)

© John Wiley and Sons Australia Ltd, 2016 9.10


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

EXERCISE 9.10

Premier Investment Ltd

(a)

($ in thousands) 2013

1, Working capital
422 27589 588 = 332 687
Current assets  Current liabilities
2. Current ratio
422 275
Current assets
89 588 = 4.71:1
Current liabilities
3. Quick ratio
313 157+0 +6 858
Cash+ Marketable securities + Net receivables
89 588 = 3.57:1
Current liabilities
4. Debt to total assets ratio
261 648
Total liabilities
1 562 014 = 0.17:1
Total assets
5. Times interest earned
Profit before income tax + Interest expense* 245 956 + 6 988
Interest expense 6 988 = 36.20

also referred to as EBIT* ... earnings before interest and tax

(b) Financial statement users are not only interested in a company’s trends, but also how
the entity has performed relative to its competitors. Ratios vary from industry to
industry. A positive trend in the debt to asset ratio gains more meaning if the
company’s debt to asset ratio compares favorably in comparison to competitors and
entities in similar industries.

© John Wiley and Sons Australia Ltd, 2016 9.11


Chapter 9: Reporting and analysing liabilities

EXERCISE 9.11
Speedy Delivery Ltd
30 June Speedy Delivery Ltd is renting a truck from Fast Trucks Ltd under an
operating lease. The journal entry is to record accrual of lease expense for the period ending
30 June.

31 August This entry records the payment made by Speedy Delivery Ltd to Fast Trucks
Ltd on 31 August. Part of the payment is for the lease accrued to 30 June and the rest is for
lease due in the current accounting period.

30 June This journal entry is for Fast Trucks to record accrual of operating lease
revenue earned from Speedy Deliver Ltd up to 30 June.

31 August This journal entry is for Fast Trucks to record the receipt from Speedy
Delivery Ltd of operating lease revenue. Part of the receipt is for lease accrued to 30 June
and the rest is for lease due in the current accounting period.

EXERCISE 9.12
Sunny Nursery Ltd (lessee)
30 June Gardening tools lease expense $400
Gardening tools lease payable $400

31 July Gardening tools lease expense $400


Gardening tools lease payable 400
Cash $800

Bunning’s Rentals Ltd (lessor)


30 June Gardening tools lease receivable $400
Gardening tools lease revenue $400

31 July Cash $800


Gardening tools lease receivable $400
Gardening tools lease revenue 400

© John Wiley and Sons Australia Ltd, 2016 9.12


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

EXERCISE 9.13

Grand Design Ltd (lessee)

30 Jun Office Space lease expense $500


Office Space lease payable $500

31 Aug Office Space lease expense $1000


Office Space lease payable 500
Cash $1500

30 Nov Office Space lease expense $1500


Cash $1500

Doby Ltd (lessor)

30 Jun Office Space lease Receivable $500


Accrued Office Space lease revenue $500

31 Aug Cash $1500


Office Space lease receivable $500
Office Space lease revenue 1500

30 Nov Cash $1500


Office Space lease revenue $1500

© John Wiley and Sons Australia Ltd, 2016 9.13


Chapter 9: Reporting and analysing liabilities

SOLUTIONS TO PROBLEM
SET A

PROBLEM SET A 9.1


Cling-on Ltd

(a) Sept. 1 Inventory or Purchases .................................. $16,000


Notes Payable ................................................... $16,000

30 Interest Expense ............................................ $120


($16,000 X .09 X 1/12)
Interest Payable ................................................ $120

Oct. 1 Climbing Wall ................................................. $10,000


Notes Payable ................................................... $10,000

31 Interest Expense ............................................ $220


($10,000 X .12 X 1/12 + $120)
Interest Payable ................................................ $220

Nov. 1 Vehicles ......................................................... $26,000


Notes Payable ................................................... $18,000
Cash at Bank ..................................................... 8,000

Nov. 30 Interest Expense ............................................ $430


($18,000 X .14 X 1/12 + $100 + $120)
Interest Payable ................................................ $430

Dec. 1 Notes Payable................................................ $16,000


Interest Payable ............................................... 360
Cash at Bank ..................................................... $16,360

31 Interest Expense ($100 + $210) ..................... $310


Interest Payable ................................................ $310

© John Wiley and Sons Australia Ltd, 2016 9.14


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

(b)
Notes Payable
$ $
1/12 16,000 1/9 16,000
1/10 10,000
Clos. Bal. 28,000 1/11 18,000
44,000 44,000
Op. Bal. 28,000

Interest Payable
$ $
1/12 360 30/9 120
31/10 220
30/11 430
Clos. Bal. 720 31/12 310
1,080 1,080
Op. Bal. 720

Interest Expense
$ $
30/9 120 Closing
31/10 220 Entry to
30/11 430 P/L summary
31/12 310 1,080
1,080 1,080

Note: The general ledger account Interest Expense will be closed to Income Summary at the
end of each accounting period.

(c) Current liabilities


Notes payable ................................................................................... $28,000
Interest payable .................................................................................. 720

(d) Total interest expense is $1,080.

(e) The advantage of using notes payable for purchasing inventory is that the purchaser
will probably have a longer period of time to pay for the inventory than under the
normal credit terms for accounts payable.
The disadvantage is that interest will have to be paid on the notes whereas accounts
payable is usually interest free. In fact, suppliers often offer a discount for early
payment. That would not be available in a notes payable scenario.
.

