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CHAPTER 10
LIABILITIES
OVERVIEW OF EXERCISES, PROBLEMS, CASES,
AND INTERNET ASSIGNMENT
Exercises
10–1
10–2
10–3
Topic
Learning
Objectives
10–4
10–5
10–6
10–7
10–8
You as a student
Accounting equation
Effects of transactions upon
financial statements
Balance sheet presentation
Payroll-related costs
Payroll-related costs
Use of an amortization table
Tax benefit of debt financing
10–9
10–10
10–11
10–12
Bonds payable and interest
Accounting for bond premiums
Accounting for bond discounts
Analyzing solvency
5
5, 6
5, 6
9
Accounting for leases
Accounting for pensions
Deferred income taxes
Identifying debt
10
10
10
9
*10–13
*10–14
*10–15
10–16
Problems
10–1
10–2
10–3
10–4
10–5
10–6
*10–7
Effects of transactions upon the
accounting equation
Balance sheet presentation
Notes payable
Preparation and use of an
amortization table
Bonds issued at par
Bond discount and premium
Balance sheet presentation
4
1–6
1, 2, 4, 5,
6, 8
1, 5, 6, 8
3
3
4
5
1, 2, 3, 4, 5,
6, 8
1, 2, 4, 8
2
4
5
5, 6
1, 5, 6, 10
Characteristics
Personal, mechanical
Conceptual
Conceptual
Conceptual
Mechanical
Mechanical, conceptual
Mechanical, conceptual
Mechanical, conceptual, real—
DuPont
Mechanical, conceptual
Mechanical, conceptual
Mechanical, conceptual
Mechanical, analytical, real—Tyco
Toys and Hasbro
Mechanical, conceptual, ethics
Conceptual, mechanical, ethics
Conceptual, mechanical
Conceptual, real—Tootsie Roll
Conceptual
Conceptual
Mechanical, conceptual
Mechanical, conceptual
Mechanical, conceptual
Mechanical, conceptual
Conceptual, mechanical
____________
*Supplemental Topic: “Special Types of Liabilities.”
334
© The McGraw-Hill Companies, Inc., 2005
Cases
*10–1
Topic
Nature of liabilities
10–2
Factors affecting bond prices
10–3
Loss contingencies
Learning
Objectives
1, 10
5, 6, 7
8
Characteristics
Conceptual, can be group
assignment, real—8 companies
Conceptual, analytical, group,
real—Abbott Labs
Conceptual, group
Business Week
Assignment
*10–4
Internet
Assignment
10–1
Business Week assignment
5, 6, 7
Conceptual, analytical
Credit ratings for bonds
5, 6, 9
Internet, research
____________
*Supplemental Topic: “Special Types of Liabilities.”
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
335
DESCRIPTIONS OF PROBLEMS, CASES,
AND INTERNET ASSIGNMENT
Below are brief descriptions of each problem, case, and the Internet assignment. These descriptions are
accompanied by the estimated time (in minutes) required for completion and by a difficulty rating. The time
estimates assume use of the partially filled-in working papers.
Problems
10–1
Computer Specialists, Inc.
Show the effects of various transactions upon the accounting equation. Also
calls for distinction between current and long-term liabilities. Quick and
easy, but quite comprehensive.
25
Easy
10–2
Seattle Chocolates
From an unclassified listing of account balances and other information,
prepare current and long-term liability sections of a balance sheet. Explain
treatment of various items.
30
Medium
10–3
Swanson Corporation
Accounting for notes payable, with interest stated separately.
25
Medium
10–4
Quick Lube
Involves conceptual discussion of an amortization table, use of the table, and
extension of a partially completed table for two more payments.
25
Medium
10–5
Blue Mountain Power Company
Journal entries to record issuance of bonds between interest payment dates,
payment of interest, and accrual of interest at year-end. Requires student to
know that bonds are issued at par when the prevailing market rate of interest
equals the contract rate of interest.
15
Easy
10–6
Park Rapids Lumber Company
Year-end adjusting entries for bond interest when bonds are issued at a
discount and when bonds are issued at a premium. Bond discount and
premium amortized by the straight-line method.
35
Strong
Minnesota Satellite Telephone Corporation
From an unclassified list of account balances and other information, student
is asked to prepare and discuss the current and long-term liability sections of
a balance sheet.
45
Strong
*10–7
____________
*Supplemental Topic: “Special Types of Liabilities.”
336
© The McGraw-Hill Companies, Inc., 2005
Cases
*10–1
* 10–2
10–3
Liabilities in Published Financial Statements
Discuss the nature of various liabilities appearing in the balance sheets of
well-known companies.
30
Medium
Abbott Labs
Requires student to understand the relationship between a bond’s issue price
and the effective rate of interest, and to differentiate between cash flow and
interest expense. Also requires that students understand that the time
remaining until a bond matures is a factor in determining the bond’s current
value.
20
Strong
Loss Contingencies?
Students are asked to evaluate four situations, indicating whether the
situation describes a loss contingency and explaining the proper financial
statement treatment of the matter.
25
Medium
15
Medium
Business Week Assignment
*10–4
Business Week Assignment
Students are asked to explain the relationship between changing interest
rates and bond values.
Internet Assignment
10–1
Credit Ratings
Students are introduced to bond ratings and how they correspond to bond
yields.
No time
estimate
____________
*Supplemental Topic: “Special Types of Liabilities.”
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
337
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
1. Liabilities are debts or obligations arising from past transactions or events, and which require
settlement at a future date. Liabilities and owners’ equity are the two primary means by which a
business finances ownership of its assets and its business operations.
The feature which most distinguishes liabilities from equity is that liabilities mature, whereas
owners’ equity does not. In the event of liquidation of the business, the claims of creditors
(liabilities) have priority over the claims of owners (equity). Also, interest paid to creditors is
deductible in the determination of taxable income, whereas dividends paid to stockholders are not
deductible.
2. In the event of liquidation of a business, the claims of creditors (liabilities) have priority over the
claims of owners (equity). The relative priorities of individual creditors, however, vary greatly.
Secured creditors have top priority with respect to proceeds stemming from the sale of the specific
assets that have been pledged as collateral securing their loans. The priority of unsecured creditors
is determined by legal statutes and indenture contracts.
3. Current liabilities are those maturing within one year or the company’s operating cycle (whichever
is longer) and expected to be paid from current assets. Liabilities classified as long-term include
obligations maturing more than one year in the future, and also shorter term obligations that will be
refinanced or paid from noncurrent assets.
A 10-year bond issue would be classified as a current liability once it comes within 12 months of
the maturity date, assuming that the issue will be paid from current assets.
