A firm is required by its creditors to maintain a 2.00 (or greater) current ratio in order to maintain compliance with a debt covenant. The current ratio of the firm is currently at the minimum before any of the transactions are listed. Which of the following actions would cause the firm to fall out of compliance?
- Sell a used plant asset at book value.
- Pay an account payable.
- Declare cash dividends.
- Pay cash dividends previously declared.
Declare cash dividends.
This transaction increases current liabilities, thus reducing the current ratio. The current ratio is current assets divided by current liabilities. There is no effect on current assets.
Which of the following actions helps a firm to maintain compliance with a debt covenant that includes a minimum current ratio and a minimum retained earnings balance: (1) refinancing current debt on a long-term basis, (2) appropriating retained earnings, (3) purchasing treasury stock, (4) declaring cash dividends.
- 1 and 3
- 2 and 4
- 1 and 2
- 1, 2 and 3
1 and 2
Both actions are appropriate. Refinancing current debt on a long-term basis reduces current liabilities (increases noncurrent debt) and increases the current ratio. Appropriating retained earnings is an action that typically signals a future reduction in dividends, albeit on a temporary basis. As a result, total retained earnings is maintained at a higher level.
A firm's debt to equity ratio (total debt to total owners' equity) cannot exceed 3.0 without allowing a major creditor to call a loan to the firm. The ratio is currently at the maximum before any of the transactions are listed. Which of the following transactions would not subject the firm to an immediate call by the creditor?
- Recognize an increase in the current deferred income tax liability.
- Purchase treasury stock for less than its original issue price.
- Purchase treasury stock for more than its original issue price.
- Retire a different loan by issuing common stock.
Retire a different loan by issuing common stock.
This transaction reduces total liabilities and increases OE by the same amount. The numerator of the ratio is reduced and the denominator is increased. Both factors cause the ratio to decrease below the maximum.
A company has outstanding accounts payable of $30,000 and a short-term construction loan in the amount of $100,000 at year end. The loan was refinanced through issuance of long-term bonds after year end but before issuance of financial statements. How should these liabilities be recorded in the balance sheet?
- Long-term liabilities of $130,000.
- Current liabilities of $130,000
- Current liabilities of $30,000, long-term liabilities of $100,000
- Current liabilities of $130,000, with required footnote disclosure of the refinancing of the loan
Current liabilities of $30,000, long-term liabilities of $100,000
The accounts payable is a current liability. The refinancing resulted in reclassifying the construction loan (which would otherwise also be current) as a noncurrent liability. The replacement of the loan with a noncurrent liability (bonds) took place before the financial statements were issued, thus meeting the requirements for refinancing on a long-term basis.
Cali, Inc., had a $4,000,000 note payable due on March 15, 2006. On January 28, 2006, before the issuance of its 2005 financial statements, Cali issued long-term bonds in the amount of $4,500,000. Proceeds from the bonds were used to repay the note when it came due.
How should Cali classify the note in its December 31, 2005, financial statements?
- As a current liability, with separate disclosure of the note refinancing.
- As a current liability, with no separate disclosure required.
- As a noncurrent liability, with separate disclosure of the note refinancing
- As a noncurrent liability, with no separate disclosure required
As a noncurrent liability, with separate disclosure of the note refinancing
The note was refinanced (replaced) with a long-term liability (bonds) between the balance sheet date and the balance sheet issuance date. This is one of the conditions under which a current liability can be reclassified as long term at the balance sheet date. Another is to enter into an irrevocable refinancing agreement (FAS 6).
The details of the refinancing must be disclosed in the notes. The note is not to be classified as a current liability because it will cause no reduction in current assets or increase in current liabilities during the coming period.
On December 31, 2002, Paxton Co. had a note payable due on August 1, 2003. On January 20, 2003, Paxton signed a financing agreement to borrow the balance of the note payable from a lending institution to refinance the note. The agreement does not expire within one year, and no violation of any provision in the financing agreement exists. On February 1, 2003, Paxton was informed by its financial advisor that the lender is not expected to be financially capable of honoring the agreement. Paxton's financial statements were issued on March 31, 2003. How should Paxton classify the note on its balance sheet at December 31, 2002?
