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P8-2
Obj. 3 Stevie Gordon, age 40, is evaluating several supplemental retirement annuity plans offered by
her employer. In general, all the plans call for Stevie to make annual contributions, some of
which will be partially matched by the employer. The two plans drawing most of her atten-
tion are as follows. Plan 1 requires $3,000 annual end-of-year contributions by Stevie; the em-
ployer will match 20% of Stevie’s contribution each year; and the plan guarantees an 8% overall
return. Plan 2 requires $2,500 annual end-of-year contributions by Stevie; the employer will
match 85% of Stevie’s contribution; and the plan guarantees a 6% overall return.

Required Which option has the higher expected future value when Stevie reaches age 65?
Which option would you recommend to Stevie? Why?
F310 SECTION F2: Analysis and Interpretation of Financial Accounting Information
311
The Time Value of Money

P8-3 The Power of Compound Interest
Obj. 3
Prudence and Margo are identical twins. Early on, it became clear that Prudence was a bit of
a plodder whereas Margo was the fun-loving, carefree type. At age 15, both started working
regularly after school. Prudence became a saver while Margo specialized in stimulating the
economy with immediate purchases. Following her grumpy old grandfather’s advice, Prudence
began making annual contributions of $2,000 to an IRA (individual retirement account) on
her 16th birthday. Margo’s response to her grandfather’s suggestion was “gimme a break.”
Two strange events occurred, however, on their 23rd birthday. First, Prudence made her
annual $2,000 IRA contribution, bringing her balance to $21,273.26. She never contributed
again. Second, Margo promised to begin making $2,000 annual contributions to an IRA on
her 26th birthday. She kept her promise and continued through her 65th birthday, which is
today. Tomorrow, each will begin making withdrawals from their IRAs, which have been earn-
ing an 8% return.

Required
A. How much cash did Prudence contribute to her IRA over the years? How much cash
did Margo contribute?
B. What is the balance in Prudence’s IRA account today? (Hint: The interest factor for the
future value of a single sum for 42 periods at 8% is 25.33948.)
C. What is the balance in Margo’s IRA account today? (Hint: The interest factor for the
future value of an ordinary annuity for 40 periods at 8% is 259.05652.)
D. Suppose Prudence had never stopped making contributions to her IRA. What would be
her account balance today? (Hint: The interest factor for the future value of an ordi-
nary annuity for 50 periods at 8% is 573.77016.)
E. What lesson does this suggest about the power of compound interest?

Using Time Value Techniques in Retirement Planning
P8-4
Objs. 3, 4 Starla has decided to retire in 12 years. She has $44,400 available today and wants to invest
the money to supplement her pension plan.

Required
A. Assume Starla wants to accumulate $100,000 by her retirement date. Will she achieve
her goal if she invests $44,400 today and earns 7%?
B. If Starla invests, a total of $44,400 through a series of 12 equal annual installments in-
stead of a single amount, would Starla accumulate the desired $100,000? The first in-
vestment would be made one year from today. Show calculations and explain what you
find.
C. If the amount accumulated in part A does not equal $100,000, approximately how
many years would be required, assuming the same interest rate and equal annual de-
posits as above.

Computing Present Value
P8-5
Objs. 4, 5 Tyrone Flower plans to choose one of three investments. Investment A pays $500 at the end
of each year for four years. Investment B pays $2,250 at the end of four years. Investment C
pays $300 at the end of each year for three years and pays $1,200 at the end of the fourth year.
Tyrone requires a return of 8% on each of these investments.

Required Provide information to help Tyrone decide how much he should pay for each of
these investments.

Annuity Deposits at the Beginning of Periods Versus Deposits at the
P8-6
End
Objs. 2, 3, 5
Laura has decided to set up an IRA (Individual Retirement Account) in which she will make
a deposit to her plan at the end of each year, beginning one year from today. She expects to
earn 9% on her investment, over a period of 10 years.

Required
A. If she invests the maximum amount of $3,000 at the end of each of the 10 years, how
SPREADSHEET much will she have accumulated after 10 years? How much of this will be interest?
F311
CHAPTER F8: The Time Value of Money
312 The Time Value of Money

B. Assume the same facts as stated previously, except that Laura plans to make her deposit
for each of the 10 years beginning today. How much will she have accumulated 10
years from today? (Hint: You do not have a table in the text for this type of annuity.
But you can compute the future value of each deposit separately and add the totals to-
gether.) How much of the ending account balance will be composed of interest?
C. Refer to the answers for parts A and B. Which one is larger? Why? Explain.


Using Time Value to Determine a Company’s Pension Liability
P8-7
Objs. 4, 5 Cellex Manufacturing is a family-owned company preparing its year-end 2004 financial state-
ments. The firm will follow generally accepted accounting principles for the first time. There-
fore, it is required to record, for the first time, a long-term liability for its employee pension
plan. Employees who retire from the company will be paid $10,000 at the end of each year
following retirement for five years. Below is the number of employees expected to receive ben-
efits and their projected retirement dates:
1. Ten employees retiring at the end of 2008
2. Twenty employees retiring at the end of 2013
3. Thirty employees retiring at the end of 2018

Required
A. If all employees retire when scheduled and receive their full expected retirement bene-
fits, what total amount of cash will this require?
B. If the applicable interest rate is 7%, what is the amount of the liability that should be
recorded for 2004? (Hint: Calculate the solution in two steps. First, calculate the pres-
ent value of a five-year annuity for each of the three employee groups. Second, calcu-
late the present value of those three amounts based on the number of years until each
annuity begins.)
C. Using the format presented in the chapter, show how the liability would be recorded in
the accounting system.


Using Spreadsheet Functions in a Car Buying Decision
P8-8
Objs. 4, 5 Ricardo recently received a major promotion at work and a significant raise. He is shopping
for a new car. He really likes large sport utility vehicles and has his eye on one priced at $35,000.
He is not sure how to finance the vehicle, however. He has three choices.
1. The dealer has offered to finance the vehicle with zero down on a six-year, 14% loan.
2. A local bank will finance the vehicle for five years at 10% if he makes a 15% down pay-
ment.
3. His credit union will finance the vehicle for four years at 8% if he makes a 25% down
SPREADSHEET
payment.
Under all three options, equal-sized end-of-the-month payments are required. Ricardo has
the cash available for a down payment but was hoping to use it for other purposes.

Required Use the Excel PMT function to help you answer the following questions.
A. For each financing alternative, identify the rate, number of periods, and amount that
you must enter into the PMT function.
B. What is the size of the monthly payment under each alternative?
C. Based only on your answers to parts A and B, which option looks best to you?
D. What is the sum of the payments required under each financing option?
E. What total amount of interest will be paid under each financing option?
F. Based on the information available, which financing option would you recommend to
Ricardo?


Refinancing Decisions
P8-9
Obj. 6 The Taylors are considering refinancing the loan on their home. Currently, they have a 30-
year loan with an 8% annual interest rate. The original loan was for $250,000, but over
three years the Taylors have reduced the loan balance to $243,200. A local bank has offered
them a 15-year loan with a 6.5% annual interest rate. The bank will charge a 1% fee of
F312 SECTION F2: Analysis and Interpretation of Financial Accounting Information
313
The Time Value of Money

$2,432 (0.01 $243,200 $2,432) to prepare the paperwork associated with the new loan.
The fee will be added to the existing loan balance if the Taylors refinance.

Required
A. Using a spreadsheet program such as Excel, determine the Taylors existing monthly
payment. Next, multiply their payment times the number of months remaining on the
loan to determine the total amount of payments remaining.
B. Determine the monthly payment if the Taylors refinance their loan.
SPREADSHEET
C. What will be the total amount the Taylors will pay the bank over the life of the loan if
they refinance?
D. What advice would you give the Taylors?

