Module 8

Module 8
Reporting and Analyzing Nonowner

Financing
Learning Objectives – coverage by question
True/ Multiple Essay
Exercises Problems
False Choice Questions
LO1 Describe
the accounting
for current
operating
liabilities,
1-5 1-12 1-9 1-5 1-3
including
accounts
payable and
accrued
liabilities.
LO2 Describe
the accounting
for current and
6-11 13-18 10-19 4-9 4-6
long-term
nonoperating
liabilities.
LO3 Explain
how credit
ratings are
determined
12-16 19-25 20-21 8-10 6-9
and identify
their effect on
the cost of
debt.
© Cambridge Business Publishers, 2010

Test Bank, Module 8 8-1
Module 8: Reporting and Analyzing Nonowner Financing
True/False
Topic: Accounts payable as a source of financing
LO: 1
1. Accounts payable are a short-term source of non-interest bearing financing.
Answer: True
Rationale: Accounts payable that arise from the purchase of goods and services usually do not
carry any interest charges and can represent a good source of short-term inexpensive financing.
Topic: Deferred revenue

LO: 1
2. Unearned revenue, a current operating liability, arises when a company receives cash before
any goods are delivered or services are rendered.
Answer: False
Rationale: Deferred revenues can also be long-term liabilities.
Topic: Accrued liabilities

LO: 1
3. Accrued liabilities are obligations for which there is no external transaction.
Answer: True
Rationale: Companies must estimate accrued liabilities such as rent payable because there has
been no bill received or no transaction.
Topic: Income shifting

LO: 1
4. If accrued liabilities are overestimated in the current period, the reported income in a following
period will be lower than it should be.
Answer: False
Rationale: If the accrued liabilities in this period are overestimated, then the current income is
lower than it should be. This error will be corrected in a following period, and will artificially inflate
income.
Topic: Contingent liabilities

LO: 1
5. Contingent liabilities that are ‘probable’ are can be reasonably estimated are recorded on the
balance sheet as a liability and as an expense in the income statement.
Answer: True
Rationale: Only ‘probable’ contingent liabilities are estimated and recorded on the balance sheet
or the income statement. Anything less than ‘probable’ liabilities (such as ‘reasonably possible’)
are referenced in footnotes.
Cambridge Business Publishers, ©2010

8-2 Financial Accounting for MBAs, 4th Edition
Topic: Discount bond
LO: 2
6. A bond selling for an amount above face value is said to be selling at a discount.
Answer: False
Rationale: This bond sells at a premium, not a discount.
Topic: Reporting of current portion of long-term debt.

LO: 2
7. The principal and interest that will be paid on long-term debt within the next operating cycle
are reported on the balance sheet as “current portion of long-term debt.”
Answer: False
Rationale: Only the principal portion is classified as “current portion of long-term debt.”
Topic: Secondary market for bonds

LO: 2
8. Unlike stock, once sold, bonds can only be traded in private transactions between arms’ length
parties.
Answer: False
Rationale: There exists a secondary market for previously issued bonds.
Topic: Bond prices

LO: 2
9. Market prices of bonds fluctuate because the company’s obligation (in the form of principal
and interest payments) remains fixed.
Answer: True
Rationale: Market prices fluctuate similar to stocks. The reasoning behind this is that bonds
compete with other investments and become more or less attractive based on the interest rates of
competing securities and the financial condition of the borrowing company.
Topic: Reporting gains (losses) on bond repurchase

LO: 2
10. Most gains and losses on bond repurchases are reported as extraordinary items.
Answer: False
Rationale: GAAP specifies that gains and losses should be included as extraordinary items
(below income from continuing operations) only if they meet the criteria of unusual and infrequent.
As relatively few bond repurchases meet these criteria, they are typically included as part of
income from ongoing operations.

Topic: Secured debtholders
LO: 2
11. Secured debtholders have a preferred position over other creditors but not over preferred
stock holders.
Answer: False
Rationale: When a company provides collateral, it provides security for the debt in the form of
liens on the company’s assets. Secured debtholders have a priority claim on those secured
assets. These come before all stockholder claims, even those from preferred stockholders.
Topic: Cost of debt

LO: 3
12. The effective rate of a bond typically equals the yield (market) rate.
Answer: False
Rationale: Bonds are priced to yield the return (market rate) demanded by investors.
Consequently, the effective rate of a bond always equals the yield (market) rate.
Topic: Cost of Debt

LO: 3
13. The market rate of interest is equal to the risk-free rate plus a credit-rating premium.
Answer: False
Rationale: The market rate of interest is usually defined as the yield on U.S. Government
borrowings such as treasury bills, notes, and bonds, called the risk-free rate, plus a spread (also
called a risk premium).
Topic: Debt ratings

LO: 3
14. Credit ratings are an opinion of a company’s relative default risk.
Answer: True
Rationale: The credit rating agencies provide an assessment of their view of the likelihood that a
company will default on its debt obligations.
Topic: Cost of Debt

LO: 3
15. The market rate of interest is equal to the risk-free rate plus a risk premium.
Answer: True
Rationale: The market rate of interest is usually defined as the yield on U.S. Government
borrowings such as treasury bills, notes, and bonds, called the risk-free rate, plus a spread (also
called a risk premium).

Topic: Bond interest rates
LO: 3
16. Higher credit-rated borrowers receive lower interest rates than lower credit-rated borrowers,
but the differences are typically not significant.
Answer: False
Rationale: The difference is significant. Highest credit-rated borrowers receive interest rates
approximately ½ that of lowest credit-rated borrowers.

Multiple Choice
LO: 1
1. Contingent Liabilities must have the following criteria – select all that apply.
a. The obligation is certain to require payment at some point in the future
b. The obligation will probably require payment at some point in the future
c. The obligation is estimable
d. The obligation will possibly require payment at some point in the future
e. None of the above.
Answer: b and c
Rationale: Contingent liabilities are only included when the amount is probable and estimable. An
obligation that is guaranteed at some point in the future is a liability, and one for which the liability
is less than reasonably possible does not need to be reported.
Topic: Current liabilities

LO: 1
2. Which of the following does not affect the current liabilities section of the balance sheet?
a. Purchase of inventory on credit
b. Wages owning to employees but not yet paid
c. Insurance bill to be paid next month
d. Sale of goods on credit
e. A probable legal obligation, due within 12 months
Answer: d
Rationale: The sale of goods on credit impacts non-cash assets, specifically accounts receivable;
all the other items are liabilities that the company must pay within the next year, hence current
liabilities.
Topic: Interest accrual – Numerical calculations required

LO: 1
3. Badgers Inc. issued a 120-day note in the amount of $80,000 on 12/14/08 with an annual rate
of 9%. What amount of interest has accrued as of 12/31/08?
a. $0
b. $7,200
c. $335
d. $3,600
e. $600
Answer: c
Rationale: $80,000 × 9% × 17 / 365 days = $335.34.

Topic: Contingent liability
LO: 1
4. Which one of the following would be considered a contingent liability?
a. A company owes $12,000 on inventories purchased on credit.
b. A company estimates that it will probably have to pay $15,000 to the EPA for a chemical spill.
c. A company has access to a line of credit with a bank in the amount of $23,000.
d. A company believes that it is reasonably possible it will lose a lawsuit and damages could be
$13,000.
e. None of the above
Answer: c
Rationale: For a liability to be a contingent liability, the amount must be estimable and probable.
Topic: Transaction analysis of current liabilities– Numerical calculations required

LO: 1
5. Nike Inc. offers Foot Locker credit terms of 2/20, net 45. If Foot Locker does not take the early
payment discount, Foot Locker is effectively paying what annual rate of interest?
a. 20.0%
b. 14.6%
c. 2.0%
d. 29.2%
Answer: d
Rationale: The difference between paying early and paying when the bill comes due is 25 days
(45 days – 20 days). Foot Locker gets a 2% discount for those 25 days. Annualized, this is (365 /
25) × 2% = 29.2%.
Topic: Reporting of accruals

LO: 1
6. Which of the following would not require the company to record an accrual on the balance
sheet?
a. The company owes $20,000 in wages to its employees for the previous two weeks.
b. Interest will be paid when a note payable matures in the following accounting period
c. Management believes a lawsuit against the company is meritless because they have never had
a single complaint about dangerous side effects of their drug in two years.
d. The company knows that they will be fined for pollution as a result of their manufacturing
process and can estimate the amount of the obligation.
e. None of the above.
Answer: c
Rationale: Based on management’s belief, the lawsuit at hand can be deemed less than
reasonably possible and therefore does not need to be disclosed in the financial statements.

