Ch08 Harrison 8e GE SM (Revised)

Chapter 8
Liabilities
Short Exercises
(10 min.) S 8-1
Journal
DATE ACCOUNT TITLES AND EXPLANATION DEBIT CREDIT
2010
Sept. 30 Inventory…………………………………….. 5,000
Note Payable, Short-Term…………….. 5,000
Purchased inventory by issuing a note
payable
2011
June 30 Interest Expense ($5,000 × .08 × 9/12)…. 300
Interest Payable………………………… 300
Accrued interest expense.
Sept. 30 Note Payable, Short-Term………………... 5,000

Interest Payable……………………………. 300
Interest Expense ($5,000 × .08 × 3/12)…. 100
Cash………………………………………. 5,400
Paid note payable and interest at
maturity.
Chapter 8 Liabilities 605

(5-10 min.) S 8-2
Req. 1
Balance Sheet
June 30, 2011
ASSETS LIABILITIES
Current liabilities:
Note payable, short-term.. $5,000
Interest payable
($5,000 × .08 × 9/12)….. 300
Income Statement
Year Ended June 30, 2011
Revenues:
Expenses:
Interest expense ($5,000 × .08 × 3/12)…………….. $ 300
Req. 2
The 2012 income statement will report:
Interest expense ($5,000 × .08 × 3/12)………. $100
606 Financial Accounting 8/e Solutions Manual

(10 min.) S 8-3
Req. 1
Journal
Cash ($483,000 × .30)…………………..….. 144,900

Notes Receivable ($483,000 − $144,900).. 338,100
Sales Revenue…………………………… 483,000
To record cash sales and sales on
account.
Warranty Expense ($483,000 × .06)……… 28,980

Provision for Warranty Repairs………. 28,980
To accrue warranty expense.
Provision for Warranty Repairs………..... 19,000

Cash…………………………………….…. 9,000
To pay warranty claims.
Req. 2
Provision for Warranty Repairs

Bal. 11,000
19,000 28,980
Bal. 20,980

(5-10 min.) S 8-4
Warranty expense = $28,980
The matching principle addresses this situation.
The warranty expense for the year does not necessarily equal
the year’s cash payments for warranties. Cash payments for
warranties do not determine the amount of warranty expense
for that year. Instead, the warranty expense is estimated and
matched against revenue during the period of the sale,
regardless of when the company pays for warranty claims.
Note that the relevance qualitative characteristic also applies. If

warranty costs are not expensed at the same period as revenue
generated, it reduces the predictive value of the financial
information produced.
Student responses may vary.

(5-10 min.) S 8-5
1. These are contingent liabilities because Marley-David, Inc.
was not liable for any of these product losses as at the time
of the note but the firm may be liable for possible future
product loses.
2. In the United States, the contingency can become a real

liability if the user of a Marley David product suffers a loss
for which the company is responsible.
Marley David must pay for all losses up to $3.2 million and all
losses above $25.2 million. The company is insured against
losses between $3.2 million and $25.2 million.
3. Outside the United States, the contingency becomes a real

liability the same way — if a Marley David user suffers a loss
for which the company is responsible.
Outside the United States, Marley David must pay only for
losses above $25.2 million because the company is insured
against losses up to $25.2 million.

(5-10 min.) S 8-6
a. $227,250 ($ 300,000 × .7575)
b. $308,250 ($ 300,000 × 1.0275)
c. $283,500 ($ 300,000 × .9450)
d. $313,500 ($ 300,000 × 1.0450)
(5 min.) S 8-7
a. Discount
b. Premium
c. Par (face) value
d. Discount

(5-10 min.) S 8-8
Journal
2010
a. July 1 Cash…………………………………………… 80,000
Bond Payable…………………………….. 80,000
To issue bond payable at par.
b. Dec. 31 Interest Expense ($80,000 × .055 × 6/12) 2,200

Interest Payable………………………….. 2,200
To accrue interest expense.
2011
c. Jan. 1 Interest Payable…………………………….. 2,200
Cash……………………………………….. 2,200
To pay semiannual interest on bond
payable.
2025
d. July 1 Bond Payable………………………………... 80,000
Interest Expense…………………………….. 2,200
Cash………………………………………... 82,200
To pay final interest payment and to
redeem bond at maturity.

(10-15 min.) S 8-9
1. Amortization table
A B C D E
Interest
Expense
Interest (4 % of Discount Bond
Payment Preceding Account Carrying
Semiannual (2.5% of Bond Carrying Discount Balance Amount
Interest Maturity Amount Amortization (Preceding ($600,000
Date Value) [4% x E]) (B - A) D - C) - D)
Mar. 31, 2010 $138,000 $462,000
$15,00 $18,480 $3,480 134,520 465,480
Sept. 30, 2010 0
18,619 3,619 130,901 469,099
Mar. 31, 2011 15,000
18,764 3,764 127,137 472,873
Sept. 30, 2011 15,000
2.
Journal
2010
Mar. 31 Cash ($600,000 × .77)…………… 462,000
Discount on Bonds Payable…… 138,000
Bonds Payable………………… 600,000
Sept. 30 Interest Expense…………………. 18,480

Discount on Bonds Payable… 3,480
Cash…………………………….. 15,000

(10 min.) S 8-10
1. Borrowed $462,000
Pay back $600,000 at maturity
2. Pay cash interest of $15,000 each six months.
3. Interest expense:
Sept. 31, 2010…………….. $18,480

Mar. 31, 2011………………. $18,619
Interest expense increases because the bond carrying amount

increases as the bonds move toward maturity. An increasing
bond carrying amount produces an increasing amount of
interest expense each period.
(5-10 min.) S 8-11

1. $1,825,000 ($5,000,000 × .365)
2. $5,000,000 on July 1, 2020
3. $75,000 ($5,000,000 × .03 × 6/12)
4. Market interest rate = 15.88%

Interest expense for:
31 Dec 2010 = $1,825,000 × .1588 × 6/12 = $144,862
1 Jul 2011 = $1,894,862 × .1588 × 6/12 = $150,407
*Note: Market interest rate needs to be computed to attempt
this question.
(10 min.) S 8-12
Journal
2010
a. July 1 Cash ($500,000 × .94)……………………… 470,000
Discount on Bonds Payable……………... 30,000
Bonds Payable…………………………... 500,000
To issue bonds at a discount.
b. Dec. 31 Interest Expense ($470,000 x 0.0892 x 20,960

6/12)……………………………
Discount on Bonds Payable 960
Interest Payable ($500,000 × .08 × 6/12) 20,000
To accrue interest and amortize bonds.
2011
c. Jan. 1 Interest Payable…………………………….. 20,000
Cash……………………………………….. 20,000
To pay semiannual interest.

(10-15 min.) S 8-13
Plan A Plan B
Borrow $3,000,000 Issue $3,000,000
at 8% of Common Shares
Net income before expansion……………….. $300,000 $300,000
Project income before interest
and income tax……………………………... $500,000 $500,000
Less interest expense ($3,000,000 × .08)….. (240,000) -0-
Project income before income tax………….. 260,000 500,000
Less incremental income tax expense (35%) (91,000) (175,000)
Project net income…………………………….. 169,000 325,000
Total company net income…………………… $469,000 $625,000
Earnings per share including expansion:

Plan A ($469,000 / 100,000 shares)……… $4.69
Plan B ($625,000 / 200,000 shares)……… $3.13
Recommendation: To increase earnings per share,

Speedtown Marina should borrow the
money.

(5-10 min.) S 8-14
Times-interest- Operating income $5.0
= = = 3.1 times
earned ratio Interest expense $1.6
This means that for every dollar of interest expense, Houle

Plumbing earned $3.10 of operating income.
Based on this ratio, the authors would be willing to lend $1

billion to Houle Plumbing. In 2010 Houle Plumbing was able to
cover its existing interest expense 3.1 times with operating
income.
Students’ conclusions may vary.

(10 min.) S 8-15
LIABILITIES
Current:
Accounts payable……………………….. $ 36,000
Current portion of bonds payable……. 51,000
Interest payable………………………….. 1,000
Total current liabilities………………. $ 88,000
Non-current:
Notes payable, long-term………………. 300,000
Bonds payable…………………………… $400,000
Less: Discount on bonds payable……. (12,000) 388,000
Total liabilities………………………………. $776,000

Exercises
Group A
(5-15 min.) E 8-16A
Req. 1
Journal
Warranty Expense ($161,000 × .07) 11,270

…..
Provision for Warranty Repairs….. 11,270
Provision for Warranty Repairs…..….. 8,000

Cash…………………………………… 8,000
Req. 2
INCOME STATEMENT
Sales revenue……………………………………… $161,000
Warranty expense………………………………… 11,270
BALANCE SHEET
Current liabilities
Estimated warranty payable
($3,000 + $11,270 − $8,000)………………. $ 6,270
Req. 3
Provision for Warranty Repair, a current liability, will cause a

company’s current ratio to decrease.