Repaying a Note
P8-10
Obj. 6 Georgia Company borrowed $600,000 from a bank on May 1, 2004. The bank required a re-
turn of 12% on the loan. The loan is to be repaid over 12 months in equal installments. Geor-
gia Company’s fiscal year ends on December 31.

Required
A. Prepare an amortization table for the loan for the 12-month period.
B. How much interest expense would Georgia report on the loan for its 2004 fiscal year?
SPREADSHEET
C. How much interest expense would it report for 2005?
D. What amount of liability would Georgia report for the loan at the end of 2004?
E. What amount would it report at the end of 2005?

Understanding an Amortization Table
P8-11
Obj. 6 On January 1, 2004, Waldman Enterprises purchased machinery on credit by signing a note
payable for the full purchase price. The note payable called for interest to be paid on the un-
paid balance and required three equal end-of-year payments. Waldman’s accounting staff pre-
pared the following amortization table related to the note:

Balance at Balance at
Beginning Interest End-of-Year End of
Year of Year Expense Payment Year
1 $2,577.10 $206.17 1,000.00 ?
2 1,783.27 142.66 1,000.00 ?
3 925.93 74.07 1,000.00 ?

Required
A. What was the purchase price of the machinery?
B. What was the interest rate called for by the note?
C. By what amount was the principal balance of the note reduced during the first year?
D. What amount will be reported on Waldman’s year 2 income statement regarding this
note? What will it be labeled?
E. What amount will be reported on Waldman’s year 3 statement of cash flows regarding
this note?
F. What amount will be reported on Waldman’s year 1 balance sheet regarding this note?
In what section and under what title will it be reported?

Preparation of an Amortization Table
P8-12
Obj. 6 Rebecca is the owner of Sunnybrook Farm. On January 1, 2004, the beginning of the com-
pany’s fiscal year, Rebecca borrowed $750,000 at 10% annual interest to purchase equipment.
The loan is to be repaid over five years in equal annual installments. (Round each amount to
the nearest dollar.)

Required
A. What is the amount of Rebecca’s loan payment each year?
SPREADSHEET
B. Prepare an amortization table for the loan.
C. What will be the amount of interest expense reported by Sunnybrook Farm for the
loan in 2004 and in 2005?
F313
CHAPTER F8: The Time Value of Money
314 The Time Value of Money

Entering Loan Data into the Accounting System
P8-13
Obj. 6 Turn Buckle Company financed new equipment costing $50,000 with a five-year loan from a
local bank. The bank charged 11% interest on the note. (Round each amount to the nearest
dollar.)

Required
A. What would Turn Buckle’s annual payments be to the bank each year, assuming that
the note and interest are paid in equal annual installments?
B. How much interest expense would the company record for the first year of the note
and for the second year?
C. Using the format presented in the chapter, show how the first and second year-end
loan payments would be recorded in the accounting system.


Calculation of Notes Payable
P8-14
Obj. 6 You have decided to purchase a car. You have found a clean used car that will cost you $8,500.
You can finance your purchase through the dealer at an annual rate of 12% for 24 months.
The dealer requires a down payment of $2,000.

Required
A. What will be the amount of your monthly payments?
B. How much will you pay the dealer over the life of the loan?
SPREADSHEET
C. How much of this amount will be interest?
D. If you decide to pay off the loan at the end of the first year, how much will you owe
the dealer?


Reconstructing Facts from Partial Information
P8-15
Obj. 6 Mezzelano Company was involved in a transaction in which a three-year note was exchanged.
The note requires equal year-end payments. The accounting department prepared the fol-
lowing amortization table and sent you a copy. All amounts were rounded to the nearest dol-
lar. Unfortunately, the copy machine malfunctioned, and none of the column headings are
readable on your copy.

(i) (ii) (iii) (iv) (v) (vi)
1 130,000 10,400 50,444 40,044 89,956
2 89,956 7,196 50,444 43,248 46,708
3 46,708 3,737 50,444 46,708 -0-

Required
A. Identify each of the missing column headings. Explain why each one must be as you
identified it.
B. What is the principal amount of the note?
C. What is the interest rate of the note?
D. Is this an amortization table for a note receivable or a note payable? How can you tell?
Discuss.
E. At the end of year 2, what amount from this table will be reported on the income state-
ment?
F. At the end of year 2, what amount from this table will be reported on the balance
sheet?
G. At the end of year 2, what total amount from this table will be reported on the state-
ment of cash flows (direct approach)?


Combining Two Annuities of Different Size
P8-16
Obj. 6 The Faithful Servants Church has started a building fund. Annual end-of-year deposits of
$4,000 will begin at the end of the current calendar year. The accumulating balance will earn
6% compound interest per year. The $4,000 deposits are expected to be made for eight years
and then increased to $7,000 for four additional years.
(Continued)
F314 SECTION F2: Analysis and Interpretation of Financial Accounting Information
315
The Time Value of Money

Required
A. What balance will be in the fund immediately after the 12th deposit is made?
B. If no further deposits are made, and the balance is left to earn interest for 10 more
years, what amount will be in the account?
C. What amount of interest revenue will be earned by the building fund up to the date of
the 12th deposit?

Computing Withdrawals from an Annuity
P8-17
Objs. 5, 6 Kwana Lovejoy received a cash gift of $30,000 from his grandfather exactly one year before he
planned to start college. The gift was to be used to help pay Kwana’s tuition and so it was de-
posited into an investment account earning 7% per year. The plan is for Kwana to withdraw
equal annual amounts for each of four years so that at the end of that time, there will be a
zero balance in the account and he will have completed his undergraduate degree.

Required
A. Given the above conditions, how much should Kwana withdraw at the beginning of
each of his four college years?
B. What total amount of interest will the investment earn over the four years?
C. Assume that Kwana’s grandfather agrees to allow him to withdraw a total of $12,000 at
the beginning of his first year of college. (This will allow Kwana to pay his tuition and
to buy a cheap used car.) What equal annual withdrawals can Kwana then make for the
remaining three years of college?

The Effect of Interest Rate on Cost of an Investment
P8-18
Objs. 5, 6 Milo Moneybags is considering an investment that will pay him $1,050 at the end of each year
for seven years and then will pay a lump sum of $15,000 at the end of that time.

Required
A. If Milo requires his investments to earn 9% interest, what is the maximum amount he
should pay for the investment at the beginning of the seven-year period?
B. Assume Milo requires his investment to earn 5% interest. What is the maximum
amount he should pay for the investment described in part A?
C. Which investment will cost Milo the greater amount? Why is there a difference in the
costs?

Using Spreadsheet Functions in a Home-Buying Decision
P8-19
Objs. 5, 6 Prosperous Pauline is about to make an offer to buy a home. The list price is $235,000 but
Pauline will make an offer of $209,500. She plans to make a $21,500 down payment with the
balance financed with a 30-year mortgage at 8.4% annual interest. Pauline wonders what her
monthly “principal and interest” payment would be under these circumstances. Use an Excel
spreadsheet (and the PMT function) to help you answer the questions below.

Required
SPREADSHEET
A. What is the interest rate that should be entered into the PMT function?
B. What is the number of periods that should be entered into the PMT function?
C. What is the amount that should be entered into the PMT function?
D. What is the amount of Pauline’s monthly “principal and interest” payment?
E. When Pauline makes her first payment, what amount will go to pay interest and what
amount will be repayment of principal? (Hint: What amount did she owe during the
first month and what rate of interest did she incur during the month?)
F. Suppose Pauline decides to obtain a 15-year mortgage instead and that the annual rate
is 8%. What will be the amount of her monthly payment?
G. How much interest will Pauline avoid paying if she takes the 15-year mortgage instead
of the 30-year mortgage?

