CH 10

Download as docx, pdf, or txt
Download as docx, pdf, or txt
You are on page 1of 97
At a glance
Powered by AI
The key takeaways are that long-term liabilities include obligations to lenders, other creditors, and employees that are due beyond one year. Different types of long-term liabilities have different accounting treatments.

The different types of long-term liabilities that arise from transactions with lenders include bonds payable and long-term notes payable. Liabilities that arise from transactions with other creditors include accounts payable. Liabilities from transactions with employees include pension obligations.

Long-term liabilities that arise from transactions with employees include pension obligations from defined benefit plans. The employer is required to make contributions to pension funds to meet future obligations. Defined contribution plans require employer contributions based on salaries but do not guarantee future benefits.

Burnley, Understanding Financial Accounting, Second Canadian Edition 

                                            

CHAPTER 10
LONG-TERM LIABILITIES
Learning Objectives
1. Explain why long-term liabilities are of significance to users.
2. Identify the long-term liabilities that arise from transactions
with lenders and explain how they are accounted for.
3. Identify the long-term liabilities that arise from transactions
with other creditors and explain how they are accounted for.
4. Identify the long-term liabilities that arise from transactions
with employees and explain how they are accounted for.
5. Identify the long-term liabilities that arise from differences
between accounting standards and income tax regulations or
law.
6. Explain what commitments and guarantees are and how they
are treated.
7. Explain contingencies and how they are accounted for.
8. Calculate leverage and coverage ratios and use the
information from these ratios to assess a company’s financial
health.

Solutions Manual 10-1 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

Summary of Questions by Learning Objectives and Bloom’s Taxonomy

Ite LO BT Item LO BT Item LO BT Item LO BT Item LO BT


m
Discussion Questions
 1. 2 C  7. 2 C 13. 2 C 19. 4 C 25. 7 C
 2. 2 C  8. 2 C 14. 2 C 20. 4 C 26. 6 C
 3. 2 C  9. 2 C 15. 3 K 21. 4 C 27. 8 C
 4. 2 C 10. 2 C 16. 3 C 22. 4 C 28. 8 C
5 2 C 11. 2 C 17. 3 C 23. 5 C
 6. 2 C 12. 2 C 18. 4 K 24. 5 C
Application Problems
 1. 2 AP  4. 2 AP  7. 2 AP 10. 2 AP 13. 8 AN
 2. 2 AP  5. 2 AP  8. 2 AP 11. 2 AP 14. 8 AN
 3. 2 AP  6. 2 AP  9. 2 AP 12. 3 AP 15. 8 AN
User Perspective Problems
 1. 2 C  4. 2 C  7. 3 C 10. 4 C 13. 6,7 C
 2. 2 C  5. 2 C  8. 3 C 11. 4 C 14. 5 C
 3. 2 C  6. 3 C  9. 4 C 12. 4 C 15. 5 C
Work in Process
 1. 2 C  3. 3 C  4. 4 C 5. 7 C 6. 8 C
 2. 2 C
Reading and Interpreting Published Financial Statements
 1. 8 AN  4. 2 C  7. 8 AN 10. 6 C
 2. 2 C  5. 4 C  8. 8 AN 11. 7 C
 3. 2 C  6. 5 C  9. 8 AN 12. 5,6,7, AN
8
Cases
 1. 2,3 C 2. 2 C 3. 3 C 4. 3 C 5. 4 C

Solutions Manual 10-2 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

Legend: The following abbreviations will appear throughout the


solutions manual file.

LO Learning objective  
Bloom's
BT Taxonomy  
  K Knowledge  
  C Comprehension
  AP Application  
  AN Analysis  
  S Synthesis  
  E Evaluation  
Difficulty: Level of difficulty  
  E Easy  
  M Medium  
  H Hard  
Time: Estimated time to complete in minutes
AACSB Association to Advance Collegiate Schools of Business
  Communication Communication
  Ethics Ethics
  Analytic Analytic
  Tech. Technology
  Diversity Diversity
  Reflec. Thinking Reflective Thinking
CPA CM CPA Canada Competency Map
  Ethics Professional and Ethical Behaviour
  PS and DM Problem-Solving and Decision-Making
  Comm. Communication
  Self-Mgt. Self-Management
  Team & Lead Teamwork and Leadership
  Reporting Financial Reporting
  Stat. & Gov. Strategy and Governance
  Mgt. Accounting Management Accounting
  Audit Audit and Assurance
  Finance Finance
  Tax   Taxation

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                                             

SOLUTIONS TO DISCUSSION QUESTIONS

DQ10-1 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.

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

DQ10-2 If a loan requires blended payments, it is repaid on an instalment


basis and the instalment payment is made up of both interest and
a partial return of principal. An instalment basis means that
payments are made periodically rather than only at the end of the
loan. The total amount of the payment is the same each period,
but the portion of each payment that represents interest gets
smaller with each payment, as the principal amount of the loan
outstanding is reduced with each payment.

LO 2 BT: C Difficulty: E Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

DQ10-3 Loan covenants are requirements written into a legal loan


agreement that set out conditions required of the borrower, by the
creditor, during the term that the loan is outstanding. Failure to
comply with the covenants usually allows the creditor to call in the
loan. The covenants are inserted in the agreement to protect the
creditor and reduce the risk of non-collection.

LO 2 BT: C Difficulty: M Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-4 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

DQ10-4 Covenants written into a loan agreement can be either financial or


non-financial in nature. Examples of financial covenants include
the requirement to maintain a current ratio of at least 1 to 1, or a
debt-to-equity ratio of no greater than 50%. With financial
covenants, company management is often motivated to seek
accounting methods and choices that will keep the company
within the limits set out in the agreement. Non-financial covenants
are other requirements that do not depend on accounting
measures, such as requiring interim financial statements be sent
to creditor or requiring annual audit to be conducted.

LO 2 BT: C Difficulty: M Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

DQ10-5 Indenture agreement: A formal agreement between a borrowing


entity and lender that specifies the terms of the contract. In the
case of a bond offering, it specifies (among other things) the face
value, the maturity date, the contract interest rate, the collateral, if
any, and the covenants.

Collateral: Assets that the borrower pledges to the lender in the


event that the borrower defaults on the loan.
Face value: The measure of denomination of a debt instrument.
For example, typically a single bond has a face value of $1,000.
The face value also determines the cash principal payout at
maturity and is used to calculate the periodic interest payments.
Contract rate: The contract rate is the rate of interest that is
written into an indenture agreement. This is the interest rate the
borrower agrees to pay the bond holder and it is applied to the
face value of the bonds to determine the interest payment.
Maturity date: The date at which borrower pays back the face
value to the bondholder and the date at which the interest
payments cease.

LO 2 BT: C Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-5 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

DQ10-6 Three typical ways in which bonds differ from other loans include:
 Bonds are held by many creditors, whereas loans are usually
held by a single creditor.
 Investors in bonds can sell the bonds in an active secondary
market, similar to the stock exchange for equity investments,
while loans are not normally bought and sold in a secondary
market.
 Interest payments are usually made semi-annually and the
principal is repaid at maturity, which is usually at the end of the
term of the debt. On the other hand, loans usually pay interest on
a monthly basis, and the principal payments could be blended
with the interest, or made on a variety of payment dates before
entire loan is repaid.
 In addition, bonds tend to have a much longer term to maturity
(as much as 40 years) than loans (usually 1 to 5 years).
LO 2 BT: C Difficulty: M Time: 15 min. AACSB: None CPA: cpa-t001 CM: Reporting

DQ10-7 The yield rate (often referred to as the effective rate, or market
rate) of interest with respect to a bond issue is the interest rate
required by the buyer for investing in the debt instrument. The
yield rate is affected by the rate of interest the buyer could obtain
from similar instruments with similar payments, timing of
payments and level of risk.

LO 2 BT: C Difficulty: M Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

DQ10-8 The stated or nominal rate of interest on a bond is also known as


the contract interest rate. The contract rate determines the
amount of the semi-annual interest payments (face value x
annual contract rate x 6/12). This rate is written into the indenture
contract. It is not the same as the effective or yield rate of interest
unless the bond is sold at par. The yield rate is the interest rate
required by the buyer and it is determined by taking into account
a combination of the actual interest paid/received under the bond
contract and any premium or discount on the bond when making
the investment. The yield rate is the return (the discount rate) that
equates the amount paid for the bond with the present value of
the cash receipts promised in the indenture.
LO 2 BT: C Difficulty: M Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-6 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

DQ10-9 When a company wants to borrow money using a bond issue, it


contacts an investment banker. With the help of the investment
banker, the company structures the bond offering with terms that
will have the most appeal to investors while still satisfying the
company’s objectives. This includes setting the contract rate of
interest at a rate that the investment banker thinks investors
require for a bond with the risk characteristics of the company
and this rate is written into the bond indenture.
The investment banker then sells the bonds to its customers and
when all the bonds are sold, they can then be traded on the bond
market. The price the investor pays for the bond investment
depends on what has happened to market rates of interest since
the bond indenture and the contract rate were finalized. If market
interest rates for other debt instruments with similar risk have
increased, investors will be unwilling to pay face value for these
bonds. They will buy the bonds, but will pay less than face or par
value. In this way, the cash flows returned to the investor will
represent a higher rate of return than the contract rate specified in
the indenture. If market rates have fallen below the contract rate
promised, the price of the bonds (which pay a higher rate) will be
bid up and the investors will pay a premium to purchase these
bonds. In this way, the cash flows returned to the investor will
represent a lower rate of return than the contract rate. In all
cases, however, the price of the bond will be equal to the present
value of the future cash flows, discounted at the
market/yield/effective rate when the bond is acquired. The price of
the bonds in the secondary market will continue to change as
market rates/yields wanted by investors change.

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

Solutions Manual 10-7 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

DQ10-10 The par value of a bond is the same as its face value and maturity
value. Most individual bonds have a par value of $1,000. Bonds
will be bought and sold at this par value only when the contract
rate of interest promised in the indenture is the same as the yield,
market or effective rate required by investors.

If the yield, market, or effective rate falls below the contract rate,
investors will bid up the price of the bond above $1,000 because
this bond has agreed to pay a rate higher than is available
elsewhere for similar instruments. The price will get bid up to a
value that makes the cash flows promised by the indenture
provide a yield to the investor equal to the current market rate on
the cost of the bond to the investor. This bond will sell at a
premium, that is, at an amount above $1,000.

However, if the yield, market, or effective rate rises above the rate
promised by the bond indenture, investors will pay less than
$1,000 for the bond because this bond has agreed to pay a rate
lower than the rate investors can achieve elsewhere. The price
will be reduced to a value that makes the cash flows promised by
the indenture provide a yield to the investor equal to the current
market rate on the cost of the bond to the investor. This bond will
sell at a discount, that is, at an amount less than $1,000.

To summarize, the terms par, premium, and discount refer to


whether the selling price of a bond is equal to, above, or below
the face value of the bond.

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

DQ10-11 If bonds are issued at a discount, the cash received on issuance


is less than the face value of the bonds. Because the investor
pays less than par but will receive an amount equal to par or face
value on maturity, the yield to the investor (and the interest cost
to the issuer) is increased above the contract rate of interest
promised in the indenture.

LO 2 BT: C Difficulty: E Time: 5 min. AACSB: None CPA: cpa-t001 CM: Reporting

DQ10-12 If bonds are issued at a premium, the cash received on issuance


is more than the face value of the bonds. Because the investor

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                                             

pays more than par but will receive only the par or face value on
maturity, the yield to the investor (and the interest cost to the
issuer) is below the contract rate of interest promised in the
indenture.

LO 2 BT: C Difficulty: E Time: 5 min. AACSB: None CPA: cpa-t001 CM: Reporting

DQ10-13
When the interest rate required by the market (i.e. investors) is
greater than the contract interest rate promised by the bond, the
bond will sell for less than its face value (at a discount). Bond
interest payments are fixed based upon the face value of the
bond and the contract interest rate. By paying less than the face
value of the bond while receiving the stated interest payment, the
investors effectively earn a return that is higher than the contract
interest rate stated on the bond. It is necessary to sell bonds at a
discount when alternative investments with similar risk will provide
a higher interest rate for investors.
A discount on a bond refers to the amount by which the current
market price differs from (is less than) the face value. The face
value refers to the amount that will be paid on the maturity date of
the bond. The current market value is the present value of the
maturity payment plus the present value of the interest payments
that the bond will make over its life, both discounted at the current
market rate of interest. When the bond is recorded on the books
of the borrower, the accountant records the present value of bond
at its issuance which is equal to face value of the bond less the
discount.

