Financial Accounting: An Introduction To Concepts Methods And Uses 14 Chapter 11

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Chapter 11: Notes, Bonds, and Leases

Student: ___________________________________________________________________________

1. Firms typically finance long-term assets, particularly property, plant, and equipment, with long-term

2. The more long-term debt in a firm’s capital structure, the less the risk that the firm will experience difficulty

4. Modern business usage has come to restrict the word equity to mean only shareholders’ equity, both

7. The amount borrowed initially and the market value of a note or bond at any date subsequent to the initial

borrowing equals the present value of the future, or remaining, cash flows discounted at an appropriate interest

8. The internal rate of return, often called yield to maturity, is the discount rate that equates the future cash

10. Common terminology refers to the calculations for amortizing a financial instrument to its maturity value

12. When the coupon rate equals the historical market interest rate or initial yield to maturity, then the initial

13. U.S. GAAP and IFRS provide for two methods of accounting for long-term leases: the operating lease

14. Operating leases are economically similar to purchasing assets with funds obtained from issuing long-term

15. Capital leases are economically similar to purchasing assets with funds obtained from issuing long-term

16. When analyzing leases, the risks of ownership include the risk of interest rate increases, the risk of

17. Firms must disclose in notes to the financial statements the cash flows associated with capital leases and

18. Both the lease asset and the lease liability appear on the lessee’s balance sheet under the capital lease

19. The capital lease method classifies all of the lease payment each period as an operating

22. Big City Electric is a regulated monopoly providing electric services in a large city. Property, plant, and

23. Charm City Electric is a regulated monopoly providing electric services in a large city. Property, plant, and

24. Divine Paper, a United States-based company, processes wood pulp into paper products in fixed-asset

intensive facilities. It has a large ratio of property, plant, and equipment to total assets and a high debt-equity

25. Excellent Paper, a United States-based company, processes wood pulp into paper products in fixed-asset

intensive facilities. It has a large ratio of property, plant, and equipment to total assets and a high debt-equity

26. First Communications Group is a communication services firm whose employees provide advertising,

market research, public relations, and other services world-wide. Other than relatively small amounts of

equipment, it owns virtually no property, plant, and equipment (it leases most of its office space). Which of the

27. General Semiconductor is a European-based designer and manufacturer of semiconductors. It manufactures

semiconductors in fixed-asset intensive plants. The moderate fraction of its total assets that are property, plant,

and equipment results from depreciating its technology-intensive manufacturing facilities over periods as short

28. Firms that need cash for long-term purposes, such as acquiring buildings and equipment or financing a

29. Firms that need cash for long-term purposes, such as acquiring buildings and equipment or financing a

33. A _____ is a financial contract in which the borrower and the lender agree to certain conditions about

37. A zero coupon bond provides for _____ periodic payments of interest while the bond is outstanding; and the

38. A _____ bond requires periodic payments of interest plus a portion of the principal throughout the life of the

39. Some bonds are _____, which means the issuing firm has the right to repurchase the bonds prior to maturity

40. Investors in bonds sometimes hold a _____ option, meaning they can force the issuing company to repay the

41. Investors in bonds might exercise a _____ option if interest rates increase, and investors can reinvest the

42. The typical _____ bond pays interest periodically, usually every six months, during the life of the bond and

43. _____bonds permit the holder to exchange the bonds for shares of the firm’s common stock under certain

44. The conversion option of convertible bonds has value because the holder can benefit from some of the later

45. What determine(s) the risk of investing in a bond issue, which in turn affects the interest rate investors

47. _____ of a note or bond at any date subsequent to the initial borrowing equals the present value of the

48. The amount borrowed initially and the market value of a note or bond at any date subsequent to the initial

50. The approach which dominates current financial reporting of financial instruments [uses the historical

market interest rate to compute the carrying value of notes and bonds while these obligations are outstanding] is

51. Firms typically borrow from banks, insurance companies, and other financial institutions by signing a note,

52. When the stated interest rate for a loan equals the yield required by the lender, then the amount borrowed

54. _____ often advise corporate borrowers on the sorts of financial instruments the lending market appears to

