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CHAPTER 14

BONDS PAYABLE AND


INVESTMENTS IN BONDS
CLASS DISCUSSION QUESTIONS
1. (1) To pay the face (maturity) amount of the
bonds at a specified date. (2) To pay
periodic interest at a specified percentage of
the face amount.
2. a. Bonds that may be exchanged for other
securities under specified conditions.
b. The issuing corporation reserves the
right to redeem the bonds before the
maturity date.
c. Bonds issued on the basis of the
general credit of the corporation.
3. The phrase time value of money means
that an amount of cash to be received today
is worth more than the same amount of
cash to be received in the future. This is
because cash on hand today can be
invested to earn income.
4. (b) $2,500 to be received at the end of each
of the next two years has the higher present
value.
5. Less
than
face
amount.
Because
comparable investments in bonds provide a
market interest rate (7%) that is greater than
the rate on the bond being purchased (6%),
the bond will sell at a discount as the
markets means of equalizing the two
interest rates.
6. a. Greater than $10,000,000
b. 1. $10,000,000
2. 5%
3. 6%
4. $10,000,000
7. Less than the contract rate
8. a. Premium
b. $150,000
c. Premium on Bonds Payable

9. a. Debit Interest Expense


Credit Discount on Bonds Payable
b. Debit Premium on Bonds Payable
Credit Interest Expense
10. No. Because zero-coupon bonds do not
provide for interest payments, they will sell
at a discount.
11. The purpose of a bond sinking fund is to
accumulate over the life of a bond issue
enough funds to pay the indebtedness at the
maturity date.
12. Earnings from investments in a sinking fund
are reported on the income statement as
Other Income.
13. Investments
14. The bond issue that is callable is more risky
for investors, because the company may
redeem (call) the bond issue if interest rates
fall. In addition, since the bonds may be
called at their face amount, they will sell for
a lower value than the noncallable bond
issue.
15. A loss of $5,000 [($750,000 0.99)
($750,000 $12,500)]
16. Gains or losses on bond redemptions are
reported as extraordinary items on the
income statement.
17. Investment in Bonds; Interest Revenue
18. a. As an addition to Bonds Payable
b. As a deduction from Bonds Payable
19. Under the caption Investments
20. At their cost less any amortized premium or
plus any amortized discount

89

EXERCISES
Ex. 141

a.

Earnings before bond interest and income tax............


Bond interest...................................................................
Balance.............................................................................
Income tax........................................................................
Net income.......................................................................
Dividends on preferred stock........................................
Earnings available for common stock..........................

Compatriot
Co.
$ 1,000,000
400,000
$ 600,000
240,000
$ 360,000
300,000
$
60,000

Earnings per share on common stock..........................

b. Earnings before bond interest and income tax............


Bond interest...................................................................
Balance.............................................................................
Income tax........................................................................
Net income.......................................................................
Dividends on preferred stock........................................
Earnings available for common stock..........................
c.

0.30

$ 1,500,000
400,000
$ 1,100,000
440,000
$ 660,000
300,000
$ 360,000

Earnings per share on common stock..........................

1.80

Earnings before bond interest and income tax...........


Bond interest...................................................................
Balance.............................................................................
Income tax........................................................................
Net income.......................................................................
Dividends on preferred stock........................................
Earnings available for common stock..........................

$ 2,500,000
400,000
$ 2,100,000
840,000
$ 1,260,000
300,000
$ 960,000

Earnings per share on common stock..........................

4.80

Ex. 142
Factors other than earnings per share that should be considered in evaluating
financing plans include: bonds represent a fixed annual interest requirement,
while dividends on stock do not; bonds require the repayment of principal, while
stock does not; and common stock represents a voting interest in the ownership
of the corporation, while bonds do not.

Ex. 143
a. Cisco Systems major source of financing is common stock. Although it has
established a line of credit, it has not borrowed any monies under this
agreement.
b. Cisco Systems has relatively little investment in property and equipment.
Instead, it has chosen to lease its fixed assets.

Ex. 144
a. $10,000 1.06 = $9,434
$ 9,434 1.06 = $8,900
$ 8,900 1.06 = $8,396
b. $10,000 0.83962 = $8,396.20*
*The difference of $0.20 between answers (a) and (b) is due to rounding.

Ex. 145
a. First Year:
$6,000 0.95238 =
Second Year: $6,000 0.90703 =
Third Year:
$6,000 0.86384 =
Fourth Year: $6,000 0.82270 =
Total present value

$ 5,714.28
5,442.18
5,183.04
4,936.20
$ 21,275.70

b. $6,000 3.54595 = $21,275.70

Ex. 146
$400,000 11.65358 = $4,661,432

Ex. 147
No. The present value of your winnings using an interest rate of 14% is $2,749,172
($400,000 6.87293), which is more than one-half of the present value of your
winnings using an interest rate of 7% ($4,661,432; see Ex. 146). This is because
of the effect of compounding the interest.

Ex. 148
Present value of $1 for 10 (semiannual)
periods at 5% (semiannual rate)...........................
Face amount of bonds................................................
Present value of an annuity of $1
for 10 periods at 5%...............................................
Semiannual interest payment....................................
Total present value (proceeds)..................................

0.61391
$ 8,000,000
$

7.72174
360,000

$ 4,911,280
2,779,826
$ 7,691,106

Ex. 149
Present value of $1 for 10 (semiannual)
periods at 5 1/2% (semiannual rate)....................
Face amount of bonds................................................
Present value of an annuity of $1
for 10 periods at 5 1/2%.........................................
Semiannual interest payment....................................
Total present value (proceeds)..................................

0.58543
$10,000,000
$

7.53763
600,000

$ 5,854,300
4,522,578
$10,376,878

Ex. 1410
The bonds were selling at a premium. This is indicated by the selling price of
102 5/8, which is stated as a percentage of face amount and is more than par
(100%). The market rate of interest for similar quality bonds was lower than
7 1/2% on September 7, 2000, and this is why the bonds are selling at a premium.

Ex. 1411
Apr.

Cash....................................................................... 12,000,000
Bonds Payable......................................................
12,000,000

Oct.

Interest Expense...................................................
Cash.......................................................................

