ISB FADM 2021

Practice Set 9: Accounting for Bonds

QUESTION 1

SOLUTION

a. Selling price for $700,000, 9% bonds discounted at 8% (4% semiannually):

Calculator inputs: N = 20 I/Y = 4 PMT = -31,500 FV = -700,000

PV = 747,566.14

Excel inputs: = PV(4%,20,-31500,-700000,0) Cell will display: 747,566.14

Present value of principal repayment ($700,000  0.45639a) $319,473

Present value of interest payments ($31,500  13.59033b) 428,095
Selling price of bonds $747,568

aPresent value of a lump sum, 20 periods at 4%.

b Present value of an ordinary annuity, 20 periods at 4%.

b. Selling price for $700,000, 9% bonds discounted at 10% (5% semiannually):

Calculator inputs: N = 20 I/Y = 5 PMT = -31,500 FV = -700,000,

PV = 656,382.26

Excel inputs: = PV(5%,20,-31500,-700000,0) Cell will display: 656,382.26

Present value of principal repayment ($700,000  0.37689a) $263,823

Present value of interest payments ($31,500  12.46221b) 392,560
Selling price of bonds $656,383

a Present value of a lump sum, 20 periods at 5%.

b Present value of an ordinary annuity, 20 periods at 5%.
QUESTION 2

SOLUTION

a. Selling price of zero coupon bonds discounted at 8%

Calculator inputs: N =20 I/Y = 4 PMT = 0 FV = -350,000,

PV = 159,735.43

Excel inputs: =PV(4%,20,0,-350000,0) Cell will display: 159,735.43

Present value of principal repayment ($350,000  0.45639a) $159,737

a
Present value of a lump sum, 20 periods at 4%.

b. Selling price of zero coupon bonds discounted at 10%

Calculator inputs: N =20 I/Y = 5 PMT = 0 FV = -350,000,

PV = 131,911.32

Excel inputs: =PV(5%,20,0,-350000,0) Cell will display: 131,911.32

Present value of principal repayment ($350,000  0.37689a) $131,912

a Present value of a lump sum, 20 periods at 5%.

QUESTION 3
SOLUTION
QUESTION 4

SOLUTION
QUESTION 5

SOLUTION

Amount paid to retire bonds ($200,000 × 101%) .................................................... $202,000

Book value of retired bonds, net of $3,400 unamortized discount........................... 196,600
Loss on bond retirement ......................................................................................... $ 5,400

Gains and losses from bond redemptions typically arise during refinancing in which new bonds
are issued to retire existing bonds. The resulting gains or losses are not real economic gains
and losses. The loss on retirement results from Middleton’s use of historical costing for its
bonds. The $5,400 loss will be offset by correspondingly lower interest payments in the future.
Middleton does not recognize the present value of these future interest payments nor the
present value of the difference between the current face amount of the bond and the former
face amount. These present values will exactly offset the reported loss on retirement and no
“real” loss is realized.
QUESTION 4

SOLUTION

a. The leased asset is office space and with a lease term of 5 years, the value of the leased
asset is not being conveyed to CCH. Therefore this is an operating lease (consistent with
most leases for office, retail, or production space).

b. We can use Excel and the PV function to determine that the present value of the future lease
payments as follows: =PV(5%,5,115,487,0,0) = $500,000.

c. CCH Corporation will add $510,000 to the balance sheet as a right-of-use asset. This
includes the $500,000 present value of future lease payments along with the $10,000 up
front fees paid at the lease inception.

d. The lease amortization schedule follows:

e.
Implicit Interest Lease Amortization Lease Liability, End
Lease Liability, (Lease Liability, (Lease payment – (Lease Liability, Start –
Year Start Start x 5%) Implicit interest) Lease Amortization)
1 500,000 25,000 90,487 409,513
2 409,513 20,476 95,012 314,501
3 314,501 15,725 99,762 214,738
4 214,738 10,737 104,750 109,988
5 109,988 5,499 109,988 ―
 f. The financial statement effects template shows the transactions for the first two years.

Balance Sheet Income Statement

Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net

Transaction + = + + – =
Asset Assets ities Capital Capital enues ses Income
ROU 510,000
510,000 500,000
LL 500,000 Record lease - 10,000
Right-of- = Lease
Cash 10,000 at inception Cash
use asset Liability

RE 117,487
Year 1 lease
LL 90,487 -92,487 -90,487 -117,487 117,487
payment and - 115,487
Cash 115,487 Right-of- = Lease Retained Rent -117,487
lease Cash
ROU 92,487 use asset Liability Earnings Expense
amortization
RE 117,487
Year 2 lease
LL 95,012 -97,012 -95,012 -117,487 117,487
payment and - 115,487
Cash 115,487 Right-of- = Lease Retained Rent -117,487
lease Cash
ROU 97,012 use asset Liability Earnings Expense
amortization

g. The table below presents future lease payments.

