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Chapter 13: Financial Instruments: Long-term Debt
Case 13-1 Huy Publications Ltd.
13-2 Dry Clean Depot Limited
13-3 Darcy Limited
Suggested Time
Technical Review
TR13-1 Debt Present Value …………………………………… 10
TR13-2 Interest Expense—Effective-Interest …………… 10
TR13-3 Debt Issuance Costs………………………………….. 10
TR13-4 Borrowing Costs ………………………………………. 5
TR13-5 Debt Retirement……………………………………….. 10
Assignment A13-1 Sources of Financing…………………………………. 10
A13-2 Sources of Financing…………………………………. 10
A13-3 Sources of Financing…………………………………. 10
A13-4 Debt Issuance—Fair Value ………………………… 20
A13-5 Debt Issuance—Interest Expense…………….. 20
A13-6 Interest Expense ……………………………………….. 20
A13-7 Interest Expense (*W)……………………………….. 30
A13-8 Interest Expense ……………………………………….. 30
A13-9 Bonds Issuance and Interest Dates………………. 25
A13-10 Bonds Issued Between Interest Dates (*W)….. 30
A13-11 Bonds Issued Between Interest Dates ………….. 30
A13-12 Bonds Issued Between Interest Dates …………. 40
A13-13 Debt Issuance Costs………………………………….. 20
A13-14 Debt Issuance Costs………………………………….. 20
A13-15 Foreign Currency ……………………………………… 20
A13-16 Foreign Currency (*W)……………………………… 20
A13-17 Borrowing Costs ………………………………………. 20
A13-18 Borrowing Costs ………………………………………. 25
A13-19 Borrowing Costs ………………………………………. 25
A13-20 Debt Retirement–Open Market Purchase …….. 25
A13-21 Debt Retirement (*W)……………………………….. 25
A13-22 Debt Retirement……………………………………….. 30
A13-23 Debt Retirement ………………………………………. 30
A13-24 Debt Issuance and Retirement—Accrued Interest 40
A13-25 Bond Issuance—Defeasance………………………. 30
A13-26 Partial Statement of Cash Flows…………………. 40
A13-27 Partial Statement of Cash Flows…………………. 30
A13-28 ASPE—Straight-Line Amortization ……………. 20
A13-29 ASPE—Straight-Line Amortization …………… 20
A13-30 ASPE—Comprehensive, Straight-Line Amortization40
*W The solution to this assignment is on the text website, Connect.
The solution is marked WEB.
13-2 Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition
Questions
1. The primary advantage of trade credit is that it (typically) has no interest cost. That
is, suppliers give a company 30 (for example) days to pay an invoice and charge no
interest for this period.
2. An operating line of credit, or credit facility, is usually the form of bank loan secured
by accounts receivable and inventory. These loans are due on demand, and are
expected to fluctuate with higher or lower levels of accounts receivable and
inventory over the business cycle. Land and building usually provide collateral for a
commercial mortgage or a term loan.
3. As compared to equity, long-term loans are often more easily arranged; do not give
up any voting control (no ownership dilution). In addition, loans involve interest
expense, which is a tax deduction, and allow leverage to boost returns for equity
investors.
4. A long-term loan might involve a blended payment, where equal regular payments
are part interest and part principal. Over time, the portion related to principal grows,
because the loan principal declines from prior payments and less interest is required.
Alternatively, a loan may require designated scheduled principal payments, plus
regular interest. In this scheme, a payment is designated all principal or interest.
5. The term of a long-term loan is the period for which there is an agreement on terms
and conditions, most obviously the interest cost. The amortization period is the
period used to determine regular blended payments. A twenty-five year amortization
period would include five different five-year terms, for example.
6. Long-term loans may be arranged with pension funds or insurance companies. Both
of these investors potentially have large cash balances that must be invested for long
time periods to generate appropriate returns for stakeholders.
7. Accounting covenants might include maximum debt-to equity, minimum current
ratio or minimum interest coverage. Restricted actions might involve restrictions on
dividend payout, restrictions on adding additional debt, restrictions on share
transactions including transfer of control, restrictions on pledging assets on other
loans, and restrictions on changes of key employees. (Only two examples are
required.)