55. Bonds whose indentures contain a provision which gives the issuing company the option to retire portions of

the bond issue before maturity if it so desires, but the provision does not require the company to do so are called

57. A firm classifies mortgages, notes, bonds, and leases which were used to acquire its long-term assets that

58. When the bond indenture provides that stated amounts of principal will become due during the term of the

60. Bonds whose indentures contain a provision which requires the issuing firm to make a provision for partial

62. In return for promising to make future payments, a firm receives cash or other assets with a measurable

cash-equivalent value. The firm records a long-term liability for that amount and the book value of that

63. In return for promising to make future payments, a firm receives cash or other assets with a measurable

cash-equivalent value. The firm records a long-term liability for that amount and determines the market interest

65. Borrowers who retire long-term liabilities debit the liability account for its current book value, credit Cash,

66. Bonds whose indentures contain a provision which requires the issuing firm to make a provision for partial

68. In historical cost accounting, the discounting process uses the original interest rate appropriate for the

particular borrower at the time it incurred the obligation. That rate will have depended on the amount and terms

of the borrowing arrangement as well as the risk that the borrower will default on the obligations. The rate is

69. A document or agreement giving the terms of the bond and the rights and duties of the borrower and other

parties to the contract that provides some protection to the bondholders and typically limits the borrower's right

70. The most common type of corporate bond, except in the railroad and public utility industries, that carries no

71. A bond that does not require a periodic cash payment, but instead promises a single payment at maturity, is

72. Debentures that the holder (lender) can exchange, possible after some specific period of time has elapsed,

for a specific number of shares of common stock or, perhaps, preferred stock of the borrower are called _____

73. Common terminology refers to the calculations for amortizing a financial instrument to its maturity value

75. An initial issue price equal to the face value of the bonds means that the implicit interest rate equals the

76. On January 1, Year 4, Jones Realty Company issued 8 percent term bonds with a face amount of $1 million

due January 1, Year 14. Interest is payable semi-annually on January 1 and July 1. On the date of issue,

investors were willing to accept an effective interest rate of 6 percent. Assume the bonds were issued on

January 1, Year 4. for $1,148,959. Using the effective interest amortization method, Jones Realty Company

77. On January 1, Year 4, Jones Realty Company issued 8 percent term bonds with a face amount of $1 million

due January 1, Year 14. Interest is payable semi-annually on January 1 and July 1. On the date of issue,

investors were willing to accept an effective interest rate of 6 percent. Assume the bonds were issued on

78. On February 1, Year 1, Centra issues $100,000 semi-annual 12% bonds at par plus accrued interest. The

interest is payable on July 1 and January 1 of each year. What entry is necessary to record the issuance of the

79. In Year 7, Nortel Manufacturing issued $100,000 semi-annual 12% bonds at par. Interest is payable on July

81. Fox Co., Inc.

On January 1, Year 1, Fox Co., Inc., issues $100,000 par value, 10% bonds maturing in 10 years to yield 12%

per year, compounded semiannually on January 1 and July 1. Use the present value tables.

Refer to the Fox Co. Inc. example. What is the bonds payable account (net of any bond discount or premium)

82. Fox Co., Inc.

On January 1, Year 1, Fox Co., Inc., issues $100,000 par value, 10% bonds maturing in 10 years to yield 12%

per year, compounded semiannually on January 1 and July 1. Use the present value tables.

84. (CMA adapted, Jun 86 #5) A bond issue sold at a premium is valued on the statement of financial position

85. (CMA adapted, Dec 86 #20) On January 1, Year 1, Nicole Company sold its 5-year, $100,000 face value,

8% bonds at $108,530, to yield an effective annual interest rate of 6%. The bonds are dated January 1, Year 1,

and interest is payable annually on January 1. Using the effective interest method of premium amortization, the

86. Heather Corporation

Heather Corporation issued $2,000,000, 10-percent, 10-year bonds on January 2, Year 2. The bonds pay interest

semiannually on January 1 and July 1. The bonds were priced on the market to yield 8 percent.

