Accounting for Liabilities

Transcription

1 Chapter 7 Accounting for Liabilities LEARNING OBJECTIVES 1. Define definitely determinable liability and explain how payroll is recorded. 2. Define estimated liability and explain how warranties are recorded. 3. Explain how long-term notes and mortgages work. 4. Record the issue of bonds and payment of interest to bondholders. 5. Prepare financial statements that include long-term debt. 6. Explain capital structure and compute the debt-to-equity ratio. 7. Identify the major risk associated with long-term debt and the related controls. 8. (Appendix 7) Compute present value and proceeds from a bond issue. Questions 1. What are the two main sources of financing for a business? The two main sources of financing for a business are debt and equity. 2. What is the difference between a definitely determinable liability and an estimated liability? Give an example of each. A definitely determinable liability is one that can be measured exactly such as an account payable or a note payable. An estimated liability is a liability whose amount is not certain such as liabilities under a warranty agreement. 3. What is a mortgage? A mortgage is a long-term liability that gives the lender a claim against property if the borrower does not make payments. 4. When installment loan payments on a mortgage are made, the amount paid reduces cash. What other two items on the financial statements are affected? Installment loan payments reduce principal and interest expense is recorded. The balance in liabilities (notes payable) decreases on the balance sheet and the interest expense is reported on the income statement. 5. What is the difference between how bonds are repaid compared to other forms of financing that require installment payments? Bonds are repaid with periodic payments of interest to the bondholders and with the principal amount repaid at the maturity date of the bond. Installment payments are part interest and part principal and occur every year or every month over the life of the loan. 6. What advantage is there to obtaining financing using bonds compared to getting a loan from a bank? Advantages to issuing bonds include: the larger amount of money the company is able to borrow, the longer period of time of the loan, and the lower interest rate on the debt. 346

2 7. How are the interest payments associated with a bond calculated? Interest payments for a bond are calculated by multiplying the stated interest rate times the principal amount of the bond. 8. Explain the difference between the stated rate and the effective rate of interest on a bond. The stated interest rate determines the cash (interest) payment of the bond. The effective interest rate is the market rate of interest that investors actually demand. 9. What is another name for the face value of a bond? The face value of a bond is also called the stated value or par value. 10. When is a bond issued at a discount? When is a bond issued at a premium? A bond is issued at a discount when the stated rate is less than the market rate. A bond is issued at a premium when the stated rate is greater than the market rate. 11. How is the debt-to-equity ratio calculated, and what does this ratio measure? The debt-to-equity ratio divides total liabilities by total shareholders equity. The ratio compares the amount of creditors claims to the assets of the firm with owners claims to assets of the firm. 12. To what does the term capital structure refer? Capital structure refers to the relative amounts of debt and equity used to finance the firm. CHAPTER 7 ACCOUNTING FOR LIABILITIES Explain financial leverage. Financial leverage refers to the use of debt to increase earnings. If a company earns more with the money it borrows than it has to pay to borrow the money, then it is called positive financial leverage. Multiple-Choice Questions 1. Partco hired a secretary for $900 a week. The secretary s first paycheck had 20% withheld for income taxes, 6.2% for social security, and 1.45% for Medicare taxes. What is Partco s total expense (including payroll tax expense) related to this payment? a. $68.85 b. $ c. $ d. $ All of the following are current liabilities except a. salaries payable. b. mortgage payable. c. unearned revenue. d. accounts payable. 3. The amount a company owes its employees for current work done is a. shown on the balance sheet as pension liability. b. shown as a current liability. c. called postretirement benefits on the balance sheet. d. not shown on the balance sheet.

3 348 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL 4. Liabilities are often estimated because a. the related expense needs to be recorded to match the appropriate revenues. b. it gives managers a way to manage assets. c. they are usually not disclosed until they are settled. d. the related assets are already recorded. 5. Advanced Music Technology, Inc., estimated that its warranty costs would be $900 for items sold during the current year, an amount it considers significant. During the year Advanced paid $750 to repair merchandise that was returned by customers. What is the amount of warranty expense for the current year? a. $750 b. $900 c. $150 d. Cannot be determined 6. On January 1, Sonata Company issued 10-year bonds with a face value of $400,000 and a stated rate of 10%. The cash proceeds from the bond issue amounted to $354,120. Sonata Company will pay interest to the bondholders annually. How much cash will Sonata pay the bondholders on the first payment date? a. $40,000 b. $48,000 c. $35,412 d. $42, Refer to the information in multiple-choice question 6. How did the market interest rate compare to the stated rate on the date the bonds were issued? a. The market rate is higher than the stated rate. b. The market rate is lower than the stated rate. c. Both rates are the same. d. It cannot be determined. 8. Bonds issued with a stated interest rate that is higher than the prevailing market rate are issued at a. a premium. b. a discount. c. par. d. It cannot be determined. 9. A $1,000 bond with a stated rate of 8% is issued when the market rate is 10%. How much interest will the bondholders receive each year for the annual interest payments? a. $100 b. $80 c. $20 d. $ Positive financial leverage means that a company a. has more debt than equity. b. earns more with borrowed money than the cost of borrowing it. c. has the correct amount of debt. d. has more equity than debt. Short Exercises Set A SE7-1A. Classify liabilities. (LO 1, 2). Tell whether each of the following liabilities is definitely determinable or an estimate: accounts payable, unearned revenue, and warranty liability.

