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									Chapter 12
long-Term liaBiliTieS

                              assessment Questions

Question 1

Name the typical forms of long-term debt.

Question 1 – answer

A typical and common form of long-term debt is a term loan from a bank. Another form of
______________________________________________________________________________
long-term debt is bonds.
______________________________________________________________________________

______________________________________________________________________________


Question 2

What is a bond?

Question 2 – answer

A bond, also known as a fixed-income security, is a fixed interest financial asset issued by
______________________________________________________________________________
governments, companies, banks, public utilities and other large entities. It is a loan from
______________________________________________________________________________
private investors as opposed to a term loan, which is from a bank.
______________________________________________________________________________


Question 3

An investor pays $83,333 for a bond, but will receive $100,000 when the bond matures. Has
the investor bought the bond at a discount or at a premium?

Question 3 – answer

The investor has bought the bond at a discount. A discount bond is bought below par (face
______________________________________________________________________________
value). At maturity the buyer receives the face value of the bond.
______________________________________________________________________________

______________________________________________________________________________




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Chapter 12                                                                       Long-Term Liabilities



Question 4

Bonds can be issued at different prices relative to their face value. Name the three types of
bonds relative to face value.

Question 4 – answer

       Par – issued at face value
______________________________________________________________________________
       Discounted – issued at a price less than face value
______________________________________________________________________________
       Premium – issued at a price more than face value.
______________________________________________________________________________


Question 5

When would a bond be issued at a discount? At a premium?

Question 5 – answer

A bond is issued at a discount, when the current market interest rate for bonds is above the
______________________________________________________________________________
stated rate for the bond to be issued.
______________________________________________________________________________
A bond is issued at a premium when the current market interest rate for bonds is below the
______________________________________________________________________________
stated rate for the bond to be issued.
______________________________________________________________________________


Question 6

A $100,000 bond is issued for $110,000. Is the current market interest rate for bonds above or
below the rate stated in the bond contract?

Question 6 – answer

The rate stated in the bond contract is above the current market interest rate for bonds.
______________________________________________________________________________

______________________________________________________________________________


Question 7

What amount remains in the discount on bond amortized account or premium on bonds
account related to a bond on the maturity date of the bond?




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Long-Term Liabilities                                                                   Chapter 12



Question 7 – answer

The discount on bond amortized account or premium on bonds account would have a zero
______________________________________________________________________________
balance on the maturity date of the bond.
______________________________________________________________________________


Question 8

What is generally considered the maximum acceptable debt-to-total-assets ratio? Why?

Question 8 – answer

Generally, the maximum acceptable debt-to-total-assets ratio is 50%. If the ratio is above 50%,
______________________________________________________________________________
it means that lenders have more of an interest in the assets of the company than owners. Thus
______________________________________________________________________________
if financial difficulties arise, owners have little incentive to turnaround the company because
______________________________________________________________________________
they do not have as big of a stake in the company as its lenders. Note, however, that the
______________________________________________________________________________
interpretation of this ratio will vary among different industries.
______________________________________________________________________________

______________________________________________________________________________


Question 9

Funds raised from long-term debt are used for what kind of investments?

Question 9 – answer

Typically, funds raised from long-term debt are used to finance the purchase of capital assets
______________________________________________________________________________
that will last a long time. This use demonstrates the principle of matching the life of assets to
______________________________________________________________________________
their source of financing. Cash raised from long-term debt may also be used to finance “base”
______________________________________________________________________________
levels of receivables and inventory.
______________________________________________________________________________

______________________________________________________________________________

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Chapter 12                                                                                  Long-Term Liabilities



Question 10

What is the difference between bonds and stocks?

