Moodle Solutions - Ch10 PDF

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Solution Chapter 10 ACCT1115...

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Burnley, Understanding Financial Accounting, Second Canadian Edition

A mortgage (loan) is simply a long-term debt with a capital asset —such as land with a building or piece of equipment—pledged as collateral or security for the loan. If the borrower fails to repay the loan according to the specified terms, the lender has the legal right to have the asset seized and sold, and the proceeds from the sale applied to the repayment of the outstanding debt.

DQ10-1

Mortgages are usually instalment loans. This means that payments are made periodically rather than only at the end of the loan. Also, the periodic payments are usually blended payments, consisting of both interest and principal components. LO 2 BT: C Difficulty: E Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

DQ10-15   



Companies may lease capital assets rather than purchase them outright for a number of reasons: Company does not have sufficient cash for outright purchase, or the cash it does have is required for other purposes The company may have reached its borrowing limits and therefore, cannot borrow the cash that would be required to purchase the asset Some assets, such as technology assets, become obsolete after a relatively short time. Rather than purchase this type of asset and then have to deal with its subsequent disposal and replacement, it may be more effective for the company to lease the assets and have the lessor replace them on a periodic basis. Some assets, such as buildings or parts of buildings may be required for only a small portion of the asset’s useful life. In this case, it may be more cost effective to lease asset for the period the asset is needed.

LO 3 BT: K Difficulty: M Time: 15 min. AACSB: None CPA: cpa-t001 CM: Reporting

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Chapter 10

Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Burnley, Understanding Financial Accounting, Second Canadian Edition

DQ10-16

Virtually all the leases entered into by public companies result in a right-of-use asset and a lease liability being recorded. Accounting for a lease is identical to accounting for borrowing of funds on a long-term basis and using the proceeds to acquire the capital asset. The asset is recognized as a right-of-use asset and the long-term obligation to make lease payments is recognized as a long-term lease liability. The right-of-use asset is then depreciated, and the lease payments typically involve blended payments for the interest expense and the reduction of principal of the lease liability. The statement of financial position reports the right-of-use asset, net of accumulated depreciation within the PP&E section; and the lease liability outstanding is split between its current portion (in current liabilities) and long-term portion (in long-term liabilities). Interest expense and depreciation expense are reported on the statement of income.

LO 3 BT: C Difficulty: M Time: 15 min. AACSB: None CPA: cpa-t001 CM: Reporting

DQ10-18

Defined contribution pension plans are plans in which the employer agrees to contribute a prescribed amount each period to the retirement fund of the employee. There is no guarantee by the employer as to the level of the benefits that the employee will receive upon retirement. The benefits depend on the investment success of the pension fund itself. Therefore, the employee bears the risk of inadequate pension assets on retirement. A defined benefit plan, on the other hand, is one in which the employer agrees to provide a prescribed amount of benefits upon retirement. The benefits are usually determined using a benefit formula that incorporates the number of years of service of the employee and some measure of the amount of salary earned. If the assets in the fund are not sufficient to pay the prescribed benefits when employees retire, the employer is required to make up any deficiency. The employer bears the risk in this type of plan.

LO 4 BT: K Difficulty: E Time: 15 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual

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Chapter 10

Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Burnley, Understanding Financial Accounting, Second Canadian Edition

Solutions Manual

10-3

Chapter 10

Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Burnley, Understanding Financial Accounting, Second Canadian Edition

DQ10-23 Deferred income taxes arise because income tax expense on the statement of income is based on the accounting income determined according to accounting standards, while the income taxes payable to the government (i.e. income taxes payable reported on the statement of financial position) are based on taxable income determined under the Income Tax Act and its regulations. A company may deduct an expense in the current period (e.g., warranty expense on an assurance-type warranty) when the related sale is made, but this amount is not deductible for tax purposes until a future period when the actual warranty expenditures are made. In the future, when the expenditures are made, the company can reduce its taxes owing by the amount of tax on the actual warranty expenditures. Therefore, there is a tax benefit associated with the warranty expenditures that won’t be realized until a future period – the tax effect related to recognizing warranty expense now is deferred until the future. This is reported as a deferred (or future) income tax asset on statement of financial position. Alternatively, a company may have deducted more capital cost allowance (CCA) for tax purposes than depreciation expense on its statement of income. This gives rise to a temporary difference between the income tax expense reported and the income tax payable reported. In effect, in the future when the company deducts more depreciation expense than CCA, the company will increase its taxable income and pay more income tax to the government than it recognizes as expense on the statement of income. In effect, it is deferring the tax liability to a future year. This is reported as a deferred (or future) income tax liability on the current statement of financial position. Deferred income tax assets and liabilities, therefore, represent the future income tax effects of the company’s temporary differences between its past incomes reported under accounting standards (i.e. IFRS or ASPE) and taxable incomes reported under Income Tax Act. LO 5 BT: C Difficulty: H Time: 25 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual

