CHAPTER 9
Financing Activities
THINKING BEYOND THE QUESTION
What are the fundamental accounting issues associated with financing activities?
Debt increases a company’s financial risk. The debt and interest on the
debt have to be paid by the borrower. If a company fails to make these
QUESTIONS
Q9-1 Liabilities are sometimes liquidated with resources other than cash, but it
is cash that is most often used. Therefore, separation of liabilities into
Q9-2 Debentures are unsecured bonds. This means there is no specific collat-
eral backing for the bonds. Specific assets are not pledged as security.
Instead, bondholders rely on the general credit worthiness of the compa-
234 Chapter 9
Q9-3 The stated rate (nominal rate) is the interest rate that is printed on the
face of the bond. When multiplied by the face value of the bond, it deter-
Q9-4 A capital lease is simply a means of financing the acquisition of assets.
For example, a capital lease has the same economic effects as if a com-
pany borrowed money from a bank and then used that money to pur-
chase a resource outright from a seller. First, in both a purchase and a
Q9-5 A contingency is an existing condition that may result in an economic ef-
fect if a future event occurs. A liability, on the other hand, is an existing
Q9-6 A contingency arises from a possibility that some future event might take
place. Whether the future event will occur or not is uncertain. A commit-
Q9-7 I do not agree. Contributed capital includes only those items of stock-
holders’ equity that resulted from a direct contribution by the owners to
Financing Activities 235
Q9-8 Yes, I agree. Most, but not all, current liabilities arise from operating activ-
(1) Accounts payable generally arise from purchasing inventory on
credit. This is an operating activity because it deals with providing
goods and services to customers. (2) Income taxes payable arise
from providing goods and services to customers profitably. There-
Q9-9 Beach Club Inc. should increase its cash account by $200,000, increase
Q9–10 Most companies report the detailed changes in stockholders’ equity ac-
counts in a financial statement titled Statement of Stockholders’ Equity
Q9–11 The difference is that the purchase and sale of widgets involves an exter-
nal party—a customer. Revenues are generated from selling goods and
Q9–12 The three terms concern the distribution of dividends. The date of decla-
ration is the date that the board of directors announce that a dividend will
be paid. The date of record establishes who will receive the dividend.
236 Chapter 9
Q9–13 Instead of voting rights, the preferred stockholders generally have a divi-
dend preference and a liquidation preference over common stockholders.
That is, if dividends are to be paid in any given period, the preferred divi-
Q9–14 The dividend preference only protects preferred shareholders during the
current period. If preferred stock is not cumulative, a choice by the Board
of Directors to bypass dividends in a given year means the preferred div-
Q9–15 This is the risk-return trade-off at work. Investors are rewarded for taking
on risk. The more risk an investor is willing to accept, the greater are the
potential rewards. If an investor desires to limit risk, the investor automat-
Q9–16 Contributed capital is the term that describes direct stockholder invest-
ments in a corporation. When an investor purchases stock from a corpora-
tion, the funds collected by the corporation are called contributed capital.
Common stock is that category of stock that controls the corporation
Financing Activities 237
have voting rights.
EXERCISES
E9-1 Definitions of all terms are listed in the glossary.
0.64993 (5 periods, 9%)
PV of bonds = $311,172 + $649,930
0.78353 (5 periods, 5%)
E9-3 a. The bonds sold at a discount. Buyers paid less than the face value of
the bonds so they could earn a higher return on the bonds than the
stated rate. Therefore, interest expense recognized by the issuer
238 Chapter 9
E9-4 a. $746,320 Interest expense would be the effective rate times the
present value of the bonds at the beginning of the 2008
fiscal year: 0.08 × $9,329,000 = $746,320.
b. $9,375,320 The net liability is the present value of the bonds on
E9-5 a. Income statement: The income statement would report a gain on ex-
tinguishment of debt of $11,400 ($186,400 − $175,000). This would
raise net income by the same amount (ignoring taxes).