- As a current liability because the financing agreement as signed after the balance sheet date.
- As a current liability because the lender is not expected to be financially capable of honoring the agreement.
- As a long-term liability because the agreement does not expire within one year
- As a long-term liability because no violation of any provision in the financing agreement exists
As a current liability because the lender is not expected to be financially capable of honoring the agreement.
This is a short-term note that is scheduled to mature within one year. This type of note is excluded from current liabilities and shown as a long-term liability if both the following conditions are met:
- The company intends to refinance and,
- The company demonstrates an ability to refinance.
The financial statements were issued after Paxton was informed that the financial institution would not be capable of honoring the commitment. Therefore, there is no intention or ability in existence when the financial statements were issued. As a result, this would be shown as a current liability.
illem Co. reported the following liabilities at December 31, 2001:
- Accounts payable-trade $750,000
- Short-term borrowings $400,000
- Mortgage payable, (current portion $100,000) $3,500,000
- Other bank loan, matures June 30, 2002 $1,000,000
The $1,000,000 bank loan was refinanced with a 20-year loan on January 15, 2002, with the first principal payment due January 15, 2003. Willem's audited financial statements were issued February 28, 2002. What amount should Willem report as current liabilities at December 31, 2001?
The $1,000,000 loan was successfully refinanced on a long-term basis and therefore was moved to the noncurrent liability category. The refinancing took place before the financial statements were issued, thus meeting the requirements for reclassification on a long-term basis. The remaining items are all current: $750,000 accounts payable + $400,000 short term borrowings + $100,000 current portion of mortgage payable = $1,250,000 total current liabilities.
A company has the following liabilities at year end:
- Mortgage note payable; $16,000 due within 12 months $355,000
- Short-term debt that the company is refinancing with long-term debt $175,000
- Deferred tax liability arising from depreciation $25,000
What amount should the company include in the current liability section of the balance sheet?
Only the principal portion of the mortgage note is current. The short-term debt has been refinanced and reclassified as noncurrent. The deferred tax liability relating to depreciation is noncurrent. The classification of a deferred tax account is based on the classification of the underlying account, which in this case is a plant asset (always noncurrent).
Verona Co. had $500,000 in short-term liabilities at the end of the current year. Verona issued $400,000 of common stock subsequent to the end of the year, but before the financial statements were issued. The proceeds from the stock issue were intended to be used to pay the short-term debt. What amount should Verona report as a short-term liability on its balance sheet at the end of the current year?
There is no net use of current assets to liquidate the $400,000 amount of the liabilities because the stock issuance provided the necessary cash. Only the remaining $100,000 is classified as current.
Weald Co. took advantage of market conditions to refund debt. This was the fifth refunding operation carried out by Weald within the last four years.
The excess of the carrying amount of the old debt over the amount paid to extinguish it should be reported as a(an)
- Deferred credit to be amortized over life of new debt.
- Part of continuing operations.
- Part of other comprehensive income for the year.
Part of continuing operations.
This gain is included in income from continuing operations, as would other gains and losses such as on equipment disposal.
On June 30, 2000, King Co. had outstanding 9%, $5,000,000 face value bonds maturing on June 30, 2005. Interest was payable semi-annually every June 30 and December 31.
On June 30, 2000, after amortization was recorded for the period, the unamortized bond premium and bond issue costs were $30,000 and $50,000, respectively. On that date, King acquired all its outstanding bonds on the open market at 98 and retired them.
On redemption of the bonds at June 30, 2000, what amount should King recognize as gain before income taxes?
A journal entry illustrates the calculation:
- Dr. Bonds payable 5,000,000
Dr. Bond premium 30,000
- Cr. Bond issue costs 50,000
- Cr. Cash .98( $5,000,000) 4,900,000
- Cr. Gain 80,000
Gains or losses from the early extinguishment of debt, if material, should be
- Recognized in income from continuing operations in the period of extinguishment.