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                                             

DQ10-13 (Continued)

Since the issuing company must repay the bond’s face value on
maturity, the amount in the bond (note) liability account at the
maturity date must equal the face or maturity value of the bond.
Therefore, the carrying amount in the bond (note) account must
increase over time and be equal to the face value at the maturity
date (the opposite is true for bond premiums).
The periodic increase in the liability account over time is referred
to as the amortization of the discount. In terms of the accounting
entry to record the cash outflow and the expense related to the
interest payments, the amortization of the discount results in the
cash outflow for the interest payments being less than the interest
expense and consequently the carrying amount of the bond (note)
liability is increased. The following journal entry demonstrates
this:
Interest Expense XXXX
Notes Payable XXXX
Cash XXXX

LO 2 BT: C Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-10 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

DQ10-14 Bonds will be issued at a discount whenever market/yield rates


required by investors exceed the contract rate of interest
promised by the bond indenture. The difference between the face
or maturity value that the investors will receive at maturity and the
discounted issue price the investors pay for the bonds equals the
discount amount. This represents an additional cost of borrowing
to the issuing company and a bonus or additional return to the
investors. When the discount amount and the contract interest
payments are added together, the company’s interest cost, and
the investors’ return on the bond investment are equal to the
higher market/yield rate when the bond was issued. Therefore,
the effect of issuing bonds at a discount is to increase the interest
expense recognized by issuing company above contract rate of
interest.
In the accounts, the effect is recognized as the discount is
amortized whenever interest is paid or payable:
Interest Expense XXX
Cash or Interest Payable XXX
Notes Payable XXX
The discount is amortized by increasing the note liability account
over the term of the bond, from its discounted amount at issuance
to its par value at maturity, as seen in the above entry.

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

Solutions Manual 10-11 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

DQ10-15 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

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

Solutions Manual 10-12 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

DQ10-17
If the low-value lease exemption is used (which is for leases of
assets with a value of $5,000 US or less when new), the lease
payments can be treated as rent expense in the period they are
incurred. With the low-value lease exemption, there is nothing
reported on the statement of financial position related to the
lease. This differs from the normal lease treatment of setting up a
right-of-use asset and lease liability. This supports the cost
constraint from the conceptual framework, where the cost of
capturing and reporting financial information exceeds the benefits
of reporting it.

LO 3 BT: C Difficulty: M Time: 10 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 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                                             

DQ10-19 A hybrid pension plan differs from a defined benefit pension plan
in that the employer and the employee share the risk of
inadequate pension fund assets. Under a hybrid plan, either the
targeted benefits could be reduced, or both the employer and
employee together would be responsible for making up a pension
deficiency.

LO 4 BT: C Difficulty: E Time: 5 min. AACSB: None CPA: cpa-t001 CM: Reporting

DQ10-20 There are benefits to both defined benefit plans and defined
contribution plans. Under a defined benefit plan, the employee
can better plan for retirement as it is easier to determine how
much pension income s/he will receive, the pension is payable
for life, the retiree does not have to worry about using up all the
pension assets during the retirement period, and the employer
takes on the risk if there are economic downturns in the future.

On the other hand, if the economy is strong, the assets in an


employee’s defined contribution account can grow to provide a
larger pension than would have been provided under a defined
benefit plan (although there is an offsetting downside risk that
the opposite will happen). Individual employees have more
control over how their pension assets are invested. However,
investments managed by individuals rarely do as well as those in
a defined benefit plan. When a retiree dies, the assets remaining
in the defined contribution pension plan funds can be passed
down to the heirs of the retiree’s estate. Under a defined benefit
plan, the pension stops on the death of the retiree (with
provision for some continuance to a spouse, perhaps) and no
assets are returned to the retiree’s estate if the retiree dies after
the guaranteed period has expired. Therefore, if the employee
expects to have a long life, a defined benefit plan is probably
preferred, whereas if a short life is expected, a defined
contribution plan might be preferred.

A hybrid plan has the benefit of the employees and employer


working together to address any pension deficiency rather than
simply leaving it as is (which would be the case with a defined
contribution plan). These plans are more of a shared risk model.

Solutions Manual 10-14 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

DQ10-20 (Continued)

My thinking would likely change somewhat if I was considering


this from the perspective of an employer. A defined contribution
plan would likely be my preferred choice as the company’s
obligations are satisfied when the contributions to the plan are
made. Once these contributions have been made, there are no
ongoing obligations if the returns in the plan are poor.

LO 4 BT: C Difficulty: M Time: 25 min. AACSB: None CPA: cpa-t001 CM: Reporting

DQ10-21 Vesting is important to an employee because it means that the


employee is entitled to the pension benefits promised (under a
defined benefit plan) or to the employer’s contributions made
into the plan for the employee (under a defined contribution plan)
even if the employee leaves the company.

Pension plans represent an obligation of the company to provide


retirement benefits in the future to its employees. When a
pension plan is fully funded, it means that the assets held in the
pension fund equal the present value of the company’s
obligation at the reporting date for those future benefits.
Funding provides a measure of safety for the employee. If the
employer company experiences financial difficulties and it has
an underfunded plan the employer may not be able to meet its
obligations in relation to the plan.

LO 4 BT: C Difficulty: M Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-15 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

DQ10-22 While the employer’s contribution to the pension fund, and thus
the amount of the expense, are known directly for defined
contribution plans, the measurements associated with a defined
benefit plan are much more difficult. This is because the
company must estimate its present obligation for benefits that
will be paid far into the future to determine its current pension
expense. This is done through a complex calculation using such
variables as the employees’ length of service, best salary years,
amount of salary earned in those years, turnover rates, and so
on. Two of the most difficult variables to estimate are the long-
run rate of return expected to be earned on the pension assets
and the discount rate in determining the present value of these
pension obligations.

LO 4 BT: C Difficulty: M Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

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.

Solutions Manual 10-16 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 (Continued)

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

DQ10-24 Deferred income taxes are not amounts currently owing to the
government. Any taxes owing to the government would be
presented as income taxes payable on the statement of financial
position. Deferred income taxes can meet the definition of a
liability if it is probable that differences between accounting and
tax treatment for certain items (i.e. depreciation versus CCA or
the treatment of warranties) will result in net income for tax
purposes being higher than net income for accounting purposes
in future periods. This will result in income taxes payable
(determined using net income for tax purposes) being higher
than income tax expense (determined using net income for
accounting purposes). There will be a future outflow of
economic benefits which can be measured reliably and results
from actions already taken, thus the definition of a liability is met.
It should be noted that deferred income taxes can also be an
asset if net income for accounting purposes will be higher than
net income for tax purposes in the future.

LO 5 BT: C Difficulty: H Time: 15 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-17 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

Solutions Manual 10-18 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

Solutions Manual 10-19 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

AP10-1A
a. The interest expense decreases each month because the monthly
payment includes a payment on the principal as well as interest.
Therefore, the outstanding balance of the loan is reduced with each
payment so the interest portion of the next payment reduces. Interest
expense is calculated as the carrying amount (outstanding principal
balance) times the interest rate for the loan. Since the carrying
amount of the loan decreases with each blended payment, the interest
expense portion of each payment also decreases, while the principal
portion of each payment increases.

b.
Oct. 1 Cash 1,000,000
Mortgage Payable 1,000,000

Oct. 31 Interest Expense 5,000


Mortgage Payable 14,333
Cash 19,333

Nov. 30 Interest Expense 4,928


Mortgage Payable 14,405
Cash 19,333
LO 2 BT: AP Difficulty: S Time: 15 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-20 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-2A

a. (1) Amount is given


Payment = Interest + Principal = $5,250 + $7,020 = $12,270

(2) Ending Mortgage Balance = $900,000 - $7,020 = $892,980

(3) Interest = $892,980 x 7% x 1/12 = $5,209

(4) Principal = $12,270 – $5,209 = $7,061

(5) Beginning Mortgage Balance = ending Mortgage balance =


$885,919 after previous payment

(6) Ending Mortgage Balance = $885,919 – $7,102 = $878,817

b. Inception of the mortgage:

Cash 900,000
Mortgage Payable 900,000

Payment 1:

Interest Expense 5,250


Mortgage Payable 7,020
Cash 12,270

Payment 2:

Interest Expense 5,209


Mortgage Payable 7,061
Cash 12,270

LO 2 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-21 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-3A

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 = $4,000,000
Less amount recognized in 2020 2,000,000
Expense for Jan. 1 – March 31 $2,000,000
Interest Expense 2,000,000
Interest Payable 2,000,000
Cash 4,000,000
Interest entry, September 30, 2021:
Interest Expense 4,000,000
Cash 4,000,000

Solutions Manual 10-22 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

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

Solutions Manual 10-23 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-4A

a. Investors were not willing to pay $50 million for the bonds for one of two
reasons. The risks associated with Spring Water Company Ltd. may
have increased since the terms of the bond indenture were fixed, so that
the investors required a higher yield on their investment than the contract
rate written into the bond indenture. Alternatively, the risk associated with
Spring Water Company might be unchanged, but the yield rate
demanded in the general economy for an investment of the same risk
might have increased, so that the alternative investments to the company
bond were providing a higher yield. In either case, the yield required
ended up being 5% when the bonds were issued and this exceeded the
contract interest rate offered on the bonds (4.5%). Consequently, the
bonds sold at less than their par or face value, and the company was not
able to raise the $50 million that it had hoped for.

b. Journal entry for issuance:

Cash 48,050,000
Notes Payable 48,050,000

c. Calculations for interest expense in 2021:

Interest payments: $50,000,000 x 4.5% x 6/12 = $1,125,000

Interest expense on June 30, 2021:


$48,050,000 x 5% x 6/12 = $1,201,250

Discount amortized, June 30, 2021: $1,201,250 - $1,125,000


= $76,250

Interest expense on Dec. 31, 2021:


($48,050,000 + $76,250) x 5.0% X 6/12 = $1,203,156

Discount amortized, Dec. 31, 2021: $1,203,156 - $1,125,000 =


$78,156

Solutions Manual 10-24 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-4A (Continued)

Total interest expense for Year 1 = $1,201,250 + $1,203,156 =


$2,404,406

June 30
Interest Expense 1,201,250
Cash 1,125,000
Notes Payable 76,250

December 31
Interest Expense 1,203,156
Cash 1,125,000
Notes Payable 78,156
d. The amount reported for the bond (notes) payable at December
31, 2021 = $48,050,000 + $76,250 + $78,156 = $48,204,406.

LO 2 BT: AP Difficulty: M Time: 25 min. AACSB: None CPA: cpa-t001 CM: Reporting

AP10-5A

a. The proceeds on the issuance of the bonds


= $100,000,000 X 1.0435 = $104,350,000
Journal entry for the issuance of the bonds (notes):
Cash 104,350,000
Notes Payable 104,350,000
b. Investors are willing to pay more than the face value for the bonds
because the bond’s contract interest rate is higher than the market
rate (the return they would receive had they chosen the next best
investment). The bond price gets bid up in this situation until the yield
to the investor equals the lower market rate.
c. The bond notes were issued at a premium (since the bond contract or
stated rate is higher than the market or yield rate). Thus, the initial
carrying amount of the bonds is higher than the face value of the
bonds. The carrying value will decrease over the period to maturity as
the premium is amortized until the carrying value is equal to the face
value of the bonds. This will occur at maturity.

Solutions Manual 10-25 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-5A (Continued)

d. Interest entry for the first interest payment:


Interest Expense1 2,869,625
Notes Payable 130,375
Cash2 3,000,000
1
Interest Expense = Carrying Value x Yield Rate x Time
= $104,350,000 x 5.5% x 6/12 = $2,869,625
2
Cash paid = Face Value x Contract Rate x Time
= $100,000,000 X 6% x 6/12 = $3,000,000
Interest entry for the second interest payment:

Interest Expense 2 2,866,040


Notes Payable 133,960
Cash 3,000,000
2
Interest Expense = Carrying Value x Yield Rate x Time
= ($104,350,000 - $130,375) x 5.5% x 6/12 = $2,866,040

LO 2 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-26 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-6A
a. Journal entry for the issuance of the bonds (notes):
Cash 57,069,000
Notes Payable 57,069,000
b. The face value of the bonds:
Issue price $57,069,000 / 1.2682 = $45,000,000

Investors are willing to pay more than the face value for the bonds
because the bond’s contract interest rate is higher than the market
rate (the return they would receive had they chosen the next best
investment). The bond price gets bid up in this situation until the
yield to the investor equals the lower market rate.
c. Interest entry for the first interest payment:

Interest Expense1 1,712,070


Notes Payable 312,930
Cash2 2,025,000
1
Interest Expense = Carrying Value x Yield Rate x Time
= $57,069,000 x 6% x 6/12 = $1,712,070
2
Cash paid = Face Value x Contract Rate x Time
= $45,000,000 X 9% x 6/12 = $2,025,000

Interest entry for the second interest payment:

Interest Expense3 1,702,682


Notes Payable 322,318
Cash 2,025,000
3
Interest Expense = Carrying Value x Yield Rate x Time
= ($57,069,000 - $312,930) x 6% x 6/12 = $1,702,682
d. The carrying value of the bond will decrease over time. The
bond was issued over face value. However, when the bond
matures, the bond carrying value needs to be the face value
(what will be paid back to the investor), so the carrying value
will decrease over time.