(10-15 min.) E 8-17A
Journal
2010
Oct. 1 Cash…………………………………………. 1,512
Unearned Subscription Revenue……. 1,400
Sales Tax Payable ($1,400 × .08)…….. 112
Nov. 15 Sales Tax Payable………………………… 112

Cash………………………………………. 112
Dec. 31 Unearned Subscription Revenue………. 350

Subscription Revenue ($1,400 × 3/12) 350
BALANCE SHEET
Unearned subscription revenue ($1,400 − $350)…… $1,050
(10 min.) E 8-18A

INCOME STATEMENT
Expenses:
Payroll expense………………………………………. $200,000
Payroll tax expense ($200,000 × .08)……………… 16,000
BALANCE SHEET
Salary payable………………………………………… $ 8,100
Payroll tax payable…………………………………... 800

(5-10 min.) E 8-19A
Req. 1
Interest to
accrue at = $83,000 × .06 × 8/12 = $3,320
Dec. 31, 2010
Req. 2
Final payment
= $83,000 + ($83,000 × .06) = $87,980
on May 1, 2011
Req. 3

2010 = $83,000 × .06 × 8/12 = $3,320
2011 = $83,000 × .06 × 4/12 = $1,660

(10-15 min.) E 8-20A
Souza’s balance sheet
at December 31, 2011, reported:
Income tax payable…………………………………... $242,000*
Young’s 2011 income statement reported:

Income tax expense ($1,200,000 × .36)…………… $432,000
_____
* Beginning income tax payable…………………….. $180,000
+ Income tax expense (and payable) for the year
($1,200,000 × .36)……………………………… 432,000
− Income tax payments during the year……………. (370,000)
= Ending income tax payable………………………… $242,000

(10-20 min.) E 8-21A
Req. 1
Accounts payable are amounts owed to suppliers for products or

services that have been purchased on account.
Accrued expenses are expenses that the company has incurred but
not paid. They are liabilities for expenses such as interest and
income taxes.
Employee compensation and benefits are amounts owed to

employees for salaries and other payroll-related expenses.
Current portion of long-term debt is the portion of the long-term

debt that is due within next year.
Long-term debt is the amount of long-term notes and bonds

payable that the company expects to pay after the coming year.
Postretirement benefits are the company’s liabilities for providing

benefits — mainly health care — to retirees.
The other liabilities are a catch-all group of liabilities that do not fit
one of the more specific categories and are not significant enough
to have a category of their own. The other liabilities are long-term,
as shown by the fact that they are not listed among the current
liabilities.

(continued) E 8-21A
Req. 2
Total assets = $3,995 million, the sum of total liabilities and

shareholders’ equity
Total liabilities ($3,995 million − $2,027 million)*

Debt ratio = = 0.49
Total assets ($3,995 million)
A debt ratio of 49% is satisfactory.

____
*Or, $340 + $1,494 + $122 + $12 = $1,968

(5-10 min.) E 8-22A
Req. 1
Roden Security Systems should report this situation in a note

to the financial statements. The note should convey essentially
the same message given in Note 14.
Req. 2
Roden would report:
INCOME STATEMENT
Estimated loss (or expense)……………… $1,500,000
BALANCE SHEET
Estimated liability…………………………… $1,500,000
Note 14 -
Same as above.
Journal
2010
Estimated Loss (or Expense)…... 1,500,000
Estimated Liability……………. 1,500,000

(15-20 min.) E 8-23A
McKinley Electronics
Balance Sheet (partial)
June 30, 2010
a. Estimated warranty payable
[$34,000 + ($2,200,000 × .07) − $50,000]……… $138,000
b. Current portion of long-term note payable……... 13,750
Interest payable ($55,000 × .06 × 1/12)…………… 275
c. Unearned sales revenue ($125,000 − $70,000)…. 55,000
d. Employee withheld income tax payable………… 30,000
FICA tax payable ($260,000 × .0765)……………… 19,890
Total current liabilities………………………….. $256,915
Non-current liabilities:
Note payable ($55,000 − $13,750)……………... $41,250

(10-15 min.) E 8-24A
Req. 1
Journal
2010
a. Jan. 31 Cash ($13,000,000 × 0.94)..…………… 12,220,000
Discount on Bonds Payable…………. 780,000
Bonds Payable……………………… 13,000,000
b. July 31 Interest Expense ($12,220,000 × . 417,812

0684 × 6/12)………………………..
Cash ($13,000,000 × .06 × 6/12)….. 390,000
Discount on Bonds Payable 27,812
To pay interest and amortize
discount on bond payable.
c. Dec. 31 Interest Expense ($12,247,812 × . 348,969

0684 × 5/12)………………………..
Interest Payable
($13,000,000 × .06 × 5/12)……… 325,000

this question.

(10-15 min.) E 8-25A
1. Cash received = $500,000 × 1.03 = $515,000
2. Principal……………………………………………………… $500,000
Interest ($500,000 × .07 × 20)…………………….............. 700,000
Total cash paid……………………………………………… $1,200,000
3. Total cash paid……………………………………………… $1,200,000

Less: Cash received……………………………………... (515,000)
Difference = Total interest expense……………………... $685,000

31 Dec 2010 = $1,825,000 × .1588 × 6/12 = $144,862
1 Jul 2011 = $1,894,862 × .1588 × 6/12 = $150,407

this question.

(15-20 min.) E 8-26A
Req. 1 (amortization table)
A B C D E
INTEREST
EXPENSE
INTEREST (6% OF DISCOUNT
PAYMENT PRECEDING ACCOUNT BOND
SEMIANNUAL (5% OF BOND DISCOUNT BALANCE CARRYING
INTEREST MATURITY CARRYING AMORTIZATION (PRECEDING AMOUNT
DATE VALUE) AMOUNT) (B – A) D – C) ($2,400,000 – D)
Dec. 31, 2010 $271,200 $2,128,800
June 30, 2011 $120,000 $127,728 $ 7728 263,472 2,136,528
Dec. 31, 2011 120,000 128,192 8,192 255,280 2,144,720
June 30, 2012 120,000 128,683 8,683 246,597 2,153,403
Dec. 31, 2012 120,000 129,204 9,204 237,393 2,162,607

(continued) E 8-26A
Req. 2
Journal
DATE ACCOUNT TITLES AND DEBIT CREDIT
EXPLANATION
2010
Dec. 31 Cash……………………………….. 2,128,800
Discount on Bonds Payable…… 271,200
Bonds Payable……………….. 2,400,000
2011
June 30 Interest Expense....................................... 127,728
Cash...................................................... 120,000
Discount on Bonds Payable............... 7,728
To pay semiannual interest and
amortize discount on bond payable.
2011
Dec. 31 Interest Expense....................................... 128,192
Cash...................................................... 120,000
amortize bonds.

(15-20 min.) E 8-27A
A B C D E
INTEREST
EXPENSE
INTEREST (2% OF PREMIUM
SEMIANNUAL (2½% OF BOND PREMIUM BALANCE CARRYING
DATE VALUE) AMOUNT) (A – B) D – C) ($800,000 + D)
June 30, 2010 $139,040 $939,0401
Dec. 31, 2010 $20,000 $18,781 $1,219 137,821 937,821
June 30, 2011 20,000 18,756 1,244 136,577 936,577
Dec. 31, 2011 20,000 18,732 1,268 135,309 935,309
June 30, 2012 20,000 18,706 1,294 134,015 934,015
_____
1
$800,000 × 1.1738 = $939,040

(continued) E 8-27A
Req. 2 (journal entries)
Journal
2010
June 30 Cash ($800,000 × 1.1738)…………….. 939,040
Bonds Payable……………………... 800,000
Premium on Bonds Payable…….. 139,040
To issue bonds at a premium.
Dec. 31 Interest Expense………………………. 18,781

Premium on Bonds Payable………… 1,219
Cash………………………………….. 20,000
To pay semiannual interest and amortize bond
premium.
2011
June 30 Interest Expense………………………. 18,756
Premium on Bonds Payable.………... 1,244
Cash………………………………….. 20,000
To pay semiannual interest and amortize bonds.

(15-20 min.) E 8-28A
A B C D E F
1 Bond
2 Interest Interest Discount Discount Carrying
3 Date Payment Expense Amortization Balance Amount
4
5 Jan. 1, 2010 $12,289 $87,711
6 Dec. 31, 2010 $8,000 $8,771 $ 771 11,518 88,482
7 Dec. 31, 2011 8,000 8,848 848 10,670 89,330
8 Dec. 31, 2012 8,000 8,933 933 9,737 90,263
9 Dec. 31, 2013 8,000 9,026 1,026 8,711 91,289
10 Dec. 31, 2014 8,000 9,129 1,129 7,582 92,418
11 Dec. 31, 2015 8,000 9,242 1,242 6,339 93,661
12 Dec. 31, 2016 8,000 9,366 1,366 4,973 95,027
13 Dec. 31, 2017 8,000 9,503 1,503 3,471 96,529
14 Dec. 31, 2018 8,000 9,653 1,653 1,818 98,182
15 Dec. 31, 2019 8,000 9,818 1,818 0 100,000
Note: Computer-generated solutions may contain slight

rounding differences.