8. Par value (also known as the face value, principal or maturity value) is the principal
amount paid on maturity. The issue price of the bond is the present value of its cash
flows (both principal and normal interest payments) discounted at the market interest
rate on the issuance or valuation date. Par value and the issue price will be identical
when the stated (contractual) interest rate equals the market interest rate. The two
Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition 13-3
values are different when the interest rates are different. If a $5,000 bond is sold for
101, the proceeds would be $5,050 ($5,000 × 101%)
9. If market yield rates decline after issuance, the discount rate used in valuation
declines (assuming company-specific risk is stable). This would cause the present
value of the bond to rise. If the bond was originally issued at 98, it was issued below
par and now might trade above par to reflect lower yield. This shift is not reflected
on the company’s books; measurements are based on the 98 issuance price. Fair
values are disclosed, however.
10. The bond premium or discount is a contra account to the par value of the long-term
liability, bonds payable, on the statement of financial position, and either increases
(premium) or decreases (discount) it accordingly. The amortization of the bond
premium or discount is part of interest expense, and either increases (discount) or
decreases (premium) the cash paid to arrive at the expense. This adjusts the cash paid
at the nominal rate to an expense which is an approximation of the effective rate.
11. a) The amount of accrued interest expense recognized at the end of the accounting
period is the amount of interest that has accumulated (i.e., incurred and not yet
paid) since the last interest payment. It will be paid on the next interest date.
b) The amount of discount or premium amortization recognized is the amount that is
required to reflect the yield rate in interest expense. Interest expense is not the cash
paid after this adjustment. It is related to time and the carrying amount of the bond.
12. Accrued interest must be recognized when bonds are sold (or purchased) between
interest dates because the full amount of the cash interest as specified in the bond
agreement is paid to the holder of the bond on each interest date regardless of the
sale (or issue) date. The purchaser advances to the seller that portion of the periodic
interest accrued (i.e., incurred) up to the date of sale. The net amount reflects the
period the bond was actually outstanding.
13. The upfront administration fee would not be recognized as an expense when paid.
Instead, it would factor into a calculation of the effective interest rate over the life of
the loan, which would be higher than the stated interest rate of 6%.
14. Exchange gain: $325,000 ($0.98 – $1.03) = $16,250. This is the change in the
exchange rate during the year.
15. Capitalization of borrowing costs begins at the earliest of the date when the money is
borrowed, a payment is made on the asset, and work starts to make the asset ready
for use.
16. The borrowing cost for general borrowings reflects the weighted average of loan
sources, or 6.4% ((4% x $2 million) + (7% x $8 million)/$10 million total financing.)
13-4 Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition
17. A gain or loss will occur on the repayment of a bond payable at any time that the
repayment price is different than the net carrying value of the bond, including
unamortized premium or issuance costs, if any.
18. The bond discount or premium would be part of a bond retirement entry when the
bond is retired prior to maturity, because the discount or premium would have a
remaining balance to be eliminated. The amount that is eliminated is the unamortized
balance.
19. A defeasance is a financial arrangement where the debtor irrevocably places
investments in a trust fund for the sole purpose of using those resources to pay
interest and principal on specified debt. The creditor agrees to this and legal release
is given to the borrower. In an in-substance defeasance, the transaction is the same
except there is no legal release by the creditor. Debt subject to a defeasance
arrangement is derecognized, but debt subject to an in-substance defeasance is left on
the books.
20. Cash flow for interest is $39,000 ($45,500 – $4,500 – $2,000).
21. The primary difference between straight-line and effective-interest amortization is
the measurement of interest expense. Under the straight-line method, an equal dollar
amount of expense and amortization is recognized each period; under the effective-
interest method, a constant rate (i.e., the market interest rate on the day of issuance)
is used to calculate interest. The expense is a function of the outstanding net liability;
the dollar amount of interest expense and amortization recognized changes annually.
The effective interest method is required IFRS practice because it provides a more
accurate measure of the cost of borrowing. ASPE allows straight-line method
because there is a more restricted user group and potentially a less complicated
business situation/reporting environment.
Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition 13-5
Cases
Case 13-1 Huy Publications Ltd.
Overview
Huy Publications Ltd. (HPL) operates in a risky industry, known for its business
failures. While HPL itself is reportedly stable, they have had loss years and
have new facilities and new debt (government-guaranteed) in addition to that
described. Reporting healthy, stable annual profits must be a concern in such an
environment, as is complying with any and all debt covenants, some of which are
based on financial statement information. Lenders would require GAAP-based
financial statements, since covenants are calculated from audited information.