87. (CMA adapted, Dec 90 #12) Marla, Inc. issued $6,000,000 of 12% bonds on December 1, Year 1, due on

December 1, Year 6, with interest payable each December 1 and June 1. The bonds sold for $5,194,770 to yield

16%. If the discount is amortized by the effective interest method, Marla, Inc.'s interest expense for the fiscal

88. U.S. GAAP and IFRS permit firms to account for notes and bonds under which of the following

89. The FASB and the IASB refer to the approach that uses the current market interest rate instead of the

90. A firm that does not account for long-term notes and bonds using the fair value option, uses the _____ to

91. Authoritative guidance requires firms that account for notes and bonds using the _____ market interest rate

to report the carrying values, or book values, on the balance sheet and to disclose the _____ of these notes and

95. The capital lease method is appropriate when the lessee enjoys most of the _____ and bears most of the

96. The operating lease method is appropriate when the lessor enjoys most of the _____ and bears most of the

100. The capital lease method classifies the portion of the lease payment related to interest expense as an

104. Firms must disclose in notes to the financial statements the cash flows associated with capital leases and

with operating leases for each of the succeeding _____ years and for all years after _____ years in the

110. (CMA adapted, Dec 92 #10) There are many similarities between lessee and lessor accounting for the

111. Henson Manufacturing Company signed a 3-year contract for the use of certain manufacturing equipment

with an estimated life of three years. Henson Manufacturing Company cannot cancel the contract. What entry is

112. Quan Restaurant

On January 1, Year 7, Quan Restaurant is planning to enter as the lessee into the two lease agreements

described below. Each lease is noncancelable, and Quan does not receive title to either leased property during or

at the end of the lease term. All payments required under these agreements are due on January 1 each year.

Present value factor at 10% (of an annuity due)

6.76

2.74

113. Quan Restaurant

On January 1, Year 7, Quan Restaurant is planning to enter as the lessee into the two lease agreements

described below. Each lease is noncancelable, and Quan does not receive title to either leased property during or

at the end of the lease term. All payments required under these agreements are due on January 1 each year.

Present value factor at 10% (of an annuity due)

6.76

2.74

(CMA adapted, Dec 93 #28) Refer to the Quan Restaurant example. Quan Restaurant should treat the lease agreement with Cutter Electronics as

114. On January 1, Year 1, Lamp Company acquires new equipment in exchange for a note. Lamp must pay a

lump sum of $32,000 on December 31, Year 3. The equipment is being specifically manufactured for Lamp, so

no market price exists for the equipment. On similar types of equipment purchases, Lamp has paid 15% interest.

The equipment has a five-year life and the company uses straight-line depreciation with a 10% salvage value.

Required:

Prepare journal entries to record the following:

115. On January 1, Year 6, Pearson Corporation issued $1,000,000 face value, 20-year bonds. The bonds carry

coupon interest of 6 percent per year, payable semiannually on June 30 and December 31. The bonds were

initially priced on the market to yield 8 percent, compounded semiannually (for an effective annualized yield

greater than 8 percent).

Required:

Compute the issue price of these bonds on January 1, Year 6.

Compute the amount of interest expense on these bonds for Year 6, assuming that the firm uses the effective-interest method of amortizing

bond premium or discount.

116. Rotor Corporation issues $10,000,000 face value, 10-year, 6% semiannual coupon bonds

on January 1, 2013. The bonds require coupon payments on June 30 and December 31 of

each year. The market initially priced the bonds to yield 6% compounded semiannually.

The current market yield on these bonds was 6.2% compounded semiannually on June 30,

2013, and 6.6% compounded semiannually on December 31, 2008. Rotor Corporation

computes interest expense for each six-month period using the market yield at the beginning

of the period.

Required:

117. Indicate whether each of the following independent transactions is a capital (C) or operating (O) lease.

118. The annual report of Sign Corporation for Year 1 reports capital leases requiring payments totaling $228

million over future years, including $58 million payable at the end of Year 2. The interest rate on these

obligations is 12 percent and their present value (discounted at 12 percent) at the end of Year 1 was $181

million. The assets financed by capital leases appear on the Year 1 year-end balance sheet at $220 million.