Topic: Accounts payable discounts– Numerical calculations required
LO: 1
7. Acme Inc. receives a bill from RoadRunner Inc. for $15,000. RoadRunner has credit terms of
3/15, net 45. If Acme takes advantage of the discount, how much cash do they pay to
Roadrunner?
a. $15,450
b. $15,000
c. $14,550
d. $12,750
Answer: c
Rationale: If Acme paid within 15 days, it would pay cash of $14,550 ($15,000 – ($15,000 × 3%)).
Topic: Current liability

LO: 1
8. Which of the following does not represent a current liability?
a. Accrual of taxes payable
b. Short-term loan
c. Purchase of equipment on credit
d. Bond issue
Answer: d
Rationale: Bonds are issued to raise capital with repayment of the principal amount on a
specified date in the future (more than one year from the point of issue); therefore, bonds are
considered long-term liabilities.
Topic: Accounting for short-term debt– Numerical calculations required

LO: 1
9. On January 1, Jason’s Club borrows $10,000 from First State Bank. The loan is due in one
year along with 6% interest. The company is preparing its quarterly report for March 31. Which of
the following best describes the necessary accrual for interest expense?
a. $150 increase liabilities, increase expenses
b. $600 decrease liabilities, decrease cash
c. $600 increase expenses, decrease cash
d. $600 increase liabilities, decrease expenses
e. $150 decrease liabilities, decrease cash
Answer: a
Rationale: The quarterly interest charge is calculated by multiplying the loan amount ($10,000)
by the interest rate (6%) and then by the portion of the year outstanding (3/12), or $150 accrued
interest. The company needs to reflect the outstanding interest owed (accrued interest) by
increasing liabilities and increasing interest expense.

Topic: Computing and interpreting accounts payable ratios– Numerical calculations required
LO: 1
10. Selected recent balance sheet and income statement information for American Eagle
Outfitters follows:
(in thousands) 2008

Year-end accounts payable $ 152,068
Average accounts payable 154,998
Sales 2,988,866
Cost of goods sold 1,814,765
Accounts payable turnover for 2008 is:

a. 11.93
b. 19.65
c. 11.71
d. 19.28
Answer: c
Rationale: APT = COGS / average Accounts payable = $1,814,765 / $154,998 = 11.71.
Topic: Computing and interpreting days payables outstanding– Numerical calculations required
LO: 1
11. Selected recent balance sheet and income statement information for Gap, Inc. follows:
(in millions) 2008
Year-end accounts payable $ 975
Average accounts payable 990
Sales 14,526
Cost of goods sold 9,079
Accounts payable days outstanding for 2008 is:

a. 39.2 days
b. 24.5 days
c. 39.8 days
d. 24.9 days
Answer: a
Rationale: APDO = Accounts payable / average daily COGS = $975 / [$9,079 / 365 days] = 39.2
days

Topic: Computing and interpreting accounts payable ratios– Numerical calculations required
LO: 1
12. Selected recent balance sheet and income statement information for American Eagle
Outfitters and Gap, Inc. follows:
American Eagle Outfitters

(in thousands) 2008
Sales 2,988,866
Cost of goods sold 1,814,765
Gap, Inc.
(in millions) 2008
Year-end accounts payable $ 975
Average accounts payable 990
Sales 14,526
Which of the two companies listed above is leaning on the trade more?
a. American Eagle because its accounts payable turnover is greater and its accounts payable
days outstanding is lower.
b. American Eagle because its accounts payable turnover is lower and its accounts payable days
outstanding is higher.
c. Gap because its accounts payable turnover is higher and its accounts payable days
outstanding is lower.
d. Gap because its accounts payable turnover is lower and its accounts payable days outstanding
is higher.
e. Gap because its accounts payable turnover is lower and its accounts payable days outstanding
is lower.
Answer: d
Rationale: Gap’s APT ($9,079 / $990.5 = 9.17) is lower than American Eagles’ APT ($1,235,620
/ $124,063 = 11.71).
Gap’s APDO ($975 / [$9,079 / 365 days] = 39.2 days) is higher than American Eagles’ APDO
($152,068 / [$1,814,765 / 365 days] = 30.59 days.
A company is said to be leaning on the trade more when it has a lower accounts payable turnover
and a higher accounts payable days outstanding.
Topic: Interest payment– Numerical calculations required

LO:2
13. Williams Electric Corp. sells $50,000 of bonds to private investors. The bonds have an 8%
coupon rate and interest is paid semi-annually. The bonds were sold to yield 9%. What periodic
interest payment does Williams make?
a. $2,000
b. $4,000
c. $8,000
d. $2,250
Answer: a
Rationale: Coupon rates are used to compute the dollar amount in interest payments paid to the
bondholder semi-annually. Williams pays $50,000 × 8% × ½ year = $2,000.

Topic: Interest payment– Numerical calculations required
LO:2
14. Keskek Corp. sells $100,000 of bonds to private investors. The bonds have a 9% coupon
rate and interest is paid semi-annually. The bonds were sold to yield 8%. What periodic interest
payment does Keskek make?
a. $4,000
b. $8,000
c. $9,000
d.$4,250
Answer: e
Rationale: Coupon rates are used to compute the dollar amount in interest payments paid to the
bondholder semi-annually. Keskek pays $100,000 × 9% × ½ year = $4,500.
Topic: Understanding bonds

LO:2
15. Which one of the following is not correct?
a. For debt issued at par: interest expense reported on the income statement equals the cash
paid for interest.
b. For bond repurchases: Gain (loss) on bond repurchase = Cash paid to repurchase – Net book
value of bonds.
c. For debt issued at a discount: interest expense reported on the income statement equals cash
interest payment less amortization of the discount.
d. For debt issued at a premium, interest expense reported on the income statement equals cash
interest payment less amortization of the premium.
Answer: c
Rationale: For debt issued at a discount, interest expense reported on the income statement is
cash interest paid plus amortization of the discount.
Topic: Bond pricing– Numerical calculations required

LO: 2
16. Mayberry Gas Corp. sells $200,000 of bonds to private investors. The bonds are due in five
years, have an 8% coupon rate, and interest is paid semi-annually. The bonds were sold to yield
6%. What proceeds does Mayberry receive from the investors?
a. $200,000
b. $217,060
c. $206,000
d. $183,777
Answer: b
Rationale: Present value of principal (10 periods, 3%) = $200,000 × 0.74409 = $148,818;
Present value of interest payments (10 payments, 3%) = $8,000 ×8.5302 = $68,242; Total
present value = $217,060.

LO: 2
17. Mayberry Gas Corp. sells $200,000 of bonds to private investors. The bonds are due in five
years, have a 6% coupon rate and interest is paid semi-annually. The bonds were sold to yield
8%. What proceeds does Mayberry receive from the investors?
a. $183,777
b. $200,000
c. $217,060
d. $194,000
Answer: a
Rationale: Present value of principal (10 periods, 4%) = $200,000 × 0.67556 = $148,818;
Present value of interest payments (10 payments, 4%) = $6,000 ×8.1109 = $51,181; Total
present value = $183,777.
Topic: Effective rate– Numerical calculations required

Note to instructor: requires that students use IRR function on calculator
LO: 2
18. Schmidt Diamond Corp. sells $150,000 of bonds to private investors. The bonds are due in
10 years, have a 10% coupon rate and interest is paid semi-annually. Schmidt received $132,794
for the bonds at issuance. The effective rate on these bonds is:
a. 13%
b. 9%
c. 10%
d. 12%
Answer: d
Rationale: Present value of principal (20 periods, 6%) = $150,000 × 0.3118 = $46,770; Present
value of interest payments (20 payments , 6%) = $7,500 × 11.46992 = $86,024; Total present
value = $132,794.

LO: 3
19. In January 2009, Vivendi announced a €1 billion bond issuance. The bonds have a coupon
rate of 7.75% payable semi-annually. According to the company’s website, the bonds have been
assigned credit ratings of BBB (stable outlook) by Standard and Poor’s, Baa2 (stable outlook) by
Moody’s, and BBB (stable outlook) by Fitch. Which of the following is not true?
a. The yield on these bonds would have been lower if Standard and Poor’s, Moody’s, and Fitch
had assigned higher credit ratings.
b. The periodic interest payment will be €38.750 million.
c. The coupon rate on these bonds would have been higher if Standard and Poor’s, Moody’s, and
Fitch had assigned lower credit ratings.
d. The periodic interest expense will depend on the bond’s yield.
Answer: c
Rationale: Credit ratings affect the bond’s yield but not the coupon payments determined by the
issuer.

