CH 12

Chapter 12—Debt Financing
MULTIPLE CHOICE
1. For a liability to exist,

a. a past transaction or event must have occurred.
b. the exact amount must be known.
c. the identity of the party owed must be known.
d. an obligation to pay cash in the future must exist.
ANS: A DIF: Easy OBJ: LO 1
TOP: AICPA FN-Measurement MSC: AACSB Reflective
2. The most conceptually appropriate method of valuing a liability under the historical cost basis is to
a. discount the amount of expected cash outflows that are necessary to liquidate the liability
using the market rate of interest at the date the liability was initially incurred.
b. discount the amount of expected cash outflows that are necessary to liquidate the liability
using the market rate of interest at the date financial statements are prepared subsequent to
issuance.
c. record as a liability the amount of cash or cash-equivalent value that the company would
be required to pay to eliminate the liability in the ordinary course of business on the date
of the financial statements.
d. record as a liability the amount of cash or cash-equivalent proceeds actually received when
a liability was incurred.
ANS: A DIF: Medium OBJ: LO 1
TOP: AICPA FN-Measurement MSC: AACSB Reflective Thinking
3. Which of the following represents a liability?

a. The obligation to pay for goods that a company expects to order from suppliers next year.
b. The obligation to provide goods that customers have ordered and paid for during the
current year.
c. The obligation to pay interest on a five-year note payable that was issued the last day of
the current year.
d. The obligation to distribute share of a company's own common stock next year as a result
of a stock dividend declared near the end of the current year.
ANS: B DIF: Medium OBJ: LO 1
TOP: AICPA FN-Measurement MSC: AACSB Analytic
4. A short-term note payable with no stated rate of interest should be

a. recorded at maturity value.
b. recorded at the face amount.
c. discounted to its present value.
d. reported separately from other short-term notes payable.
ANS: C DIF: Easy OBJ: LO 2
5. At December 31, 2008, Jenkins Sales & Service has a $100,000, 120-day note payable outstanding.
The company has followed the policy of replacing the note rather than repaying it over the last three
years. The company's treasurer says that this policy is expected to continue indefinitely, and the
arrangement is acceptable to the bank to which the note was issued. The proper classification of the
note on the December 31, 2008, balance sheet is
1
2  Chapter 12/Debt Financing
a. dependent on the intention of management.

b. dependent on the actual ability to refinance.
c. current liability, unless specific refinancing criteria are met.
d. noncurrent liability.
TOP: AICPA FN-Reporting MSC: AACSB Reflective Thinking
6. Which of the following does not meet the FASB's definition of a liability?
a. The signing of a three-year employment contract at a fixed annual salary
b. An obligation to provide goods or services in the future
c. A note payable with no specified maturity date
d. An obligation that is estimated in amount
7. Bruemmer Co. has a $20,000, two-year note payable to Second City Bank that matures June 30, 2008.
Bruemmer's management intends to refinance the note for an additional three years and is negotiating
a financing agreement with Second City. In order to exclude this note from current liabilities on its
December 31, 2007, balance sheet, Bruemmer Co. must
a. pay off the note and complete the refinancing before the 2007 financial statements are
issued.
b. demonstrate an ability to refinance the obligation before the 2007 financial statements are
issued.
c. complete the refinancing before the balance sheet date.
d. complete the refinancing before the note's maturity date.
8. In theory (disregarding any other marketplace variables), the proceeds from the sale of a bond will be
equal to
a. the face amount of the bond.
b. the present value of the bond maturity value plus the present value of the interest
payments to be made during the life of the bond.
c. the face amount of the bond plus the present value of the interest payments made during
the life of the bond.
d. the sum of the face amount of the bond and the periodic interest payments.
9. Kenwood Co. neglected to amortize the premium on outstanding ten-year bonds payable. What is the
effect of the failure to record premium amortization on interest expense and bond carrying value,
respectively?
a. Understate; understate
b. Understate; overstate
c. Overstate; overstate
d. Overstate; understate
ANS: C DIF: Medium OBJ: LO 4
Chapter 12/Debt Financing  3
10. Unamortized debt premium should be reported on the balance sheet of the issuer as a
a. direct addition to the face amount of the debt.
b. direct addition to the present value of the debt.
c. deferred credit.
d. deduction from the issue costs.
11. Which one of the following is true when the effective-interest method of amortizing bond discount is
used?
a. Interest expense as a percentage of the bonds' book value varies from period to period.
b. Interest expense remains constant for each period.
c. Interest expense increases each period.
d. The interest rate decreases each period.
12. Scott Inc. neglected to amortize the discount on outstanding ten-year bonds payable. What is the effect
of the failure to record discount amortization on interest expense and bond carrying value,
respectively?
a. Understate; understate
b. Understate; overstate
c. Overstate; overstate
d. Overstate; understate
13. Bond discount should be presented in the financial statements of the issuer as a(n)
a. contra liability.
b. adjunct liability.
c. deferred charge.
d. contra asset.
14. Any gains or losses from the early extinguishment of debt should be
a. recognized in income of the period of extinguishment.
b. treated as an increase or decrease in Paid-In Capital.
c. allocated between a portion that is an increase (decrease) in Paid-In Capital and a portion
that is recognized in current income.
d. amortized over the remaining original life of the extinguished debt.
15. When bonds are retired prior to maturity with proceeds from a new bond issue, gain or loss from the
early extinguishment of debt, if material, should be
a. amortized over the remaining original life of the retired bond issue.
b. amortized over the life of the new bond issue.

c. recognized as an extraordinary item in the period of extinguishment.
d. recognized in income from continuing operations in the period of extinguishment.
ANS: D DIF: Medium OBJ: LO 4
16. When bonds are redeemed by the issuer prior to their maturity date, any gain or loss on the
redemption, if material, is
a. amortized over the period remaining to maturity and reported as an extraordinary item in
the income statement.
b. amortized over the period remaining to maturity and reported as part of income from
continuing operations in the income statement.
c. reported in the income statement as an extraordinary item in the period of redemption.
d. reported in the income statement as part of income from continuing operations in the
period of redemption.
17. The market price of a bond issued at a discount is the present value of its principal amount at the
market (effective) rate of interest
a. plus the present value of all future interest payments at the market (effective) rate of
interest.
b. plus the present value of all future interest payments at the rate of interest stated on the
bond.
c. minus the present value of all future interest payments at the market (effective) rate of
interest.
d. minus the present value of all future interest payments at the rate of interest stated on the
bond.
18. When the interest payment dates of a bond are May 1 and November 1, and the bond is issued on June
1, the amount of interest expense at December 31 of the year of issuance would be for
a. two months.
b. six months.
c. seven months.
d. eight months.
19. For a bond issue that sells for more than its face value, the market rate of interest is
a. dependent on the rate stated on the bond.
b. equal to the rate stated on the bond.
c. less than the rate stated on the bond.
d. higher than the rate stated on the bond.
20. How would the carrying value of a bond payable be affected by amortization of each of the following?
Discount Premium
a. No effect No effect
b. Increase No effect
c. Increase Decrease
d. Decrease Increase

21. For the issuer of ten-year bonds, the amount of amortization using the effective-interest method would
increase each year if the bonds were sold at a
Discount Premium
a. No No
b. Yes Yes
c. No Yes
d. Yes No

22. Outstanding bonds payable are converted into common stock. Under either the book value or market
value method, the same amount would be debited to
Bonds Premium on
Payable Bonds Payable
a. No No
b. No Yes
c. Yes No
d. Yes Yes

23. Debentures are

a. unsecured bonds.
b. secured bonds.
c. ordinary bonds.
d. serial bonds.
24. Callable bonds

a. can be redeemed by the issuer at some time at a pre-specified price.
b. can be converted to stock.
c. mature in a series of payments.
d. None of the above.
25. The issuance price of a bond does not depend on the

a. face value of the bond.
b. riskiness of the bond.
c. method used to amortize the bond discount or premium.
d. effective interest rate.
26. The effective interest rate on bonds is higher than the stated rate when bonds sell
a. at face value.
b. above face value.
c. below face value.
d. at maturity value.
27. Bonds usually sell at a discount when

a. investors are willing to invest in the bonds at the stated interest rate.
b. investors are willing to invest in the bonds at rates that are lower than the stated interest
rate.
c. investors are willing to invest in the bonds only at rates that are higher than the stated
interest rate.
d. a capital gain is expected.
28. Bonds usually sell at a premium

a. when the market rate of interest is greater than the stated rate of interest on the bonds.
b. when the stated rate of interest on the bonds is greater than the market rate of interest.
c. when the price of the bonds is greater than their maturity value.
d. in none of the above cases.
29. The effective interest rate on bonds is lower than the stated rate when bonds sell
a. at maturity value.
b. above face value.
c. below face value.
d. at face value.
30. To compute the price to pay for a bond, you use

a. only the present value of $1 concept.
b. only the present value of an annuity of $1 concept.
c. both a and b.
d. neither a nor b.

