Chapter10SolutionsManual.xls

CHAPTER 10LIABILITIESOVERVIEW OF BRIEF EXERCISES,EXERCISES,PROBLEMS,AND CRITICALTHINKING CASESBriefLearningExercisesTopicObjectivesSkillsB.Ex.10.1Cash effects of borrowing2AnalysisB.Ex.10.2Effective interest rate5AnalysisB.Ex.10.3Bonds issued at a discount6AnalysisB.Ex.10.4Bonds issued a premium6AnalysisB.Ex.10.5Recording bonds issued at adiscount6AnalysisB.Ex.10.6Recording bonds issued at apremium6AnalysisB.Ex.10.7Debt ratio9Analysis,communicationB.Ex.10.8Early retirement of bonds6AnalysisB.Ex.10.9Deferred income taxes10AnalysisB.Ex.10.10Pension and other postretirementbenefits10Analysis LearningObjectives ExercisesTopic Skills10.1You as a student4Analysis10.2Accounting equation1-6Analysis10.3Effects of transactions uponfinancial statements1,2,4,5,6,8Analysis10.4Payroll-related costs3Analysis10.5Payroll-related costs3Analysis10.6Use of an amortization table4Analysis10.7Real World:MTRTax benefit of debt financing5Analysis,communication10.8Bonds payable and interest5Analysis,communication10.9Accounting for bond premiums5,6Analysis,communication10.10Accounting for bond discounts5,6Analysis,communication10.11Analyzing solvency9Analysis,communication,judgment10.12Accounting for leases10Analysis,communication,judgment10.13Accounting for pensions10Analysis,communication,judgment10.14Deferred taxes10Analysis,communication10.15Real World:adidas AG,Herzogenaurach Examiningcapital structure9Analysis,communication,judgment The McGraw-Hill Companies,Inc.,2010OverviewProblemsLearningObjectivesSets A,BTopicSkills10.1 A,BEffects of transactions upon accountingequation16,8Analysis10.2 A,BBalance sheet presentation1,2,4,8Analysis,communication,judgment10.3 A,BNotes payable2Analysis,communication10.4 A,BPreparation and use of an amortizationtable4Analysis,communication10.5 A,BBonds issued at face value5Analysis,communication10.6 A,BBond discount and premium5,6Analysis,communication10.7 A,BBalance sheet presentation1,5,6,10Analysis,communication,judgment10.8 A,BBalance sheet presentation1,5,6,8,10Analysis,communication,judgmentCritical Thinking Cases 10.1Real World:8 Companies Nature ofliabilities1,10 Analysis,communication.Judgment10.2Real World:Abbott Labs Factorsaffecting bond prices57 Analysis,communication,judgment10.3Contingent liabilities8 Analysis,communication,judgment10.4Real World:Cathay Pacific Airways1,10Analysis,communication,judgmentOff-Balance-Sheet financing(Ethics,fraud&corporate governance)10.6Real World:Securities and Futures5,6,9Analysis,communication,judgment,research,technologyCommission.Credit ratings for bonds(Internet)_*Supplemental Topic,“Special types of Liabilities.”The McGraw-Hill Companies,Inc.,2010Overview(p.2)SkillsAnalysis,communication,judgmentAnalysis,communicationAnalysis,communicationAnalysis,communicationAnalysis,communicationAnalysis,communication,judgmentAnalysis,communication,judgment Analysis,communication.JudgmentAnalysis,communication,judgmentAnalysis,communication,judgmentAnalysis,communication,judgmentAnalysis,communication,judgment,research,technology The McGraw-Hill Companies,Inc.,2010Overview(p.2)DESCRIPTIONS OF PROBLEMS AND CRITICAL THINKING CASESBelow are brief descriptions of each problem and case.These descriptions are accompanied by theestimated time(in minutes)required for completion and by a difficulty rating.The time estimates assumeuse of the partially filled-in working papers.Problems(Sets A and B)10.1 A,BComputer Specialists/Westmar Company25 EasyShow the effects of various transactions upon the accountingequation.Also calls for distinction between current and noncurrentliabilities.Quick and easy,but quite comprehensive.10.2 A,BMacau Chocolates/Shanghai Peach30 MediumFrom an unclassified listing of account balances and otherinformation,prepare current and noncurrent liability sections of abalance sheet.Explain treatment of various items.10.3 A,BSwanson Corporation/Lee Corporation25 MediumAccounting for notes payable with interest stated separately.10.4 A,BQuick Lube/Walla25 MediumInvolves conceptual discussion of an amortization table,use of thetable,and extension of a partially completed table for two morepayments.10.5 A,BBlue Mountain Power Company/Lake Company15 EasyJournal entries to record issuance of bonds between interestpayment dates,payment of interest,and accrual of interest at year-end.Requires students to know that bonds are issued at par whenthe prevailing market rate of interest equals their contract rate.10.6 A,BPark Rapids Lumber Company/Bella Company35 StrongYear-end adjusting entries for bond interest when bonds are issuedat a discount and when bonds are issued at a premium.10.7 A,BHome Satellite Telephone Corporation/Canton Utility45 StrongFrom an unclassified list of account balances and otherinformation,students are asked to prepare and discuss the currentand noncurrent liability sections of a balance sheet.10.8 A,BNorman Company/Far East Company20 StrongFrom a list of items that include liabilities and include additionalinformation