540,000

Interest Expense...................................................
Interest Payable....................................................

270,000

Dec. 31

540,000
270,000

Ex. 1412
a.

1. Cash.............................................................................
Discount on Bonds Payable.....................................
Bonds Payable......................................................

4,434,676
565,324

2. Interest Expense........................................................
Cash.......................................................................

200,000

3. Interest Expense........................................................
Cash.......................................................................

200,000

4. Interest Expense........................................................
Discount on Bonds Payable................................
$565,324 5 years = $113,065

113,065

5,000,000
200,000
200,000
113,065

b. Annual interest paid........................................................


Plus discount amortized.................................................
Interest expense for first year........................................

$ 400,000
113,065
$ 513,065

Note: The following data in support of the proceeds of the bond issue stated
in the exercise are presented for the instructors information. Students are
not required to make the computations.
Present value of $1 for 10 (semiannual)
periods at 5 1/2% (semiannual rate)...................
Face amount..........................................................
Present value of annuity of $1 for 10
periods at 5 1/2%..................................................
Semiannual interest payment..............................
Total present value of bonds payable................

0.58543
$ 5,000,000 $ 2,927,150

7.53763
$200,000

1,507,526
$ 4,434,676

Ex. 1413
a.

Cash.............................................................................
Premium on Bonds Payable................................
Bonds Payable......................................................

10,386,057
386,057
10,000,000

Note: The following data are in support of the determination of the proceeds
of the bond issue stated in the exercise:
Present value of $1 for 10 (semiannual)
periods at 5% (semiannual rate).........................
0.61391
Face amount............................................................... $10,000,000

$ 6,139,100

Present value of an annuity of $1 for 10


periods at 5%........................................................
Semiannual interest payment...................................
Proceeds.....................................................................

4,246,957
$10,386,057

b. Interest Expense........................................................
Premium on Bonds Payable.....................................
Cash.......................................................................

7.72174
$550,000
511,394
38,606*

550,000

*$386,057 10 semiannual payments

Ex. 1414
2003
Mar. 1
Sept. 1
2007
Sept. 1

Cash....................................................................... 15,000,000
Bonds Payable..................................................
15,000,000
Interest Expense...................................................
Cash...................................................................

600,000
600,000

Bonds Payable...................................................... 15,000,000


Loss on Redemption of Bonds...........................
150,000
Cash...................................................................
15,150,000

Ex. 1415
2003
June 1
Dec.

2008
Dec. 1

Cash....................................................................... 20,000,000
Bonds Payable..................................................
20,000,000
Interest Expense...................................................
Cash...................................................................

900,000
900,000

Bonds Payable...................................................... 20,000,000


Gain on Redemption of Bonds.......................
200,000
Cash...................................................................
19,800,000

Ex. 1416
1. The significant loss on redemption of the series A bonds should be reported
in the income statement separately as an extraordinary loss, not as part of
Other Expense.
2. The series B bonds outstanding at the end of the current year should be
reported as a noncurrent liability on the balance sheet because they are to be
paid from funds set aside in a sinking fund.

Ex. 1417
The discount of $811 ($1,000 $189) is amortized as interest revenue over the life
of the bonds, using the straight-line method (illustrated in this chapter) or the
interest method (illustrated in the appendix to this chapter).

Ex. 1418
a.

Investment in Glitz Co. Bonds.......................................


Interest Revenue..............................................................
Cash.............................................................................

307,500
6,000

b. Cash..................................................................................
Interest Revenue........................................................

12,000

c.

313,500
12,000

Interest Revenue..............................................................
Investment in Glitz Co. Bonds..................................

250

d. Cash..................................................................................
Loss on Sale of Investments..........................................
Investment in Glitz Co. Bonds..................................
Interest Revenue........................................................

297,500
7,000

250

302,500
2,000

Ex. 1419
a.

Investment in Sequoyah Co. Bonds..............................


Interest Revenue..............................................................
Cash.............................................................................

172,800
1,500

b. Cash..................................................................................
Interest Revenue........................................................

4,500

c.

Investment in Sequoyah Co. Bonds..............................


Interest Revenue........................................................

1,440

d. Cash..................................................................................
Investment in Sequoyah Co. Bonds.........................
Gain on Sale of Investments.....................................
Interest Revenue........................................................

181,200

174,300
4,500
1,440
176,300
1,900
3,000

Ex. 1420
a.

Current year:
Number of times interest charges earned: 2.0 =
Preceding year:
Number of times interest charges earned: 5.7 =

$135,178,000 $130,598,000
$130,598,0 00
$329,079,0 00 $70,350,00 0
$70,350,00 0

b. The number of times interest charges earned has declined from 5.7 to 2.0 in
the current year. This would potentially cause concern among debtholders.

Appendix Ex. 1421


a.

1. Cash.............................................................................
Discount on Bonds Payable.....................................
Bonds Payable......................................................

4,434,676
565,324

2. Interest Expense........................................................
Cash.......................................................................

200,000

3. Interest Expense........................................................
Cash.......................................................................

200,000

4. Interest Expense........................................................
Discount on Bonds Payable................................

90,229

5,000,000
200,000
200,000
90,229

Computations:
$4,434,676 0.055 = $243,907
$243,907 $200,000 = $43,907 first semiannual amortization
$4,434,676 + $43,907 = $4,478,583
$4,478,583 0.055 = $246,322
$246,322 $200,000 = $46,322 second semiannual amortization
$43,907 + $46,322 = $90,229 amortization for first year
Note: The following data in support of the proceeds of the bond issue stated
in the exercise are presented for the instructors information. Students are
not required to make the computations.
Present value of $1 for 10 (semiannual)
periods at 5 1/2% (semiannual rate)...................
Face amount...............................................................
Present value of annuity of $1 for
10 periods at 5 1/2%.............................................
Semiannual interest payment...................................
Total present value of bonds payable.....................
b. Annual interest paid........................................................
Plus discount amortized.................................................
Interest expense for first year........................................

0.58543
$5,000,000 $ 2,927,150

7.53763
$200,000

1,507,526
$ 4,434,676
$400,000
90,229
$490,229

Appendix Ex. 1422


a.