31. Which of the following is true of a premium on bonds payable?

a. It is a contra-stockholders' equity account.
b. It is an account that appears only on the books of the investor.
c. It increases when amortization entries are made until it reaches its maturity value.
d. It decreases when amortization entries are made until its balance reaches zero at the
maturity date.
32. The net amount of a bond liability that appears on the balance sheet is the
a. call price of the bond plus bond discount or minus bond premium.
b. face value of the bond plus related premium or minus related discount.
c. face value of the bond plus related discount or minus related premium.
d. maturity value of the bond plus related discount or minus related premium.
ANS: B DIF: Easy OBJ: LO 4
33. When interest expense is calculated using the effective-interest amortization method, interest expense
(assuming that interest is paid annually) always equals the
a. actual amount of interest paid.
b. book value of the bonds multiplied by the stated interest rate.
c. book value of the bonds multiplied by the effective interest rate.
d. maturity value of the bonds multiplied by the effective interest rate.
34. When a company issues bonds, how are unamortized bond discounts and premiums classified on the
balance sheet?
a. Bond discounts are classified as assets, and bond premiums are classified as contra-asset
accounts.
b. Bond discounts are classified as expenses, and bond premiums are classified as revenues.
c. Bond premiums are classified as additions to, and bond discounts are classified as
deductions from, the face value of bonds.
35. The effective-interest method of amortizing bond premiums

a. is too complicated for practical use.
b. uses a constant rate of interest.
c. is another name for the straight-line method.
d. is needed to determine the amount of cash to be paid to bondholders at each interest date.
36. The net amount required to retire a bond before maturity (assuming no call premium and constant
interest rates) is the
a. issuance price of the bond plus any unamortized discount or minus any unamortized
premium.
b. face value of the bond plus any unamortized premium or minus any unamortized discount.
c. face value of the bond plus any unamortized discount or minus any unamortized premium.
d. maturity value of the bond plus any unamortized discount or minus any unamortized
premium.
ANS: B DIF: Challenging OBJ: LO 4
37. RCM Corporation, a calendar-year firm, is authorized to issue $200,000 of 10 percent, 20-year bonds
dated January 1, 2008, with interest payable on January 1 and July 1 of each year. If the bonds were
issued to yield 12 percent, the entry to account for the discount amortization and accrual of interest on
December 31, 2008, would include a
a. debit to Discount on Bonds Payable.
b. credit to Cash.
c. credit to Interest Payable.
d. debit to Bonds Payable.
38. Accrued interest on bonds that are sold between interest dates
a. is ignored by both the seller and the buyer.
b. increases the amount a buyer must pay to acquire the bonds.
c. is recorded as a loss on the sale of the bonds.
d. decreases the amount a buyer must pay to acquire the bonds.
39. When bonds are sold between interest dates, any accrued interest is credited to
a. Interest Payable.
b. Interest Revenue.
c. Interest Receivable.
d. Bonds Payable.
40. Which of the following is true of accrued interest on bonds that are sold between interest dates?
a. It is computed at the effective market rate.
b. It will be paid to the seller when the bonds mature.
c. It is extra income to the buyer.
41. On July 1, 2008, Riviera Manufacturing Co. issued a five-year note payable with a face amount of
$250,000 and an interest rate of 10 percent. The terms of the note require Riviera to make five annual
payments of $50,000 plus accrued interest, with the first payment due June 30, 2009. With respect to
the note, the current liabilities section of Riviera's December 31, 2008, balance sheet should include
a. $12,500.
b. $50,000.
c. $62,500.
d. $75,000.
42. In an effort to increase sales, Blue Razor Blade Company inaugurated a sales promotion campaign on
June 30, 2008, whereby Blue placed a coupon in each package of razor blades sold, the coupons being
redeemable for a premium. Each premium costs Blue $.50, and five coupons must be presented by a
customer to receive a premium. Blue estimated that only 60 percent of the coupons issued will be
redeemed. For the six months ended December 31, 2008, the following information is available:
Packages of razor blades sold ......................... 400,000

Premiums purchased .................................... 30,000
Coupons redeemed ...................................... 100,000
What is the estimated liability for premium claims outstanding at December 31, 2008?
a. $10,000
b. $14,000
c. $18,000
d. $24,000
43. Included in Kaiser Corporation's liability account balances at December 31, 2008, were the following:
14 percent note payable issued October 1, 2008, $250,000

maturing September 30, 2009 .............
16 percent note payable issued April 1, 2006, payable
in six annual installments of $100,000
beginning April 1, 2007 ................. 400,000
Kaiser's December 31, 2008, financial statements were issued on March 31, 2009. On January 15,
2009, the entire $400,000 balance of the 16 percent note was refinanced by issuance of a long-term
obligation payable in a lump sum. In addition, on March 10, 2009, Kaiser consummated a
noncancelable agreement with the lender to refinance the 14 percent, $250,000 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, 2008, balance sheet, the amount of the notes payable that Kaiser should classify
as noncurrent obligations is
a. $100,000.
b. $250,000.
c. $350,000.
d. $650,000.
44. At December 31, 2008, Reed Corp. owed notes payable of $1,000,000 with a maturity date of April
30, 2009. These notes did not arise from transactions in the normal course of business. On February 1,
2009, Reed issued $3,000,000 of ten-year bonds with the intention of using part of the bond proceeds
to liquidate the $1,000,000 of notes payable. Reed's December 31, 2008, financial statements were
issued on March 29, 2009. How much of the $1,000,000 notes payable should be classified as current
in Reed's balance sheet at December 31, 2008?
a. $0
b. $100,000
c. $900,000
d. $1,000,000
45. Dean, Inc. has $2,000,000 of notes payable due June 15, 2009. At the financial statement date of
December 31, 2008, Dean signed an agreement to borrow up to $2,000,000 to refinance the notes
payable on a long-term basis. The financing agreement called for borrowings not to exceed 80 percent
of the value of the collateral Dean was providing. At the date of issue of the December 31, 2008,
financial statements, the value of the collateral was $2,400,000 and was not expected to fall below this
amount during 2009. In its December 31, 2008, balance sheet, Dean should classify notes payable as
Short-Term Long-Term
Obligations Obligations
a. $2,000,000 $0
b. $400,000 $1,600,000
c. $80,000 $1,920,000
d. $0 $2,000,000

46. Swanson Inc. purchased $400,000 of Malone Corp. ten-year bonds with a stated interest rate of 8
percent payable quarterly. At the time the bonds were purchased, the market interest rate was 12
percent. Determine the amount of premium or discount on the purchase of the bonds.
a. $92,442 premium
b. $92,442 discount
c. $81,143 premium
d. $81,143 discount
47. Madison Corporation had two issues of securities outstanding-- common stock and a 5 percent
convertible bond issue in the face amount of $10,000,000. Interest payment dates of the bond issue are
June 30 and December 31. The conversion clause in the bond indenture entitles the bondholders to
receive 40 shares of $20 par value common stock in exchange for each $1,000 bond. On June 30,
2008, the holders of $1,800,000 face value bonds exercised the conversion privilege. The market price
of the bonds on that date was $1,100 per bond and the market price of the common stock was $35. The
total unamortized bond discount at the date of conversion was $500,000. What amount should
Madison credit to the account "Paid-In Capital in Excess of Par" as a result of this conversion
assuming Madison does not want to recognize any gain (or loss) on the conversion?
a. $0
b. $270,000
c. $360,000
d. $920,000
48. Selected financial data of Alexander Corporation for the year ended December 31, 2008, is presented
below:
Operating income ...................................... $900,000