Solutions Manual 10-27 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

LO 2 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-28 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-7A

a. The proceeds on the issuance of the bonds


= $80,000,000 X 0.978 = $78,240,000

Journal entry for the issuance of the bonds (notes):

Cash 78,240,000
Notes Payable 78,240,000
b. Interest entry for the first interest payment:

Interest Expense1 1,956,000


Notes Payable 156,000
Cash2 1,800,000
1
Interest Expense = Carrying Value x Yield Rate x Time
= $78,240,000 x 5% x 6/12 = $1,956,000
2
Cash paid = Face Value x Contract Rate x Time
= $80,000,000 X 4.5% x 6/12 = $1,800,000

Interest entry for the second interest payment:

Interest Expense3 1,959,900


Notes Payable 159,900
Cash 1,800,000
3
Interest Expense = Carrying Value x Yield Rate x Time
= ($78,240,000 + $156,000) x 5% x 6/12 = $1,959,900

c. At December 31st of the first year, the statement of financial position


will report notes payable as long-term liabilities of:

$78,240,000 + $156,000 + $159,900 = $78,555,900

LO 2 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-29 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-8A

a. The proceeds on the issuance of the bonds


= $118,112,500 (given in the question) The bonds were issued
at 94.4900 ($118,112,500 ÷ $125,000,000)

Journal entry for the issuance of the bonds (notes):

Cash 118,112,500
Notes Payable 118,112,500
b. Interest entry for the first interest payment:

Interest Expense1 7,677,313


Notes Payable 177,313
Cash2 7,500,000
1
Interest Expense = Carrying Value x Yield Rate x Time
= $118,112,500 x 13% x 6/12 = $7,677,313
2
Cash paid = Face Value x Contract Rate x Time
= $125,000,000 X 12% x 6/12 = $7,500,000

Interest entry for the second interest payment:

Interest Expense3 7,688,838


Notes Payable 188,838
Cash 7,500,000
3
Interest Expense = Carrying Value x Yield Rate x Time
= ($118,112,500 + $177,313) x 13% x 6/12 = $7,688,838

c. At December 31st of the first year, the statement of financial position


will report notes payable as long-term liabilities of:
$118,112,500 + ($177,313 * 5/6) = $118,260,261

LO 2 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-30 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-9A

a. The cash proceeds on the issuance of the bonds


= $120,000,000 X 1.0399 = $124,788,000
b. Journal entry for the issuance of the bonds (notes) on August 1, 2020:
Cash 124,788,000
Notes Payable 124,788,000
c. Interest entry for the interest payment on January 31, 2021:
Interest Expense1 2,807,730
Notes Payable 192,270
Cash2 3,000,000
1
Interest Expense = Carrying Value x Yield Rate x Time
= $124,788,000 x 4.5% x 6/12 = $2,807,730
2
Cash paid = Face Value x Contract Rate x Time
= $120,000,000 X 5.0% x 6/12 = $3,000,000

Interest entry for the interest payment on July 31, 2021:

Interest Expense3 2,803,404


Notes Payable 196,596
Cash 3,000,000
3
Interest Expense = Carrying Value x Yield Rate x Time
= ($124,788,000 - $192,270) x 4.5% x 6/12 = $2,803,404

d. At July 31, 2021, the statement of financial position will report


bonds payable as long-term liabilities of:
$124,788,000 - $192,270 - $196,596 = $124,399,134
LO 2 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-31 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-10A

a. Amount of cash received:

i. At 6%, the market or yield rate equals the bond contract rate.
Therefore, the full face value ($100,000,000) will be received.
ii. At 6.5%, issued at 94.448 (or 94.448% of face value):
Cash received = $100,000,000 X .94448
= $94,448,000
iii. At 5.5%, issued at 106.02 (or 106.02% of face value):
Cash received = $100,000,000 X 1.0602
= $106,020,000

b. i. Cash 100,000,000
Notes Payable 100,000,000
Cash interest paid semi-annually:
$100,000,000 X 6% X 6/12 = $3,000,000
First interest:
Interest Expense 3,000,000
Cash 3,000,000
Second interest:
Interest Expense 3,000,000
Cash 3,000,000

ii. Cash 94,448,000


Notes Payable 94,448,000
First interest:
Interest Expense 1 3,069,560
Cash 3,000,000
Notes Payable 69,560
Interest expense:
1
$94,448,000 x 6.5% x 6/12 = $3,069,560

Solutions Manual 10-32 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-10A (Continued)
Second interest:
Interest Expense 2 3,071,821
Cash 3,000,000
Notes Payable 71,821
2
Interest expense:
($94,448,000 + $69,560) x 6.5% x 6/12 = $3,071,821

iii. Cash 106,020,000


Notes Payable 106,020,000
First interest:
Interest Expense3 2,915,550
Notes Payable 84,450
Cash 3,000,000
3
Interest expense:
$106,020,000 x 5.5% x 6/12 = $2,915,550
Second interest:
Interest Expense4 2,913,228
Notes Payable 86,772
Cash 3,000,000
4
Interest expense:
($106,020,000 - $84,450) x 5.5% x 6/12 = $2,913,228

LO 2 BT: AP Difficulty: M Time: 35 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-33 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-11A

a. Cash received on issuance of bonds at 89.322 or


89.322% of face value:
= $75,000,000 x 0.89322 = $66,991,500

Cash 66,991,500
Notes Payable 66,991,500

b. Interest paid each payment:


$75,000,000 x 6% x 6/12 = $2,250,000

First interest:
Interest Expense1 2,344,703
Cash 2,250,000
Notes Payable 94,703
1
Interest expense:
$66,991,500 x 7% x 6/12 = $2,344,703

Second interest:
Interest Expense2 2,348,017
Cash 2,250,000
Notes Payable 98,017
2
Interest expense:
($66,991,500 + $94,703) x 7% x 6/12 = $2,348,017

The carrying value on the bonds one year after issuance, just after
the second semi-annual interest payment is:
$66,991,500 + $94,703 + $98,017 = $67,184,220

LO 2 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-34 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-12A
a. Bountee’s statement of financial position would include a right-of-use
leased capital asset and a corresponding lease liability. The right-of-
use asset would be initially recorded at $537,800 (the present value
of the lease payments under the lease) and a lease liability would be
recorded in the same amount. The right-of-use asset would be
depreciated, so its carrying value at the end of January would be:
$533,318 [$537,800 – ($537,800/10 years / 12 months = $4,482)].
The lease liability at the end of January would be:
The lease liability January 1, 2020 $537,800
Monthly repayment January 2020:
Total monthly payment amount $6,535
Less interest ($537,800 x 8% x 1/12) 3,535
Principal repayment $2,940 (2,940)
The lease liability at the end of January $534,860

b. Bountee’s statement of income for the one month ended January 31,
2020 would show:
Depreciation expense $4,482
Interest expense 3,585

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

Solutions Manual 10-35 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-13A

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 = 53% or 0.53:1


$450 + $575 - $75

b. If Fessenden acquires Sonar their debt would increase by $80


million, the updated ratios are:

Debt to Equity = $575 + $80 - $75 = 1.29:1


450

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 10-36 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-14A

a. 2020
Debt to Equity = Net Debt (Interest Bearing Debt – Cash)
Shareholder’s Equity

=$500,000 + $50,000 – $245,000 = 0.22:1


$1,400,000

Net Debt as a Percentage of Total Capitalization


= Net Debt (Interest Bearing Debt – Cash)
Shareholder’s Equity + Interest Bearing Debt – Cash

= $500,000 + $50,000 - $245,000 = 0.18:1


$1,400,000 + $500,000 + $50,000 - $245,000

2019
Debt to Equity = Net Debt (Interest Bearing Debt – Cash)
Shareholder’s Equity

=$800,000 + $60,000 – $260,000 = 0.47:1


$1,275,000

Net Debt as a Percentage of Total Capitalization


= Net Debt (Interest Bearing Debt – Cash)
Shareholder’s Equity + Interest Bearing Debt – Cash

= $800,000 + $60,000 - $260,000 = 0.32:1


$1,275,000 + $800,000 + $60,000 - $260,000

b. In 2020 the debt to equity ratio has improved significantly from


the perspective of potential purchasers of the company’s bonds.
The ratio has reduced to 0.22:1 from 0.47:1. The net debt as a
percentage of total capitalization has also improved to 0.18:1
from 0.32:1.

LO 8 BT: AN Difficulty: M Time: 20 min. AACSB: Analytic CPA: cpa-t001, cpa-t005


CM: Reporting and Finance

Solutions Manual 10-37 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-15A

a. Debt to Equity = Net Debt (Interest Bearing Debt – Cash)


Shareholder’s Equity
=$50,000 – $20,000 = 0.33:1
$90,000
Net Debt as a Percentage of Total Capitalization
= Net Debt (Interest Bearing Debt – Cash)
Shareholder’s Equity + Interest Bearing Debt – Cash

= $50,000 - $20,000 = 0.25:1


$90,000 + $50,000 - $20,000

b. If Taube borrows $35 Million, the updated ratios would be:

Debt to Equity = Net Debt (Interest Bearing Debt – Cash)


Shareholder’s Equity
= $50,000 + $35,000 – $20,000 = 0.72:1
$90,000
Net Debt as a Percentage of Total Capitalization
= Net Debt (Interest Bearing Debt – Cash)
Shareholder’s Equity + Interest Bearing Debt – Cash
= $50,000 + $35,000 - $20,000 = 0.42:1
$90,000 + $50,000 +$35,000 - $20,000

c. If Taube issues $35 million in bonds at 90.61, they would receive


$31,713,500. As a result, they would need to use $3,286,500
($35,000,000 - $31,713,500) of their $20 million in cash balance to
fund the balance of the equipment purchase. This would result in the
company having a cash balance of $16,713,500 ($20,000,000 -
$3,286,500).

Debt to Equity = Net Debt (Interest Bearing Debt – Cash)


Shareholder’s Equity

=$50,000 + $31,713.5 – $16,713.5 = 0.72:1


$90,000

Solutions Manual 10-38 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-15A (Continued)

Net Debt as a Percentage of Total Capitalization


= Net Debt (Interest Bearing Debt – Cash)
Shareholder’s Equity + Interest Bearing Debt – Cash

= $50,000 + $31,713.5 - $16,713.5 = 0.42:1


$90,000 + $50,000 +$31,713.5 - $16,713.5

d. The bonds would be a better option as they would have a lower


interest rate (8%) than the bank loan (10%). They would have to
pay less interest over the six-year life of the debt. However, the
company would not receive the entire $35 million (as the bonds
were issued at a discount) and there would be additional costs
incurred to issue bonds instead of borrowing from the bank. The
company would also have to use $3,286,500 of its cash to fund
the balance of the equipment purchase.