Excel in Action
P8-20
In December 2004, Millie and Milo Wermz decided to purchase the property they had been
renting for The Book Wermz. The cost of the building was $120,000 and the cost of the land
was $60,000. A local bank agreed to lend $160,000 toward the purchase price in exchange for
F315
CHAPTER F8: The Time Value of Money
316 The Time Value of Money

a mortgage on the property. The loan is to be repaid in equal monthly installments over 30
years beginning in January 2005. Interest on the loan is 8% and is fixed over the term of the
loan.

Required
SPREADSHEET
A. Determine the monthly payments on the loan using a spreadsheet. Enter the following
captions in cells A1 to A4: Principal, Period, Interest Rate, Payment. In cell B1, enter
“160000”, the amount borrowed. In cell B2, calculate the number of months over
which the loan will be repaid ( 30*12). In cell B3, calculate the monthly interest rate
on the loan ( 0.08/12). In cell B4, use a function to calculate the payment amount.
Click on the Function Ć’x button, select Financial from the Category list, and select
PMT from the list of functions. Click the OK button. In the dialog box, enter B3 for
Rate, B2 for Nper, and B1 for Pv. (You can move the box by clicking and dragging it so
that the data you entered in the spreadsheet are visible.) Nper is the number of periods
and Pv is the present value of the loan (the amount borrowed). Leave the Fv and Type
boxes blank, and click on the OK button. Cell B4 contains the monthly payment
amount as a negative number, because it is a cash outflow. Make this number positive
by clicking on cell B4 and changing the formula to read PMT(B3,B2,B1)*( 1). You
can make this change in the formula bar just above the column headers and then click
the green checkmark.
Beginning in cell A6, prepare an amortization table for the first year of the loan.
Enter captions in row 6 like those in Exhibit 5 of this chapter. Center the captions, use
text wrapping, and make the captions bold.
Enter 1 through 12 in column A, beginning with cell A7.
In cell B7, reference the principal amount ( B1).
In cell C7, calculate the interest expense for the first month, the principal times the
monthly interest rate ( B7*$B$3). Note that an absolute address should be provided for
the interest rate ($B$3) because you will always reference this cell to determine the rate.
In cell D7, reference the amount paid ( $B$4). Again, use an absolute address.
In cell E7, calculate the principal paid ( C7–D7).
In cell F7, calculate the amount owed at the end of the month ( B7–E7).
In cell B8, reference the amount owed at the beginning of the second month ( F7).
Copy the contents of cells C7 through F7 to cells C8 through F8. Then copy the
contents of cells B8 through F8 to the remaining rows to complete the monthly calcu-
lations.
In cell A19, enter “Total.”
In cell C19, calculate the total interest expense for 2005 using the sum function.
In cell D19, calculate the total amount paid on the loan for 2005 using the sum
function.
Format the numbers in the spreadsheet using the Comma button. Use single lines
to separate captions from calculations in the amortization table. Use single lines before
totals and double lines after totals.
B. How much does The Book Wermz owe the bank on December 31, 2005? What amount
of interest expense is incurred the first year?
C. Suppose the Wermz’s decided to repay the loan over 15 years instead of 30 years. What
would be the monthly payment? Change the number of periods in cell B2 to 15 years
( 15*12). What amount would be owed on December 31, 2005? What is the total in-
terest incurred in the first year?
D. Suppose the interest rate charged by the bank was 9% over a 30-year repayment period.
What effect would this rate have on the monthly payments and total interest for the
first year?


Multiple-Choice Overview of the Chapter
P8-21
1. For a given amount, interest rate, and number of years, which of the following will
yield the highest number?
a. Future value of a single sum
b. Future value of an annuity
c. Present value of a single sum
d. Present value of an annuity
(Continued)
F316 SECTION F2: Analysis and Interpretation of Financial Accounting Information
317
The Time Value of Money

2. You have purchased an investment at a price of $1,500. It guarantees a 7% return,
compounded annually, over its 10-year life. At the end of 10 years, your $1,500 will be
returned to you plus all investment profit. Your investment revenue will be
a. larger each year than the year before.
b. smaller each year than the year before.
c. equal each year to the year before.
d. larger than the year before for the first five years and then smaller for the next five
years.
3. The present value of an investment is $600. The investment earns a 7% annual rate of
return. The investment consists of one payment made at the end of two years. The
amount an investor should receive from the investment at the end of the second year
would be
a. $600 (1.07)2.
b. $600 (1.07)2.
c. $600 1.07.
d. $600 1.07.
4. The present value of an investment that paid $500 at the end of three years and earned
a 6% return would be
a. $419.81.
b. $471.70.
c. $30.00.
d. $470.00.
5. The present value of an investment that paid $100 at the end of each year for five years
and earned a 6% return would be
a. $470.00.
b. $471.70.
c. $373.63.
d. $421.24.
6. A company borrowed $100,000 from a bank on July 1, 2004. The company made
monthly payments of $5,235 on the note at the end of each month from July through
December. Total interest expense on the note for this six-month period was $4,410. If
this is the company’s only note, what amount should the company report on its De-
cember 31, 2004 balance sheet for notes payable?
a. $100,000
b. $95,590
c. $73,000
d. $68,590
7. You are inspecting a present value table. As the interest rate increases, you should ex-
pect the table value to:
a. increase.
b. decrease.
c. increase if it is a present value of a single sum table, but decrease if it is a present
value of an annuity table.
d. decrease if it is a present value of a single sum table, but increase if it is a present
value of an annuity table.
8. A friend obtained a $7,500 car loan from a local bank at 9% interest. The loan requires
36 equal-sized monthly payments. The portion of the payment that goes to pay interest
will
a. increase each month.
b. decrease each month.
c. stay the same each month.
d. decrease for the first 18 months and then increase during the last 18 months.
9. Clementine is part owner of a mining venture. A saver by nature, she puts part of her
profits into a 6% savings account every other month. The first month she deposited
$50. She has increased each of three subsequent deposits by $10. If she wants to fore-
F317
CHAPTER F8: The Time Value of Money
318 The Time Value of Money

cast what the account balance will be after 10 months, she should use which of the fol-
lowing tables?
a. Future value of a single sum
b. Future value of an annuity
c. Present value of a single sum
d. Present value of an annuity
10. Assume that you borrowed $1,000 from a bank. The bank charges 12% interest and re-
quires that the loan be repaid in 24 monthly installments. The interest expense you
would incur for the first year would be:
a. $120.
b. more than $120.
c. less than $120.
d. less than interest expense for the second year.




Projects
CASES
Borrowing Costs
C8-1
Obj. 6 Darren Driver is in the market for a new car. He has found a model he likes and has received
prices from two dealers. The first dealer will charge $20,500 for the car. Darren will receive a
rebate of $1,400 from the manufacturer, for a net price of $19,100. The dealer also will allow
Darren $3,600 for his old car as a trade-in. The dealer will finance the purchase for four years
at 12% per year. Interest and principal will be paid in four annual installments. The second
dealer will charge $19,000 for the car after a $1,000 rebate. This dealer will allow $3,000 for
the old car and will finance the purchase for four years at 10% per year, also payable in four
annual installments.

Required Which is the better deal? Provide evidence to support your answer. (You are not
required to prepare an amortization table.)

Principal and Interest Payments
C8-2
Obj. 6 Homer has decided to purchase a house. The price of the house is $80,000 after a down pay-
ment of $20,000. The bank will finance the purchase for 25 years at 9%. Alternatively, it will
finance the house for 15 years at 8%. Under either option, the bank wants Homer to retire
the loan by making a series of equal-sized year-end payments.

Required Evaluate the options for Homer. Write a memo to Homer (in good form) that
explains how much total interest he will pay under each option and how much his total pay-
ments will be each year and over the life of the loan. Advise Homer about which choice he
should take and the factors that are important in making the decision. (You do not have to
prepare an amortization table.)