1. Interest Expense........................................................
Cash.......................................................................

550,000

2. Interest Expense........................................................
Cash.......................................................................

550,000

3. Premium on Bonds Payable.....................................


Interest Expense...................................................

62,929

550,000
550,000
62,929

Computations:
$10,386,057 5% = $519,303
$550,000 $519,303 = $30,697 first semiannual amortization
$10,386,057 $30,697 = $10,355,360
$10,355,360 5% = $517,768
$550,000 $517,768= $32,232 second semiannual amortization
$30,697 + $32,232 = $62,929 first year amortization
b. Annual interest paid........................................................
Less premium amortized................................................
Interest expense for first year........................................

$1,100,000
62,929
$1,037,071

Appendix Ex. 1423


a.

Present value of $1 for 10 (semiannual)


periods at 5 1/2% (semiannual rate)...................
0.58543
Face amount............................................................... $25,000,000

$14,635,750

Present value of annuity of $1 for 10


periods at 5 1/2%..................................................
7.53763
Semiannual interest payment................................... $1,500,000
Proceeds of bond sale..............................................

11,306,445
$25,942,195

b. First semiannual interest payment..........................


5 1/2% of carrying amount of $25,942,195..............
Premium amortized....................................................

$ 1,500,000
1,426,821
$
73,179

c.

$ 1,500,000
1,422,796
$
77,204

Second semiannual interest payment.....................


5 1/2% of carrying amount of $25,869,016*.............
Premium amortized....................................................
*$25,942,195 $73,179 = $25,869,016

d. Annual interest paid...................................................


Less premium amortized...........................................
Interest expense for first year..................................
*$73,179 + $77,204 = $150,383

$ 3,000,000
150,383*
$ 2,849,617

Appendix Ex. 1424


a.

Present value of $1 for 10 (semiannual)


periods at 6% (semiannual rate).........................
0.55840
Face amount............................................................... $14,000,000
Present value of annuity of $1 for 10 periods at 6%...
7.36009
Semiannual interest payment...................................
$700,000
Proceeds of bond sale..............................................

$ 7,817,600
5,152,063
$12,969,663

b. 6% of carrying amount of $12,969,663.....................


First semiannual interest payment..........................
Discount amortized....................................................

c.

6% of carrying amount of $13,047,843*...................


Second semiannual interest payment.....................
Discount amortized....................................................

778,180
700,000
78,180
782,871
700,000
82,871

*$12,969,663 + $78,180 = $13,047,843


d. Annual interest paid...................................................
Plus discount amortized...........................................
Interest expense first year........................................
*$78,180 + $82,871 = $161,051

$ 1,400,000
161,051*
$ 1,561,051

PROBLEMS
Prob. 141A
1.
Earnings before interest and income tax......
Deduct interest on bonds................................
Income before income tax...............................
Deduct income tax...........................................
Net income........................................................
Dividends on preferred stock.........................
Available for dividends on common stock....
Shares of common stock outstanding...........
Earnings per share on common stock...........

Plan 1
$ 2,500,000

$ 2,500,000
1,000,000
$ 1,500,000

$ 1,500,000
500,000
$
3.00

Plan 2
$ 2,500,000

$ 2,500,000
1,000,000
$ 1,500,000
600,000
$ 900,000
250,000
$
3.60

Plan 3
$ 2,500,000
750,000
$ 1,750,000
700,000
$ 1,050,000
400,000
$ 650,000
125,000
$
5.20

2.
Earnings before interest and income tax......
Deduct interest on bonds................................
Income before income tax...............................
Deduct income tax...........................................
Net income........................................................
Dividends on preferred stock.........................
Available for dividends on common stock....
Shares of common stock outstanding...........
Earnings per share on common stock...........

Plan 1
$ 1,500,000

$ 1,500,000
600,000
$ 900,000

$ 900,000
500,000
$
1.80

Plan 2
$ 1,500,000

$ 1,500,000
600,000
$ 900,000
600,000
$ 300,000
250,000
$
1.20

Plan 3
$ 1,500,000
750,000
$ 750,000
300,000
$ 450,000
400,000
$
50,000
125,000
$
0.40

Prob. 141A

Concluded

3. The principal advantage of Plan 1 is that it involves only the issuance of


common stock, which does not require a periodic interest payment or return
of principal, and a payment of preferred dividends is not required. It is also
more attractive to common shareholders than is Plan 2 or 3 if earnings before
interest and income tax is $1,500,000. In this case, it has the largest EPS
($1.80). The principal disadvantage of Plan 1 is that it requires an additional
investment by present common shareholders to retain their current interest in
the company. Also, if earnings before interest and income tax is $2,500,000,
this plan offers the lowest EPS ($3.00) on common stock.
The principal advantage of Plan 3 is that little additional investment would
need to be made by common shareholders for them to retain their current
interest in the company. Also, it offers the largest EPS ($5.20) if earnings
before interest and income tax is $2,500,000. Its principal disadvantage is that
the bonds carry a fixed annual interest charge and require the payment of
principal. It also requires a dividend payment to preferred stockholders
before a common dividend can be paid. Finally, Plan 3 provides the lowest
EPS ($0.40) if earnings before interest and income tax is $1,500,000.
Plan 2 provides a middle ground in terms of the advantages and
disadvantages described in the preceding paragraphs for Plans 1 and 3.

Prob. 142A
1.

Cash.............................................................................
Premium on Bonds Payable................................
Bonds Payable......................................................

8,498,492*
498,492
8,000,000

*Present value of $1 for 20 (semiannual)


periods at 5% (semiannual rate).........................
0.37689
Face amount............................................................... $8,000,000
Present value of an annuity of $1 for 20
periods at 5%........................................................
12.46221
Semiannual interest payment................................... $440,000
Proceeds of bond issue............................................
2.

a. Interest Expense...................................................
Premium on Bonds Payable ($498,492 20).....
Cash..................................................................

415,075
24,925

b. Interest Expense...................................................
Premium on Bonds Payable................................
Cash..................................................................

415,075
24,925

$ 3,015,120
5,483,372
$ 8,498,492

440,000

440,000

3.

$415,075

4.

