FAR 24 - LT Debt (Financial liab) 1 - Notes Payable and Types of Notes Flashcards Preview

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Flashcards in FAR 24 - LT Debt (Financial liab) 1 - Notes Payable and Types of Notes Deck (17):
1

On October 1, 2004, Fleur Retailers signed a 4-month, 16% note payable to finance the purchase of holiday merchandise.

At that date, there was no direct method of pricing the merchandise, and the note's market rate of interest was 11%. Fleur recorded the purchase at the note's face amount. All of the merchandise was sold by December 1, 2004.
Fleur's 2004 financial statements reported interest payable and interest expense on the note for three months at 16%. All amounts due on the note were paid February 1, 2005.

As a result of Fleur's accounting treatment of the note, interest, and merchandise, which of the following items was reported correctly?
12/31/04 retained earnings
12/31/04 interest payable

12/31/04 retained earnings - No
12/31/04 interest payable - Yes
Interest expense on notes should reflect the market interest rate at the date of issuing the note. This firm is recording interest expense at the 16% stated rate rather than the 11% market rate. Thus, interest expense is incorrectly recorded.

Also, the merchandise and note should have been recorded at the present value of the note using the market interest rate. Thus, cost of goods sold is incorrectly measured. The result of these two effects is that income and retained earnings are misstated.

However, interest payable reflects the stated rate which determines the cash amount to be paid. Interest payable is correctly stated.

2

On September 1, 2003, Brak Co. borrowed on a $1,350,000 note payable from the Federal Bank.

The note bears interest at 12% and is payable in three equal annual principal payments of $450,000. On this date, the bank's prime rate was 11%. The first annual payment for interest and principal was made on September 1, 2004.

At December 31, 2004, what amount should Brak report as accrued interest payable?

$36,000
Although the question is not completely clear, interest is paid at the time each principal payment is made. Thus, on 9/1/04, after the principal payment of $450,000 (and interest as well) is made, the remaining note balance is $900,000 ($1,350,000 - $450,000). Note that only the principal payment reduces the note balance. Interest for four months to 12/31/04 is recorded in accrued interest payable: $36,000 ($900,000 x .12 x 1/3 year).

3

On October 1, 2005, Fleur Retailers signed a 4-month, 16% note payable to finance the purchase of holiday merchandise. At that date, there was no direct method of pricing the merchandise, and the note's market rate of interest was 11%.

Fleur recorded the purchase at the note's face amount. All of the merchandise was sold by December 1, 2005. Fleur's 2005 financial statements reported interest payable and interest expense on the note for three months at 16%. All amounts due on the note were paid February 1, 2006.

Fleur's 2005 cost of goods sold for the holiday merchandise was
A. Overstated by the difference between the note's face amount and the note's October 1, 2005 present value.
B. This is overstated by the difference between the note's face amount and the note's present value at October 1, 2005 plus 11% interest for two months.
C. Understated by the difference between the note's face amount and the note's October 1, 2005 present value.
D. Understated by the difference between the note's face amount and the note's October 1, 2005 present value plus 16% interest for two months.

C. The note (and merchandise) should have been recorded at its present value using the market interest rate of 11%. This rate is lower than the stated rate of 16% implying that the present value of the note (face value and interest payments at 16%) using 11% exceeds the face value of the note.

Thus, the merchandise was recorded at an amount which understated its market value. All the merchandise was sold before the end of the year causing cost of goods sold to be similarly understated.

4

T/F: Noncurrent Notes Payable are issued for the present value of all future cash flows, including Principal payments only.
are not current in the next year. Due in 2-5 years. longer would be bond payable

False. The PV of all future cash flows, including Principal and interest payments.

5

How does the Effective interest method calculate the interest expense for a period?

Interest expense for a period = market rate x beginning note balance

The difference between cash interest paid and interest expense recognized at each payment date is the amortization of discount or premium

6

T/F: At the date of issuance and subsequent balance sheets, noncurrent notes payable are reported at the PV of remaining payments, using the yield rate at the date of issuance.

True.

7

T/F: The straight line method of amortizing the discount or premium is only allowed if it results in interest expense amounts not materially different from the effective interest method.

True.

8

A company issued a short-term note payable to a bank with a stated 12 percent rate of interest . The bank charged a .5% loan origination fee and remitted the balance to the company.

The effective interest rate paid by the company in this transaction would be
A. Equal to 12.5%.
B. More than 12.5%
C. Less than 12.5%.
D. Independent of 12.5%

B. The .5% loan origination fee reduces the proceeds to the borrower AND increases the total interest to be paid by the same amount. The effect is to raise the interest rate above 12.5%.