LO 8 BT: AN Difficulty: M Time: 20 min. AACSB: Analytic CPA: cpa-t001, cpa-t005


CM: Reporting and Finance

Solutions Manual 10-39 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-1B

a. Interest expense decreases each month because the monthly


payment includes a payment on the principal as well as interest.
Therefore, the outstanding balance of the loan is reduced with each
payment and so the interest portion on the next payment reduces.
Interest expense is calculated as the carrying amount (outstanding
principal balance) times the interest rate for the loan. Since the
carrying amount of the loan decreases with each blended payment,
the interest expense portion of each fixed dollar payment also
decreases, and principal portion of each payment increases.

b.
May 1 Cash 800,000
Mortgage Payable 800,000

May 31 Interest Expense 3,333


Mortgage Payable 15,090
Cash 18,423

Jun. 30 Interest Expense 3,270


Mortgage Payable 15,153
Cash 18,423

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

Solutions Manual 10-40 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-2B

a. (1) Amount is given


Payment = Interest + Principal = $1,667 + $6,156 = $7,823

(2) Interest = $493,844 x 4% x 1/12 = $1,646

(3) Principal = $7,823 - $1,646 = $6,177

(4) Ending Mortgage Balance = $487,687 – $6,197 = $481,470

(5) Opening Mortgage Balance = (4) = $481,470

(6) Interest = $481,470 x 4% x 1/12 = $1,605

b. Inception of the mortgage:

Cash 500,000
Mortgage Payable 500,000

Payment 1:

Interest Expense 1,667


Mortgage Payable 6,156
Cash 7,823

Payment 2:

Interest Expense 1,646


Mortgage Payable 6,177
Cash 7,823

c. Final Payment (72):


Interest Expense1 26
Mortgage Payable 7,797
Cash 7,823
1
($7,823 - $7,797)

LO 2 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-41 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 year-
end 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 2,000,000
Interest Payable 1,000,000
Cash 3,000,000
LO 2 BT: AP Difficulty: E Time: 15 min. AACSB: None CPA: cpa-t001 CM:

Solutions Manual 10-42 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-4B

a. Investors were not willing to pay $150 million for the bonds for one of
two reasons. The risks associated with Volta Desalination Ltd. may
have increased since the terms of the bond indenture were fixed, so
that the investors required a higher yield on their investment than the
contract rate written into the bond indenture of 3% (calculated using
the interest payment amount of $2,250,000 ÷ the face amount of the
bonds $150,000,000 x 2 = 1.5% x 2 = 3% annual interest rate).
Alternatively, the risk associated with Volta Desalination might be
unchanged, but the yield rate demanded in the general economy for
an investment of the same risk might have increased, so that the
alternative investments to the company bond were providing a higher
yield. In either case, the yield required ended up being 3.54% when
the bonds were issued and this exceeded the contract interest rate
offered on the bonds of 3%. Consequently, the bonds sold at less
than their par or face value, and the company was not able to raise
the $150 million that it had hoped for and did not raise enough funds
for the construction of their water desalination facility.

b. Journal entry for issuance:

Cash 141,600,000
Notes Payable 141,600,000

c. Calculations for interest expense in 2021:

Interest payments: $150,000,000 x 3% x 6/12 = $2,250,000

Interest expense on March 31, 2021:


$141,600,000 x 3.54% x 6/12 = $2,506,320

Discount amortized, March 31, 2021: $2,506,320 - $2,250,000 = $256,320

Interest expense on September 30, 2021:


($141,600,000 + $256,320) x 3.54% X 6/12 = $2,510,857

Discount amortized, Sept 30, 2021: $2,510,857 - $2,250,000 = $260,857

Solutions Manual 10-43 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-4B (Continued)

March 31
Interest Expense 2,506,320
Cash 2,250,000
Notes Payable 256,320

September 30
Interest Expense 2,510,857
Cash 2,250,000
Notes Payable 260,857

d. The amount reported for the bond (notes) payable at December


31, 2020 = $141,600,000 + 128,160* = $141,728,160.

*December 31 is 3 months from issue. The first interest expense


payment Oct 1 to March 31 is $2,506,320 so from Oct 1 to Dec 31
is 3 months or half of the first interest payment: $2,506,320 / 2 =
$1,253,160. The interest payable would also be half the interest
payment $2,250,000/2 = $1,125,000. The discount amortization
for the 3 months is $1,253,160 - $1,125,000 = $128,160.

LO 2 BT: AP Difficulty: M Time: 25 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-44 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-5B

a.

Date Interest Interest Amortizatio Balance of Carrying


Payment Expense n of Bond Bond Value
(5%) (4.45%) Premium Premium of the Bond
Issuance $4,200,000 $74,200,000
Payment 1 $1,750,000 $1,650,950 $99,050 4,100,950 74,100,950
Payment 2 1,750,000 1,648,746 101,254 3,999,696 73,999,696
Payment 3 1,750,000 1,646,493 103,507 3,896,189 73,896,189
Payment 4 1,750,000 1,644,190 105,810 3,790,379 73,790,379

b. Investors are willing to pay more than the face value for the bonds
because the bond’s contract interest rate is higher than the market rate
(the return they would receive had they chosen the next best
investment). The bond price gets bid up in this situation until the yield to
the investor equals the lower market rate.
The bond notes were issued at a premium (since the bond contract or
stated rate is higher than the market or yield rate). Thus, the initial
carrying amount of the bonds is higher than the face value of the bonds.
The carrying value will decrease over the period to maturity as the
premium is amortized until the carrying value is equal to the face value of
the bonds. This will occur at maturity.
c. The carrying value of the bonds at the end of payment 4 is $73,790,379.

d. Interest entry for the fourth interest payment:

Interest Expense 1,644,190


Notes Payable 105,810
Cash 1,750,000

LO 2 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-45 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-6B

a. Journal entry for the issuance of the bonds (notes):


Cash 102,393,000
Notes Payable 102,393,000
b. The face value of the bonds:
Issue price $102,393,000 / 1.1377 = $90,000,000

c. The bonds have been issued at a premium. Investors are willing to


pay more than the face value for the bonds because the bond’s
contract interest rate is higher than the market rate (the return they
would receive had they chosen the next best investment). The
bond price gets bid up in this situation until the yield to the investor
equals the lower market rate. The carrying value of the bond will
decrease over time. The bond was issued over face value.
However, when the bond matures, the bond carrying value needs
equal the face value (what will be paid back to the investor) so the
carrying value will decrease over time.
d. Interest entry for the first interest payment:

Interest Expense1 3,629,832


Notes Payable 195,168
Cash2 3,825,000
1
Interest Expense = Carrying Value x Yield Rate x Time
= $102,393,000 x 7.09% x 6/12 = $3,629,832
2
Cash paid = Face Value x Contract Rate x Time
= $90,000,000 X 8.5% x 6/12 = $3,825,000

Interest entry for the second interest payment:

Interest Expense3 3,622,913


Notes Payable 202,087
Cash 3,825,000
3
Interest Expense = Carrying Value x Yield Rate x Time
= ($102,393,000 - $195,168) x 7.09% x 6/12 = $3,622,913

Solutions Manual 10-46 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

LO 2 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-47 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-7B

a. (1) Issue date May 1, 2020


Carrying of bonds = $100,000,000 x 0.955 = $95,500,000

(2) October 31, 2021


Interest payment = $100,000,000 x 10.2% x 6/12 = $5,100,000

(3) April 30, 2021


Interest expense = $95,533,125 x 10.75% x 6/12 = $5,134,905

(4) Oct. 31, 2021


Amortization of bond discount
($5,100,000 - $5,136,782 = $36,782)

(5) Carrying value April 30,2022 after interest payment


($95,604,812 + $38,759) = $95,643,571

b. Interest entry October 31, 2021:

Interest Expense 5,136,782


Notes Payable 36,782
Cash 5,100,000
c. At December 31st 2021, the statement of financial position will
report notes payable as long-term liabilities of $95,604,812 +
($38,759 * 2/6) = $95,617,732.

LO 2 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-48 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-8B

a. The face value of the bonds


= $197,000,000 carrying value + $3,000,0000 discount =
$200,000,000

Journal entry October 1, for the issuance of the bonds (notes):

Cash 197,000,000
Notes Payable 197,000,000
b. Interest entry for December 31 accrual:

Interest Expense1 7,564,800


Notes Payable 64,800
Cash2 7,500,000
1
Interest Expense = Carrying Value x Yield Rate x Time
= $197,000,000 x 15.36% x 3/12 = $7,564,800
2
Cash paid = Face Value x Contract Rate x Time
= $200,000,000 X 15% x 3/12 = $7,500,000

At December 31st of the first year, the statement of financial


position will report notes payable as long-term liabilities of:

$197,000,000 + $64,800 = $197,064,800

LO 2 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-49 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-9B
a. The cash proceeds on the issuance of the bonds
= $150,000,000 X 1.0697 = $160,455,000

The yield is $9,675,437/$160,455,000 = 6.03% x 2 = 12.06%


Journal entry for the issuance of the bonds (notes) on
November 1, 2020:
b. Cash 160,455,000
Notes Payable 160,455,000
c. Interest entry for the interest payment on April 30, 2021:
Interest Expense1 9,675,437
Notes Payable 74,563
Cash2 9,750,000
1
Interest Expense = Carrying Value x Yield Rate x Time
= $160,455,000 x 12.06% x 6/12 = $9,675,437 (also given)
2
Cash paid = Face Value x Contract Rate x Time
= $150,000,000 X 13% x 6/12 = $9,750,000

d. At October 31, 2021, the statement of financial position will report


bonds payable as long-term liabilities of:
$160,455,000 - $74,563 - $79,060* = $160,301,377

*($160,455,000 – $74,563) x 12.06% x 6/12 = $9,670,940


$9,750,000 - $9,670,940 = $79,060

LO 2 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-50 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-10B
a. Amount of cash received:
i. At 7%, the market or yield rate equals the bond contract rate.
Therefore, the full face value ($200,000,000) will be received.
ii. Issued at 95.542 (or 95.542% of face value):
Cash received = $200,000,000 X .95542
= $191,084,000
iii. Issued with a $9,500,000 premium
Cash received = $200,000,000 + $9,500,000
= $209,500,000

b. i. Cash 200,000,000
Notes Payable 100,000,000

ii. Cash 191,084,000


Notes Payable 191,084,000
iii. Cash 209,500,000
Notes Payable 209,500,000
c. i. Cash interest paid semi-annually:
$200,000,000 X 7% X 6/12 = $7,000,000
First interest payment (June 30, 2020):
Interest Expense 7,000,000
Cash 7,000,000
ii. First interest payment (June 30, 2020):
Interest Expense 7,165,650
Cash 7,000,000
Notes Payable 165,650
iii. First interest payment (June 30, 2020):
Interest Expense 6,808,750
Notes Payable 191,250
Cash 7,000,000

LO 2 BT: AP Difficulty: M Time: 35 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-51 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-11B

a.

Date Interest Interest Balance of Carrying


Payment Expense Amortization Bond Value of
(4%)1 (6%)2 of Discount Discount Bonds
Issuance $10,676,850 $74,323,150
Payment 1 $1,700,000 $2,229,695 $529,695 10,147,155 74,852,845
Payment 2 1,700,000 2,245,585 545,585 9,601,570 75,398,430
1
($85,000,000 x 4% x 6/12) = $1,700,000
2
($74,323,150 x 6% x 6/12) = $2,229,695
($74,852,845 x 6% x 6/12) = $2,245,595

Payment 1 interest journal entry:


Interest Expense 2,229,695
Notes Payable 529,695
Cash 1,700,000

Payment 2 interest journal entry:


Interest Expense 2,245,585
Notes Payable 545,585
Cash 1,700,000

b. The carrying value of the bond one year after issuance is


$75,398,430.

LO 2 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-52 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-12B
a. MUHC Ltd’s statement of financial position would include a right-of-
use leased capital asset and a corresponding lease liability. The
right-of-use asset would be initially recorded at $368,175 the present
value of the lease payments under the lease) and a lease liability
would be recorded in the same amount. The right-of-use asset would
be depreciated, so its carrying value at the end of January would be
$357,948 [$368,175 – ($368,175 / 3 years / 12 months = $10,227)].

The lease liability at the end of January would be:


The lease liability January 1, 2020 $368,175
Monthly repayment January 2020:
Total monthly payment amount $10,870
Less interest ($368,175 x 3% x 1/12) 920
Principal repayment $9,950 (9,950)
The lease liability at the end of January $358,225

b. MUHC Ltd’s statement of income for the one month ended January
31, 2020 would show:
Depreciation expense $10,227
Interest expense 920

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

Solutions Manual 10-53 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 = 1.14:1


$900
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

Solutions Manual 10-54 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-14B

a. 2020
Debt to Equity = Net Debt (Interest Bearing Debt – Cash)
Shareholder’s Equity

=$900,000 + $85,000 – $65,000 = 0.49:1


$1,875,000

Net Debt as a Percentage of Total Capitalization


= Net Debt (Interest Bearing Debt – Cash)
Shareholder’s Equity + Interest Bearing Debt – Cash

= $900,000 + $85,000 - $65,000 = 0.33:1


$1,875,000 + $900,000 + $85,000 - $65,000

2019
Debt to Equity = Net Debt (Interest Bearing Debt – Cash)
Shareholder’s Equity

=$985,000 + $95,000 – $85,000 = 0.57:1


$1,750,000

Net Debt as a Percentage of Total Capitalization


= Net Debt (Interest Bearing Debt – Cash)
Shareholder’s Equity + Interest Bearing Debt – Cash

= $985,000 + $95,000 - $85,000 = 0.36:1


$1,750,000 + $985,000 + $95,000 - $85,000

b. Debt to Equity = Net Debt (Interest Bearing Debt – Cash)


Shareholder’s Equity

= X – $65,000 = 0.75
$1,875,000

= X - $65,000 = $1,406,250 (0.75 x 1,875,000)

X = $1,406,250 + $65,000 = $1,471,250 total debt

Solutions Manual 10-55 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-14B (Continued)

Total debt – current debt = $1,471,250 – $900,000 - $85,000 =


$486,250 amount of debt OPoole can issue and still remain
compliant.