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Chapter 10

Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Burnley, Understanding Financial Accounting, Second Canadian Edition

DQ10-25

Uncertainty is what distinguishes a contingent liability (which is not recognized in the accounts) from a liability (which is recognized on the statement of financial position). This uncertainty may be in relation to whether an obligation exists, or it may be uncertainty with respect to the measurement of the obligation. A contingent liability is something that may become an actual obligation (i.e. liability) in the future, depending upon some future event (i.e. a court decision). It is not a present obligation at the reporting date. Therefore, it is not reported on the statement of financial position as a liability. Similarly, if the amount of the obligation cannot be reliably measured, no liability can be recorded. Contingent liabilities become recognized liabilities and expenses when it is probable, at the reporting date, that there will be a future sacrifice of economic benefits and when the amount can be reasonably measured. Accounting standards require companies to disclose information about contingent liabilities in the notes to their financial statements.

LO 7 BT: C Difficulty: M Time: 15 min. AACSB: None CPA: cpa-t001 CM: Reporting

DQ10-26

A financial statement user would be interested in reviewing a company’s contractual commitment note because it contains information about significant transactions the entity has committed itself to in the future. These could be contracts to purchase certain quantities of raw materials at specified fixed prices, contracts for significant capital acquisitions, etc. These contracts usually commit the company to spending large amounts of cash in the future. This information would be important to any financial user interested in the future cash flows of the company.

LO 6 BT: C Difficulty: E Time: 5 min. AACSB: None CPA: cpa-t001 CM: Reporting

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Chapter 10

Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Burnley, Understanding Financial Accounting, Second Canadian Edition

DQ10-27

The debt to equity ratio provides a measure of the relationship between a company’s debt financing and equity financing, or the proportion of a company’s assets that are financed by creditors (debt) rather than by owners (equity). Too high a proportion is risky for an entity as it might not be able to meet its interest and principal payments as they come due. Too small a proportion means that the owners are not making effective use of leverage – the ability to increase returns for shareholders by earning a higher return on debt-sourced funds than must be paid out as interest on borrowed funds. The interest coverage ratio measures a company’s ability to meet its interest payment from operating income. This ratio is also a risk-related measure, because if the company barely earns enough income to cover its interest charges, it runs the risk of not being able to meet this important commitment and underlying assets securing the debt could be seized by the creditors. The higher is the ratio, the lower the risk.

LO 8 BT: C Difficulty: M Time: 15 min. AACSB: None CPA: cpa-t001 CM: Reporting

DQ10-28 From the perspective of the investor, a higher degree of leverage is preferable than a lower one. This is because it would mean that the company is using the capital of others (creditors) to generate higher returns for the investors. There is a point where investors would consider a company to be over-leveraged, resulting in a higher risk of the company defaulting on its debt obligations and being forced into bankruptcy. LO 8 BT: C Difficulty: M Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

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Chapter 10

Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Burnley, Understanding Financial Accounting, Second Canadian Edition

SOLUTIONS TO APPLICATION PROBLEMS AP10-3A a. Face value of the bonds issued: $80,000,000 Interest payments= $80,000,000 x 10% x 6/12 = $4,000,000 Given the bonds were issued at par, the Oct 1, 2020 entry: Cash

80,000,000 Notes Payable

80,000,000

b. On December 31, 2020, Deleau’s year end, it is necessary to accrue interest expense for the three months since bonds were issued, even though it does not coincide with an interest payment date. As of December 31, there is an obligation (liability) related to three months interest. The liability for interest and interest expense both accrue with the passage of time. The interest payable and the interest expense for October, November and December must be recorded for inclusion in year-end financial statements. Interest expense and interest payable at December 31, 2020 for October, November and December 2020: $80,000,000 x 10% x 3/12 = $2,000,000 Note that amount payable and expense are the same in this case because bonds were issued at par or face value. Journal entry on December 31, 2020: Interest Expense 2,000,000 Interest Payable 2,000,000 March 31, 2021 entry: Interest expense for the first six months: $80,000,000 x 10% x 6/12 = Less amount recognized in 2020 Expense for Jan. 1 – March 31 Interest Expense Interest Payable Cash

$4,000,000 2,000,000 $2,000,000

2,000,000 2,000,000 4,000,000

Interest entry, September 30, 2021:

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Chapter 10

Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Burnley, Understanding Financial Accounting, Second Canadian Edition

Interest Expense Cash

4,000,000 4,000,000

AP10-13A a. Debt to Equity = Net Debt (Interest Bearing Debt – Cash) Shareholder’s Equity =$575 – $75 = 1.11:1 $450 Net Debt as a Percentage of Total Capitalization = Net Debt (Interest Bearing Debt – Cash) Shareholder’s Equity + Interest Bearing Debt – Cash =

$575 - $75 $450 + $575 - $75

= 53% or 0.53:1

b. If Fessenden acquires Sonar their debt would increase by $80 million, the updated ratios are: Debt to Equity = $575 + $80 - $75 450