Interest expense ...................................... (100,000)
Income before income tax .............................. $800,000
Income tax expense .................................... (320,000)
Net income ............................................ $480,000
Preferred stock dividends ............................. (200,000)
Net income available to common stockholders ........... $280,000
Common stock dividends were $120,000. The times-interest-earned ratio is

a. 2.8 to 1.
b. 4.8 to 1.
c. 6.0 to 1.
d. 9.0 to 1.
49. Littleton Corp. had the following long-term debt at December 31:
Collateral trust bonds, having securities of unrelated

corporations as security ............................ $250,000
Bonds unsecured as to principal ....................... 150,000
The debenture bonds amounted to

a. $0.
b. $150,000.
c. $250,000.
d. $400,000.
50. Miller Enterprises had the following long-term debt:

Sinking fund bonds, maturing in installments .......... $1,100,000

Industrial revenue bonds, maturing in installments .... 900,000
Subordinated bonds, maturing on a single date ......... 1,500,000
The total of the serial bonds amounted to

a. $900,000.
b. $1,500,000.
c. $2,000,000.
d. $2,400,000.
51. On January 1, MAX issued ten-year bonds with a face amount of $1,000,000 and a stated interest rate
of 8 percent payable annually each January 1. The bonds were priced to yield 10 percent. The total
issue price (rounded) of the bonds was
a. $1,000,000.
b. $980,000.
c. $920,000.
d. $880,000.
52. During the year, Hancock Corporation incurred the following costs in connection with the issuance of
bonds:
Printing and engraving ................................ $ 30,000

Legal fees ............................................ 160,000
Fees paid to independent accountants for registration 20,000
information ...........................................
Commissions paid to underwriter ....................... 300,000
The amount recorded as a deferred charge to be amortized over the term of the bonds is
a. $0.
b. $30,000.
c. $300,000.
d. $510,000.
ANS: D DIF: Easy OBJ: LO 4
53. On January 1, 2008, Lisbon Corp. issued 2,000 of its 9 percent, $1,000 bonds at 95. Interest is payable
semiannually on July 1 and January 1. The bonds mature on January 1, 2018. Lisbon paid bond issue
costs of $80,000, which are appropriately recorded as a deferred charge. Lisbon uses the straight-line
method of amortizing bond discount and bond issue costs. On Lisbon's December 31, 2008, balance
sheet, how much would be shown as the carrying amount of the bonds payable?
a. $2,110,000
b. $2,090,000
c. $1,982,000
d. $1,910,000
ANS: D DIF: Challenging OBJ: LO 4
54. On October 1, 2008, Westridge Inc. issued, at 101 plus accrued interest, 800 of its 10 percent, $1,000
bonds. The bonds are dated July 1, 2008, and mature on July 1, 2015. Interest is payable semiannually
on January 1 and July 1. At the time of issuance, Westridge would receive cash of
a. $800,000.
b. $808,000.
c. $820,000.
d. $828,000.
55. On January 1, 2008, Matlock Inc. issued its 10 percent bonds in the face amount of $1,500,000. They
mature on January 1, 2018. The bonds were issued for $1,329,000 to yield 12 percent, resulting in
bond discount of $171,000. Matlock uses the effective-interest method of amortizing bond discount.
Interest is payable July 1 and January 1. For the six months ended June 30, 2008, Matlock should
report bond interest expense of
a. $75,000.
b. $79,740.
c. $83,550.
d. $85,260.
56. On July 1, 2008, TJR issued 2,000 of its 8 percent, $1,000 bonds for $1,752,000. The bonds were
issued to yield 10 percent. The bonds are dated July 1, 2008, and mature on July 1, 2018. Interest is
payable semiannually on January 1 and July 1. Using the effective-interest method, how much of the
bond discount should be amortized for the six months ended December 31, 2008?
a. $15,200
b. $12,400
c. $9,920
d. $7,600
57. On July 1, 2008, Houston Company purchased as a long-term investment Essex Company's ten-year, 9
percent bonds, with a face value of $100,000 for $95,200. Interest is payable semiannually on January
1 and July 1. The bonds mature on July 1, 2012. Houston uses the straight-line method of amortization.
What is the amount of interest revenue that Houston should report in its income statement for the year
ended December 31, 2008?
a. $3,900
b. $4,500
c. $5,100
d. $5,700
58. On February 1, 2006, Lantern Corp. issued 12 percent, $2,000,000 face value, ten-year bonds for
$2,234,000 plus accrued interest. The bonds are dated November 1, 2005, and interest is payable on
May 1 and November 1. Lantern reacquired all of these bonds at 102 on May 1, 2009, and retired
them. Unamortized bond premium on that date was $156,000. Ignoring the income tax effect, what
was Lantern's gain on the bond retirement?
a. $116,000
b. $194,000
c. $234,000
d. $236,000
ANS: A DIF: Challenging OBJ: LO 4
59. Laker, Inc. had outstanding 10 percent, $1,000,000 face value, convertible bonds maturing on
December 31, 2011. Interest is paid December 31 and June 30. After amortization through June 30,
2008, the unamortized balance in the bond premium account was $30,000. On that date, bonds with a
face amount of $500,000 were converted into 20,000 shares of $20 par common stock. Recording the
conversion by using the carrying value of the bonds, Laker should credit Additional Paid-In Capital for
a. $0.
b. $85,000.
c. $100,000.
d. $115,000.
60. On July 1, 2005 Cooper Corporation issued for $960,000 one thousand of its 9 percent, $1,000 callable
bonds. The bonds are dated July 1, 2005, and mature on July 1, 2015. Interest is payable semiannually
on January 1 and July 1. Cooper uses the straight-line method of amortizing bond discount. The bonds
can be called by the issuer at 101 at any time after June 30, 2010. On July 1, 2011, Cooper called in all
of the bonds and retired them. Ignoring income taxes, how much loss should Cooper report on this
early extinguishment of debt for the year ended December 31, 2011?
a. $50,000
b. $34,000
c. $26,000
d. $10,000
ANS: C DIF: Challenging OBJ: LO 4
61. On June 30, 2008, Country Inc. had outstanding 10 percent, $1,000,000 face amount, 15-year bonds
maturing on June 30, 2013. Interest is paid on June 30 and December 31, and bond discount and bond
issue costs are amortized on these dates. The unamortized balances on June 30, 2008, of bond discount
and bond issue costs were $55,000 and $20,000, respectively. Country reacquired all of these bonds at
96 on June 30, 2008, and retired them. Ignoring income taxes, how much gain or loss should Country
record on the bond retirement?
a. Loss of $15,000
b. Loss of $35,000
c. Gain of $5,000
d. Gain of $40,000
62. White Sox Corporation issued $200,000 of 10-year bonds on January 1. The bonds pay interest on
January 1 and July 1 and have a stated rate of 10 percent. If the market rate of interest at the time the
bonds are sold is 8 percent, what will be the issuance price of the bonds?
a. $175,078
b. $211,283
c. $215,902
d. $227,183
63. White Sox Corporation issued $200,000 of 10-year bonds on January 1. The bonds pay interest on
January 1 and July 1 and have a stated rate of 10 percent. If the market rate of interest at the time the
bonds are sold is 12 percent, what will be the issuance price of the bonds?
a. $114,699
b. $177,059
c. $190,079
d. $224,926
64. On January 1, 2008, $50,000 of 20-year, 6 percent debentures were issued for $56,275.20. Interest
payment dates on the bonds are January 1 and July 1. The amount of premium to be amortized on July
1, 2008, when using the straight-line method is
a. $313.76.
b. $156.88.
c. $776.50.
d. $93.11.
65. The total interest expense on a $200,000, 10 percent, 10-year bond issued at 95 would be
a. $190,000.
b. $195,000.
c. $200,000.
d. $210,000.
66. The effective interest rate of a 10-year, 8 percent, $1,000 bond issued at 103 would be approximately
a. 7.6 percent.
b. 7.8 percent.
c. 8.0 percent.
d. 8.2 percent.
67. On January 1, 2008, Deily Corporation issued $500,000 of 10 percent, 10-year bonds at 88.5. Interest
is payable on December 31. If the market rate of interest was 12 percent at the time the bonds were
issued, how much cash was paid for interest in 2008?
a. $44,250
b. $50,000
c. $53,100
d. $60,000
68. Assuming the straight-line method of amortization is used, the average yearly interest expense on a
$250,000, 11 percent, 20-year bond issued at 94 would be
a. $26,750.
b. $27,500.
c. $28,250.
d. $29,500.
69. The annual interest expense on a $50,000, 15-year, 10 percent bond issued for $45,650 plus accrued
interest 6 months after authorization, assuming straight-line amortization, would be
a. $4,975.
b. $5,000.
c. $5,025.
d. $5,300.
70. On January 1, 2008, Felipe Hospital issued a $250,000, 10 percent, 5-year bond for $231,601. Interest
is payable on June 30 and December 31. Felipe uses the effective-interest method to amortize all
premiums and discounts. Assuming an effective interest rate of 12 percent, how much interest expense
should be recorded on June 30, 2008?
a. $11,935.14
b. $12,500.00
c. $13,896.06
d. $14,729.82
71. A $50,000 bond with a carrying value of $52,000 was called at 103 and retired. In recording the
retirement, the issuing company should
a. record no gain or loss.
b. record a $1,500 loss.
c. record a $2,000 gain.
d. record a $500 gain.
ANS: D DIF: Easy OBJ: LO 4
72. On January 1, 2008, Felipe Hospital issued a $250,000, 10 percent, 5-year bond for $231,601. Interest
is payable on June 30 and December 31. Felipe uses the effective-interest method to amortize all
premiums and discounts. Assuming an effective interest rate of 12 percent, approximately how much
discount will be amortized on December 31, 2008?
a. $2,230
b. $1,480
c. $1,396
d. $987
Kiyabu County issued a $500,000, 10 percent, 10-year bond on January 1, 2008, for 113.6 when the
effective interest rate was 8 percent. Interest is payable on June 30 and December 31. Kiyabu uses the
effective-interest method to amortize all premiums and discounts.
73. How much premium or discount should be amortized on June 30, 2008?
a. $2,790
b. $2,280
c. $2,000
d. $1,970
74. How much interest expense should Kiyabu record on December 31, 2008?
a. $25,000.00
b. $23,810.15
c. $22,628.80
d. $19,920.10
75. Foster Corporation issued a $100,000, 10-year, 10 percent bond on January 1, 2007, for $112,000.
Foster uses the straight-line method of amortization. On April 1, 2010, Foster reacquired the bonds for
retirement when they were selling at 102 on the open market. How much gain or loss should Foster
recognize on the retirement of the bonds?
a. $2,000 loss
b. $3,900 gain
c. $6,100 gain
d. $8,200 loss
ANS: C DIF: Challenging OBJ: LO 4
76. If a $1,000, 9 percent, 10-year bond was issued at 96 plus accrued interest one month after the
authorization date, how much cash was received by the issuer?
a. $967.50
b. $960.00
c. $1,007.50
d. $992.50