- Recognized as other comprehensive income in the period of extinguishment.
- Amortized over the life of the new issue
- Amortized over the remaining original life of the extinguished issue
Recognized in income from continuing operations in the period of extinguishment.
The gain or loss on retirement of debt is included in income from continuing operations..
On June 30, 2005, Town Co. had outstanding 8%, $2,000,000 face amount, 15-year bonds that matured on June 30, 2015. Interest is payable on June 30 and December 31.
The unamortized balances in the bond discount and deferred bond issue costs accounts on June 30, 2005 were $70,000 and $20,000, respectively. On June 30, 2005, Town acquired all these bonds at 94 and retired them.
What net carrying amount should be used in computing gain or loss on this early extinguishment of debt?
The journal entry for retirement:
Dr. Bonds payable 2,000,000
- Cr. Bond discount70,000
- Cr. Bond issue costs20,000
- Cr. Cash .94($2,000,000)1,880,000
- Cr. Gain30,000
A bond premium represents what to the issuer?
Reduction of interest expense.
In a modification of the terms, troubled debt restructure of type II (sum of new flows > book value of debt), what amount of gain is recognized by the debtor?
- The difference between the book value of the debt and the sum of new cash flows.
- The difference between the present value of the new flows using the original rate of interest and the book value of the debt.
- No gain is recognized.
- The difference between the present value of the new flows using the new rate of interest (based on the restructured flows) and the book value of the debt
No gain is recognized.
Although the debtor has an economic gain (the creditor is making a concession), GAAP requires that the debtor compute the new rate of interest based on the restructured cash flows and recognize interest expense over the note term. No gain is recognized by the debtor.
During 2005, Colt Co. experienced financial difficulties and was likely to default on a $1,000,000, 15%, three-year note dated January 1, 2004, payable to Cain National Bank.
On December 31, 2005, the bank agreed to settle the note and unpaid 2005 interest of $150,000 for $820,000 cash payable on January 31, 2006.
What is the amount of gain, before income taxes, from the debt restructuring?
Gain = book value of note plus interest - cash paid
Gain = $1,000,000 + $150,000 - $820,000 = $330,000.
Choose the correct statement regarding the accounting treatment of troubled debt restructures (TDRs) under international accounting standards (IAS).
- Settlements are treated the same way as under U.S. standards.
- Modification of terms TDRs are treated the same way as under U.S. standards.
- A significant modification of terms for IAS is treated as a modification of terms type II under U.S. standards.
- A non-significant modification of terms for IAS is treated as a modification of terms type I under U.S. standards.
Settlements are treated the same way as under U.S. standards.
Both sets of standards treat settlements as extinguishments with a gain to the debtor for the difference between debt book value and fair value of consideration paid.
A debtor and a creditor have negotiated new terms on a note. How can you determine whether the restructuring is a troubled debt restructure?
- If the interest rate as stated in the restructuring agreement has been reduced relative to the original loan agreement
- If the present value of the restructured flows using the original interest rate is less than the book value of the debt at the date of the restructure.
- If the interest rate that equates (1) the book value of the debt at the date of the restructure and (2) the present value of restructured cash flows, exceeds the original interest rate
- If the present value of the restructured flows using the original interest rate is less than the market value of the original debt at the date of the restructure
If the present value of the restructured flows using the original interest rate is less than the book value of the debt at the date of the restructure.
This is one of the ways to determine if a restructuring is troubled. Under the terms of this answer, the creditor is receiving a stream of cash flows with a present value less than what is currently owed and is making a concession.
On December 30, 2004, Hale Corp. paid $400,000 cash and issued 80,000 shares of its $1 par value common stock to its unsecured creditors on a pro rata basis pursuant to a reorganization plan under Chapter 11 of the bankruptcy statutes. Hale owed these unsecured creditors a total of $1,200,000. Hale's common stock was trading at $1.25 per share on December 30, 2004.