(15-20 min.) E 8-29A
Req. 1
Initial carrying amount of notes ($3,300,000 × 0.95) $3,135,000

Market interest rate 6.45%
Carrying amount of notes at December 31, 2015…. $3,159,300

this question. Carrying amount at December 31, 2015 can be
computed either using an amortization table or by finding the
future value of the bond in five years’ time.
Req. 2
Journal
2015
Dec. 31 Notes Payable………………………. 3,300,000
Discount on Notes Payable
($3,300,000− $3,159,300)........ 140,700
Share Capital
($3,300,000 / $1,000 × 50 × $1 par) 165,000
Paid-in Capital in Excess of
Par — Common...................... 2,994,300

(20-25 min.) E 8-30A
Amounts in millions or billions
Company Company Company
Ratio A N S
Current Total current assets $431 ¥5,932 €170,140

= =
ratio Total current liabilities $197 ¥2,197 € 72,400
= 2.19 = 2.70 = 2.35
A N S
Debt Total liabilities $197 + $137 ¥2,197 + ¥2,341 €72,400 + €110,737

= = $431 + $139 ¥5,932 + ¥39 €170,140 + €45,315
ratio Total assets
= 0.59 = 0.76 = 0.85
A N S
Times-
interest- Operating income $291 ¥222 €5,581
= = $42 ¥31 €671
earned Interest expense
ratio
= 6.92 times = 7.16 times = 8.32 times
Based on these ratio values, Company N looks the least risky.
*N has the best current ratio and middle of the range debt and times
interest earned ratios; whereas both A and S have at least one ratio
where they are the worst of the pack.

(15-20 min.) E 8-31A
Req. 1
PLAN B
PLAN A ISSUE
BORROW $800,000
$800,000 OF COMMON
AT 10% SHARES
Net income before expansion…………………….. $600,000 $600,000
Project income before interest and income tax.. $800,000 $800,000
Less interest expense ($800,000 × .10)…………. 80,000 -0-
Project income before income tax………………. 720,000 800,000
Less income tax expense (25%)…………………. 180,000 200,000
Project net income………………………………….. 540,000 600,000
Total company net income……………………. $1,140,000 $1,200,000
Earnings per share including new project:
Plan A ($1,140,000 / 200,000 shares)………. $5.70
Plan B ($1,200,000 / 400,000 shares)………… $3.00

(continued) E 8-31A
Req. 2
MEMORANDUM
TO: Board of Directors of First Bank Financial Services
FROM: Student Name
SUBJECT: Financing plan to expand operations
Plan A (borrowing) results in much higher earnings per share.

Plan A also allows the existing shareholders to retain control of
the company because the company issues no new shares. But
Plan A also creates more financial risk because borrowing
obligates the company to pay the interest and the principal of
the debt. On balance, I prefer Plan A, assuming the company’s
level of debt is not already too high.
Students can defend either plan based on their preferences for

control of the business, avoidance of risk, and higher earnings
per share.

Exercises
Group B
(5-15 min.) E 8-32B
Req. 1
Journal
Warranty Expense ($160,000 × .04)….. 6,400

Provision for Warranty Repairs….. 6,400
Provision for Warranty Repairs…..….. 5,000

Cash…………………………………… 5,000
Req. 2
INCOME STATEMENT
Sales revenue……………………………………… $160,000
Warranty expense………………………………… 6,400
BALANCE SHEET
Current liabilities
Estimated warranty payable
($4,000 + $6,400 − $5,000)………………..... 5,400
Req. 3
Provision for Warranty Repairs, a current liability, will cause a

company’s current ratio to decrease.

(10-15 min.) E 8-33B
Journal
2010
Oct. 1 Cash…………………………………………. 1,417
Unearned Subscription Revenue……. 1,300
Sales Tax Payable ($1,300 × .09)…….. 117
Nov. 15 Sales Tax Payable………………………… 117

Cash………………………………………. 117
31 Unearned Subscription Revenue………. 325

Subscription Revenue ($1,300 × 3/12) 325
BALANCE SHEET
Unearned subscription revenue ($1,300 − $325)…… $975
(10 min.) E 8-34B

INCOME STATEMENT
Expenses:
Payroll expense………………………………………. $160,000
Payroll tax expense ($160,000 × .09)……………… 14,400
BALANCE SHEET
Salary payable………………………………………… $ 7,900
Payroll tax payable…………………………………... 850

(5-10 min.) E 8-35B
Req. 1
Interest to
accrue at = $82,000 × .05 × 10/12 = $3,417
Dec. 31, 2010
Req. 2
Final payment
= $82,000 + ($82,000 × .05) = $86,100
on March 1, 2011
Req. 3

2010 = $82,000 × .05 × 10/12 = $3,417
2011 = $82,000 × .05 × 2/12 = $ 683

(10-15 min.) E 8-36B
Saglio’s balance sheet
at December 31, 2011, reported:
Income tax payable…………………………………... $265,000*
Saglio’s 2010 income statement reported:

Income tax expense ($1,500,000 × .25)…………… $375,000
_____
* Beginning income tax payable…………………….. $190,000
+ Income tax expense (and payable) for the year
($1,500,000 × .25)……………………………… 375,000
− Income tax payments during the year……………. (300,000)
= Ending income tax payable………………………… $265,000

(10-20 min.) E 8-37B
Req. 1
Accounts payable are amounts owed to suppliers for products or

services that have been purchased on account.
Accrued expenses are expenses that the company has incurred but
not paid. They are liabilities for expenses such as interest and
income taxes.
Employee compensation and benefits are amounts owed to

employees for salaries and other payroll-related expenses.
Current portion of long-term debt is the portion of the long-term

debt that is due within next year.
Long-term debt is the amount of long-term notes and bonds

payable that the company expects to pay after the coming year.
Postretirement benefits are the company’s liabilities for providing

benefits — mainly health care — to retirees.
The other liabilities are a catch-all group of liabilities that do not fit
one of the more specific categories and are not significant enough
to have a category of their own. The other liabilities are long-term,
as shown by the fact that they are not listed among the current
liabilities.

(continued) E 8-37B
Req. 2
Total assets = $3,998 million, the sum of total liabilities and

shareholders’ equity
Total liabilities ($3,998 million − $2,030 Million)*

Debt ratio = = 0.49
Total assets ($3,998 million)
A debt ratio of 49% is satisfactory

____
*Or, $340 + $1,488 + $129 + $11 = $1,968

(5-10 min.) E 8-38B
Req. 1
Peterson Security Systems should report this situation in a

note to the financial statements. The note should convey
essentially the same message given in Note 14.
Req. 2
Peterson would report:
INCOME STATEMENT
Estimated loss (or expense)……………… $2,500,000
BALANCE SHEET
Estimated liability…………………………… $2,500,000
Note 14 -
Same as above.
Journal
2010
Estimated Loss (or Expense)…... 2,500,000
Estimated Liability……………. 2,500,000

(15-20 min.) E 8-39B
Five Mile Electronics
Balance Sheet (partial)
September 30, 2010
a. Estimated warranty payable
[$33,000 + ($2,150,000 × .05) − $57,000]……… $83,500
b. Current portion of long-term note payable……... 10,000
Interest payable ($40,000 × .04 × 1/12)…………… 133
c. Unearned sales revenue ($110,000 − $90,000)…. 20,000
d. Employee withheld income tax payable………… 30,000
FICA tax payable ($240,000 × .0765)……………… 18,360
Total current liabilities………………………….. $161,993
Note payable ($40,000 − $10,000)……………... $30,000

(10-15 min.) E 8-40B
Req. 1
Journal
a. Jan. 31 Cash ($11,000,000 × 0.95)…………… 10,450,000

Discount on Bonds Payable………… 550,000
Bonds Payable…………………… 11,000,000
b. July 31 Interest Expense ($10,450,000 × .0618

× 6/12).........................................................322,781
Cash ($11,000,000 × .05 × 6/12)........... 275,000
Discount on Bonds Payable................ 47,781
To pay interest and amortize discount
on bond payable.
c. Dec. 31 Interest Expense ($10,497,781 × .0618 270,214

× 5/12).........................................................
Interest Payable
($11,000,000 × .05 × 5/12)................ 229,167
Discount on Bonds Payable................ 41,047

this question.

(10-15 min.) E 8-41B
1. Cash received = $400,000 × 1.04 = $416,000
2. Principal……………………………………………………… $400,000
Interest ($400,000 × .09 × 20)…………………….............. 720,000
Total cash paid……………………………………………… $1,120,000
3. Total cash paid……………………………………………… $1,120,000

Less: Cash received……………………………………... (416,000)
Difference = Total interest expense……………………... $704,000

2010 = $416,000 × .0858 = $35,672
2011 = $415,672 × .0858 = $35,644
*Note: Market interest rate needs to be computed to attempt this

question. Interest expense will gradually decrease over the life of the
bond. The sum of the total interest expense will equal to the amount
calculated in requirement 3.
If straight-line amortization is used, the interest rate will be equal for

each period and a multiplication of the interest expense by 20 will
equal to the amount calculated in requirement 3.