Evaluating Contract Proposals
C8-3
Obj. 6 Fleet LaMont, a running back, was selected #1 in the recent draft of the National Football
League. Fleet’s agent and the team’s general manager are locked in arduous negotiations. Each
side has presented several proposals, but no agreement is in sight. All proposed contracts, ex-
cept #6 on the next page, are guaranteed. This means the contractual payments must be made
even if Fleet is injured or cut from the team. Under contract proposal #6, all payments to Fleet
may be cancelled by the team if Fleet is injured or cut. The average career in the NFL is less
than four years. A brief summary of each proposal follows:



(Continued)
F318 SECTION F2: Analysis and Interpretation of Financial Accounting Information
319
The Time Value of Money

Sum of Cash
Contract Payments in
Proposal Contract Summary of Terms
1 $3,000,000 A three-year contract at $1 million per year payable
quarterly starting on the date of signing the contract.
2 $4,000,000 A four-year contract at $1 million per year payable at
the end of each completed year of the contract.
3 $2,900,000 A four-year contract with signing bonus of $900,000
(payable at signing) plus end-of-quarter salary
payments of $125,000. The salary payments would
begin three months after signing the contract.
4 $26,200,000 A three-year contract at $400,000 per year paid at
each year-end plus a single $25 million payment
to be paid 25 years after signing.
5 $2,500,000 A three-year contract with 2.5 million signing bonus
and no salary payments.
6 $9,000,000 A six-year contract at $1,500,000 per year. Payable
quarterly, cancelable if Fleet is injured or cut from
the team.

Required Carefully evaluate each contract proposal. Fleet believes a 4% interest rate is ap-
propriate for determining the present value of his contract offers. If you were Fleet, which
contract would you accept? Write a memorandum to your agent explaining which contract
you have chosen and the financial and non-financial reasons that support your decision. Be
sure to include a discussion of why your choice is superior to each of the other alternatives.
F9
9

FINANCING ACTIVITIES
What are the fundamental accounting issues
associated with financing activities?

A s companies grow, they often need additional financial resources to pay for new as-
sets. Successful companies frequently borrow from various sources and issue stock
as a means of acquiring necessary financial resources. Maria and Stan have decided that
it’s time for Mom’s Cookie Company to increase the size of its operations. Consequently,
they need to understand various types of financing activities and how to account for these
activities.


FOOD FOR THOUGHT
What are the primary characteristics of debt and equity? How do these characteristics affect how we
account for financing activities? Maria and Stan are considering these questions. The company has hired
Ellen as a full-time accountant, and Maria and Stan are seeking her advice.


To become a larger company, we need additional financing.
Stan:
Yes, and you need to understand how the financing will affect the company.
Ellen:
Financing provides additional money for us to use in the company.
Maria:
That’s correct, but different types of financing involve different types of commitments and can affect your
Ellen:
ability to control the company and make decisions in the future.
So, we need to understand how financing activities will affect our company.
Stan:
Yes, but first you need to understand some fundamental accounting issues associated with these
Ellen:
activities.
We hired you to do that for us.
Maria:
True, but you need to understand these issues as well. They affect the company’s cash flows and will
Ellen:
affect your ability to raise additional funds in the future. To make decisions about how much debt and
equity you want to issue, you need to understand how financing activities affect your company’s balance
sheet, income statement, and statement of cash flows.
F320 FinancingSECTION F2: Analysis and Interpretation of Financial Accounting Information
322 Activities


OBJECTIVES

Once you have completed this chapter, you balance sheet and distinguish contributed
should be able to: capital from retained earnings.
1 Identify information that companies report 4 Explain transactions affecting stockholders’
about obligations to lenders and explain equity and describe how these transactions
the transactions affecting long-term debt. are reported in a company’s financial
statements.
2 Describe appropriate accounting
procedures for contingencies and 5 Distinguish between preferred stock and
commitments, including capital leases. common stock, and discuss why
3 Identify information reported in the corporations may issue more than one
stockholders’ equity section of a corporate type of stock.




TYPES OBLIGATIONS
OF
Organizations engage in activities that obligate them to make future payments of cash
or to provide goods or services. Most obligations are reported as liabilities on a com-
pany’s balance sheet. Liabilities result from transactions with creditors, suppliers, cus-
tomers, employees, and others.
An organization incurs debt when it borrows from creditors. For example, a com-
pany may borrow from a bank, another company, or an individual. The lender agrees
to provide resources to the borrower. In exchange, the borrower signs a note (a con-
tract), promising to repay the amount borrowed (the principal) plus interest.
In addition to contracting with creditors, organizations contract with suppliers,
employees, and other providers of goods and services. Retail stores, for example, of-
ten acquire merchandise on credit from manufacturers and agree to pay for the goods
in the near future. Companies also contract with their employees, exchanging wages
for labor. Some compensation, such as retirement benefits, may be deferred to the fu-
ture. Obligations to creditors, suppliers, and employees are all part of an organiza-
tion’s liabilities.
The term liabilities refers to an organization’s obligations to deliver payments,
goods, or services in the future. A liability links a past event (receiving something of
value) and a future event (giving value back for what was received). So, three attrib-
utes define a liability for an organization: (1) a present responsibility exists to trans-
fer resources to another entity at some future time, (2) the organization cannot
choose to avoid the transfer, and (3) the event creating the responsibility has already
occurred.1
Exhibit 1 presents the liabilities reported on the balance sheet of Mom’s Cookie
Company. The liabilities are like those of most companies. They include obligations to
lenders (Notes Payable and Interest Payable), suppliers (Accounts Payable), employees
(Wages Payable), and customers (Unearned Revenue).
Many of the liabilities reported by a company are associated with its operating ac-
tivities. These liabilities result from transactions with suppliers, employees, and cus-
tomers and involve resources used to produce and sell products. These obligations will
be considered in a future chapter that examines operating activities. This chapter fo-
cuses on liabilities resulting from borrowing money from creditors.

1
“Elements of Financial Statements,” FASB Statement of Financial Accounting Concepts, no. 6
(1985).
F321
CHAPTER F9: Financing Activities
323
Financing Activities

Exhibit 1 December 31, 2005 2004
Balance Sheet
Liabilities:
Presentation of
Current liabilities:
Liabilities for Mom’s
Accounts payable $ 16,260 $ 9,610
Cookie Company
Wages payable 3,590
Unearned revenue 2,770 4,250
Interest payable 810 650
Notes payable, current portion 6,000 5,000
Total current liabilities 29,430 19,510
Notes payable, long-term 80,200 73,200
Total liabilities $109,630 $92,710




DEBT OBLIGATIONS
An organization’s short-term and long-term borrowings are obligations to creditors.
OBJECTIVE 1
Typically, those obligations are a major portion of a company’s liabilities. Debt is sep-
Identify information that arated on a balance sheet into current- and long-term amounts (as in Exhibit 1).
companies report about
obligations to lenders and
explain the transactions
Short-Term Debt
affecting long-term debt.
An organization has an obligation to repay short-term debt during the coming fiscal
period. That debt consists of all obligations that mature during that time, including in-
stallments of long-term debt. For example, notes that will come due in 2004 are clas-
sified as current liabilities on the December 31, 2003 balance sheet.