Topic: Credit analysis
LO: 3
20. Credit analysis concerns which of the following?
a. The price of a company’s stock
b. The ability of a company to consistently pay dividends
c. The probability a company will make timely payments
d. An assessment of a company’s credit-granting policies.
Answer: c
Rationale: The probability a company will make timely payments, that is, the potential risk of
default. Bond investors are primarily concerned with a company’s ability to make interest and
principal payments per the bond agreement.
Topic: Credit ratings

LO: 3
21. Which of the following corporate debt ratings are ordered in terms of decreasing market
interest rate?
a. AAA, A, BB, C
b. A, AAA, BB, C
c. BB, C, A, AAA
d. C, BB, A, AAA
Answer: d
Rationale: As debt quality moves from AAA to CCC, the market interest rate required increases.
So, the required rate decreases from CCC to AAA.

LO: 3
22. Which of the following business factors does not play a role in determining a company’s
credit rating?
a. Industry characteristics
b. Capital structure
c. Management
d. Corporate marketing
e. Profitability
Answer: d
Rationale: Corporate marketing is not a risk factored into the rating agencies’ determination of a
company’s credit rating.

LO: 3
23. What is the risk premium for a company that has a yield rate of 6.07% when the risk-free rate
is 3.28%?
a. 2.79%
b. -2.79%
c. 9.35%
d. 1.85%
Answer: a
Rationale: The risk premium can be found by subtracting the risk-free rate from the yield rate
(6.07% - 3.28% = 2.79%).

LO: 3
24. In general, how do credit analysts determine the risk-free rate?
a. The average corporate yield
b. The yield on U.S. Government borrowings
c. The rate defined by the largest U.S. banks
d. The weighted-average corporate yield based on the preceding four quarters
Answer: b
Rationale: The risk-free rate is the yield on U.S. Government borrowings such as treasury bills,
notes, and bonds.

LO: 3
25. Which of the following does Moody’s not consider in deriving the credit rating of a company?
a. Profitability ratios
b. Loan covenants
c. Solvency ratios
d. Collateral
Answer: e
Rationale: Moody’s considers many factors in deriving a credit rating, including profitability ratios,
covenants, solvency ratios, and collateral.

Exercises
Topic: Current liabilities
LO: 1
1. For each of the following, indicate the liability that Favre Inc. would show on its December 31,
2008 balance sheet.
a. Favre Inc. has accounts payable of $30,000 for products that are included in the 2008 year-end
inventory.
b. Favre Inc. received an invoice for a one-year insurance policy beginning December 2008. The
$2,000 invoice has yet to be paid at year end.
c. Favre Inc. has an unused line of credit of $10,000 from E-Z Loan Bank.
Answer:
a. This is a current liability as products have been acquired on credit but have not yet been paid
for.
b. This is included as a current liability as the money is owed but not yet paid. This is an accrued
liability.
c. This is not included as a liability. It is a line of credit that Favre Inc. has an option to use and is
currently not using.
Topic: Accounts payable discounts– Numerical calculations required

LO: 1
2. Acme Inc. receives a bill from RoadRunner Inc. for $20,000. RoadRunner has credit terms of
3/15, net 45. If Acme Inc takes advantage of the discount, how much cash does Acme pay
Roadrunner?
Answer: If Acme paid within 15 days, it would pay cash of $19,400 ($20,000 – ($20,000 × 3%)).
Topic: Interest accrual

LO: 1
3. On July 1, 2008, Beantown Coffee took out a short-term loan of $8,000 to be repaid in one
year. The annual interest rate is 5% with no interest payments due until the loan is repaid. How
much interest should Beantown accrue by year-end December 31, 2008? How should it be
recorded in the financial statements?
Answer: Interest expense = $8,000 × 5% × (6/12) = $200.

The $200 should be recorded as an increase in current liabilities (interest payable) and an
increase in expenses (interest expense) on the income statement.

Topic: Accrued interest
LO: 1
4. Compute the accrued interest as of December 31, 2008 on each of the following notes
payable:
Date of note Principal Coupon Rate Term

a. 11/26/08 $12,000 7% 60 days
b. 12/19/08 $40,000 13% 30 days
c. 10/31/08 $24,000 14% 90 days
Answer:
a. $12,000 × 0.07 × 35 days / 365 days = $80.55
b. $40,000 × 0.13 × 12 days / 365 days = $170.96
c. $24,000 × 0.14 × 61 days / 365 days = $561.53
Topic: Transaction analysis

LO:1
5. For each item below, identify the amount (if any) that would be reported as a liability on Coach
Inc’s month-end balance sheet.
a. Coach Inc. agreed to purchase next month, fabric for their new line of bags.
b. Coach borrowed $15,000 to finance its seasonal working capital needs this month.
c. Coach has accounts payable of $75,000 for fabric included in current inventory
d. Coach Inc. is obligated $40,000 rent each month. Rent for this month has not yet been paid.
Answer:
a. Not recorded as a liability, the transaction is happening next month.
b. $15,000 is recorded as a current non-operating liability.
c. $75,000 is recorded in accounts payable (current liability) on the balance sheet.
d. $40,000 is recorded as an accrued liability (current liability) on the balance sheet.

Topic: Transaction analysis – accounts payable
LO: 1
6. Computers-R-Us (CRU) purchased 30 computers from its supplier on credit at a cost of
$1,500 per computer. The computers were purchased to be held for sale to customers. By the
end of the month, CRU had sold all 30 computers for $1,700 each. The store received payment
for these computers but waited until the end of the month to settle its account payable with the
supplier. Use the financial statement effects template, below to record these transactions.
Balance Sheet Income Statement
Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net

Transaction
Asset
+
Assets = ities
+
Capital
+
Capital enues – ses = Income
Purchase
computers = – =
Sell
Computers = – =
Record Cost of
Goods Sold = – =
Pay for
computers = – =
Answer:

Transaction
Asset
+
Assets = ities
+
Capital
+
Purchase +45,000 +45,000
computers (INV) = (AP) – =
+51,000
Sell +51,000
+51,000 = (Retained
(Sales) – = +51,000
Computers Earnings)
+45,000
Record Cost of -45,000 +45,000
(INV) = (Retained – (COGS) = -45,000
Goods Sold Earnings)
Pay for -45,000
computers
-45,000 = (AP) – =
Topic: Computing and interpreting accounts payable ratios

LO: 1
7. Use the selected financial statement information for Target Corp. to determine, a. Accounts
payable turnover, and b. Accounts payable days outstanding.
(in millions) 2008

Sales 62,884
Answer:
a. APT = COGS / average accounts payable = $44,157 / $6,529 = 6.76.
b. APDO = Accounts payable / average daily COGS = $6,337 / [$44,157 / 365 days] = 52.38 days

LO: 1
8. Use the selected financial statement information for Kroger Co. to determine, a. Accounts
payable turnover and b. Days payables outstanding.
(in millions) 2008

Sales 76,000
Answer:
a. APT = COGS / average accounts payable = $58,564 / $3,845 = 15.23.
b. APDO = Accounts payable / average daily COGS = $3,822 / [$58,564 / 365 days] = 23.8 days
Topic: Accounting for warranties

LO: 1
9. K2 Inc, manufactures equipment for individual and team sports including skiing, snowboarding
and in-line skating. The company offers a one-year warranty on all products. During 2008, the
company recorded net sales of $1,934.7 million. Historically, about 2% of all sales are returned
under warranty and the cost of repairing and or replacing goods under warranty is about 50% of
retail value. Assume that at the start of the year K2’s balance sheet included an accrued warranty
liability of $8.43 million and at the end of the year, the accrued warranty liability balance was
$6.49 million.
a. How should K2 account for warranty claims?
b. Calculate K2’s warranty expense for 2008.
c. How much did K2 pay during the year to repair and or replace goods under warranty?
Answer:
a. K2 should record the estimated cost of product warranties at the time sales are recognized. To
do this, the company should estimate warranty obligation by reference to historical product
warranty return rates, material usage and service delivery costs incurred in correcting the
product. Should actual product warranty return rates, material usage or service delivery costs
differ from the historical rates, K2 should revise its warranty liability.
b. Warranty expense for 2008 = $1,934.7 million × 2% × 50% = $19.35 million.
c. During the year, the accrued warranty liability decreased. This means that K2 paid out more to
replace or repair warrantied goods than the expense the company recorded. Total cash paid out
is $8.43 million + $19.35 million - $6.49 million = $21.29 million.