(15-20 min.) E 8-42B
A B C D E
INTEREST
EXPENSE
SEMIANNUAL (4-1/2% OF BOND DISCOUNT BALANCE CARRYING
DATE VALUE) AMOUNT) (B – A) D – C) ($800,000 – D)
Dec. 31, 2010 $49,768 $750,232
June 30, 2011 $36,000 $37,512 1,512 48,256 751,744
Dec. 31, 2011 36,000 37,587 1,587 46,669 753,331
June 30, 2012 36,000 37,667 1,667 45,002 754,998
Dec. 31, 2012 36,000 37,750 1,750 43,252 756,748

(continued) E 8-42B
Req. 2
Journal
2010
Dec. 31 Cash........................................................... 750,232
Discount on Bonds Payable.................... 49,768
Bonds Payable..................................... 800,000
2011
June 30 Interest Expense....................................... 37,512
Cash...................................................... 36,000
amortize discount on bond payable.
2011
Dec. 31 Interest Expense....................................... 37,587
Cash...................................................... 36,000
amortize bonds.

(15-20 min.) E 8-43B
A B C D E
INTEREST
EXPENSE
INTEREST (4-1/2% OF PREMIUM
SEMIANNUAL (5% OF BOND PREMIUM BALANCE CARRYING
DATE VALUE) AMOUNT) (A – B) D – C) ($3,200,000 + D)
June 30, 2010 $208,000 $3,408,000
Dec. 31, 2010 $160,000 $153,360 $6,640 201,360 3,401,360
June 30, 2011 160,000 153,061 6,939 194,421 3,394,421
Dec. 31, 2011 160,000 152,749 7,251 187,170 3,387,170
June 30, 2012 160,000 152,423 7,577 179,593 3,379,593
_____
1
$3,200,000 × 1.065 = $3,408,000

(continued) E 8-43B
Req. 2 (journal entries)
Journal
DATE ACCOUNT TITLES AND DEBIT CREDIT
EXPLANATION
2010
June 30 Cash ($3,200,000 × 1.065)……….. 3,408,000
Bonds Payable………………… 3,200,000
Premium on Bonds Payable… 208,000
To issue bonds at a premium.
Dec. 31 Interest Expense……………………. 153,360

Premium on Bonds Payable……… 6,640
Cash ………………………………. 160,000
To pay semiannual interest and amortize bond
premium.
2011
June 30 Interest Expense……………………. 153,061
Premium on Bonds Payable.……... 6,939
Cash……………………………….. 160,000
To pay semiannual interest and amortize bonds.

(15-20 min.) E 8-44B
A B C D E F
1 Bond
2 Interest Interest Discount Discount Carrying
3 Date Payment Expense Amortization Balance Amount
4
5 Jan. 1, 2010 $40,682 $679,318
6 Dec. 31, 2010 $79,200 $81,518 $2,318 38,364 681,636
7 Dec. 31, 2011 79,200 81,796 2,596 35,768 684,232
8 Dec. 31, 2012 79,200 82,108 2,908 32,860 687,140
9 Dec. 31, 2013 79,200 82,457 3,257 29,603 690,397
10 Dec. 31, 2014 79,200 82,848 3,648 25,955 694,045
11 Dec. 31, 2014 79,200 83,285 4,085 21,870 698,130
12 Dec. 31, 2014 79,200 83,776 4,576 17,294 702,706
13 Dec. 31, 2014 79,200 84,325 5,125 12,169 707,831
14 Dec. 31, 2014 79,200 84,940 5,740 6,430 713,570
15 Dec. 31, 2014 79,200 85,628 6,428 1 719,999
*Note: Computer-generated solutions may contain slight

rounding differences.

(15-20 min.) E 8-45B
Req. 1
Initial carrying amount of notes ($3,600,000 × 0.94) $3,384,000

Market interest rate 9.98%
Carrying amount of notes at December 31, 2015….. $3,466,799

this question. Carrying amount at December 31, 2015 can be
computed either using an amortization table or by finding the
future value of the bond in five years’ time.
Req. 2
Journal
2015
Dec. 31 Notes Payable...................................3,600,000
Discount on Notes Payable
($216,000 − $108,000)............. 108,000
Share Capital
($3,600,000 / $1,000 × 60 × $1 par) 216,000
Par — Common……………. 3,276,000

(20-25 min.) E 8-46B
Amounts in millions or billions
Compan
Company
y Company
Ratio F L V
Current Total current assets $433 ¥5,414 €147,378

= =
ratio Total current liabilities $227 ¥2,237 €72,600
= 1.91 = 2.42 = 2.03
F L V
Debt Total liabilities $227 + $107 ¥2,237 + ¥2,310 €72,600 + €110,907

= = $433 + $137 ¥5,414 + ¥731 €147,378 + €61,153
ratio Total assets
= 0.59 = 0.74 = 0.88
F L V
Times-
interest- Operating income $294 ¥229 €5,627
= = $43 ¥29 €687
earned Interest expense
ratio
= 6.84 times = 7.90 times = 8.19 times
Based on these ratio values, Company L looks the least risky.
*L has the best current ratio and middle of the range debt and times
interest earned ratios; whereas both F and V have at least one ratio
where they are the worst of the three.

(15-20 min.) E 8-47B
Req. 1
PLAN B
PLAN A ISSUE
BORROW $600,000
$600,000 OF COMMON
AT 5% SHARES
Net income before expansion…………………….. $400,000 $400,000
Project income before interest and income tax.. $550,000 $550,000
Less interest expense ($600,000 × .05)…………. 30,000 -0-
Project income before income tax………………. 520,000 550,000
Less income tax expense (40%)…………………. 208,000 220,000
Project net income………………………………….. 312,000 330,000
Total company net income……………………. $712,000 $730,000
Earnings per share including new project:
Plan A ($712,000 / 100,000 shares)…………... $7.12
Plan B ($730,000 / 200,000 shares)…………... $3.65

(continued) E 8-47B
Req. 2
MEMORANDUM
TO: Board of Directors of First Federal Financial

Services
FROM: Student Name
SUBJECT: Financing plan to expand operations
Plan A (borrowing) results in much higher earnings per share.

Plan A also allows the existing shareholders to retain control of
the company because the company issues no new shares. But
Plan A also creates more financial risk because borrowing
obligates the company to pay the interest and the principal of
the debt. On balance, I prefer Plan A, assuming the company’s
level of debt is not already too high.
Students can defend either plan based on their preferences for

control of the business, avoidance of risk, and higher earnings
per share.

Challenge Exercises
(10-15 min.) E 8-48
Total current assets $324,700

Current ratio = = = 1.68
Total current liabilities $193,400
Pratt Marketing Services should pay off $88,360* of current

liabilities. Then the current ratio will be:
$324,700 − $88,360 $236,340

= 2.25
$193,400 − $88,360 $105,040 =
_____
*Computation:
Let X = amount of current liabilities to pay in order to achieve

a current ratio of 2.25.
$324,700 − X
= 2.25
$193,400 − X
$324,700 − X = 2.25 ($193,400 − X)
−X = $435,150 − 2.25X −
$324,700
1.25X = $110,450
X = $88,360

(20-25 min.) E 8-49
Req. 1
Millions
Bonds Payable, 5 3/4%…………………………… 140
Bonds Payable, 11%……………………….. 77
Cash…………………………………………... 8
Gain on Retirement of Bonds Payable….. 55
Req. 2 (Dollar amounts in millions)
Old Bonds New Bonds
$140 × .0575 $77 × .11

Annual interest expense…..
= $8.05 = $8.47
Req. 3
Possible reasons for the debt refinancing:

1. To decrease annual interest expense: NO, because annual
interest expense on the old bonds is a little less ($420,000)
than interest expense on the new bonds.
2. To increase net income: YES, because the gain on
retirement of bonds payable added $55 million to net
income (less the $420,000 incremental interest expense).
3. To decrease the debt ratio: YES, as follows:
(Dollar amounts in millions) Before Refinancing After Refinancing
Debt Total liabilities $357 $357 − $140 + $77

= =
ratio Total assets $497 $497 − $8
= 0.72 = 0.60

(20-30 min.) E 8-50
Req. 1
2010
Mar. 15 Cash ($700,000 × .945)……………… 661,500
Discount on Bonds Payable……….. 38,500
Bonds Payable……………………. 700,000
Holiday Corporation issued the bonds payable to bondholders
in order to borrow $661,500 ($700,000 × 0.945) from the
bondholders. Holiday Corporation received the cash that the
bondholders paid.
Req. 2
The stated interest rate is high because the bonds are

debentures, which means that there is no collateral. If Holiday
Corporation defaults on the bond interest or principal, the
bondholders can claim no assets as collateral. Furthermore,
the debentures are subordinated, which means that the
bondholders will line up behind the line of general creditors in
the event of Holiday Corporation’s bankruptcy. These factors
combine to make the bonds very risky, and risky bonds bear a
high rate of interest.
Req. 3
$42,000 ($700,000 × 0.12 × 6/12)

(continued) E 8-50
Req. 4
Initial carrying amount of notes ($700,000 × $661,500

0.945)
x Semiannual market interest rate 6.5%
Semiannual interest expense $42,992

this question.
Req. 5
Effective-interest amortization method (amounts in thousands):
A B C D E
BOND
INTEREST INTEREST DISCOUNT CARRYING
SEMIANNUAL PAYMENT EXPENSE BALANCE AMOUNT
INTEREST (0.06 × (0.065 × DISCOUNT ($700,000
DATE $700,000) E) AMORTIZATION D − C) − D)
Mar. 15, 2010 $38,500 $661,500
Sept. 15 $42,000 $42,998 $ 998 37,503 662,498
Mar. 15, 2011 42,000 43,062 1,062 36,440 663,560
Sept. 15 42,000 43,131 1,131 35,309 664,691
Mar. 15, 2012 42,000 43,205 1,205 34,104 665,896
Interest exp. for yr. 1: $86,060 ($42,998 + $43,062)

yr. 2: $86,336 ($43,131 + $43,205)
Interest expense is greater in the second year because the

bond carrying amount increases as the bonds are amortized
toward their maturity value.