A note payable maturing in 30 days would be classified as a long-term liability if (a) management
had both the intent and the ability to refinance this obligation on a long-term basis, or (b) the
liability will be paid from noncurrent assets.
4. Accounts Payable (Smith Supply Company) ..................................................
Notes Payable .....................................................................................
Issued a 12%, 90-day note payable to replace an account payable to Smith
Supply Company.
8,000
Notes Payable .................................................................................................
Interest Expense ..............................................................................................
Cash ....................................................................................................
Paid 12%, 90-day note to Smith Supply Company.
8,000
240
8,000
8,240
5. All employers are required by law to pay the following payroll taxes and insurance premiums:
Social Security and Medicare taxes, unemployment taxes, and workers’ compensation insurance
premiums. In addition, many employers include the following as part of the “compensation
package” provided to employees: group health insurance premiums, contributions to employee
pension plans, and postretirement benefits (such as health insurance). Both mandated and
discretionary costs are included as part of total payroll cost in addition to the wages and salaries
earned by employees.
6. Workers’ compensation premiums are a mandated payroll cost—the cost of providing insurance
coverage to employees in case of job-related injury. The dollar amount of the premiums varies by
state and by employees’ occupation. The employer pays workers’ compensation premiums. Social
Security and Medicare taxes are paid half by the employer and half by the employee.
7. $62,537 [$63,210 balance at the beginning of the period, less $673 of the payment that applies to
principal ($1,200  $527 representing interest)].
338
© The McGraw-Hill Companies, Inc., 2005
8. The analysis is incorrect, because the principal amount of the mortgage note will not be paid off at a
constant rate of $17.84 per month. The portion of each payment representing an interest charge is
based upon the unpaid balance of the loan. Since the principal amount is being reduced each month,
the portion of each successive payment representing interest will decrease, and the portion applied
to reducing the unpaid balance will increase. For example, let us look into the future to the time
when the loan has been paid down to $10,000. At this point, a $476.17 monthly payment would be
allocated as follows: interest, $91.67 ($10,000 principal  11%  112), and reduction in principal,
$384.50 ($476.17  $91.67 interest). Thus, the unpaid balance of the loan will be paid off at an
ever-increasing rate.
Note to instructor: This mortgage will be paid in full in 30 years.
9. The income tax advantage of raising capital by issuing bonds rather than stock is that interest
payments on bonds are deductible in determining income subject to income taxes. This reduces the
“after-tax” cost of borrowing. Dividend payments to stockholders, on the other hand, are not
deductible in the determination of taxable income.
10. Annual interest payments ($5 million  10%)....................................................................
Less: Annual tax savings ($500,000  30%) ......................................................................
Annual after-tax cost of borrowing.....................................................................................
$500,000
150,000
$350,000
After-tax cost of borrowing as a percentage of amount borrowed:
$350,000  $5,000,000 = 7%
11. The present value of a future amount is the amount that a knowledgeable investor would pay today
for the right to receive the future amount. This present value always will be less than the future
amount, because the investor will expect to earn some return while waiting to receive the future
amount.
12. From an investor’s perspective, a bond represents a series of future cash receipts that are fixed in
amount by the contract rate of interest printed on the bonds and by the bonds’ maturity value. As
market interest rates rise, a series of future receipts that are fixed in dollar amount look less
attractive in relation to other investment opportunities, and the price of the bond falls. As interest
rates fall, any series of fixed cash receipts begins to look better in relation to other opportunities,
and bond prices rise.
13. Bonds with contract rates of interest above current market interest rates should be trading at prices
above their face values. Bond prices vary inversely with market interest rates.
14. The market value of $25,000 in bonds trading at 102 would be $25,500 ($25,000 par value 
102%). The market rate of interest for bonds of this quality must be lower than the 8% contract rate,
thereby causing investors to be willing to pay a premium for these bonds.
15. A superior credit rating is one reason why one company’s bonds might trade at a higher price than
those of another company. However, the higher market price for the Interstate Power bonds does
not, in itself, prove that Interstate has the better credit rating. As current market interest rates are
well above the 6% level, it is logical that both bonds should be selling at a discount. The fact that
the Interstate Power bonds are selling at a market price very close to their par value probably
indicates that these bonds will mature in the very near future. Thus, the difference in the market
price of the two bond issues may well be explained by a difference in maturity dates, rather than by
a difference in the companies’ credit ratings.
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
339
16. Issuing bonds at a discount increases the cost of borrowing. Not only does the issuing company
have the use of less borrowed money in exchange for its regular interest payments, but it also must
repay more than the original amount borrowed. Thus, an additional interest charge is built into the
maturity value of the bonds.
17. Because the maturing bonds were paid from a sinking fund, the bonds were never classified as a
current liability. As the sinking fund was never classified as a current asset, the maturity of the
bonds had no effect upon the company’s current ratio.
The debt ratio is equal to total liabilities divided by total assets. NDP is a solvent business;
therefore, the total liabilities are less than total assets, and the debt ratio is less than 100%. Under
these circumstances, reducing the numerator and denominator of the ratio by an equal amount
causes the debt ratio to decrease. One also should arrive at this conclusion through common
sense—repaying debt reduces the percentage of total assets financed with capital provided by
creditors.
18. Low-Cal’s very low interest coverage ratio should be of greater concern to stockholders than to
short-term creditors. The fact that operating income amounts to only 75% of annual interest implies
that Low-Cal may have great difficulty in remaining solvent in the long run. It does not imply,
however, that the company is not currently solvent. Short-term creditors, because of their shorter
investment horizon, should be concerned about the current relationships between the company’s
liquid resources and its short-term obligations.
19. The return on assets represents the average return that a business earns from all of the capital. If this
average rate is higher than the cost of borrowing, the business can benefit from using borrowed
capital—that is, applying leverage. In essence, if you can borrow money at a relatively low rate and
invest it at a significantly higher one, you will benefit from doing so.
But some businesses have borrowed such large amounts—and at such high interest rates—that they
have been unable to earn enough to pay the interest. In these cases, the owners must come up with
additional money to cover the interest charges, or the business eventually will “go under.”
20. Estimated liabilities have two basic characteristics: (1) the liability is known to exist and (2) the
precise dollar amount cannot be determined until a later date. Examples include the liability to
honor warranties on products sold, liabilities for income taxes payable, and an accrual of liability
relating to a loss contingency.
21. A loss contingency is a possible loss (or expense) stemming from past events that will be resolved
as to existence and amount by some future event. Examples include pending litigation, all estimated
liabilities, the allowance for uncollectible accounts, and the risk that the political climate in foreign
countries has impaired the value of assets in those locations.
Loss contingencies are accrued (recorded) if it is both (1) probable that a loss has been incurred,
and (2) the amount of loss can be estimated reasonably. Even if these conditions are not met, loss
contingencies should be disclosed in financial statements if it is reasonably possible that a material
loss has been incurred.