Yes. Investors will be willing to pay more than the face amount of the bonds
when the interest payments they will receive from the bonds exceed the
amount of interest that they could receive from investing in other bonds.

Prob. 142A

Concluded

This solution is applicable only if the GENERAL LEDGER SOFTWARE that


accompanies this text is used.
MORESBY INC.
Balance Sheet
December 31, 2003
Assets
Cash .................................................................
Accounts receivable.........................................
Merchandise inventory....................................
Prepaid insurance............................................
Supplies.............................................................
Total current assets....................................

$ 9,356,392
228,950
2,681,650
139,650
182,950
$12,589,592

Equipment......................................................... $ 1,390,000
Accum. depreciationequipment.............
109,600 $ 1,280,400
Building............................................................. $ 5,405,000
Accum. depreciationbuilding.................
672,000
Total plant assets.....................................

4,733,000
6,013,400

Total assets.......................................................
Liabilities
Accounts payable.............................................
Bonds payable..................................................
Premium on bonds payable............................
Total long-term liabilities...........................

$18,602,992
$

32,000

$ 8,000,000
448,642
8,448,642

Total liabilities...................................................

$ 8,480,642

Stockholders Equity
Paid-in capital:
Preferred stock............................................ $ 2,100,000
Excess of issue price over parPS.........
172,500
Common stock............................................ 4,500,000
Excess of issue price over parCS......... 1,100,000
From sale of treasury stock.......................
2,000
Total paid-in capital.................................
$ 7,874,500
Retained earnings............................................
2,467,850
Total..............................................................
Deduct treasury stock......................................
Total stockholders equity...............................
Total liabilities and stockholders equity.......

$ 10,342,350
220,000
10,122,350
$18,602,992

Prob. 143A
1.

Cash.............................................................................
Discount on Bonds Payable.....................................
Bonds Payable......................................................

9,376,895*
623,105
10,000,000

*Present value of $1 for 20 (semiannual)


periods at 5% (semiannual rate).........................
0.37689
Face amount............................................................... $10,000,000
Present value of an annuity of $1 for 20
periods at 5%........................................................
12.46221
Semiannual interest payment...................................
$450,000
Proceeds of bond issue............................................
2.

a. Interest Expense...................................................
Discount on Bonds Payable
($623,105 20).................................................
Cash..................................................................

481,155

b. Interest Expense...................................................
Discount on Bonds Payable..........................
Cash..................................................................

481,155

$ 3,768,900
5,607,995
$ 9,376,895

31,155
450,000
31,155
450,000

3.

$481,155

4.

Yes. Investors will not be willing to pay the face amount of the bonds when
the interest payments they will receive from the bonds are less than the
amount of interest that they could receive from investing in other bonds.

Prob. 143A

Concluded

This solution is applicable only if the GENERAL LEDGER SOFTWARE that


accompanies this text is used.
CUCUMBER COMMUNICATIONS EQUIPMENT INC.
Balance Sheet
June 30, 2003
Assets
Cash ..............................................................
Accounts receivable......................................
Merchandise inventory..................................
Prepaid insurance..........................................
Supplies..........................................................
Total current assets.................................
Equipment......................................................
Accumulated depreciationequipment
Total plant assets..................................

$ 8,869,695
602,200
809,300
46,400
85,000
$ 10,412,595
$ 1,132,900
69,000
1,063,900

Total assets....................................................

$ 11,476,495

Liabilities
Accounts payable..........................................
$ 835,100
Bonds payable............................................... $10,000,000
Discount on bonds payable..........................
560,795
Total long-term liabilities..........................
9,439,205
Total liabilities...................................................

$ 10,274,305

Stockholders Equity
Paid-in capital:
Preferred stock......................................... $
600,000
Excess of issue price over parPS.......
75,000
Common stock.........................................
400,000
Excess of issue price over parCS.......
200,000
From sale of treasury stock....................
11,000
Total paid-in capital...............................
$ 1,286,000
Deficit..............................................................
62,810
Total...........................................................
Deduct treasury stock...................................
Total stockholders equity............................
Total liabilities and stockholders equity....

$ 1,223,190
21,000
1,202,190
$ 11,476,495

Prob. 144A
1.
2002
July

Dec.

2003
June
Dec.

2004
July

1 Cash................................................................ 21,472,126
Premium on Bonds Payable....................
1,472,126
Bonds Payable..........................................
20,000,000
31 Interest Expense............................................
Cash...........................................................

1,400,000

31 Premium on Bonds Payable.........................


Interest Expense.......................................

147,213

31 Income Summary...........................................
Interest Expense.......................................

1,252,787

30 Interest Expense............................................
Cash...........................................................

1,400,000

31 Interest Expense............................................
Cash...........................................................

1,400,000

31 Premium on Bonds Payable.........................


Interest Expense.......................................

294,425

31 Income Summary...........................................
Interest Expense.......................................

2,505,575

1,400,000
147,213
1,252,787

1,400,000
1,400,000
294,425
2,505,575

1 Bonds Payable............................................... 20,000,000


Premium on Bonds Payable.........................
883,275
Gain on Redemption on Bonds..............
483,275
Cash...........................................................
20,400,000

2.

a.
b.

2002: $1,252,787
2003: $2,505,575

3.

Initial carrying amount of bonds....................................


Premium amortized on December 31, 2002..................
Premium amortized on December 31, 2003..................
Carrying amount of bonds, December 31, 2003...........

$21,472,126
(147,213)
(294,425)
$21,030,488

Prob. 144A

Concluded

This solution is applicable only if the GENERAL LEDGER SOFTWARE that


accompanies this text is used.
DOWNING CO.
Balance Sheet
July 1, 2004
Assets
Cash ............................................................
Accounts receivable...................................
Merchandise inventory...............................
Prepaid insurance.......................................
Supplies.......................................................
Total current assets..............................

$ 2,110,044
728,950
4,681,650
139,650
182,950
$ 7,843,244

Equipment....................................................
Accum. depreciationequipment.......

$ 2,390,000
109,600

$ 2,280,400

Building........................................................
Accum. depreciationbuilding...........
Total plant assets...............................

$ 7,405,000
772,018

6,632,982
8,913,382

Total assets.................................................