about items that may be mistaken as liabilities,students are asked to prepare the current and noncurrent liabilitysections of a balance sheet and to explain why the three excludeditems are not included.The McGraw-Hill Companies,Inc.,2010Description ProblemsCritical Thinking Cases10.1Liabilities in Published Financial Statements30 MediumDiscuss the nature of various liabilities appearing in the balance sheetsof well-known companies.10.2Abbott Labs20 StrongBond PricesRequires students to understand the relationship between a bonds issueprice and the effective rate of interest,and to differentiate between cashflow and interest expense.Also requires that students understand thatthe time remaining until a bond matures is a factor in determining thebonds current value.10.3Contingent Liabilities25 MediumStudents are asked to evaluate four situations indicating whether eachsituation describes a contingent liability and explaining the properfinancial statement treatment of the matter.10.4Cathay Pacific Airways Limited20 MediumEthics,Fraud&Corporate GovernanceStudents are asked to examine and evaluate off-balance-sheet financingarrangements of Cathay Pacific Airways Limited.10.5Securities and Futures Commission20 StrongInternetStudents are introduced to different types of bonds and are encouragedto explore current financial market events and trends that exists on websites._*Supplemental Topic,“Special Types of Liabilities.”The McGraw-Hill Companies,Inc.,2010Desc.of CasesSUGGESTED ANSWERS TO DISCUSSION QUESTIONS1.Liabilities is a present obligation of the entity arising from past events,the settlement of which isexpected to result in an outflow from the entity of resources embodying economic benefits.Liabilities and owners equity are the two primary means by which a business financesownership of its assets and its business operations.The feature which most distinguishes liabilities from equity is that liabilities mature,whereasowners equity does not.In the event of liquidation of the business,the claims of creditors(liabilities)have priority over the claims of owners(equity).Also,interest paid to creditors isdeductible in the determination of taxable income,whereas dividends paid to shareholders arenot deductible.2.In the event of liquidation of a business,the claims of creditors(liabilities)have priority over theclaims of owners(equity).The relative priorities of individual creditors,however,vary greatly.Secured creditors have top priority with respect to proceeds stemming from the sale of thespecific assets that have been pledged as collateral securing their loans.The priority ofunsecured creditors is determined by legal statutes and indenture contracts.3.Current liabilities are obligations that must be paid within one year or within the operating cycle,whichever is longer.An entity holds the liability primarily for the purpose of trading or the entitydoes not have an unconditional right to defer settlement of the liability for at least one year afterthe balance sheet date.Liabilities that do not meet one of these conditions are classified asnoncurrent or long-term liabilities.A 10-year bond issue would be classified as a current liability once it comes within 12 months ofthe maturity date,assuming that the issue will be paid from current assets.A note payable maturing in 30 days would be classified as a noncurrent liability if(a)management had both the intent and the ability to refinance this obligation on a long-term basis,or(b)the liability will be paid from noncurrent assets.4.Accounts Payable(Smith Supply Company)8,000Notes Payable 8,000Issued a 12%,90-day note payable to replace an account payable toSmith Supply Company.Notes Payable.8,000Interest Expense 240Cash 8,240Paid 12%,90-day note to Smith Supply Company.5.All employers are required by law to pay one or a combination of the following payroll taxesand insurance premiums:Social Security and medicarel care taxes,unemployment taxes,andworkers compensation insurance premiums.In addition,many employers include the followingas part of the“compensation package”provided to employees:group health insurance premiums,contributions to employee pension plans,and postretirement benefits(such as health insurance).Both mandated and discretionary costs are included as part of total payroll cost in addition to thewages and salaries earned by employees.The McGraw-Hill Companies,Inc.,2010Q1-56.Workers compensation premiums are a mandated payroll costthe cost of providing insurancecoverage to employees in case of job-related injury.The dollar amount of the premiums varies bycountry and by employees occupation.The employer pays workers compensation premiums.7.