E9-6
ASSETS
=
LIABILITIES
+
OWNERS’ EQUITY
Date
Accounts
Other
Assets
Contributed
Capital
Retained
Earnings
a.
Cash
Bonds Payable
360,728
Cash
Interest Expense
Bonds Payable
c.
Cash
Financing Activities 239
E9-7 a. $629,503
b.
A
B
C
D
E
F
Year
PV at
Beginning
of Year
Interest
Incurred
(Column B ×
Interest Rate)
Amount
Paid
Amortization
of Principal
(Column C –
Column D)
Value at End
of Year
(Column B +
Column E)
1
629,503
37,770
42,000
(4,230)
625,273
2
625,273
37,516
42,000
(4,484)
620,789
3
620,789
37,247
42,000
(4,753)
616,036
4
616,036
36,962
42,000
(5,038)
610,998
5
610,998
36,660
(5,340)
605,658
6
605,658
36,339
42,000
(5,661)
600,000*
c.
ASSETS
=
LIABILITIES
+
OWNERS’ EQUITY
Date
Accounts
Other
Assets
Contributed
Capital
Retained
Earnings
Jan. 1, 2007
Cash
Bonds Payable
629,503
Dec. 31, 2007
Cash
Interest Expense
Bonds Payable
Dec. 31, 2012
Cash
Interest Expense
Bonds Payable
Dec. 31, 2012
Cash
Bonds Payable
The bonds sold for an amount less than the face amount; i.e., at a dis-
count. This occurred because the bonds will pay interest at a lesser rate
than the market rate.
(continued)
240 Chapter 9
The bonds sold for an amount greater than the face amount; i.e., at a
premium. This occurred because the bonds will pay interest at a greater
rate than the market rate.
$1,283,506 For the bonds in part (b), those sold at a premium, the
interest expense over the five-year period would be the
E9-9 This exercise requires students to determine the present value of lease
payments and to separate the first lease payment into its interest compo-
nent and its reduction of liability component. Entries are required (a) at
the beginning of the lease and (b) at the date of the first lease payment.
ASSETS
=
LIABILITIES
+
OWNERS’ EQUITY
Accounts
Other
Assets
Contributed
Capital
Retained
Earnings
Diagnostic Equipment
Capital Lease Obligation
Financing Activities 241
ASSETS
=
LIABILITIES
+
OWNERS’ EQUITY
Accounts
Other
Assets
Contributed
Capital
Retained
Earnings
E9–10 a. Liability; Notes Payable; current
E9–11 1. f 5. g 9. n 13. d
E9–12 a. A charter is the legal document granted by a state government that
d. 79,000 Outstanding shares is the number of shares held by
stockholders. In this case, 80,000 were initially sold, but
1,000 have been reacquired.
Cash
Capital Lease Obligation
Interest Expense
242 Chapter 9
E9–13 a. 1 million Authorized shares is the number permitted by the com-
pany’s charter.
E9–14
Quick Chips Company
Stockholders’ Equity
Stockholders’ Equity: 2009 2008
Common stock, $0.25 par value,
600,000 shares authorized,
E9–15 a. Date of declaration: January 27
c. There are only two choices that a board of directors can make re-
garding profits. It can pay them out as dividends, or it can retain
profits for reinvestment in the company (hence the term retained
Financing Activities 243
E9–16 a. Cash dividend: There is no effect on the income statement (divi-
b. Stock dividend: There is no effect on the income statement. On the
balance sheet, Retained Earnings decreases by $21,000 and Contrib-
c. Stock split: There is no effect on the income statement. The only
f. Cash flow: Paid for dividends $(335,000)
Purchases of stock (220,000)
create net income.
E9–18 a. The increase in Retained Earnings was caused by the transfer of net
income to Retained Earnings when the revenue and expense ac-
counts were closed.