© John Wiley and Sons Australia Ltd, 2016 9.15


Chapter 9: Reporting and analysing liabilities

PROBLEM SET A 9.2


Annie Clothing Ltd

(a) July 14 Revenue Received in Advance ........................ $7,500


Service Revenue ................................................. $7,500

20 PAYG Withheld Tax Payable ........................... $1,750


Cash at Bank....................................................... $1,750

24 Cash at Bank ................................................... $27,000


Notes Payable ..................................................... $27,000

(b) July 31 Interest Expense ............................................... $71


Interest Payable .................................................. $71
($27,000 X 12% X 8/365 = $71)

31 Salaries and Wages Expense .......................... $20,000


Health Fund Payable ........................................... $1,400
PAYG Withheld Tax Payable ............................... 1,900
Superannuation Payable ..................................... 1,800
Salaries and Wages Payable .............................. 14,900

(c) Current liabilities


Notes payable ................................................................................... $ 27,000*
Accounts payable ............................................................................. 78,000*
Revenue in advance ($21,000 – $7,500) ........................................ 13,500*
Interest payable ................................................................................. 71*
Health Fund Payable ........................................................................ 1,400*
PAYG withheld tax payable .............................................................. 1,900*
Superannuation payable ................................................................... 1,800*
Salaries and wages payable ............................................................. 14,900*
Total current liabilities .............................................................. $138,571

(d) Examples of other costs employers might incur in relation to their employees include
obligations for sick leave, annual leave, union dues, and charitable contributions.

© John Wiley and Sons Australia Ltd, 2016 9.16


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

PROBLEM SET A 9.3


D100 Ltd
2017
(a) Jan 1 Interest Payable................................... $240,000**
Cash at Bank ........................................ $240,000

(b) July 1 Interest Expense................................ $240,000**


($4,000,000 X .12 X 1/2)
Cash at Bank ........................................ $240,000
2018
(c) July 1 Unsecured Notes Payable ................... $2,000,000**
Loss on Redemption of Unsecured
Notes ............................................... 60,000
Cash at Bank ($2,000,000 X 1.03) ........ $2,060,000

(d) The advantages of debt financing over issuing shares are:


 debt financing does not affect shareholder control of the entity because no
additional shares are issued.
 the interest paid on the debt is tax deductible whereas dividends paid to
shareholders are not and
 earnings per share may end up being higher even though interest has to be
paid, because of the effects of financial leverage, i.e., if EBIT (earnings before
interest and taxes) generated from the debt exceeds interest expense, then the
benefit will go to the existing owners.

PROBLEM SET A 9.4


Cameron Ltd

(a) 2015
Jan. 1 Cash at Bank ........................................... $1,000,000*
Debentures Payable ................................. $1,000,000

(b) July 1 Interest Expense........................................... $50,000*


Cash at Bank ............................................ $50,000

Dec. 31 Interest Expense........................................... $50,000*


Interest Payable ........................................ $50,000

(c) 2016
Dec. 31 Debentures Payable ................................. $1,000,000
Loss on Redemption of Debentures......... 40,000*
Cash at Bank ($1,000,000 X 104%)………………. $1,040,000

© John Wiley and Sons Australia Ltd, 2016 9.17


Chapter 9: Reporting and analysing liabilities

PROBLEM SET A 9.5


Southbank Mechanic Ltd
(a) April. 1 Cash at Bank $112,550
Loan Payable $112,550
(To record loan from the bank)
(b)

Month Beginning Reduction of Closing


Ending Balance Payment Interest Principal Balance
30.4.15 $112550 $10000 $1126 $8875 $103676
31.5.15 103676 10000 1037 8963 94712
30.6.15 94712 10000 947 9053 85659
31.7.15 85659 10000 857 9143 76516
31.8.15 76516 10000 765 9235 67281
30.9.15 67281 10000 673 9327 57954
31.10.15 57954 10000 580 9420 48533
30.11.15 48533 10000 485 9515 39019
31.12.15 39019 10000 390 9610 29409
31.1.16 29409 10000 294 9706 19703
28.2.16 19703 10000 197 9803 9900
31.3.16 9900 10000 100 9900 0

* rounding of $1 has been adjusted against interest expense

(c) 30 April Interest Expense $1,126


Loan Payable 8,875
Cash at Bank $10,000
(To record the loan payment for April)

31 May Interest Expense $1,037


Loan Payable 8,963
Cash at Bank $10,000
(To record the loan payment for May)

© John Wiley and Sons Australia Ltd, 2016 9.18


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

PROBLEM SET A 9.6


Cherry Ltd

(a) Interest Expense $6,000


Loan Payable 4,000
Cash at Bank $10,000
(To record the loan payment to Eastpac Bank)

Interest Expense $2,500


Loan Payable 9,500
Cash at Bank $12,000
(To record the loan payment to State Bank)

Interest Expense $7,500


Loan Payable 32,500
Cash at Bank $40,000
(To record the loan payment to NZA Bank)

(b) Interest expense for the current month is $16,000.

(c) Interest expense will be less than $16,000 in the next month because the
opening balance of each mortgage liability, on which the interest is calculated,
will be lower.