Quiz
Q8-51 c
Q8-52 d
Q8-53 a
Q8-54 b
Q8-55 c
Q8-56 d [($450,000 + $750,000) × .07] − $3,150 − $30,000
= $50,850
Q8-57 c
Q8-58 a
Q8-59 f
Q8-60 d
Q8-61 a
Q8-62 e Under effective interest amortization method, the
interest expense is different every year
Q8-63 Interest Expense (192,000 x 0.125 x

9/12)………………………. 18,000
Interest Payable ($200,000 × .12 × 9/12) 18,000
*Note: Implied market interest rate for a price of 96 is
12.73%. Using a market rate of 12.5% will yield an
interest expense similar to cash interest payable, which
result in zero amortization.
Q8-64 Interest Payable………………………........ 18,000
Interest Expense…………………………… 6,000
Cash ($200,000 × .12)…………………... 24,000
Q8-65 e ($236,370 x .07) = $16,546)

Q8-66 b
Q8-67 d
Q8-68 a
Q8-69 a

Problems
Group A
(15-20 min.) P 8-70A

a. Sales tax payable ($120,000 × .05)............................. $6,000
b. Note payable, short-term............................................ $85,000

Interest payable ($85,000 × .04 × 4/12)...................... 1,133
c. Unearned service revenue ($2,400 × 4/6).................. $1, 600
d. Estimated warranty payable

($11,600 + $34,000 − $34,800)................................ $10,800
e. Portion of long-term note payable due

within one year....................................................... $35,000
Interest payable ($70,000 × .12)................................. 8,400

(30-40 min.) P 8-71A
Journal
2010
Mar. 3 Inventory.................................................... 70,000
Note Payable, Short-term.................... 70,000
May 31 Cash........................................................... 75,000

Note Payable, Short-term.................... 15,000
Note Payable, Long-term..................... 60,000
Sept. 3 Note Payable, Short-term......................... 70,000

Interest Expense ($70,000 × .04 × 6/12) 1,400
Cash...................................................... 71,400
Dec. 31 Warranty Expense ($190,000 × .03).......... 5,700

Provision for Warranty Repairs........... 5,700
31 Interest Expense ($75,000 × .04 × 7/12) 1,750

Interest Payable.................................... 1,750
2011
May 31 Note Payable, Short-term......................... 15,000
Interest Payable......................................... 1,750
Interest Expense ($75,000 × .04 × 5/12)….. 1,250
Cash...................................................... 18,000

(20-25 min.) P 8-72A
Req. 1
Journal
2010
a. May 31 Cash ($9,000,000 × 1/2)…………... 4,500,000
Bonds Payable…………………. 4,500,000
To issue bonds at par.
b. Nov. 30 Interest Expense…………………... 225,000

Cash ($4,500,000 × .10 × 6/12). 225,000
To pay interest on bonds.
c. Dec. 31 Interest Expense

($4,500,000 × .10 × 1/12)………….. 37,500
Interest Payable………………... 37,500
To accrue interest.
2011
d. May 31 Interest Payable…………………… 37,500
Interest Expense
($4,500,000 × .10 × 5/12)………….. 187,500
Cash ($4,500,000 × .10 × 6/12). 225,000

(continued) P 8-72A
Req. 2 (reporting the liabilities on the balance sheet at
December 31, 2010)
Interest payable...................................... $ 37,500
Bonds payable....................................... $4,500,000
(30-40 min.) P 8-73A

Req. 1
The 8 % bonds issued when the market interest rate is 7% will

be priced at a premium. They are relatively attractive in this
market, so investors will pay a price above par value to acquire
them.
Req. 2
The 8% bonds issued when the market interest rate is 9% will

be priced at a discount. They are relatively unattractive in this
market, so investors will pay less than par value to acquire
them.

(continued) P 8-73A
Req. 3
Journal
2010
a. Feb. 28 Cash ($900,000 × .99)............................891,000
Discount on Bonds Payable................. 9,000
Bonds Payable................................. 900,000
b. Aug. 31 Interest Expense 35,640

($891,000 x 0.0815 x 6/12).....................
Cash ($900,000 × .08 × 6/12)............ 36,000
Discount on Bonds Payable
................................................................ 360
To pay interest and amortize bonds.
c. Dec. 31 Interest Expense 24,300

($891,360 x 0.0815 x 6/12 x 4/6)............
Interest Payable ($36,000 × 4/6)...... 24,000
................................................................ 300
2011
d. Feb. 28 Interest Payable (from Dec. 31)………. 24,000
Interest Expense 11,884
($891,360 x 0.0815 x 6/12 x 2/6)............
Cash ($900,000 × .08 × 6/12)............ 36,000
........................................................ 116

this question.

(continued) P 8-73A
December 31, 2010)
Interest payable………………………… $ 24,000
Bonds payable…………………………. $900,000
Less: Discount on bonds payable
($9,000 − $360 − $230)………. (8,410) 891,590

(30-40 min.) P 8-74A
Req. 1
Journal
2010
Jan. 1 Cash ($7,000,000 × .96).......................6,720,000
Bonds Payable……………………. 7,000,000
July 1 Interest Expense ($6,720,000 x . 323,634

0963 x 6/12)..........................................
Cash ($7,000,000 × .09 × 6/12)....... 315,000
Dec. 31 Interest Expense ($6,728,634 x . 324,050

0963 x 6/12)..........................................
Interest Payable
($7,000,000 × .09 × 6/12).............. 315,000
2011
Jan. 1 Interest Payable.................................. 315,000
Cash................................................ 315,000
To pay interest.
2020
Jan. 1 Bonds Payable.....................................7,000,000
Cash................................................. 7,000,000
To pay bonds at maturity.

this question.

(continued) P 8-74A
Req. 2
Carrying amount at December 31, 2010.
Bonds payable, net

($7,000,000 − $280,000 + $8,634 + $9,050)……… $6,737,684
Req. 3
a. Interest expense = $323,634
b. Cash interest paid = $315,000
Interest expense exceeds cash interest paid because the

company issued the bonds at a discount and must pay back
the full face value of the bonds at maturity. Amortization of the
bond discount over the life of the bond causes the interest
expense on the bonds to exceed the amount of cash interest
paid.

(30-45 min.) P 8-75A
Req. 1
a. Maturity value is $3,000,000
b. Annual cash interest payment is $210,000

($3,000,000 × .07)
c. Carrying amount is $2,861,314
A B C D E
INTEREST
EXPENSE
ANNUAL (7% OF BOND DISCOUNT BALANCE CARRYING
DATE VALUE) AMOUNT) (B – A) D – C) ($3,000,000–D)
Dec. 31, Yr. $138,686 $2,861,314
Dec. 31, Yr. 1 $210,000 $228,905 $18,905 119,781 2,880,219
Dec. 31, Yr. 2 $210,000 230,418 20,418 99,363 2,900,637
Dec. 31, Yr. 3 $210,000 232,051 22,051 77,312 2,922,688
Dec. 31, Yr. 4 $210,000 233,815 23,815 53,497 2,946,503
Interest expense for the year ended December 31, Year 4, is

$233,815.

(continued) P 8-75A
Req. 3 (reporting the liabilities at December 31, Year 4)
Current installment of notes payable…….. $ 55,000
Bonds payable………………………………... $3,000,000
Less: Discount on bonds payable………. ( 53,497) 2,946,503
Notes payable………………………………… 275,000

(40-50 min.) P 8-76A
A B C D E
INTEREST
EXPENSE
SEMIANNUAL (3.5% OF BOND DISCOUNT BALANCE CARRYING
12-31-10 $205,050 $2,794,950*
6-30-11 $105,000 $111,798 $6,798 198,252 2,801,748
12-31-11 105,000 112,070 7,070 191,182 2,808,818
6-30-12 105,000 112,353 7,353 183,829 2,816,171
12-31-12 105,000 112,647 7,647 176,183 2,823,817
_____
*$3,000,000 × .93165 = $2,794,950

(continued) P 8-76A
Req. 2
Journal
2010
a. Dec. 31 Cash ($3,000,000 × .93165)................... 2,794,950
Discount on Bonds Payable.................205,050
Convertible Bonds Payable............. 3,000,000
2011
b. June 30 Interest Expense...................................111,798
Cash.................................................. 105,000
Discount on Bonds Payable............ 6,798
bonds.
c. Dec. 31 Interest Expense...................................112,070

Cash.................................................. 105,000
Discount on Bonds Payable............ 7,070
bonds.
2012
d. July 1 Convertible Bonds Payable.................. 1,200,000
($183,829 × $1.2M / $3.0M)…… 73,532
Share Capital (40,000 × $1).............. 40,000
Par — Common........................... 1,086,468
To record conversion of bonds.