340
© The McGraw-Hill Companies, Inc., 2005
22. A commitment is a contractual obligation to conduct future transactions on agreed-upon terms.
Examples include employment contracts, contracts with suppliers of services, and contracts to make
future purchases or sales of inventory or of other assets.
If they are material in dollar amount, the terms of commitments should be disclosed in financial
statements. No liability normally is recorded, because the commitment relates to future transactions,
rather than to past transactions.
*23. The lessee accounts for an operating lease as a rental arrangement; the lease payments are recorded
as rental expense and no asset or liability (other than a short-term liability for accrued rent payable)
is recorded. A capital lease, on the other hand, should be viewed by the lessee as essentially a
purchase of the related asset. The lessee accounts for a capital lease by debiting an asset account
(such as Leased Equipment) and crediting a liability account (Lease Payment Obligation) for the
present value of the future lease payments. Lease payments made by the lessee must be allocated
between interest expense and a reduction in the liability, Lease Payment Obligation. The asset
account is depreciated over the life of the leased asset.
An operating lease is sometimes called off-balance-sheet financing because the obligation for future
lease payments does not appear as a liability in the lessee’s balance sheet.
*24. As the pension plan is fully funded, Ortega Industries has paid its pension obligations to the pension
fund trustee as these obligations have accrued. Therefore, no liability need appear in Ortega’s
balance sheet relating to the pension plans. Retired employees will collect their postretirement
benefits directly from the trustee of the pension plan.
*25. Most pension plans are fully funded—that is, the corporation deposits cash in the pension fund each
period in an amount equal to the current-period liability. Thus, no liability for pension payments
appears in the corporation’s balance sheet.
Most corporations, however, do not fully fund their obligations for nonpension postretirement
benefits. The difference between the amount funded and the present value of promised future
benefits—the unfunded amount—is reported as a liability. This liability gets larger each year as the
funded portion lags further and further behind the present value of promised benefits.
*26. Postretirement costs are recognized as expense currently as workers earn the right to receive these
benefits. If these costs are fully funded, the company makes cash payments within the current
period equal to the expense recognized. If the benefits are not funded, the cash payments are not
made until after the employees retire.
*27. Deferred income taxes are the portion of this year’s income taxes expense (as shown in the income
statement) which will appear in the income tax returns of future years. Therefore, due to differences
between income tax regulations and accounting principles, the taxpayer is able to postpone the
payment of some income taxes so long that these obligations become a long-term liability.
Note to instructor: Situations in which certain expenses are deductible for financial reporting
purposes but not for income tax purposes may cause deferred taxes to be classified as an asset
instead of a liability.
____________
*Supplemental Topic: “Special Types of Liabilities.”
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
341
SOLUTIONS TO EXERCISES
Ex. 10–1
You would need to save $7,760, as shown in the following loan amortization table:
Interest
Period
Annual
Payment
Annual
Interest
Expense @ 8%
Reduction
in Unpaid
Balance
Unpaid
Balance
Date of Graduation
Year 1
Year 2
Year 3
$1,490
1,490
1,490
$800
745
685
$690
745
805
$10,000
9,310
8,565
7,760
Ex. 10–2
Transaction
Income Statement
Balance Sheet
Net
Revenue  Expenses = Income
Current Long-Term Owners’
Assets = Liab. +
Liab.
+ Equity
a.
b.
c.
d.
e.
f.
g.
h.
NE
NE
NE
NE
NE
NE
NE
NE
I
I
I
NE
NE
NE
I
I
D
D
D
NE
NE
NE
D
D
NE
D
D
NE
D
I
D
NE
NE
NE
NE
D
NE
I
NE
I
D
D
D
NE
NE
NE
D
D
Transaction
Current
Liabilities
Long-Term
Liabilities
Net
Income
Net Cash Flow
From Operating
Activities
Net Cash Flow
From All
Sources
a.
b.
c.
d.
e.
f.
D
D
NE
NE
NE
I
NE
NE
I
I
I
NE
NE
D
NE
D
D
D
D
D
NE
D
NE
NE
D
D
I
D
NE
NE
Ex. 10–3
342
I
D
I
I
D
NE
NE
I
© The McGraw-Hill Companies, Inc., 2005
Ex. 10–4
a. Current liabilities:
Unearned revenue .........................................................................................
Notes payable (current portion) ..................................................................
Accrued bond interest payable ....................................................................
Total current liabilities.....................................................................................
b. Long-term liabilities:
Notes payable ($80,000  $10,000) ..............................................................
Bonds payable ...............................................................................................
Notes payable to be refinanced on a long-term basis ................................
Total long-term liabilities.................................................................................
$300,000
10,000
36,000
$346,000
$
70,000
900,000
75,000
$1,045,000
 The interest expense that will arise from existing obligations is not yet a liability.
 The lawsuit pending against the company is a loss contingency. It should be disclosed,
but no liability is recorded as no reasonable estimate can be made of the dollar
amount.
 The 3-year salary commitment relates to future transactions and, therefore, is not
yet a liability of the company.
Ex. 10–5
a. Total payroll related costs:
Wages and salaries expense ......................................................................... $ 7,200,000
Payroll taxes ..................................................................................................
580,000
Workers’ compensation premiums .............................................................
250,000
Group health insurance premiums .............................................................
725,000
Contributions to employees’ pension plan .................................................
450,000
Total payroll related costs ............................................................................ $ 9,205,000
b. Employees’ “take-home pay”:
Wages and salaries earned ...........................................................................
Amounts withheld from employees’ pay ....................................................
“Take-home pay” ..........................................................................................
$7,200,000
2,200,000
$5,000,000
c. (1) 128% ($9,205,000  $7,200,000)
(2) 184% ($9,205,000  $5,000,000)
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
343
Ex. 10–6
a. Wages Expense .................................................................................
State Income Tax Payable ...................................................
Federal Income Tax Payable ..............................................
Social Security and Medicare Taxes Payable....................
Cash (or Wages Payable) ....................................................
To record gross wages, employee withholdings, and employee
take-home pay in February.
250,000
b. Payroll Tax Expense ........................................................................
Social Security and Medicare Taxes Payable....................
Federal and State Unemployment Taxes Payable ............
Prepaid Workers’ Compensation Insurance ....................
To record employer payroll tax expense in February, $8,500 of
which is the expiration of prepaid workers’ compensation
insurance premiums.
43,125
c. Employee Health and Life Insurance Expense .............................
Pension Fund Expense.....................................................................
Prepaid Employee Health and Life Insurance ..................
Cash (or Pension Benefits Payable) ...................................
