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Chapter 12
Non-current Financial Liabilities
O. Problems
P12-1. Suggested solution:
a. Companies may be motivated to keep debt off the balance sheet so as to improve key
financial ratios and free up borrowing capacity.
b. Examples of obligations that were previously off-balance-sheet but now have to be
recognized include: i) those emanating from derivative contracts; ii) special-purpose entities;
iii) decommissioning costs; and iv) finance leases.
P12-2. Suggested solution:
a. Proposal one Proposal two
Estimated EBIT $300,000 $300,000
Less: Interest $2,000,000 × 4% 80,000 $3,000,000 × 4% 120,000
Income before taxes 220,000 180,000
Income taxes $220,000 × 30% 66,000 $180,000 × 30% 54,000
Net income after taxes $154,000 $126,000
ROE (Net income / $154,000 / 7.7% $126,000 / 12.6%
Market value of equity) $2,000,000 $1,000,000
b. Proposal two results in the higher of the two estimated ROEs (Proposal two ROE 12.6% >
proposal one ROE 7.7%)
c. The primary benefit to the shareholders of adopting proposal two is the higher envisaged
return. Drawbacks to increased financial leverage include a heightened risk of loss if estimates
are not realized and an increased risk of bankruptcy.
P12-3. Suggested solution:
a. Financial leverage quantifies the relationship between the relative level of a firm’s debt and
its equity base. Financial leverage offers investors the opportunity to increase their return on
equity when the business performs well but in so doing exposes them to an increased risk of
loss and bankruptcy.
b. The function of debt rating agencies is to provide investors with an independent evaluation of
the riskiness of debt securities and in so doing assist investors in making informed
investment decisions.
c. Financial liabilities are contractual obligations to deliver cash or other financial assets to
another party.
d. Companies sell notes directly to the investing public to reduce interest costs. They do this by
decreasing or eliminating the spread charged by financial intermediaries.
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P12-4. Suggested solution:
a. A bond indenture is the contract that outlines the terms of the bond, including the maturity
date; rate of interest and interest payment dates; security pledged; and financial covenants.
b. A covenant is the borrower’s promise to restrict certain activities. There are both positive and
negative covenants. A positive covenant is one where the borrower promises to do
something, e.g., maintain a current ratio in excess of 2:1. A negative covenant is one in
which the borrower pledges not to do something, e.g., will not pay dividends without the
lender’s prior consent.
c. Companies issue bonds for reasons that include reducing the cost of borrowing and accessing
large amounts of capital.
d. Corporations usually engage an investment bank to underwrite (sell) the bonds on its behalf
on either a firm commitment or a best-efforts basis. The more common method is the firm
commitment underwriting, where the investment bank guarantees the borrower a price for the
bonds. Another arrangement is the best-efforts approach, where the broker agrees to try to
sell as much of the issue as possible to investors.
P12-5. Suggested solution:
Callable bonds permit the issuing company to “call” for the bonds to be redeemed before
maturity.
Convertible bonds can be exchanged or “converted” for other securities in the corporation,
usually ordinary shares.
Debentures are unsecured bonds.
Real-return bonds provide protection against inflation. While the mechanics differ slightly
across issues, the basic premise is that the principal owed is indexed to inflation; thus, at
maturity the principal is repaid at the inflated amount.
Perpetual bonds are bonds that never mature.
Secured bonds are bonds backed by specific collateral such as a mortgage on real estate.
Serial bonds are bonds issued at the same time that mature at regular intervals, rather than all
on the same date.
Stripped (zero-coupon) bonds are bonds that do not pay interest. Stripped bonds are sold at a
discount and mature at face value.