4 CHAPTER 7 ACCOUNTING FOR LIABILITIES 349 SE7-2A. Classify liabilities. (LO 1). Taylor Company has the following obligations at December 31: (a) a note payable for $10,000 due in six months; (b) unearned revenue of $12,500; (c) interest payable of $15,000; (d) accounts payable of $60,000; and (e) note payable due in two years. For each obligation, indicate whether or not it should be classified as a current liability. SE7-3A. Account for payroll. (LO 1). Jimmy Paycheck earned $1,500 per month as the manager of a recording studio. Jimmy has 25% of his earnings withheld for federal income taxes. There are no other amounts withheld except for those required by the federal government. What are the other amounts that must be deducted from Jimmy s earnings? Calculate the net amount Jimmy will receive on his next paycheck. SE7-4A. Account for warranties. (LO 2). Key Company offers a three-year warranty on its premium door locks. During the year, the company had sales of $100,000. Related to the sales, warranty costs should be approximately $3,000 per year. How much warranty expense related to these sales will Key Company s income statement show in the year of the sales? How much warranty expense related to these sales will Key Company have in the two years after the sales? SE7-5A. Account for mortgages. (LO 3). Nunez Company has arranged to borrow $25,000 for five years at an interest rate of 8%. The annual payments will be $6, When Nunez makes its first payment at the end of the first year of the loan, how much of the payment will be interest? SE7-6A. Account for mortgages. (LO 3). Feathers and Furs borrowed $75,000 to buy a new faux fur storage facility. The company borrowed the money for 10 years at 12%, and the monthly payments are $1, When the company makes the first monthly payment at the end of the first month of the loan, by how much will the payment reduce the principal of the loan?

5 350 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL SE7-7A. Account for bonds. (LO 4). If a $1,000 bond is selling at 95, how much cash will the issuing company receive? If a $1,000 bond is selling at par, how much cash will the issuing company receive? If a $1,000 bond is selling at 101, how much cash will the issuing company receive? SE7-8A. Account for bonds. (LO 4). For each of the following situations, tell whether the bond described will be issued at a premium, at a discount, or at par: 1. Colson Company issued $200,000 worth of bonds with a stated interest rate of 10%. At the time of issue, the market rate of interest for similar investments was 9%. 2. Dean Company issued $100,000 worth of callable bonds with a stated rate of 12%. At the time of issue, the market rate of interest for similar investments was 9%. 3. Liddy Company issued $200,000 worth of bonds with a stated rate of 8%. At the time of issue, the market rate of interest for similar investments was 9%. SE7-9A. Account for bonds. (LO 4). For each of the following situations, compute the proceeds from the bond issue: 1. Haldeman Hair Systems issued $20,000 worth of bonds at Erlichman Egg Company issued $100,000 worth of bonds at Carl s Cutlery Company issued $500,000 worth of bonds at SE7-10A. Account for bonds. (LO 4). Altoona Company was able to issue (sell) $200,000 of 9% bonds for $220,000 because its credit rating is excellent and market interest rates have fallen. How much interest will be paid in cash during the first year? Will the interest expense be higher or lower than the interest payment? SE7-11A. Calculate the debt-to-equity ratio. (LO 6). Suppose that for 2010 Axel Company s current assets totaled $57,855; total assets totaled $449,999; current liabilities totaled $71,264; and total liabilities totaled $424,424. Calculate the debt-to-equity ratio for Axel for 2010.

6 CHAPTER 7 ACCOUNTING FOR LIABILITIES 351 Set B SE7-12B. Classify liabilities. (LO 1). Tell whether each of the following liabilities is definitely determinable or an estimate: salaries payable, warranty liability, and notes payable. SE7-13B. Classify liabilities. (LO 1, 2). Swift Company has the following obligations at December 31: (a) a note payable for $10,000 due in 18 months; (b) unearned revenue of $12,500; (c) interest payable of $15,000; (d) accounts payable of $60,000; and (e) note payable due in three months. For each obligation, indicate whether or not it should be classified as a current liability. SE7-14B. Account for payroll. (LO 1). Johnny Worker earns $2,500 per month as the manager of a grocery store. Johnny has 20% of his earnings withheld for federal income taxes. There are no other amounts withheld except for those required by the federal government. What are the other amounts that must be deducted from Johnny s earnings? Calculate the net amount Johnny will receive on his next paycheck. SE7-15B. Account for warranties. (LO 2). Tom s Toasters, Inc., began the year with $30,000 in its warranty liability. During the year, the firm spent $20,000 to honor past warranties. Will the $20,000 be the warranty expense for the year? Why or why not?

7 352 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL SE7-16B. Account for mortgages. (LO 3). Curtain Company borrowed $10,000 at 9% for seven years. The loan requires annual payments of $1, When Curtain Company makes the first annual payment at the end of the first year of the loan, how much of the payment will be interest and how much will reduce the principal of the loan? SE7-17B. Account for mortgages. (LO 3). On July 1, 2006, Maxine s Equipment Company signed a long-term note with the local bank for $50,000. The term of the note was 10 years, at an annual interest rate of 8%. If Maxine s makes annual payments of $7,451.47, beginning on June 30, 2007, how much of the first payment will be interest? SE7-18B. Account for bonds. (LO 4). If $100,000 of 8% bonds are issued (sold) for $95,000, was the market rate of interest at the time of issue higher or lower than 8%? What is the amount of the annual interest payments to be received by the bondholders? SE7-19B. Account for bonds. (LO 4). For each of the following situations, tell whether the bond described will be issued at a premium, at a discount, or at par: 1. Kami Company issued $100,000 worth of bonds with a stated interest rate of 9%. At the time of issue, the market rate of interest for similar investments was 10%. 2. Fun Company issued $300,000 worth of callable bonds with a stated rate of 4.5%. At the time of issue, the market rate of interest for similar investments was 4%. 3. Rider Company issued $500,000 worth of bonds with a stated rate of 5%. At the time of issue, the market rate of interest for similar investments was 5.2%. SE7-20B. Account for bonds. (LO 4). For each of the following situations, compute the proceeds from the bond issue: 1. Quality Bank issued $100,000 worth of bonds at Tool & Dye Company issued $50,000 worth of bonds at Connie s Can Company issued $400,000 worth of bonds at 97.5.