To record employee benefit expenses in February, $10,000 of
which is the expiration of prepaid employee health and life
insurance premium.
10,000
22,875
5,875
56,000
19,125
169,000
19,125
15,500
8,500
10,000
22,875
d. The $81,000 amount withheld from the employees’ gross wages does not represent a
tax levied on the employer. The $81,000 is simply a portion of the gross wage expense
that must be sent directly to the proper tax authorities, rather than paid to the
employees. In the company’s balance sheet, these withholdings represent current
liabilities until the actual payment to various tax authorities is made.
344
© The McGraw-Hill Companies, Inc., 2005
Ex. 10–7
a.
Monthly
Interest
Period
Original balance
1
2
Amortization Table
(12% Note Payable for $150,000; Payable
in Monthly Installments of $1,543)
(A)
(B)
Interest Expense
Reduction in
Monthly
(1% of the Last
Unpaid Balance
Payment Unpaid Balance)
(A)  (B)
—
$1,543
1,543
—
$1,500
1,500
Unpaid
Balance
—
$43
43
b. Interest Expense ...............................................................................
Mortgage Payable ............................................................................
Cash .......................................................................................
To record second monthly installment on mortgage payable.
$150,000
149,957
149,914
1,500
43
1,543
c. Decrease. Interest expense is based on the unpaid principal balance at the end of each
month. As the unpaid principal balance decreases each period, interest expense will
decrease also.
Ex. 10–8
a. Annual interest expense ($340 million  6.2%) ..............................................
$21.080 million
Less: Income tax savings ($21.080 million  40%) .........................................8.432 million
Annual after-tax cost of borrowing..................................................................
$12.648 million
b. 3.72% ($12.648 million  340 million)
c. The obvious advantage of debt financing is that interest expense is tax deductible,
whereas dividends are not.
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
345
Ex. 10–9
a. Apr. 30 Cash .................................................................................
Bonds Payable .....................................................
Bond Interest Payable ........................................
Issued $50,000 face value of 9%, 30-year bonds at
100 plus accrued interest for one month.
50,375
b. Sept. 30 Bond Interest Payable ....................................................
Bond Interest Expense ...................................................
Cash .....................................................................
Paid semiannual interest on $50,000 face value
of 9% bonds.
375
1,875
c. Dec. 31 Bond Interest Expense ...................................................
Bond Interest Payable ........................................
Adjusting entry to recognize three months’ interest
accrued on $50,000 face value 9% bonds since
September 30.
1,125
50,000
375
2,250
1,125
d. This practice enables the corporation to pay a full six months’ interest on all bonds
outstanding at the semiannual interest payment date, regardless of when the bonds
were purchased. The accrued interest collected from investors who purchase
bonds between interest payment dates is, in effect, returned to them at the next
interest payment date. In this exercise, Gardner collected one month’s interest at
issuance and then paid six months’ interest on September 30 after the bonds were
outstanding for only five months.
346
© The McGraw-Hill Companies, Inc., 2005
Ex. 10–10 a. 2005
Apr. 1
Cash .................................................................................
Premium on Bonds Payable ..............................
Bond Payable ......................................................
To record issuance of bonds at 102.
b. 2005
Sept. 30 Bond Interest Expense ...................................................
Premium on Bonds Payable ..........................................
Cash .....................................................................
To pay interest and amortize bond premium:
Semiannual interest payment:
$8,000,000 x 8% x ½ ....................................
$320,000
Less premium amortized:
[$160,000  20yrs.] x ½ ................................(4,000)
Interest expense
$316,000
8,160,000
160,000
8,000,000
316,000
4,000
320,000
c. 2025
Mar. 31 Bond Interest Payable ....................................................
160,000
Bond Interest Expense ...................................................
158,000
Premium on Bonds Payable ..........................................
2,000
Cash .....................................................................
320,000
To record final interest payment and amortize bond
premium:
(1) Interest expense for 3 months in 2025 = $316,000 x 3/6 = $158,000
(2) Premium amortized in 2025 = $4,000 x 3/6 = $2,000
(3) Interest payable from 12/31/24 = $320,000 x 3/6 = $160,000
Mar. 31 Bonds payable .................................................................
Cash .....................................................................
To retire bonds at maturity.
8,000,000
8,000,000
d. (1) Amortization of a bond premium decreases annual interest expense and,
consequently, increases annual net income.
(2) Amortization of a bond premium is a noncash component of the annual interest
expense computation. Thus, it has no effect upon annual net cash flow from
operating activities.
(Receipt of cash upon issuance of bonds and payment of cash to retire bonds at
maturity are both classified as financing activities.)
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
347
Ex. 10–11 a. 2005
July
1 Cash .............................................................................
Discount on Bonds Payable .......................................
Bonds Payable ................................................
To record issuance of bonds at 98.
4,900,000
100,000
5,000,000
b. 2005
Dec. 31 Bond Interest Expense ...............................................
Discount on Bonds Payable ...........................
Cash .................................................................
To pay interest and amortize bond discount:
240,000
2,500
237,500
Semiannual interest payment:
$5,000,000 x 9 ½% x ½ ..............................................
$237,500
Add discount amortized:
2,500
[$100,000  20 yrs.] x ½ ............................................
Interest expense .....................................................
$240,000
c. 2025
June 30 Bond Interest Expense ...............................................
Discount on Bonds Payable ...........................
Cash .................................................................
To make final interest payment and amortize bond
discount.
(same calculation as in part b. above)
June 30 Bond Payable ..............................................................
Cash .................................................................
To retire bonds at maturity.
240,000
2,500
237,500
5,000,000
5,000,000
d. (1) Amortization of bond discount increases annual interest expense and,
consequently, reduces annual net income.
(2) Amortization of bond discount is a noncash component of annual interest
expense and has no effect upon annual net cash flow from operating activities.
(Receipt of cash upon issuance of bonds and payment of cash to retire bonds at
maturity are both classified as financing activities.)
348
© The McGraw-Hill Companies, Inc., 2005
Ex. 10–12 a. (1) Debt ratio:
Tyco:
$349,792
= 57%
$615,132
Hasbro:
$1,090,776
= 42%
$2,616,388
(2) Interest coverage ratio:
Tyco:
$13,028
$28,026
= 0.46 times
Hasbro:
$304,672
= 8.11 times
$37,588
b. Long-term creditors probably would regard Hasbro as the safer investment. Hasbro
has a smaller percentage of its assets financed by creditors’ capital, and thereby
provides its creditors with a bigger “buffer” of equity capital. Also, Hasbro earns over
8 times the amount of its interest expense, whereas Tyco Toys earns only 46 cents for
every dollar of interest expense it incurs. Thus, interest payments pose a great burden
on Tyco Toys.