P12-6. Suggested solution:
Discount to be amortized per period ($5,000,000 - $4,850,000) / (5 × 2) = $15,000
Interest expense per period ($5,000,000 × 4% / 2) + $15,000 = $115,000
a. Journal entry on issuance (Jan. 1, 2018)
Dr. Cash (Sales proceeds – transaction costs) 4,850,000
Cr. Bonds payable ($4,900,000 – $50,000) 4,850,000
b. Journal entry on interest payment date (July 1, 2018)
Dr. Interest expense (from above) 115,000
Cr. Cash ($5,000,000 × 4% / 2) 100,000
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Chapter 12: Non-current Financial Liabilities
Cr. Bonds payable ($115,000 - $100,000) 15,000
c. Journal entry at year-end (Dec. 31, 2018)
Dr. Interest expense (from above) 115,000
Cr. Interest payable ($5,000,000 × 4% / 2) 100,000
Cr. Bonds payable ($115,000 - $100,000) 15,000
P12-7. Suggested solution:
a. The fair value of the note is determined using discounted cash flow analysis.
PVFA(0.5%, 36) = 1/0.005 - 1/0.005(1.005)36 = 32.8710
PV of the note = $1,000 × PVFA(0.5%, 36) = $1,000 x 32.8710 = $32,871
Or using a BAII PLUS financial calculator:
36 N, 0.50 I/Y, 1,000 PMT, CPT PV PV = −32,871 (rounded)
Dr. Automobile 32,871
Cr. Notes payable 32,871
b. Dr. Interest expense ($32,871 × 0.50% = $164 (rounded)) 164
Cr. Notes payable* 164
Dr. Notes payable* 1,000
Cr. Cash 1,000
*May be combined
P12-8. Suggested solution:
a. The fair value of the note is determined using discounted cash flow analysis.
Value of = $10,.043 $8,890
principal
Value of coupons = $200 × PVFA(4%,3) = $200 × 2.77509 555
Total $9,445
Using a BAII PLUS financial calculator:
3 N, 4 I/Y, 10000 FV, 200 PMT, CPT PV PV = –9,445 (rounded)
Dr. Office furniture 9,445
Cr. Notes payable 9,445
b. Dr. Interest expense ($9,445 × 4% = $378 (rounded)) 378
Cr. Cash 200
Cr. Notes payable 178
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P12-9. Suggested solution:
Premium to be amortized per period ($5,180,000 - $5,000,000) / (6 × 2) = $15,000
Interest expense per period ($5,000,000 × 6% / 2) - $15,000 = $135,000
a. Journal entry on issuance (Jan. 1, 2019)
Dr. Cash (Net sales proceeds $5,200,000 – $20,000) 5,180,000
Cr. Bonds payable 5,180,000
b. Journal entry on interest payment date (July 1, 2019)
Dr. Interest expense (from above) 135,000
Dr. Bonds payable ($150,000 - $135,000) 15,000
Cr. Cash ($5,000,000 × 6% / 2) 150,000
c. Journal entry at year-end (Dec. 31, 2019)
Dr. Interest expense (from above) 135,000
Dr. Bonds payable ($150,000 - $135,000) 15,000
Cr. Interest payable ($5,000,000 × 6% / 2) 150,000
d. A firm commitment underwriting is when the investment bank guarantees the borrower a
price for the bonds, expecting to resell them to its investment clients at a profit. The best
efforts approach is when the broker simply agrees to try to sell as much of the issue as
possible to investors.
P12-10. Suggested solution:
a. Journal entry on issuance (May 1, 2021)
Dr. Cash ($1,000,000 + $13,333) 1,013,333
Cr. Bonds payable 1,000,000
Cr. Accrued interest payable ($1,000,000 × 4% × 4/12) 13,333
b. Journal entry on interest payment date (June 30, 2021)
Dr. Accrued interest payable 13,333
Dr. Interest expense ($1,000,000 × 4% × 2/12) 6,667
Cr. Cash 20,000
c. Journal entry on interest payment date (Dec. 31, 2021)
Dr. Interest expense ($1,000,000 × 4%/2) 20,000
Cr. Cash 20,000
P12-11. Suggested solution:
Most non-current financial liabilities are initially valued at fair value minus debt issue costs. Fair
value is determined by, in order of preference: using active market values; referencing recent
similar transactions; and employing discounted cash flow analysis. The debt and equity
components of compound financial instruments must be separately valued.