Question 10 – answer

Bonds are debt instruments while stocks are equity instruments.
______________________________________________________________________________
Interest is paid on bonds while dividends are paid on stocks.
______________________________________________________________________________
Bondholders are creditors of the company while stockholders are owners of the company.
______________________________________________________________________________
Interest is deductible for tax purposes while dividends are not deductible for tax purposes.
______________________________________________________________________________
Interest must be paid while dividends are only paid when they are declared by the board of
______________________________________________________________________________
directors.
______________________________________________________________________________
**Note to instructor: Figures determined using present value factors have been rounded for ease


                                    application Questions

Question 1

A company issued $500,000 of bonds at par. Write the journal entry to record the transaction.

Question 1 – answer
               DaTe                       DeSCriPTion                        Dr            Cr
                           Cash                                              500,000
                              Bonds Payable                                               500,000
                           Issue of bonds at par

Question 2

A company issued $500,000 of bonds at a discount of 5%. Write the journal entry to record the
transaction.


Question 2 – answer

                DaTe                       DeSCriPTion                        Dr            Cr
                            Cash                                              475,000
                            Discount on Bonds                                  25,000
                               Bonds Payable                                                500,000
                            Issue of bonds at a discount



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Long-Term Liabilities                                                                      Chapter 12



Question 3

A company issued $500,000 of bonds at a premium of 1%. Write the journal entry to record
the transaction.

Question 3 – answer

                   DaTe                 DeSCriPTion                    Dr        Cr
                          Cash                                         505,000
                             Bonds Payable                                       500,000
                             Premium on Bonds                                      5,000
                          Issue of bonds at a premium


Question 4

A company is issuing $300,000 worth of 5-year bonds, bearing an interest rate of 4%. Assume
that the current, market rate of interest is 5%.

           a) Will the bond be issued at a discount or at a premium?
           b) Calculate the value of the resulting discount or premium.
           c) Record the journal entry to reflect the sale of bonds and the appropriate discount
              or premium.

Note that the present value factor for the principal is 0.784 (5%, 5-years) and that the present
value factor for the recurring interest payments is 4.329 (5%, 5-years).


Question 4 – answer

       a) Since the market rate is higher than the rate on the bond, these bonds will be issued
______________________________________________________________________________
          at a discount.
______________________________________________________________________________
       b) The present value of principal = $300,000 * 0.784 = $235,000. The present value of
______________________________________________________________________________
          interest payments = $300,000 * 4% * 4.329 = $52,000. Therefore, the bond will be
______________________________________________________________________________
          issued for = $235,000 + $52,000 = $287,000. The resulting discount is $300,000 -
______________________________________________________________________________
          $287,000 = $13,000
______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________


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Chapter 12                                                                       Long-Term Liabilities




             c)

                  DaTe                  DeSCriPTion                    Dr        Cr
                         Cash                                          287,000
                         Discount on Bonds                              13,000
                           Bonds Payable                                         300,000
                         Issue of bonds at a discount

Question 5

Refer to question 4. Assuming interest is paid annually; write the journal entry to record
payment of interest.

Question 5 – answer

                  DaTe                  DeSCriPTion                    Dr        Cr
                         Interest Expense                              14,600
                           Discount on Bonds                                       2,600
                           Cash                                                   12,000
                         To record discount amortization and payment
                         of interest



Discount on bonds = $13,000 ⁄ 5 years = $2,600
______________________________________________________________________________
Cash paid out for interest = $300,000 × 4% = $12,000
______________________________________________________________________________




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Long-Term Liabilities                                                                           Chapter 12



Question 6


Shown below is a segment of the financial statements of a large company.