Note to instructor: For the year in question, Tyco’s interest expense actually resulted in reporting an
overall net loss for the period.
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
349
*Ex. 10–13 a. Rent Expense ....................................................................................
Cash .......................................................................................
To record monthly rental expense on equipment under an
operating lease agreement.
2,500
b. Leased Equipment ...........................................................................
Lease Payment Obligation ..................................................
Cash .......................................................................................
To record the acquisition of equipment through a capital lease
agreement.
76,021
2,500
73,521
2,500
c. Under an operating lease, no asset or liability (other than perhaps a short-term liability
for accrued rent payable) relating to the lease appears in the lessee’s balance sheet.
d. If the lease is unquestionably a capital lease, it would be unacceptable, unethical and
possibly illegal for a publicly owned company to account for it as an operating lease.
Such presentation would understate the company’s total liabilities.
*Ex. 10–14 a. Pension Expense ...............................................................................
Cash .......................................................................................
To summarize payments to a fully funded pension plan.
2,500,000
b. Nonpension Postretirement Benefits Expense ..............................
Cash .......................................................................................
Unfunded Liability for Nonpension
Postretirement Benefits.....................................................
To summarize partial funding of nonpension postretirement
benefits expense for the year and an increase in the related
unfunded liability.
750,000
2,500,000
50,000
700,000
c. Because the pension plan is fully funded each year, and because the plan is an entity
separate from Western Electric, this plan should contain assets approximately equal
to the pension benefits earned by employees in prior years. Thus, even if Western
Electric becomes insolvent, the plan will continue to invest these assets and should be
able to pay these earned benefits in future years.
d. A company does not have an ethical (or legal) responsibility to fund its nonpension
postretirement benefits as they accrue. It does, however, have an ethical responsibility
to provide to employees all of the benefits they have earned during their working
careers.
____________
*Supplemental Topic: “Special Types of Liabilities.”
350
© The McGraw-Hill Companies, Inc., 2005
*Ex. 10–15 a. Deferred taxes are the income taxes that will become due in future years upon
earnings that already have been reported in a company’s income statement. Deferred
taxes arise because of timing differences between the recognition of certain revenue
and expenses in income tax returns and in financial statements.
b. $1,300,000 ($960,000 already paid, plus $340,000 currently payable)
c. Current liabilities:
Income taxes payable..................................................................................... $ 340,000
Deferred taxes payable (current portion) ....................................................
30,000
Total current tax liabilities ....................................................................... $ 370,000
Long-term liabilities:
Deferred taxes payable ($200,000, less current portion of $30,000) ......... $ 170,000
Ex. 10–16
a. Current Ratio:
(1) Current assets 12/31/02
(2) Current liabilities 12/31/02
Current ratio (1)  (2)
$224,948
63,096
3.57:1
Quick Ratio:
(1) Financial assets 12/31/02
(2) Current liabilities 12/31/02
Quick ratio (1)  (2)
$173,003
63,096
2.74:1
Given these strong ratios, and the fact that the company has over $146 million in cash, cash
equivalents, and marketable securities, it appears that it will have no problem repaying its
current liabilities as they come due.
b. Debt Ratio:
(1) Total liabilities 12/31/02
(2) Total assets 12/31/02
Debt ratio (1)  (2)
$119,340
646,080
18.5%
The company has a very low debt load. Only 18.5% of each asset dollar is debt financed. Of this
amount, most is short-term.
c. The company reports current liabilities of approximately $63.1 million at the end of 2002. Cash
flows from operating activities for the year amount to $71.2 million. If similar cash flows are
generated in 2003, no problems should be encountered in paying these liabilities.
____________
*Supplemental Topic: “Special Types of Liabilities.”
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
351
SOLUTIONS TO PROBLEMS
PROBLEM 10–1
COMPUTER SPECIALISTS, INC.
25 Minutes, Easy
Income Statement
Transaction
a
b
c
d
e
f
g
h
i
j
k
l
*m
*n
*o
Revenue
NE
NE
NE
I
NE
NE
NE
NE
NE
NE
NE
NE
NE
NE
NE

Expenses
I
NE
I
NE
NE
I
I
NE
I
I
NE
I
I
NE
NE

Net Income
D
NE
D
I
NE
D
D
NE
D
D
NE
D
D
NE
NE
Assets
NE
NE
D
NE
NE
D
D
I
D
NE
I
NE
NE
NE
NE

Balance Sheet
Current
Long-Term
Liabilities
Liabilities

I
NE
I
D
I
NE
D
NE
D
I
D
NE
NE
D
NE
I
NE
I
I
I
NE
I
I
D
I
NE
NE
NE
NE
NE

Owners’
Equity
D
NE
D
I
NE
D
D
NE
D
D
NE
D
D
NE
NE
© The McGraw-Hill Companies, Inc., 2005
30 Minutes, Medium
a.
PROBLEM 10–2
SEATTLE CHOCOLATES
SEATTLE CHOCOLATES
Partial Balance Sheet
December 31, 2005
Liabilities:
Current liabilities:
Income taxes payable
Accrued expenses and payroll taxes
Mortgage note payable—current portion ($750,000 - $739,000)
Accrued interest on mortgage note payable
Trade accounts payable
Unearned revenue
Total current liabilities
Long-term liabilities:
Note payable to Northwest Bank
Mortgage note payable ($750,000 - $11,000 current portion)
Total long-term liabilities
Total liabilities
$
4 0 0 0
6 0 0 0
1 1 0 0
5 0 0
2 5 0 0 0
1 5 0 0
$3 8 1 0 0
$5
7
$1 2
$1 6
0
3
3
2
0
9
9
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
b. Comments on information in the numbered paragraphs:
(1) Although the note payable to Northwest Bank is due in 60 days, it is classified as a long-term
liability because it is to be refinanced on a long-term basis.
(2) The $11,000 principal amount of the mortgage note payable scheduled for repayment in 2006
($750,000  $739,000) is classified as a current liability. Principal to be repaid after December
31, 2006, is classified as a long-term liability.
(3) As the accrued interest is payable within one month, it is a current liability.
(4) The pending lawsuit is a loss contingency. As no reasonable estimate can be made of the loss
incurred (if any), this loss contingency does not meet the criteria for accrual. It will be
disclosed in the notes accompanying the financial statements, but it should not be shown as a
liability.
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
353
25 Minutes, Medium
PROBLEM 10–3
SWANSON CORPORATION
a.
General Journal
20__
Aug 6 Cash
1 2 0 0 0
Notes Payable
Borrowed $12,000 @ 12% per annum from Maple Grove Bank.
issued a 45-day promissory note.
1 2 0 0 0
Sept 16 Office Equipment
Notes Payable
Issued 3-month, 10% note to Seawald Equipment as payment
for office equipment.