77. Bonds that were authorized on January 1, 2008, and that pay interest on January 1 and July 1 of each
year were issued on October 1, 2008. If the issuer's accounting year ends on December 31, how many
months would any discount or premium be amortized in 2008?
a. 3 months
b. 6 months
c. 9 months
d. 12 months
78. If a $1,000, 9 percent, 10-year bond was issued at 103 plus accrued interest one month after the
authorization date, how much cash did the issuer receive?
a. $1,037.50
b. $1,030.00
c. $1,007.50
d. $992.50
RCM Corporation, a calendar-year firm, is authorized to issue $200,000 of 10 percent, 20-year bonds
dated January 1, 2008, with interest payable on January 1 and July 1 of each year.
79. If the bonds were issued on April 1, 2008, the amount of accrued interest on the date of sale is
a. $20,000.
b. $10,000.
c. $5,000.
d. $2,500.
80. If the bonds were issued at 97 on April 1, 2008, plus accrued interest, the amount of cash received by
RCM Corporation would be
a. $200,000.
b. $194,000.
c. $199,000.
81. If the bonds were issued at 97 on April 1, 2008, the amount of the discount amortized on July 1 (using
the straight-line method) would be approximately
a. $25.
b. $76.
c. $67.
d. $152.

82. If a $6,000, 10 percent, 10-year bond was issued at 104 plus accrued interest two months after the
authorization date, how much cash was received by the issuer?
a. $6,000
b. $6,240
c. $6,340
d. $6,600
83. ABC Corporation is authorized to issue $500,000 of 6 percent, 10-year bonds dated July 1, 2008, with
interest payments on December 31 and June 30. When the bonds are issued on November 1, 2008,
ABC Corporation receives cash of $515,000, including accrued interest. The journal entry to record
the issuance of the bonds would include
a. $15,000 bond premium.
b. $5,000 bond premium.
c. $15,000 bond discount.
d. no bond premium or discount.
84. On January 1, 2008, Williams Company lent $17,800 cash to Stone Company. The promissory note
made by Stone for $20,000 did not bear explicit interest and was due on December 31, 2010. No other
rights or privileges were exchanged. The prevailing interest rate for a loan of this type was six percent.
Assume that the present value of $1 for two periods at six percent is .89. Stone should recognize
interest expense in 2008 of
a. $0.
b. $1,068.
c. $1,100.
d. $1,200.
85. Johnson Corporation bought a new machine and agreed to pay for it in equal annual installments of
$6,000 at the end of each of the next five years. Assume the prevailing interest rate for this type of
transaction is 12%. Assume the present value of an ordinary annuity of $1 at 12% for five periods is
3.60. The future amount of an ordinary annuity of $1 at 12% for five periods is 6.35. The present value
of $1 at 12% is 0.567. How much should Johnson record as the note payable on the balance sheet if
financial statements were prepared today?
a. $17,010
b. $21,600
c. $30,000
d. $38,100
86. On December 31, 2008, Carlton Corporation's current liabilities total $50,000 and long-term liabilities
total $150,000. Working capital at December 31, 2008, is equal to $80,000. If Carlton Corporation's
debt-to-equity ratio is .32 to 1, total long-term assets must equal
a. $625,000.
b. $745,000.
c. $825,000.
d. $695,000.
87. On December 31, 2008, Roberts Corporation's current liabilities total $60,000 and long-term liabilities
total $160,000. Working capital at December 31, 2008, is equal to $90,000. If Roberts Corporation's
a. $620,000.
b. $770,000.
c. $550,000.
d. $680,000.
88. On December 31, 2008, Anderson Company's current liabilities total $55,000 and long-term liabilities
total $155,000. Working capital at December 31, 2008, is equal to $85,000. If Anderson Company's
a. $910,000.
b. $770,000.
c. $700,000.
d. $825,000.
89. An entity would be considered the primary beneficiary of a variable interest entity (VIE) if
a. the entity provides the majority of financial support when other parties are providing
financial support to the VIE as well.
b. the entity holds the largest voting interest in the VIE.
c. the entity holds an equity interest equal to 10% of the total assets of the VIE.
d. the entity holds an equity interest equal to 20% of the total assets of the VIE.
90. A variable interest in a variable interest entity (VIE) may arise from all of the following except
a. management contracts.
b. service contracts.
c. leases.
d. defined-benefit pension plans.
PROBLEM
1. In an effort to increase sales, Rofix Company began a sales promotion campaign on June 30, 2008.
Part of this promotion included placing a special coupon in each package of candy bars sold.
Customers were able to redeem ten coupons for a Frisbee. Each premium costs Rofix $1.50. Rofix
estimated that 60 percent of the coupons issued will be redeemed. For the six months ended December
31, 2008, the following information is available:
Packages of candy bars sold ........................... 3,200,000

Premiums purchased .................................... 172,000
Coupons redeemed ...................................... 1,425,000
ANS:
Number of coupons issued .............................. 3,200,000
Expected participation rate ...........................  60%
Expected coupon redemptions ........................... 1,920,000
 10%
Estimated total premiums .............................. 192,000
Number redeemed to date (1,425,000 coupons  10%) ..... - 142,500
Expected remaining premiums ........................... 49,500
49,500 premiums @ $1.50 each = ........................ $ 74,250
DIF: Challenging OBJ: LO 2 TOP: AICPA FN-Measurement

MSC: AACSB Analytic
2. Monumental Studios, in an effort to promote the release of their new movie "Ninjas from Space,"
began a national sales promotion campaign. Two coupons from specially marked boxes (one coupon in
each box) of "Sugar Charms" cereal are redeemable for one ticket to the show. Tickets cost
Monumental $1.50 each. Monumental estimates that 40 percent of the coupons will be redeemed. At
the end of 2008, the following information is available:
Boxes of cereal sold 640,000

Movie tickets purchased by Monumental 140,000
Coupons redeemed 250,000
ANS:
Number of coupons available 640,000
Expected redemption rate  40%
256,000
(two coupons per ticket)  50%
Estimated premiums 128,000
Premiums redeemed to date (250,000/2 coupons per ticket) 125,000
Expected remaining premiums 3,000
3,000 tickets  $1.50 each = $ 4,500