8 CHAPTER 7 ACCOUNTING FOR LIABILITIES 353 SE7-21B. Account for bonds. (LO 4). Data Company was able to issue (sell) $100,000 of 6% bonds for $110,000 because its credit rating is excellent and market interest rates have fallen. How much interest will be paid in cash during the first year? Will the interest expense be higher or lower than the interest payment? SE7-22B. Calculate the debt-to-equity ratio. (LO 6). Suppose that for 2011 Rod Company s current assets totaled $35,600; total assets totaled $70,000; current liabilities totaled $16,000; and total liabilities totaled $25,600. Calculate the debt-to-equity ratio for Rod Company for Exercises Set A E7-23A. Classify liabilities. (LO 1). For each item in the following list, tell whether it is a definitely determinable liability, an estimated liability, or neither: 1. Amount owed to vendor for purchase of inventory 2. Potential proceeds from pending lawsuit 3. Amount of warranty obligations 4. Amount of loan payment due next year 5. Amount of vacation pay to accrue for employees for next year E7-24A. Account for payroll. (LO 1). A company has gross payroll of $30,000; federal income tax withheld of $6,000; FICA (social security) taxes withheld of $1,860; and Medicare taxes withheld of $ How much will the balance sheet show for salaries payable (to employees)? 2. How much will the income statement show for salary expense? 3. What type of liability is salaries payable?

9 354 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL E7-25A. Account for payroll. (LO 1). During February, Winter Company s employees earned wages of $50,000. Social security (FICA) withheld was $2,500; federal income taxes withheld were $3,500; and employees contributions to United Way withheld totaled $500. Use the accounting equation to record wages expense and wages payable at the end of February. Winter Company will pay employees their February wages and pay the payroll taxes to the government during the first week in March. E7-26A. Account for warranties. (LO 2). When Park Avenue Pet Shop sells a puppy, it provides a health warranty for the little critter. If a puppy becomes ill in the first two years after the sale, Park Avenue Pet Shop will pay the vet bill up to $300. Because this is normally a significant expense for the shop, the accountant insists that Park Avenue Pet Shop record an estimated warranty liability at the end of every year before the financial statements are prepared. On December 31, 2010, the accountant estimated that the warranty costs for puppies sold in 2010 would be $2,000 and made the appropriate entry to record that liability. On March 30, 2011, the store received a $50 vet bill from one of its customers, who had bought a puppy in Park Avenue Pet Shop wrote a check for $50 to reimburse the puppy s owner. 1. Enter the transaction into the accounting equation to record the estimated warranty liability at December 31, Enter the transaction into the accounting equation to record the payment of the vet bill on March 30, What effect did this payment have on the 2011 financial statements of Park Avenue Pet Shop?

10 CHAPTER 7 ACCOUNTING FOR LIABILITIES 355 E7-27A. Account for long-term liabilities. (LO 3, 5). Larry the Locksmith needed some long-term financing and arranged for a $200,000, 20-year mortgage loan on December 31, The interest rate is 7% per year, with $20,000 (rounded) payments made at the end of each year, starting December 31, What is the amount of interest expense related to this loan for 2010? 2. What amount of liability should appear on the December 31, 2010, balance sheet? 3. What is the amount of interest expense related to this loan for 2011? 4. What amount of liability should appear on the December 31, 2011, balance sheet? E7-28A. Account for long-term liabilities. (LO 3, 5). Grace s Gems purchased some property on December 31, 2011, for $100,000, paying $20,000 in cash and obtaining a mortgage loan for the other $80,000. The interest rate is 8% per year, with $2,925 payments made at the end of March, June, September, and December What amounts should appear as interest expense on the quarterly income statements and as liabilities on the quarterly balance sheets during 2012? 2. What amount of interest expense should appear on the income statement for the year ended December 31, 2012?

11 356 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL E7-29A. Account for long-term liabilities. (LO 3, 5). Suppose MegaStore, Inc., signed a $750,000, 15-year, 10% note payable to finance the expansion of its business on January 1, The terms provide for semiannual payments of $49,000 on June 30 and December 31, On the December 31, 2010, balance sheet, how much will MegaStore show as the principal of this note payable? E7-30A. Account for long-term liabilities. (LO 3). On April 1, Mark Hamm borrowed $15,000 on an eight-month, 6% note from State Bank of New York to open a business, Gymnastics World. The debt was in the company s name. The note and interest will be repaid on November Use the accounting equation to show how Gymnastics World would record the receipt of the funds. 2. Suppose Gymnastics World wants to prepare an income statement for the month of April. Use the accounting equation to show how the firm will accrue interest for the month. 3. Assume that Gymnastics World accrues the interest expense related to this note at the end of each month. What is the balance in the interest payable account on September 30? 4. Use the accounting equation to show how the firm would record the transaction on November 30, when the loan is repaid with the interest. (Assume 3. above was completed.)