LO 8 BT: AN Difficulty: M Time: 20 min. AACSB: Analytic CPA: cpa-t001, cpa-t005


CM: Reporting and Finance

AP10-15B

a. Debt to Equity = Net Debt (Interest Bearing Debt – Cash)


Shareholder’s Equity

= $565,000 + $75,000 – $100,000 = 0.86:1


$625,000

Net Debt as a Percentage of Total Capitalization


= Net Debt (Interest Bearing Debt – Cash)
Shareholder’s Equity + Interest Bearing Debt – Cash

= $565,000 + $75,000 - $100,000 = 0.46:1


$625,000 + $565,000 + $75,000 - $100,000

b. If Hopps borrows $235 Million, and uses it to fund development


costs, the updated ratios would be:

Debt to Equity = Net Debt (Interest Bearing Debt – Cash)


Shareholder’s Equity

=$565,000 + $75,000 + $235,000 – $100,000 = 1.24:1


$625,000

Solutions Manual 10-56 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

AP10-15B (Continued)

c. If Hopps issues bonds at 1.277 the proceeds would be


$300,095,000 ($235 million x 1.277). This would provide cash in
excess of the $235 million required to fund the development
costs. The excess cash would amount to $65,095,000 and the
debt to equity ratio would be:

Debt to Equity = Net Debt (Interest Bearing Debt – Cash)


Shareholder’s Equity

=$565,000 + $75,000 + $300,095 – $100,000 - $65,095 = 1.24:1


$625,000

c. Neither option results in the covenant being breached. The


bonds would be a better option as they would have a lower
interest rate (6.25%) than the bank loan (13%) and provide an
additional $65.095 million in funding, that Hopps will be able to
use.

LO 8 BT: AN Difficulty: M Time: 20 min. AACSB: Analytic CPA: cpa-t001, cpa-t005


CM: Reporting and Finance

Solutions Manual 10-57 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

UP10-1 With a blended payment for a mortgage, the total amount of


each payment is the same, but the portion of each payment
that represents interest is reduced as the principal balance is
reduced. From a management perspective, the advantage of
paying blended payments is that (1) there is not a large
principal payment at the end of the term of the loan (as there is
with a bond payable where the entire principal is paid at the
end instead of over the term of the loan), thus making it easier
to budget cash flows and debt repayment over time, and (2) the
interest expense, and thus the cost of borrowing to the
company decreases over time because the interest is
calculated on the remaining outstanding carrying value
(principal) of the loan, which decreases with each mortgage
payment. In addition, lender may have a lower required rate of
return on mortgage because risk of non-payment is reduced.
Finally, some financial ratios will improve with the repayments
reducing the debt load and with the reduced interest costs.

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

UP10-2 From a lender’s perspective, the primary advantage of having


long-term loans such as mortgages structured to be repaid
through equal, blended monthly payments is the reduction of
risk. The lender can require cash flows of repayment of the loan
principal throughout the term of the loan instead of hoping that
the borrower will be able to pay off a large significant loan in 20
or 25 years. Also, as capital assets used as security for the
mortgage loan age and their fair value is reduced, amount
outstanding on loan reduces as well.

LO 2 BT: C Difficulty: M Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-58 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

UP10-3 As a lender, a company’s property, plant and equipment gives


me some level of comfort because it can be used as collateral
for a long-term loan, although the value depends on how
specialized and how marketable these assets might be.

Goodwill gives a lot less comfort, as it is not an identifiable asset


that can be sold apart from the company as a whole to generate
cash to repay debt. Goodwill is often difficult to value and could
even be a sign that company paid too much for acquiring
another business.

In addition to knowing about the carrying amount of the PP&E


and goodwill assets on the statement of financial position, we
would like to know their fair value, and whether the assets are
presently being used as collateral for other creditors. As part of
the valuation process, the condition of the property, plant and
equipment can be determined as well as the evidence related to
excess cash flows that underlie the valuation of the goodwill.

LO 2 BT: C Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

UP10-4 Seniority is very important because, in the event of bankruptcy,


the company must satisfy creditors in the order of their seniority.
Some debt is secured by a first charge on specific assets, some
by a second charge on specific assets, some by a general claim
to all assets, some debt is senior debt and other is subordinate
debt. These descriptions indicate the degree of security and the
creditor’s rank in terms of rights to assets should the company
experience financial difficulties. Since the most secured and
senior obligations will be satisfied before unsecured and
subordinate debt, the creditor takes on less risk the more senior
its claims.

LO 2 BT: C Difficulty: M Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-59 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

UP10-5 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

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 10-60 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

UP10-7 Whether it is appropriate or not to include the computer


equipment on the company’s statement of financial position
depends on the nature and terms of the lease. Leases normally
result in the leased assets being recorded as right-of-use assets
and a corresponding lease liability. However, if the leases qualify
for the low-value lease exemption, then they would not be
recorded as right-of-use assets and no lease liability would be
recorded.

The shareholder should read the accounting policy notes to the


financial statements that explain how the leases are accounted
for. It is quite likely that large amounts of computer equipment
are, in substance, asset acquisitions.

LO 3 BT: C Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

UP10-8
I agree with this statement. It is possible that two separate
companies could report the transaction in a different way if the
computers met the criteria for a short term or low-value lease (12
months in length or less or $5,000 US in value or less when
new). One company could elect to use the exemption while the
other company could elect not to use it.

LO 3 BT: C Difficulty: E Time: 5 min. AACSB: None CPA: cpa-t001 CM: Reporting

UP10-9

a. There are three main types of pension plans: defined


contribution plans, defined benefit plans, and hybrid plans.
In a defined contribution plan, the employer contributes a
defined amount each period to the pension plan for each eligible
employee. The amount that employees are entitled to on
retirement is contingent upon the performance and management
of the plan assets set aside over the employees’ working lives.

Solutions Manual 10-61 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

UP10-9(Continued)

In a defined benefit plan, the employer defines, usually by a


formula that takes into consideration salary levels and years of
service, the amount that employees are entitled to receive as a
pension benefit in their retirement years. If there are insufficient
assets in the pension fund to provide this level of benefit, the
employer is responsible for making up the deficiency.

In a hybrid plan, the employer and the employee share the risk
of inadequate pension fund assets. These plans combine
features of both defined contribution plans and defined benefit
plans. They establish targeted benefit levels (similar to defined
benefit plans) which are targets rather than guaranteed benefits.
The contributions from the employee and employer are fixed
(similar to defined contribution plans), but these can be adjusted
by mutual consent. If need be, either the targeted benefits could
be reduced, or both the employer and employer together could
agree to change their contributions if this was necessary to
make up a pension deficiency.

a. From the perspective of company management, I would


recommend a defined contribution plan. This is because the
amount of company assets to be contributed into the plan is
known and the employees bear the consequences (the risk) if
the pension assets they are entitled to on retirement are not
sufficient to provide an adequate pension. This type of plan is
much easier to plan and budget for and has significantly lower
risk.

b. From the perspective of an employee, I would probably prefer a


defined benefit plan. This is because the company that sponsors
the plan is required to pay me the defined benefit I am entitled to
and to make up any deficiency should the pension fund be
underfunded. I can be certain about the benefit amount,
regardless of economic conditions, interest rates, and the
performance of plan assets.

LO 4 BT: C Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-62 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

UP10-10 a. and b.

Memo:

Why authorize a pension plan?


There are costs associated with implementing a pension plan for
our employees, and the costs differ with the type of plan that we
might authorize. Regardless of which type of plan may be
decided on, a pension plan is an additional employee benefit.
The costs can be shared with the employees (a contributory
plan) or it could be a non-contributory plan where the company,
as plan sponsors, absorbs the total cost. Increasingly, however,
employer sponsors are assumed to also have responsibility for
providing information to the employees on the type of plan they
have and what should be considered in their pension planning.

The benefit of introducing such a plan lies in the quality of


employee we are able to attract. Most reputable companies now
offer such plans and our company would be at a competitive
disadvantage if we failed to offer this type of benefit. To be
competitive, we would either have to offer a retirement plan of
some sort or compensate the potential employee with additional
salary that he or she could use to contribute to a similar plan
outside the company. We would do better to sponsor our own
plan as an indicator, that we are concerned about the financial
health of our employees, that we recognize that such costs
should be a normal cost of the salary package as the employee
provides services currently, and that the plan will be beneficial in
attracting and keeping good employees.

Recommendation – a hybrid plan

As you are likely aware, there have historically been two basic
types of pension plans – defined benefit plans and defined
contribution plans. Each has its advantages.

Solutions Manual 10-63 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

UP10-10(Continued)

A defined benefit plan is the type usually preferred by employees


because the amount of the pension benefit that will be received
by them on retirement is defined in the benefit formula. It is a
function of the years of service and salaries earned (i.e. best or
highest five years earnings). The company takes on
considerable risk, however, because if insufficient assets have
been set aside to fund the retirement benefits, the company
must make up any deficiency. The pension costs to the company
are difficult to estimate and the cash requirements can vary
considerably over the life of the plan.

A defined contribution plan is the type usually preferred by


companies because the company’s only commitment is to make
pension contributions for each employee into a pension fund,
usually based on the gross salary of the employee. At
retirement, the employee gets whatever has accumulated in the
fund through contributions and investment income. The
employer bears no risk associated with the potential insufficiency
of assets to fund a certain level of pension. This type of plan has
little variability in pension fund contributions and is much more
straightforward for cash flow and budget planning.

In recent years, a third type of plan, hybrid pension plans, have


become increasingly common. This is the type of plan I am
recommending for our company. Hybrid plans have some
features of defined benefit plans and some features of defined
contribution plans. Generally, this type of plan requires fixed
contributions from both the employer and employee (it is usually
a contributory plan), which are intended to fund specific pension
benefits. If the fund is unable to meet the obligations related to
those benefits, either the benefits are reduced or both the
employee and employer share in funding the deficiency.

In this way, both the risks and costs are shared between the
employer and the employee, and the employee is more certain
of the benefit outcomes that he or she can expect.
LO 4 BT: C Difficulty: M Time: 20 min. AACSB: Communication CPA: cpa-t001 CM: Reporting

Solutions Manual 10-64 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

UP10-11

Defined benefit plans are the most beneficial plans for employees to
have. They define how much the employees will receive in retirement
and the employer bears the risk of making sure it is funded properly.
This can cause pension envy among employees if they don’t have as
good a pension plan or any at all. It is the defined benefit plan that
would cause the most pension envy.

LO 4 BT: C Difficulty: E Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

UP10-12
a. As a manager, I might prefer to record the cost of post-
employment benefits as the expenditures are incurred, because
I would not have to record obligations (liabilities) related to these
future payments on my current statement of financial position
nor large estimated expenses on the current statement of
income. Also, it is difficult to estimate the present value of these
obligations as they may not be settled for many years and
amounts accrued will require adjustments.

b. Requiring companies to record the obligation currently is


supported by the conceptual framework. First, the obligation to
pay post-employment benefits related to the services performed
by employees to-date, less the amount of the obligation that has
been funded to-date, meets the definition of a liability. If the
obligation is not reported, the company’s liabilities are
understated.

In addition, accrual accounting requires expenses to be reported


in the same period in which the employees earn the entitlement
to the future benefits, that is, in the same period as the
expenses are incurred. The cost of post-employment benefits is
related to current period, and should thus be accrued.

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

Solutions Manual 10-65 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, including potential product liability


losses, relate to lawsuits and potential litigation where the
company may be required to incur future expenditures, but the
outcome will not be known until a future date. At the reporting
date, management and their legal advisors have concluded that
it is not likely or probable that the company will be required to
make future payments, or they have no basis on which to make
an estimate.