ASPE versus IFRS has not been specified, but ASPE seems logical considering the size
of the company. The ethics of choice are important here, as there might be
temptation to pick an alternative that artificially creates acceptable results for key
users. Financial position must be accurately portrayed.
Issue
Evaluation of loan alternatives
Analysis and Conclusions
Alternative 1 – Canadian Bank
a) The effective interest rate is 8.225% (solved by spreadsheet) over the ten-year
life of the loan, after factoring in the $19,000 u p -front fee and the $5,500
transaction fees. The interest rate is fixed for the ten-year life.
b) Principal need not be repaid until the end of the loan, allowing HPL flexibility in
arranging either operating cash flow to finance the repayment or refinancing
through another borrowing arrangement.
c) HPL would have to t r a n s f e r banking business to Canadian away from their
current bank, which may not be attractive.
d) The loan requires corporate guarantees but also personal guarantees from HPL’s
shareholders, which may be particularly unwelcome in this risky business sector.
e) Debt:equity ratios must be kept at 2:1, but dividends can be up to 30% of
earnings; current levels are only 10-15% of earnings. The debt: equity
covenant may be viewed as reasonably restrictive; the dividend covenant less so.
13-6 Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition
Alternative 2 – Ottawa Bank
a) The interest rate for the first five years (6.5%) is lower than the interest rate
for Alternative 1. If the up-front fee is factored in (over ten years), the loan
would have to bear a stated interest rate of 10.5% (solved by spreadsheet) over
the second five years in order to have an overall cost equivalent to Alternative 1.
Will the interest rate in the second five-year period be below 10.5% or above
10.5%? Accurate response to this question will tell HPL which alternative is
cheaper, but interest rates are notoriously unpredictable.
b) The up-front fee is considerably larger, which is less attractive to HPL.
c) The debt covenants are more restrictive for HPL, requiring that no new long-
term debt be issued and that dividends not exceed current percentages of income.
d) Corporate security is quite similar to Alternative 1, but also requires a
floating charge on all corporate assets. Significantly, no personal guarantee
is required, which may be a major factor for HPL.
e) Principal payment is not required until the end of the term.
Alternative 3 – Pension fund bond
a) The effective interest rate on this loan is 8.4% (solved by spreadsheet),
considering both the fact that the interest is compounded semi-annually and
there are $227,500 in legal, etc. fees paid up front. The loan cost is fixed over
the life on the loan.
b) The security is the least onerous for any alternative; general credit rating only.
c) The covenants are severe (no dividends unless current ratio is 3.5 or above after
declaration, no repurchase if issue of common shares, restrictions on current
ratio and debt ratios, no changes in management, etc.)
d) HPL would have to agree to put a representative of the lender on their
Board, which is potentially undesirable.
e) Upfront fees are high, which is less attractive to HPL because less net cash is
available at the beginning of the loan period.
Conclusion
When comparing these alternatives, the cost of borrowing must be revised to include
fees and transaction costs so that comparisons are fair and complete.
Senior management of HPL must prioritize the factors that are different for these loans.
Cost of borrowing, future interest rates, restrictive covenants, personal guarantees,
security, and a position on the Board are all factors.
In addition, there may be some leeway to further negotiate unattractive terms if HPL
can articulate the tradeoffs they are willing to make.
Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition 13-7
Case 13-2 Dry Clean Depot Limited
Overview
Dry Clean Depot Limited (DCDL) is a private company that has elected to comply with
IFRS. The company is reasonably small, with $7 million in sales, and 40 retail locations.
DCDL has just negotiated a new equipment loan, with covenants that specify a maximum
2-to-1 debt-to-equity ratio. Other covenants require a minimum level of $500,000 in cash,
and restrict dividends to $100,000 per year. These latter covenants require compliance,
but are not affected by accounting policies. The debt-to-equity ratio restriction means that
the company would prefer to maximize equity (earnings) and minimize debt, but ethical
boundaries must be respected.
