Tutorial Questions for Topic 2

Q1: Accounting for bonds

At the very beginning of 2008, Heatseaker Ltd issued 200, $1,000 bonds with a coupon rate
of 7.3 percent which is paid annually in arrears to bond holders. The bonds have a 4 year
maturity. The bonds were very well received by the market, so Heatseaker Ltd received
$1045 for each of the bonds. This suggests an effective interest rate (market rate at time when
the bonds were issued) of about 6 per cent.

(Hint: the interest expense for a period is the market rate multiplied with the carrying amount
of the bonds payable (period’s opening balance). The amortisation of either premium or
discount for the period is the different between the period’s coupon payment and the period’s
interest expense. Any rounding error is adjusted for in the last period)

a) Write down the journal entries to record the bond issue at the very beginning of 2008.
Dr Cash 209,000
Cr Bond Premium 9,000
Cr Bonds Payable 200,000

DO NOT WRITE OUTSIDE THE BOX

b) For the year ending 2008, what will be the journal entry?
Dr Interest Expense 12,540.00
Dr Bond Premium 2,060.00
Cr Cash 14,600.00

*Carrying amount at beginning period: 209,000

* Interest expense: 6%*209,000=12,540.00
* Coupon payment: 7.3%*200,000=14,600.00
*Amortisation of Premium: 14,600.00-12,540.00=2,060.00
DO NOT WRITE OUTSIDE THE BOX

c) For the year ending 2009, what will be the journal entry?
Dr Interest Expense 12,416.40
Dr Bond Premium 2,183.60
Cr Cash 14,600.00

*Carrying amount at beginning period: 206,940

* Interest expense: 6%*206,940=12,416.40
* Coupon payment: 7.3%*200,000=14,600.00
*Amortisation of Premium: 14,600.00-12,416.40=2,183.60
DO NOT WRITE OUTSIDE THE BOX
d) For the year ending 2010, what will be the journal entry?
Dr Interest Expense 12,285.38
Dr Bond Premium 2,314.62
Cr Cash 14,600.00

*Carrying amount at beginning period: 204,756.40

* Interest expense: 6%*204,756.40=12,285.38
* Coupon payment: 7.3%*200,000=14,600.00
*Amortisation of Premium: 14,600.00-12,285.38=2,314.62
DO NOT WRITE OUTSIDE THE BOX

e) For the year ending 2011, what will be the journal entry?

Dr Interest Expense 12,158.22

Dr Bond Premium 2,441.78
Cr Cash 14,600.00

*Carrying amount at beginning period: 202,441.78

* Interest expense: 6%*202,441.78=12,146.51
* Coupon payment: 7.3%*200,000=14,600.00
*Amortisation of Premium: 14,600.00-12,146.51=2453.49
*Decrease amortisation of premium to by 11.71 (to 2,441.78) and increase interest expense
with 11.71 (to 12,158.22). This is due to rounding errors. At this stage, the bond premium
account needs to be equal to zero.

Dr Bond Payable 200,000.00

Cr Cash 200,000.00

DO NOT WRITE OUTSIDE THE BOX

f) Is the periodic interest expense higher or lower than the coupon payment?

Lower.

DO NOT WRITE OUTSIDE THE BOX

g) Over the life of the bond, how much will Heatseaker Ltd pay in coupon payments?

58,400 = 4*200,000*7.3%

DO NOT WRITE OUTSIDE THE BOX

h) Over the life of the bond, how much will Heatseaker Ltd record as interest expense?

49400 = 4*200,000*7.3% - 9,000

DO NOT WRITE OUTSIDE THE BOX

Q2: Mid-Session Supplementary Exam 2011, Semester 2: Question 5 (Adapted)

Dig Hard Pty Ltd. is a mining company and has since 2000 conducted mining operations
across two developing countries that are lacking environmental laws. Dig Hard Pty Ltd.’s
mining operations cause severe contamination at local production sites. Although there is no
readily available published environmental policy, Dig Hard Pty Ltd’s CEO, David Kerr, has
in an interview stated that “[Dig Hard] always considers the environment”.

After significant pressure from Environment groups, one of the countries in which Dig Hard
Pty Ltd. has operations passed a new environmental act on the 1 March 2008 that requires
Dig Hard Pty Ltd. to clean its mining sites when it is finished mining. Expert advice obtained
by Dig Hard Pty Ltd. estimate that the fair value of costs to clean up its mining sites when
production is finished is $3,400,000, where 47% is related to the mining operations in the
country that has not yet passed any environmental laws.

a) As of 30 June 2007, did Dig Hard Pty Ltd.’s have a present obligation (justify your
answer) and if yes, what would be the amount of that obligation (1 mark):

No. There is no present obligation. No legal obligation exists. No constructive obligation

exists: the statement by CEO is not enough to create valid expectations (or similar words).

DO NOT WRITE OUTSIDE THE BOX

b) As of 30 June 2008, did Dig Hard Pty Ltd.’s have a present obligation (justify your
answer) and if yes, what would be the amount of that obligation (1 mark):

Yes, legal obligation exists in the country that passed the new environmental act.

Obligation would be: 1,802,000 (3,400,000*53%)

DO NOT WRITE OUTSIDE THE BOX

At 20 June 2010, Dig Fast – one of Dig Hard Pty Ltd.’s subsidiaries – obtains a loan from a
creditor. Dig Hard officially guarantee for the borrowings of Dig Fast in the case default. Dig
Fast financial condition at that time is sound. However, during the financial year ending 30
June 2011, the financial condition of Dig Fast Pty Ltd. deteriorates and it looks unlikely that
Dig Fast Pty Ltd will continue as a going concern. Dig Fast Pty Ltd. files for bankruptcy on 5
September 2011.

c) At 30 June 2010, will this information be mentioned in Dig Hard’s annual report? If yes,
where? Justify your answer.