Contractual commitments are also entered into by companies,


that can commit the company to significant outflows of cash in
the future. This might be for large capital expenditures, fixing the
purchase price of raw material for the next year, or other similar
agreements where neither party to the contract has yet
performed. Because there is no performance by either party at
the reporting date, the obligation to pay out future funds is offset
by the right to receive certain goods and services in the future.
This is known as a mutually unexecuted contract with neither the
obligation nor the asset being recognized on the statement of
financial position. No liability would be reflected on the
statement of financial position related to this.

Financing related to operating leases is similar to a contractual


commitment whereby the company has contracted to rent an
asset in the future and has agreed to pay a certain amount to do
this. Again, no liability would be reported.

Solutions Manual 10-66 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 (Continued)

The factoring of accounts receivable with recourse (the company


is responsible to make good on the receivable if another party
fails to) is similar to a contingent liability.

b. Information included in the notes should identify contingent


liabilities to the extent that these losses are probable but there is
no basis for estimating or measuring them, or if the likelihood of
the outcome cannot be determined. The notes should indicate
an estimate of the possible financial effect they might have, an
indication of the likelihood of occurrence and timing. Contractual
commitments related to significant and unusual transactions, as
well as operating leases and factoring, should also be disclosed
in the notes with sufficient information that users can assess the
potential future impact on the company.

LO 6,7 BT: C Difficulty: M Time: 30 min. AACSB: None CPA: cpa-t001 CM: Reporting

UP10-14 Deferred or future income tax liabilities result from temporary


differences between income amounts reported in a company’s
financial statements and income amounts included in its taxable
income, on which it pays income tax. For example, a company
might sell land in the current year and report the gain on sale on
the current statement of income. However, for tax purposes, the
gain is not included in the current year’s taxable income because
the cash has not yet been collected from the sale. When the
cash is collected and the gain is “realized” in cash in the future,
the company will report it in taxable income and pay tax on the
gain in that future year. Alternatively, a company might use
straight-line depreciation for accounting purposes, but use the
CCA declining-balance method for tax purposes. This means
that taxable income and taxes payable will be lower than income
and current income tax expense on the financial statements in
an asset’s early years of use. In both cases, the company, in the
current year, entered into transactions and events and reported
revenue and expense that are consistent with accounting
standards, but which will result in the related payment of income
tax in a future year.

Solutions Manual 10-67 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

UP10-14 (Continued)

For example, when the cash is received in the future from the
sale of land, taxable income will increase and income tax will be
payable on the gain. And when the company takes less CCA
(tax depreciation) than straight-line depreciation in the future, the
company’s taxable income will be higher than its accounting-
reported income and the company will have to pay additional
income tax. The additional tax really relates to the previous
years when its actual taxes paid were reduced by taking more
CCA than depreciation expense. In both cases, in the current
year, the company reports the income taxes that will become
payable in the future as a deferred income tax liability and
includes the related future tax expense on the current year’s
income statement. This matches the total tax expense with the
decisions and transactions and amounts reported for accounting
purposes in the current year.

So, do deferred income taxes qualify as liabilities? From Chapter


9 we saw that a liability:
 Is a present obligation of the entity,
 Which the company expects to settle with an outflow of
economic resources or other economic benefits, and
 which results from a past transaction.

Recognition criteria for a liability also require that it is likely that


there will be an outflow of assets and that amount can be
reasonably estimated.

Are deferred taxes a present obligation at the reporting date?


The answer to this question is yes: in the current year the
company has sold land and reported a gain. When the cash is
received in the future, additional taxes will have to be paid.

Will the obligation have to be met with an outflow of economic


resources (assets)? Yes, additional cash will have to be paid out
to the government.

Solutions Manual 10-68 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

UP10-14 (Continued)

Does the obligation result from a past transaction? Yes, the land
was sold during the current year and this is what gives rise to
the deferred income tax obligation. More CCA (tax depreciation)
was claimed than book depreciation in the current period. This
will require a reversal and more tax to be paid in the future.

Are the recognition criteria met? Is it likely that cash will be


received in the future on the sale of land and that less CCA will
have to be taken in the future? The answer to both is “yes.” Can
a reasonable estimate be made of the amount of future taxes
that the company will be obligated to pay? The temporary
differences between the books and the tax return are both
known, as is the rate of tax. So, the recognition criteria are also
met.

Arguments have been made against the recognition of deferred


tax accounts such as:
 Changes in tax rules and rates are difficult to anticipate, so
the deferred tax liability might not be an accurate measure
of the assets that must be transferred in the future.
 The company may use tax minimization opportunities such
as continuing to buy plant and equipment that is subject to
CCA, thus avoiding the future reversal of CCA
 Because the reversal of the income or expense transaction
that has caused the deferred taxes may indeed not be
realized in the future, the argument can be made that the
transaction or event that will cause the future payment of
tax has not yet occurred.

The arguments supporting the recognition of deferred income


tax obligations as a liability outweigh arguments to the contrary.

LO 5 BT: C Difficulty: H Time: 45 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-69 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

UP10-15 As a potential lender, I should look at a deferred tax liability as a


legitimate obligation of the company to pay taxes in the future
over and above the current income tax liability reported on the
statement of financial position. Income taxes payable included in
current liabilities (and making up only a portion of the income tax
expense on the statement of income) is based only on the
taxable income reported in the current year. Deferred income tax
liability is a legitimate obligation as it relates to transactions
reported in the current period that have tax consequences, but
the tax consequences have been deferred to a future period. To
omit these amounts as not being “real” obligations would
understate the outstanding obligations related to transactions
that occurred before the statement of financial position date.

However, a deferred tax liability is different from a long-term


bank loan because, unlike the bank loan, there is uncertainty
regarding both the amount and the timing of the obligation. For
example, the company can undertake tax planning activities
which could defer the payment of the related tax far into the
future. This cannot be done with a long-term bank loan which
comes due on a stated date and then would have to be
renegotiated, if possible. The CRA cannot demand payment of
this deferred liability until the temporary differences reverse, and
even then, the tax that would otherwise be payable could be
deferred by other tax planning deductions.
As a potential lender, I would be interested in finding out what
type of transactions resulted in the deferred tax account so that I
could better understand the likely reversals. This information is
required to be disclosed by the company in the notes to its
financial statements.

LO 5 BT: C Difficulty: H Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-70 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

WORK IN PROGRESS

WIP10-1

a. Parts that are correct:


 There is a 1% point difference in the contract rate and the
market yield rate.
 The interest expense is calculated using the yield rate of
4%
b. Parts that are incorrect:
 When the contract rate is higher than the market rate, the
bond is issued at a premium, not a discount.
 The contract rate is desirable as it is higher than the
market rate, so bond purchasers are willing to pay more
than face value for the bond.

LO 2 BT: C Difficulty: M Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

WIP10-2

Parts that are correct:


 When the contract rate is 6% and the yield is 7% the bond is
issued at a discount
 When bonds are issued at a discount, the company’s interest
expense will be greater than the cash interest payments made to
the bondholder’s each period.
Parts that are incorrect:
 The interest expense will be calculated using the bond carrying
value and the yield rate. It is the interest payment that is
calculated by the face value of the bond and the contract rate.

LO 2 BT: C Difficulty: M Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-71 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

WIP10-3

Improvements to the answer:


 There are more reasons why a company may lease an asset
other than not having the cash to purchase it, others include:
o Wanting to use cash for purposes other than purchasing
assets.
o It is unable or willing to obtain a loan to finance the
purchase of the asset.
o It only has a short-term need for the asset, that is, it will
not need the asset for most of its useful life.
o The asset is expected to quickly become obsolete and the
company wants to be able to have the newest model
without having to sell the old asset and purchase the latest
one.
 The financial statement effects are exactly the same if a
company leases or borrows money and purchases the assets.
Also, if the lease has a term of 12 months or less or is for an
asset with a fair value of $5,000 US or less when new, the lease
could be different as they could elect to use the short-term low-
value exemption and treat the lease payments as rent expense.

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

WIP10-4
Flaws:
 A pension plan does not defer wage-related expenses to
future periods, pension expense is recognized in the current
year to reflect the pension benefit earning in the current
period. Only a portion of the payment may be deferred if the
company doesn’t fully fund its pension obligation.

 A defined contribution plan not a defined benefit plan, is best


from the perspective of the company and its shareholders as
they “fix” the amount of the company’s pension contributions
rather than leaving the company exposed to the potential of
making additional payments to the plan in the future to cover
the pension benefits promised in a defined benefits plan.

LO 4 BT: C Difficulty: M Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-72 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

WIP10-5

Flaws:
The lawsuit creates a contingent liability. The need to record the
liability is dependent upon the outcome of the case, or the
settlement of the case out of court. To the extent that management
has the view that a negative outcome is probable and can be
reasonably be determined and measured, the amount must be
recorded in the financial statements. In addition, details of any
additional exposure in the matter would be discussed in the notes
to the financial statements. If the probability of the occurrence of
the liability could not established, or is low, or if the amount cannot
be estimated, the contingent liability would only be disclosed in the
notes to the financial statements. The company must not delay in
the recognition and disclosure of the contingent liability merely
based on an ongoing court case.

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

WIP10-6

Items that are correct:


 A low level of leverage reduces the company’s exposure to
interest rate changes and there would be less repayment of
interest and debt principal in future periods.

 Items that are incorrect: The investors normally view a moderate


level of leverage as a positive thing as it is the extent to which a
company is using the funds provided by creditors to generate
returns for shareholders that exceed their interest costs.
Investors will not want a extremely high degree of leverage as
the obligation for repayment of debt and interest can cripple a
company.

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

Solutions Manual 10-73 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

READING AND INTERPRETING


PUBLISHED FINANCIAL STATEMENTS SOLUTIONS

RI10-1 Metro Inc.

a. A revolving credit facility is a line of credit, with a pre-approved


maximum borrowing, which can be drawn on at any time, and
repaid when the company has available funds to do so. In
Metro’s case, the maximum is $600 million.

b. An unsecured liability has no specific assets pledged as


collateral to secure repayment; in such cases, the creditors
simply rely on the general creditworthiness (repayment record,
as well as assets and cash flows) of the company.

c. The Series B Notes mature on October 15, 2035, the company


can opt to redeem these notes at any time before this date. The
Series C Notes mature on December 1, 2021 and can be retired
earlier at the option of the company. The Series D Notes mature
on December 1, 2044 and can be retired at the option of the
company at any time before this date.

d. Assuming the notes were issued at face value, the annual


interest expense is calculated using the fixed nominal rate:

Series B: $400 million x 5.97% = $23,880,000


Series C: $300 million x 3.20% = 9,600,000
Series D: $300 million x 5.03% = 15,090,000
Total interest expense = $48,570,000

e. Percentage of non-current debt to total of non-current debt and


equity (using interest-bearing debt only, excluding current
portion):
$1,231.0 = 31.4%
$1,231.0 + $2,693.2

Solutions Manual 10-74 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

RI10-1 (Continued)

Metro’s non-current debt to total capital ratio is well below the 50%
limit. It may set this objective to control the risk associated with
having too much debt that requires regular interest and principal
repayments. If the ratio is too high, company runs the risk of not
being able to meet its commitments and the creditors will require
higher interest rates to compensate them for additional risk they
take on.

LO 8 BT: AN Difficulty: M Time: 25 min. AACSB: Analytic CPA: cpa-t001, cpa-t005


CM: Reporting and Finance

Solutions Manual 10-75 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

RI10-2 Open Text Corporation

a. A revolving credit facility is a loan arrangement with a financial


institution that sets a maximum amount that can be borrowed,
but the amount outstanding at any one time could be anywhere
between $0 and the maximum amount specified. It is referred
to as “revolving” because the balance goes up and down as the
company needs extra cash and when it has extra cash to pay it
down.

b. At June 30, 2017, there was $175 million used on “the


Revolver.” The maximum amount Open Text could have
accessed through “the Revolver” was $450 million.

c. At June 30, 2017, the outstanding principal balance related to


the U.S. $800 million term loan facility was $772,120 thousand.

d. While the term loan has a seven-year term, a portion of the


principal amount is payable in each quarter of the seven year
period. Because of this, the amount of principal to be repaid in
the following year must be included in current liabilities.

e. The Senior Note 2026 does not have any principal repayment
over their term, just at maturity and the interest payments are
due semi-annually at 5.875% per annum. The Senior Note
2023 does not have any principal repayment over their term,
just at maturity and the interest payments are due semi-
annually at 5.625% per annum.