244 Chapter 9
E9–19
Year
Total
Dividends Paid
Dividends
to Preferred
Dividends
to Common
Unpaid Dividends
to Preferred
2007
$50,000
$28,000a
$22,000b
$ 0
2008
2010
0
E9–20 1. r 5. g 9. l 13. q 17. e
E9–21 a. 50,000 $2,500,000 preferred stock balance ÷ $50 par value per
share
Financing Activities 245
PROBLEMS
D. 9% The amount of interest incurred in any year divided by
its corresponding “beginning–of–year present value.” In
G. The total interest incurred, $175,560, is the total amount paid to cred-
itors for the use of their funds over the five years. That total amount
is paid out in pieces. First, an interest check is sent to creditors at
P9-2 A. 7% The bonds sold at a price of $310,394. This is a price above
face value, so the stated rate is greater than the 6% effective
rate.
To determine the stated rate:
246 Chapter 9
B. An amortization table was not part of the requirements but is helpful
to answer part B.
A
B
C
D
E
F
Year
Present
Value at
Beginning
of Year
Interest
Incurred
(B × Interest
Rate)
Amount
Paid
Amortization
of Principal
(C − D)
Value
at End of
the Year
(B + E)
The necessary entries to the accounting system are as follows:
At date of issuance
ASSETS
=
LIABILITIES
+
OWNERS’ EQUITY
Date
Accounts
Other
Assets
Contributed
Capital
Retained
Earnings
Cash
Bonds Payable
ASSETS
=
LIABILITIES
+
OWNERS’ EQUITY
Date
Accounts
Other
Assets
Contributed
Capital
Retained
Earnings
At date of last interest payment
ASSETS
=
LIABILITIES
+
OWNERS’ EQUITY
Date
Accounts
Other
Assets
Contributed
Capital
Retained
Earnings
Cash
Interest Expense
Bonds Payable
Bonds Payable
Cash
(2,376)
(2,519)
(2,670)
Financing Activities 247
B.
A
B
C
D
E
F
Period
Present
Value at
Beginning
of Period
Effective
Interest
(B × 0.07)
Interest
Payment @
0.08
Amortization
of Principal
(C – D)
Value
At End of
Period
(B + E)
C.
ASSETS
=
LIABILITIES
+
OWNERS’ EQUITY
Date
Accounts
Other
Assets
Contributed
Capital
Retained
Earnings
Cash
Interest Expense
Bonds Payable
248 Chapter 9
B. The amortization schedule would show the following:
A
B
C
D
E
F
Period
Present
Value at
Beginning
of Period
Effective
Interest
(B × 0.10)
Interest
Payment
@ 0.09
Amortization
of Principal
(C − D)
Value
at End of
Period
(B + E)
1
9,682,983
968,298
900,000
68,298
9,751,281
C.
ASSETS
=
LIABILITIES
+
OWNERS’ EQUITY
Date
Accounts
Other
Assets
Contributed
Capital
Retained
Earnings
P9-5 The price of a 10-year bond paying 8% interest, with semiannual pay-
ments, and yielding a 6% market rate would be $1,149 [($40 × 14.87747) +
2
9,751,281
975,128
900,000
75,128
9,826,409
3
9,826,409
982,641
900,000
82,641
9,909,050
4
9,909,050
990,950*
900,000
90,950
Financing Activities 249
P9-6 A. Option #1 annual payment is $14,761
B.
Total Cash
Outflow
Total Interest
Expense
C. The firm would pay more under option 2 because no principal is re-
paid until the end of the four years. Hence, the entire balance is out-
each year.
D. The better choice would depend on the firm’s cash position. If there
P9-7 A. Dealer A: Because the present value of an annuity is known
250 Chapter 9
B. Dealer A Dealer B
C. Total of payments $2,717,360 $ 2,682,530
D. If the company will finance the equipment, it should accept Dealer
E. A cash outflow will appear in the financing section each year for 10
B.
A
B
C
D
E
F
Year
Present
Value at
Beginning
of Year
Interest
Incurred
(B × Interest
Rate)
Amount
Paid
Amortization
of Principal
(C − D)
Value
at End of
the Year
(B + E)
(8,711)
(9,495)
C. The lease transaction is being used as a method of financing acqui-
sition of the asset. Therefore, every lease payment is part interest