The Dig Hard’s guarantee over Dig Fasts’ borrowings is a contingent liability as at 30 June
2010 because it is not a probable that the outflow will occur since the subsidiary is financially
sound. It will appear in the notes to the financial statements (or similar words).

DO NOT WRITE OUTSIDE THE BOX

d) At 30 June 2011, will this information be mentioned in Dig Hard’s annual report? If yes,
where? Justify your answer.

The Dig Hard’s guarantee over Dig Fasts’ borrowings is a liability as at 30 June 2011
because it is probable that the outflow will occur as it is unlikely that the Dig Fast will
continue as a going concern (or similar words). It will appear on the balance sheet.

DO NOT WRITE OUTSIDE THE BOX

Q3: Final Exam 2012, Semester 2: Question 8 (Adapted)

Metal Fuzz Pty Ltd. produces and sells a particular model of electric guitars. You have just
taken up the position as the chief accounting for Metal Fuzz Pty Ltd. but the auditors have
questioned the previous accounting treatment of Metal Fuzz Pty Ltd.’s return policy.

Metal Fuzz Pty Ltd. does not provide a warranty on its product, but is aware that in order to
be successful it must maintain good customer relationships. Consequently, Metal Fuzz Pty
Ltd. has a policy of replacing any faulty product with new ones or to return the purchase price
in cash to the customer even if it is under no legal obligation to do so. This policy is publicly
disclosed on the company website and customers within the electric guitar community are
well aware of this policy. Prior experience suggests that about 3% of the guitars Metal Fuzz
Pty Ltd sell is faulty. Prior experience also suggest that about half of those that return their
faulty guitars to Metal Fuzz Pty Ltd want their purchase price returned and the other half
would like it replaced with a new guitar.

During the financial year ending 30 June 2013, Metal Fuzz Pty Ltd. had incurred revenue of
$500,000 and cost of goods sold of $250,000, and it had replaced faulty products worth
$5,000 and also returned $5,000 cash for faulty products. Metal Fuzz Pty Ltd. has previously
not recognised anything in their accounting records in relations to their return policy.

(a) Does Metal Fuzz have a present obligation (justify your answer):

Yes. There is a present obligation. Although no legal obligation exists, there is a constructive
obligation because Metal Fuzz has a well-known product replacement policy that is published on
the website (or similar words).

DO NOT WRITE OUTSIDE THE BOX

(b) Write down all journal entries (if any) in relation to Metal Fuzz Pty Ltd recognising a
liability in relation to its policy:

Dr Warranty Expense 11,250

Cr Provision for Warranty 11,250

(Expected returns 3%: about half (i.e. 1.5% of total) was for return of purchase price and the
other half (i.e. 1.5% of total) was for replacing goods. Expected cost associated with refunding
purchase price is 1.5%*500,000=7,500. Expected cost of replacing goods is
1.5%*250,000=3750)
DO NOT WRITE OUTSIDE THE BOX

(c) Write down all journal entries (if any) in relation to Metal Fuzz Pty Ltd replacement of
faulty products or returning cash to customers (given what you have done in part b):

Dr Provision for Warranty 10,000

Cr Cash 5,000
Cr Inventory 5,000

DO NOT WRITE OUTSIDE THE BOX

Q4: Dentro Retail Group

Dentro Retail Group specialises in the ownership and management of shopping centres. The
following events unfolded for the Dentro Retail Group in the late 2007.

Dentro’s 2007 financial year ended 30 June. On 6 September the board approved and signed
off on the financial statement. And the audited full financial statements were lodged with
ASIC 18 September. It turned out, however, that the figures reported in the financial
statements lodged was not entirely correct, and on the 20 December the Dentro Retail Group
publically acknowledged these errors.

Timeline:

Extracts from Dentro’s 2007 Financial Statements, are disclosed below. The first column
details the incorrect figures reported in the financial statements lodged on 18 September, the
second column details the figured that should have been reported, and that was released 20
December.

Financial Statement Extract

($'000) ($'000)
Balance Sheet 2007 Reported 2007 Corrected
Current Assets 1,337,991 1,821,976
Non-Current Assets 6,827,065 6,827,065
Total Assets 8,165,056 8,649,041

Current Liabilities 1,753,499 3,751,581

Non-Current Liabilities 2,846,434 1,332,337
Total Liabilities 4,599,933 5,083,918

Total Equity 3,565,123 3,565,123

Income Statement
Revenue 795,166 795,166
Expenses 324,933 324,933
Net Income 470,233 470,233
The following chart details the share price movement of Dentro Retail Group:

Required:
a) list three differences between the reported and the corrected 2007 figures:
1.
Current assets increased by $483,985,000

2.
Current liabilities increased by $1,998,082,000

3.
Non-current liabilities decreased by $1,514,097,000

DO NOT WRITE OUTSIDE THE BOX

b) Calculate the current ratio (current assets/current liabilities) for both the reported and
corrected 2007 figures:
Calculation for 2007 reported figures:

1,337,991/1,753,499 = 0.763

Calculation for 2007 corrected figures:

1,821,976/3,751,581=0.486

DO NOT WRITE OUTSIDE THE BOX

c) With reference to the current ratios calculated in part (b), do you think the
shareholders’ reaction to the corrected 2007 numbers is justified? Justify your answer.
The current ratio shows that the liquidity of the firm has severely decreased and that after the
figures were corrected that Dentro has over twice as much in current liabilities as in current
assets. This brings out the question of whether Dentro can service its debt, and whether
Dentro actually is a going concern. In this respect, it is not surprising that shareholders
reacted negatively to the “news” contained in the corrected 2007 figures.

DO NOT WRITE OUTSIDE THE BOX