(continued) P 8-76A
Req. 3 (balance sheet presentation of bonds payable at
December 31, 2012)
Convertible bonds payable

($3,000,000 − $1,200,000)................... $1,800,000
Less: Discount on bonds payable
($176,182 × 3/5*).................................. (105,709) $1,694,291
_____
*3/5 of the bonds are outstanding, so 3/5 of the discount
remains.

(20-30 min.) P 8-77A
Req. 1
TO: Management of Paulus Sporting Goods
FROM: Student Name
SUBJECT: Advantages and disadvantages of borrowing

versus issuing shares to raise cash for
expansion
Raising money by borrowing has at least two advantages over

issuing common shares. Borrowing does not change the
present ownership of the business. It enables the present
owners to keep their proportionate interests in the business
and to carry out their plans without interference from a new
group of shareholders. Under normal conditions, borrowing
results in a higher earnings per share of common shares
because the interest expense on the debt is tax-deductible. And
higher earnings per share usually lead to higher share prices
for company owners.
The main disadvantage of borrowing is that the debt increases

the financial risk of the company. The principal and the related
interest expense must be paid whether the company is earning
a profit or not. If times get sufficiently bad, the debt burden
could threaten the ability of the business to continue as a going
concern.
(continued) P 8-77A
The main advantage of issuing shares is that owners avoid the
burden of making interest and principal payments on the debt.
Issuing shares creates no liability to pay anything to the
owners. If the directors consider it necessary, they can refuse
to pay dividends in order to conserve cash. Therefore, it is
safer to issue shares.
One disadvantage of issuing shares is dilution of the

ownership interests of existing shareholders if the purchasers
of new shares are outsiders. The new shareholders may have
different ideas about how to manage the business and that may
pose difficulties for the original shareholder group. Another
disadvantage of issuing shares is that earnings per share are
usually lower because of (1) the greater number of shares of
shares outstanding, and (2) the non-tax-deductibility of
dividends paid on the shares.
There is insufficient information available upon which to make

a decision. Sporting Goods’ management must prepare
budgets which indicate the impact of the new stores in terms of
net income and cash flow. Management must also estimate the
cost of borrowing the funds.

(20-30 min.) P 8-78A
Req. 1
Barnstable Foods, Inc.

Partial Balance Sheet
December 31, 2010
PPE: Current liabilities:
Equipment...............$745,000 Mortgage note
Accumulated payable, current.......... $ 94,000
depreciation......... (164,000) Bonds payable,
current portion............ 400,000
Interest payable............. 72,000*
Total current liabilities...... $566,000
Mortgage note payable… $ 319,000
Bonds payable. $1,200,000
Discount on bonds
payable……. (27,000)* 1,173,000
Net Pension liability....... 60,000**
Total non-current liabilities $1,552,000
Notes:
* The order of listing current liabilities and non-current liabilities is optional.
However, Discount on Bonds Payable should come immediately after Bonds
Payable. Also, it is customary to report Interest Payable after the related
liability accounts, Mortgage Note Payable and Bonds Payable, Current
Portion.
** Computation of pension liability:

Accumulated pension benefit obligation…………….……............ $465,000
Less: Pension plan assets, at market value………………............ (405,000)
Net Pension liability to be reported on the balance sheet……… $ 60,000

(continued) P 8-78A
Req. 2
a. Carrying amount of bonds payable:

Current portion……………………………… $ 400,000
Long-term portion ($1,200,000 − $27,000)… 1,173,000
Carrying amount……………………………….. $1,573,000
b. Interest payable is the amount of interest that Barnstable

owes at year end. Interest expense is the company’s
cost of borrowing for the full year.
Req. 3
Operating income $ 400,000

Times-interest-earned ratio = =
Interest expense $ 222,000
= 1.80 times

Problems
Group B
(15-20 min.) P 8-79B

a. Sales tax payable ($110,000 × .08).......................... $8,800
b. Note payable, short-term......................................... $82,000

Interest payable ($82,000 × .04 × 4/12).................... 1,093
c. Unearned service revenue ($1,200 × 4/6)............... $ 800
d. Estimated warranty payable

($11,400 + $30,000 − $34,600)............................ $6,800
e. Portion of long-term note payable due

within one year..................................................... $25,000
Interest payable ($85,000 × .10)............................... 8,500

(30-40 min.) P 8-80B
Journal
2010
Mar. 3 Inventory…………………………………… 30,000
Note Payable, Short-term……………. 30,000
May 31 Cash…………………………………………. 75,000

Note Payable, Short-term……………. 15,000
Note Payable, Long-term…………….. 60,000
Sept. 3 Note Payable, Short-term……………….. 30,000

Interest Expense ($30,000 × .10 × 6/12). 1,500
Cash……………………………………... 31,500
Dec. 31 Warranty Expense ($196,000 × .015)….. 2,940

Provision for Warranty Repairs...... 2,940
Dec. 31 Interest Expense

($75,000 × .06 × 7/12)…………………….. 2,625
Interest Payable……………………….. 2,625
2011
May 31 Note Payable, Short-term……………….. 15,000
Interest Payable…………………………… 2,625
Interest Expense ($75,000 × 0.06 × 5/12).. 1,875
Cash [$15,000 + ($75,000 × .06)]..…... 19,500

(20-25 min.) P 8-81B
Req. 1
Journal
2010
a. May 31 Cash..............................................3,000,000
Bonds Payable........................ 3,000,000
To issue bonds at par.
b. Nov. 30 Interest Expense………………... 120,000

Cash ($3,000,000 × .08 × 6/12)… 120,000
c. Dec. 31 Interest Expense

($3,000,000 × .08 × 1/12).............. 20,000
Interest Payable...................... 20,000
To accrue interest.
2011
d. May 31 Interest Payable........................... 20,000
Interest Expense
($3,000,000 × .08 × 5/12).............. 100,000
Cash ………………………….. 120,000

(continued) P 8-81B
December 31, 2010)
Interest payable……………………………. $ 20,000
Bonds payable……………………………... $3,000,000
(30-40 min.) P 8-82B

Req. 1
The 6% notes issued when the market interest rate is 5% will be

priced at a premium. They are relatively attractive in this
market, so investors will pay a price above par value to acquire
them.
Req. 2
The 6% notes issued when the market interest rate is 7%will

be priced at a discount. They are relatively unattractive in this
market, so investors will pay less than par value to acquire
them.

(continued) P 8-82B
Req. 3
Journal
2010
a. Feb. 28 Cash ($1,800,000 × 0.96)………………………… 1,728,000
Discount on Bonds Payable…………………… 72,000
Bonds Payable……………………………….. 1,800,000
To issue bonds payable at a discount.
b. Aug. 31 Interest Expense…………………………………. 54,917

Discount on Bonds Payable)………………. 917
Cash ($1,800,000 × .06 × 6/12)……………… 54,000
To pay interest and amortize bonds payable.
c. Dec. 31 Interest Expense…………………………………. 36,631

Discount on Bonds Payable ..……………... 631
Interest Payable ($54,000  4/6)……………. 36,000
To accrue interest and amortize bonds payable.
2011
d. Feb. 28 Interest Payable (from Dec. 31)………………… 36,000
Interest Expense………………………………….. 18,315
Discount on Bonds Payable……………….... 315
Cash ($1,800,000 × .06 × 6/12)………………. 54,000
To pay interest and amortize bonds payable.

this question.

(continued) P 8-82B
December 31, 2010)
Interest payable................................ $ 36,000
Notes payable................................... $1,800,000
Less: Discount on notes payable
($72,000 − $917 − $631)................ (70,452) 1,729,548

(30-40 min.) P 8-83B
Req. 1
Journal
2010
Jan. 1 Cash ($4,000,000 × .96).........................3,840,000
Discount on Bonds Payable................. 160,000
Bonds Payable.................................. 4,000,000
July 1 Interest Expense.................................... 145,492

Cash ($4,000,000 × .07 × 6/12)......... 140,000
Dec. 31 Interest Expense.................................... 145,700

Interest Payable
($4,000,000 × .07 × 6/12)................ 140,000
2011
Jan. 1 Interest Payable……………………… 140,000
Cash………………………………… 140,000
To pay interest.
2020
Jan. 1 Bonds Payable……………………… 4,000,000
Cash……………………………… 4,000,000
To pay off bonds at maturity.

this question.