Long-Term Debt
Long-term debt includes notes and bonds payable. Notes and bonds payable are con-
tracts between borrowers and creditors. In the contract, the borrower agrees to repay the
amount borrowed at specified dates and agrees to pay specified amounts of interest.
A note usually is an agreement between a company and a financial institution that
lends money to the company. A bond is debt in the form of a certificate in which the
http://ingram.swlearning. issuer (borrower) agrees to pay the maturity value of the bond at a predetermined date.
com Bonds often are marketable and are sold through brokers, like stock. Individuals, com-
panies, and institutions can buy and sell bonds. Most corporate bonds have maturity
Learn more about
values of $1,000 per bond. They can be sold to many individuals or organizations, per-
bonds.
mitting an issuer to borrow large amounts of money.
Some companies issue debt that is secured by specific assets, such as land, build-
ings, or equipment. These obligations are referred to as secured debt or secured loans.
If a company does not have the cash to pay back secured debt when it comes due, the
company must sell those assets pledged as security to pay the debt or transfer owner-
ship of the assets to the creditor. Other types of debt are unsecured. For example, ma-
jor corporations often issue debentures, which are unsecured bonds. If a company
cannot repay this type of debt, it can be forced to liquidate (sell some or all of its non-
cash assets). In this situation, debentures and other unsecured debts are repaid from
the sale of assets that are not pledged as security for secured debt. Therefore, secured
debt typically is less risky than unsecured debt.
Debt can be issued with any maturity date. Most bonds mature in 10, 20, or 30
years from the date on which they are issued. In the notes of their financial reports,
companies must disclose the maturity dates of their long-term debt and other relevant
information.
F322 FinancingSECTION F2: Analysis and Interpretation of Financial Accounting Information
324 Activities


Case In Point
Disclosure of Long-Term Debt
The disclosure of long-term debt information communicates information that may be
significant to a company’s investors and creditors. Information about the expected debt
payments for the next several years helps external entities determine the risk they may
http://ingram.swlearning. face if they lend the company money or buy its stock.
com For example, Krispy Kreme Doughnuts reported the following information about
its long-term debt in its 2002 annual report:
Find out more about
Krispy Kreme.
BANK FINANCING. On December 29, 1999, the Company entered into an unse-
cured Loan Agreement (the “Agreement”) with a bank to increase borrowing avail-
ability and extend the maturity of its revolving credit facility. The Agreement
provides a $40 million revolving line of credit which replaced a $28 million line of
credit and $12 million term loan. The Agreement, as amended, expires on June
30, 2004.

Summaries of our contractual obligations and other commercial commitments as
of February 3, 2002 are as follows:

(Dollars in Thousands)
Payments Payments Payments Payments
Contractual Total Due In Due In Due In Due Beyond
Cash Obligations Amount Fiscal 2003 Fiscal 2004 Fiscal 2005 Fiscal 2005
Long-term debt $ 4,643 $ 731 $ 523 $ 540 $ 2,849
Operating leases $58,001 $ 9,845 $7,478 $5,640 $35,038
Total $62,644 $10,576 $8,001 $6,180 $37,887




Debt obligations have many different characteristics. Some require periodic in-
terest and principal payments until the debt is repaid; others require principal repay-
ment at the end of the debt’s life. For example, most corporate bonds are repaid at the
end of a fixed period, such as 10 years. But other bonds repay a portion of the prin-
cipal each year over the life of the bond issue. Bond issues that require a portion of
the bonds to be repaid each year are called serial bonds. They commonly are issued
by governments.
A company can repurchase its own debt if it has enough cash and wants to reduce
its liabilities. Or a company can repurchase its existing debt and replace (refinance) it
with new debt. Refinancing becomes attractive when the general level of interest rates
in the economy goes down. A company then can issue new debt at a lower rate of in-
terest than its existing debt.
Some bonds require bondholders to resell the bonds to the issuing company at
specific dates and prices if the issuer chooses to repurchase the bonds. Callable bonds
are bonds that a company can reacquire after the bonds have been outstanding for a
specific period. For example, a company might issue 30-year bonds that are callable
after five years at 102% of maturity value. The 2% premium is compensation for call-
ing the bonds.
When a company repurchases its debt, it may
LEARNING NOTE realize a gain or loss. For example, if debt is
recorded on a company’s books at $2,000,000, and
A gain increases net income, and a loss decreases it. The terms
the company repurchases the debt for $2,050,000,
gain and loss are commonly used instead of revenue and ex-
the company records a loss of $50,000. If, on the
pense for items that are not a primary part of a company’s op-
erating activities. Gains and losses from the repurchase of debt other hand, the repurchase price is less than the is-
are treated as extraordinary items. suing price (book value) of the debt, the issuer
would record a gain.
F323
CHAPTER F9: Financing Activities
325
Financing Activities

Debt Transactions
As an illustration of transactions involving issuing and repaying debt, assume that
Mom’s Cookie Company issued $20,000 of five-year bonds on January 1, 2005. The
bonds pay $1,600 of interest (8% of $20,000) annually at the end of each year. The
$20,000 is the amount the company will pay creditors at the end of the five-year pe-
riod and is known as the maturity value or face value of the bonds. The annual inter-
est paid on the debt (8%) is the stated rate of interest. Bonds often are sold to yield a
return to creditors that is greater or less than the stated rate. For example, Mom’s Cookie
Company’s bonds might be sold to give creditors a return of 9%. The actual rate of re-
turn earned by creditors is the effective rate of interest.
The effective rate of interest is determined by the amount creditors are willing to
pay for the bonds and affects the amount of cash the company receives from its bonds
when they are sold. A company may set the stated interest rate paid on debt it issues at
any level it wishes. Suppose a company wants to borrow $100 for one year and agrees
to pay $5 interest (5%) on the debt. A creditor agrees to loan $100 to the company but
demands 8% interest. As shown in Exhibit 2, if the company agrees to this rate, the
creditor can obtain an 8% return by lending the borrower $97.22 at the beginning of
the year and receive $105 (the amount the borrower wants to pay) at the end of the
year. The interest rate earned by the creditor is still 8% ($105 $97.22 1.08). In this
alternative, the creditor discounts the amount of the loan (reduces the amount of the
loan) by an amount sufficient to provide an 8% return.


Exhibit 2
Effective and Stated
Rate borrower pays (stated rate) 5%
Rates of Interest
Rate lender demands (effective rate) 8%
Interest paid by borrower ($100 0.05) $5.00
Amount lender pays borrower at beginning of year $97.22
Amount borrower pays lender at end of year $105.00
Interest earned by borrower ($105.00 $97.22) $7.78
Interest rate earned by borrower $7.78 $97.22 8%




This method is common for bonds and certain other types of debt issued by com-
panies. The borrower determines the amount of interest paid, and creditors set the price
of the bonds to earn the interest rate they require. If a deal cannot be struck between
the borrower and creditors, the borrower can look for other financing arrangements
and the creditors can look for other investments.
To determine the amount received, we need to calculate the present value of the bonds,
the amount they are worth at the time they are issued. The present value of a bond is the
present value of the amounts the purchasers of the bonds (creditors) will receive over the
life of the bonds. As illustrated in Exhibit 3, the purchasers of Mom’s Cookie Company’s
bonds will receive five annual interest payments of $1,600 ($20,000 8%) plus $20,000
when the bonds mature. (See Chapter F8 for coverage of present value calculations.)
Therefore, the present value of the bonds is the present value of an annuity plus
the present value of a single amount. We can use the present value tables (Table 3 and
Table 4) to determine the present value of the bonds.
Let’s assume the bonds will be sold to yield a 9% return to creditors. Therefore, we
need to determine the present value of the interest that will be received by creditors
plus the present value of the principal:
PV of bonds PV of annuity PV of single amount
PV of bonds $1,600 3.88965 (5 periods, 9%) $20,000 0.64993 (5 periods, 9%)
PV of bonds $6,223 $12,999
PV of bonds $19,222
F324 FinancingSECTION F2: Analysis and Interpretation of Financial Accounting Information
326 Activities

Exhibit 3 Future Cash Flows
Issue Date
Example of the
Relationship of Bond 01-01-05 12-31-05 12-31-06 12-31-07 12-31-08 12-31-09
Cash Flows to Present
Value
$1,600


$1,600
Present
Value $1,600


$1,600


$1,600


$20,000




Thus, the amount Mom’s Cookie Company will receive from selling the bonds is
$19,222. Observe that the effective rate of interest (9%) is used to determine the inter-
est factor for the present value calculation. Mom’s Cookie Company receives less than
maturity value for the bonds because the effective rate of interest (9%) on the bonds is
higher than the stated rate (8%). When the effective rate is higher than the stated rate,
bonds sell at a discount. Mom’s Cookie Company’s bonds sold at a discount of $778
($20,000 $19,222), or approximately 96% of maturity ($19,222 $20,000). When
bonds sell at maturity value, they are said to sell at par. If they sell at less than matu-
rity value, they are said to sell at a discount. The issue price often is stated as a per-
centage of par, such as 96% of par. If bonds sell at more than maturity value, they sell
at a premium. We will consider a premium later in this section.
To determine transactions recorded for the bonds, we need to prepare an amorti-
zation table similar to that described in the previous chapter. Exhibit 4 provides an
amortization table for Mom’s Cookie Company’s bonds.