MSC: AACSB Analytic
3. On March 1, 2008, Pyne Furniture Co. issued $700,000 of 10 percent bonds to yield 8 percent. Interest
is payable semiannually on February 28 and August 31. The bonds mature in ten years. Pyne Furniture
Co. is a calendar-year corporation.
(1) Determine the issue price of the bonds. Show your computations.
(2) Prepare an amortization table through the first two interest periods using the
effective-interest method.
(3) Prepare the journal entries to record bond-related transactions as of the following
dates:
(a) March 1, 2008
(b) August 31, 2008
(c) December 31, 2008
(d) February 28, 2009
ANS:
(1)
Calculation of bond sale price: i = 4% n = 20
Present value of the face amount ($700,000  .4564) $319,480
Present value of the interest ($35,000  13.5903) 475,661
$795,141
(2)
Amortization table:
Interest Interest Amortization Carrying
Date Payment Expense of Premium Value
3/1/2008 $795,141
8/31/2008 $35,000 $31,806* $3,194 791,947
2/28/2009 35,000 31,678** 3,322 788,625
Computations:
* $795,141  4% = $31,806
** $791,947  4% = $31,678
(3)
Journal entries:
(a) 3/1/2008 Cash 795,141

Premium
on Bonds 95,741
Payable
Bonds
700,000
Payable
(b) Interest
8/31/2008 31,806
Expense
Premium on
Bonds 3,194
Payable
Cash 35,000
(c) 12/31/2008 Interest 21,119

Expense
($31,678
 4/6)
Premium on
Bonds
Payable 2,215
($3,322 
4/6)
Interest
Payable
23,334
($35,000 
4/6)
(d) Assuming no reversing entries:

2/28/2009 Interest Payable 23,334
Premium on
Bonds 1,107
Payable
Interest
10,559
Expense
Cash 35,000

MSC: AACSB Analytic
4. On June 1, 2008, Jefferson Controls, Inc. issued $12,000,000 of 10 percent bonds to yield 12 percent.
Interest is payable semiannually on May 31 and November 30. The bonds mature in 15 years.
Jefferson Controls, Inc. is a calendar-year corporation.
(1) Determine the issue price of the bonds. Show computations.

(2) Prepare an amortization table through the first two interest periods using the
effective-interest method.
(3) Prepare the journal entries to record bond-related transactions as of the following
dates:
(a) June 1, 2008
(b) November 30, 2008
(c) December 31, 2008
(d) May 31, 2009
ANS:
(1)
Calculation of bond sale price: i = 6% n = 30
Present value of face amount ($12,000,000  .1741) ..... $ 2,089,200
Present value of interest ($600,000  13.7648) ......... 8,258,880
$10,348,080
(2)
Amortization table:
Interest Interest Amortization Carrying
Date Payment Expense of Discount Value
6/1/2008 $10,348,080
11/30/2008 $600,000 $620,885* $20,885 10,368,965
5/31/2009 600,000 622,138** 22,138 10,391,103
Computations:
* $10,348,080  6% = $620,885
** $10,368,965  6% = $622,138
(3)
Journal entries:
(a)
6/1/2008 Cash ........................... 10,348,080
Discount on Bonds Payable ...... 1,651,920
Bonds Payable .................. 12,000,000
(b)
11/30/2008 Interest Expense ............... 620,885
Cash ......................... 600,000
Discount on Bonds Payable .... 20,885
(c)
12/31/2008 Interest Expense
($622,138  1/6 = $103,690) ... 103,690
Discount on Bonds Payable
($22,138  1/6 = 3,690) ..... 3,690
Interest Payable
($600,000  1/6) ............ 100,000
(d)
Assuming no reversing entries:
5/31/2009 Interest Expense ............... 518,448
Interest Payable ............... 100,000
Discount on Bonds Payable .... 18,448
Cash ......................... 600,000

MSC: AACSB Analytic
5. The December 31, 2008, balance sheet of Far Imports includes the following items:
9% bonds payable due 12/31/2017 ...................... $800,000

Discount on bonds payable ............................. 21,600
The bonds were issued on December 31, 2007, at 97, with interest payable on June 30 and December
31 of each year. The straight-line method is used for discount amortization.
On March 1, 2009, Far Imports retired $400,000 of these bonds at 98 plus accrued interest. Prepare the
journal entries to record retirement of the bonds, including accrual of interest since the last payment
and amortization of the discount.
ANS:
3/1/2009 Interest Expense ................ 6,000
Interest Payable .............. 6,000
($400,000  9%  2/12)
Interest Expense ................ 200

Discount on Bonds Payable ..... 200
$24,000/10 years = $2,400 per year
$2,400  1/2  2/12 = $200
Interest Payable ................. 6,000

Bonds Payable .................... 400,000
Loss on Early Retirement of Bonds** 2,600
Discount on Bond Payable* ...... 10,600
Cash ($392,000 + $6,000) ....... 398,000
* $10,800 - $200 = $10,600
** Reacquisition Price ($400,000  98%) $392,000
Carrying Value ($400,000 - $10,600)... 389,400
Loss on Early Retirement of Bonds..... $ 2,600

MSC: AACSB Analytic
6. On May 1, 2007, J. Cumming acquired $300,000 of Belred Enterprises 12 percent bonds due in five
years with interest payable semiannually on May 1 and November. The bonds were purchased at
$325,268--a price to return 10 percent on the investment. On November 1, 2007, and May 1, 2008,
Cumming collected the interest on the bonds. On August 1, 2008, Cumming sold the bonds at 107 plus
accrued interest.
Rounding figures to the nearest dollar, provide the entries required to record the:
(1) Interest collections in 2007 and 2008, assuming that the entries for the premium
amortization are made at the time interest is collected. (Use the effective-interest
method.)
(2) Sale of bonds.
ANS:
(1)
2007
Nov. 1 Cash ($300,000  12%  6/12) ........ 18,000
Interest Revenue* ................. 16,263
Investment in Carpenter Bonds ..... 1,737
2008
May 1 Cash ................................ 18,000
Interest Revenue** ................ 16,177
(2)
Aug. 1 Cash*** ............................. 330,000
Interest Revenue**** .............. 8,043
Gain on Sale of Investment ........ 249
* ($325,268  10%  6/12) = $16,263

** [($325,268 - $1,737)  10%  6/12] = $16,177
*** [$321,000 + ($300,000  12%  3/12)] = $330,000
**** [($325,268 - $1,737 - $1,823)  10%  3/12] =
$8,043

MSC: AACSB Analytic
7. On February 1, 2004, AmeriGas sold $300,000, 12 percent, ten-year bonds at 96 plus accrued interest.
Interest is payable semiannually on June 1 and December 1. The bond issue was dated December 1,
2003. On July 31, 2005, $150,000 of the issue was reacquired at 95 plus accrued interest.
Make the entries on the issuer's books for the sale of the bonds, the payment of interest, amortization
of premium or discount, and accrual of interest, and reacquisition as needed for 2004 and 2005.
Straight-line amortization is recorded at the end of the calendar year and accruals are reversed. (Round
all calculations.)
ANS:
2007
Feb. 1 Cash .............................. 294,000
Discount on Bonds Payable ......... 12,000
Interest Expense ................ 6,000
Bonds Payable ................... 300,000
June 1 Interest Expense .................. 18,000

Cash ............................ 18,000
Dec. 1 Interest Expense .................. 18,000

Cash ............................ 18,000
Dec. 31 Interest Expense .................. 4,119

Discount on Bonds Payable 1,119
(11/118  $12,000) ............
Interest Payable ................ 3,000
2008
Jan. 1 Interest Payable .................. 3,000
Interest Expense ................ 3,000
June 1 Interest Expense .................. 18,000

Cash ............................ 18,000
July 31 Interest Expense (7/118  $6,000).. 356

Discount on Bonds Payable ....... 356
July 31 Bonds Payable ..................... 150,000

Interest Expense .................. 3,000
Discount on Bonds Payable ....... 5,085
Cash ............................ 145,500
Gain on Bond Reacquisition ...... 2,415
Note: $150,000 of bonds remain outstanding.