$ 16,756,626

Liabilities
Accounts payable.......................................

32,000

Stockholders Equity
Paid-in capital:
Preferred stock......................................
Excess of issue price over parPS....
Common stock.......................................
Excess of issue price over parCS....
From sale of treasury stock.................
Total paid-in capital............................
Retained earnings.......................................
Total........................................................
Deduct treasury stock................................
Total stockholders equity..........................
Total liabilities and stockholders equity.

$ 4,100,000
672,500
6,500,000
1,600,000
2,000
$12,874,500
4,070,126
$16,944,626
220,000
16,724,626
$ 16,756,626

Prob. 145A
2002
Sept. 1

Dec. 31
31
2007
June 30
Oct. 31
31

Dec. 31
31

Investment in Donner Company Bonds.............


Interest Revenue ($500,000 9% 2/12)............
Cash...................................................................

482,150
7,500

Cash.......................................................................
Interest Revenue...............................................

22,500

Investment in Donner Company Bonds.............


Interest Revenue...............................................

300

Cash.......................................................................
Interest Revenue...............................................

22,500

Investment in Donner Company Bonds.............


Interest Revenue...............................................

375

489,650
22,500
300

22,500
375

Cash.......................................................................
248,350*
Loss on Sale of Investments...............................
2,550
Investment in Donner Company Bonds.........
Interest Revenue...............................................
*($250,000 0.965) + ($250,000 9% 4/12) $400
Cash.......................................................................
Interest Revenue...............................................

11,250

Investment in Donner Company Bonds.............


Interest Revenue...............................................

450

243,400
7,500

11,250
450

Appendix Prob. 146A


1.

a. Interest Expense........................................................
Premium on Bonds Payable
[$440,000 (5% $8,498,492)]..................................
Cash.......................................................................

424,925

b. Interest Expense........................................................
Premium on Bonds Payable
[$440,000 (5% $8,483,417)]..................................
Cash.......................................................................

424,171

15,075
440,000

15,829
440,000

2. $424,925

Appendix Prob. 147A


1.

a. Interest Expense........................................................
Discount on Bonds Payable
[($9,376,895 5%) $450,000]............................
Cash.......................................................................

468,845

b. Interest Expense........................................................
Discount on Bonds Payable
[($9,395,740 5%) $450,000]............................
Cash.......................................................................

469,787

2. $468,845

18,845
450,000

19,787
450,000

Prob. 141B
1.
Earnings before interest and income tax......
Deduct interest on bonds................................
Income before income tax...............................
Deduct income tax...........................................
Net income........................................................
Dividends on preferred stock.........................
Available for dividends on common stock....
Shares of common stock outstanding...........
Earnings per share on common stock...........
2.
Earnings before interest and income tax......
Deduct interest on bonds................................
Income before income tax...............................
Deduct income tax...........................................
Net income........................................................
Dividends on preferred stock.........................
Available for dividends on common stock....
Shares of common stock outstanding...........
Earnings per share on common stock...........

Plan 1
$ 5,000,000

$ 5,000,000
2,000,000
$ 3,000,000

$ 3,000,000
1,000,000
$
3.00
Plan 1
800,000

$ 800,000
320,000
$ 480,000

$ 480,000
1,000,000
$
0.48
$

Plan 2
$ 5,000,000

$ 5,000,000
2,000,000
$ 3,000,000
250,000
$ 2,750,000
500,000
$
5.50
$
$
$
$

Plan 2
800,000

800,000
320,000
480,000
250,000
230,000
500,000
0.46

Plan 3
$ 5,000,000
500,000
$ 4,500,000
1,800,000
$ 2,700,000
125,000
$ 2,575,000
250,000
$
10.30
$
$
$
$

Plan 3
800,000
500,000
300,000
120,000
180,000
125,000
55,000
250,000
0.22

Prob. 141B

Concluded

3. The principal advantage of Plan 1 is that it involves only the issuance of


common stock, which does not require a periodic interest payment or return
of principal, and a payment of preferred dividends is not required. It is also
more attractive to common shareholders than is Plan 2 or 3 if earnings before
interest and income tax is $800,000. In this case, it has the largest EPS
($0.48). The principal disadvantage of Plan 1 is that it requires an additional
investment by present common shareholders to retain their current interest in
the company. Also, if earnings before interest and income tax is $5,000,000,
this plan offers the lowest EPS ($3.00) on common stock.
The principal advantage of Plan 3 is that little additional investment would
need to be made by common shareholders for them to retain their current
interest in the company. Also, it offers the largest EPS ($10.30) if earnings
before interest and income tax is $5,000,000. Its principal disadvantage is that
the bonds carry a fixed annual interest charge and require the payment of
principal. It also requires a dividend payment to preferred stockholders
before a common dividend can be paid. Finally, Plan 3 provides the lowest
EPS ($0.22) if earnings before interest and income tax is $800,000.
Plan 2 provides a middle ground in terms of the advantages and
disadvantages described in the preceding paragraphs for Plans 1 and 3.

Prob. 142B
1.

Cash.............................................................................
Premium on Bonds Payable................................
Bonds Payable......................................................

13,495,471*
1,495,471
12,000,000

*Present value of $1 for 20 (semiannual)


periods at 5% (semiannual rate).........................
0.37689
Face amount............................................................... $12,000,000
Present value of an annuity of $1 for 20
periods at 5%........................................................
12.46221
Semiannual interest payment...................................
$720,000
Proceeds of bond issue............................................
2.

a. Interest Expense...................................................
Premium on Bonds Payable ($1,495,471 20). .
Cash..................................................................

645,226
74,774

b. Interest Expense...................................................
Premium on Bonds Payable................................
Cash..................................................................

645,226
74,774

$ 4,522,680
8,972,791
$13,495,471

720,000

720,000

3. $645,226
4. Yes. Investors will be willing to pay more than the face amount of the bonds
when the interest payments they will receive from the bonds exceed the
amount of interest that they could receive from investing in other bonds.