USING EXCEL
Alternatively, we can use a spreadsheet to calculate the present value of the bonds.
The annuity portion can be calculated using the PV function. In Excel, the function
For Present Value of
entered in a cell would be: PV(0.09,5, 1600), where 0.09 is the effective interest
Bonds
rate, 5 is the number of periods, and 1600 is the amount of payment each period.
Remember that the function uses a negative value for payments in computing the
present value. This function returns a value of $6,223 (rounded to the nearest dollar)
and is equivalent to the amount determined by using Table 4. The present value of
the maturity value of $20,000 can be calculated in Excel by entering 20000/(1.09)
^5, where 20000 is the maturity value, 1.09 is one plus the actual rate of interest,
SPREADSHEET
and 5 is the number of periods. This equation returns $12,999 (rounded to the near-
est dollar) the same value as that calculated from Table 3. Adding the two values to-
gether ($6,223 $12,999) results in the total present value of $19,222.




To prepare the table, we first determine the present value of the bonds. This amount
is entered in column B for year 1. The interest expense on the bonds is the present value
F325
CHAPTER F9: Financing Activities
327
Financing Activities

Exhibit 4 Bond Amortization Table*

A B C D E F
Amortization
Present Value Interest Incurred of Principal Value at End of
at Beginning of (Column B Real Amount (Column C Year (Column
Year Year Interest Rate) Paid Column D) B Column E)

2005 19,222 1,730 1,600 130 19,352
2006 19,352 1,742 1,600 142 19,494
2007 19,494 1,754 1,600 154 19,648
2008 19,648 1,768 1,600 168 19,816
2009 19,816 1,783 1,600 183 20,000
Total 8,778 8,000 778
*Slight adjustments have been made for rounding errors.




from column B times the real interest rate (9%). Consequently, the interest expense in-
curred by Mom’s Cookie Company for the first year is $1,730 ($19,222 9%), shown
in column C. The amount of interest Mom’s Cookie Company pays each year is $1,600
(column D). The difference between the amount of interest expense (column C) and
the amount of interest paid (column D) is the amortization of bond principal (column
E). When bonds are issued at a discount, the amortization is added to the beginning-
of-period present value to calculate the end-of-period value (column F). These calcu-
lations continue for each period. Observe that the value of the bonds at the end of the
five-year period is their maturity value, the amount Mom’s Cookie Company will re-
pay in the fifth year.
The transactions associated with the bonds begin with their sale on January 1,
2005:



ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Jan. 1, 2005 Cash 19,222
Bonds Payable 19,222




The amount of liability owed by Mom’s Cookie Company when the bonds are issued
is the amount received for the bonds.
At the end of the first year, Mom’s Cookie Company records the interest paid and
interest expense:



ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2005 Interest Expense 1,730
Bonds Payable 130
Cash 1,600
F326 FinancingSECTION F2: Analysis and Interpretation of Financial Accounting Information
328 Activities

The difference between the cash paid and the interest expense is added to Bonds Payable
when bonds are issued at a discount. The amount Mom’s Cookie Company owes its
creditors at the end of the first year is $19,352 ($19,222 $130), as shown in Exhibit 4.
Mom’s Cookie Company continues to record the interest payments and interest
expense each year. In the fifth year, it records the final interest payment:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2009 Interest Expense 1,783
Bonds Payable 183
Cash 1,600




This transaction increases Bonds Payable to its maturity value of $20,000.
Then, Mom’s Cookie Company pays creditors the maturity value of the bonds:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2009 Bonds Payable 20,000
Cash 20,000




Over the life of the bonds, Mom’s Cookie Company pays its creditors $28,000 ($20,000
maturity value $8,000 interest payments). The amount the company received for the
bonds was $19,222. Therefore, its total interest expense for the bonds was $8,778
($28,000 $19,222). This amount provided creditors with a 9% effective rate of re-
turn over the life of the bonds.
The information used in this example as a basis for transactions recorded by the
issuer of debt also can be used for transactions involving the purchasers of the debt. If
several creditors bought Mom’s Cookie Company’s bonds, the amounts recorded by
each creditor would be a portion of the total. The totals for all the creditors would be
the same as the amounts recorded by Mom’s Cookie Company. Instead of recording
interest expense and interest paid, the creditors would record interest revenue and in-
terest received. Their cash outflow at the time of purchase would be $19,222, and the
cash received at the end of the five-year period would be $20,000.
When the effective rate of interest on debt is less than the stated rate, the debt is
said to be issued at a premium. The borrower receives more for the bonds when they
are sold than the maturity value of the bonds: The bonds sell at more than 100% of
par. A premium reduces the interest expense on the debt each period. A portion of the
amount paid by the borrower each period is a repayment of the amount borrowed, in
http://ingram.swlearning. addition to the payment of interest. The amount of principal amortized each period is
com subtracted from the beginning-of-period present value to calculate the end-of-period
value in the amortization table. Self-Study Problem 1 illustrates transactions involving
Find out about getting
the sale of bonds at a premium.
online bond quote
information. If the effective and stated rates of interest are the same, bonds are sold at their ma-
turity value (100% of par) and no premium or discount is recorded. Interest expense
will equal interest paid each period. Exhibit 5 summarizes the relationships between ef-
fective and stated interest rates.
F327
CHAPTER F9: Financing Activities
329
Financing Activities

Exhibit 5 The Relationship between Effective and Stated Interest Rates

Relation between Interest Effect on Principal
Interest Rate Comparison Bonds Sell At and Amount Paid Each Period

Effective Rate Stated Rate Discount Interest Expense Amount Paid Increase
Effective Rate Stated Rate Par Interest Expense Amount Paid No Change
Effective Rate Stated Rate Premium Interest Expense Amount Paid Decrease




1 SELF-STUDY PROBLEM Assume that instead of issuing its debt to yield an effective rate
of 9%, Mom’s Cookie Company issued the debt to yield an ef-
fective rate of 7%.

Required Using the information provided in the previous example as a guide:

A. Calculate the present value of the bonds at the time they are issued.
B. Prepare an amortization table.
C. Record transactions for Mom’s Cookie Company for the first and fifth years.
The solution to Self-Study Problem 1 appears at the end of the chapter.