PROBLEM SET A 9.7


Botch’s Watches Ltd

Summary entry for the year ended 30 June 2017

(a) Warranty Provision $1,500


Parts Inventory $500
Wages Payable 1,000
(To record watch repairs under warranty)

(b) 30 Jun. Warranty Expense $1,500


Warranty Provision $1,500
(To adjust the liability for Warranty Provision account to total estimated liability
for contracts outstanding at balance date)

(c) Holding product quality constant (no change in suppliers), the Warranty Provision is
likely to be understated at $1,200. In the previous year, a provision of $1,200 was
demonstrated to be inadequate: the provision account had a debit balance prior to
adjusting entries on 30 June 2017. Furthermore, the current estimate does not
reflect the increased sales volume. An increase in the number of watches sold
during the year (indicated by the increase in sales revenue in the absence of an
increase in prices) suggests that there will be additional warranty claims in the
coming year.

© John Wiley and Sons Australia Ltd, 2016 9.19


Chapter 9: Reporting and analysing liabilities

PROBLEM SET A 9.8


Lennox Plumbing Services Pty Ltd

(a)

WARRANTY PROVISION ACCOUNT


Spare parts inventory (amount
of warranty claims) $110,000 2016 Beginning balance $100,000
Warranty Expense (amount
of adjusting journal entry)
Closing balance 130,000 140,000
$240,000 $240,000
2017 Beginning balance $130,000

(b) Summary entry for the year


Warranty Provision $110,000
Spare Parts Inventory $110,000
(To record plumbing repairs under warranty)

Balance day adjustment


Warranty Expense $140,000
Warranty Provision $140,000
(To adjust the liability for Warranty Provision account to total estimated liability for
contracts outstanding at balance date)

© John Wiley and Sons Australia Ltd, 2016 9.20


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

PROBLEM SET A 9.9


(a)

Telco Ltd
Telecom Telco
New Zealand Ltd Ltd
2013 2013
($ in NZ millions) ($ in millions)
1. Current ratio
838 10 085
Current assets
1 086 = 0.77:1 8 680 = 1.16:1
Current liabilities
2. Quick ratio
118+348 5 530+23 +4 170
Cash+ Marketable securities + Net rec.
1 086 = 0.43:1 8 680 = 1.12:1
Current liabilities
3. Debt to total assets ratio
2 080 25 400
Total liabilities
3 493 = 0.60:1 39 360 = 0.65:1
Total assets
4. Times interest earned
341 + 74 6 230 + 1 115
Profit before income tax + Interest expense*
74 = 5.61 1 115 = 6.59
Interest expense

also referred to as EBIT* ... earnings before interest and tax

(b) Liquidity can be measured using the current and quick ratios. In 2013 Telco Ltd
outperformed Telecom New Zealand in both measures. Telco Ltd has a higher debt
to total assets ratio than Telecom New Zealand, indicating a larger proportion of
assets financed by creditors, however it also has higher interest coverage than
Telecom New Zealand. In summary, Telco Ltd appears to be more liquid and solvent
than Telecom New Zealand.

© John Wiley and Sons Australia Ltd, 2016 9.21


Chapter 9: Reporting and analysing liabilities

PROBLEM SET A 9.10


Bayside Ltd

(a)

1. Working capital
29  600 - 15  390 = 14 210
Current assets  Current liabilities

2. Current ratio
29  600
Current assets
15  390 = 1.92 :1
Current liabilities
3. Quick ratio
6 207+3 400+10 840
Cash+ Marketable securities + Net receivables
15  390 = 1.33:1
Current liabilities
4. Debt to total assets ratio
125 295
Total liabilities
357  875= 0.35:1
Total assets
5. Times interest earned
246  950 + 11  440
Profit before income tax + Interest expense*
11  440 = 22.59
Interest expense

also referred to as EBIT* ... earnings before interest and tax

(b) Bayside Ltd’s working capital indicates a positive balance of 14 210. Its current ratio
appears to be adequate with $1.92 of current assets to cover each $1 of current
liabilities; it still falls below the rule of thumb of 2:1. As measure of liquidity risk, the
current ratio has certain limitations as it does not take into account the composition of
current assets. The quick ratio compensates for this by including only the most liquid
current assets in its numerator. The quick ratio of 1.33 is greater than the rule of
thumb of 1:1; this is a good result for Bayside Ltd. As the working capital also is
positive, all three liquidity calculations indicate that Bayside Ltd is likely to be able to
meet its short term debts. The Debt to total assets ratio shows that only 35% of its
assets are funded by creditors, the times interest earned ratio of 22.29 times is much
greater than the general rule of thumb of 3 to 4 times, which is the minimum level
creditors like to see. These ratios suggest that Bayside Ltd is in a strong financial
position and not facing any solvency issues. Even though it appears from the
calculations in part (a) that Bayside Ltd is quite capable of meeting its long and short
term debts, ratios should always be compared with industry averages.

© John Wiley and Sons Australia Ltd, 2016 9.22


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

PROBLEM SET A 9.11


(a)

Beginning Reduction of Closing


Month Ending Balance Payment Interest Principal Balance
30.6.2015 $200,000 $55,480 $24,000 $31,480 $168,520
30.6.2016 168,520 55,480 20,222 35,258 133,262
30.6.2017 133,262 55,480 15,991 39,489 93,774
30.6.2018 93,774 55,480 11,253 44,227 49,547
30.6.2019 49,547 55,480 5,934* 49,546 0
*Rounding error $12 adjusted against interest

(b)

2015
30 Jun. Interest Expense $24,000
Loan Payable 31,480
Cash at Bank $55,480
(To record the annual loan payment)

2016
30 Jun. Interest Expense $20,222
Loan Payable 35,258
Cash at Bank $55,480
(To record the annual loan payment)