Issues
1. Effective cost of loan
2. Capitalization of borrowing costs
3. Capital cost of equipment and depreciation
4. Lease arrangement
5. Environmental obligation
6. Revenue recognition
7. Lease terms
Analysis and conclusion
1. Effective cost of loan
The effective interest rate for the $2,000,000 loan is determined by looking at the
annual carrying cost ($90,000 per year) and also the $377,000 upfront fee. When
both are factored in, the effective interest rate is 7.2%:
Effective interest rate =
Solve for x in,
$2,000,000 = $377,000 + $90,000 (P/A, x %, 10) + $2,000,000 (P/F, x %, 10)
x = 7.2%
Upfront fees are recorded as a discount and amortized to interest expense (etc.)
during the life of the loan. Since the discount is netted with the loan on the SFP,
this helps modestly reduce debt balances for covenant calculations.
2. Capitalization of borrowing costs
Borrowing costs must be capitalized during the acquisition period, which is lengthy.
This applies to the specific loan, and also money used from general borrowing.
13-8 Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition
After the acquisition period, interest is an expense. If there were investment
earnings on idle loan cash, for the period between the time that the loan money is
advanced and amounts are paid out to suppliers, such earnings are netted in the
interest capitalization calculation.
General borrowing costs for the portion of the purchase price financed through
DCDL cash flows are also be capitalized, but no imputed costs for equity. The
borrowing cost must be calculated on a weighted average basis.
Further information on each of these issues must be gathered.
Interest to be capitalized:
Loan balance $2,000,000 × 7.2% × 10/12 $120,000
The ten month period consists of six months for production, three months for
shipping plus one month for installation and testing. In terms of time line, the loan
is assumed to be advanced and the equipment immediately ordered. This must be
verified.
Additional interest will be capitalized for amounts financed from general
borrowings. This amount is not determinable but information must be gathered to
calculate the adjustment.
Interest capitalization will preserve levels of earnings (equity), making the debt-to-
equity ratio easier to achieve.
3. Capital cost of equipment and depreciation
Many of the costs associated with equipment acquisition will be capitalized, as
follows:
Description Amount
Invoice price $2,450,000
Interest cost (above) 120,000
Interest on general borrowing ??
Shipping 34,000
Duty ($2,450,000 x 20%) 490,000
Installation & testing 38,000
$3,132,000 + ??
Equipment is depreciated over its life using an acceptable depreciation method such
as straight-line or declining balance. Policy for this must be set, along with a
determination of the useful life and salvage value, or the declining balance rate. The
Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition 13-9
equipment should be evaluated to see if components have various life spans; if so,
then depreciation must be stratified to reflect this fact.
4. Lease Arrangement
DCDL must evaluate the need to record a liability for the onerous contract that is
represented by the lease situation in Sudbury. The landlord has been informed that
DCDL will vacate, and a sub-tenant located, with a signed contract for the sub-
lease. This proves positive intent to act.
DCDL has an obligation to pay $27,500 for occupancy costs each year for the next
three years, and has a sub-tenant that is willing to pay at least $5,000 per year.
Therefore, there is an unfunded obligation of $22,500 per year. This may be less if
the extra sub-rent in years 2 and 3, 10% of the sub-tenant sales in excess of
$150,000, can be reliably estimated. However, since DCDL has had negative
experience with this location, and the nature of the sub-tenant operation is
unknown, no amount has been estimated in these calculations. This area must be
explored further.
Since the payments take place over three years, the time value of money must be
estimated to value the liability. Interest expense (accretion) will then be recorded
each year. The interest rate to use should be a borrowing rate for operating activities
over a three-year period. This rate is not known and must be established. A rate of
7%, based on the equipment loan (7.2%) has been used but this rate may not be
comparable because term (10 years) and security are different.
Using the 7% rate, and assuming rent is payable at the beginning of each year:
Liability balance $22,500 × (P/AD, 7 %, 3) (rounded) $63,000
This amount will be recorded as a loss and a liability, worsening the debt-to-equity
ratio. It is not avoidable.
13-10 Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition
5. Environmental obligation
DCDL has a contractual liability in eight locations for environmental remediation in
the event of contamination caused by dry cleaning operations, in particular,
contamination caused by perc.
These obligations must be estimated and discounted for the time value of money if
payment is delayed. As for the onerous contract obligation, an interest rate of 7%
will be used as an estimate but a more appropriate interest rate (term and security)
must be estimated.