Topic: Accounting for bonds
LO: 2
10. J&G Confectionary needed financing to build a new ice cream plant. On June 30th, 2008,
J&G issued $700,000 of 10-year bonds with an 8% coupon rate (payments due on December
31st and June 30th). The effective interest rate was 10%. Use the financial statement effects
template below to record the bond issue and J&G first two interest payments.

Transaction
Asset
+
Assets = ities
+
Capital
+
Bond issue = – =
Interest 12/31 = – =
Interest 6/30 = – =
Answer:

Transaction
Asset
+
Assets
= ities
+
Capital
+
Capital enues
– ses
= Income
+612,765
Bond issue +612,765 = (LTD)
– =
+2,638 -30,638 +30,638
Interest 12/31 -$28,000 = (LTD)
(Retained – (IE)
= -30,638
earnings)
+2,770 -30,770 +30,770
Interest 6/30 -$28,000 = (LTD)
(Retained – (IE)
= -30,770
earnings)
Bond issue price:

Present value of principal repayment ($700,000 × .37689) $263,823
Present value of interest payments ($28,000 × 12.46221) $348,942
$612,765
Interest Cash payment= $700,000 × 0.04.
12/31 Interest expense = $612,765 × 0.05 = $30,638. Bond net book value increases by the
difference of $2,638.
6/30 Interest expense = ($612,765 + $2,638) × 0.05 = $30,770. Bond net book value increases by
the difference of $2,770.

Topic: Accounting for bonds
LO: 2
11. On December 31st, 2008, Rasso Performing Arts Studio opened for business. The company
borrowed $5,000,000 at 10% and signed a 10 year note that is to be repaid in 19 equal
semiannual payments of $275,000 on June 30th and December 31st, with a balloon payment at
maturity. Use the financial statement effects template below to record the issuance of the note
and the payments of the first four installments.

Transaction
Asset
+
Assets = ities
+
Capital
+
1) = – =
2) = – =
3) = – =
4) = – =
5) = – =
Answer:

Transaction
Asset
+
Assets
= ities
+
Capital
+
Capital enues
– ses
= Income
+5 mill.
1) +5 mill. = (LTD) – =
-250,000
-275,000 -25,000 +250,000
2) = (LTD)
(Retained – IE(1) = -250,000
earnings)
-248,750
-275,000 -26,250 +248,750
3) = (LTD)
(Retained – IE(2) = -248,750
earnings)
-247,438
-275,000 -27,562 +247,438
4) = (LTD)
(Retained – IE(3) = -247,438
earnings)
-246,059
-275,000 -28,941 +246,059
5) = (LTD)
(Retained – IE(4) = -246,059
earnings)
(1) 0.05 × $5,000,000 = $250,000 interest expense. The difference between the installment cash
payment and the interest expense is the repayment of principal.
(2) 0.05 × ($5,000,000 - $25,000) = $248,750 interest expense. The difference between the
installment cash payment and the interest expense is the repayment of principal.
(3) 0.05 × ($5,000,000 - $25,000 - $26,250) = $247,438 interest expense. The difference
between the installment cash payment and the interest expense is the repayment of principal.
(4) 0.05 × ($5,000,000 - $25,000 - $26,250 - $27,562) = $246,059 interest expense. The
difference between the installment cash payment and the interest expense is the repayment of
principal.

Topic: Bond pricing
LO: 2
12. Madison Company issues $300,000 of 10% bonds that pay interest semiannually and mature
in 10 years. Compute the bonds’ issue price assuming that the bonds’ market interest rate is:
a. 8% per year compounded semiannually
b. 12% per year compounded semiannually
Answer:
a. Present Value of Principal repayment ($300,000 × 0.45639) = $136,917
Present Value of Interest payments ($15,000 × 13.59033) =$203,855
Total $136,917 + $203,855 = $340,772
b. Present Value of Principal repayment ($300,000 × 0.3118) = $93,540
Present Value of Interest payments ($15,000 × 11.46992) =$172,049
Total $93,540 + $172,049 = $265,589
Topic: Bond interest received

LO: 2
13. At the beginning of 2002, Risotto Company bought a bond with a $12 million face value and
an annual coupon rate of 6.7%. It has a maturity of 10 years. How much total interest income has
Risotto Company received through the end of 2008 (cumulatively) if interest is paid
semiannually?
Answer: Interest received = Face Value × # of semiannual payments × semiannual interest rate
Interest received = $12 million × 14 payments × 3.35% = $5.628 million
Topic: Bond pricing

LO: 2
14. Flora’s Fine Fruits issues $1,300,000 in 5% bonds due in five years with semiannual interest
payments. How much should Flora’s expect to raise if the market return for similar bonds is 6%?
Answer:
PV of the principal = 0.74409 × $1,300,000 = $967,317
PV of the interest payments = 8.53020 × $32,500 =$ 277,232
Total bond proceeds $967,317 + $277,232 = $1,244,549
Topic: Bond pricing

LO: 2
15. Rainbow Sports issued $550,000 of 5% bonds that mature in five years. Compute the bond
issue price assuming that the market rate for similar bonds is:
a. 6% per year compounded annually (and interest is paid annually)
b. 8% per year compounded semi-annually (and interest is paid semi-annually)
Answer:
a. PV of principal repayment $550,000 × 0.74726 = $410,993
PV of interest payment ($550,000 × 0.05) × 4.21236= $115,840
Total bond proceeds= $526,833
b. PV of principal repayment $550,000 × 0.67556 = $371,558
PV of interest payment ($550,000 × 0.025) × 8.11090 = 111,525
Total bond proceeds = $483,083

Topic: Calculating gain or loss on bond redemption
LO: 2
16. Black Rock Brewing Company retired $400,000 of 7% bonds payable at 97 on June 30,
2008, two years before the bonds matured. The bond book value on June 30, 2008 is $385,000,
and bond interest is paid up to the date of retirement. What is the gain/loss on the retirement of
these bonds?
Answer: Amount to retire bonds = $400,000 × 0.97 = $388,000

Bond book value = $385,000
Loss on bond =$388,000 - $385,000 = $3,000

LO: 2
17. White Rock Metallurgy paid $42,000 to retire $45,000 worth of notes. The notes were issued
with a 9% coupon rate paid semiannually. If the bonds were three years from maturity and had a
net book value of $35,000, what is the net gain or loss on the redemption of these notes?
Answer: $42,000 paid - $35,000 book value = $7,000 net loss on redemption

LO: 2
18. On June 30th, one year before maturity, Thompson, Inc. retired $200,000 of 10% bonds at a
cost of 99. The bond’s had a net book value on June 30th of $195,000. Bond interest is presently
paid up to the date of retirement. What is the gain or loss on the retirement of these bonds?
Answer: Gain (loss) on bond repurchase = Net book value of bonds - Repurchase payment
Gain (loss) = $195,000 - (99% of the bond face value) = $195,000 – $198,000 = ($3,000)
Loss = $3,000
Topic: Calculating book value of bonds redeemed

LO: 2
19. Mustang Inc. issued $800,000 of 5%, 20-year bonds at 96 on January 1, 2000. Through Jan
1, 2008, Mustang amortized $20,000 of the bond discount. On January 1, 2008, Mustang Inc.
retired the bonds at 102 (after making the interest payment on that date). Calculate the net book
value of the bond on January 1, 2008 and the gain or loss that Mustang would report for this
retirement.
Answer: Net book value = Bond proceeds at issuance + discount amortization.

Net book value = ($800,000 × 0.96) + $20,000 = $788,000
Gain (loss) = Net book value – Cash to retire bonds.
Gain (loss) = $788,000 – ($800,000 × 1.02) = ($28,000). Mustang must report a loss of $28,000
on the bond retirement.