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Chapter 12
Non-current Financial Liabilities
O. Problems
P12-1. Suggested solution:
a. Companies may be motivated to keep debt off the balance sheet so as to improve key
financial ratios and free up borrowing capacity.
b. Examples of obligations that were previously off-balance-sheet but now have to be
recognized include: i) those emanating from derivative contracts; ii) special-purpose entities;
iii) decommissioning costs; and iv) finance leases.
P12-2. Suggested solution:
a. Proposal one Proposal two
Estimated EBIT $300,000 $300,000
Less: Interest $2,000,000 × 4% 80,000 $3,000,000 × 4% 120,000
Income before taxes 220,000 180,000
Income taxes $220,000 × 30% 66,000 $180,000 × 30% 54,000
Net income after taxes $154,000 $126,000
ROE (Net income / $154,000 / 7.7% $126,000 / 12.6%
Market value of equity) $2,000,000 $1,000,000
b. Proposal two results in the higher of the two estimated ROEs (Proposal two ROE 12.6% >
proposal one ROE 7.7%)
c. The primary benefit to the shareholders of adopting proposal two is the higher envisaged
return. Drawbacks to increased financial leverage include a heightened risk of loss if estimates
are not realized and an increased risk of bankruptcy.
P12-3. Suggested solution:
a. Financial leverage quantifies the relationship between the relative level of a firm’s debt and
its equity base. Financial leverage offers investors the opportunity to increase their return on
equity when the business performs well but in so doing exposes them to an increased risk of
loss and bankruptcy.
b. The function of debt rating agencies is to provide investors with an independent evaluation of
the riskiness of debt securities and in so doing assist investors in making informed
investment decisions.
c. Financial liabilities are contractual obligations to deliver cash or other financial assets to
another party.
d. Companies sell notes directly to the investing public to reduce interest costs. They do this by
decreasing or eliminating the spread charged by financial intermediaries.
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ISM for Lo/Fisher, Intermediate Accounting, Vol. 2, Fourth Edition
P12-4. Suggested solution:
a. A bond indenture is the contract that outlines the terms of the bond, including the maturity
date; rate of interest and interest payment dates; security pledged; and financial covenants.
b. A covenant is the borrower’s promise to restrict certain activities. There are both positive and
negative covenants. A positive covenant is one where the borrower promises to do
something, e.g., maintain a current ratio in excess of 2:1. A negative covenant is one in
which the borrower pledges not to do something, e.g., will not pay dividends without the
lender’s prior consent.
c. Companies issue bonds for reasons that include reducing the cost of borrowing and accessing
large amounts of capital.
d. Corporations usually engage an investment bank to underwrite (sell) the bonds on its behalf
on either a firm commitment or a best-efforts basis. The more common method is the firm
commitment underwriting, where the investment bank guarantees the borrower a price for the
bonds. Another arrangement is the best-efforts approach, where the broker agrees to try to
sell as much of the issue as possible to investors.
P12-5. Suggested solution:
Callable bonds permit the issuing company to “call” for the bonds to be redeemed before
maturity.
Convertible bonds can be exchanged or “converted” for other securities in the corporation,
usually ordinary shares.
Debentures are unsecured bonds.
Real-return bonds provide protection against inflation. While the mechanics differ slightly
across issues, the basic premise is that the principal owed is indexed to inflation; thus, at
maturity the principal is repaid at the inflated amount.
Perpetual bonds are bonds that never mature.
Secured bonds are bonds backed by specific collateral such as a mortgage on real estate.
Serial bonds are bonds issued at the same time that mature at regular intervals, rather than all
on the same date.
Stripped (zero-coupon) bonds are bonds that do not pay interest. Stripped bonds are sold at a
discount and mature at face value.