Prob. 142B

Concluded

This solution is applicable only if the GENERAL LEDGER SOFTWARE that


accompanies this text is used.
PARNELL CORPORATION
Balance Sheet
June 30, 2004
Assets
Cash ..............................................................
Accounts receivable......................................
Merchandise inventory..................................
Prepaid insurance..........................................
Supplies..........................................................
Total current assets.................................
Equipment......................................................
Accum. depreciationequipment..........
Total plant assets..................................

$12,448,271
602,200
809,300
46,400
85,000
$13,991,171
$ 1,132,900
69,000
1,063,900

Total assets....................................................

$15,055,071

Liabilities
Accounts payable..........................................
$ 835,100
Bonds payable............................................... $ 12,000,000
Premium on bonds payable..........................
1,345,923
Total long-term liabilities.........................
13,345,923
Total liabilities................................................

$14,181,023

Stockholders Equity
Paid-in capital:
Preferred stock......................................... $
600,000
Excess of issue price over parPS.......
75,000
Common stock.........................................
400,000
Excess of issue price over parCS.......
200,000
From sale of treasury stock....................
11,000
Total paid-in capital...............................
$ 1,286,000
Deficit..............................................................
390,952
Total...........................................................
Deduct treasury stock...................................
Total stockholders equity............................
Total liabilities and stockholders equity....

895,048
21,000
874,048
$15,055,071

Prob. 143B
1.

Cash.............................................................................
Discount on Bonds Payable.....................................
Bonds Payable......................................................

6,639,795*
860,205
7,500,000

*Present value of $1 for 20 (semiannual)


periods at 6% (semiannual rate).........................
0.31181
Face amount............................................................... $7,500,000
Present value of an annuity of $1 for 20
periods at 6%........................................................
11.46992
Semiannual interest payment................................... $375,000
2.

a. Interest Expense...................................................
Discount on Bonds Payable
($860,205 20).................................................
Cash..................................................................

418,010

b. Interest Expense...................................................
Discount on Bonds Payable..........................
Cash..................................................................

418,010

$ 2,338,575
4,301,220
$ 6,639,795

43,010
375,000
43,010
375,000

3.

$418,010

4.

Yes. Investors will not be willing to pay the face amount of the bonds when
the interest payments they will receive from the bonds are less than the
amount of interest that they could receive from investing in other bonds.

Prob. 143B

Concluded

This solution is applicable only if the GENERAL LEDGER SOFTWARE that


accompanies this text is used.
RAPTOR CORPORATION
Balance Sheet
June 30, 2003
Assets
Cash .................................................................
Accounts receivable.........................................
Merchandise inventory....................................
Prepaid insurance............................................
Supplies.............................................................
Total current assets....................................

$ 7,627,695
228,950
2,681,650
139,650
182,950
$10,860,895

Equipment......................................................... $ 1,390,000
Accum. depreciationequipment.............
109,600 $ 1,280,400
Building............................................................. $ 5,405,000
Accum. depreciationbuilding.................
672,000
Total plant assets.....................................

4,733,000
6,013,400

Total assets.......................................................

$16,874,295

Liabilities
Accounts payable.............................................
$
32,000
Bonds payable.................................................. $ 7,500,000
Discount on bonds payable............................
774,185
Total long-term liabilities...........................
6,725,815
Total liabilities...................................................

$ 6,757,815

Stockholders Equity
Paid-in capital:
Preferred stock............................................ $2,100,000
Excess of issue price over parPS.........
172,500
Common stock............................................ 4,500,000
Excess of issue price over parCS......... 1,100,000
From sale of treasury stock.......................
2,000
Total paid-in capital.................................
$ 7,874,500
Retained earnings............................................
2,461,980
Total..............................................................
Deduct treasury stock......................................
Total stockholders equity...............................
Total liabilities and stockholders equity.......

$ 10,336,480
220,000
10,116,480
$16,874,295

Prob. 144B
1.
2002
July

Dec.

2003
June
Dec.

2004
June

1 Cash................................................................
Discount on Bonds Payable.........................
Bonds Payable..........................................

9,227,796
772,204

31 Interest Expense............................................
Cash...........................................................

400,000

31 Interest Expense............................................
Discount on Bonds Payable....................

77,220

31 Income Summary...........................................
Interest Expense.......................................

477,220

30 Interest Expense............................................
Cash...........................................................

400,000

31 Interest Expense............................................
Cash...........................................................

400,000

31 Interest Expense............................................
Discount on Bonds Payable....................

154,440

31 Income Summary...........................................
Interest Expense.......................................

954,440

10,000,000
400,000
77,220
477,220

400,000
400,000
154,440

30 Bonds Payable............................................... 10,000,000


Loss on Redemption of Bonds....................
313,324
Discount on Bonds Payable....................
Cash...........................................................

2.

a.
b.

3.

Initial carrying amount of bonds....................................


Discount amortized on December 31, 2002..................
Discount amortized on December 31, 2003..................
Carrying amount of bonds, December 31, 2003...........

954,440

463,324
9,850,000

2002: $477,220
2003: $954,440
$9,227,796
77,220
154,440
$9,459,456

Prob. 144B

Concluded

This solution is applicable only if the GENERAL LEDGER SOFTWARE that


accompanies this text is used.
SHADWELL INC.
Balance Sheet
06/30/04
Assets
Cash .................................................................
Accounts receivable.........................................
Merchandise inventory....................................
Prepaid insurance............................................
Supplies.............................................................
Total current assets....................................
Equipment.........................................................
Accum. depreciationequipment.............
Total plant assets.....................................

$ 8,820,596
1,352,200
809,300
46,400
85,000
$ 11,113,496
$ 1,882,900
69,000
1,813,900

Total assets.......................................................

$12,927,396

Liabilities
Accounts payable.............................................

835,100

Stockholders Equity
Paid-in capital:
Preferred stock............................................ $ 4,600,000
Excess of par over issue pricePS.........
1,075,000
Common stock............................................
4,400,000
Excess of par over issue priceCS.........
1,200,000
From sale of treasury stock.......................
11,000
Total paid-in capital.................................
$ 11,286,000
Retained earnings............................................
827,296
Total..............................................................
Deduct treasury stock......................................
Total stockholders equity...............................
Total liabilities and stockholders equity.......