                                                                                        as at
                                                                            march 1, 2008 march 1, 2009
 assets
 Current
    Cash and Cash Equivalents (note 4)                                          1,184,398         677,144
    Short-Term Investments (note 4)                                              420,709         310,082
    Accounts Receivables                                                        1,174,692        572,637
    Other Receivables                                                             74,689           40,174
    Inventory (note 5)                                                           396,267         255,907
    Other Current Assets (note 18)                                                226,599         63,321
                                                                                3,477,354       1,919,265
 long-Term investments (note 4)                                                  738,889         425,652
 Capital assets (note 6)                                                         705,955         487,579
 intangible assets (note 7)                                                      469,988          138,182
 goodwill (note 8)                                                               119,001          118,271
                                                                                 5,511,187      3,088,949
 liabilities
 Current
    Accounts Payable                                                             271,076         130,270
    Accrued Liabilities (notes 13 and 17 (c))                                    690,442         287,629
    Income Taxes Payable (note 9)                                                475,328          99,958
    Deferred Revenue                                                              37,236          28,447
    Current Portion of Long-Term Debt (note 10)                                       349             271
                                                                                1,474,431        546,575
 long-Term Debt (note 10)                                                         72,317          58,874
 income Tax Payable                                                                30,873               −
                                                                                1,577,621        605,449
 Stockholder’s equity
 Contributed Capital (note 11)
    authorized - unlimited number of non-voting, cumulative, redeem-
    able, retractable preferred stocks; unlimited number of voting common
    stocks issued - 562,652,451 voting common stocks (March 1, 2008 -
    557,613,432)                                                                2,169,856       2,099,696
 retained earnings                                                             1,653,094         359,227
 Paid-in Capital                                                                  80,333          36,093
 accumulated other Comprehensive income (loss) (note 16)                           30,283         (11,516)
                                                                                3,933,566       2,483,500
                                                                                 5,511,187      3,088,949
                                                                                                     271
Chapter 12                                                                                  Long-Term Liabilities



Calculate the debt-to-total assets ratio. Comment on the ratio. The formula for this ratio is:

                                                                Total Liabilities
                    Debt to Total Assets Ratio         =
                                                                    Total Assets

Question 6 – answer

Debt to total assets = 1,577,621 ⁄ 5,511,187 = 28.6 %
______________________________________________________________________________
The company has a ratio of less than 50%. The company has little in the way of debt, and can
______________________________________________________________________________
be considered to be in a good financial position.
______________________________________________________________________________


Question 7

On April 30, year 1, a company issued $600,000 worth of 4% bonds. The term of the bonds is
10 years, with interest payable semi-annually. The year-end of the company is November 30.
Record the journal entries related to interest for year 1, and year 2. Note that interest must be
accrued at the end of each year.

Question 7 – answer
                DaTe                       DeSCriPTion                         Dr           Cr
             Oct 31 yr. 1   Bond Interest Expense                                  12,000
                              Cash                                                          12,000
                            Payment of bond interest
                            $600,000 × 4% × 6/12
             Nov 30 yr. 1   Bond Interest Expense                                   2,000
                              Accrued Bond Interest Payable                                  2,000
                            Accrued interest on bonds at year-end
                            $600,000 × 4% × 1/12
             Apr 30 yr. 2   Accrued Bond Interest Payable                           2,000
                            Bond Interest Expense                                  10,000
                              Cash                                                          12,000
                            Payment of bond interest
                            $600,000 × 4% × 5/12
             Oct 31 yr. 2   Bond Interest Expense                                  12,000
                              Cash                                                          12,000
                            Payment of bond interest
                            $600,000 × 4% × 6/12
             Nov 30 yr. 2   Bond Interest Expense                                   2,000
                              Accrued Bond Interest Payable                                  2,000
                            Accrued interest on bonds at year-end
                            $600,000 × 4% × 1/12

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Long-Term Liabilities                                                                             Chapter 12



Question 8

Sam’s Construction is a construction company (with a December 31 year-end) that is planning
to expand its facilities by constructing a new building, and acquiring new equipment. In order
to complete this project, the company has decided to issue $100,000 worth of 10-year bonds
at 5% on March 1, 2010. The interest payment is made semi-annually on September 1 and
March 1. Just as the company completes all the necessary contracts, and is ready to issue the
bonds, the market rate increases to 6%, resulting in a price of $92,640 for these bonds.