LO 2 BT: C Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-76 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

RI10-3 University of Toronto

a. When it states that the all the Series debentures are “senior
unsecured debentures” it means that these unsecured debt
instruments (i.e., debentures) have a priority claim to the
organization’s assets before any unsecured subordinated
debentures, should the University encounter difficulties
repaying its debt.

b. The debentures are carried on the Balance Sheet at $708.8


million. The debentures will be $710 million at maturity, as each
will be at their face value at the point of maturity. The current
balance of the unamortized transaction costs is $1.2 million.
Net unamortized transaction costs are comprised of discounts,
premiums and transaction issue costs. These will have been
completely amortized by the maturity date. Series A will be
$160 million. Series B and Series E will both be $200 million.
Series C and Series D will both be $75 million.

c. Some of the debentures were issued at a discount and some


were issued at a premium as indicated in the notation: “Net
unamortized transaction costs are comprised of discounts,
premiums and transaction issue costs”. The net amount of
these three items is a discount as the carrying value of the
debentures is less than the face value. The interest costs will
be more than the contract rate of the debentures as they will
have to amortize the net discount each period into the interest
expense.

d. The mortgages are secured by the related properties pledged


as security so they are secured mortgages. The mortgage does
require blended repayments as there is a current portion of
long-term debt disclosed meaning the university will repay
some principal in the next year.

LO 2 BT: C Difficulty: E Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-77 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

RI10-4 Alimentation Couche-Tard Inc.

a. Based on Couche-Tard’s three tranches (1 through 3 issued in


2012), the longer the term to maturity, the higher the interest rate
required by investors. This would be important to me as an
investor because the longer the term to maturity, the higher the
risk of non-payment I take on. Also, because interest rates in the
market may rise over time and reduce the fair value of my
investment, I would want to be paid higher interest for a long-
term bond than for one that matures in the near term.

b. Couche-Tard may have wanted to spread its borrowing out


across three tranches with different maturities to take advantage
of the lower rates for the shorter-term debt. If the cash payback
on the investment acquired with this financing takes place over
the 2017 to 2022 period, it makes sense to stagger the
repayments to correspond to the cash inflows coming back into
the company. Also, the staggered maturities reduce the risk
associated with refinancing.
c. The fact that the effective rates of interest are higher than the
coupon rate for all five tranches tells us that all the tranches
were issued at a discount.

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

Solutions Manual 10-78 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

RI10-5 Rogers Sugar Inc.

a. Rogers Sugar has defined benefit pension plans, as noted in the


title to the schedule provided of note 19 to its financial
statements.

b. The total obligation for the defined benefit plans at October 1,


2016 was $126,972,000.

c. The fair value of the defined benefit plan assets for Rogers
Sugar is $97,033,000 at October 1, 2016 .

d. The defined benefit plan is underfunded by $29,939,000 as the


plan obligation is higher than the fair value of the plan assets.
($126,972,000 - $97,033,000 - $29,939,000)

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

Solutions Manual 10-79 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

RI10-6 Rogers Sugar Inc.

a. Current and deferred income tax expense:

Year Source Current Deferred Total


2016 Earnings $14,214 $9,193 $23,407
OCI (1,993) (1,993)
Total $14,214 $7,200 $21,414

OCI = Other comprehensive income

b. Rogers reported income taxes recoverable in 2015 of $147


thousand on the statement of financial position and income taxes
payable in 2016 of $3,473 thousand on the statement of financial
position. It is possible to have taxes payable and taxes recoverable
on the same statement of financial position and in the same year
because accounting standards do not allow companies to report a
net amount if one amount cannot legally or contractually be used to
offset the other. For example, the income taxes recoverable may
relate to one specific subsidiary of Rogers and the income taxes
payable may relate to another separate subsidiary company. A
recoverable tax relating to one legal entity cannot be used to offset
the tax liability of another legal entity.

c. Given that a large deferred tax liability exists because of property,


plant, and equipment assets, we know that, in the past, Rogers has
taken more capital cost allowance (i.e., CCA or tax depreciation) for
tax purposes than depreciation expense reported on the statement
of income. In the future, when taxable income is being determined,
Rogers Sugar will have to take less CCA than depreciation
expense, increasing the amount of taxable income above the
accounting income reported, and pay additional income taxes. This
is because the company cannot deduct depreciation expense for
tax purposes, it can only deduct CCA. In effect, the company has
deferred its tax liability into the future because of its past decisions
to claim more CCA than depreciation expense.

LO 5 BT: C Difficulty: M Time: 30 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-80 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

RI10-7 ZoomerMedia Limited

a. Debt to equity ratio:


2016 = $0 + $935,246 - $3,943,778 N/A
$46,708,798
2015 = $5,975,054 + $15,339,470 - $0 0.60
$35,764,907

Net Debt as a Percentage of Total Capitalization:


2016 = $0 + $935,246 - $3,943,778 N/A
$0 + $46,708,798
2015 = $5,975,054 + $15,339,470 - $0 0.37
$20,314,524 + $35,764,907

Times interest earned ratio1


2016 = $17,980,8602 23.1 times
$778,557
2015 = $5,444,8163 3.5 times
$1,548,701
1
EBITDA = income before interest, taxes, depreciation and
amortization (including intangible asset write-offs)
2
$10,819,537 + $2,362,113 + $778,557 +$1,220,523 +
$1,075,130 + $1,725,000 = $17,980,860
3
$137,454 + $211,994 + $1,548,701 + $1,029,779 + $1,487,109
+ 1,029,779 = $5,444,816

b. The major change in the ratios is causes by the net debt being
reduced to zero in 2016, likely by using the proceeds from the
sale of the property. The gain from the sale is the main source
of the net income for 2016 and explains the increase in the
times interest earned ratio. If the gain had been excluded from
net income the times interest earned ratio for 2016 would have
essentially become income from operations divided by interest
expense or 7.8 times ($52,718,589 - $46,659,169) ÷ $778,557].
With the elimination of debt and substantial amounts of cash
and short term investments, the first two ratios are not
applicable.

Solutions Manual 10-81 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

RI10-7 (Continued)

c. Because of the substantial amount of cash received from the sale


of the property, and the related elimination of all of the debt, 2016
ratios are not to be relied upon to assess management’s handling
of debt. A more typical year, possibly 2015, can be used for ratio
analysis.

As an existing shareholder, I would be interested in determining


how much of the company’s investments in assets had been
financed by the shareholders and what proportion are financed by
creditors. In a typical year, the debt to equity ratio would be a
good general indicator for this. The 2015 ratios could be used to
compare to other companies in the industry.

I would also be interested in knowing whether the company has


been using leverage to the shareholders’ advantage. That is, has
management been using long-term debt to our advantage in the
past by incurring interest costs related to the debt that are lower
than the return they earn on the borrowed funds they invest. My
analysis would have to go further by comparing the return earned
on assets to the return earned on total shareholders’ equity.

From the perspective of a potential lender of long-term debt, I


would be interested in much of the same information as indicated
above for an investor in an equity position. I would be interested
in the risk associated with lending to the company and its
capability to cover interest and principal repayments in the future.
The 2015 debt to equity and net debt as a percentage of
capitalization ratios would provide an indication of what proportion
of the assets were financed by creditors. The higher the ratios,
the higher is the risk of the company being unable to meet
required interest and debt repayments. I would also want to
assess the interest coverage ratio to ensure that it is high enough
to comfortably cover interest charges. I would be interested in
what assets could be used as collateral for any lending and what
conditions could be written into the debt covenants for my
protection.

LO 8 BT: AN Difficulty: H Time: 25 min. AACSB: Analytic CPA: cpa-t001, cpa-t005


CM: Reporting and Finance

Solutions Manual 10-82 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

RI10-8 Fortress Paper Ltd.

a. Debt to equity ratio:


2016 = $25,851 + $171,979 - $22,132 0.83
$210,549
2015 = $41,069 + $200,348 - $33,964 0.96
$215,948

Net Debt as a Percentage of Total Capitalization:


2016 = $25,851 + $171,979 - $22,132 0.45
$210,549 + $175,698
2015 = $41,069 + $200,348 - $33,964 0.49
$215,948 + $207,453

Times interest earned ratio1 and 2

2016 = ($10,468) + $31,594 1.0 times


$21,211
2015 = ($18,724) + $29,753 0.5 times
$20,756
1
EBITDA = operating loss before amortization
2
Finance expense without deducting finance income

Several decisions were made in arriving at EBITDA in this case:


 The reversal of impairment charges on PP&E was not
included as part of EBITDA because it is similar to
depreciation and amortization and are likely related to the
sale of PPE.
 The gains on sale of PP&E were not included as part of
EBITDA because these are one-time items that will not be
available to cover interest charges in the future, nor do they
result from operations

b. The debt to equity and net debt to total capitalization ratios


decreased from the prior year due to a significant decrease in the
net debt reported. This was likely made possible by using the
proceeds from the sale of assets. The interest coverage doubled in
2016 enough to be able to cover the company’s interest costs
through operating income. This is likely due to having a smaller
operating loss in 2016.

Solutions Manual 10-83 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

RI10-8 (Continued)

c. The debt to equity and net debt as a percentage of capitalization


ratios reported, on their own, appear satisfactory from the
perspective of an existing shareholder or a potential lender of long-
term debt. As a shareholder, I would not want the ratio to become
too low as this would indicate that the company is not able to take
advantage of much leverage to increase the return to
shareholders. However, lower debt would result in lower interest
charges and therefore an increased likelihood of dividend
payments. In Fortress Paper’s case, however, because it just
starting to generate enough income from current operations to
cover existing interest charges, I would want the debt to be lower
still until operations improve. The company is obviously
experienced operating difficulties in the past and appears to be
recovering slightly in 2016.

From the point of view of a potential lender of long-term debt, I


would be very concerned by the results of the ratios taken
together. As a potential creditor, I would be very cautious about
extending credit to Fortress Paper, although it appears there may
be significant PP&E assets available to use as collateral in order to
reduce the risk of non-payment in the future.

LO 8 BT: AN Difficulty: M Time: 35 min. AACSB: Analytic CPA: cpa-t001, cpa-t005


CM: Reporting and Finance

Solutions Manual 10-84 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

RI10-9 Big Rock Brewery Inc.

a. (i) 2016 EBITDA to long-term debt ratio =

Net Debt = $8,844 1 - $207 = 21.3


EBITDA $4052
1
$5,339 + $662 + $2,843 = $8,844
2
2016 EBITDA = -$453 + $548 + $349 - $39 = $405

2015 EBITDA to long-term debt ratio =

Net Debt = $5,1363 - $540 = -11.6 therefore N/A


EBITDA -$3954
3
$3,485 + $404 + $1,247 = $5,136
4
2015 EBITDA = -$1,075 + $376 + $180 + $124 = -$395

(ii) 2016 EBITDA to interest, debt repayments and dividends:

= Interest + debt repayments + dividends


EBITDA

= $349 + $0 + $0 = $349 = .86


-$453 + $548 + $349 - $39 $405

2015 EBITDA to interest, debt repayments and dividends:

= Interest + debt repayments + dividends


EBITDA

= $180 + $0 + $1,375 = $1,555 = -3.94 therefore


N/A
-$1,075 + $376 + $180 + $124 -$395

Solutions Manual 10-85 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

RI10-9 (Continued)

b. EBITDA to long-term debt: the way that Big Rock Brewery


calculates this ratio indicates the relationship between the
outstanding debt and the near-cash earnings generated to pay off
the debt. The ratio in 2015 cannot be used as it is a negative
multiple. For 2016, the ratio indicates it takes over 21 times the
EBITDA to cover the net debt. Although this is an improvement
over the 2015 ratio, this result is not a good sign.

For the EBITDA to interest, debt repayments and dividends, in


2015 the ratio is negative and cannot be used. For 2016, with the
suspension of the payment of dividends, the ratio indicates that
86% of the EBITA is used up by interest charges. Ideally this ratio
should be a multiple, and not a fraction, as is the case for Big
Rock. This ratio is intended to indicate the earnings needed to
meet the company’s returns to creditors and shareholders plus
the repayment of long-term debt. Although the 2016 position is
more favourable than in 2015, it is somewhat alarming.

As debt levels keep increasing, and losses accumulate to a


substantial accumulated deficit, Big Rock has less flexibility in
managing its capital structure.

LO 8 BT: AN Difficulty: H Time: 35 min. AACSB: Analytic CPA: cpa-t001, cpa-t005


CM: Reporting and Finance

Solutions Manual 10-86 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

RI10-10 The Second Cup Ltd.