12 CHAPTER 7 ACCOUNTING FOR LIABILITIES 357 E7-31A. Account for bonds. (LO 4). On December 31, 2009, Alejandro Enterprises issued $25,000 worth of 5% bonds at 99. These are 10-year bonds with interest paid annually on December What are the interest payments for the first two years? 2. Was the market interest rate higher or lower than 5% at the date of issue? 3. Will the interest expense be higher or lower than the interest payment? E7-32A. Account for bonds. (LO 4). On December 31, 2010, Carl s Cartons, Inc., issued $100,000 worth of 9% bonds at 104. The interest on these bonds is paid annually on December What are the interest payments for the first two years? 2. Was the market interest rate higher or lower than 9% at the date of issue? 3. Will the interest expense be higher or lower than the interest payment? E7-33A. Account for bonds. (LO 4). On January 1, 2010, Conway Computers issued $500,000, 15%, 10-year bonds at face value. Interest is payable on January 1. Use the accounting equation to record the following: 1. The bond issue 2. The accrual of interest on December 31, The payment of interest on January 1, 2011

13 358 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL E7-34A. Account for bonds. (LO 4). On December 31, 2012, Dave s Delivery Service issued $10,000 worth of 10% bonds at approximately 89. These are 10-year bonds with interest paid semiannually on June 30 and December What are the interest payments for the first two years? 2. Was the market interest rate higher or lower than 10% at the date of issue? 3. Will the interest expense be higher or lower than the interest payment? E7-35A. Account for bonds. (LO 4). On June 30, 2009, Sam s Office Supplies issued $50,000 face value of 8% bonds at 106. They were five-year bonds with interest paid semiannually, on December 31 and June What are the interest payments for the first two years? 2. Was the market interest rate higher or lower than 8% at the date of issue? 3. Will the interest expense be higher or lower than the interest payment? E7-36A. Account for bonds. (LO 4). On June 30, 2011, Sugar Fudge Co. issued $50,000 worth of 10% bonds for $50,000. The interest is paid annually on June What are the interest payments for the first two years? 2. Was the market interest rate higher or lower than 10% at the date of issue? 3. Will the interest expense be higher or lower than the interest payment? E7-37A. Calculate interest expense using the effective interest method. (LO 4, 5). On June 30, 2010, Mako Company issued $50,000 worth of five-year, 10% bonds when the market rate was 9%. Proceeds were $51,945. The interest is paid annually on June What is the annual interest payment? 2. What is the amount of interest expense on the date of the first interest payment? 3. How would the bonds payable and the interest expense be shown on the year-end financial statements (June 30, 2011)?

14 CHAPTER 7 ACCOUNTING FOR LIABILITIES 359 E7-38A. Calculate interest expense using the effective interest method. (LO 4, 5). On June 30, 2010, Superfast Shoes issued $200,000 worth of 15-year, 9% bonds when the market rate was 10%. Proceeds were $184,788. The interest is paid annually on June What is the annual interest payment? 2. What is the amount of interest expense on the date of the first interest payment? 3. How would the bonds payable and the interest expense be shown on the year-end financial statements (June 30, 2011)? E7-39A. Prepare an amortization schedule for a bond issued at a discount. (LO 4). Jamison Corporation issued $100,000, 8%, 10- year bonds on January 1, 2012, when the market rate of interest was 10%. Proceeds were $87, Interest is payable annually on January 1. Jamison uses the effective interest method to amortize bond premiums and discounts. Prepare an amortization schedule for the life of the bonds.

15 360 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL E7-40A. Prepare an amortization schedule for a bond issued at a premium. (LO 4). Old School Vacations issued $100,000, 10%, 10-year bonds on January 1, 2010, when the market rate of interest was 8%. Proceeds were $113, Interest is payable annually on January 1. Old School uses the effective interest method to amortize bond premiums and discounts. Prepare an amortization schedule for the life of the bonds. Use the following financial data for ebay to answer E7-41A: From the Consolidated Balance Sheet of ebay Inc. Assets Total current assets Total assets December 31, (dollars in thousands) $ 7,122,505 $15,366,037 $ 6,286,590 $15,592,439 Liabilities and stockholders equity Total current liabilities Total liabilities Total stockholders equity Total liabilities and stockholders equity $ 3,099,579 3,661,435 11,704,602 $15,366,037 $ 3,705,087 4,508,581 11,083,858 $15,592,439 E7-41A. Calculate the debt-to-equity ratio. (LO 6). Using the information provided for ebay, calculate the debt-to-equity ratio at December 31, 2007, and December 31, (Notice that ebay puts the most recent year in the right column rather than the usual left column.) Provide an explanation of what this ratio measures and whether the ratio has improved from 2007 to 2008.