Note: The premium/discount is amortized using the straight-line method.

           a) Are these bonds issued at a discount or at a premium? Prepare the journal entry for
              the issuance of bonds on March 1, 2010.
           b) Prepare the journal entry for the first payment of interest on September 1, 2010
           c) Prepare the adjusting entry on December 31, 2010



Question 8 – answer

       a) Since the bonds are being issued at $92,640 (which is less than their face value of
______________________________________________________________________________
          $100,000), these bonds are being offered at a discount.
_____________________________________________________________________________ .

                        DaTe                    DeSCriPTion                       Dr       Cr
                        Mar 1    Cash                                             92,640
                                 Discount on Bonds                                 7,360
                                   Bonds Payable – 5%                                      100,000
                                 Issuance of bonds at a discount



           b)

                        DaTe                    DeSCriPTion                       Dr       Cr
                        Sept 1   Interest Expense                                  2,868
                                   Discount on Bonds – Amortization                             368
                                   Cash                                                      2,500
                                 Recording interest and the amortization of the
                                 discount on bonds
                                 $100,000 × 5% x 6/12 = $2,500
                                 $7,360 ⁄ 10 years x 6/12 = $368




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Chapter 12                                                                         Long-Term Liabilities



             c)
                     DaTe                    DeSCriPTion                 Dr          Cr
                    Dec 31     Interest Expense                            1,912
                                 Discount on Bonds – Amortization                         245
                                 Interest Payable                                       1,667
                               Recording accrued interest on bonds
                               $100,000 × 5% x 4/12 = $1,667
                               $7,360 ⁄ 10 years x 4/12 = $245


Question 9

Burroughs Corporation (with a December 31 year-end) issued $450,000, 9.5% bonds due in 8
years on May 1, 2010. Interest is paid semi-annually on November 1 and May 1 of each year.
On the issuance date, the market rate of interest was 8.5%, resulting in a price of $475,000 for
these bonds.

Note: The premium/discount is amortized using the straight-line method.

             a) Is this bond issued at a discount or at a premium? Prepare the journal entry on May
                1, 2010, to issue the bonds.
             b) Prepare the journal entry on November 1, 2010, to record the first interest payment
                and the amortization of the premium/discount.
             c) Prepare the adjusting entry on December 31, 2010.
             d) Show the balance sheet presentation of Bonds Payable and related accounts as at
                December 31, 2010.


Question 9 – answer

       a) Since the bonds are being issued at greater than face value, this bond has been
______________________________________________________________________________
          issued at a premium.
______________________________________________________________________________


                     DaTe                     DeSCriPTion                Dr          Cr
                     May 1     Cash                                      475,000
                               Premium on Bonds                                       25,000
                                 Bonds Payable                                       450,000
                               Issuance of Bonds




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Long-Term Liabilities                                                                               Chapter 12



           b)
                        DaTe                    DeSCriPTion                         Dr         Cr
                        Nov 1    Interest Expense                                   19,812
                                 Premium on Bonds                                    1,563
                                   Cash                                                        21,375
                                 Payment of interest and amortization of
                                 Premium ($25,000 ⁄ 8 years) x (6/12) = $1,563
                                 ($450,000 x 9.5%) x 6/12 = $21,375


           c)
                        DaTe                    DeSCriPTion                         Dr         Cr
                        Dec 31   Interest Expense                                    6,604
                                 Premium on Bonds                                        521
                                   Interest Payable                                             7,125
                                 Accrual of interest on bonds
                                 ($25,000 ⁄ 8 years) x (2/12)= $521
                                 ($450,000 x 9.5%) x 2/12 = $7,125


           d)
                 Bonds Payable                                            450,000
                 Add : Unamortized Premium                                 22,916
                 Book Value                                               472,916



Unamortized premium is = $25,000 - $1,563 - $521 = $22,916
______________________________________________________________________________

______________________________________________________________________________




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Chapter 12                                                                      Long-Term Liabilities



Question 10

Mustafa has recently graduated from an Aerospace Engineering program and is training to
become an astronaut. Part of the training program includes a basic course in accounting
and finance (it is important for astronauts to be well-rounded). Mustafa is posed with the
following question on his exam:

MT Biotech has issued $3,500,000, 5% callable bonds due in 12 years. At the time of issue the
market interest rate is 6% (interest is due annually). Calculate the discount at which the bonds
were issued.