$62,537$63,210 balance at the beginning of the period,less$673 of the payment that applies toprincipal($1,200-$527 representing interest).8.The analysis is incorrect,because the principal amount of the mortgage note will not be paid off at aconstant rate of$178.4 per month.The portion of each payment representing an interest charge isbased upon the unpaid balance of the loan.Since the principal amount is being reduced each month,the portion of each successive payment representing interest will decrease,and the portion applied toreducing the unpaid balance will increase.For example,let us look into the future to the time when theloan has been paid down to$100,000.At this point,a$4761.7 monthly payment would be allocated asfollows:interest,$916.7($100,000 principal 11%112),and reduction in principal,$3845.0($4761.7-$916.7 interest).Thus,the unpaid balance of the loan will be paid off at an ever-increasingrate.Note to instructor:This mortgage will be paid in full in 30 years.9.The income tax advantage of raising capital by issuing bonds rather than shares is that interestpayments on bonds are deductible in determining profit subject to income taxes.This reduces the“after-tax”cost of borrowing.Dividend payments to shareholders,on the other hand,are not deductible in thedetermination of taxable income.10.Annual interest payments($5 million 10%).$500,000Less:Annual tax savings($500,000 30%).150,000Annual after-tax cost of borrowing$350,000After-tax cost of borrowing as a percentage of amount borrowed:$350,000$5,000,000=7%11.The present value of a future amount is the amount that a knowledgeable investor would pay today forthe right to receive the future amount.This present value always will be less than the future amount,because the investor will expect to earn some return while waiting to receive the future amount.12.From an investors perspective,a bond represents a series of future cash receipts that are fixed inamount by the contract rate of interest printed on the bonds and by the bonds maturity value.Asmarket interest rates rise,a series of future receipts that are fixed in dollar amount look less attractivein relation to other investment opportunities,and the price of the bond falls.As interest rates fall,anyseries of fixed cash receipts begins to look better in relation to other opportunities,and bond pricesrise.13.Bonds with contract rates of interest above current market interest rates should be trading at pricesabove their face values.Bond prices vary inversely with market interest rates.The McGraw-Hill Companies,Inc.,2010Q6-1314.The market value of$25,000 in bonds trading at 102 would be$25,500($25,000 par value 102%).Themarket rate of interest for bonds of this quality must be lower than the 8%contract rate,thereby causinginvestors to be willing to pay a premium for these bonds.15.A superior credit rating is one reason why one companys bonds might trade at a higher price than thoseof another company.However,the higher market price for the Interstate Power bonds does not,in itself,prove that Interstate has the better credit rating.As current market interest rates are well above the 6%level,it is logical that both bonds should be selling at a discount.The fact that the Interstate Power bondsare selling at a market price very close to their face value probably indicates that these bonds will maturein the very near future.Thus,the difference in the market price of the two bond issues may well beexplained by a difference in maturity dates,rather than by a difference in the companies credit ratings.16.Issuing bonds at a discount increases the cost of borrowing.Not only does the issuing company have theuse of less borrowed money in exchange for its regular interest payments,but it also must repay morethan the original amount borrowed.Thus,an additional interest charge is built into the maturity value ofthe bonds.17.Because the maturing bonds were paid from a sinking fund,the bonds were never classified as a currentliability.As the sinking fund was never classified as a current asset,the maturity of the bonds had noeffect upon the companys current ratio.The debt ratio is equal to total liabilities divided by total assets.NDP is a solvent business;therefore,thetotal liabilities are less than total assets,and the debt ratio is less than 100%.Under these circumstances,reducing the numerator and denominator of the ratio by an equal amount causes the debt ratio to decrease.One also should arrive at this conclusion through common senserepaying debt reduces the percentageof total assets financed with capital provided by creditors.18.Low-Cals very low interest coverage ratio should be of greater concern to shareholders than to short-termcreditors.The fact that operating income amounts to only 75%of annual interest implies that Low-Calmay have great difficulty in remaining solvent in the long run.It does not imply,however,that thecompany is not currently solvent.Short-term creditors,because of their shorter investment horizon,should be concerned about the current relationships between the companys liquid resources and its short-term obligations.19.The return on assets represents the average return that a business earns from all capital.If this average rateis higher than the cost of borrowing,the business can benefit from using borrowed capitalt