16 CHAPTER 7 ACCOUNTING FOR LIABILITIES 361 Set B E7-42B. Classify liabilities. (LO 1, 2). For each item in the following list, tell whether it is a definitely determinable liability, an estimated liability, or neither: 1. Amount of cash revenue received from customer that is unearned 2. Corporate income tax for the year 3. Coupons unredeemed at the end of the year (some percentage expected to be redeemed) 4. Amount of salaries payable to accrue at the end of the year 5. Account payable owed to vendor for purchase on credit E7-43B. Account for payroll. (LO 1). A company has gross payroll of $30,000; federal income tax withheld of $6,000; and FICA (social security) taxes and Medicare taxes withheld of $2, How much will the balance sheet show for salaries payable (to employees)? 2. How much will the income statement show for salary expense? 3. What type of liability is salaries payable? E7-44B. Account for payroll. (LO 1). During March, the Wessue Coffee Emporium s employees earned wages of $18,000. Social security (FICA) withheld was $1,377; federal income taxes withheld were $3,600; and employees contributions to the American Red Cross withheld totaled $175. Use the accounting equation to record wages expense and wages payable at the end of March. Wessue will pay employees their March wages and will pay the withholding taxes during the first week in April.

17 362 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL E7-45B. Account for warranties. (LO 2). When Boyd Pools installs a pool, it provides a three-year warranty (from the date of the sale) for any repairs needed that are not considered general maintenance. If a pool should need to be repaired in the first three years after the sale, Boyd will repair the pool for a cost of up to $1,000. Because this is normally a significant expense, the accountant insists that Boyd record an estimated warranty liability at the end of every year before the financial statements are prepared. On average, Boyd spends $400 per pool to fulfill its warranty obligations over the life of the warranty. For the year ended June 30, 2011, the accountant made the appropriate entry to record that liability based on sales and installations for the year of 360 pools. On January 4, 2012, Boyd paid $750 to an independent contractor to repair a pool for one of its customers, who had purchased the pool on March 15, Enter the transaction into the accounting equation to record the estimated warranty liability at June 30, Enter the transaction into the accounting equation to record the payment of the repair bill on January 4, For the year ended June 30, 2012, what effect did this payment have on the financial statements of Boyd Pools? E7-46B. Account for long-term liabilities. (LO 3, 5). Mark s Martial Arts Academy needed some long-term financing and arranged for a $200,000, 20-year mortgage loan on December 31, The interest rate is 7.5% per year, with $19,620 (rounded) payments made at the end of each year, starting December 31, What is the amount of interest expense related to this loan for 2010? 2. What amount of liability should appear on the December 31, 2010, balance sheet? 3. What is the amount of interest expense related to this loan for 2011? 4. What amount of liability should appear on the December 31, 2011, balance sheet? E7-47B. Account for long-term liabilities. (LO 3, 5). Molly Merry s Accounting Firm purchased some property on December 31, 2010, for $150,000, paying $30,000 in cash and obtaining a mortgage loan for the other $120,000. The interest rate is 12% per year, with $8,065 payments made at the end of March, June, September, and December What amounts should appear as interest expense on the quarterly income statements and as liabilities on the quarterly balance sheets during 2011? 2. What amount of interest expense should appear on the 2011 year-end income statement?

18 CHAPTER 7 ACCOUNTING FOR LIABILITIES 363 E7-48B. Account for long-term liabilities. (LO 3). The Decadent Ice Cream Company signed a $250,000, 15-year, 9% note payable to finance the expansion of its business on January 1. The terms provide for semiannual payments of $15,350 on June 30 and December 31. Use the accounting equation to record the receipt of the proceeds of the loan and the first two payments. E7-49B. Account for long-term liabilities. (LO 3, 5). On March 1, Delvis Cromartie borrowed $7,500 on a five-month, 8% note from Florida First Bank & Trust to open a business, Orchids & Such Nursery. The debt was in the company s name. The note and interest will be repaid on July Use the accounting equation to record the receipt of the funds. 2. Suppose Orchids & Such Nursery wants to prepare an income statement for the month of March. Use the accounting equation to accrue interest for the month. 3. Assume that Orchids & Such Nursery accrues the interest expense related to this note at the end of each month. What is the balance in the interest payable account on May 31? 4. Use the accounting equation to record the transaction on July 31, when the loan is repaid with the interest. (Assume 3. above was completed.)

19 364 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL E7-50B. Account for bonds. (LO 4). On June 30, 2010, Kenneth s Watch Co. issued $50,000 worth of 6% bonds at 110. These are 10-year bonds with interest paid annually on June What are the interest payments for the first two years? 2. Was the market interest rate higher or lower than 6% at the date of issue? 3. Will the interest expense be higher or lower than the interest payment? E7-51B. Account for bonds. (LO 4). On February 28, 2011, Newman & Spears Enterprises, Inc., issued $150,000 worth of 7% bonds at 92. The interest on these bonds is paid annually on February What are the interest payments for the first two years? 2. Was the market interest rate higher or lower than 7% at the date of issue? 3. Will the interest expense be higher or lower than the interest payment? E7-52B. Account for bonds. (LO 4). On January 1, 2011, Allied Robotics issued $500,000, 4%, five-year bonds at par. Interest is payable on January 1. Use the accounting equation to record the following: 1. The bond issue 2. The accrual of interest on December 31, The payment of interest on January 1, 2012

20 CHAPTER 7 ACCOUNTING FOR LIABILITIES 365 E7-53B. Account for bonds. (LO 4). On June 30, 2010, McCorvey s Lawn Service issued $7,500 worth of 6% bonds at approximately 102. These are five-year bonds with interest paid semiannually on December 31 and June What are the interest payments for the first two years? 2. Was the market interest rate higher or lower than 6% at the date of issue? 3. Will the interest expense be higher or lower than the interest payment? E7-54B. Account for bonds. (LO 4). On December 31, 2012, Advanced Defense Contractors issued $25,000 face value of 10% bonds at 95. They were five-year bonds with interest paid semiannually, on June 30 and December What are the interest payments for the first two years? 2. Was the market interest rate higher or lower than 10% at the date of issue? 3. Will the interest expense be higher or lower than the interest payment? E7-55B. Account for bonds. (LO 4). On June 30, 2010, Nikki C. Records, Inc., issued $35,000 worth of 8% bonds for $35,000. The interest is paid annually on June What are the interest payments for the first two years? 2. Was the market interest rate higher or lower than 8% at the date of issue? 3. Will the interest expense be higher or lower than the interest payment?