(c)
Current Liabilities
Current portion of long term loan $39,488

Non-Current Liabilities
Loan payable $93,774

© John Wiley and Sons Australia Ltd, 2016 9.23


Chapter 9: Reporting and analysing liabilities

PROBLEM SET A 9.12

Duncan Ltd

(a) Lease repayment schedule:

Balance
Principal lease
Lease Interest 8% reduction obligation
Date Payment $ $ $ $
01.07.2015 100,000
30.6.2016 38,803 8,000 30,803 69,197
30.6.2017 38,803 5,536 33,267 35,930
30.6.2018 38,803 2,875* 35,929 0
*Rounding error $1 adjusted against interest

(b)

2016

30 Jun Lease Liability $30,803


Interest Expense 8,000
Cash at Bank $38,803
(To record the annual lease repayment)

30 Jun Lease Amortisation Expense $33,333


Accumulated Amortisation $33,333
(To record the lease amortization expense
At the end of the period $100,000 ÷ 3)

(c)
Statement of Financial Position (Extract)
As at 30 June 2016

Non-current assets
Lease asset $100,000
Less: Accumulated amortisation ( 33,333)
66,667

Current liabilities
Lease liability $33,267

Non-current liabilities
Lease liability 35,930

© John Wiley and Sons Australia Ltd, 2016 9.24


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

SOLUTIONS TO PROBLEM
SET B

PROBLEM SET B 9.1

Mountain Bikes Pty Ltd


(a) Mar. 1 Bikes ............................................................... $8,000
Notes Payable ................................................... $8,000

31 Interest Expense .................................................. $60


($8,000 X .09 X 1/12)
Interest Payable ................................................ $60

Apr. 1 Land ............................................................. $20,000


Notes Payable ................................................... $20,000

30 Interest Expense ............................................ $260


($20,000 X .12 X 1/12 + $60)
Interest Payable ................................................ $260

May 1 Cash at Bank ................................................. $15,000


Notes Payable ................................................... $15,000

31 Interest Expense ............................................ $335


($15,000 X .06 X 1/12 + $200 + $60)
Interest Payable ................................................ $335

Jun. 1 Notes Payable.................................................. $8,000


Interest Payable ............................................... 180
Cash at Bank ..................................................... $8,180

30 Interest Expense ($75 + $200) ....................... $275


Interest Payable ................................................ $275

© John Wiley and Sons Australia Ltd, 2016 9.25


Chapter 9: Reporting and analysing liabilities

(b)
Notes Payable
$ $
1/6 8,000 1/3 8,000
1/4 20,000
Clos. Bal. 35,000 1/5 15,000
43,000 43,000
Op. Bal. 35,000
Interest Payable
$ $
1/12 180 31/3 60
30/4 260
31/5 335
Clos. Bal. 750 30/6 275
930 930
Op. Bal. 750

Interest Expense
$ $
31/3 60 Closing
30/4 260 Entry to
31/5 335 P/L summary
30/6 275 930
930 930

(c) Current liabilities


Notes payable ................................................................................... $35,000
Interest payable .................................................................................. 750

(d) Total interest expense is $930.

(e) The advantage of using notes payable for purchasing inventory is that the purchaser
will probably have a longer period of time to pay for the inventory than under the
normal credit terms for accounts payable.
The disadvantage is that interest will have to be paid on the notes whereas accounts
payable is usually interest free. In fact, suppliers often offer a discount for early
payment. That would not be available in a notes payable scenario.

© John Wiley and Sons Australia Ltd, 2016 9.26


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

PROBLEM SET B 9.2


Jasmine Ltd

(a) Jan 1 Cash at Bank ................................................... $30,000


Notes Payable ..................................................... $30,000

Jan 16 Service Revenue Received in Advance ............. $2,000


Service Revenue ................................................. $2,000

22 PAYG Taxes Payable ...................................... $1,320


Cash at Bank....................................................... $1,320

(b) Jan. 31 Interest Expense ............................................... $250


Interest Payable .................................................. $250
($30,000 X 10% X 1/12 = $250)

31 Salaries and Wages Expense .......................... $16,000


Health Fund Payable ........................................... $2,000
PAYG Taxes Payable .......................................... 1,450
Superannuation Payable ..................................... 1,440
Salaries and Wages Payable .............................. 11,110

(c) Current liabilities


Notes payable .......................................................................... $ 30,000*
Accounts payable ...................................................................... 8,500*
Revenue in advance ($3,800 – $2,000) ................................... 1,800*
Interest payable ...................................................................... 250*
Health Fund Payable ............................................................... 2,000*
PAYG Taxes payable............................................................... 1,450*
Superannuation payable .......................................................... 1,440*
Salaries and wages payable .................................................... 11,110*
Total current liabilities $56,550*

(d) Examples of other costs employers might incur in relation to their employees include
obligations for sick leave, annual leave, union dues, and charitable contributions.

© John Wiley and Sons Australia Ltd, 2016 9.27


Chapter 9: Reporting and analysing liabilities

PROBLEM SET B 9.3


Spring Hill Capital Ltd

2016
(a) Jan. 1 Interest Payable................................................... $60,000
Cash at Bank ............................................ $60,000

(b) Jul. 1 Interest Expense................................................. $60,000


Cash at Bank ............................................ $60,000

2017
(c) Jul 1 Notes Payable ..................................................... $30,000
Loss on Redemption of Notes................................ 900
Cash at Bank ($30,000 X 103%) .......................... $30,900

(d) The advantages of debt financing over issuing shares are:


 debt financing does not affect shareholder control of the entity because no
additional shares are issued.
 the interest paid on the debt is tax deductible whereas dividends paid to
shareholders are not and
 earnings per share may end up being higher even though interest has to be
paid, because of the effects of financial leverage, i.e., if EBIT (earnings before
interest and taxes) generated from the debt exceeds interest expense, then the
benefit will go to the existing owners.