FINANCIAL REPORTING DEBT
OF
A corporation’s financial statements and accompanying notes provide much useful in-
formation. They help readers calculate the amount of debt a company has outstanding,
and they also indicate changes in debt, the interest rates on debt, the interest expense
during a given fiscal period, and current and future cash flows associated with existing
debt and interest payments.
Exhibit 6 shows the items that would be reported on Mom’s Cookie Company’s fi-
nancial statements at the end of each fiscal year during the life of the bonds described
in the previous section. Amounts are from the amortization table in Exhibit 4.
The amount owed by Mom’s Cookie Company to its creditors at the end of each
year is reported on the balance sheet. At the end of the first three years, these amounts
are reported as long-term debt. At the end of the fourth year, the amount owed is re-
ported as a current liability because it will be repaid in the following fiscal year. At the


Exhibit 6 Financial Statement Presentation of Debt Activities for Mom’s Cookie Company

December 31, 2009 2008 2007 2006 2005

Balance sheet
Liabilities:
Current maturities
of long-term debt — $19,816 — — —
Long-term debt — — $19,648 $19,494 $ 19,352
Income statement
Nonoperating expenses:
Interest expense $ 1,783 1,768 1,754 1,742 1,730
Statement of cash flows
Cash flow from operating activities:
Interest paid (1,600) (1,600) (1,600) (1,600) (1,600)
Cash flow from financing activities:
Long-term debt issued — — — — 192,220
Debt repaid (20,000) — — — —
F328 FinancingSECTION F2: Analysis and Interpretation of Financial Accounting Information
330 Activities

end of the fifth year, the company reports no liability for these bonds because they have
been repaid.
Interest expense, based on the effective rate of interest, is reported each year on the
income statement. For most companies, interest expense is a nonoperating expense and
is reported on the income statement after operating income.
The amount of interest paid is reported each year on the statement of cash flows
as part of operating activities. If the indirect format of the statement is used, interest
paid may not appear as a separate item on the statement of cash flows. In that case, the
amount of interest paid usually is listed either at the bottom of the statement of cash
flows (as supplemental data) or in the notes to the financial statements.
When debt is issued, the amount of cash received is reported on the statement of
cash flows as cash from financing activities. When debt is repaid, the amount of cash
paid is listed there as cash paid for financing activities.



OTHER OBLIGATIONS
Other types of obligations that involve financing activities also are reported on the bal-
OBJECTIVE 2
ance sheet or in notes to the financial statements. Among those obligations are con-
Describe appropriate tingencies and commitments.
accounting procedures for
contingencies and
Contingencies
commitments, including
capital leases.
A contingency is an existing condition that may result in an economic effect if a fu-
ture event occurs. GAAP require companies to report contingencies that could result
in future obligations.
For most contingencies, a current obligation does not exist. If some future event
occurs, however, an obligation might result. For example, suppose Mom’s Cookie Com-
pany guarantees debt of one of its customers, Fair Price Foods. If Fair Price Foods is
unable to make the loan payments, Mom’s Cookie Company becomes liable for the
payments. Mom’s Cookie Company does not have a liability, however, unless Fair Price
Foods is unable to pay.
Other common contingencies involve environmental costs and litigation. Gov-
ernment regulations in recent years have made companies contingently liable for
costs associated with environmental cleanup and restoration if the companies are
found not to have met regulatory requirements. Companies often face lawsuits as-
sociated with problems such as product defects and unfair treatment of employees.
Until these suits are settled, a company is contingently liable for losses associated
with the litigation.
Under certain circumstances, contingencies are reported as liabilities. If a contingency
probably will result in a loss, and the amount of the loss can be reasonably estimated, it
should be included as a liability on a company’s balance sheet. Also, the amount of the
expected loss is recognized on the income statement in computing net income.




Case In Point
Disclosure of Contingencies
In its 2002 annual report, Krispy Kreme reported the following contingency:

In order to assist certain associate and franchise operators in obtaining third-party
financing, the Company has entered into collateral repurchase agreements in-
volving both Company stock and doughnut-making equipment. The Company's
contingent liability related to these agreements is approximately $1,266,000 at Jan-
uary 28, 2001 and $70,000 at February 3, 2002.
F329
CHAPTER F9: Financing Activities
331
Financing Activities

Commitments
A commitment is a promise to engage in some future activity that will have an eco-
nomic effect. Commitments usually involve agreements to purchase or sell some-
thing in the future. For instance, airlines place orders with airplane manufacturers
several years prior to completion of the planes. These commitments will require the
airlines to finance their purchases at some time in the future, but they are not lia-
bilities until the airplanes have been manufactured and ownership is transferred to
the airlines.
Leased assets are a common form of commitment. Certain leases, called capital
leases, are financing arrangements and are examined in the next section. In addition
to capital leases, companies use operating leases to obtain machinery, equipment, and
other resources. Costs of operating leases are recorded as expenses in the period in
which the leased assets are used. Liabilities are not recorded for operating leases. Some
operating leases cannot be canceled, however, resulting in a commitment for future
payments. The amount of future payments is reported in the notes to the financial state-
ments. Companies typically report the amount they are committed to paying for oper-
ating leases in each of the next five years and the total amount of commitments that
extend beyond five years. Disclosures like these help investors and other decision mak-
ers forecast future cash flows and profits.




Case In Point
Disclosure of Lease Agreements
Krispy Kreme reported the following lease arrangements in its 2002 annual report:

The Company conducts some of its operations from leased facilities and, addi-
tionally, leases certain equipment under operating leases. Generally, these have
initial lease terms of 5 to 18 years and contain provisions for renewal options of
5 to 10 years.

At February 3, 2002, future minimum annual rental commitments, gross, under
noncancelable operating leases, including lease commitments on consolidated
joint ventures, are as follows:

In Thousands
Fiscal Year Ending In Amount
2003 $ 9,845
2004 7,478
2005 5,640
2006 4,074
2007 3,562
Thereafter 27,402
$58,001

Rental expense, net of rental income, totaled $6,220,000 in fiscal 2000, $8,540,000
in fiscal 2001, and $10,576,000 in fiscal 2002.



Capital Leases
Leases often provide a means of financing asset acquisitions. When a company leases a
resource, usually buildings or equipment, for most of the useful life of the resource and
controls the resource as though it had been purchased, the lease is treated as a capital
lease. Capital leases are recorded as liabilities, and the related leased resources are
recorded as assets.
F330 FinancingSECTION F2: Analysis and Interpretation of Financial Accounting Information
332 Activities

For example, suppose Mom’s Cookie Company signs a lease on January 1, 2005 to
acquire computer equipment. The lease is for three years, the assumed useful life of the
equipment. The company agrees to pay $10,000 a year, including 8% interest. In effect,
Mom’s Cookie Company is purchasing the equipment and borrowing money from the
lessor (the company that owns the equipment and leases it to Mom’s Cookie Company)
http://ingram.swlearning. to finance the purchase.
com To determine the amount of the lease obligation, we have to calculate the present value
of the lease payments. We can make this calculation using the interest factor in Table 4 be-
Find out more about
cause the lease payments are an annuity. We use the interest factor for three periods at 8%:
leasing.

PVA A IF (Table 4)
$25,771 $10,000 2.57710




USING EXCEL
For Present Value of Alternatively, we can use the present value function in a spreadsheet. In Excel, we
Leases would enter the function PV(0.08,3, 10000) to make this calculation. The amount
returned is $25,771, rounded to the nearest dollar.




SPREADSHEET




Mom’s Cookie Company records the present value of lease payments as an asset
and a liability:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Jan. 1, 2005 Leased Assets 25,771
Capital Lease Obligation 25,771




Other transactions associated with the lease payments are like those for repayment
of a loan. The amortization table in Exhibit 7 provides the necessary information.
This table is like that for a note that is repaid in equal installments, as described in
Chapter F8. Observe that a portion of the principal is repaid each period, along with
the interest.
Mom’s Cookie Company records the payments and interest expense each period.
For example, the transaction for the first year is:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Dec. 31, 2005 Capital Lease Obligation 7,938
Interest Expense 2,062
Cash 10,000
F331
CHAPTER F9: Financing Activities
333
Financing Activities

Exhibit 7 Amortization Table for a Capital Lease

A B C D E F
Interest Amortization Value
Present Value Incurred of Principal at End of Year
at Beginning (Column B Amount (Column C (Column B
Year of Year Real Interest Rate) Paid Column D) Column E)

Dec. 31, 2005 25,771 2,062 10,000 (7,938) 17,833

Dec. 31, 2006 17,833 1,427 10,000 (8,573) 9,260

Dec. 31, 2007 9,260 740 10,000 (9,260) 0

Total 4,229 30,000 (25,771)




This transaction reduces the capital lease liability by the amount of principal paid. Over
the course of the three years, the entire principal will be repaid. The amount of lease
liability remaining at the end of the first year ($17,833 from Exhibit 7) is reported as a
liability on Mom’s Cookie Company’s balance sheet at December 31, 2005.
From the perspective of the lessor, the $25,771 present value of the lease is the
amount received for the equipment and is treated as sales revenue. Amounts received
in excess of the present value are interest revenue. Therefore, the lessor would record
$2,062 of interest revenue in the first year (see Exhibit 7).