MSC: AACSB Analytic
8. On January 1, 2007, Kate Products issued ten-year convertible bonds of $1,800,000 at 105. Interest is
payable semiannually on June 30 and December 31 at a rate of 12 percent. On June 30, 2009, the
company retired bonds of $150,000 at 102 plus accrued interest. Straight-line amortization is recorded
at the end of the calendar year.
(1) Provide the entries required to record the issuance and retirement of the bonds.
(2) Assuming that each $1,000 bond is convertible into eight shares of Kate Products'
$120 par common stock (with market value of $130), provide the entries on June
30, 2000, for the two methods that may be used to record a conversion rather than a
retirement of $150,000 of bonds.
ANS:
(1)
2007
Jan. 1 Cash ($1,800,000  1.05) ............. 1,890,000
Bonds Payable ...................... 1,800,000
Premium on Bonds Payable ........... 90,000
2009
June 30 Premium on Bonds Payable .............
(6/120  $150,000/$1,800,000  $90,000) 375
Interest Expense ................... 375
June 30 Bonds Payable ........................ 150,000

Premium on Bonds Payable .............
(90/120  $150,000/$1,800,000  $90,000) 5,625
Interest Expense ..................... 9,000
Gain on Bond Retirement ............ 2,625
Cash ............................... 162,000
(2)
Stock recorded at book value of bonds:
2009
June 30 Premium on Bonds Payable ............. 375
Bonds Payable ........................ 150,000

Premium on Bonds Payable ............. 5,625
Cash 9,000
Common Stock (1,200 shares  $120).. 144,000
Paid-In Capital in Excess of Par ... 11,625
Stock recorded at market value of stock:

2009
June 30 Premium on Bonds Payable ............. 375
Bonds Payable ........................ 150,000

Premium on Bonds Payable ............. 5,625
Loss on Conversion of Bonds .......... 375
Cash ............................... 9,000
Common Stock (1,200 shares  $120).. 144,000
Paid-In Capital in Excess of Par ... 12,000

MSC: AACSB Analytic
9. On January 2, 2003, Picard Enterprises issued $2,400,000 of 8 percent, 15-year semiannual coupon
bonds to yield 7.5 percent. Each bond is convertible into 40 shares of $15 par common stock, which
was trading at $20 per share on the date of the bond issue. The bonds were issued at 106. Without the
conversion feature, the bonds would have been issued for 104.5.
On January 3, 2008, all of the bonds were converted into common stock. The market price of the stock
was $28 per share on the date of conversion. The issue premium is amortized using the straight-line
method.
(1) Provide the journal entry to record issuance of the bonds.

(2) Provide the journal entry to record the conversion of the bonds assuming Picard
considers the conversion
(a) not to be a significant culminating transaction.
(b) to be a significant culminating transaction.
(3) Explain the theoretical justification for either the book value or market value
method of recording conversion.
ANS:
(1)
Issuance of Bonds:
Cash ($2,400,000  106%) .................... 2,544,000
Bonds Payable ............................. 2,400,000
Premium on Bonds Payable .................. 144,000
(2)
Conversion:
(a)
Book value method:
Bonds Payable ............................... 2,400,000
Premium on Bonds Payable .................... 96,000
Common Stock (2,400  40  $15 par) ....... 1,440,000
Paid-In Capital in Excess of Par .......... 1,056,000
Note: The bonds were converted after five years, so 1/3 of the $144,000 issue
premium would have been amortized and 2/3 would be unamortized at the
date of conversion.
(b)
Bonds Payable ............................... 2,400,000
Premium on Bonds Payable .................... 96,000
Loss on Conversion .......................... 192,000
Common Stock (2,400  40  $15 par) ....... 1,440,000
Paid-In Capital in Excess of Par
(2,400  40  $13) ........................ 1,248,000
Note: Paid-In Capital in Excess of Par would be credited for $13 per share ($28 fair
market value - $15 par). A loss is recorded for the difference between the fair
market value of the stock and the carrying value of the bonds.
(3)
Theoretical justification:
Book value method: Most companies record the conversion using the book value method because they
do not want to record a loss on the conversion, which generally arises because an increase in the
market value of the stock triggers the conversion. Use of the book value method is theoretically
justified if the conversion is viewed as the second step of a two-step transaction to issue common
stock, the first step being the issuance of the convertible bonds. Since the issuer's intent was ultimately
to issue stock, and the issue price received in cash is the issue price of the bonds, the book value
method accurately reflects the amount of capital provided by the financing.
Market value method: If the issuance of convertible debt is viewed as a separate and independent
transaction from the conversion of the debt, the market value method would be used. Proponents of
this view argue that the issuance of the bonds is a debt transaction and that the loss that generally
results upon conversion should be recorded to disclose the amount of capital foregone by issuing stock
through a convertible debt security. The major advantage to the market value method is that
contributed capital is stated at a higher amount than under the book value method, which may be
interpreted positively in the consideration of capital structure. However, the higher contributed capital
is achieved by a corresponding reduction in retained earnings, so total stockholders' equity is the same
using both methods. Since the increase in contributed capital also necessitates a charge against
earnings, most companies prefer to record the conversion using the book value method.

MSC: AACSB Analytic
10. Debt securities frequently are issued with a convertible feature that permits the holder to convert the
bond certificates into a determinable number of shares of common stock at any time before the
conversion privilege expires. The conversion feature offers many advantages and some disadvantages
both to the issuer and the investor, however.
Required:
Identify the advantages of convertible debt both to the issuer and the investor.
ANS:
Convertible bonds offer a number of advantages to the issuer. The bonds typically sell at a price
considerably above that which could be obtained for nonconvertible bonds with the same contractual
interest rate due to the conversion feature. The conversion feature also reduces the number of
restrictions on the debt than would be found with nonconvertible debt, again as a result of the
perceived value of the conversion feature. The convertibility feature enhances an enterprise's prospects
for raising debt capital. The cost of equity capital also is lowered through the use of convertible debt.
The issuer can set the conversion price above the prevailing stock price and thus issue fewer shares to
obtain the same amount of capital. If the bonds actually are converted, the issuer is not required to pay
the maturity value of the bonds. Disadvantages associated with convertible debt for the issuer include
the possibility that the conversion feature will not be exercised by investors. If stock prices remain
stable or fall, then investors have little desire to own the stock and will hold the debt to receive the
interest payments. The fact that investors choose not to convert means that the issuer must then
continue to service the debt. The servicing of the debt may become burdensome since the failure of the
stock price to rise to a level to make conversion attractive to investors may be indicative of financial
difficulties of the issuer. The issuer is then left with the burden of servicing the debt under more
difficult circumstances. Alternatively, if the stock price rises, the issuer still incurs a cost, namely, the
opportunity cost of foregoing the sale of the shares converted at a higher price.
Major advantages to the investor in convertible debt include the security provided by fixed interest
payments and payment of the maturity value should the issuer not prove to be successful to the degree
that conversion is desirable. Additionally, the investor has the option of becoming an equity holder
should the enterprise prove to be extremely successful thus enhancing the potential for increased
wealth in terms of both price appreciation of the shares and/or larger cash flows from dividends.
DIF: Medium OBJ: LO 4 TOP: AICPA FN-Measurement

MSC: AACSB Reflective Thinking
11. The Financial Accounting Standards Board issued Statement of Financial Accounting Standard No.
133, "Accounting for Derivatives and Hedging Activities," as part of its project on financial
instruments and its effort to deal with off-balance-sheet financing.
Explain what is meant by the term "off-balance-sheet financing" and give two reasons why "off-
balance-sheet financing" is attractive to the management of an enterprise.
ANS:
Off-balance-sheet financing is an attempt to borrow money such that the obligation is not recorded.
Long-term liability measurement and disclosure are important in measuring the risk and financial
strength of an enterprise. The criteria for recognizing liabilities are imprecise and, as a result, creative
individuals have devised financial instruments that avoid the criteria for recognition of a liability. Such
financial instruments allow enterprises to raise debt capital without reporting liabilities.
Off-balance-sheet financing is attractive to managers because it allows an enterprise to raise debt

capital without reporting the associated liability. The debt-equity ratio of the enterprise thus is not
increased. An increase in the debt-equity ratio can be a major problem if the debt-equity ratio already
is considered high. A high debt-equity ratio suggests that the enterprise has greater risk, particularly if
business conditions deteriorate since interest payments must be made even though profits have
declined. Shareholders who wish to avoid such risk may sell their shares in the stock of the enterprise
thus causing the price of the shares to decline. Additionally, creditors may view the enterprise as
"loaded-up" with debt and may refuse to grant additional credit due to the risk associated with an
enterprise with high levels of existing debt.
Off-balance-sheet financing also is attractive to management because of restrictions related to debt

covenants. Existing debt covenants with current bond-holders may include restrictions designed to
protect the investments of the bond-holders. A very common covenant in this regard is to prevent an
enterprise from issuing additional debt without the consent of the existing bondholders. A similar
restriction frequently is used by banks in making loans. Off-balance-sheet financing is a means of
issuing additional debt without reporting the debt and thus without technically violating existing debt
covenants. Failure to disclose information about these off-balance-sheet financing activities hinders
investors and creditors in assessing the risk associated with an enterprise.
DIF: Medium OBJ: LO 5 TOP: AICPA FN-Reporting