The liability exists because DCDL stands ready to meet any potential costs. The
major issue is measurement of the liability. If there is no contamination, then the
liability has a zero value and there is no amount recorded. This appears to be the
case for most premises, and regular testing provides comfort that liabilities are
identified on a timely basis.
For one location, however, it appears as though there might be an environmental
issue. Further testing is being done to confirm this, and the outcome of this testing
will determine if remediation, and liability recognition, is needed.
If action is needed, then the cost and the timing of action must be determined. The
cost has been suggested in the $250,000 to $500,000 range. Costs must be further
explored, and an expected value established. If, for example, both of these estimates
were equally likely, then the amount to be accrued would be $375,000. Discounted
for two years at 7%, this is a $325,000 (rounded) liability. This amount is also
capitalized as an asset, amortized over the remaining lease term.
Note that additional liability recognition of a significant amount has negative
implications for the covenant agreement. Some covenant renegotiation might be
considered, or perhaps additional equity financing might be possible.
More importantly, the environmental obligations call the business model into
question, and appropriate pricing and management of operational risks should be
considered and evaluated at a strategic level.
The cost of vacating premises at the end of the lease would also have to be
identified and evaluated for recognition. If DCDL has agreed to move after
environmental cleanup, and this has costs, then the amount must be reflected in the
financial statements. It may well be immaterial.
Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition 13-11
6. Revenue recognition
DCDL sold prepaid dry cleaning services cards this year. When cards are issued, a
liability for unearned revenue is created, and when the cards are used, the liability
is decreased and revenue is recognized. This is appropriate accounting. Card value
of $126,000 ($468,000 – $342,000) is outstanding at year-end, or 27% of the gross
cards issued.
The issue that needs to be examined is how the initial $20 price reduction is
treated. A $120 card costs $100 for the customer, which is in essence a sales
discount. The amount must be relabeled as a sales discount, not an expense, and
shown as a contra account to sales. This is a presentation issue. Revenue should
reflect cash value.
This issue can be explained in one of two ways:
1. Services are being sold for a lower price, but this is not below cost (gross profit
is usually 60%); services are still profitable after the reduction granted with the
cards. Valuation of revenue and liability should be at the cash amount received
not the regular price. Therefore, sales of the period should be $285,000
($342,000/1.2), and the liability should be recorded at $105,000
($126,000/1.2). This increases net income (now has $342,000 – $78,000
recorded) and liabilities.
2. Alternatively, valuation can be explained through the discount account. The
discount amount, $78,000 for the cards issued, has been entirely expensed in
the current period. The question is whether this relates to this period, or
whether the $78,000 should be prorated consistent with card use. If it were
prorated, the unused portion would reduce the reported liability.
There is no need to establish a liability for more than the proceeds received.
Accordingly, the sales discount should be recognized as it is used. The discount
should be adjusted to $57,000 ($78,000 x 342/468) and the remaining $21,000
recorded as a contra to the liability account, reducing it to $105,000 ($126,000
– $21,000).
Either of these explanations is acceptable.
DCDL expects that 5 to 10% of the value on the cards will not be used. At the
volumes sold this year, this represents $23,400 to $46,800 of the liability (gross)
outstanding at year-end or $19,500 to $39,000 when deflated to the lower cash
amount. At year–end, this is approximately 20% to 45% of the outstanding
liability, which is very high. The company has a legal obligation in perpetuity for
these amounts, and must stand ready to honor the cards if they are used at any
point in the future. The company lacks history to use in determining any unused
13-12 Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition
percentage. Accordingly, at this stage in the life of this program, it would not be
advisable to decrease the liability for expected unused cards.
In terms of covenant implications, scaling back the liability and increasing
earnings this year are both positive outcomes. It would be preferable to reduce the
liability for unused cards, but if this cannot be measured, it certainly cannot be
manipulated.
7. Lease arrangements
DCDL is a tenant in forty locations. The leases have been described as short-term
rentals, over three to five years As such, they would almost certainly qualify as
operating leases, and no liability for the leases would be recorded. DCDL should
be aware, though, that the IASB is considering a proposal to capitalize all leases
regardless of length of term. This would result in liability recognition for DCDL.
