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Chapter 14

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									Chapter 14
Financing with Debt
EXERCISES E 14-2 Determining Current Liability Amounts a. The amount of the note payable is $14,400 ($18,000  0.80). This note is a current liability because it will be paid within the next year. A liability for interest on the note also exists for $1,440 ($14,400  0.12  10/12). The interest payable is also a current liability. b. An account payable of $60,000 was created by the purchase of inventory. c. An account payable of $15,000 was created by the purchase of office equipment. d. The account payable in (c) was paid off. e. Sales transactions create an account receivable but not a current liability. f. When the money was received, an unearned revenue account was created for $9,600. By the end of the year, the company has earned three months’ worth of rent. Earned revenue is $2,400 ($9,600  3/12). At year-end, the balance in the unearned revenue account is $7,200 ($9,600 – $2,400). The current liabilities as of December 31, 2006 are as follows: Note payable $14,400 Interest payable 1,440 Accounts payable 60,000 Unearned revenue 7,200 Total $83,040 E 14-4 Mortgage Amortization Schedule 1. Month July August September October November December Totals 2. 3. Monthly Payment $1,075 1,075 1,075 1,075 1,075 1,075 $6,450 Principal Paid $ 242 244 246 248 250 252 $1,482 Interest Paid $ 833 831 829 827 825 823 $4,968 Outstanding Balance $100,000 99,758 99,514 99,268 99,020 98,770 98,518

Interest of $4,968 will be paid during the last six months of 2006. By the end of 2006 the balance of the mortgage will have been reduced by $1,482 to $98,518.

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E 14-6 Issuing Bonds at Par, Premium, or Discount a. The bonds were issued at a discount because the stated rate of interest was less than the market rate of interest. b. The bonds were issued at a premium because the stated rate of interest was higher than the market rate of interest. c. The bonds were issued at a discount because the stated rate of interest was less than the market rate of interest. d. The bonds were issued at par because the stated rate of interest and market rate of interest rate were the same on the date of issuance. E 14-12 Accounting for Leases 1. If the lease is properly classified as an operating lease, a lease expense of $10,619 will be shown on the income statement. The lease will not be shown on the balance sheet because it is not a capital lease. 2. 3. Total lease expense (over 10-year period): $10,619  10 = $106,190. On the date of purchase, the present value of the equipment will be recorded as a purchase of leased equipment for $60,000 and a liability for the capital lease of $60,000. The interest expense for the year is $7,200 ($60,000  0.12). Cash paid is $10,619, so the reduction of the liability is $3,419 ($10,619 – $7,200). Depreciation expense of $6,000 ($60,000/10 years) will also be recorded. Balance Sheet: Assets Equipment under capital lease $60,000 Less: Accumulated depreciation (6,000) $54,000 Liabilities Obligation under capital lease ($60,000 – $3,419) Income Statement Expenses Interest expense Depreciation expense 4. $56,581

$ 7,200 $ 6,000

Total interest expense: $106,190 – $60,000 = $46,190 Total depreciation expense = $60,000 Total expense related to capital lease: $46,190 + $60,000 = $106,190 If the lease is recorded as an operating lease, the lease expense will appear on the income statement as a single item. If the lease is recorded as a capital lease, the depreciation expense on the leased property and the interest expense on the obligation under capital lease will be included on the income statement. Although the total amount of expense shown on the income statements over the period of the lease agreement is (generally*) the same under both the operating and the capital lease (e.g., $106,190), the equipment lease expense over the 10-year period is equal to the depreciation expense of $60,000* plus the total interest expense of $46,190 over the same period; the periodic expense may differ under the two treatments. Additionally, the equipment under capital leases and the related obligation will appear on the balance sheet as an asset and a liability, respectively. Under operating leases, however, no information about the lease arrangement will

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appear on the balance sheet. There will, however, be required disclosure regarding future payments in the notes to the financial statements. *If the salvage value is assumed to be any amount other than zero, which may be the case under some capital leases, the total amount of the expense will be different. E 14-15 Off-Balance Sheet Financing 1. The investment in Mercur would be reported as an asset for $125,000. None of Mercur’s individual assets or liabilities would be reported in TNT’s balance sheet. Consolidated statements are required if the investing company owns more than 50 percent of the ownership interest in another company. TNT owns 50 percent but not more than 50 percent, so TNT will not consolidate Mercur. If consolidation were required, Mercur’s assets and liabilities would be reported on TNT’s balance sheet. Also, a minority interest would be reported to represent the percentage ownership that TNT doesn’t own.