PROBLEM SET B 9.4


Thompson Ltd

(a) 2015
Jul. 1 Cash at Bank ................................................. $4,000,000*
Debentures Payable ................................. $4,000,000

2015/16
(b) Dec. 31 Interest Expense............................................... $180,000*
Cash at Bank ............................................ $180,000

Jun. 30 Interest Expense............................................... $180,000*


Cash at Bank ............................................ $180,000

(c) 2017
Dec. 31 Debentures Payable .................................... $4,000,000
Loss on Redemption of Debenture ................ 80,000
Cash at Bank ($4,000,000 X 102%) ..................... $4,080,000

© John Wiley and Sons Australia Ltd, 2016 9.28


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

PROBLEM SET B 9.5


Sunflower Ltd
(a) April 1 Cash at Bank $56,870
Loan Payable $56,870
(To record loan from the bank)
(b)
Month Beginning Reduction of
Ending Balance Payment Interest Principal Closing Balance
30.4.15 $56870 $5000 $474 $4526 $52344
31.5.15 52344 5000 436 4564 47780
30.6.15 47780 5000 398 4602 43178
31.7.15 43178 5000 360 4640 38538
31.8.15 38538 5000 321 4679 33859
30.9.15 33859 5000 282 4718 29141
31.10.15 29141 5000 243 4757 24384
30.11.15 24384 5000 203 4797 19587
31.12.15 19587 5000 163 4837 14751
31.1.16 14751 5000 123 4877 9874
28.2.16 9874 5000 82 4918 4956
31.3.16 4956 5000 44 4956 0
* rounding of $3 has been adjusted against interest expense

(c) 30 April Interest Expense $474


Loan Payable 4,526
Cash at Bank $5,000
(To record the loan payment for April)

31 May Interest Expense $436


Loan Payable 4,564
Cash at Bank $5,000
(To record the loan payment for May)

© John Wiley and Sons Australia Ltd, 2016 9.29


Chapter 9: Reporting and analysing liabilities

PROBLEM SET B 9.6


Book City Ltd

(a) Interest Expense $1,500


Loan Payable $3,500
Cash at Bank $5,000
(To record the loan payment to Aussie Bank)

Interest Expense $1,125


Loan Payable $4,875
Cash at Bank $6,000
(To record the loan payment to Kiwi Bank)

Interest Expense $1,750


Loan Payable $18,250
Cash at Bank $20,000
(To record the loan payment to Bank Outback)

(b) Interest expense for the current month is $4,375.

(c) Interest expense will be less than $4,375 in the next month because the
opening balance of each mortgage liability, on which interest is calculated, will
be lower.

PROBLEM SET B 9.7


Quinton Mechanics Ltd

Summary entry for the year ended 30 June 2016

(a) Warranty Provision $3,000


Parts Inventory $1,000
Wages Payable 2,000
(To record car repairs under warranty)

(b) 30 Jun. Warranty Expense $3,000


Warranty Provision $3,000
(To adjust the liability for Warranty Provision account to total estimated liability
for contracts outstanding at balance date)

(c) Holding product quality constant (no change in suppliers),the Warranty Provision is
likely to be understated at $2,400. In the previous year, a provision of $2,400 was
demonstrated to be inadequate: the provision account had a debit balance prior to
adjusting entries on 30 June 2016. Furthermore, the current estimate does not
reflect the increased sales volume. An increase in the number of car repairs and
service during the year (indicated by the increase in revenue from car repairs in the
absence of an increase in prices) suggests that there will be additional warranty
claims in the coming year.

© John Wiley and Sons Australia Ltd, 2016 9.30


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

PROBLEM SET B 9.8


Davis Builders Pty Ltd

(a)

WARRANTY PROVISION ACCOUNT


Spare parts inventory (amount
of warranty claims) $133,000 2016 Beginning balance $130,000
Warranty Expense (amount
Closing balance 39,000 of adjusting journal entry) 42,000
$172,000 $172,000
2017 Beginning balance $39,000

(b) Summary entry for the year


Warranty Provision $133,000
Spare Parts Inventory $133,000
(To record plumbing repairs under warranty)

Balance day adjustment


Warranty Expense $42,000
Warranty Provision $42,000

(To adjust the liability for Warranty Provision account to total estimated liability for contracts
outstanding at balance date).

© John Wiley and Sons Australia Ltd, 2016 9.31


Chapter 9: Reporting and analysing liabilities

PROBLEM SET B 9.9

Omnicom Ltd
(a)

Telecom Omnicom
New Zealand Ltd Ltd
2013 2013
($ in NZ millions) ($ in millions)
1. Current ratio
838 501 581
Current assets
1 086 = 0.77:1 175 896 = 2.85:1
Current liabilities
2. Quick ratio
118+348
Cash+ Marketable securities + Net Rec. 61 086+10 241+175 272
1 086 = 0.43:1
Current liabilities 175 896 = 1.40:1
3. Debt to total assets ratio
2 080 392 638
Total liabilities
3 493 = 0.60:1 982 180 = 0.40
Total assets
4. Times interest earned
341 + 74 165  877 +15 700
Profit before income tax + Interest expense*
74 = 5.61 15 700 = 10.57
Interest expense

also referred to as EBIT* ... earnings before interest and tax

b) Liquidity can be measured using the current and quick ratios. In 2013 Omnicom Ltd
outperformed Telecom New Zealand in both measures. Omnicom Ltd also has a
much lower debt to total assets ratio than Telecom New Zealand, indicating a smaller
proportion of assets is financed by creditors. Omnicom Ltd also has a much higher
interest coverage than Telecom New Zealand. In summary, Omnicom Ltd appears to
be more liquid and solvent than Telecom New Zealand.

