FAR 7 Flashcards
On January 1, 2004, Bay Co. acquired a land lease for a 21-year period with no option to renew.
The lease required Bay to construct a building in lieu of rent. The building, completed on January 1, 2005, at a cost of $840,000, will be depreciated using the straight-line method. At the end of the lease, the building’s estimated market value will be $420,000.
What is the building’s carrying amount in Bay’s December 31, 2005 Balance Sheet?
The building is a leasehold improvement because it reverts to the lessor at the end of the lease. The residual value belongs to the lessor and is not relevant to the lessee. The building was completed at the beginning of the second year of the lease. Therefore, the total cost to the lessee of $840,000 is amortized over 20 years, not 21.
The carrying value of the leasehold improvement at the end of 2005, the first year of the building’s life but the second year of the lease, is $798,000 = $840,000(19/20).
Firm A is negotiating with Firm B to purchase Firm B and bring it into the corporate organization headed by Firm A. The two firms agree to the following:
•Firm B’s average annual income is $900, to continue for 10 years after purchase.
•Firm B’s total owner’s equity is $2,000.
•Firm B’s market value of net identifiable assets is $3,500.
•The average rate of return in B’s industry is 10%.
•The risk adjusted rate of return for the purchase is 8%.
Compute the purchase price for B implied by this information. The present value of an annuity of $1 for 10 years at 8% is 6.71008, and at 10% is 6.14457.
With the information provided, goodwill can be computed directly as the present value of excess earnings. Goodwill is then added to the market value of net identifiable assets to yield the purchase price. Excess earnings is the difference between B’s earnings and the expected earnings in B’s industry for a firm the size of B, based on market value of net assets. Given B’s size, B is expected to earn $350 per year (.10 x $3,500). Excess earnings = $900 - $350 = $550. Goodwill = present value of excess earnings = $550(6.71008) = $3,691. The implied purchase price = $3,500 + $3,691 = $7,191.
Kent, Co. filed a voluntary bankruptcy petition on August 15, 2005 and the statement of affairs reflects the following accounts:
Book Value Current Value
Assets:
Assets pledged with fully secured creditors $ 300,000 $370,000
Assets pledged with partially secured creditors 180,000 120,000
Free assets 420,000 320,000
$ 900,000 $810,000
========== ==========
Liabilities:
Liabilities with priority $ 70,000
Fully secured creditors 260,000
Partially secured creditors 200,000
Unsecured creditors 540,000
$1,070,000
==========
Assume that the assets are converted to cash at the estimated current values and the business is liquidated. What amount of cash will be available to pay unsecured non-priority claims?
Unsecured non-priority creditors are the last to receive assets. The book value information is not relevant to the question.
Free assets $320,000
Assets pledged with fully secured creditors $370,000
Less payments to fully secured creditors (260,000)
Equals pledged assets available for unsecured claims 110,000
Total cash available for unsecured claims 430,000
Less priority claims (70,000)
Equals amount available to pay unsecured non-priority claims $360,000
The partially secured creditors receive payment from the assets pledged for partially secured creditors. Any remaining claims fall under the category of unsecured non-priority.
Leaf Co. purchased from Oak Co. a $20,000, 8%, 5-year note that required five equal annual year-end payments of $5,009. The note was discounted to yield a 9% rate to Leaf. At the date of purchase, Leaf recorded the note at its present value of $19,485.
What should be the total interest revenue earned by Leaf over the life of this note?
Total interest revenue is the amount received over the term of the note less the present value of the note: 5($5,009) - $19,485 = $5,560.
Leaf paid $19,485 for the note, and will receive 5($5,009) over the note term. The difference is interest revenue.
Roth, Inc. received from a customer a one-year, $500,000 note bearing annual interest of 8%. After holding the note for six months, Roth discounted the note at Regional Bank at an effective interest rate of 10%. What amount of cash did Roth receive from the bank?
Maturity value of the note: $500,000(1.08)
$540,000
Less discount to the bank: $540,000(.10)(6/12)
(27,000)
Equals proceeds to Roth
$513,000
Seco Corp. was forced into bankruptcy and is in the process of liquidating assets and paying claims. Unsecured claims will be paid at the rate of forty cents on the dollar.