The loan contract just negotiated puts a limit on debt-to-equity over a ten-year
time span, and capitalization might be required within this window. Therefore,
DCDL should negotiate in advance with the lender around the scenario of an
eventual capitalization, perhaps asking that such lease obligations be excluded
from the ratio, or that the ratio be increased to reflect the alternate accounting
rules.
Conclusion
Overall, liabilities have been established for environmental issues, onerous
contracts, and potentially for leases. If DCDL is now close to the debt covenant
for debt-to-equity, this will be uncomfortable. It is still the inception of the loan
contract. The company should look at projections for key financial variables and
decide whether the loan covenant is reasonable. If not, re-negotiation or alternate
financing sources must be explored.
Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition 13-13
Case 13-3 Darcy Limited
Overview
Michel Lessard has requested that the financial statements of Darcy Limited, a company
that manufactures equipment for the oil and gas industry, be reviewed for the purpose of
valuation. Ethically, it is important to provide advice on a fair price to Mr. Lessard
without overstating or understating the company’s situation; however, there is a natural
bias to reduce earnings and assets given that Mr. Lessard represents a group of purchasers
and this is the beginning of negotiations. Since no one else is relying on this report, this
bias is ethically acceptable.
The valuation formula is based on net tangible assets and earnings, so any adjustment that
changes either of these metrics will change the purchase price. Earnings must include
only recurring items, assumed to repeat in the future. Ongoing items must be valued at the
amount that would be expected to continue, and one-time items are not included in the
valuation rule.
Issues
1. Financial health of Darcy Limited
2. Valuation of low-interest loan
3. Valuation of warranty expense and obligation
4. Goodwill write-up
5. Valuation of capital assets
6. Revenue recognition
7. Valuation of allowance for doubtful accounts
8. Restatement of foreign currency accounts receivable
9. Adjustments to earnings for non-recurring items now included
10. Calculation of bid ranges/ Conclusion.
Analysis and conclusion
1. Financial health of Darcy Limited
The financial health of Darcy is somewhat suspect. There is no cash on the SFP, and there
is a new operating loan that is likely needed just for day-to-day purposes. The current
ratio has declined from 2.94 to 1.69, reflecting additional short-term debt. However, the
company is carrying little long-term debt, and has significant capital assets. If land or
other assets could be sold or mortgaged, liquidity may not be a concern.
There has been a large buildup in accounts receivable. Both the warranty liability and the
allowance for doubtful accounts are very low, and research expenses have been curtailed,
13-14 Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition
indicating that the company’s actions and policies may be affected by the potential sale of
the company. This may reflect badly on the ethics of management.
Of critical concern is that there appears to be no real history of profits, as all the retained
earnings balance comes from this current year plus the past year; retained earnings were
only $20 prior to last year. Either there were no profits, or sizable dividends were
declared.
Sales declined from $45 million to $32.7 million this year, indicating possible operating
problems. Alternatively, the industry may be going through a cyclical downturn. Many
expenses appear to be low – including research and administrative expenses – and this
has helped keep earnings at a respectable level. This may not be reflective of ongoing
operations, though. Return on equity is low, even with the curtailed expenses.
These factors must be investigated prior to any offer being made. Valuation rules of
thumb are meaningless if the company has operating problems. Budgets and prospects for
the coming years must be carefully investigated.
Assuming that the purchasers wish to go ahead, valuation adjustments have been
examined in several areas.
2. Valuation of low-interest loan
Darcy purchased $2,600 of capital equipment this year, financed with a five-year low-
interest loan. The loan is at 2%, while market rates are 6%. In such a case, the loan and
the capital assets are valued at the present value of the loan, and interest is based on the
6% market rate. Amortization is based on the (lower) present value, not the nominal
amount, of the transaction.
These adjustments are calculated in Exhibit 3. Including revaluation and three months of
amortization, the loan balance reduces from $2,600 to $2,181, and the capital assets
reduce from $2,519 to $2,094. Interest and amortization also change. These adjustments
have a minor effect on the purchase price because they reduce both assets and liabilities,
and increase and reduce earnings to net out to a small adjustment.
3. Valuation of warranty expense and obligation
The warranty obligation is very low, and has declined significantly over the year.
Adequacy of this obligation has been evaluated by looking at the actual claims history,
related to the year of sale. See Exhibit 4. Only two years’ data has been made available
over the complete warranty term. Once the expenditures have been related to the year of
sale, though, it appears that 3% of sales (or perhaps up to 3.4% of sales) is a more
appropriate expense level than the 2% of sales used now. Additional evidence should be
gathered to prove this calculation.
Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition 13-15
If the warranty expense were increased to 3% of sales, an additional $330 of warranty
expense would be recorded in the current year, and the warranty obligation should include
accruals for one remaining year of 20X6 sales, and two remaining years for the 20X7
sales. This would increase the warranty obligation, and reduce net assets, by $1,534. Note
that the cumulative effect of the change from 2% to 3% has not been adjusted to earnings
as it would be non-recurring. 20X7 expense is adjusted to 3% of sales.
These amounts are approximate because part years have been disregarded.
4. Goodwill write-up
Goodwill is an intangible asset and is not included in the purchase price formula, which is
based on net tangible assets. Therefore, goodwill has been excluded in Exhibit 2 in the
initial calculation of net tangible assets.
However, management has written up goodwill by $50 each year as an assessment of the
increase in goodwill over the year. This amount is included in earnings. This is not
acceptable in the financial statements, as the increase is not verifiable and also is not
related to a tangible asset. This amount has been removed from earnings in Exhibit 1.
5. Valuation of capital assets
The pre-20X7 balances of capital assets has been revalued to fair market value. This is
necessary to reflect fair value in the net tangible assets used to value the company.
Land, with a book value of $7,000, is likely worth $10,500, increasing net assets in
Exhibit 2 by $3,500. The opening balance of capital assets in 20X7 (closing 20X6),
excluding land, has be revalued by 20% and additional amortization on the higher fair
value has been recorded. An average life of 6 years (range was four to eight years; six was
used as the average). Additional verification may be done to ascertain whether this
amortization period is reasonable. See Exhibit 7.
As a result of these adjustments, earnings declines by $320 for additional amortization,
and net assets increase by another $1,600 for the net increase. See Exhibits 1 and 2.
6. Revenue recognition
Darcy has engaged in a barter transaction during the year, and has given up inventory
with a cost of $23. This amount has been expensed but no revenue has been recorded.
Since the company has received something of value (future services) it is tempting to
record revenue at some reasonable amount.
However, this barter transaction is just one step in satisfying an order from a second
customer, and value is not verified until that second order is complete. While it is not the
13-16 Solutions Manual to accompany Intermediate Accounting, Volume 2, 6th edition
classic acquisition of inventory to facilitate a second sale, it is not the end of the earnings
process in a string of transactions. Thus, no revenue should be recognized.
It is not appropriate, though, to record only the $23 expense, because this can be recorded
as the value of the machining work to be received in the future (book value). Both assets
and earnings are adjusted to eliminate the $23 expense recorded. See Exhibit 6.
Others might argue that for the purposes of valuation, recognition of full value might be
appropriate, and record revenue of $28, using the most conservative value in the range.
The difference is not material to the calculations.
7. Valuation of allowance for doubtful accounts
The allowance for doubtful accounts has historically been recorded at the level of 5% of
accounts receivable. The existing allowance is not this high. Refer to Exhibit 5. The
foreign-denominated account receivable, which is agreed to be collectible, is first
removed from the accounts receivable total. Five percent of the remaining balance is
$569, or $299 different than currently recorded. Both net assets and earnings are reduced
accordingly.
Note that this adjustment affects 20X7 earnings only because the allowance looked
adequate up to the beginning of 20X7, which indicates that only the current year expense
must be increased.
In general, valuation of accounts receivable is sensitive, and the purchaser group should
carefully evaluate the collectability of all accounts receivable.
8. Restatement of foreign currency accounts receivable
The foreign account receivable is in US dollars, and it must be restated to the current
exchange rate at the end of year, as the best predictor of its value at maturity. This
increases net assets by $220. See Exhibit 5.
The exchange gain was not included in earnings because it would not be recurring, and
therefore should not be included in a purchase price calculation.
9. Adjustments to earnings for non-recurring items now included
The gain on disposal of capital assets has been excluded from earnings used for valuation
purposes. This gain is not likely a recurring operating item. Assets are being purchased at
fair value and no gains or losses on sale should be considered.
In addition, research expenditures should be increased from $120 to the prior level of
$350. Experts should be consulted to ensure that $350 is indeed an appropriate level of
research activity.