1 8 0 0 0
Sept 20 Notes Payable
Interest Expense
Cash
Paid note and interest to Maple Grove Bank ($12,000 x 12%
x 45/360 = $180).
1 2 0 0 0
1 8 0
Nov
1 Cash
1 8 0 0 0
1 2 1 8 0
2 5 0 0 0 0
Notes Payable
Obtained 90-day loan from Mike Swanson; interest @ 15%
per annum.
Dec
1 Inventory
Notes Payable
To record purchase of merchandise, and issuance of 90-day,
14% note payable to Gathman Corporation.
Dec 16 Notes Payable
Interest Expense
Cash
Notes Payable
Paid interest on note to Seawald Equipment which matured
today and issued a 30-day, 16% renewal note.
Interest: $18,000 x 10% x3/12 = $450.
b.
Adjusting Entry
Dec 31 Interest Expense
Interest Payable
To record interest accrued on notes payable:
Mike Swanson ($250,000 x 15% x 2/12 = $6,250);
Gathman Corporation ($5,000 x 14% x 1/12 = $58); and
Seawald Equipment ($18,000 x16% x1/12 x 1/2 = $120).
2 5 0 0 0 0
5 0 0 0
5 0 0 0
1 8 0 0 0
4 5 0
4 5 0
1 8 0 0 0
6 4 2 8
6 4 2 8
c. The Seawald Equipment note dated September 16 was due in full on December 16. The higher
rate of interest on the new note may be associated with the increased risk of collecting in 30 days
the $18,000 principal, plus accrued interest due.
354
© The McGraw-Hill Companies, Inc., 2005
25 Minutes, Medium
PROBLEM 10–4
QUICK LUBE
a. and d.
a. The amount of the monthly payments exceeds the amount of the monthly interest expense.
Therefore, a portion of each payment reduces the unpaid balance of the loan. The continuous
reduction in the unpaid balance, in turn, causes the monthly interest expense to be less in each
successive month, and the amount applied to the unpaid balance to increase. Thus, the loan
principal is repaid at an ever-increasing rate.
d. At December 31, 2005, two amounts relating to this mortgage loan will appear as current
liabilities in the borrower’s balance sheet. First, as payments are due on the first day of each
month, one month’s interest has accrued since the December 1 payment. This accrued interest will
be paid on January 1, 2006, and therefore, is a current liability.
Next, the portion of the unpaid principal that will be repaid during 2006 represents a current
liability.
Parts b and c appear on the following page.
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
355
PROBLEM 10–4
QUICK LUBE (concluded)
b.
General Journal
2005
Oct 1 Interest Expense
Mortgage Note Payable
Cash
To record monthly payment on mortgage.
Nov
1 Interest Expense
Mortgage Note Payable
Cash
To record monthly mortgage payment.
c.
Interest
Period
Issue date
1
2
3
4
356
1 0 8 0 0
3 1 0
1 1 1 1 0
1 0 7 9 7
3 1 3
1 1 1 1 0
Amortization Table
(12%, 30-Year Mortgage Note Payable for $1,080,000;
Payable in 360 Monthly Installments of $11,110)
Reduction in
Payment
Monthly
Interest
Unpaid
Date
Payment
Expense
Balance
Sept. 1, 2005
—
—
—
Oct. 1
$ 1 1 1 1 0
$ 1 0 8 0 0
$ 3 1 0
Nov. 1
1 1 1 1 0
1 0 7 9 7
3 1 3
Dec. 1
1 1 1 1 0
1 0 7 9 4
3 1 6
Jan. 1, 2006
1 1 1 1 0
1 0 7 9 1
3 1 9
$1
1
1
1
1
Unpaid
Balance
0 8 0 0 0 0
0 7 9 6 9 0
0 7 9 3 7 7
0 7 9 0 6 1
0 7 8 7 4 2
© The McGraw-Hill Companies, Inc., 2005
15 Minutes, Easy
PROBLEM 10–5
BLUE MOUNTAIN POWER COMPANY
General Journal
a.
2005
Aug
1 Cash
10 2 5 0 0 0 0
Bonds Payable
Bond Interest Payable
Issued $10,000,000 face value of 10%, 20-year bonds at 100
plus accrued interest for three months ($10,000,000 x .10
x 3/12 =$250,000).
b.
Nov
c.
Dec
10 0 0 0 0 0 0
2 5 0 0 0 0
1 Bond Interest Payable
Bond Interest Expense
Cash
Paid semiannual interest ($10,000,000 x .10 x 1/2 = $500,000).
2 5 0 0 0 0
2 5 0 0 0 0
31 Bond Interest Expense
Bond Interest Payable
To accrue two months’ interest expense ($10,000,000 x .10 x
2/12 = $166,667).
1 6 6 6 6 7
d.
2006
May
1 Bond Interest Payable
Bond Interest Expense
Cash
To record semiannual bond interest payment and interest
expense for four months since Dec. 31
($10,000,000 x .10 x 4/12 = $333,333).
5 0 0 0 0 0
1 6 6 6 6 7
1 6 6 6 6 7
3 3 3 3 3 3
5 0 0 0 0 0
e. The market rate of interest on the date of issuance was 10%. Because the bonds were issued at
par (100), the market rate had to have equaled the contract interest rate printed on the bonds.
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
357
35 Minutes, Strong
PROBLEM 10–6
PARK RAPIDS LUMBER COMPANY
a.
General Journal
(1)
Bonds issued at 98:
2005
Dec 31 Bond Interest Expense
Discount on Bonds Payable
Bond Interest Payable
To record accrual of bond interest expense for four
months in 2002:
Contract interest ($80,000,000 x 10% x 4/12)
Discount amortization ($1,600,000  20 years) x
4/12
Bond interest expense for four months
2 6 9 3 3 3 4
2 6 6 6 7
2 6 6 6 6 6 7
$2,666,667
26,667
$2,693,334
2006
Mar
1 Bond Interest Payable
Bond Interest Expense
Discount on Bonds Payable
Cash
To record semiannual bond interest payment and
interest expense for two months (1/2 of interest for
four months, as computed in preceding entry).*
(2)
Bonds issued at 101:
2005
Dec 31 Bond Interest Expense
Premium on Bonds Payable
Bond Interest Payable
Accrual of interest on bonds for four months:
Contract interest ($80,000,000 x 10% x 4/12)
Less: Premium amortization
($800,000  20 years) x 4/12
Bond interest expense for four months
2006
Mar
1 Bond Interest Payable
Bond Interest Expense
Premium on Bonds Payable
Cash
Semiannual bond interest payment and interest
expense for two months (1/2 of interest for four
months, as computed in preceding entry).*
2 6 6 6 6 6 7
1 3 4 6 6 6 7
1 3 3 3 4
4 0 0 0 0 0 0
2 6 5 3 3 3 4
1 3 3 3 3
2 6 6 6 6 6 7
$2,666,667
(13,333)
$2,653,334
2 6 6 6 6 6 7
1 3 2 6 6 6 7
6 6 6 6
4 0 0 0 0 0 0
*Actual amount differs slightly due to rounding errors.
