Ch. 6 Long Term Liabilities and Owners' Equity

Question 1

What is the future value/compound interest formula?

What is the present value formula, given a future value and you need a present value?

Why do I need to understand present value for accounting?

What are annuities?

Answer 1

Principal x (1 + (r/t))^(nt)

Future Value/(1 + rate)^# of periods

Many components of the balance sheet are measured in present value.

Multiple payments that are the same amount and spread across an equal interval/

Question 2

What 4 criteria designate something as a capital lease?

Answer 2

1. At the end of the lease, the title of the leased asset transfers from the lessor to the lessee.
2. The lease includes a bargain purchase option. This is an option that allows the lessee to purchase the leased asset at the end of a lease at an option price less than the expected fair market value.
3. The lease term is 75% or more than the expected life of the asset
4. The PV of the lease payments is 90% or more of the fair market value of the asset at the inceptoion of the lease.

Question 3

Example:

A firm (a lessee) signs a lease contract that requires it to make annual lease payments of $121 per year for 2 years to the lessor. The lease asset has a useful life of 2 years. Thus, this becomes a capital lease. The interest rate is 10%. Make the initial entry and the entry for after year 1 of the lease. Assume straightline depreciation.

Answer 3

Example:

PV = 210

$210 Leased Asset

$210 Lease Liability

Then

($121) cash

($100) lease liablity

($21) interest expense

Then

($105) AD

($105) Depreciation expense

Question 4

What are the two types of leases?

Do both types of leases have the same impact to the P&L? How are they different?

Answer 4

Capital leases and operating leases

Yes, both impact the P&L but in different ways. Capital leases impact the P&L via interest and depreciation expense. Also, a lease asset and lease liability are created. In an operating lease, the only expense is lease expense, which is the intially agreed upon payments.

Question 5

Operating Lease: Assume that a firm, a lessee, signs a lease contract that requires it to make annual lease payments of $121 for two years to the lessor. Assume the leases expected life is also 2 years. Assume the interest rate charged is 10%.

1. Make the entries required for showing an operating lease

Answer 5

($121) cash

($121) lease expense

The above entry is the same entry for both years.

Question 6

How are bonds payable valued?

Which interest rate do you use to calculate the above- stated interest rate or market interest rate?

Answer 6

At present value

Use both. Use market interest rate to discount. Use stated interest rate to calculate interest payments used in the PV calculation.

Question 7

Assume a firm issues a $1000 face value bond at 10% interest for 2 years. Make the entries from the bond issuer perspective.

Answer 7

$1000 cash

$1000 bond payable

Then

($100) cash

($100) interest expense

Then

($100) cash

($100) interest expense

Finally

($1000) cash

($1000) bond payable

Question 8

How do you adjust the return of a bond with a stated interest rate?

Answer 8

Adjust the issue price. Decrease the price to increase returns (issue at discount), or increase the price for lower returns (issue at premium).

Question 9

Assume a face value of $1000. The stated interest rate is 10%, but the market interest rate is 12%. 2 year period. Make the entries from the bond issuers perspective (firm receiving the money)

Answer 9

$966 cash

$966 bond payable

Then

($100) cash

$16 bond payable

($116) interest expense

Then

($100) cash

$18 bond payable

($118) interest expense

Finally

($1000) cash

($1000) bond payable

The above was created via an accretion table because the bond was sold at a discount. The reverse would occur if the bond was sold at a premium.

Question 10

Assume a face value of $1000. The stated interest rate is 10%, but the market interest rate is 8%. 2 year period. Make the entries from the bond issuers perspective (firm receiving the money)

Answer 10

$1036 cash

$1036 bond payable

Then

($100) cash

($17) bond payable

($83) interest expense

Then

($100) cash

($19) bond payable

($81) interest expense

Finally

($1000) cash

($1000) bond payable

Question 11

1. If the stated interest rate > market interest rate, the bond is issued at what?
2. If the stated interest rate
3. If the stated interest rate = market interest rate, the bond is issued at what?
4. The stated rate is also know as?
5. The market rate is also known as?

Answer 11

1. Premium
2. Discount
3. Par
4. Coupon payment or nominal interest
5. Yield/Effective Interest rate

Question 12

1. What is the difference between taxable and deductible items for taxes?
2. Postponed deductions will lead to what?

Answer 12

1. Taxable items are taxed, whereas deductible items reduce your taxable income, therefore reducing the amount of taxes a firm owes.
2. Deferred Tax Assets

Question 13

1. Explain the logic behind deferred tax assets in regards to contingent liabilities and restructurings.
2. Explain how deferred tax liablities result.

Answer 13

1. Contingent liabilities and restructurings are accrued prior to cash disbursement. Thus, tax authorities will not allow a company to realize the tax benefit of those deductions until the cash disbursements have been made. Thus, a deferred tax asset is created.
2. Deferred tax liabilities result when a company has accelerated deductions, thus leaving future periods with little tax deductions, thus resulting in higher taxes..

Question 14

Assume a firm has $100 in revenues and spends $20 on an asset that has a 2 year life. Using straight line depreciation, show the current income statement and then the tax return if the government allowed accelerated depreication for the current tax return. Assume a 40% tax rate.

Also, make the appropriate entry showing taxes.

Answer 14

Income statement

$100 revenues

($10) depreciation expense

$90 pre-tax income

($36) taxes

Tax Return

$100 revenues

($20) depreciation expense

$80 taxable income

($32) taxes

Entry

($32) cash

$4 Deferred Tax Liability

($36) Tax Expense

Question 15

1. What is the owner’s equity formula?
2. Describe preferred stock
3. Describe common stock
4. Descrbie Additional Paid in Capital

Answer 15

1. Assets-Liabilities
2. Has traits of both debt and equity in that it is equity financing that receives a dividend payment and has the ability to appreciate in value
3. Common stock is the preferred type of equity financing but has the lowest claim to assets in the event of bankruptcy.
4. Additional paid in capital is the excess amount of equity financing from investors that is above par value

Question 16

1. What is treasury stock?
2. Why would a firm repurchase stock?

Answer 16

1. Treasury stock is stock that a firm repurchases from investors. It is a CONTRA EQUITY account
2. Boost EPS

Repurchases are favored over dividend increases because they are taxed at a lower rate

Dilute the effect of employee stock option exercising

Defense against a takeover

Question 17

1. Assume a company issues 10 shares of common stock for $10 per share. The stock’s par value is $1 per share. Make the initial journal entry.
2. Assume a company issues 10 shares of preferred stock for $20 per share with a par value of $5. Make the entry.

Answer 17

1. $100 cash

$10 Common Stock

$90 APIC

2. $200 cash

$50 Preferred stock

$150 APIC

Question 18

Make the entry for $12 in dividends declared and then distributed.

Answer 18

Declared

$12 Dividends payable

($12) retained earnings

Paid

($12) cash

($12) dividends payable

Question 19

1. Make the entry for $100 in stock repurchases.
2. Make the journal entry if the firm were to resell that $100 in stock for $120.

Answer 19

1. ($100) cash

($100) Treasury Stock

2. $120 cash

$100 treasury stock

$20 APIC

APIC absorbs in the gains or losses from reselling shares. No specific gain or loss is listed!

Reverse the same amount of treasury stock at which it was initially acquired.