(continued) P 8-83B
Req. 2
Carrying amount at December 31, 2010:
Bonds payable, net

($4,000,000 − $160,000 + $5,492 + $5,700) = $3,851,492
Req. 3
a. Interest expense = $145,492
b. Cash interest paid = $140,000
Interest expense exceeds cash interest paid because the

company issued the bonds at a discount and must pay back
the full face value of the bonds at maturity. Amortization of the
bond discount over the life of the bond causes the interest
expense on the bonds to exceed the amount of cash interest
paid.

(30-45 min.) P 8-84B
Req. 1
a. Maturity value is $6,000,000.
b. Annual cash interest payment is $240,000 ($6,000,000 × .04).
c. Carrying amount is $5,695,458.
A B C D E
INTEREST
EXPENSE
ANNUAL (4% OF BOND DISCOUNT BALANCE CARRYING
Dec. 31, Yr. 0 $304,542 $5,695,458
Dec. 31, Yr. 1 $240,000 $284,773 $44,773 259,769 5,740,231
Dec. 31, Yr. 2 240,000 287,012 47,012 212,758 5,787,242
Dec. 31, Yr.3 240,000 289,362 49,362 163,395 5,836,605
Dec. 31, Yr.4 240,000 291,830 51,830 111,565 5,888,435
Interest expense for the year ended December 31, Year 4 is

$291,830.

(continued) P 8-84B
Req. 3 (reporting the liabilities at December 31, Year 4)
Current portion of notes payable............ $ 60,000
Bonds payable.......................................... $6,000,000
Less: Discount on bonds payable (111,565) 5,888,435
Notes payable
($360,000 − $60,000).............................. 300,000

(40-50 min.) P 8-85B
A B C D E
INTEREST
EXPENSE
SEMIANNUAL (4-1/2% OF BOND DISCOUNT BALANCE CARRYING
DATE VALUE) AMOUNT) (B – A) D – C) ($2,000,000 - D)
12-31-10 $124,420 $1,875,580*
6-30-11 90,000 $93,779 $3,779 120,641 1,879,359
12-31-11 90,000 93,968 3,968 116,673 1,883,327
6-30-12 90,000 94,166 4,166 112,507 1,887,493
12-31-12 90,000 94,375 4,375 108,132 1,891,868
_____
*$2,000,000 × .93779 = $1,875,580

(continued) P 8-85B
Req. 2
Journal
2010
a. Dec. 31 Cash ($2,000,000 × .93779)................1,875,580
Discount on Bonds Payable……… 124,420
Convertible Bonds Payable.......... 2,000,000
2011
b. June 30 Interest Expense................................. 93,779
Cash................................................ 90,000
Discount on Bonds Payable........ 3,779
c. Dec. 31 Interest Expense................................. 93,968

Cash................................................ 90,000
Discount on Bonds Payable.............. 3,968
2012
d. July 1 Convertible Bonds Payable............... 800,000
($112,507 × $0.8M / $2.0M)......... 45,003
Share Capital ($90,000 × 1)........... 90,000
Par — Common.......................... 664,997
To record conversion of bonds.

(continued) P 8-85B
Req. 3 (balance sheet presentation of bonds payable at
December 31, 2012)
Convertible bonds payable

($2,000,000 − $800,000)..............................….$1,200,000
Discount on bonds payable ($108,132 × 3/5)* 64,879 $1,135,121
_____
*3/5 of the bonds are outstanding, so 3/5 of the discount
remains.

(15-30 min.) P 8-86B
TO: Management of Fitzpatrick Sporting Goods
FROM: Student Name
SUBJECT: Advantages and disadvantages of borrowing

versus issuing shares to raise cash for
expansion
Raising money by borrowing has at least two advantages over

issuing common shares. Borrowing does not change the
present ownership of the business. It enables the present
owners to keep their proportionate interests in the business
and to carry out their plans without interference from a new
group of shareholders. Under normal conditions, borrowing
results in a higher earnings per share of common shares
because the interest expense on the debt is tax-deductible. And
higher earnings per share usually lead to higher share prices
for company owners.
The main disadvantage of borrowing is that the debt increases

the financial risk of the company. The principal and the related
interest expense must be paid whether the company is earning
a profit or not. If times get sufficiently bad, the debt burden
could threaten the ability of the business to continue as a going
concern.

The main advantage of issuing shares is that owners avoid the
burden of making interest and principal payments on the debt.
Issuing shares creates no liability to pay anything to the
owners. If the directors consider it necessary, they can refuse
to pay dividends in order to conserve cash. Therefore, it is
safer to issue shares.
One disadvantage of issuing shares is dilution of the

ownership interests of existing shareholders if the purchasers
of new shares are outsiders. The new shareholders may have
different ideas about how to manage the business and that may
pose difficulties for the original shareholder group. Another
disadvantage of issuing shares is that earnings per share are
usually lower because of (1) the greater number of shares of
shares outstanding, and (2) the non-tax-deductibility of
dividends paid on the shares.
There is insufficient information available upon which to make

a decision. Fitzpatrick’s management must prepare budgets
which indicate the impact of the new stores in terms of net
income and cash flow. Management must also estimate the
cost of borrowing the funds.

(20-30 min.) P 8-87B
Req. 1
Brilliant Foods, Inc.

Partial Balance Sheet
December 31, 2010
PPE: Current liabilities:
Equipment….. $746,000 Bonds payable
Accumulated current portion………… $ 500,000
depreciation. (165,000) Mortgage note payable
581,000 current portion……….. 95,000
Interest payable…………. 72,000*
Total current liabilities…… 667,000
Mortgage note payable… $ 313,000
Bonds payable. $200,000
Discount on bonds
payable……. 23,000* 177,000
Net Pension liability…… 50,000**
Total non-current liabilities 540,000
_____
Notes:
* The order of listing non-current liabilities is optional. However, Discount on
Bonds Payable should come immediately after Bonds Payable. Also, it is
customary to report Interest Payable after the related liability accounts.
** Computation of pension liability:

Accumulated pension benefit obligation…………………….. $460,000
Less: Pension plan assets, at market value…………………. (410,000)
Net Pension liability to be reported on the balance sheet… $ 50,000

(continued) P 8-87B
Req. 2
a. Carrying amount of bonds payable:

Current portion..................................................... $ 500,000
Long-term portion ($200,000 - $23,000)............. 177,000
Carrying amount.................................................. $677,000
b. Interest payable is the amount of interest that Brilliant owes

at year-end. Interest expense is the company’s cost of
borrowing for the full year.
Req. 3
Operating income $360,000

Times-interest-earned ratio = =
Interest expense $224,000
= 1.6 times

Decision Cases
(15-20 min.) Decision Case 1
Req. 1
As After Including the

Reported Special-Purpose Entities
Total liabilities $54,033 $54,033 + $6,900

Debt ratio = =
Total assets $65,503 $65,503 − $600 + $500
= 0.82 = 0.93
Operating
Times-interest- Income $1,953 $1,953
= =
earned ratio Interest $ 838 $838 + ($6,900 × .10)
expense
= 2.3 times = 1.3 times
Req. 2
It appears that Enron excluded the special-purpose-entities

(SPEs) from its financial statements in order to hide their debt
from Enron’s investors and creditors. The purpose was to
understate Enron’s liabilities. We would view Enron as much
more risky after including the SPEs in Enron’s financial
statements. So did their banks, which is why they stopped
lending money to them, causing them to have to file for
bankruptcy.

(30-40 min.) Decision Case 2
Req. 1 (Analysis of financing plans)
PLAN A PLAN B PLAN C

ISSUE $3.75
ISSUE NONVOTING
BORROW COMMON PREFERRED
AT 6% SHARES SHARES
Net income before expansion $3,500,000 $3,500,000 $3,500,000
Project income before interest
and income tax $1,500,000 $1,500,000 $1,500,000
Less interest expense
($5,000,000 × .06) 300,000 -0- -0-
Project income before income tax 1,200,000 1,500,000 1,500,000
Less income tax expense (35%) 420,000 525,000 525,000
Project net income 780,000 975,000 975,000
Less preferred dividends
(100,000 × $3.75) -0- -0- 375,000
Additional net income available
to common shareholders 780,000 975,000 600,000
Total company net income $4,280,000 $4,475,000 $4,100,000
Earnings per share including new

project:
Plan A
($4,280,000 / 1,000,000 shares) $ 4.28
Plan B
($4,475,000 / 1,100,000 shares) $ 4.07
Plan C
($4,100,000 / 1,000,000 shares) $ 4.10

(continued) Decision Case 2
Req. 2 (Recommendation)
The best choice appears to be Plan A — borrowing at 6% —

because:
(1) Borrowing allows the family to maintain control of the

business;
(2) EPS is higher under borrowing than under issuing preferred

shares (which would also maintain family control); and
(3) EPS under borrowing is higher than it would be if common

shares were issued. Also, cash flow under Plan A
(borrowing) may be almost as good as under Plan B
(issuing common shares) after considering shareholders’
demands for dividends.