P12-6. Suggested solution:
Discount to be amortized per period ($5,000,000 - $4,850,000) / (5 × 2) = $15,000
Interest expense per period ($5,000,000 × 4% / 2) + $15,000 = $115,000
a. Journal entry on issuance (Jan. 1, 2018)
Dr. Cash (Sales proceeds – transaction costs) 4,850,000
Cr. Bonds payable ($4,900,000 – $50,000) 4,850,000
b. Journal entry on interest payment date (July 1, 2018)
Dr. Interest expense (from above) 115,000
Cr. Cash ($5,000,000 × 4% / 2) 100,000
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Chapter 12: Non-current Financial Liabilities
Cr. Bonds payable ($115,000 - $100,000) 15,000
c. Journal entry at year-end (Dec. 31, 2018)
Dr. Interest expense (from above) 115,000
Cr. Interest payable ($5,000,000 × 4% / 2) 100,000
Cr. Bonds payable ($115,000 - $100,000) 15,000
P12-7. Suggested solution:
a. The fair value of the note is determined using discounted cash flow analysis.
PVFA(0.5%, 36) = 1/0.005 - 1/0.005(1.005)36 = 32.8710
PV of the note = $1,000 × PVFA(0.5%, 36) = $1,000 x 32.8710 = $32,871
Or using a BAII PLUS financial calculator:
36 N, 0.50 I/Y, 1,000 PMT, CPT PV PV = −32,871 (rounded)
Dr. Automobile 32,871
Cr. Notes payable 32,871
b. Dr. Interest expense ($32,871 × 0.50% = $164 (rounded)) 164
Cr. Notes payable* 164
Dr. Notes payable* 1,000
Cr. Cash 1,000
*May be combined
P12-8. Suggested solution:
a. The fair value of the note is determined using discounted cash flow analysis.
Value of = $10,.043 $8,890
principal
Value of coupons = $200 × PVFA(4%,3) = $200 × 2.77509 555
Total $9,445
Using a BAII PLUS financial calculator:
3 N, 4 I/Y, 10000 FV, 200 PMT, CPT PV PV = –9,445 (rounded)
Dr. Office furniture 9,445
Cr. Notes payable 9,445
b. Dr. Interest expense ($9,445 × 4% = $378 (rounded)) 378
Cr. Cash 200
Cr. Notes payable 178
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ISM for Lo/Fisher, Intermediate Accounting, Vol. 2, Fourth Edition
P12-9. Suggested solution:
Premium to be amortized per period ($5,180,000 - $5,000,000) / (6 × 2) = $15,000
Interest expense per period ($5,000,000 × 6% / 2) - $15,000 = $135,000
a. Journal entry on issuance (Jan. 1, 2019)
Dr. Cash (Net sales proceeds $5,200,000 – $20,000) 5,180,000
Cr. Bonds payable 5,180,000
b. Journal entry on interest payment date (July 1, 2019)
Dr. Interest expense (from above) 135,000
Dr. Bonds payable ($150,000 - $135,000) 15,000
Cr. Cash ($5,000,000 × 6% / 2) 150,000
c. Journal entry at year-end (Dec. 31, 2019)
Dr. Interest expense (from above) 135,000
Dr. Bonds payable ($150,000 - $135,000) 15,000
Cr. Interest payable ($5,000,000 × 6% / 2) 150,000
d. A firm commitment underwriting is when the investment bank guarantees the borrower a
price for the bonds, expecting to resell them to its investment clients at a profit. The best
efforts approach is when the broker simply agrees to try to sell as much of the issue as
possible to investors.
P12-10. Suggested solution:
a. Journal entry on issuance (May 1, 2021)
Dr. Cash ($1,000,000 + $13,333) 1,013,333
Cr. Bonds payable 1,000,000
Cr. Accrued interest payable ($1,000,000 × 4% × 4/12) 13,333
b. Journal entry on interest payment date (June 30, 2021)
Dr. Accrued interest payable 13,333
Dr. Interest expense ($1,000,000 × 4% × 2/12) 6,667
Cr. Cash 20,000
c. Journal entry on interest payment date (Dec. 31, 2021)
Dr. Interest expense ($1,000,000 × 4%/2) 20,000
Cr. Cash 20,000
P12-11. Suggested solution:
Most non-current financial liabilities are initially valued at fair value minus debt issue costs. Fair
value is determined by, in order of preference: using active market values; referencing recent
similar transactions; and employing discounted cash flow analysis. The debt and equity
components of compound financial instruments must be separately valued.
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