© John Wiley and Sons Australia Ltd, 2016 9.32


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

PROBLEM SET B 9.10


Matrix Ltd

(a)

2016 2015

Working capital
5  450 - 7  120 =- 1 670 4  650 - 5  760= -1110
Current assets  Current liabilities

Current ratio
5  450 4  650
Current assets
7  120 = 0.77:1 5  760 = 0.81:1
Current liabilities
Quick ratio
2 860 3  145
Cash+ Marketable securities + Net Rec.
7  120 = 0.40:1 5  760 = 0.55:1
Current liabilities
Debt to total assets ratio
25 620 21  960
Total liabilities
32  700 = 0.78:1 29  750 = 0.74:1
Total assets
Times interest earned
2 710 + 450 2 670 + 390
Profit before income tax + Interest expense*
450 = 7.02 390 = 7.85
Interest expense

also referred to as EBIT* ... earnings before interest and tax

(b) In 2016, working capital was a larger negative amount, and both the current ratio
and the quick ratio declined. In both years the current and quick ratios were both
well below 1.0 and should be monitored closely to avoid future liquidity problems.
The debt to asset and times interest earned ratios measure solvency. The
reliance on debt financed increased slightly from 74% to 78% and the times
interest earned ratio dropped from 7.85 times to 7.02 times in 2016. In summary,
Matrix Ltd’s liquidity levels dropped significantly but there was relatively little
change in its solvency.

© John Wiley and Sons Australia Ltd, 2016 9.33


Chapter 9: Reporting and analysing liabilities

PROBLEM SET B 9.11


(a)
Month Beginning Reduction of Closing
Ending Balance Payment Interest Principal Balance
30.6.2016 $100000 $26380 $10000 $16380 $83620
30.6.2017 83620 26380 8362 18018 65602
30.6.2018 65602 26380 6560 19820 45782
30.6.2019 45782 26380 4578 21802 23980
30.6.2020 23980 26380 2400* 23980 0

 Rounding error $2 adjusted against interest

(b)

2016
30 Jun. Interest Expense $10,000
Loan Payable 16,380
Cash at Bank $26,380
(To record the annual loan payment)

2017
30 Jun. Interest Expense $8,362
Loan Payable 18,018
Cash at Bank $26,380
(To record the annual loan payment)
(c)

Current Liabilities
Current portion of long term loan $19,820

Non-Current Liabilities
Loan payable $45,782

© John Wiley and Sons Australia Ltd, 2016 9.34


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

PROBLEM SET B 9.12


Cooper Ltd
(a) Lease repayment schedule:
Balance
Lease Interest 12% Principal lease
Date Payment $ $ reduction $ obligation $
01.7.2016 75000
30.6.2017 20,805 9,000 11,805 63,195
30.6.2018 20,805 7,583 13,222 49,973
30.6.2019 20,805 5,997 14,808 35,165
30.6.2020 20,805 4,220 16,585 18,580
30.6.2021 20,805 2,235* 18,575 0
 Rounding error $5 adjusted against interest

(b) 2017 30 Jun Lease Liability $11,805


Interest Expense 9,000
Cash at Bank $20,805
(To record the annual lease repayment)

30 Jun Lease Amortisation Expense $15,000


Accumulated Amortisation $15,000
(To record the lease amortization expense
At the end of the period $75,000 ÷ 5)

(c) 2018 30 Jun Lease Liability $13,222


Interest Expense 7,583
Cash at Bank $20,805
(To record the annual lease repayment)

30 Jun Lease Amortisation Expense $15,000


Accumulated Amortisation $15,000
(To record the lease amortization expense
At the end of the period $75,000 ÷ 5)

(d) Statement of Financial Position (Extract)


As at 30 June 2018
Non-current assets
Lease asset $75,000
Less: Accumulated amortisation ( 30,000)
45,000
Current liabilities
Lease liability $14,808

Non-current liabilities
Lease liability 35,165

© John Wiley and Sons Australia Ltd, 2016 9.35


Chapter 9: Reporting and analysing liabilities

BUILDING BUSINESS SKILLS

FINANCIAL REPORTING AND ANALYSIS

BUILDING BUSINESS SKILLS 9.1 FINANCIAL REPORTING PROBLEM

Domino’s Pizza Enterprises Ltd

(a) current liabilities at 30 June 2013 were $51,304,000

(b) current provisions at 30 June 2013 were $3,109,000

(c) change in the value of total liabilities from 2012 to 2013:

$87,169,000 - 458,278,000 = $28,891,000

(d) working capital, current ratio, quick ratio, debt to total assets ratio and times interest earned for 2013.