= 1.29:1

Fessenden would exceed the 1.25:1 ratio set by the lender. Net Debt as a Percentage of Total Capitalization = $575 + $80 - $75 $450 + $575 + $80 - $75 = 56% or 0.56:1 Fessenden would not exceed the .9:1 ratio set by the lender. Fessenden cannot acquire Sonar Corporation with a debt issue and remain in compliance with its existing debt covenants. LO 8 BT: AN Difficulty: M Time: 25 min. AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance

Solutions Manual

10-8

Chapter 10

Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Burnley, Understanding Financial Accounting, Second Canadian Edition

Solutions Manual

10-9

Chapter 10

Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Burnley, Understanding Financial Accounting, Second Canadian Edition

AP10-3B a. The cash received on issuance was equal to the face value of the bonds issued ($100,000,000) as the bond was issued at par. The yield is 6%. Interest payments= $100,000,000 x 6% x 6/12 = $3,000,000 b. Given the bonds were issued at par, the May 1, 2020 entry: Cash 100,000,000 Notes Payable 100,000,000 c. Journal entry on October 31, 2020 Interest expense 3,000,000 Cash 3,000,000 On December 31, 2020, Morneau’s year end, it is necessary to accrue interest expense for two months since the last interest payment. As of December 31, an obligation (liability) exists related to two months interest. The liability for interest and interest expense both accrue with the passage of time. The interest payable and the interest expense for November and December must be recorded and reported on the yearend financial statements. Interest expense and interest payable at December 31, 2020 for November and December 2020: $100,000,000 x 6% x 2/12 = $1,000,000 Note that amount payable and expense are the same in this case because bonds were issued at par or face value. Journal entry on December 31, 2020: Interest Expense 1,000,000 Interest Payable 1,000,000 April 30, 2021 entry: Interest expense for second period of six months: $100,000,000 x 6% x 6/12 = $3,000,000 Less amount recognized in 2020 1,000,000 Expense for Jan. 1 – April 30 $2,000,000 Interest Expense Interest Payable Cash

2,000,000 1,000,000 3,000,000

LO 2 BT: AP Difficulty: E Time: 15 min. AACSB: None CPA: cpa-t001 CM:

Solutions Manual

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Chapter 10

Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Burnley, Understanding Financial Accounting, Second Canadian Edition

AP10-13B If Ferguson Theatres borrows $475 million to fund their expansion in China, their ratios are: Debt to Equity = $650 + $475 - $100 $900

= 1.14:1

Ferguson would exceed the 1.10:1 ratio set by the lender. Net Debt as a Percentage of Total Capitalization = $650 + $475 - $100 $900 + $650 + $475 - $100 = 53% Ferguson would also exceed the 50% ratio set by the lender. Ferguson Theatres cannot borrow $475 Million and remain in compliance with its existing debt covenants. LO 8 BT: AN Difficulty: M Time: 15 min. AACSB: Analytic CPA: cpa-t001, cpa-t005 CM: Reporting and Finance

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Chapter 10

Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Burnley, Understanding Financial Accounting, Second Canadian Edition

USER PERSPECTIVE SOLUTIONS UP10-5

Bond covenants attempt to provide protection to the bond investor by restricting the actions of management who might otherwise take actions in the best interests of the shareholders instead of the creditors. It is important for the bondholders because the more restrictive the covenants, the more protection is afforded to the bondholder against the company defaulting on its obligations. Examples include maintaining a minimum working capital level, maintaining a certain quick ratio, not exceeding a particular debt to equity ratio, restricting dividends paid to shareholders, and restricting the sale of certain assets.

LO 2 BT: C Difficulty: M Time: 15 min. AACSB: None CPA: cpa-t001 CM: Reporting

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Chapter 10

Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Burnley, Understanding Financial Accounting, Second Canadian Edition

UP10-6 a. The effect of the use of this exemption has on the financial statements relates more to the statement of financial position than to the statement of income. On the statement of income, the effect is often insignificant because the rent expense recorded on the low-value exemption is similar in amount to the total of depreciation expense and interest expense recorded for leases. On the statement of financial position, the company’s contractual obligations to make rental payments into the future are not captured as liabilities under the low-value exemption and the assets being leased are not captured and reported as assets. Therefore, the debt to total assets ratio is understated and the return on total assets ratio is overstated. Because of this, the company appears to be using less debt in its financial structure than it is (and is perceived to be less risky), and it appears to be generating income on a smaller amount of assets than it is using for operations (and therefore appears more profitable). LO 3 BT: C Difficulty: M Time: 15 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual

10-13

Chapter 10

Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.

Burnley, Understanding Financial Accounting, Second Canadian Edition

UP10-13 a. Potential liabilities that might not appear on statement of financial position include uncertain contingent losses, potential product liability losses, obligations associated with commitments, and financing arrangements such as operating leases or factoring of accounts receivable when factor has recourse for amounts that cannot be collected. Uncertain contingent losses, includi...