Topic: Bond investment comparison – credit analysis
LO: 3
20. You are a pension fund manager looking for an investment that will provide a reliable stream
of income over the next 10 years. You want to find the best yield possible while still conforming
to the pension fund covenant of investing in investment grade bonds or better. Decide among the
following investment options for your fund.
a. ComCom Cable Company: 10 years, 11% yield, EBIT Interest Coverage ratio = 4.2, EBITDA
interest coverage ratio = 6.1, total debt of $120,000,000 (all of which is long term), total equity of
$250,000,000, and a return on equity (ROE) of 8.3%.
b. High Flier VOIP Technology: 10 years, 5% yield, EBIT Interest Coverage ratio = 23.0, EBITDA
interest coverage ratio = 31.0, total debt of $80,000,000 (all of which is long term), total equity of
$2,500,000,000, and a return on equity (ROE) of 25.0%.
c. Einstein Nuclear Weapons: 10 years, 17% yield, EBIT Interest Coverage ratio = .78, EBITDA
interest coverage ratio = 1.2, total debt of $52,500,000, total equity of $80,000,000, and a return
on capital (ROE) of 8.2%.
The table below shows the three-year median ratios for U.S. Industrials with long-term
debt. Use the table to discuss the pros and cons of each investment option, described
above. Determine the grade of each bond (as closely as you can). Which bond is
appropriate for your pension fund?
AAA AA A BBB BB B CCC
EBIT Interest Coverage 21.4 10.1 6.1 3.7 2.1 0.8 0.1
EBITDA Interest Coverage 26.5 12.9 9.1 5.8 3.4 1.8 1.3
Return on equity (%) 34.9 34.9 19.4 13.6 11.6 6.6 1
Long-term debt/equity (%) 13.3 13.3 33.9 42.5 57.2 69.7 68.8
Total debt/equity (%) 22.9 22.9 42.5 48.2 62.6 74.8 87.7
Answer:
a. ComCom Cable Company: ComCom’s issue is teetering between an investment grade bond
and a high yield bond. With interest coverage ratios coming in right at the BBB benchmark and a
debt/equity ratio of 48%, which is also approximately right at the BBB benchmark it is likely that
this bond is a feasible investment option, especially attractive is the 11% yield. However,
ComCom’s ROE measure is well below the BBB benchmark and could be a cause for concern.
b. High Flier VOIP Technology: With a 3.2% debt/equity ratio, an attractive ROE of 25%, and
AAA quality interest coverage ratios, High Flier’s bond looks to be approximately a AAA quality
bond. Thus, this company is rather healthy, making this bond a relatively safe play.
c. Einstein Nuclear Weapons: This bond is unquestionably a high yield bond based the fact that it
has a profile that lies somewhere between a B grade bond and a CCC grade bond. Especially
troubling are the interest coverage ratios, which are both below B grade. The high yield that this
bond offers is inherent due to the high risk that is associated with it as well. There is a very good
chance that it will default, and as a result it would be an inappropriate investment for a pension
fund.
Summary - The most appropriate bond for a pension fund is probably High Flier. While it offers a
lower yield, it is relatively lower risk. Considering you manage a pension fund, you are more
interested in preserving capital than earning high returns.

Topic: Understanding credit ratings and financial ratios
LO: 3
21. The table below shows financial ratios that S&P uses to assess risk for corporate debt. For
each ratio, indicate whether financial risk increases or decreases when the ratio is higher.
Ratio Increases / Decreases

Total debt/ equity (%)
EBITDA interest coverage
Operating income/Sales (%)
Free operating cash flow/Total debt (%)
Return on equity (%)
FFO/Total debt (%)
Long-term debt/ equity (%)
EBIT interest coverage
Answer:
Ratio Increases / Decreases
Total debt/ equity (%) Increases
EBITDA interest coverage Decreases
Operating income/Sales (%) Decreases
Free operating cash flow/Total debt (%) Decreases
Return on equity (%) Decreases
FFO/Total debt (%) Decreases
Long-term debt/ equity (%) Increases
EBIT interest coverage Decreases

Problems
Computing and interpreting accounts payable ratios
LO: 1
1. Selected recent balance sheet and income statement information for 3M Company follows:
(in millions) 2008 2007
Year-end accounts payable $ 1,301 $ 1,505
Average accounts payable 1,403 1,454
Sales 25,269 24,462
Cost of goods sold $13,379 $12,735
Required:
a. Calculate accounts payable turnover (APT) for 2008 and 2007. Did turnover improve in 2008?
b. In general do companies prefer a higher or a lower APT? Why?
c. Calculate accounts payable days outstanding for both years.
d. What effect does the change in APT have on net cash flows from operating activities?
Answer:
a. 2008 APT = $13,379 / $1,403 = 9.54 times per year
2007 APT = $12,735 / $1,454 =8.76 times per year
Turnover did not improve in 2008 because the company paid off its bills more quickly.
b. In general, companies prefer a lower APT because it means they are paying more slowly and
keeping their cash longer. However, if companies do not pay promptly, suppliers may cut them off
or offer less attractive credit terms.
c. 2008 accounts payable days outstanding = $1,301 / ($13,379 / 365) = 35.49 days
2004 accounts payable days outstanding = $1,505 / ($12,735 / 365) = 43.14 days
d. An increase in APT results in a decrease in net cash flows from operating activities because
3M is speeding up its payments to suppliers.

LO: 1
2. Selected financial information for Hewlett-Packard Corporation follows:
Average accounts payable $ 12,963 $ 11,945
Year-end accounts payable 14,138 11,787
Sales (products) 91,697 84,229
Cost of goods sold (products) 69,342 63,435
Required:
a. Calculate accounts payable turnover (APT) for 2008 and 2007.
b. In general do companies prefer a higher or a lower APT? Why?
c. Calculate accounts payable days outstanding for both years.
d. What effect does the change in APT have on net cash flows from operating activities?

Answer:
a. 2008 APT = $69,342 / $12,963 = 5.35 times per year
2007 APT = $63,435 / $11,945 = 5.31 times per year
b. In general, companies prefer a lower APT because it means they are paying more slowly and
keeping their cash longer. However, if companies do not pay promptly, suppliers may cut them off
or offer less attractive credit terms.
c. 2008 accounts payable days outstanding = $14,138 / ($69,342 / 365) = 74.42 days
d. An increase in APT results in an decrease in net cash flows from operating activities because
Hewlett-Packard Corporation is speeding up its payments to supplier.

LO: 1
3. Selected recent balance sheet and income statement information for Carmike Cinemas, Inc.
follows:
(in thousands) 2008 2007

Average accounts payable $ 26,093 $ 25,751
Year-end accounts payable 23,995 28,190
Sales 474,403 483,958
Cost of goods sold $ 189,185 $ 192,744
Required:
a. Calculate accounts payable turnover (APT) for 2008 and 2007.
b. Calculate accounts payable days outstanding (APDO) for both years.
c. In general do companies prefer a higher or a lower number of days payables outstanding?
Why?
d. What effect does the change in APDO have on net cash flows from operating activities?
Answer:
a. 2008 APT = $189,185 / $26,093= 7.25
2007 APT = $192,744 / $25,751= 7.48
b. 2008 accounts payable days outstanding = $23,995 / ($189,185 / 365) = 46.29 days
c. In general, companies prefer a higher number of AP days outstanding because it means they
are paying more slowly and keeping their cash longer. However, if companies do not pay
promptly, suppliers may cut them off or offer less attractive credit terms.
d. A decrease in APDO from 53 to 46 days results in an decrease in net cash flows from
operating activities because Carmike Cinemas is speeding up its payments to suppliers.

Topic: Interpreting contingency footnote
LO: 1 & 2
4. Merck & Co. included the following footnote in its 2008 annual report:
Environmental Matters
The Company believes that it is in compliance in all material respects with applicable
environmental laws and regulations. In 2008, the Company incurred capital expenditures of
approximately $18.7 million for environmental protection facilities. The Company is also
remediating environmental contamination resulting from past industrial activity at certain of its
sites. Expenditures for remediation and environmental liabilities were $34.5 million in 2008,
$19.5 million in 2007, $12.6 million in 2006, and are estimated at $47.1 million for the years 2009
through 2013. These amounts do not consider potential recoveries from other parties. The
Company has taken an active role in identifying and providing for these costs and, in
management’s opinion, the liabilities for all environmental matters which are probable and
reasonably estimable have been accrued and totaled $89.5 million at December 31, 2008.
Although it is not possible to predict with certainty the outcome of these environmental matters, or
the ultimate costs of remediation, management does not believe that any reasonably possible
expenditures that may be incurred in excess of the liabilities accrued should exceed $70.0 million
in the aggregate. Management also does not believe that these expenditures should have a
material adverse effect on the Company’s financial position, results of operations, liquidity or
capital resources for any year.
Required:
a. How does Merck account for environmental liabilities that are probable and reasonably
estimable? At December 31, 2008, how much were these liabilities?
b. How does Merck account for environmental liabilities that are reasonably possible? At
December 31, 2008, how much were these liabilities?
c. The footnote mentions $47.1 million and $89.5 million as estimated future expenditures.
Explain what each of these amounts represents and why they differ.
d. Use the financial statement effects template below, to record Merck’s 2008 capital
expenditures for environmental protection facilities and to record the 2008 remediation and
environmental expenditures.