Ethical Issue 1
Req. 1
A company would prefer not to disclose its contingent

liabilities because they cast a shadow on the business and
create a negative impression. Contingent liabilities relating to
defending legal suits may be taken as admission of legal
responsibility when disclosed.
Req. 2 and 3
The potential parties and economic consequences of the

decision not to disclose contingent liabilities are:
1. The bank and its shareholders: With misleading

information, they might extend additional funds to the borrower
assuming a better ability to pay back the funds than actually
exists. A contingent liability creates risk for a company. If the
contingent liability is not reported, the bank may view the
company as low-risk. This may lead the bank to loan money at
low interest rates and with easy payment terms. With
knowledge of the contingent liability, the bank might not have
made the loan at all. Or the bank might have required a higher
interest rate or more stringent payment terms. Making loans on
too-easy terms expropriate the bank’s owners of their money.

(continued) Ethical Issue 1
2. The company seeking the loan: Might become overextended

in its borrowing and risk default on debt in the future.
Req. 3 Legal and ethical consequences
Banks have legal requirements to keep certain ratios of assets

and liabilities on their books or risk default. Failure of a
company to report its contingent liabilities to a bank requesting
this disclosure could subject the company to a lawsuit later on.
From an ethical standpoint, reporting a contingent liability
requires a delicate balancing act. Ethics require that outsiders’
interests be protected. The company must disclose enough
information to give outsiders a reasonable basis for making
informed decisions about the company. At the same time, the
company should avoid giving away secrets that could damage
its owners’ investment in the business. This dilemma is clear
when a defendant fears losing an important lawsuit. Fortunately
for accountants, most companies settle out of court those
lawsuits that they expect to lose. In such cases, there are no
contingent liabilities to disclose.

Ethical Issue 2
1. The ethical issue is whether to structure this lease to avoid
its having to be disclosed as a capital lease. The company will
do that if it is possible. It appears that Gocker and Moran have
some flexibility in setting the life of the lease (4-6 years). If they
set the term of the lease at 4 years, it will be only 66 2/3 percent
of the economic life of the asset (6 years). Thus, the lease will
fail all of the mechanical tests for the lease to be treated as a
capital lease, and by default, it will be treated as an operating
lease, and Gocker can avoid capitalizing the asset and
including the liability on her financial statements. If they set
the term of the lease at 5 or 6 years, it will exceed 75% of the
economic life of the asset, and thus the lease will have to be
capitalized.
2. The stakeholders are Gocker, the lessee; Morgan, the lessor;

and Last National Bank, Gocker’s present creditor. The
potential consequences to the stakeholders are:
a. economic: If the lease is structured as a capital lease,

Gocker
will violate its long-term loan covenant with Last National Bank.
As a result, the bank might demand immediate payment of their

loan. This may damage Gocker’s credit rating and create
difficulty getting future bank loans. Alternatively, Last National
Bank may waive the loan covenant in exchange for a higher
interest rate or more stringent repayment terms. This too could
cause Gocker financial difficulties. Morgan is not affected
economically, because Morgan will receive its payments on the
leased property regardless of how the transaction is disclosed.
b. legal: If we assume that GAAP substitutes for legal

requirements, if Gocker is careful to structure the lease terms
so that it avoids the requirements for a capital lease, there
should be no problem stating that the lease agreement
complies with GAAP.
c. ethical: The substance of a capital lease is one that

transfers the risks and rewards of ownership to the lessee. If in
fact, the substance of the terms of this lease do that, the
equipment should be capitalized by the lessee regardless of the
form of the lease terms. To use mechanical rules to avoid
recognizing assets and liabilities hardly seems like a truthful
way to do business. Nevertheless, U.S. GAAP presently allow
it!

3. Student responses will vary on this question. Some will say
that, if the rules allow it, then why not engineer the transaction
in such as way as to benefit Gocker by keeping the asset, and
the lease obligation, off the books. After all, this is perfectly
legal, and perfectly in accordance with existing U.S. GAAP
(FAS 13). In the view of the authors, Gocker should evaluate
whether, in fact, she obtains the rights and rewards associated
with ownership of the machine. If so, she could so structure
the lease that it fits the economic substance of the transaction,
which is what should also be disclosed in the financial
statements. If it turns out that the equipment and the related
lease obligation will have to be added to assets and liabilities in
the balance sheet, thus causing Gocker to default on the loan
covenant, she should attempt to obtain a waiver of the
covenant. This option is going to prove costly for Gocker, so
she’s going to have to be convinced that she did the right thing
in order to be motivated to follow this course of action.

Focus on Financials: Nokia Corporation
(20 min.)
Req. 1
Nokia’s accounts payable decreased from $7,074 million in
2007 to $5,225 million in 2008, a decrease increase of about
26.1 percent. The most obvious reason for this significant
decrease is that the company paid more payables than
purchasing on account.
Req. 2
Nokia’s income tax expense for 2008 was $1,081 million

Deferred tax refers to a tax payable, i.e., the amount of tax the
company owes but has yet paid.
Req. 3
We may refer to cash flow from financing activities on the cash

flow statement of Nokia. Proceeds from long term borrowings
were $714 million and repayments of long term borrowings
were only $34 million. Thus Nokia borrowed more than it repaid
in 2008.

Req. 4
Nokia acts as a guarantor for loans made to 3rd parties. Should
these companies be unable to repay the loans then Nokia will
be required to foot them.
“Routine litigation incidental to the normal conduct of

business”. It is a dispute with Qualcomm Incorporated which
was resolved on 24 July 2008. It involved an expense due to a
lump sum payment made in settlement of the liability ($1.7
billion expensed over 15 years).
Req. 5
Nokia’s debt ratio is defined as total liabilities/total assets. Its
debt ratio was 0.58 in 2008 and 0.54 in 2007. The lower debt
ratio implies that Nokia is less leveraged.
Req. 6
Nokia has provisions for warranties, restructuring, IPR

infringements, tax. A provision is recognized only when a past
event has created a legal or constructive obligation, an outflow
of resources is probable, and the amount of the obligation can
be estimated reliably.

Nokia needs provisions for warranties to recognize the fact that
not all handsets it sells will work perfectly - it must recognize
an expense to match against the revenues that the sale of
handsets brings to cover their repair expenses.
IPR provisions are based on estimated future settlements for

asserted and unasserted past IPR infringements.
A provision is a present liability but a contingent liability is a

future liability.

Group Projects
Student responses will vary.

Ch08 Harrison 8e GE SM (Revised)

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Chapter 8

(10 min.) S 8-1

Sept. 30 Note Payable, Short-Term………………... 5,000

Chapter 8 Liabilities 605

The 2012 income statement will report:

Interest expense ($5,000 × .08 × 3/12)………. $100

606 Financial Accounting 8/e Solutions Manual

Cash ($483,000 × .30)…………………..….. 144,900

Warranty Expense ($483,000 × .06)……… 28,980

Provision for Warranty Repairs………..... 19,000

Provision for Warranty Repairs

Chapter 8 Liabilities 607

The matching principle addresses this situation.

Note that the relevance qualitative characteristic also applies. If

Student responses may vary.

608 Financial Accounting 8/e Solutions Manual

2. In the United States, the contingency can become a real

3. Outside the United States, the contingency becomes a real

Chapter 8 Liabilities 609

b. $308,250 ($ 300,000 × 1.0275)

c. $283,500 ($ 300,000 × .9450)

d. $313,500 ($ 300,000 × 1.0450)

c. Par (face) value

610 Financial Accounting 8/e Solutions Manual

b. Dec. 31 Interest Expense ($80,000 × .055 × 6/12) 2,200

Chapter 8 Liabilities 611

Sept. 30 Interest Expense…………………. 18,480

612 Financial Accounting 8/e Solutions Manual

2. Pay cash interest of $15,000 each six months.

Sept. 31, 2010…………….. $18,480

Interest expense increases because the bond carrying amount

(5-10 min.) S 8-11

2. $5,000,000 on July 1, 2020

3. $75,000 ($5,000,000 × .03 × 6/12)

4. Market interest rate = 15.88%

b. Dec. 31 Interest Expense ($470,000 x 0.0892 x 20,960

614 Financial Accounting 8/e Solutions Manual

Earnings per share including expansion:

Recommendation: To increase earnings per share,

Chapter 8 Liabilities 615

This means that for every dollar of interest expense, Houle

Based on this ratio, the authors would be willing to lend $1

Students’ conclusions may vary.

616 Financial Accounting 8/e Solutions Manual

Total liabilities………………………………. $776,000

Chapter 8 Liabilities 617

Warranty Expense ($161,000 × .07) 11,270

Provision for Warranty Repairs…..….. 8,000

Provision for Warranty Repair, a current liability, will cause a

618 Financial Accounting 8/e Solutions Manual

Nov. 15 Sales Tax Payable………………………… 112

Dec. 31 Unearned Subscription Revenue………. 350

(10 min.) E 8-18A

Chapter 8 Liabilities 619

Interest expense for:

620 Financial Accounting 8/e Solutions Manual

Young’s 2011 income statement reported:

Chapter 8 Liabilities 621

Accounts payable are amounts owed to suppliers for products or

Employee compensation and benefits are amounts owed to

Current portion of long-term debt is the portion of the long-term

Long-term debt is the amount of long-term notes and bonds