$ 12,113,296
21,000
12,092,296
$12,927,396

Prob. 145B
2002
Sept. 1

Dec. 31
31
2008
June 30
Aug. 31
31

Investment in Joshua Company Bonds.............


Interest Revenue ($240,000 8% 2/12)............
Cash...................................................................

247,375
3,200

Cash.......................................................................
Interest Revenue...............................................

9,600

Interest Revenue...................................................
Investment in Joshua Company Bonds.........

250

Cash.......................................................................
Interest Revenue...............................................

9,600

Interest Revenue...................................................
Investment in Joshua Company Bonds.........

250

Cash.......................................................................
Gain on Sale of Investments...........................
Investment in Joshua Company Bonds.........
Interest Revenue...............................................

250,575
9,600
250

9,600
250
123,500*
462
121,438
1,600

*($120,000 1.02) + ($120,000 8% 2/12) $500


Dec. 31
31

Cash.......................................................................
Interest Revenue...............................................

4,800

Interest Revenue...................................................
Investment in Joshua Company Bonds.........

375

4,800
375

Appendix Prob. 146B


1.

a. Interest Expense........................................................
Premium on Bonds Payable
[$720,000 (5% $13,495,471)]................................
Cash.......................................................................

674,774

b. Interest Expense........................................................
Premium on Bonds Payable
[$720,000 (5% $13,450,245)]................................
Cash.......................................................................

672,512

45,226
720,000

47,488
720,000

2. $674,774

Appendix Prob. 147B


1.

a. Interest Expense........................................................
Discount on Bonds Payable
[($6,639,795 6%) $375,000]..................................
Cash.............................................................................

398,388

b. Interest Expense........................................................
Discount on Bonds Payable
[($6,663,183 6%) $375,000]..................................
Cash.............................................................................

399,791

2. $398,388

23,388
375,000

24,791
375,000

COMPREHENSIVE PROBLEM 4
1.

a. Cash.............................................................................
Common Stock.....................................................
Paid-in Capital in Excess of Par
Common Stock.....................................................

540,000

b. Cash.............................................................................
Preferred Stock.....................................................
Paid-in Capital in Excess of Par
Preferred Stock.....................................................

900,000

c. Cash.............................................................................
Bonds Payable......................................................
Premium on Bonds Payable................................

6,373,869

300,000
240,000
750,000
150,000
6,000,000
373,869

Computations:
Present value of face amount: $6,000,000 0.37689
[present ...value of $1 for 20 (semiannual) periods
at 5% (semiannual rate)]............................................
Present value of semiannual interest payments of
$330,000 at 5% compounded semiannually:
$330,000 12.46221 (present value of annuity
of $1 for 20 periods at 5%)........................................
Total present value of bonds.........................................

$2,261,340

4,112,529
$6,373,869

d. Cash Dividends..........................................................
Cash Dividends Payable......................................

55,000

e. Cash Dividends Payable...........................................


Cash.......................................................................

55,000

f. Bonds Payable...........................................................
Premium on Bonds Payable.....................................
Cash.......................................................................
Gain on Redemption of Bonds...........................

500,000
6,150

g. Treasury Stock...........................................................
Cash.......................................................................

210,000

55,000
55,000

505,000
1,150
210,000

Comp. Prob. 4

Continued

h. Stock Dividends.........................................................
Cash Dividends................................................................
Stock Dividends Distributable..................................
Paid-In Capital in Excess of Par
Common Stock...........................................................
Cash Dividends Payable...........................................

77,900*
30,000
47,500
30,400
30,000

*100,000 5,000 = 95,000


95,000 2% = 1,900
1,900 $41 = $77,900
i. Stock Dividends Distributable..................................
Cash Dividends Payable...........................................
Common Stock.....................................................
Cash.......................................................................

47,500
30,000

j. Investment in Key West Sports Inc. Bonds.............


Interest Revenue........................................................
Cash.......................................................................

97,000
3,750

k. Cash.............................................................................
Treasury Stock......................................................
Paid-In Capital from Sale of Treasury Stock.....

144,000

l. Interest Expense........................................................
Premium on Bonds Payable.....................................
Cash.......................................................................

311,307
18,693

47,500
30,000

100,750
126,000
18,000

330,000

Computations:
Semiannual interest payment........................................
Amortization premium [($373,869 120 months)
6 months, rounded] ..................................................
Interest expense..............................................................
m. Interest Receivable....................................................
Interest Revenue...................................................

$330,000
18,693
$311,307
5,000
5,000

Computation: $100,000 15% 4/12 = $5,000


Investment in Key West Sports Inc. Bonds..................
Interest Revenue........................................................

100
100

Comp. Prob. 4
2.

Continued

a.

HEYWOOD PRODUCTS INC.


Income Statement
For the Year Ended July 31, 2003
Sales..................................................................
Cost of merchandise sold...............................
Gross profit.......................................................
Operating expenses:
Selling expenses:
Sales salaries expense.........................
Sales commissions...............................
Advertising expense.............................
Depreciation expensestore buildings
and equipment..................................
Delivery expense...................................
Store supplies expense........................
Miscellaneous selling expense............
Total selling expenses.....................
Administrative expenses:
Office salaries expense........................
Office rent expense...............................
Depreciation expenseoffice buildings
and equipment..................................
Office supplies expense.......................
Miscellaneous administrative expense
Total administrative expenses........
Total operating expenses..........................
Income from operations..................................
Other expenses and income:
Interest expense..........................................
Interest revenue..........................................
Income from continuing operations before
income tax...................................................
Income tax.........................................................
Income from continuing operations...............
Loss from disposal of a business segment. .
Less applicable income tax............................
Income before extraordinary item..................
Extraordinary item:
Gain on redemption of bonds....................
Less applicable income tax.......................
Net income........................................................

$ 3,150,000
1,890,000
$ 1,260,000
$180,000
98,000
75,000
45,000
17,000
10,000
5,000
$ 430,000
$ 85,000
25,000
13,100
5,300
1,600
130,000
$
$ 311,307
1,350

309,957
$
$

390,043
156,043
234,000

72,000
162,000

1,000
163,000

$ 120,000
48,000
$

560,000
700,000

1,150
150

Comp. Prob. 4

Continued

Earnings per common share:


Income from continuing operations...................................
Loss on discontinued operations.......................................
Income before extraordinary item.......................................
Extraordinary item................................................................
Net income.............................................................................