Transaction
Asset
+
Assets = ities
+
Capital
+
2008 capital
expenditures = – =
2008
remediation
and = – =
environmental
expenditures

Answer:
a. Merck accrues a liability for environmental liabilities that the company’s management team
believes are probable and reasonably estimable. This is current GAAP. At December 31, 2008,
Merck had accrued on its balance sheet, $89.5 million for such liabilities.
b. Merck does not accrue a liability for environmental costs that are reasonably possible. Instead,
Merck discloses these potential future payments in a footnote. At December 31, 2008, these
liabilities amounted to an additional $70 million.
c. The $89.5 million is the total accrual on Merck’s balance sheet at year end. The $47.1 million is
the amount that Merck anticipates paying out in the coming five years (2009 to 2013). The
difference of $42.4 million will be paid in 2014 and later.
d.

Transaction
Asset
+
Assets = ities
+
Capital
+
2008 capital -18.7 +18.7 million
expenditures million (PPE) = – =
2008
remediation -34.5
-34.5 million
and million = (Accrued – =
environmental liabilities)
expenditures
Topic: Interpreting total liabilities footnote

LO: 1 & 2
5. Progressive Corporation (a property and casualty insurance company) reported the following
in its 2008 annual report:

Unearned premiums $ 4,175.9 $ 4,210.4
Loss reserves 6,177.4 5,942.7
Accounts payable, accrued
expenses and other liabilities 1,506.4 1,580.6
Long-term debt 2,175.5 2,173.9
Total liabilities $14,035.2 $13,907.6
Required:
a. Explain in layman’s terms the liabilities labeled “Unearned premiums” and “Loss reserves.”
b. What percentage of Progressive’s total liabilities relates to current operating liabilities? Do you
believe that this number is higher than most companies or lower? Why?
c. Which current liability reported by Progressive is the least reliably measured – that is, the most
subjective? Explain.

Answer:
a. Unearned premiums are cash premiums received from customers for future insurance
coverage. These premiums cover the future and thus Progressive has not earned them yet – they
represent a liability until time passes and the premiums are earnings.
Loss reserves are anticipated payments for claims made under current insurance policies. These
future payments are liabilities now because they arise from insurance coverage during the current
and past years. As the company recognizes premiums as revenue, the company estimates how
many claims will arise from current insurance policies and accrues the eventual (estimated)
payments. This is evidence of the matching principle.
b. ($4,175.9 + $6,177.4 + $1,506.4)/ $14,035.2 = 84.5% This is higher than most companies. It
arises from unearned premiums and loss reserves due to the nature of the insurance industry.
c. The loss reserve is the anticipated future payments and is the most subjective current liability
on Progressive’s balance sheet. To estimate the reserve, Progressive must estimate the number
of claims that will be made, the amount that will be ultimately paid out, and the timing of such
future payments. Such estimates are very difficult to audit.
Unearned premiums are more reliable (less subjective) because cash prepayments can be
verified and insurance policy terms are easy to confirm and the unearned premium calculation is
straight forward.
Accounts payable are more reliably measured because they are typically recorded when bills
received or shipping documents arrive with goods. Accrued expenses are more subjective than
accounts payable but likely less subjective than loss reserves.

Topic: Interpreting long-term debt footnote
LO: 2
6. Progressive Corporation (a property and casualty insurance company) reported the following
in its 2008 annual report:
2008 2007
(in millions) Carrying Carrying
Value Fair Value Value Fair Value
6.375% Senior Notes due 2012 (issued:
$350.0, December 2001) $ 348.9 $ 355.3 $ 348.6 $ 367.8
7% Notes due 2013 (issued: $150.0,
October 1993) 149.3 154.3 149.2 162.9
6 5⁄8% Senior Notes due 2029 (issued:
$300.0, March 1999) 294.6 272.0 294.4 311.8
6.25% Senior Notes due 2032 (issued:
$400.0, November 2002) 394.0 350.0 393.9 397.6
6.70% Fixed-to-Floating Rate Junior
Subordinated Debentures due 2067
(issued: $1,000.0, June 2007 988.7 450.0 987.8 936.5
$2,175.5 $1,581.6 $2,173.9 $2,176.6
On December 31, 2008, we entered into a 364-Day Secured Liquidity Credit Facility Agreement
with National City Bank (NCB). Under this agreement, we may borrow up to $125 million, which
may be increased to $150 million at our request but subject to NCB’s discretion. The purpose of
the credit facility is to provide liquidity in the event of disruptions in our cash management
operations, such as disruptions in the financial markets, that affect our ability to transfer or
receive funds. The revolving credit facility agreement discussed above replaced an uncommitted
line of credit with NCB in the principal amount of $125 million. Under this terminated agreement,
no commitment fees were required to be paid and there were no rating triggers. Interest on
amounts borrowed would have generally accrued at the one-month LIBOR plus .375%. We had
no borrowings under this arrangement during 2008, 2007, or 2006.
Aggregate principal payments on debt outstanding at December 31, 2008, are $0 for 2009, 2010,
and 2011, $350.0 million for 2012, $150.0 million for 2013, and $1.7 billion thereafter.
Required:
a. What amount does Progressive report for long-term debt on its balance sheet?
b. Why is there a difference between the fair value and the carrying value of Progressive’s long-
term debt?
c. Were the 6.375% notes originally issued at par, at a discount or at a premium? How do you
know?
d. What is the amount of the unamortized discount on the 7% notes as of December 31, 2008?
e. What cash interest payment did Progressive make for the 6 5/8 notes in 2008? What interest
expense did Progressive record for these notes during 2008? Assume for this question that
Progressive pays interest annually.
f. If Progressive were to repurchase all of its bonds on January 1, 2009, how would the income
statement be affected?
g. How much does the company owe under the line of credit with National City Bank at year end?
Why does Progressive discuss this in its debt footnote?
h. What is the current portion of long-term debt at December 31, 2008?

Answer:
a. Progressive reports the carrying value (net book value) of long-term debt on its balance sheet.
As of December 31, 2008 this was $2,175.5 million.
b. Carrying value and Fair Value differ because the prevailing market rates of interest are higher
than the notes’ coupon (stated) interest rate. Thus, the fair value of the notes is less than their net
book value.
c. The 6.375% notes were originally issued at a discount because the carrying value of $348.9
million is less than the face value of $350 million.
d. The unamortized discount on the 7% notes as of December 31, 2008 is $ 700,000 ($150
million - $149.3 million).
e. Progressive paid cash interest of $19.875 million for the 6 5/8% notes ($300 million × 6 5/8 %).
The interest expense for these notes was $20.075 million. Interest expense on a bond issued at a
discount = cash interest paid + amortization of bond discount. During the year, the bond’s
carrying value increased from $294.4 million to $294.6 million, an increase of $0.2 million.
Therefore, interest expense = $19.875 million + $0.2 million = $20.075 million.
f. Because the market value of Progressive’s notes is less than its book value, Progressive will
have to report this difference as a gain on the income statement when it repurchases the bonds.
g. Progressive does not owe anything under the line of credit at year end. The $125 million line of
credit ensures that the company has easy access to significant amounts of cash if the need
arises. This reduces liquidity risk to investors and creditors, which could reduce Progressive’s
cost of capital.
h. The footnote reveals that $0 is due in 2009, thus, there is no current portion of long-term debt.
Topic: Preparing bond amortization table

LO: 2
7. Neel Industries recently issued $20 million of 11% coupon bonds, payable semiannually,
which mature in 15 years. The bonds were sold for $18,623,513 to yield an 12% annual rate. Use
the table below to show the amortization of the discount, interest expense, and the carrying
amount of the bonds from issuance till the end of period 4.
Interest Interest
Expense Paid Amortization Discount Bond Payable
Answer:
Interest Interest
Expense Paid Amortization Discount Bond Payable
0 1,376,487 18,623,513
1 1,117,411 1,100,000 -17,411 1,359,076 18,640,924
2 1,118,455 1,100,000 -18,455 1,340,621 18,659,379
3 1,119,563 1,100,000 -19,563 1,321,058 18,678,942
4 1,120,737 1,100,000 -20,737 1,300,321 18,699,679