December 2020
2021 $ 115,487
2022 115,487
2023 115,487
2024 115,487
2025 -
Thereafter -
Total undiscounted lease payments 461,948
Imputed interest (52,437)
Total operating lease liability $409,511

Weighted average remaining lease life 4 years

Weighted average discount rate 5%

h. To enhance comparability we could reclassify the rent expense of $117,487 as interest

expense (from the amounts in the lease amortization table, in part d, above) and amortization
of the ROU asset (the principal portion from the lease amortization table above PLUS the
upfront fee of $10,000 divided by the lease term of 5 years.) These are the amounts shown
for the first two years, in part e, above.
QUESTION 5

SOLUTION

a. The first leased asset is land that the company will convert to an RV park. The lease term is
15 years, the value of the leased asset is not being conveyed to Alexander Mack because
land lasts longer than 15 years. Therefore, this is an operating lease (consistent with most
leases for office, retail, or production space).

The second lease is computer equipment and two facts indicate that this is a finance lease:
1) the lease term of 4 years will cover the bulk of the computer equipment’s life and 2) the
bargain purchase option at the end of the lease term.

b. We can use Excel and the PV function to determine that the present value of the future lease
payments for both leases. This will represent the amount of lease liability that Alexander
Mack will add to its balance sheet. The formulas are as follows:

Operating lease =PV(9%,15,-500,000,0,0) = $4,030,344

Finance lease = PV(9%,4,-24,694,0,0) = $80,000

c. Operating lease: Alexander Mack will add $4,480,344 to the balance sheet as a right-of-use
asset. This includes the $4,030,344 present value of future lease payments (above) along
with the $450,000 up front fees paid at the lease inception.
 Finance lease: the company will add $85,000 to the balance sheet as PPE. This includes the
$80,000 present value of future lease payments and the $5,000 upfront fees at the inception
of the lease.

d. The operating lease amortization schedule follows:

Implicit Interest Lease Amortization Lease Liability, End

Lease Liability, (Lease Liability, (Lease payment – (Lease Liability, Start –
Year Start Start x 9%) Implicit interest) Lease Amortization)
1 4,030,344 362,731 137,269 3,893,075
2 3,893,075 350,377 149,623 3,743,452
3 3,743,452 336,911 163,089 3,580,363
4 3,580,363 322,233 177,767 3,402,595
5 3,402,595 306,234 193,766 3,208,829
6 3,208,829 288,795 211,205 2,997,623
7 2,997,623 269,786 230,214 2,767,410
8 2,767,410 249,067 250,933 2,516,476
9 2,516,476 226,483 273,517 2,242,959
10 2,242,959 201,866 298,134 1,944,826
11 1,944,826 175,034 324,966 1,619,860
12 1,619,860 145,787 354,213 1,265,647
13 1,265,647 113,908 386,092 879,556
14 879,556 79,160 420,840 458,716
15 458,716 41,284 458,716 0

The finance lease amortization schedule follows:

Implicit Interest Lease Amortization Lease Liability, End

Lease Liability, (Lease Liability, (Lease payment – (Lease Liability, Start –
Year Start Start x 9%) Implicit interest) Lease Amortization)
1 80,000 7,200 17,493 62,507
2 62,507 5,626 19,068 43,439
3 43,439 3,909 20,784 22,655
4 22,655 2,039 22,655 ―

e. The operating lease for land will create a rent expense for the lease payment of $500,000
plus $30,000 per year (the upfront cost of $450,000 divided by the lease term of 15 years).
The total rent expense each period will be $530.000.

f. The finance lease for the equipment will create interest expense of $7,200 (from the
amortization table above) and straight-line depreciation of $21,250 (= $85,000/4) on the PPE
asset, for a total expense of $28,450. The expense will decrease over time because the
interest declines each year.
g. At the end of 2020, the company would make the following disclosure:

At the end of the fiscal year, remaining operating lease payments were as following:

December 2020
2021 $ 500,000
2022 500,000
2023 500,000
2024 500,000
2025 500,000
Thereafter 4,500,000
Total undiscounted lease payments 7,000,000
Imputed interest (3,106,925)
Total operating lease liability $3,893,075

Weighted average remaining lease life 14 years

Weighted average discount rate 9%

h. The ROU asset and lease liability would have the following balances at the end of 2021:

Operating lease:
Asset = $4,133,452 calculated as $4,480,344 less two years of principal payments
($137,269 and $149,623 from the table in part d., above) and less two years of
amortization of the up-front costs ($450,000 × 2/15).
Liability = $3,743,452 per the table in part d.

Finance lease:
Asset = $85,000 – 2 × $21,250 = $42,500.
Liability = $43,439 per the table in part d.

i. To enhance comparability, we could convert the operating leases to be equivalent on the

income statement to the finance lease. We would replace the rent expense of $530,000 with
interest expense (from the amounts in the lease amortization table, in part d, above) and SL
amortization of the ROU asset ($4,480,344/15).