21 366 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL E7-56B. Calculate interest expense using the effective interest method. (LO 4, 5). On March 30, 2009, Canine Company issued $80,000 worth of 10-year, 6% bonds when the market rate was 5%. Proceeds were $86,177. The interest is paid annually on March What is the annual interest payment? 2. What is the amount of interest expense on the date of the first interest payment? 3. How would the bonds payable and the interest expense be shown on the year-end (March 30, 2010) financial statements? E7-57B. Calculate interest expense using the effective interest method. (LO 4, 5). On June 30, 2010, Dogs & Cats Pet Store issued $250,000 worth of 10-year, 9% bonds when the market rate was 6%. Proceeds from the bond issue were approximately $305,200. The interest is paid annually on June What is the annual interest payment? 2. What is the amount of interest expense on the date of the first interest payment? 3. How would the bonds payable and the interest expense be shown on the year-end (June 30, 2011) financial statements? E7-58B. Prepare an amortization schedule for a bond issued at a premium. (LO 4). Designer Clothes, Inc., issued $200,000, 10%, 10-year bonds on July 1, 2011, when the market rate of interest was 8%. Interest is payable annually on July 1. Proceeds from the bond issue were approximately $226, Designer uses the effective interest method to amortize bond premiums and discounts. Prepare an amortization schedule for the life of the bonds.

22 CHAPTER 7 ACCOUNTING FOR LIABILITIES 367 E7-59B. Prepare an amortization schedule for a bond issued at a discount. (LO 4). Golden Coast Beach Resorts issued $1,000,000, 11%, 10-year bonds on June 30, 2009, when the market rate of interest was 10%. Proceeds from the bond issue were approximately $1,061, Interest is payable annually on June 30. Golden Coast uses the effective interest method to amortize bond premiums and discounts. Prepare an amortization schedule for the life of the bonds. Use the following financial data for Netflix, Inc., to answer E7-60B. Netflix, Inc. Consolidated Balance Sheet (adapted) Assets Total current assets Total assets December 31, (dollars in thousands) $432,423 $678,998 $361,447 $617,946 Liabilities and Shareholders Equity Total current liabilities Total liabilities Total shareholders equity Total liabilities and shareholders equity $208, , ,812 $678,998 $216, , ,155 $617,946

23 368 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL E7-60B. Calculate the debt-to-equity ratio. (LO 6). Using the information provided for Netflix, Inc., calculate the debt-to-equity ratio at December 31, 2007, and December 31, Provide an explanation of what this ratio measures and whether the ratio has improved from 2007 to Problems Set A P7-61A. Account for current liabilities. (LO 1, 5). On March 1, 2011, the accounting records of Stein Company showed the following liability accounts and balances: Accounts payable $21,600 Short-term notes payable 10,000 Interest payable 800 Unearned service revenue 12,500 a. On March 1, 2011, Stein Company signed a three-month note for $12,000 at 7.5%. b. During March, Stein Company paid off the $10,000 short-term note and the interest payable shown on the March 1 balance sheet. c. Stein paid off the beginning accounts payable. d. During the month, Stein purchased $25,000 of merchandise on account. e. Also during March, Stein s employees earned salaries of $36,000. Withholdings related to these wages were $2,232 for social security (FICA), $3,800 for federal income tax, and $1,140 for state income tax. The company will pay March salaries and taxes withheld on April 1. No entry had been recorded for salaries or payroll tax expense as of March 31.

24 CHAPTER 7 ACCOUNTING FOR LIABILITIES 369 Requirements 1. Use the accounting equation to show each of the transactions. 2. Use the accounting equation to show the adjustments needed for interest on the notes payable for the month of March and for salary expense and payroll tax expense. 3. Prepare the current liabilities section of the balance sheet at March 31, P7-62A. Account for warranties. (LO 2). In 2012, Best Stuff, Inc., had sales of $90,000 of its new video recorders. The company gives a two-year warranty with the purchase of a video recorder. When Best Stuff recorded the sales, the company also estimated that it would spend $8,400 to honor those warranties. When the company prepared its annual financial statements for 2012, no video recorders had been brought in for repair. In January 2013, however, 20 people brought in their broken video recorders, and Best Stuff spent a total of $750 repairing them (at no charge to the customers, because the video recorders were under warranty). Assume no additional sales were made in January 2013 (i.e., no new warranties were given in January). Requirements 1. How much warranty expense related to the sales of video recorders would Best Stuff show on an income statement for the year 2012? 2. Would Best Stuff have a warranty liability on the balance sheet at the end of 2012? If so, how much? 3. How much warranty expense would Best Stuff show on an income statement for the month of January 2013 related to these video recorders? 4. Would Best Stuff have a warranty liability on the balance sheet at January 31, 2013? If so, how much?