LO: 2, 3
8. Following is the debt footnote from the Lowe’s 2008 annual report (In millions):
Balance Balance
(in millions) Fiscal Year January 30, February 1,
Debt Category Interest Rates of Maturity 2009 2008
1
Secured debt:
Mortgage notes 7.00 to 8.25% 2018 $ 27 $ 33
Unsecured debt:
Debentures 6.50 to 6.88% 2029 694 694
Notes 8.25% 2010 500 499
Medium-term notes - series A 8.19 to 8.20% 2023 15 20
Medium-term notes - series B2 7.11 to 7.61% 2037 217 217
Senior notes 5.00 to 6.65% 2037 3,273 3,271
Convertible notes - 511
Capital leases and other 2030 347 371
Total long-term debt 5,073 5,616
Less current maturities 34 40
Long-term debt, excluding
current maturities $5,039 $5,576
1
Real properties with an aggregate book value of $35 million were pledged as collateral at
January 30, 2009, for secured debt.
2
Approximately 46% of these medium-term notes may be put at the option of the holder on the
20th anniversary of the issue at par value. The medium-term notes were issued in 1997. None
of these notes are currently putable.
Required:
a. What is the amount of long-term debt on Lowe’s balance sheet as of January 30, 2009?
b. What proportion of Lowe’s long-term debt is due before January 30, 2010?
c. How much of Lowe’s assets were pledged as collateral as of January 30, 2009?
d. What effect, if any, does Lowe’s collateral have on its debt rating and interest costs?
e. Assume that the Senior notes outstanding at the beginning of the year were 5.2% notes issued
to yield 5.5%. At the beginning of the year, these notes had an unamortized discount of $12
million. What cash interest payment did Lowe’s make for these notes? What interest expense did
Lowe’s record for these notes during the current year?
f. Explain in layman’s terms, the put feature on Lowe’s medium-term notes.
Answer: a. Total long-term debt at January 30, 2009 was $5,073 million.
b. Current portion is $34 million which is 0.67% of total debt outstanding ($34 / $5,073 =
0.00670).
c. $35 million of assets was pledged as collateral.
d. To the extent debt is secured, the debt holder is in a preferred position relative to other
creditors. The interest costs should be less to reflect the reduced credit risk.
e. Interest expense = Net book value of debt × effective interest rate = $3,271 million × 0.055 =
$179.91 million.
Cash paid for interest = Face value of debt × coupon rate = ($3,271 million + $12 million) × 0.52 =
$170.72 million.
f. With a put feature, bond holders can sell the bonds back to Lowe’s for the face value of the
bonds. Bond holders would only exercise this option if the fair value of the bonds was less than
face value on the anniversary date.

LO: 2
9. Following is a footnote for Abbott Laboratories 2008 annual report:
The following is a summary of long-term debt at December 31 (in millions):
2008 2007 2006

Various notes, due 2008 - - $1,095
3.5% Notes, due 2009 - $500 500
5.375% Notes, due 2009 - 500 500
1.51% Yen notes, due 2010 $157 135 129
3.75% Notes, due 2011 500 500 500
5.6% Notes, due 2011 1,500 1,500 1,500
5.15% Notes, due 2012 1,000 1,000 -
1.95% Yen notes, due 2013 262 226 216
4.35% Notes, due 2014 500 500 500
5.875% Notes, due 2016 2,000 2,000 2,000
5.6% Notes, due 2017 1,500 1,500 -
6.15% Notes, due 2037 1,000 1,000 -
Other, including fair value adjustments
relating to interest rate hedge contracts
designated as fair value hedges 294 127 70
Total, net of current maturities 8,713 9,488 7,010
Current maturities of long-term debt 1,041 898 95
Total carrying amount $9,754 $10,386 $7,105
Principal payments required on long-term debt outstanding at December 31, 2008, are $1.0 billion
in 2009, $160 million in 2010, $2.0 billion in 2011, $1.0 billion in 2012, $265 million in 2013 and
$5.1 billion thereafter.
At December 31, 2008, Abbott's long-term debt rating was AA by Standard & Poor's Corporation
and A1 by Moody's Investors Service. Abbott has readily available financial resources, including
unused lines of credit of $5.3 billion that support commercial paper borrowing arrangements of
which a $2.3 billion facility expires in December 2009 and a $3.0 billion facility expires in 2012.
Related compensating balances, which are subject to withdrawal by Abbott at its option, and
commitment fees are not material. Abbott's access to short-term financing has not been affected
by the recent credit market conditions. Abbott's weighted-average interest rate on short-term
borrowings was 0.5% at December 31, 2008, 3.7% at December 31, 2007 and 5.0% at
December 31, 2006.
The fair value of long-term debt at December 31, 2008 and 2007 amounted to $10.5 billion and
$10.6 billion, respectively (average interest rates of 5.2% and 5.0%, respectively) with maturities
through 2037.
Required:
a. What is a Yen note? Why might Abbott Labs issue such notes?
b. What proportion of long-term debt will Abbott Labs repay in 2009?
c. Does Abbott Labs have unrealized gains or losses on its long-term debt at December 31, 2007
and 2008? Quantify the gains/losses each year.
d. How much does the company owe under the line of credit at year end? Why does Abbott Labs
discuss this in its debt footnote?
e. What is the purpose of an interest rate hedge contract?
f. How would you characterize Abbott Labs’ default risk?

Answer:
a. Yen notes are bonds issued in Japanese yen. Abbott Labs might issue such notes because
they have operations in Japan and having to repay debt in the local currency provides an
operational currency hedge.
b. Abbott Labs will repay 10.67% of its long-term debt in 2009 ($1,041 / $9,754 = 0.10673).
c. At December 31, 2007 Abbott Labs had an unrealized loss of $214 million on its long-term
debt. The fair value exceeded book value, which means the company owes more (in market
value terms) than their balance sheet reports (fair value of $10.6 billion compared to book value
of $10.386 billion). At December 31, 2008, fair value of the debt was $10.5 billion and net book
value was $9.754. Thus, in 2008, there was an unrealized gain of $746 million.
d. Abbott Labs does not owe anything under the line of credit at year end. The $5.3 billion line of
credit ensures that the company has easy access to significant amounts of cash if the need
arises. This reduces liquidity risk to investors and creditors, which could reduce Abbott Labs’ cost
of capital.
e. An interest rate hedge contract allows a business to offset exposure to the risk of interest rate
fluctuations. According to Abbott Lab’s annual report, “the effect of these hedges is to change the
fixed interest rate to a variable rate.”
f. Abbott Labs has a very low risk of default. Both Standard & Poor’s and Moody’s give Abbott
Labs a high corporate debt rating (upper-medium grade or higher) meaning that Abbott Labs has
a high creditworthiness.
Topic: Credit rating ratios and bond ratings

LO: 3
10. RE Company reported the following in its 2007 annual report (in millions):
Sales $150
Earnings before interest and taxes 90
Interest expense 6.4
Total liabilities 250
Total equity 325
Required:
a. Calculate RE Company’s times interest earned ratios.
b. Calculate RE Company’s liabilities-to-equity ratio.
c. What type of ratio are these two ratios? How do they affect RE’s credit rating?
d. According to Standard & Poor’s, what are the two types of risk factors considered in credit
analysis?
Answer:
a. Times interest earned = $90 / $6.4 = 14.06.
b. Liabilities-to-equity = $250 / $325 = 77%
c. These are both solvency ratios and they measure a company’s ability to meet its debt
obligations – both periodic interest payments and principal repayments. These ratios are
indicators of credit risk. Times interest earned ratio provides an indication of the company’s ability
to meet its interest obligations. The higher this ratio, the lower the credit risk. The Liabilities to
Equity ratio shows the level of debt relative to owners’ financing (equity). The higher this ratio, the
higher the credit risk. The higher the credit risk the worse the company’s credit rating.
d. According to Standard & Poor’s, the two types of risk factors considered in credit analysis are
business risk and financial risk