STOCKHOLDERS’ EQUITY
Liabilities are obligations that a company has a legal responsibility to meet. Creditors’
OBJECTIVE 3
claims against a company are enforceable by law. Stockholders’ equity also represents
Identify information claims against a company, claims by investors who own a corporation’s stock. As long
reported in the as a company is a going concern (is expected to continue to exist), those claims are met
stockholders’ equity by the company’s profits. Ordinarily, a company is not obligated to make payments to
section of a corporate its stockholders or to repay them the amounts they have invested.
balance sheet and
Profit is the value created from selling goods and services during a period in excess
distinguish contributed
of the costs of resources consumed during that period. That excess value increases the
capital from retained
value of stockholders’ claims. When a company distributes its profit in the form of div-
earnings.
idends or incurs a loss, the amount of stockholders’ claims decreases.
The claims of creditors are honored before those of owners. In general, creditors’
claims are met before cash or other assets are distributed to owners (stockholders). As
a result, there is an important difference between liabilities and owners’ equity, and li-
abilities and equity are separated on a company’s balance sheet.
Exhibit 8 provides the owners’ equity section of Mom’s Cookie Company’s balance
sheet. Corporate owners’ equity is referred to as stockholders’ or shareholders’ equity
because owners hold shares of stock as an indication of their ownership.


Exhibit 8 December 31, 2006 2005
Stockholders’ Equity for
Stockholders’ equity:
Mom’s Cookie Company
Common stock, $1 par value, 50,000 shares
authorized, 20,000 and 10,000 shares issued $ 20,000 $ 10,000
Paid-in capital in excess of par value 190,000 90,000
Retained earnings 130,417 42,990
Treasury stock, 1,000 shares at cost (12,000) 0
Total stockholders’ equity $328,417 $142,990
F332 FinancingSECTION F2: Analysis and Interpretation of Financial Accounting Information
334 Activities

The exhibit shows information about two main types of stockholders’ equity: con-
tributed capital and retained earnings. Contributed capital is the direct investment
made by stockholders in a corporation. Contributed capital for Mom’s Cookie Com-
pany consists of common stock and paid-in capital in excess of par value. Retained
earnings is the accumulation of profits reinvested in a corporation. A third type of eq-
http://ingram.swlearning. uity reported by many companies, including Mom’s Cookie Company, is treasury stock.
com Treasury stock is stock repurchased by a company from its stockholders. The cost of
treasury stock is deducted from stockholders’ equity because it is an amount that a com-
Find answers to fre-
pany has repaid to stockholders.
quently asked ques-
tions about the stock Companies often repurchase their stock to distribute it to employees as part of em-
market. ployee stock ownership plans and to provide bonuses and other compensation for man-
agers and employees. Some companies repurchase stock to reduce the number of shares
available in the market. Usually, fewer shares results in a higher stock price. Also, a com-
pany may repurchase its own shares to prevent another company from buying them. One
company can take control of another company by buying its shares. Fewer shares out-
standing makes it more difficult for another company to obtain a controlling interest.
Some corporations do not have treasury stock. All corporations have contributed
capital and retained earnings. Retained earnings may be a negative amount, referred to
as a deficit.


Contributed Capital
Corporations issue shares of stock in exchange for cash (and sometimes other resources,
such as property). Common stock or capital stock, represents the ownership rights of
investors in a corporation. Each share of common stock represents an equal share in
the ownership of a corporation. Owners of the shares have the right to vote on the ac-
tivities of the corporation and to share in its earnings. For example, suppose a corpo-
ration has 100,000 shares of common stock outstanding. Someone who owns 10,000
shares controls 10% of the votes that can be cast on issues voted on by stockholders.
That investor also has the right to 10% of the dividends paid to common stockholders.
U.S. corporations must be chartered by a state. A charter is the legal right granted
by a state that permits a corporation to exist. The charter establishes a corporation as
a legal entity. It also sets limits on the corporation’s activities to protect owners and
others who contract with the corporation. Among other things, a corporation’s char-
ter specifies the maximum number of shares of stock the corporation is authorized to
issue. Mom’s Cookie Company is authorized to issue up to 50,000 shares of common
stock. At the end of 2006 it had issued 20,000 shares, and at the end of 2005 it had is-
sued 10,000 shares (Exhibit 8).
Most shares of common stock are issued with a par value because states often re-
quire that corporate stock have a par value. The par value of stock is the value as-
signed to each share by a corporation in its corporate charter.
A state may require that a corporation maintain an amount of
Percentage of Major Corporations with
equity equal to or greater than the par value of its stock. That
Par, No-Par, and Stated Value Stock
equity cannot be transferred back to the owners unless the cor-
poration liquidates its assets and goes out of business.
Originally, par value was designed to protect a corporation’s
creditors by making owners keep a certain level of investment in
the corporation. This protection was important when the sale of
87.1%
stock and financial reporting were largely unregulated. With in-
3.0%
creased regulation and requirements for financial reporting, par
value has lost much of its importance. In some states, charters do
Par
9.9% not require a par value. Stock issued without a par value is known
as no-par stock. In states where charters do require a par value, that
No-Par
value often is set very low. A dollar per share, or less, is common.
Stated
Stock usually is sold at a price greater than par value. For ex-
ample, the 20,000 shares of Mom’s Cookie Company’s common
(Data source: Accounting Trends & Techniques, 2001)
F333
CHAPTER F9: Financing Activities
335
Financing Activities

stock that had been issued by the end of 2006 were sold for
Percentage of Major Corporations
$210,000 ($20,000 $190,000 in Exhibit 8). Of this amount,
Reporting Treasury Stock
$20,000 is reported as par value (20,000 shares $1 par). The
remainder of the amount the company received from selling
its stock is reported as paid-in capital in excess of par value
($190,000).
68.3%
Paid-in capital in excess of par value is the amount in
excess of the stock’s par value received by a corporation
from the sale of its stock. Corporate financial reports refer
to this amount by many names: among them are paid-in cap-
31.7%
ital, contributed capital in excess of par, proceeds in excess
Treasury Stock
of par value, additional paid-in capital, surplus, and premium
No Treasury Stock on capital stock.
Occasionally, a corporation establishes its own stated
(Data source: Accounting Trends & Techniques, 2001)
value for no-par stock. That value appears on the balance
sheet in place of par value.
In addition to the number of shares authorized, a corporation reports the number
of shares of stock issued (sold) to investors. Issued shares are shares that have been
sold by a corporation to investors. Outstanding shares are shares currently held by in-
vestors. The difference (if any) between the number of shares issued and the number
outstanding is the number of shares of treasury stock. Thus, at the end of 2006, Mom’s
Cookie Company had issued 20,000 shares, but only 19,000 shares were outstanding.
The remaining 1,000 shares were owned by Mom’s Cookie Company (Exhibit 8).
A company repurchases its own shares for various purposes. Many companies give
these shares to managers or employees as additional compensation for their work for
the company, especially if they or the company have performed well.


Retained Earnings
Retained earnings is profit reinvested in a corporation. Retained earnings also is re-
ferred to by a variety of names, such as reinvested earnings, profit retained in the busi-
ness, or earnings reinvested in the business. The amount of retained earnings is the
accumulated net income invested in corporate resources.
For example, assume the following information for Mom’s Cookie Company for
2005 and 2006:



Increase Balance
Net in Retained of Retained
Year Income Dividends Earnings Earnings

2004 $ 0
2005 $ 52,990 $10,000 $42,990 42,990
2006 107,427 20,000 87,427 130,417

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