12. On December 31, 2007, International Refining Company purchased machinery having a cash selling
price of $85,933.75. The company paid $10,000 down and agreed to finance the remainder by making
four equal payments each December 31 at the implicit interest rate of 12%.
(1) Determine the amount of the annual payments to be made under the financing
agreement.
(2) Prepare the journal entry to record the acquisition of the machinery on December
31, 2007.
(3) Prepare the journal entry at December 31, 2008.
ANS:
(1)
The total cash price of the machinery is $85,933.75. The company paid $10,000 down, leaving a
balance of $75,933.75 to finance. This amount represents the present value of four payments of
unknown amounts discounted at 12%. The problem can be solved by dividing the amount to be
financed, $75,933.75, by the factor for the present value of an annuity for 4 years at 12%:
$75,933.75  3.03735 = $25,000
(2)
The journal entry to record the acquisition of the machinery at December 31, 2007, would be:
Machinery ................................. 85,933.75

Discount on Notes Payable ................. 24,066.25
Cash .................................... 10,000
Notes Payable ........................... 100,000
(3)
The journal entry at December 31, 2008, would be:
Notes Payable ............................. 25,000.00

Interest Expense .......................... 9,112.05
Cash .................................... 25,000.00
Discount on Notes Payable ............... 9,112.05

MSC: AACSB Analytic
13. The globalization of business has caused many changes in how enterprises are managed. One such
change is illustrated by U.S. enterprises obtaining loans denominated in foreign currencies.
Identify reasons why such borrowings may occur.
ANS:
U.S. companies may obtain loans denominated in foreign currencies for any or all of the following
reasons:
(1) Some countries are reluctant to allow large multinational corporations to do

business in their countries without using local financing.
(2) Use of local sources of financing helps to establish and maintain good local
relations.
(3) Subsidiaries of large multinational corporations may be relatively self contained,

resulting in virtually all operating, investing, and financing activities being handled
locally.
(4) Interest rates in foreign markets may be low relative to those in domestic markets.
(5) Loans denominated in foreign currencies may serve as a hedge of assets held by the
company which are denominated in foreign currency.

14. Footnote disclosures for long-term liabilities provide information that is not conveniently presented in
the balance sheet. Although detailed disclosure requirements exist for certain specialized obligations, a
set of general disclosure requirements is applicable to most enterprises.
Identify the general disclosure requirements for long-term liabilities.
ANS:
The following represent general disclosure requirements related to long-term liabilities:
(1) Interest rates, maturity dates, debt restrictions, call provisions, and conversion
privileges.
(2) Any assets pledged as collateral for debt.
(3) Aggregate maturity amounts and sinking fund requirements for all long-term
liabilities for each of the five years following the balance sheet date.
(4) Long-term debt maturing within one year should be reported as a current liability,
unless retirement is to be completed through the use of assets other than current
assets.
(5) For unconditional purchase obligations actually recorded on the balance sheet,
disclosure must be made of payments to be made under the obligation for each of
the next five years.
(6) For unconditional purchase obligations not shown on the face of the balance sheet,
the following disclosures are required:
a. The nature and term of the obligations.

b. The total amount of the fixed and determinable portion of the obligations at the
balance sheet date and for each of the next five years.
c. The nature of any variable portions of the obligations.
d. The amounts purchased under the obligations for each period for which an income
statement is presented.

15. Much of the dissatisfaction about Enron's accounting centered around its use of special purpose
entities (SPEs, now referred to by the FASB as variable interest entities or VIEs). Enterprises such as
Enron have used VIEs to avoid reporting assets and liabilities for which they are responsible, to defer
the reporting of losses that have already been incurred, or to report gains that do not exist. In response
both to the abuses of VIEs and to the fragmented and incomplete accounting standards regarding VIEs,
the FASB has proposed a new accounting interpretation. Current accounting standards require an
enterprise to include subsidiaries in which it has a controlling financial interest in its consolidated
financial statements. The focus of current standards is on a parent-subsidiary relationship established
through voting ownership interests. The relationship between a business enterprise and a VIE is
established through other means.
The proposed interpretation would explain how to identify a VIE that is not subject to control through
voting ownership interests and would require each enterprise involved with such a VIE to determine
whether it provides financial support to the VIE through a variable interest. If an enterprise holds a
majority of the variable interests of a VIE or a significant variable interest that is greater than any other
party's variable interest, then that enterprise would be the primary beneficiary and would be required to
include the VIE in its consolidated financial statements.
Explain what is meant by the term " variable interests".
ANS:
In a conventional parent-subsidiary relationship, financial support for the subsidiary is provided as a
result of the parent buying some of the voting stock of the subsidiary as well as by the profitability of
the subsidiary itself. The parent normally would include the subsidiary in its consolidated financial
statements because the parent controls the subsidiary through voting ownership interests.
In the case where no voting ownership interest exists or is not adequate to support fully the subsidiary,
the additional financial support must come in some other form. Variable interests are the means
through which financial support is provided to a VIE and through which the providers gain or lose
from the activities and events that change the values of the VIE's assets and liabilities. These variable
interests arise from contractual rights and obligations, such as those that result from loans or debt
securities, guarantees, management contracts, service contracts, and leases. The entity holding the
majority of the variable interests of a VIE is the primary beneficiary and is required to include the VIE
in its consolidated financial statements. Consider the following example.
A VIE is created in order to construct a building to be leased by a single lessee. A lender provides
money to construct the building. If the lessee guarantees the value of the VIE's assets up to the amount
of the VIE's liabilities, then the lessee is the primary beneficiary as a result of its variable interest
created by the guarantee and the lease even though the lessee owns no voting ownership interest in the
VIE. Alternatively, if the lessee makes no guarantee of the value of the VIE's assets, then the lender
becomes the primary beneficiary and must include the VIE in its (the lender's) consolidated financial
statements. In this case the lender has a controlling financial interest in the VIE.

16. The price of a bond issue is determined by the market or effective rate of interest. A bond issue with a
10% stated interest rate will sell for less than face value if the market or effective rate of interest is
12%. The creditworthiness of the issuing entity is one of the factors that influence the market rate for a
specific bond issue. Investors rely heavily on bond ratings provided by Standard & Poor’s Corporation
and by Moody’s Investors Service, Inc.
Required:
Complete the table below by entering the appropriate rating for each level of risk under the S&P and
Moody’s rating systems.
S&P Moody's
Investments Grades:
Highest
High
Medium
Minimum investment grade
"Junk" Ratings:
Speculative
Very speculative
Default of near default
ANS:
S&P Moody's
Investments Grades:
Highest AAA Aaa

High AA Aa
Medium A A
Minimum investment grade BBB Baa
"Junk" Ratings:
Speculative BB Ba
Very speculative B Ba
Default of near default CCC Caa
CC Ca
C C

MSC: AACSB Analytic
17. JDS Company is considering purchasing some new equipment for its production operations. The
purchase is scheduled to be made on January 1, 2008. The vendor offers JDS two financing options:
1. A two-year, $10,000 note with a 3 percent stated interest rate. Interest is payable
each December 31, and the entire principal is payable December 31, 2009.
2. A two-year, $8,786 note with a 10 percent stated interest rate. Interest is payable
each December 31, and the entire principal is payable December 31, 2009.
The market rate of interest for both financing options is 10 percent.
Required:
1. Which of the two options should the management of JDS choose? Explain the reasons
for your choice and show computations to support your choice.
2. For each option, prepare the journal entries to record:
a. The issuance of the note at January 1, 2008.
b. The first interest payment at December 31, 2008.
ANS:
1. APB Opinion No. 21 requires that both JDS and the vendor use the applicable market
rate of interest to account for the transaction. In this case, a two-year note with a face
value of $8,786 and a 10 percent interest rate results in the same present value as the
note with a face value of $10,000 face value and a 3 percent stated interest rate.
The present value of the $10,000, 3 percent note is:
$10,000(PV1, 10%, 2) = $10,000(.82645) = $8,265