25 370 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL P7-63A. Account for notes payable with periodic payments of principal and interest. (LO 3). Ultra Power, Inc., engaged in the following transactions related to long-term liabilities during 2011: a. On March 1, the company borrowed $50,000 for a machine. The loan is to be repaid in equal annual payments of $6,793 at the end of each of the next 10 years (beginning February 28, 2012); the interest rate is 6%. b. On October 1, the company borrowed $100,000 from the local credit union at an interest rate of 8%. The loan is for seven years, and Ultra Power will make annual payments of $19,207 on September 30 of each year. Requirements 1. For each loan, prepare an amortization schedule for the first four payments. Show the reduction in principal and the interest expense for each payment. 2. What total interest expense related to these two loans would Ultra Power, Inc., show on its income statement for the year ended December 31, 2011? 3. How much interest payable would Ultra Power, Inc., show on its balance sheet at December 31, 2011?

26 CHAPTER 7 ACCOUNTING FOR LIABILITIES 371 P7-64A. Account for notes payable with periodic payments of principal and interest. (LO 3). Joe Brinks is making plans to finance the following projects: a. Purchase a truck for $30,000 to be repaid in equal monthly payments of $601 over the next five years. The bank has quoted an interest rate of 7.5%. b. Purchase a piece of land, whose owner is offering to sell it to Joe for $25,000. The seller would accept five annual payments of $6,595 at 10%. c. Sell some old equipment for $4,000. Joe is willing to accept quarterly payments of $546 for the next two years at an interest rate of 8%. d. Purchase land and building for $50,000, with a down payment of $5,000, and semiannual payments of $3,095 for the next 10 years at an interest rate of 6.5%. Requirement For each independent scenario, show the transactions in the accounting equation for the first two payments.

27 372 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL P7-64A Solution continued: P7-65A. Account for bonds payable. (LO 4). Julie s Cleaning Service issued $25,000 worth of 10-year bonds at 105. The bonds have a stated rate of 9%. Requirements 1. Was the market interest rate at the time of issue higher or lower than 9%? How do you know? 2. What were the proceeds from the bond issue? 3. Will the interest expense each period be higher or lower than the interest payment? 4. Will the book value of the bonds be higher or lower than $25,000 after five years?

28 CHAPTER 7 ACCOUNTING FOR LIABILITIES 373 P7-66A. Account for bonds payable. (LO 4). Adam Ship Builders issued $5 million of its 7% bonds on February 8, 2010, at 96. The bonds mature on June 30, Interest is payable semiannually on June 30 and December 31. Requirements 1. What were the proceeds from the bond issue? 2. Was the market interest rate at the time of issue higher or lower than 7%? 3. Will interest expense each period be higher or lower than the interest payment? 4. What will the book value of the bonds be at maturity? Set B P7-67B. Account for current liabilities. (LO 1, 5). On May 1, 2010, the accounting records of Sea Salt Company showed the following liability accounts and balances: Accounts payable $35,600 Short-term notes payable 15,000 Interest payable 950 Unearned service revenue 6,000 a. On May 1, 2010, Sea Salt Company signed a six-month note for $20,000 at 6%. b. During May, Sea Salt Company paid off the $15,000 short-term note and the interest payable shown on the May 1 balance sheet. c. The company also paid off the beginning balance in accounts payable. d. During the month, Sea Salt purchased $40,000 of merchandise on account. e. Also during May, Sea Salt s employees earned salaries of $25,000. Withholdings related to these wages were $1,550 for social security (FICA), $5,000 for federal income tax, and $2,500 for state income tax. The company will pay May salaries and taxes withheld on June 1. No entry had been recorded for salaries or payroll tax expense as of May 31. Requirements 1. Use the accounting equation to record the transactions described. 2. Show how Sea Salt Company would record the interest on the notes payable for the month of May and the salary expense and payroll tax expense. 3. Prepare the current liabilities section of the balance sheet at May 31, 2010.

29 374 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL P7-68B. Account for warranties. (LO 2). Fancy Frames prepares monthly financial statements. The following took place during the months of April and May at Fancy Frames: a. In April, $15,000 worth of frames was sold. Each is guaranteed for 12 months. Any defective frame will be repaired or replaced free of charge during that period. b. Fancy Frames estimated that it would cost $500 during the next year to honor the warranties on the April sales. c. During May, Fancy Frames spent $150 dollars to honor warranties related to April sales. Requirements 1. What amount of warranty expense would be shown on the income statement for April? 2. What amount of warranty liability would be shown on the April 30 balance sheet? 3. What effect did recording the warranty expense have on owner s equity? 4. What amount of warranty expense related to these frames would be shown on the income statement for May? 5. What effect did spending the $150 in May have on owner s equity?

30 CHAPTER 7 ACCOUNTING FOR LIABILITIES 375 P7-69B. Account for notes payable with periodic payments of principal and interest. (LO 3, 5). Zelda s Diamond Emporium engaged in the following transactions related to long-term liabilities during 2009: a. On July 1, 2009, the company borrowed $150,000 for a new piece of office equipment. The loan is to be repaid in equal annual payments of $15,444 at the end of each of the next 15 years (beginning June 30, 2010); and the interest rate Zelda s is paying for this loan is 6%. b. On October 1, the company borrowed $250,000 from the local credit union at an interest rate of 8%. The loan is for 15 years, and Zelda s will make annual payments of $29,207 on September 30 of each year. Requirements 1. For each loan, prepare an amortization schedule for the first four payments. Show the reduction in principal and the interest expense for each payment. 2. What total interest expense related to these two loans would Zelda s show on its income statement for the year ended December 31, 2009? 3. How much interest payable would Zelda s show on its balance sheet at December 31, 2009?