To supply the needs of its cafés, the Second Cup imports


significant quantities of premium coffee from 3rd party suppliers,
for delivery to a variety of locations in the U.S and Europe. The
company contracts with these suppliers to purchase coffee for
future deliveries, and, at the end of its 2016 fiscal year, had
committed to a guarantee that it would purchase a volume of
coffee amounting to a minimum of US$849 thousand during its
next fiscal year.

This note tells us that during the next fiscal year, Second Cup has
no choice but to make good under these contractual
commitments, thus it will spend at least US$849 thousand
acquiring coffee bean inventory. This will be accounted for as
inventory purchases by the company and then into cost of goods
sold as the coffee is sold to customers. It also means that the
company will incur liabilities of an equal amount, at a minimum,
with these suppliers, and these amounts will require cash
payments in the future.

LO 6 BT: C Difficulty: M Time: 15 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-87 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

RI10-11 Bombardier Inc.

In Note 38 Commitments and Contingencies, Bombardier is


telling us two things.

First, it is saying that lawsuits and legal proceedings, in general,


are part of the normal course of business. Bombardier is currently
involved in litigation resulting from product warranties and
contract disputes and it cannot tell how they will be resolved.
However, it judges that the outcome of such legal matters will not
materially affect the financial position of the company. It does not
tell us whether any related liabilities and losses have already
been recognized in the financial statements, but indicates that, in
effect, the outcomes will not be significant to the financial position
as presented.

Secondly,
The government in Brazil is investigating and has brought
charges against BT Brazil (a wholly owned subsidiary of the
company) for cartel activity in the purchase of equipment and
construction and maintenance of rail lines in Brazil. If the charges
are successful, the company would face administrative fines,
state actions for repayment of overcharges and potentially,
disqualification for a certain period to obtain government
contracts. The company is currently and will continue to
cooperate with the investigations and intends to defend itself
vigorously.

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

RI10-12 Choice of company

Answers to this question will depend on the company selected.

LO 5,6,7,8 BT: AN Difficulty: H Time: 90 min. AACSB: Analytic CPA: cpa-t001, cpa-t005
CM: Reporting and Finance

Solutions Manual 10-88 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

CASE SOLUTIONS

C10-1 Regal Cars


Memorandum

To: Mark Quaid, Regal Cars Ltd.


From: Company Accountant
Re: Long-term debt financing

Mark,

Based on the information you provided regarding the various


financing options, they would be accounted for as follows:

1. Bank Loan—The bank loan would be considered long-term debt


and be recorded on the statement of financial position at its full
face value. The $100,000 principal repayment required in the
next year would be recorded as a current liability. Interest paid
on the loan would be expensed as it is incurred (i.e. with the
passage of time).
2. Bond Issue—Bonds Payable will be recorded on the financial
statements at their carrying amount (face value plus or minus any
premium or discount). If similar bonds are providing a return of
10%, the 10% bond issue will sell at par. The $1,000,000 will be
reported on the statement of financial position as long-term debt
up to the end of year 9, at which time it will be recognized as a
current liability. For these bonds, interest expense will be
recognized at the 10% contract rate as the interest accrues.
3. Lease—it is considered the purchase of a PP&E asset, and the
right-of-use asset and the related lease liability would be
recognized at the signing of the lease. Both the PP&E asset and
the lease liability would be recognized in the accounts and
reported on the face of the statement of financial position. The
asset would be depreciated, similar to other PP&E assets the
company owns. The lease payments would be treated as blended
payments of principal and interest, with interest expense at an 8%
rate being recognized in the statement of income, along with the
depreciation expense.

Solutions Manual 10-89 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

C10-1 (Continued)

Each of these options will increase the long-term debt reported by


Regal Cars. The increase in debt under the leasing option will be
the lowest of the three, but remember that if the lease is selected,
the company will not legally own the equipment. You may be
restricted in terms of any modifications you can make to the
equipment and you may be required to return the equipment at
the end of the lease term, depending on the lease terms.
However, if the asset is leased, the company will not have to be
concerned with selling obsolete technology in 10 years and it may
be easier to upgrade to new equipment.
If the bank loan is selected, you should realize that with a
personal guarantee, you could be required to repay the loan
personally if Regal should default on the payments, or the bank
could seize and sell your family estate to recover any
outstanding portion of the debt and interest.

I hope this information provides some guidance to you. If I can


be of any further assistance, please contact me.

LO 2,3 BT: C Difficulty: M Time: 35 min. AACSB: Communication CPA: cpa-t001 CM: Reporting

Solutions Manual 10-90 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

C10-2 Jonah Fitzpatrick

Jonah,

Great to hear from you. I hope these comments clarify things a


little for you. Let me know if you have any further questions.

1. The 8% stated rate of interest on the bonds, which is also known


as the contract rate, is used to determine the cash interest
payments that will be made each period. Because this rate is
selected when the bond issue is being prepared, interest rates
may change before the bonds are actually issued. The yield or
market rate of interest is the interest rate in effect when the
bonds are sold. If the stated rate and the market rate are the
same, the bond is sold at its face amount. If the market rate has
increased, as is the case with this bond, investors will not be
willing to pay $1,000 for a bond that pays 8% when other
investments in the market are paying 10%. The price of the
bond will then start to decline. Because the amount the bond
pays at maturity will always equal the $1,000 face amount, if an
investor can buy the bond for less than $1,000, the return on the
bond will actually increase above the 8%. The price on the bond
will continue to decline until the actual return equals 10%.
Therefore, it is always the yield or market rate of interest that
should be used to evaluate your expected return on the bonds.

2. A bond sometimes carries collateral that a company can pledge


to the lenders. However, a debenture bond carries no specific
collateral and repayment is a function of only the
creditworthiness of the company. Therefore, this bond will carry
no specific security and if the company defaults on the bond you
will only have a general claim on the company’s assets.
However, the bonds you are looking at are senior debenture
bonds, so they do have priority over other unsecured debt
issued by the company in case of financial difficulties.

Solutions Manual 10-91 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

C10-2 (Continued)

3. The purpose of an investment banker is to assist the company in


selling the bond issue. They provide advice to the issuer on
matters such as the selection of the appropriate interest rate and
how best to market the issue. Most importantly, they are
responsible for selling the issue. Although one investment
dealer may sell the issue, several dealers or brokers will often
work together. This group of investment dealers is referred to as
a syndicate and is used to spread the risk associated with selling
large dollar amounts of bonds over several companies.

4. Most bonds are sold in secondary bond markets. If this bond is


traded in the public market you should be able to sell the bond at
any given time over the five-year period. Remember, however,
that the price of the bond will vary as market interest rates
change so, like an equity investment, you will likely sell it at a
profit or incur a loss.

Let me know if you need any additional information.

Mike

LO 2 BT: C Difficulty: M Time: 30 min. AACSB: Communication CPA: cpa-t001 CM: Reporting

Solutions Manual 10-92 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

C10-3 Wasselec’s Moving and Storage

MEMO – to Dogan Yilmaz

The advantages of leasing over buying include:


1. Periodic lease payments may be financially easier to budget
and manage than having to find large amounts of cash to
periodically replace vehicles after their 200,000 km, 10-
year, or 15-year life.
2. The leasing company is very familiar with the best ways to
handle returned vehicles after the leases are up. This would
relieve the company of having to deal with these non-
operating decisions and transactions.
3. Leasing does not require increased amounts of bank debt.
4. Leasing would facilitate the replacement of our vehicles,
perhaps at better points in their lifecycles, increasing the
efficiency of their operation.
5. Vehicle maintenance may be easier and more efficient with
leased vehicles.

The disadvantages of leasing over buying include:


1. The company may be restricted in the make of the vehicle
that it is able to lease.
2. The periodic payments and overall cost may be higher than
they would be if the company borrowed the money to buy
the vehicle.
3. There are likely few leasing companies engaged in leasing
the type of equipment Wasselec needs, so we may not be
able to negotiate a very competitive deal for the large
vehicles, although the car lease should not be a problem.
4. The leasing company may have restrictions related to
periodic maintenance, usage, etc., with additional significant
costs charged to Wasselec if any requirements are
contravened.

LO 3 BT: C Difficulty: M Time: 30 min. AACSB: Communication CPA: cpa-t001 CM: Reporting

Solutions Manual 10-93 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

C10-4 Grant’s Ice Cream Shop

Jack is incorrect in his lease assumption. The assets are


capitalized and recorded as right-of-use equipment, measured at
the present value of the minimum lease payments, and a lease
liability is recorded in the same amount on the company’s
statement of financial position. In this case, the lease payments
are considered blended payments of interest and a reduction of the
principal of the lease liability. The right-of-use asset will be
depreciated using the same policy as equipment already owed by
Grant’s Ice Cream Shop Ltd.

The lease would have been treated differently if Grant’s Ice


Cream Shop had been able to elect to use the short-term or low-
value exemption and treat the lease payments as rent expense.
The equipment does not qualify as it is not short-term because
the lease is not 12 months or less in length and the equipment is
not low-value because it has a fair value of more than $5,000 US,
when new.

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

C10-5 Peterson Corporation

In a defined contribution pension plan, the employer agrees to


make payments into an employee retirement fund. In the case of
this type of plan, the monies are put in a fund managed by an
independent trustee (i.e. someone from outside the company that
has investment expertise). The fund keeps track of how much
has been contributed for each individual employee. The assets
are invested and the portion attributable to each employee is
allocated to that employee’s “account” in the fund. When an
employee retires, the amount of money that has accumulated in
the employee’s “account” is paid out into some type of deferred
tax arrangement to form the basis for generating pension income
during that employee’s retirement. The vesting relates to which
party is entitled to the employer’s contributions should an
employee no longer work for the employer company.

Solutions Manual 10-94 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

C10-5 (Continued)

Under Option 1, the company will contribute an amount equal to


10% of each employee’s gross wages into the fund. Employees
are permitted to make separate contributions into the fund in
order to build a bigger sum on retirement.

These contributions will also be invested and the return on these


investments will be added to the fund Employees are entitled to
all of the benefits from the employer’s contributions into the fund
from the first day he/she works because the plan indicates that
there is immediate vesting.

If the total of what is held in the fund for an employee is not


enough to provide an adequate pension on retirement, the
employer has no responsibility to help the employee. The
employer is responsible only for contributing an amount equal to
10% of wages into the plan. Employees take the full risk if the
amount that accumulates turns out to be insufficient.

The defined benefit pension plan, on the other hand, promises


employees a pension benefit at retirement calculated according to
a pension benefit formula. Contributions into the plan are
governed by law in most cases, and not by agreement of the
employer with its employees. Unlike a defined contribution plan,
no record is kept of how much of the employer’s contributions into
the plan are designated for an individual employee. When an
employee retires, the pension fund pays pension benefits as
determined by the pension formula. If there are insufficient assets
in the fund to meet this obligation, the employer is required to
make up any deficiency. The employees know in advance how
much they will receive when they retire.

Solutions Manual 10-95 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

C10-5 (Continued)

Under Option 2, the defined annual retirement benefit is equal to


2% of the average of the highest five years of salary, per year of
employment. For example, if the employee had an average
salary of $50,000 during their five highest earning years and had
worked for the company for 20 years the annual retirement
benefit would be 2% X $50,000 X 20 years = $20,000. The
employer will provide all the necessary funding and is responsible
for ensuring this level of benefit. The vesting provisions under
Option 2, however, are not as generous as under Option 1. Under
the defined benefit plan, there is a vesting period of 5 years. That
is, if an employee leaves the company at any time in the first five
years, he or she will not be entitled to any pension benefit related
to the service provided during that time.
LO 4 BT: C Difficulty: M Time: 30 min. AACSB: None CPA: cpa-t001 CM: Reporting

Solutions Manual 10-96 Chapter 10


Copyright © 2018 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Burnley, Understanding Financial Accounting, Second Canadian Edition                                             

Legal Notice

Copyright

Copyright © 2018 by John Wiley & Sons Canada, Ltd. or related


companies. All rights reserved.

The data contained in these files are protected by copyright. This


manual is furnished under licence and may be used only in
accordance with the terms of such licence.

The material provided herein may not be downloaded, reproduced,


stored in a retrieval system, modified, made available on a network,
used to create derivative works, or transmitted in any form or by any
means, electronic, mechanical, photocopying, recording, scanning, or
otherwise without the prior written permission of John Wiley & Sons
Canada, Ltd.
MMXVIII i F1

Solutions Manual 10-97 Chapter 10


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

You might also like