358
© The McGraw-Hill Companies, Inc., 2005
PROBLEM 10–6
PARK RAPIDS LUMBER COMPANY (concluded)
b.
Net bond liability at Dec. 31, 2006:
Bonds payable
* Less: Discount on bonds payable ($1,600,000 - $106,667)
** Add: Premium on bonds payable ($800,000 - $53,333)
Net bond liability
Bonds
Issued
at 98
$ 80 0 0 0 0 0 0
(1 4 9 3 3 3 3 )
$ 78 5 0 6 6 6 7
Bonds
Issued
at 101
$ 80 0 0 0 0 0 0
7 4 6 6 6 7
$ 80 7 4 6 6 6 7
* Discount amortized at Dec. 31, 2006:
Amount amortized in 2005 ...................................................................................
$26,667
80,000
Amount amortized in 2006 ($1,600,000  20 years) ...........................................
Discount amortized at 12/31/06 ..................................................................
$106,667
** Premium amortized at Dec. 31, 2006:
Amount amortized in 2005 ...................................................................................
$13,333
40,000
Amount amortized in 2006 ($800,000  20 years) ..............................................
Premium amortized at 12/31/06 .................................................................
$53,333
c. The effective rate of interest would be higher under assumption 1. The less that investors pay for
bonds with a given contract rate of interest, the higher the effective interest rate they will earn.
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
359
45 Minutes, Strong
a.
PROBLEM 10–7
MINNESOTA SATELLITE TELEPHONE
CORPORATION
MINNESOTA SATELLITE TELEPHONE CORPORATION
Partial Balance Sheet
December 31, 2005
(in thousands)
Liabilities:
Current liabilities:
Accounts payable
Accrued expenses payable (other than interest)
Accrued interest payable
Notes payable (short-term)
Lease payment obligation (current portion)
Unfunded obligation for postretirement benefits other than
pensions (current portion)
Income taxes payable
Total current liabilities
Long-term liabilities:
6-3/4% Bonds payable, due February 1, 2006
8-1/2% Bonds payable, due June 1, 2006
Less: Discount on bonds payable
11% Bonds payable, due June 1, 2015
Add: Premium on bonds payable
Lease payment obligation (less current portion)
Unfunded obligation for postretirement benefits other than
pensions (less current portion)
Deferred income taxes
Total long-term liabilities
Total liabilities
$
$
$
2 5 0 0
2
3 0 0 0
1 7
0
6
0
0
6 5 6
1 1 3
7 3
1 1 0 0
4 6
0
4
3
0
2
0
7
3
0
1
$
1 8 0 0 0
1 7 3 0 0
2 3 4 2 0 1
$
1 0 0 0 0 0
0
0
0
0
2 4 9 7 4 0
3 0 1 7 0 0
1 8 9 7 9
5 4 0
1 3 0 0
$ 8 5 4 4
$10 8 8 6
0
0
1
2
0
0
9
0
Part b appears on the following page.
c.
(1) Computation of debt ratio:
Total liabilities (above)
Total assets (given)
Debt ratio ($1,088,620  $2,093,500)
(2) Computation of interest coverage ratio:
Operating income (given)
Annual interest expense ($61,000 + $17,000)
Interest coverage ratio ($280,800  $78,000)
$10 8 8 6 2 0
$20 9 3 5 0 0
5 2 %
$
$
2 8 0 8 0 0
7 8 0 0 0
3.6 times
Part d appears on the following page.
360
© The McGraw-Hill Companies, Inc., 2005
PROBLEM 10–7
MINNESOTA SATELLITE TELEPHONE CORPORATION
(concluded)
b. (1) As the 634% bond issue is being refinanced on a long-term basis (that is, paid from the
proceeds of a long-term bond issue rather than from current assets), it is classified as a longterm liability rather than a current liability.
(2) The 812% bonds will be repaid from a bond sinking fund rather than from current assets.
Therefore, this liability continues to be classified as long-term, despite its maturity date in less
than one year.
(3) The portion of the capitalized lease payment obligation that will be repaid within one year
($4,621) is classified as a current liability, and the remainder of this obligation is classified as
long-term. The payments applicable to operating leases will be recognized as rental expense in
the periods in which these costs are incurred.
(4) As the pension plan is fully funded, the company has no pension liability.
(5) The $18,000 portion of the unfunded liability for nonpension postretirement benefits that will
be funded within one year is a current liability, and the remaining $54,000 ($72,000  $18,000)
is classified as long-term.
(6) Income taxes payable relate to the current year’s income tax return and, therefore, are a
current liability. Although deferred income taxes can include a current portion, all of the
deferred income taxes are stated to be a long-term liability.
d. Based solely upon its debt ratio and interest coverage ratio, Minnesota Satellite Telephone
Corporation appears to be at least a good credit risk. One must consider, however, that
Minnesota Satellite Telephone Corporation is a telephone company, not a business organization
that battles numerous competitors on a daily basis. Telephone companies enjoy a “captive
market” on a long-term basis. Also, their rates are regulated to allow them to recover their costs
and to earn a reasonable profit, except in unusual circumstances.
In summary, the fact that Minnesota Satellite Telephone Corporation is a profitable telephone
company with a reasonable debt ratio and interest coverage ratio makes this business entity an
outstanding long-term credit risk.
Note to instructor: We do not expect students to have advance knowledge of the monopoly position of
telephone companies. However, we believe this situation enables us to make a most important point:
To properly interpret financial information about a business organization, one must understand the
nature of the company’s operations and its business environment.
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
361
SOLUTIONS TO CASES
30 Minutes, Medium
CASE 10–1
LIABILITIES IN PUBLISHED
FINANCIAL STATEMENTS
a. Wells Fargo’s liability for interest-bearing deposits represents the amounts on deposit in interestbearing bank accounts. This liability arises from customers depositing money in these accounts
and is discharged whenever customers make withdrawals.
b. The New York Times’ liability for unexpired subscriptions is a form of unearned revenue, arising
from customers paying in advance to receive the newspaper over a designated subscription
period. This liability is discharged through delivering newspapers to these customers throughout
the subscription period.
c. Horse racing tracks issue mutuel tickets as evidence of the bets that customers have made on
specific races. After the race, customers can present “winning” tickets and collect an amount
greater than they had paid to purchase the ticket. The track does not redeem “losing” tickets.