($ in thousands) 2013

Working capital
60,383 - 51,304 = 9 079
Current assets  Current liabilities

Current ratio
60,383
Current assets
51,304 = 1.18:1
Current liabilities
Quick ratio
Cash+ Marketable securities + Net receivables 18 691+0 +23 597*
Current liabilities 51,304 = 0.82:1
Debt to total assets ratio
87,169
Total liabilities
189,751 = 0.46:1
Total assets
Times interest earned
40,765 + 405
Profit before income tax + Interest expense**
405 = 101.65
Interest expense

* net receivables –refer to note 13 in Annual Report

13. TRADE AND OTHER RECEIVABLES

Trade receivables 27,010


Allowance for doubtful debts (3,413)
23,597

**referred as finance costs in Domino’s Pizza Enterprises Ltd’s Statement of profit or loss

© John Wiley and Sons Australia Ltd, 2016 9.36


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

BUILDING BUSINESS SKILLS 9.2 COMPARATIVE ANALYSIS PROBLEM

Fantastic Holdings Ltd vs. Nick Scali Ltd

(a)

2013

Fantastic Holdings Nick Scali


($’000)
Limited Limited

Working capital 100 325 - 49 647 = 48 545 - 28 478 =


Current assets  Current liabilities 50 678 20 067

Current ratio
100 325 48 545
Current assets
49 647 = 2.02:1 28 478 = 1.70:1
Current liabilities
Quick ratio
18 993 + 0 + 2 597 26 441 + 852 + 6 397
Cash+ Marketable securities + Net rec.
49 647 = 0.43:1 28 478 = 1.18:1
Current liabilities
Debt to total assets ratio
76 316 37 830
Total liabilities
184 461 = 0.41:1 74 164 = 0.51:1
Total assets
Times interest earned
17 612 + 1 088 22 865 + 252
Profit before income tax + Interest expense*
1 088 = 17.19 252 = 91.73
Interest expense

also referred to as EBIT* ... earnings before interest and tax

(b) Both entities have positive working capital. Fantastic Holdings Ltd has a significantly
higher current ratio than Nick Scali Ltd, however in both cases the current ratios
appear to be comfortably greater than 1:1. Fantastic Holdings’ quick ratio of 0.43 is
well below 1:1 due to the large proportion of inventory in its current assets (74%). In
contrast, Nick Scali’s quick ratio of 1.18 is much higher as it has a relatively low
proportion of inventory in its current assets (30%).

Fantastic Holdings’ quick ratios would be of concern in the absence of industry


average information and inventory turnover ratios as it would appear that it may have
liquidity problems.

Fantastic Holdings’ debt to total assets ratios of 41% is much lower than Nick Scali’s
51% however Nick Scali Ltd’s times interest earned is substantially higher than
Fantastic Holdings’. These figures indicate that both companies are highly solvent.

© John Wiley and Sons Australia Ltd, 2016 9.37


Chapter 9: Reporting and analysing liabilities

BUILDING BUSINESS SKILLS 9.3 A GLOBAL FOCUS

Drawing on note 18 to the 2014 financial statements, Telstra has borrowings in the following
foreign currencies:
 Swiss francs
 Euro
 United States dollars
 New Zealand dollars
 Swiss francs
 Hong Kong dollars
 Japanese yen

Companies borrow overseas or in different currencies for a variety of reasons, including:

 convenience for off-shore operations due to restrictions on international currency


flows and foreign investment regulations imposed by governments of other countries;
 to reduce exposure to foreign currency risk generated by off-shore assets or exports;
 to take advantage of lower interest rates available in other countries.

The major risk involved in off-shore borrowing is that the Australian dollar (or New Zealand
dollar for a New Zealand company) might devalue against the currency in which the entity
has the off-shore loan. This would mean that the company would have to repay more in
terms of its local currency than it had originally borrowed. The extra cost resulting from local
currency devaluation would also result in greater interest payments in the local currency.
For example, if the Australian and New Zealand dollars devalued against the US dollar, it
would take more Australian and New Zealand dollars to repay US loans borrowed by
Australian and New Zealand companies, such as Telstra and Telecom New Zealand.

BUILDING BUSINESS SKILLS 9.4 FINANCIAL ANALYSIS ON THE WEB

(a) The two key areas of services offered by Moody’s are:


 Investors Service which is a provider of credit ratings, research and risk analysis.
The ratings and analysis track debt covering more than 110 countries, 12,000
corporate issuers, 25,000 public finance issuers and 106,000 structured finance
obligations.
 Analytics which offers tools for measuring and managing risk by providing
software, advisory services and research.

(b) Moody’s takes the view that most fixed-income market participants are long-term
investors and are, therefore, more concerned about the long-terms prospects of a
corporation or investment product. Accordingly, Moody’s focuses on assessing the
ability of an entity to meet its credit obligations over the long term rather than on
temporary fluctuations in prices and returns.

Moody’s long term view is, generally a time horizon of five-to-ten years, set to capture
at least one full economic cycle. They focus on the risks specific to each borrower’s
industry, country and region within the long-term horizon.

© John Wiley and Sons Australia Ltd, 2016 9.38


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

CRITICAL THINKING

BUILDING BUSINESS SKILLS 9.5 GROUP DECISION CASE

Mall Ltd

2018

(a) Jan. 1 Debentures Payable (net) ................... $1,144,000


Gain on Redemption of Debentures ..................... $144,000
Cash at Bank ....................................................... 1,000,000
(To record repurchase of 10% debentures)

Jan.1 Cash at Bank ...................................... $1,000,000


Debentures Payable ............................................. $1,000,000
(To record sale of 10-year, 17.36% debentures at face value)

(b) Dear Ms Payne,

The early redemption of the 10%, 5-year debentures results in recognising an increase
in profit of $144,000 that increases current year profit by the after-tax effect of the
gain. The amount of the liabilities on the balance sheet will be lowered by the issue of
the new debentures and retirement of the 5-year debentures.