$1.29*
0.72
$0.57
0.01
$0.58

*($234,000 $105,000 preferred dividends) 100,000 common shares


b.

HEYWOOD PRODUCTS INC.


Retained Earnings Statement
For the Year Ended July 31, 2003
Retained earnings, August 1, 2002.................
Net income for year..........................................
Less dividends:
Cash dividends............................................
Stock dividends..........................................
Decrease in retained earnings........................
Retained earnings, July 31, 2003....................

$ 677,124
$ 163,000
$ 160,000
77,900

237,900
74,900
$ 602,224

Comp. Prob. 4

Continued

c.

HEYWOOD PRODUCTS INC.


Balance Sheet
July 31, 2003
Assets
Current assets:
Cash...........................................................
$ 125,500
Accounts receivable................................ $ 280,500
Less allowance for doubtful accounts. .
21,500
259,000
Notes receivable.......................................
77,500
Merchandise inventory, at lower of cost
(fifo) or market.......................................
425,000
Interest receivable....................................
5,000
Prepaid expenses.....................................
15,900
Total current assets..............................
$ 907,900
Investments:
Investment in Key West Sports bonds...
97,100
Property, plant, and equipment:
Store buildings and equipment.............. $10,282,671
Less accumulated depreciation.............
2,214,750 $ 8,067,921
Office buildings and equipment............. $ 3,762,329
Less accumulated depreciation.............
835,250
2,927,079
Total property, plant, and equipment. .
10,995,000
Total assets....................................................
$12,000,000

Comp. Prob. 4

Concluded

Liabilities
Current liabilities:
Accounts payable.......................................
Income tax payable.....................................
Dividends payable......................................
Deferred income tax payable.....................
Total current liabilities..........................
Long-term liabilities:
Bonds payable, 11%, due 2013..................
Add premium on bonds payable...............
Deferred credits:
Deferred income tax payable.....................
Total liabilities...................................................

149,500
55,900
30,000
4,700
$

$ 6,000,000
355,176

240,100
6,355,176

21,000
$ 6,616,276

Stockholders Equity
Paid-in capital:
Preferred 8% stock, $100 par (30,000
shares authorized; 15,000 shares
issued).................................................... $ 1,500,000
Excess of issue price over par..................
240,000 $ 1,740,000
Common stock, $25 par (400,000 shares
authorized; 101,900 shares issued)..... $ 2,547,500
Excess of issue price over par..................
560,000
3,107,500
From sale of treasury stock.......................
18,000
Total paid-in capital...............................
$ 4,865,500
Retained earnings............................................
602,224
Total..............................................................
$ 5,467,724
Deduct treasury common stock (2,000
shares at cost).............................................
84,000
Total stockholders equity...............................
5,383,724
Total liabilities and stockholders equity.......
$12,000,000

SPECIAL ACTIVITIES
Activity 141
Without the consent of the bondholders, Lee Noels use of the sinking fund cash
to temporarily alleviate the shortage of funds would violate the bond indenture
contract and the trust of the bondholders. It would therefore be unprofessional. In
addition, the use of Noels brother-in-law as trustee of the sinking fund is a
potential conflict of interest that could be considered unprofessional.

Activity 142
Theoretically, accountants would be justified in using present values to value all
liabilities presented in the balance sheet. As a practical matter, however, current
liabilities that will be paid within one year are presented at their face value, since
this value usually approximates the present value of the liability. Other liabilities
such as pensions and lease obligations involve complex assumptions that
include considering the present values.
Finally, generally accepted accounting principles require that long-term liabilities
be amortized using present values (the effective interest rate method). The
straight-line amortization method may be used if the results are not materially
different from those of the effective interest rate method. In this chapter, we have
used the straight-line method to simplify our discussions. The effective interest
rate method is illustrated in an appendix to the chapter.

Activity 143
The primary advantage of issuing preferred stock rather than bonds is that the
preferred stock does not obligate Daffodil to pay dividends, while interest on
bonds must be paid. That is, the issuance of bonds will require annual interest
payments, thus necessitating a periodic (probably semiannual) cash outflow.
Given WaterWaves volatility of operating cash flows, the required interest
payments might strain Daffodils liquidity. In the extreme, this could even lead to
a bankruptcy of Daffodil.
The issuance of bonds has the advantage of providing a tax deduction for
interest expense. This would tend to reduce the net (aftertax) cost of the bonds.
Probably the safest alternative is for Daffodil to issue preferred stock. Of course,
another alternative might be to issue a combination of preferred stock and
bonds.

Activity 144
Note to Instructors: The purpose of this activity is to familiarize students with
bonds as an investment and the sources of information about bonds.

Activity 145
1.

2.

Shares of common stock................................................


Earnings before bond interest and income tax............
Deduct interest on bonds...............................................
Income before income tax..............................................
Deduct income tax..........................................................
Net income.......................................................................

Plan 1
40,000
$ 700,000
400,000
$ 300,000
120,000
$ 180,000

Plan 2
110,000
$ 700,000
260,000
$ 440,000
176,000
$ 264,000

Earnings per share on common stock..........................

a.

b.

4.50

2.40

Factors to be considered in addition to earnings per share:


1. There is a definite legal obligation to pay interest on bonds, but
there is no definite commitment to pay dividends on common stock.
Therefore, if net income should drop substantially, bonds would be
less desirable than common stock.
2. If the bonds are issued, there is a definite commitment to repay the
principal in 20 years. In case of liquidation, the claims of the
bondholders would rank ahead of the claims of the common
stockholders.
3. Present stockholders must purchase the new stock if they are to
retain their proportionate control and financial interest in the
corporation.
Since the net income has been relatively stable in the past and
anticipated earnings under Plan 1 offer $2.10 more per share for the
common stockholder, Plan 1 appears to be somewhat more
advantageous for present stockholders.

Activity 146
Note to Instructors: The purpose of this activity is to familiarize students with
bond ratings and the importance of bond ratings to the issuer as well as to the
investor.