Essay Questions
Topic: Understanding accruals and earnings management
LO: 1
1. Progressive Corp. (a property and casualty insurance company) reported “Loss and loss
adjustment expense reserves” (an operating liability) of $6,177.4 million its 2008 annual report.
What is the allowance for loan and lease losses? How could Progressive ‘s managers use the
reserve to manage income? Provide a numerical example of the income statement effect of this
sort of earnings management.
Answer: The allowance relates to anticipated payments for future insurance claims. This is a
liabilities now because the future claims arise from insurance coverage during the current and
prior years. Because loss reserves are the anticipated future payments, the number on the
balance sheet is very subjective. To estimate the reserve, Bank of America must estimate the
number of claims that will be made, the amount that will be ultimately paid out, and the timing of
such future payments. Such estimates are very difficult to audit. This makes it easy for
Progressive managers to manipulate the reserve number.
If managers want to increase current period income they could underestimate the reserve. This
would boost net income because the loss expense would be lower. Then in the next period, the
losses would be more than the accrual and next period earnings would decrease. For example, if
managers deliberately underestimated the reserve by $75 million (accruing $6,102.4 million
instead of $6,177.4 million) then 2008 income before tax would be higher by $25 million and 2009
or other future years’ income before tax would be lower by that amount.
Topic: Leaning on the trade

LO: 1
2. In an effort to improve cash flow, your supervisor suggests paying trade creditors more slowly.
Is such a move always advantageous for a company?
Answer: By extending payables, companies can avail themselves of a source of low cost funds.
They are, in effect, using other companies’ funds to finance their operations. This is known as
“leaning on the trade” and it is a way to use accounts payable to finance the working capital of a
company. Leaning on the trade improves RNOA by reducing NOA with no effect on NOPAT so
long as the company does not take undue advantage of its suppliers. If the company lengthens
payables too much, the company’s reputation may be impugned and in the extreme, the credit
rating may worsen.

LO: 1 & 2
3. What are the requirements for determining the financial reporting of a contingent liability? Why
would a company want to keep its contingent liability as low as possible? How could a company
manipulate contingent liability to its advantage?
Answer: A contingent liability is an uncertain accrual. The obligation must be “probable” and the
amount “estimable” in order to require reporting on the face of the financial statements.
A company would like to keep its contingent liability as low as possible as it appears on the
balance sheet of a company as a liability. If the accruals are underestimated, it means that the
income and retained earnings are overestimated.
As a company can determine the amount of its contingent liability and whether its “probable” or
“reasonably possible”, it could choose to aggressively recognize these as part of a “big bath” to
relieve future periods of expense or provide a cookie jar if the expenses are over estimated.

Topic: Gains (loss) on repurchase of debt
LO: 2
4. What is the difference between the reported gain (loss) on debt repurchase and the economic
gain (loss) on the repurchase? How should such gains / losses be analyzed? Why are current
values not reflected on a company’s balance sheet?
Answer: GAAP recognizes a gain (loss) on debt repurchase as the carrying amount of the debt
less the repurchase price. In addition, gains (losses) can only be reported as extraordinary items
provided that they meet the tests of both unusual and infrequent. Aside from tax effects, there is
no economic gain (loss), despite the accounting treatment.
Gains (losses) are nonoperating and transitory. Further, they have no economic substance.
Current values for debt issues are not reflected on the balance sheet, and hence the income
statement, due to the presumption that debt will not be retired prior to maturity and, at maturity, its
market value will equal the face amount that will be repaid.
Topic: Gains (losses) on bond repurchases as extraordinary items

LO: 2
5. Most gains/losses on bond repurchases are reported as part of income from continuing
operations. Why aren’t these gains/losses reported more often as an extraordinary item (net of
tax) below income from continuing operations?
Answer: Gains/losses on band repurchases can only be reported as an extraordinary item if the
transaction meets the criteria of unusual or infrequent. Relatively few debt retirements meet
these criteria.
Topic: Effective cost of debt

LO: 2 & 3
6. What determines the effective cost of debt?
Answer: The effective cost of debt is determined by the price at which a bond is issued. If a bond
is issued at par, its effective cost of debt is the cash interest paid. However in many cases debt is
either issued at a discount or a premium. The effective cost of debt is always equal to the market
rate of interest, regardless of the debt’s coupon rate. It is the amount that is reported on the
issuer’s income statement as interest expense, and it is usually different from cash interest paid.
Topic: Bond credit ratings

LO: 3
7. What are three financial factors used to determine bond quality (i.e., AAA to CCC)? Discuss
why each of these factors is important to pricing debt.
Answer: Liquidity – This is an important indicator of the firm’s ability to make short term financial
obligations. The more liquid the firm, the more cash on hand to pay expenses and to create new
business opportunities. Low liquidity indicates a higher risk investment.
Solvency – This is an important indicator of long-term ability to pay off debt. Firms with large
amounts of long-term debt are riskier investments due to the higher financial goals they must
achieve. Lower solvency indicates a riskier bond rating.
Profitability – This measure is indicative of the ability of the company to generate positive free
cash flows. The more profitable the company, the better the debt rating it should have.

Topic: Ratios indicating default risk
LO: 3
8. What ratios do investor’s use to measure default risk? What are some non-ratio factors used
to determine debt ratings?
Answer:
Investors use a number of critical ratios when determining the different classes of risk, including
 EBIT Interest coverage
 EBITDA from operations / total debt
 Funds from operations / total debt
 Free operating cash flow / total debt
 Return on Capital
 Operating Income / Sales
 Long-Term Debt / Capital
 Total Debt / Capital
Other aspects that are considered in debt ratings are:

 Collateral – security provided on debt; the extent the debt is secured impacts on the
position a debtholder has regarding repayments of debt
 Covenants – restrictions enforced by debtholders on a company
 Options – ability of debtholder to convert debt to stock or the allowance of a company to
repurchase the debt prior to maturity.
Topic: Bond default

LO: 3
9. Define bond default. What are some potential ramifications if a company defaults on its debt?
Answer: Default is the nonpayment of interest and principal of the bond. If a company defaults on
its debt, bondholders may force the company into bankruptcy and require asset liquidation to
settle debt obligations. Default often leaves the bondholder with a loss. The analysis of the risk of
nonpayment is the work that goes into pricing bonds. S&P uses financial ratios related to a
company’s liquidity, profitability, and solvency to determine a company’s ability to pay its debt.


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Module 8

Reporting and Analyzing Nonowner

© Cambridge Business Publishers, 2010

Topic: Deferred revenue

Topic: Accrued liabilities

Topic: Income shifting

Topic: Contingent liabilities

Cambridge Business Publishers, ©2010

Topic: Reporting of current portion of long-term debt.

Topic: Secondary market for bonds

Topic: Bond prices

Topic: Reporting gains (losses) on bond repurchase

© Cambridge Business Publishers, 2010

Topic: Cost of debt

Topic: Cost of Debt

Topic: Debt ratings

Topic: Cost of Debt

Cambridge Business Publishers, ©2010

© Cambridge Business Publishers, 2010

Topic: Current liabilities

Topic: Interest accrual – Numerical calculations required

Cambridge Business Publishers, ©2010

Topic: Transaction analysis of current liabilities– Numerical calculations required

Topic: Reporting of accruals

© Cambridge Business Publishers, 2010

Topic: Current liability

Topic: Accounting for short-term debt– Numerical calculations required

Cambridge Business Publishers, ©2010

(in thousands) 2008

Accounts payable turnover for 2008 is:

Accounts payable days outstanding for 2008 is:

© Cambridge Business Publishers, 2010

American Eagle Outfitters

Topic: Interest payment– Numerical calculations required

Cambridge Business Publishers, ©2010

Topic: Understanding bonds

Topic: Bond pricing– Numerical calculations required

© Cambridge Business Publishers, 2010

Topic: Effective rate– Numerical calculations required

Topic: Bond pricing– Numerical calculations required

Cambridge Business Publishers, ©2010

Topic: Credit ratings

Topic: Credit analysis

© Cambridge Business Publishers, 2010

Topic: Credit analysis

Topic: Credit analysis

Cambridge Business Publishers, ©2010

Topic: Accounts payable discounts– Numerical calculations required

Topic: Interest accrual

Answer: Interest expense = $8,000 × 5% × (6/12) = $200.

© Cambridge Business Publishers, 2010

Date of note Principal Coupon Rate Term

Topic: Transaction analysis

Cambridge Business Publishers, ©2010

Balance Sheet Income Statement

Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net

Cash Noncash Liabil- Contrib. Earned Rev- Expen- Net

Topic: Computing and interpreting accounts payable ratios

(in millions) 2008

© Cambridge Business Publishers, 2010