The following present value factors may be of use to you:

             Single:

             0.557 (5%, 12 years)

             0.497 (6%, 12 years)

             annuity:

             8.863 (5%, 12 years)

             8.384 (6%, 12 years)

Unfortunately, Mustafa spent the previous day in the centrifuge (G-force training) and, as a
result, he is finding it difficult to concentrate. Please help Mustafa solve this problem.

Question 10 - answer

To determine the discount, we have to calculate the present value of the bond. Therefore, we
______________________________________________________________________________
have to discount the premium AND discount the yearly interest payments. When determining
______________________________________________________________________________
the present value of the bond, we have to discount at the market interest rate. Therefore, we
______________________________________________________________________________
only need:
______________________________________________________________________________
       PV single payment factor: 0.497 (6%, 12 years) and
______________________________________________________________________________
       PV annuity factor: 8.384 (6%, 12 years)
______________________________________________________________________________
       PV of principal = $3,500,000 × 0.497 = $1,739,500
______________________________________________________________________________
       PV of interest payments = $3,500,000 × 5% × 8.384 = $1,467,200
______________________________________________________________________________
       Present value of bonds = $1,739,500 + $1,467,200 = $3,206,700
______________________________________________________________________________
       Discount = $3,500,000 - $3,206,700 = $293,300
______________________________________________________________________________


276
Long-Term Liabilities                                                                  Chapter 12



                                                    Case
Research and describe the role of credit rating agencies in the bond market.
Name three major credit rating agencies.
Describe and list the major categories of credit ratings for these agencies.

Case – answer

In this chapter we discussed the existence of secured and unsecured bonds. Unlike secured
______________________________________________________________________________
bonds, unsecured bonds do not come with any collateral to back up an investor’s bond
______________________________________________________________________________
purchase. How, then, does the investor have any guarantee that he will get his principal
______________________________________________________________________________
back if he purchases unsecured bonds in the marketplace? This is where bond credit rating
______________________________________________________________________________
agencies step in. Bond credit rating agencies award letter designations to organizations and
______________________________________________________________________________
the bonds they issue that rate how safe of an investment it is. Just as you, an individual, have
______________________________________________________________________________
developed a credit rating based on your ability to make interest payments on your student
______________________________________________________________________________
loan or pay your credit bill or phone bills regularly, organizations receive a credit rating on
______________________________________________________________________________
how well they honor the bonds they issue.
______________________________________________________________________________
Three major credit rating agencies:
______________________________________________________________________________
          Moody’s
______________________________________________________________________________
          Standard & Poor’s
______________________________________________________________________________
          Fitch
______________________________________________________________________________
Major categories of credit ratings:
______________________________________________________________________________
          Moody’s
______________________________________________________________________________

               Aaa      Prime
               Aa1      High grade
               A1       Upper medium grade
              Baa1      Lower medium grade
               Ba1      Non investment grade speculative
               B1       Highly speculative
              Caa1      Substantial risks
                /       In default


       Similar for S&P and Fitch (but with slightly different letter designations)
______________________________________________________________________________


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Chapter 12                                                                 Long-Term Liabilities



                            Critical Thinking exercise
Companies can choose to record interest expense on bonds using the straight-line method,
or by using a method that incorporates the time value of money. Which method do you
recommend that a company use? Support your answer.

Critical thinking exercise – answer

Neither method is preferred over the other. If you use the straight-line method, the amount
______________________________________________________________________________
of interest expense is simple to calculate and understand. Using the time value of money
______________________________________________________________________________
method, however, results in interest expense that is more accurately tied to the principal
______________________________________________________________________________
outstanding. Larger and more complex organizations choose the time-value method, whereas
______________________________________________________________________________
smaller companies choose the straight-line method because of its simplicity.
______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

______________________________________________________________________________

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______________________________________________________________________________

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