Assume no new leases were entered into during Year 2 and that leasehold assets have a remaining useful life of

10 years at the start of Year 2, but no salvage value. Ignore income taxes.

Required:

119. ALT Company, as tenant, acquired for $600,000, paid in a single amount, the right to use an entire office

building for the next ten years. ALT expects to rent out the floors in the building to various commercial tenants.

As tenant, ALT accounts for its lease as a capital lease amortizing the leasehold asset on a straight-line basis

over ten years. ALT, as landlord, signed operating leases with the tenants for all of the rentable space. The rents

total $150,000 received at the end of each year for the next ten years, $1.5 million in total.

Required:

120. Bolton Co. leases workout equipment to health clubs. On January 1, Year 1, Bolton Co. leases to

121. Raines Corporation entered into a five-year lease for a computer on January 1, Year 3. The lease requires

Raines to make equal payments of $20,000 on January 1 each year for the five years of the lease, with the first

payment made on January 1, Year 3. Raines’ borrowing rate is 10 percent. Raines uses the straight-line

depreciation method for financial reporting. It estimates a zero salvage value. The accounting period is the

calendar year. Round amounts to the nearest dollar.

Required:

122. The following information is available from the comparative balance sheets and related income statement

of the Horner Company for the year ended December 31, Year 7.

December 31,

Year 6

Year 7

Present value of lease obligation

$2,040,508.60

$1,862,939.10

123. Describe the sources of long-term debt financing.

124. Consider a firm that recently issued bonds. Further, consider that the firm also set up a bond sinking fund.

Required:

Why would a firm create a long-term liability?

Why would a firm set up a bond sinking fund?

If a firm paid $10,000 into its bond sinking fund at the end of the year, how would this transaction be journalized?

125. Part 1: Briefly explain a bond contract and its relationship to cash flows.

126. How are bonds measured at issuance?

127. Describe what bond provisions exist.

128. What are the cash flows patterns related to bonds?

129. When a company issues bonds, it must sometimes issue them at a discount, while at other times it will

issue them at a premium.

130. What are the general principles for measuring financial instruments?

131. How are notes valued and accounted for under the authoritative guidance?

132. What are the requirements for the disclosure of the carrying and fair values of debt?

133. Discuss the fair value option in accounting for certain assets and liabilities.

134. Describe the various methodologies in accounting for leases.

135. Describe the effect of the operating and capital lease methods on the financial statements of the lessee.

136. What factors enter into choosing the accounting method for leases under U.S. GAAP and IFRS?

137. How does a lessor account for leases?

138. What are the effect of the operating and capital lease methods on the financial statements of the lessor?

139. What disclosures are required for leases?

Chapter 11: Notes, Bonds, and Leases Key

1. Firms typically finance long-term assets, particularly property, plant, and equipment, with long-term

2. The more long-term debt in a firm’s capital structure, the less the risk that the firm will experience difficulty

4. Modern business usage has come to restrict the word equity to mean only shareholders’ equity, both

7. The amount borrowed initially and the market value of a note or bond at any date subsequent to the initial

borrowing equals the present value of the future, or remaining, cash flows discounted at an appropriate interest

8. The internal rate of return, often called yield to maturity, is the discount rate that equates the future cash

10. Common terminology refers to the calculations for amortizing a financial instrument to its maturity value

12. When the coupon rate equals the historical market interest rate or initial yield to maturity, then the initial

13. U.S. GAAP and IFRS provide for two methods of accounting for long-term leases: the operating lease

14. Operating leases are economically similar to purchasing assets with funds obtained from issuing long-term

15. Capital leases are economically similar to purchasing assets with funds obtained from issuing long-term

16. When analyzing leases, the risks of ownership include the risk of interest rate increases, the risk of

17. Firms must disclose in notes to the financial statements the cash flows associated with capital leases and

18. Both the lease asset and the lease liability appear on the lessee’s balance sheet under the capital lease

19. The capital lease method classifies all of the lease payment each period as an operating

22. Big City Electric is a regulated monopoly providing electric services in a large city. Property, plant, and