Assume the loan amount is $1,000 before the loan origination fee. Therefore, the net amount loaned is $995 [1 - .005($1,000)]. However, the full $1,000 must be paid at maturity. The total interest to be paid is thus increased by the $5 origination fee ($1,000 - $995).

For simplicity, assume the loan is for a full year. Then total interest paid is: .12($1,000) + $5 = $125.

The effective rate of interest for the year then is: $125/$995 = .1256. This exceeds 12.5%.

9

At December 31, 2005, a $1,200,000 note payable was included in Cobb Corp.'s liability account balances. The note is dated October 1, 2005, bears interest at 15%, and is payable in three equal annual payments of $400,000. The first interest and principal payment was made on October 1, 2006. In its December 31, 2006 balance sheet, what amount should Cobb report as accrued interest payable for this note?

$30,000 equals ($1,200,000 - $400,000)(.15)(3/12).

On 10/1/06, the first $400,000 principal payment was made. That left $800,000 of principal balance remaining on 10/1/06. The interest on that amount is computed as shown above.

10

Seco Corp. was forced into bankruptcy and is in the process of liquidating assets and paying claims. Unsecured claims will be paid at the rate of forty cents on the dollar.
Hale holds a $30,000 noninterest-bearing note receivable from Seco collateralized by an asset with a book value of $35,000, and a liquidation value of $5,000.

The amount to be realized by Hale on this note is
A. $5,000
B. $12,000
C. $15,000
D. $17,000

C. Bankruptcy law specifies that secured creditors are to be satisfied before any assets are paid to unsecured creditors. Hale is a secured creditor for the $5,000 liquidation value. A liquidation value is paid at the liquidation of the firm and thus acts as a secured debt. The remaining claim of $25,000 ($30,000 - $5,000) is unsecured and at the 40% rate yields an additional claim of $10,000, for a total amount to be realized of $15,000.

11

On March 1, 2004, Fine Co. borrowed $10,000 and signed a two-year note bearing interest at 12% per annum compounded annually. Interest is payable in full at maturity on February 28, 2006.

What amount should Fine report as a liability for accrued interest at December 31, 2005?

$2,320
he accrued interest covers the period from the borrowing to 12/31/94 because no interest has yet been paid. The interest is also compounded (this is a stumbling point easily missed).

The 2005 ending balance in accrued interest payable therefore includes interest on 2004's accrued interest:
2004: $10,000(.12)(10/12) $1,000
2005: ($10,000 + $1,000)(.12)(12/12) 1,320
Total accrued interest payable, December 31, 2005 $2,320

12

On August 21, 2003, Vann Corp.'s $500,000, one-year, noninterest-bearing note due July 31, 2004 was discounted at Homestead Bank at 10.8%. Vann uses the straight-line method of amortizing bond discounts.

What amount should Vann report for notes payable in its December 31, 2003 balance sheet?
A. $500,000
B. $477,500
C. $468,500
D. $446,000

The period from August 21, 2003 to July 31, 2004 is 11 1/3 months. The correct calculation is:
Maturity value (note is noninterest bearing)
$500,000
Less discount to bank $500,000(.108)[(11 1/3 months)/12 months]
( 51,000)
Equals book value at date of discounting = proceeds from bank
449,000
Plus amortization of discount to December 31, 2003

$51,000[(4 1/3 months)/(11 1/3 months)]

19,500
Equals book value at December 31, 2003
$468,500

The bank's discount represents the total interest to be paid over the 11 1/3 month term. As the note is amortized, the note's book value increases and interest expense is recognized. At maturity, the note book value is $500,000 and the total interest of $51,000 is paid as part of the single payment of $500,000. Total interest is $51,000 because that is the difference between the maturity value of $500,000 less the $449,000 proceeds.

13

T/F: Interest revenue is based on the ending book value of the debt.

False.
The total interest over the note term equals the difference between the total pmts required under the note and the principal amount.

14

T/F: The market rate relating to a long-term debt issue has changed dramatically since issuance several years ago. Therefore, the rate used for recording the debt and computing interest should be changed.

False.
The interest rates at issuance are the rates that are used throughout the term of the note.

15

T/F: The book value of a note is less under the net method compared with the gross method.

False.

16

T/F: Equipment purchased with a discounted note is recorded at a bargain price.

False.
Purchase is recorded at the discount, and the discount is amortized over the note term.

17

T/F: All noninterest-bearing notes are recorded at a discount from face value.

True
They are recorded at the PV of future cash flows, using the market rate of interest as the discount rate.

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