1. The annual cash flow of the company as it relates to debentures payable will be
adversely affected as follows:

Annual interest payments on the new issue $173,600


($1,000,000 X .17.36%)
Annual interest payments on the 5-year debentures 120,000
($1,200,000 X .10)
Additional cash outflows per year $ 53,600

2. The amount of interest expense shown on the income statement will be higher
as a result of the decision to issue new debentures.

These comparisons hold for only the 3-year remaining life of the 10%, 5-year
debentures. There will of course be a cash saving on the repayment of the
principal five years later but the company will be committed to a higher interest
rate for five years.
The company must contemplate either redemption of the debentures at maturity,
1 January 2021, or refinancing of that issue at that time and consider what
interest rates will be in 2021 in evaluating a redemption and issue in 2018.

Sincerely,

© John Wiley and Sons Australia Ltd, 2016 9.39


Chapter 9: Reporting and analysing liabilities

BUILDING BUSINESS SKILLS 9.6 COMMUNICATION ACTIVITY

To: Board of Directors, Dundee Pty Ltd

From: I. M. Student

Subject: Revenue Recognition on Research Contract

The revenue from the research contract, and corresponding expenses, associated with the
research contract should be recognised by reference to the stage of completion when the
outcome can be measured reliably (AASB 118). No revenue is recognised on entering into
the contract because at that time no work has been performed. The performance of services
in relation to the research contract differs from the timing of the cash flows of the contract.

Recognising revenue by reference to the stage of completion would result in 50% of the
revenue being recognised in year ended 30 June 2016, when half of the research work is to
be performed. Of the $600,000 received that year, $500,000 should be accounted for as
revenue when 50% of the research is complete. The other $100,000 is a liability for revenue
received in advance.

The remaining 50% of the revenue would be recognised in the year ended 30 June 2017,
when the remaining half of the research is to be performed. It is not necessary to delay the
recognition of revenue until the cash is received unless there is uncertainty that it will flow to
the entity.

As stated above the recognition of revenue is subject to the outcome being able to be
measured reliably. The outcome of a transaction involving the performance of services is
considered to be able to be measured reliably if:

(1) Revenue can be recognised reliably


(2) It is probable that economic benefits will flow to the entity
(3) The stage of completion can be measured reliably and
(4) The costs incurred for the transaction and the costs to complete can be measured
reliably (AASB 118 para. 20, also discussion in chapter three of this text).

The revenue can be measured reliably because the contact has a fixed price. The
recommendations for recognition of revenue in 2016 and 2017 are based on assumptions
that the stage of completion at 30 June 2016 and 30 June 2017 will be 50% and 100%,
respectively. If different levels of completion apply at the time, the actual percentages of
completion should be used, assuming they can be measured reliably. It is also assumed that
it is probable that benefits will flow to the entity (that is, that this is not a loss making
contract). Lastly, it is assumed that the costs incurred on the research contract and expected
future costs can be measured reliably at 30 June 2016 and 30 June 2017 when revenue is
to be recognised.

Signed

© John Wiley and Sons Australia Ltd, 2016 9.40


Solutions manual to accompany Financial accounting: reporting analysis and decision making 5e

BUILDING BUSINESS SKILLS 9.7 ETHICS CASE

Candy Bars Ltd

(a) The stakeholders in this situation are: shareholders; potential shareholders; creditors;
potential creditors; any users of the financial statements; customers, including any
consumers of the product; and potential customers, including any potential consumers of
the product.

(b) Creditors and potential creditors may be harmed by the non-disclosure because they
may underestimate the financial risk of extending credit to Candy Bars Ltd. Prospective
investors may also be harmed as they may understate the risk attached to future profits,
cash flows and dividends of Candy Bars Ltd and consequently pay too much for the
shares. Existing shareholders may also be harmed because the non-disclosure may
affect their decision to continue investing in the company and if Candy Bar Ltd loses the
case, the value of shares to the shareholders may decline. Some people may have
avoided that potential loss, at least partially, if, with full disclosure, they would have
decided to sell their shares earlier. The stock market as a whole is disadvantaged
because if investors cannot rely on companies to disclose information relevant to the
value of the shares, investing in companies becomes a much riskier activity. This would
be reflected in the cost of capital to companies in general. Customers may be harmed or
disadvantaged. However, annual reports are not generally used by consumers as a
source of product information.

(c) While there are arguments that ethics is a matter of individual judgement, many people
would consider this behaviour as unethical. Users are being misinformed about relevant
information. This can result in some (such as existing shareholders who wish to sell)
obtaining a benefit at the expense of another group (such as future shareholders). One
often hears attempts to use directors’ obligations to act in the interests of shareholders
as justification for unethical behaviour (and in some extreme instances, fraud and
deception). However, this argument is flawed because behaviour that would be unethical
if done by one party (shareholders) cannot become ethical simply because it is done by
that party’s agent (the directors) acting under some duty to put the interests of his
principal above all others. However, even if one did hold to the point of view that
directors’ conduct can be justified on the basis that it is in the interests of shareholders, it
is not clear in the present case that shareholders (present and future) would benefit from
the non-disclosure of the company’s contingent liability for damages caused by one of its
products.

© John Wiley and Sons Australia Ltd, 2016 9.41