Chapter_14_SM

©McGraw-Hill Companies, 2009

Solutions Manual, Chapter 14 739 Chapter 14

Long-Term Liabilities

QUESTIONS

1. A bond is a liability of the issuing company. A share of stock represents an ownership

interest in the company.

2. Notes payable generally involve borrowing from a single creditor, whereas bonds

payable are usually sold to many different lenders (bondholders).

3. Bonds can allow a company’s owners to increase their return on equity without investing

additional amounts. This result occurs as long as the rate of return on the assets

acquired from the borrowed cash is greater than the interest rate paid on the bonds.

Bonds also help the current owners remain in control of the company. There is also a tax

advantage with bonds when issued by corporations.

4. A trustee for bondholders has the responsibility of monitoring the issuer’s actions,

financial performance, and financial condition to ensure that the obligations in the bond

indenture are met.

5. A bond indenture is a legal contract between the issuing company and the bondholders

that identifies the obligations and rights of both parties. It specifies such items as the

par value of the bonds, the contract interest rate, the due dates for interest payments,

and the maturity date(s) of the bonds. It also may name a trustee, describe the bond

issue in detail, and provide for a sinking fund.

6. The contract rate (also known as the coupon rate, stated rate, or nominal rate) is the rate

that is identified in the bond indenture. It is applied to the par value to determine the size

of the cash interest payments. The market rate is the consensus rate that a company is

willing to pay and that investors are willing to accept for a specific bond.

7. In general, the supply of and demand for bonds affect market rates. The market rate for

a particular bond issue is also affected by risks unique to the issuer (e.g., financial

performance and condition) and the length of time until the bonds mature.

8.B The effective interest method creates a constant rate of interest over a bond’s life

because the market rate at the time of issuance is multiplied by the beginning balance

for each period. The straight-line method produces either an increasing or decreasing

rate because it allocates the same amount of expense to each period, even if the liability

balance is growing (a discount) or decreasing (a premium).

9.C When issuing bonds between interest dates, a company collects accrued interest from

the purchasers to avoid keeping detailed records of bond purchasers and the dates

when bonds are purchased. If the company did not collect accrued interest, individual

checks would be needed to pay the correct amount of interest to each purchaser. By

collecting in advance, the issuer merely distributes the same amount per check to all

bondholders, regardless of when they purchased the bonds.

©McGraw-Hill Companies, 2009

Fundamental Accounting Principles, 19th Edition 740 10. The price of bonds can be computed by finding the present value of both the par value at

maturity and the periodic cash interest payments discounted at the market rate of

interest.

11. The issue price of a $2,000 bond sold at 98 ¼ is 98.25% of $2,000, or $1,965. The issue

price of a $6,000 bond priced at 101 ½ is 101.5% of $6,000, or $6,090.

12. The debt-to-equity ratio is calculated by dividing total liabilities by total equity. The

higher a company’s debt-to-equity ratio, the higher proportion of a company’s assets

that are provided by creditors. If a company has a high debt-to-equity ratio, the company

may be at risk during poor economic times, because it must still pay off creditors even

though it may not be earning as much as it did in the past.

13. An entrepreneur (owner) must repay the bondholders the principal (par value) according

to the term of the bonds. He or she must also pay interest on the bonds per the amount

and frequency cited in the bond indenture, and must adhere to any stipulations

(covenants) specified in the bond contract.

14. Best Buy shows long-term both ―Long-term Liabilities‖ and ―Long-Term Debt‖ on its

balance sheet. To determine whether the long-term debt is comprised of bonds or other

obligations we must read footnote 5 disclosing details of the Long-Term Debt of the

company. The footnote reports that its long-term debt is comprised of Convertible

debentures (bonds), Lease Obligations, and other debt.

15. Per Circuit City’s February 28, 2007, statement of cash flows (financing section), the

company repaid $6,724,000 for the fiscal year ended February 28, 2007.

16. RadioShack’s long-term debt decreased by $149,100,000 ($494,900,000 - $345,800,000)