$10,000(.03)(PVA, 10%, 2) = $300(1.73554) = 521
Present value of note at 10% $8,786
The present value of the $8,786, 10% note is:
$8,786(PV1, 10%, 2) = $8,786(.82645) = $7,260

$8,786(.10)(PVA, 10%, 2) = $879(1.73554) = 1,526
Present value of note at 10% $8,786
Under either method, the present value of the note is $8,786. JDS might prefer the
low nominal (or stated) interest rate offset by the increased face value if management
is more concerned about the monthly payment than the final maturity (or balloon)
payment.
2. The journal entries for low nominal interest rate, increased face value option would be:
December 31, 2008:

Interest Expense 879
Discount on Note Payable 579
Cash 300
Discount amortization:
Interest expense for the year: $8,786  .10 = $ 879
Cash interest payment 300
Discount amortization $ 579
The journal entries for the higher nominal interest rate, lower face value option would be:
January 1, 2008:
Equipment 8,786
Note Payable 8,786
December 31, 2008:

Interest Expense 879
Cash 879
Discount amortization:
Interest expense for the year: $8,786  .10 = $ 879
Cash interest payment 300
Discount amortization $ 579

MSC: AACSB Analytic
18. Listed below are the current liability section and the note 5 for short-term obligations of the balance
sheet of NSP Corporation:
2008 2007
(in millions of dollars)
Current liabilities
Current portion of long-term obligations $ 189 $ 116
Short-term obligations 226 112
Accounts payable 2,472 2,482
Accrued liabilities 2,902 2,314
Taxes payable (including income taxes) 67 65
$ 5,856 $ 5,089
5. Short-Term Obligations
NSP’s short-term obligations consist of notes payable and commercial paper. Notes payable as
December 31, 2008, totaled $36 million at an average annual interest rate of 5.7 percent, compared
with $7 million at an average annual interest rate of 5.7 percent at year-end 2007. Commercial paper
borrowings at December 31, 2008, were $699 million at an average annual interest rate of 5.7 percent,
compared with $217 million at an average annual interest rate of 5.9 percent as of December 31, 2007.
Bank lines of credit available to support existing commercial paper borrowings of the corporation
amounted to $490 million at both December 31, 2008, and 2007. All of these were supported by
commitment fees.
The corporation also maintains compensating balances with a number of banks for various purposes.
Such arrangements do not legally restrict withdrawal or usage of available cash funds. In the
aggregate, they are not material in relation to total liquid assets.
Required:
1. What amount of NSP’s long-term debt reflected in its current liabilities did NSP pay off
in 2008?
2. Explain the origin of the $189 figure.
3. During 2008, did NSP reduce its average yearly interest requirements on its short-term
obligations described in note 5? Do you observe any interesting issues you might want
to learn more about? If so, what are they?
4. Do the lines of credit that NSP holds at the end of 2008 appear as liabilities on its
balance sheet? Explain.
ANS:
1. The company paid $116 million in 2008. They may also have elected to pay off
additional long-term debt but this is not disclosed.
2. The $189 million is the portion of NSP’s long-term debt coming due in 2009 which the
firm expects to pay off in 2009. This portion of the debt is shown as a current liability.
3. The company increased its average interest obligations because short-term borrowings
increased even though the interest rates on commercial paper declined. A reasonable
question that might be posed is why the commercial paper was used in 2007 given that
the interest rate on commercial paper was 5.9 versus 5.7 on notes.
4. Lines of credit are not obligations of NSP. The commitment fees to hold open these lines
of credit, which allow borrowing on demand, are expensed in the year due to the bank.
Disclosure of the amounts required as compensating balances would be useful as this
cash is not available for use in operations. For large firms, these amounts likely are
immaterial.

MSC: AACSB Analytic
19. A portion of the long-term liability footnote to the 2008 annual report of ACF Corporation follows:
December 31
2008 2007
(in millions of dollars)
73/4% convertible subordinated debentures,
due 2019-2023 $ 17 $ 20
The debentures were issued on January 1 of a previous year and pay interest each December 31. The
debentures retired were scheduled to mature December 31, 2021. The retirement of the debentures
occurred December 31, 2008. ACF paid the market value of the bonds which represented a yield rate
of 8%.
Required:
1. Prepare the December 31, 2008, interest payment entry
2. Prepare the December 31, 2008, entry for bond retirement
3. What may have contributed to the recognition of a loss on the early retirement?
ANS:
Requirement 1:
December 31, 2008:
Interest Expense (.10  $20) 2.00
Cash 2.00
Requirement 2:
December 31, 2008:
Bonds Payable ($20 - $17) 3.00
Loss on Bond Retirement 0.47
Cash 3.47
Calculation of cash paid:

$3.00(PV1, .08, 13) + .10($3.00)(PVA, .08, 13) = $3.47
Requirement 3:
Interest rates have declined since the issuance of the bonds, contributing to an increase in the market
price of the bonds. At early retirement, the bonds cost significantly more than their book value,
resulting in the loss on retirement. The cost to retire these bonds was 16% (.47/3.00) more than book
value.

MSC: AACSB Analytic

CH 12

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH 12

Uploaded by

Copyright:

Available Formats

Chapter 12—Debt Financing

1. For a liability to exist,

3. Which of the following represents a liability?

4. A short-term note payable with no stated rate of interest should be

a. dependent on the intention of management.

b. amortized over the life of the new bond issue.

ANS: C DIF: Medium OBJ: LO 4

ANS: B DIF: Medium OBJ: LO 4

ANS: D DIF: Medium OBJ: LO 4

23. Debentures are

24. Callable bonds

25. The issuance price of a bond does not depend on the

27. Bonds usually sell at a discount when

28. Bonds usually sell at a premium

30. To compute the price to pay for a bond, you use

ANS: C DIF: Easy OBJ: LO 4

31. Which of the following is true of a premium on bonds payable?

35. The effective-interest method of amortizing bond premiums

Packages of razor blades sold ......................... 400,000

14 percent note payable issued October 1, 2008, $250,000

TOP: AICPA FN-Measurement MSC: AACSB Analytic

ANS: C DIF: Medium OBJ: LO 2

Operating income ...................................... $900,000

Common stock dividends were $120,000. The times-interest-earned ratio is

Collateral trust bonds, having securities of unrelated

The debenture bonds amounted to

50. Miller Enterprises had the following long-term debt:

Sinking fund bonds, maturing in installments .......... $1,100,000

The total of the serial bonds amounted to

Printing and engraving ................................ $ 30,000

TOP: AICPA FN-Measurement MSC: AACSB Analytic

ANS: A DIF: Medium OBJ: LO 4

ANS: B DIF: Medium OBJ: LO 4

Packages of candy bars sold ........................... 3,200,000

DIF: Challenging OBJ: LO 2 TOP: AICPA FN-Measurement

Boxes of cereal sold 640,000

DIF: Challenging OBJ: LO 2 TOP: AICPA FN-Measurement

(a) 3/1/2008 Cash 795,141

(c) 12/31/2008 Interest 21,119

(d) Assuming no reversing entries:

DIF: Challenging OBJ: LO 4 TOP: AICPA FN-Measurement

(1) Determine the issue price of the bonds. Show computations.

5/31/2009 600,000 622,138** 22,138 10,391,103

DIF: Challenging OBJ: LO 4 TOP: AICPA FN-Measurement

9% bonds payable due 12/31/2017 ...................... $800,000

Interest Expense ................ 200

Interest Payable ................. 6,000

DIF: Challenging OBJ: LO 4 TOP: AICPA FN-Measurement

* ($325,268  10%  6/12) = $16,263

DIF: Challenging OBJ: LO 4 TOP: AICPA FN-Measurement

June 1 Interest Expense .................. 18,000

Dec. 1 Interest Expense .................. 18,000

Dec. 31 Interest Expense .................. 4,119

June 1 Interest Expense .................. 18,000

July 31 Interest Expense (7/118  $6,000).. 356

July 31 Bonds Payable ..................... 150,000

Note: $150,000 of bonds remain outstanding.

DIF: Challenging OBJ: LO 4 TOP: AICPA FN-Measurement

June 30 Bonds Payable ........................ 150,000

Bonds Payable ........................ 150,000

Stock recorded at market value of stock:

Bonds Payable ........................ 150,000

Paid-In Capital in Excess of Par ... 12,000