Therefore, Hollywood Park’s liability for outstanding mutuel tickets is its obligation to make
payments to holders of winning tickets that have not yet been redeemed. This liability comes into
existence as horses win races, and it is discharged as the track redeems the winning tickets.
d. As American Greetings is a manufacturer, it probably sells primarily to wholesalers or retailers
rather than directly to consumers. Apparently, the company allows its customers to return
merchandise that they are unable to sell and to receive a refund of the purchase price. Given the
seasonal nature of holiday greeting cards, wholesalers and retailers are quite likely to exercise
this return privilege and return to the manufacturer any cards that remain unsold at the end of
the holiday period.
The liability to pay refunds for sales returns comes into existence from making sales upon which
returns are permitted. As the returns are likely to occur in a subsequent accounting period, the
amount of this liability can only be estimated, based upon the company’s prior experiences. The
liability is discharged by making cash refunds (or crediting the account receivable of a customer
making a return).
e. Wausau Paper’s liability for “current maturities” of long-term debt is common to most large
organizations. This liability arises as debt instruments originally classified as long-term near their
maturity dates. The principal amounts scheduled for repayment within the next year (or
operating cycle) are classified as current liabilities. These liabilities normally are discharged by
making payments to creditors as the liabilities mature.
f.
362
Club Med’s liability for future vacations is unearned revenue. This liability arises when
customers pay in advance to use the company’s resort facilities at a later date. Normally, this
liability is discharged by rendering services to the customer—that is, allowing them to use the
club’s facilities. In some instances, however, the liability may be discharged by making cash
refunds for canceled reservations.
© The McGraw-Hill Companies, Inc., 2005
CASE 10–1
LIABILITIES IN PUBLISHED
FINANCIAL STATEMENTS (concluded)
g. Apple’s accrued marketing and distribution liability represents accrued marketing and
distribution expenses that have not yet been paid. This liability arises as Apple incurs marketing
and distribution costs on account; it is discharged when the company makes payment to the
individuals or organizations rendering these services.
h. GM’s liability for postretirement costs is an obligation to pay retirement benefits to workers—
some of whom are already retired and some of whom are currently employed by GM. The
liability arises as employees perform services for GM and thereby earn the right to future
postretirement benefits. GM can discharge this obligation either by funding it with an
independent trustee, or by making the future benefit payments to retired workers.
Solutions Manual Vol. I, Financial and Managerial Accounting 13/e, Williams et al
363
20 Minutes, Strong
CASE 10–2
ABBOTT LABS
a. The effective rate of interest is higher on issue A bonds. The less that investors pay for bonds with
a given contract rate of interest, the higher the effective interest rate they will earn.
b. The bonds of both issues pay the investors $60 over twelve months, computed as follows:
$1,000  6% = $60
c. Differences in the length of time remaining until the bond issues mature is the major factor
influencing the current market prices. As bonds near their maturity dates, their market prices
normally move closer and closer to their maturity value. The bonds of issue A will mature two
years before those of issue B. This explains why their market price is closer to par value than
those of issue B.
364
© The McGraw-Hill Companies, Inc., 2005
25 Minutes, Medium
CASE 10–3
LOSS CONTINGENCIES?
a. The estimated loss from uncollectible accounts is a loss stemming from past events (credit sales)
and is uncertain in dollar amount until the accounts either are paid or become obviously
uncollectible. Therefore, this item is a loss contingency. Typically, the loss contingency relating to
uncollectible accounts receivable can be estimated with sufficient reasonableness that it is
recorded in the accounts. The appropriate entry would involve a debit to Uncollectible Accounts
Expense and a credit to the Allowance for Doubtful Accounts in the amount of the estimated loss.
b. The health, retirement, or even death of company executives are not loss contingencies and are
not recorded or disclosed in financial statements. For one thing, the impact of these events is
extremely subjective. For another, such events do not immediately and directly affect the
recorded assets, liabilities, or owners’ equity of the business.
Note to instructor: An exception to this general rule could occur in the case of some professional
athletes, whose long-term contracts may appear as assets in the financial statements of a
professional sports team. In this situation, injury to an athlete could be a loss contingency that
impaired a recorded asset.
c. The risk of a future airplane crash does not stem from past events. Therefore, it is not a loss
contingency. A loss contingency would exist if an airplane had crashed, but the amount of the
airline’s liability (if any) had not yet been resolved.
The reason for not disclosing risks of future losses is that the list of risk conditions is virtually
endless. For example, an airline faces risks of loss from such factors as hijacking or other
terrorist activities, food poisoning of passengers, inadequate first aid, damages caused by parts
falling off a plane, liability for discriminatory personnel practices, etc. At what point should the
disclosure of risk stop?
d. This lawsuit is based upon past events (treatment of displaced passengers) and involves
uncertainty as to the amount of loss, if any. Thus, it is a loss contingency. As there is insufficient
information to allow for a reasonable estimate of the amount of loss, this item should be disclosed
in notes to the financial statements rather than being recorded in the accounts.
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15 Minutes, Medium
CASE 10–4
BUSINESS WEEK ASSIGNMENT
Bond prices vary inversely with changes in market interest rates. As interest rates rise, investors will
be willing to pay less money to own a bond that pays a fixed contract rate of interest. Changes in
market interest rates are not the only factors that influence bond prices. The length of time
remaining until the bonds mature is another major force. As a bond nears its maturity date, its
market price normally moves closer and closer to its par value. Thus, bonds maturing in 30 years or
more are far more susceptible to interest rate risk (i.e., declining values caused by increases in
market rates of interest) than bonds maturing in 3 years or less.
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© The McGraw-Hill Companies, Inc., 2005
SOLUTION TO INTERNET ASSIGNMENT
No time estimate
INTERNET 10–1
a. Student responses to this problem will vary as market circumstances change. Several industrial
firms currently having Aaa/AAA bond ratings, and the corresponding yields of their bonds, are
shown below:
Company
Yield
General Electric
5.561%
Toyota
2.465%
Pacificorp
3.027%
American General
5.815%
b. Again, responses to this problem will vary as market circumstances change. Several industrial
firms currently having B/B (or lower) bond ratings, and the corresponding yields of their bonds,
are shown below:
Company
Yield
Delta Airlines
23.545%
Northwest Airlines
30.375%
Calpine Corporation 10.427%
Utilicorp
10.439%
c. The search conducted in part “b” produced the bonds with the highest yields. These bonds, as
evidenced by their low credit ratings, present a much greater risk of default than those bonds
with Aaa/AAA ratings. To compensate investors for their risk, the B/B bonds (and bonds with
even lower ratings) are trading at significant discounts in order to boost their respective yields to
levels demanded in the marketplace.
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