31 376 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL P7-70B. Account for notes payable with periodic payments of principal and interest. (LO 3). Black Company is making plans to finance the following projects: a. Purchase a boat for $50,000 to be repaid in equal monthly payments of $ over the next six years. The bank has quoted an interest rate of 12%. b. Purchase a property for $125,000. The seller would accept 10 semiannual payments of $15, at 8% (annual rate). c. Sell some old equipment for $8,000. Black Company is willing to accept quarterly payments of $1,092 for the next two years at an interest rate of 8% (annual rate). d. Purchase land and building for $250,000, with a down payment of $50,000, and semiannual payments of $16, for the next 10 years at an interest rate of 10% (annual rate). Requirement For each situation, use the accounting equation to show how the firm would record the first two payments.

32 CHAPTER 7 ACCOUNTING FOR LIABILITIES 377 P7-70B Solution continued: P7-71B. Account for bonds payable. (LO 4). Hard Top Patios issued $225,000 worth of five-year bonds with a stated interest rate of 9.5% and interest payable annually on December 31. The bonds were issued at 95. The bonds were issued on January 1, The fiscal year end is December 31. Requirements 1. Was the market interest rate at the time of issue higher or lower than 9.5%? Explain. 2. Will the interest payment be more or less than the interest expense each year? 3. Will the carrying value be more or less than $225,000 after three years? After four years? At maturity?

33 378 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL P7-72B. Account for bonds payable. (LO 4). Fischer s Fishing Gear issued $100,000 worth of 15-year bonds at 105. The bonds have a stated rate of 6%. Requirements 1. What were the proceeds from the bond issue? 2. Describe the change in carrying value of the bonds over the 15-year life. 3. Will interest expense be larger or smaller than the interest payment each year? Financial Statement Analysis FSA7-1. Calculate debt-to-equity ratio and analyze financial data. (LO 5, 6, 7). The following information comes from the balance sheet of Nordstrom, Inc.: Nordstrom, Inc. Consolidated Balance Sheets (partial) (in millions) Liabilities and Shareholders Equity Current liabilities: Commercial paper Accounts payable Accrued salaries, wages and related benefits Other current liabilities Current portion of long-term debt Total current liabilities Long-term debt, net Deferred property incentives, net Other liabilities Commitments and contingencies Shareholders equity: Common stock, no par value: 1,000 shares authorized; and shares issued and outstanding Retained earnings Accumulated other comprehensive loss Total shareholders equity Total liabilities and shareholders equity January 31, 2009 $ ,601 2, (10) 1,210 $5,661 February 2, 2008 $ ,635 2, (22) 1,115 $5, Calculate the debt-to-equity ratio for the years shown. 2. Who would be interested in this information and why? 3. Suppose you were considering investing in some stock. What do you think of the change in this ratio from one year to the next? 4. If Nordstrom, Inc., has bonds payable, where do you think they might be included on the balance sheet? 5. What risks are associated with the long-term debt on Nordstrom s balance sheet?

34 CHAPTER 7 ACCOUNTING FOR LIABILITIES 379

35 380 FINANCIAL ACCOUNTING 3/E SOLUTIONS MANUAL FSA7-2. Calculate debt-to-equity ratio and analyze financial data. (LO 5, 6, 7). The following information comes from the balance sheet of Micros Systems, Inc.: Micros Systems, Inc., and Subsidiaries Consolidated Balance Sheets (in thousands, except par value data) Assets Current Assets: Cash and cash equivalents Short-term investments Accounts receivable, net of allowance for doubtful accounts of $28,348 at June 30, 2008, and $23,110 at June 30, Inventory, net Deferred income taxes Prepaid expenses and other current assets Total current assets $ 381, ,445 64,575 18,724 29, ,445 June 30, 2007 $242,702 86, ,203 47,790 16,683 27, ,978 Investments, non-current Property, plant, and equipment, net Deferred income taxes, non-current Goodwill Intangible assets, net Purchased and internally developed software costs, net of accumulated amortization of $61,691 at June 30, 2008, and $54,708 at June 30, Other assets Total assets Liabilities and shareholders equity Current Liabilities: Bank lines of credit Accounts payable Accrued expenses and other current liabilities Income taxes payable Deferred revenue Total current liabilities Income taxes payable, non-current Deferred income taxes, non-current Other non-current liabilities Total liabilities Minority interests and minority ownership put arrangement..... Commitments and contingencies (Note 12) Shareholders equity: Common stock, $ par value; authorized 120,000 shares; issued and outstanding 80,898 at June 30, 2008 and 81,096 at June 30, Capital in excess of par Retained earnings Accumulated other comprehensive income Total shareholders equity Total liabilities and shareholders equity ,216 29,165 7, ,722 16,168 30,846 7,336 $1,003,006 $ , ,913 6, , ,506 18,302 2,181 8, ,092 6, , ,777 60, ,016 $1,003,006 27,955 23, ,332 14,509 36,296 4,541 $846,756 $ 2,308 43, ,142 8,094 86, ,412 15,934 17, ,900 4, , ,785 18, ,133 $846,756 The accompanying notes are an integral part of the consolidated financial statements. 1. Calculate the debt-to-equity ratio for the years shown. 2. Who would be interested in this information and why? 3. Suppose you were considering investing in some of this firm s stock. What do you think of the change in this ratio from one year to the next?