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APPLICATIONS AND EXTENSIONS SOLUTIONS
Deciphering Actual Financial Statements Deciphering 14-1 McDonald’s 1. (Short-term notes payable + Current maturities of long-term debt + Long-term debt) / Total shareholders equity 2003: ($388.0 + $9,342.5) / $11,981.9 = 0.81 2002: ($275.8 + $9,703.6) / $10,280.9 = 0.97 The debt-to-equity ratio decreased significantly in 2003. This was a result of both a decrease in long-term debt and an increase in shareholders’ equity. 2. McDonald’s disclosed the following about its future lease payments as of the end of 2003: Future minimum payments required under existing operating leases with initial terms of one year or more are: 2004 2005 2006 2007 2008 Thereafter Total minimum payments $ 998.0 939.5 876.6 814.7 757.7 6,531.5 $10,918.0

As described in the text of the chapter, the present value of these future operating lease payments can be approximated by making some simplifying assumptions:  The appropriate interest rate is 10%.  The uneven stream of future operating lease payments by McDonald’s is roughly equivalent to $875 million per year for 12 years. This rough approximation stems from the fact that payments in the first five years are around $875 million per year, and the

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total of the payments is $10,918.0 million, which is roughly equal to $875 million a year for 12 years. Given these simplifying assumptions, the techniques described in Appendix B reveal that the approximate economic value of McDonald’s obligation under its operating leases is $5,962 ($875  6.8137 [the present value of an annuity of 12 years with a 10% interest rate]). The revised debt-to-equity ratio is computed as follows: 2003: ($388.0 + $9,342.5 + $5,962) / $11,981.9 = 1.31 The debt-to-equity ratio increases significantly when the economic value of the operating lease obligation is included in the computation. 3. McDonald’s reports the following lines of credit, exceeding $2 billion: Expires in 2005 $750.0 million Expires in 2009 500.0 million Non-U.S. subsidiaries 789.3 million Total $2,039.3 million

The cost of these lines of credit is approximately 0.07% of the unused amount. 4. McDonald’s lists debt obligations in U.S. dollars, euros, British pounds, Japanese yen, Swiss francs, Swedish Kronor, Danish Kroner, Korean Won, Chinese Renminbi, Hong Kong Dollars, Australian Dollars, and Singapore Dollars. In 2003, the largest single currency in which debt obligations were denominated was Euros. In 2002, the largest single currency was U.S. Dollars.

Ethics Dilemma: Hiding an Obligation by Calling It a Lease Yes, your partner is right. It is possible to avoid reporting the 20-year lease contract as an accounting liability. If the lease does not satisfy any of the four criteria discussed in Chapter 14, then the lease is to be accounted for as an operating lease. With an operating lease, the lease is accounted for exactly as if it were a rental agreement, and no asset or liability is recognized in the financial statements of the lessee (the person using the leased asset). By signing the 20-year lease, you are violating the spirit of the bank loan agreement. The reason the bank included this provision in the loan agreement was to increase the probability that you would be able to repay the loan in five years. The bank’s concern is that if you incur other long-term obligations, the cash generated from your business might be used to repay those obligations instead of repaying the five-year bank loan. However, don’t feel too sorry for the bank. The bank loan officer knows about, or should know about, the accounting rules regarding leases. If the bank was concerned about the possibility of your signing a long-term operating lease agreement, then the bank should have specifically included that provision in the loan agreement. The best course of action is to consult with your banker. Yes, you can probably sign the long-term operating lease and legally get away with it. However, doing so without speaking with your banker first will ruin any relationship of trust you have with the bank. When you go to talk with the banker, take your business projections for the next five years. Convince the banker that you will be able to repay the loan even with the new lease. The bank might even, on the other hand, be willing to renegotiate the amount and terms of the existing loan and include the desired financing.

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