Hale holds a $30,000 noninterest-bearing note receivable from Seco collateralized by an asset with a book value of $35,000, and a liquidation value of $5,000.
The amount to be realized by Hale on this note is
Bankruptcy law specifies that secured creditors are to be satisfied before any assets are paid to unsecured creditors. Hale is a secured creditor for the $5,000 liquidation value. A liquidation value is paid at the liquidation of the firm and thus acts as a secured debt. The remaining claim of $25,000 ($30,000 - $5,000) is unsecured and at the 40% rate yields an additional claim of $10,000, for a total amount to be realized of $15,000.
How is interest expense vs interest payable recorded regarding notes?
Interest expense on notes should reflect the market interest rate at the date of issuing the note. This firm is recording interest expense at the 16% stated rate rather than the 11% market rate. Thus, interest expense is incorrectly recorded.
However, interest payable reflects the stated rate which determines the cash amount to be paid. Interest payable is correctly stated.
On September 30, World Co. borrowed $1,000,000 on a 9% note payable. World paid the first of four quarterly payments of $264,200 when due on December 30. In its December 31, balance sheet, what amount should World report as note payable?
The first payment included interest of $22,500 (.09 x .25 x $1,000,000). Note that interest rates are always expressed for an annual period. Only 25% of year elapsed from Sept. 30 to the end of the year. The rest of the payment ($241,700 = $264,200 - $22,500) is principal. The note payable balance at Dec. 31 therefore is $758,300 ($1,000,000 - $241,700).
On August 21, 2003, Vann Corp.’s $500,000, one-year, noninterest-bearing note due July 31, 2004 was discounted at Homestead Bank at 10.8%. Vann uses the straight-line method of amortizing bond discounts.
What amount should Vann report for notes payable in its December 31, 2003 balance sheet?
The period from August 21, 2003 to July 31, 2004 is 11 1/3 months. The correct calculation is:
Maturity value (note is noninterest bearing) $500,000
Less discount to bank $500,000(.108)[(11 1/3 months)/12 months]
( 51,000)
Equals book value at date of discounting = proceeds from bank
449,000
Plus amortization of discount to December 31, 2003
$51,000[(4 1/3 months)/(11 1/3 months)]
19,500
Equals book value at December 31, 2003
$468,500
The bank’s discount represents the total interest to be paid over the 11 1/3 month term. As the note is amortized, the note’s book value increases and interest expense is recognized. At maturity, the note book value is $500,000 and the total interest of $51,000 is paid as part of the single payment of $500,000. Total interest is $51,000 because that is the difference between the maturity value of $500,000 less the $449,000 proceeds.
What is a debenture bond?
Debenture bonds are not secured but rather are backed only by the general credit of the issuing firm. Debenture bonds can be serial bonds.
What is the formula to determine the issue price?
The issue price for one $1,000 face value bond is the present value of all future payments discounted at the yield rate
On May 1, 2002, Bolt Corp. issued 11% bonds in the face amount of $1,000,000, which mature on May 1, 2012.
The bonds were issued to yield 10%, resulting in bond premium of $62,000. Bolt uses the effective interest method of amortizing bond premium. Interest is payable semiannually on November 1 and May 1.
In its October 31, 2002 balance sheet, what amount should Bolt report as unamortized bond premium?
Under the effective interest method, the interest expense on October 31 is based on the yield rate and the beginning book value at May 1. The beginning book value equals the face value plus the premium.
October 31, 2002
Interest expense ($1,000,000 + $62,000)(.10)(1/2) 53,100
Bond premium
1,900
Interest payable ($1,000,000)(.11)(1/2)
55,000
Unamortized bond premium = $62,000 - $1,900 = $60,100.
How is bond premium calculated?
The bond premium is the difference between the bond carrying value and the bond face value.
What is the bond price?
The bond price is the present value of the future cash payments to be paid by the issuer over the bond term. These payments are (1) the face value paid at maturity and (2) the interest payments. Each interest payment is the product of the coupon rate for the appropriate portion of a year (usually six months) and the face value. The stream of interest payments is an annuity. Both the single payment (face value) and the annuity are discounted at the yield or market rate of interest. The result is the bond price.
What is a term bond?
A bond that matures on a single date.
