7-1
ANSWERS TO QUESTIONS – CHAPTER 7
1. Cash payments to creditors is an asset use transaction. This type of transaction will
reduce both assets and liabilities.
3. The entry to record accrued interest consists of an increase to Interest Expense and an
increase to Interest Payable. The transaction is a claims exchange transaction and
reduces equity and increases liabilities.
5. The going concern assumption states that businesses will continue to operate in the future.
6. An adjustment for accrued but unpaid interest is necessary for the accounting records to
reflect the correct amount of liability and the correct amount of interest expense.
9. A contingent liability is a potential liability arising from a past event.
10. The three categories of contingent liabilities are:
11. Only those contingent liabilities that are probable and reasonably estimated are recorded
on the books.
liabilities that are remote are not recorded or disclosed in the financial statements.
14. A warranty is a guarantee of a product or service.
15. Recognizing future warranty obligations will increase liabilities and decrease equity. It
has the effect of increasing expenses thereby decreasing net income.
18.
Principal
Payment
Interest
Reduction
Period
Bal. 1/1
12/31
Exp. 8%
of Prin.
1
$ 72,000
$16,246
$5,760
$10,486
2
61,514
16,246
4,921
11,325
3
50,189
19. A line of credit is a preapproved amount of credit that is available to a business to use as
20. A business may need to borrow funds for a short period of time or a longer period. Most
short-term financing is in the form of loans from financial institutions. However, when a
21. One of the primary advantages of bond financing is that the company can usually obtain
22. One of the primary disadvantages of a bond issue is the restrictions that may be placed on
23. One reason that a company may be able to borrow money more cheaply if bonds are
issued rather than borrowing the money from a financial institution is the way financial
institutions make their money. Banks receive money from customers through
7-3
24. The issuance of $100,000, 5%, 10-year bonds at face value will result in an increase to
25. The mechanism that is used to adjust the stated interest rate to the market rate of interest
is called bond discount and bond premium.
26. When the effective interest rate is higher than the stated interest rate, the bond will sell at
27. The issuance of bonds by a company is an asset source transaction. Assets increase and
liabilities increase.
28. The passage of time is usually the cause of the effective interest rate and the stated
interest rate being different. When bonds are issued, the interest rate is set, usually at the
29. The cash received for the bond will be $975 ($1,000 x .975).
31. The carrying value of the bonds is $19,800 ($25,000 face minus $5,200 discount). The
carrying value of the bond represents the liability at any point in time.
32. When the effective interest rate is higher than the stated interest rate, interest expense
33. A classified balance sheet is one that separates assets and liabilities into current and
noncurrent items.
7-4
SOLUTIONS TO EXERCISES – CHAPTER 7
EXERCISE 7-1
a. $-0-. Interest will be paid at maturity of the note, April 30, 2014.
d. $61,800 [$60,000 principal + $1,800 interest ($60,000 x 6% x 6/12)]
7-6
EXERCISE 7-3
a. Book Sales $215,000
b. Total Sales:
Event 1 $215,000
Total $375,000
Total Sales $375,000
7-8
EXERCISE 7-5
a. There are three categories of contingent liabilities:
1. Probable and can be reasonably estimated. This category of contingent
liabilities is recognized in the financial statements.
b.
1. This is a contingent liability. The event occurred. The lawsuit has been filed, and
the “attorney knows that the company will have to pay…”. Therefore, the liability
3. This is not a contingent liability since the likelihood of damage is not certain. It is
not recorded on the books or mentioned in the financial statements.
EXERCISE 7-6
a.
Devon’s Computers
Financial Statements
Income Statement
Sales Revenue
$280,000
Cost of Goods Sold
(150,000)
Gross Margin
130,000
Warranty Expense
(14,000)
Net Income
$ 116,000
Statement of Cash Flows
Cash Flows From Operating Activities:
Inflow from Customers
$280,000
Outflow for Inventory
(150,000)
7-9
Outflow for Warranty Expense
(1,545)
Net Cash Flow from Operating Activities
$128,455
Cash Flows From Investing Activities
-0-
Cash Flows From Financing Activities
-0-
Net Change in Cash
128,455
Plus: Beginning Cash Balance
-0-
Ending Cash Balance
$128,455
b. The difference between net income and cash flows from operating activities is the
EXERCISE 7-7
a.
Event
Assets
=
Liab.
+
Equity
Rev.
−
Exp.
=
Net Inc.
Cash Flow
Est.
NA
+
−
NA
+
−
NA
Pd.
−
−
NA
NA
NA
NA
− OA
c. EXERCISE 7-8
a. Year 1
Option 1 – annual interest only:
$120,000 x 8% = $9,600
Note: The amount of interest paid in year 1 is the same under both options because no
payment was made on the principal until the end of the year under option two.
7-10
b. Year 2
Option 1 – annual interest only:
$120,000 x 8% = $9,600
Option 2 – annual interest and $12,000 on principal:
Note: Under option two, less interest will be paid in year two and in future years because
the amount subject to interest is less.
c. Under option one, only annual interest is paid. This is a desirable option if a company
EXERCISE 7-9
Hatch Co.
Amortization Schedule
$100,000, 4-Yr. Term Note, 6% Interest Rate
Year
Prin. Bal. on
Jan 1
Cash Pay. Dec.
31
Applied to
Interest
Applied to
Principal
Prin. Bal.
End of Period
2014
$100,000
$28,859
$6,000
$22,859
$77,141
2015
77,141
28,859
4,628
24,231
52,910
2016
52,910
28,859
3,175
25,684
27,226
2017
27,226
28,859
1,633*
27,226
-0-
*Adjusted due to rounding.
EXERCISE 7-10
The first four years are provided for the use of the instructor:
Mills Company
Amortization Schedule
$60,000, 10-Yr. Term Note, 6% Interest Rate
Prin. Bal. on
Cash Pay. Dec.
Applied to
Applied to
Prin Bal.
7-11
Year
Jan 1
31
Interest
Principal
End of Period
2014
$60,000
$8,152
$3,600
$4,552
$55,448
2015
55,448
8,152
3,327
4,825
50,623
2016
50,623
8,152
3,037
5,115
45,508
2017
45,508
8,152
2,730
5,422
40,086
a.
(1) $3,600
(2) $4,552
EXERCISE 7-11
a. $2,500 $50,000 = .05 or 5
Effect of Transactions on Financial Statements
Balance Sheet
Income Statement
Statement of
No.
Assets
=
Liab.
+
S. Equity
Rev.
−
Exp.
=
Net Inc.
Cash Flows
2014
1.
50,000
=
50,000
+
NA
NA
−
NA
=
NA
50,000 FA
2015
2.
(11,549)
=
(9,497)
+
(2,052)
NA
−
2,052
=
(2,052)
(9,497) FA
(2,052) OA
c. (1)
Revenue
$75,000
Expenses
Operating Expenses
$35,000
Interest Expense
2,500
Total Expenses
(37,500)
Net Income
$ 32,500
(2) Outflow for Expenses
(37,500)
Net Cash Flow from Operating Activities
$32,500