As a result of this transaction, Hale's total stockholders' equity had a net increase of
The market value of the stock issued to the creditors is $100,000 (80,000 x $1.25). The fair value of consideration paid to settle the debt therefore is $500,000 ($400,000 cash + $100,000 of stock). The gain on settling the debt therefore is $700,000 ($1,200,000 - $500,000 total consideration).
The gain increases owners' equity by way of net income. The issuance of stock is recorded at market value, $100,000. Thus, the total owners' equity increase is $800,000 ($700,000 + $100,000). Note that this amount is also the difference between the amount of debt retired ($1,200,000) and cash paid ($400,000).
The following information pertains to the transfer of real estate pursuant to a troubled debt restructuring by Knob Co. to Mene Corp. in full liquidation of Knob's liability to Mene:
Carrying amount of liability liquidated $150,000
Carrying amount of real estate transferred $100,000
Fair value of real estate transferred $90,000
- What amount should Knob report as an ordinary gain (loss) on transfer on disposal?
- What amount should Knob report as a gain (loss) on restructuring of payables?
Loss on Disposal ($10,000)
The real estate transferred in settlement of the debt is worth $10,000 less than its carrying value. Thus, an ordinary loss is recognized on the transfer. It is as if Knob first sold the real estate for $90,000 causing a loss of $10,000, and then used the cash for settlement of the debt.
Gain on Restructuring Payables $60,000
The gain on debt restructure recognized by the debtor Knob is the difference between the book value of the debt ($150,000) and the market value of the asset transferred in settlement ($90,000). Thus, the gain equals $60,000.
It represents the increase in net worth, measured at market value, from extinguishing debt at less than its carrying value. The carrying value of the asset transferred is not relevant to the determination of the restructuring gain.
Nu Corp. agreed to give Rand Co. a machine in full settlement of a note payable to Rand. The machine's original cost was $140,000. The note's face amount was $110,000. On the date of the agreement,
- the note's carrying amount was $105,000, and its present value was $96,000.
- The machine's carrying amount was $109,000, and its fair value was $96,000.
What amount of net gain (or losses) should Nu recognize?
The net loss listed is the difference between the carrying amount of the liability and the carrying amount of the machine. Nu has a gain of $9,000 on the note settlement, which is the difference between the liability carrying value ($105,000) and the fair value of the consideration given to extinguish the debt ($96,000). Nu also has a disposal loss on the machine. An ordinary loss of $13,000 is recognized and equals the difference between the machine's carrying value ($109,000) and its fair value ($96,000).
For a troubled debt restructuring involving only modification of terms, it is appropriate for a debtor to recognize a gain when the carrying amount of the debt
- Exceeds the total future cash payments specified by the new terms.
- Is less than the total future cash payments specified by the new terms.
- Exceeds the present value specified by the new terms.
- Is less than the present value specified by the new terms.
Exceeds the total future cash payments specified by the new terms.
ASC Topic 470 states that the debtor records a gain at the date of a restructure involving only a modification of terms when the prerestructure carrying amount exceeds the total future cash flows per the modification. The gain recognized is the difference between the prerestructure carrying amount and the future cash flows.
In year 1, May Corp. acquired land by paying $75,000 down and signing a note with a maturity value of $1,000,000. On the note’s due date, December 31, year 6, May owed $40,000 of accrued interest and $1,000,000 principal on the note. May was in financial difficulty and was unable to make any payments. May and the bank agreed to amend the note as follows:
- The $40,000 of interest due on December 31, year 6, was forgiven.
- The principal of the note was reduced from $1,000,000 to $950,000 and the maturity date extended 1 year to December 31, year 7.
- May would be required to make one interest payment totaling $30,000 on December 31, year 7.
May does not elect the fair value option for reporting its financial liabilities. As a result of the troubled debt restructuring, May should report a gain, before taxes, in its year 6 income statement of
In a troubled debt restructure involving modification of terms, the accounting depends on the relationship between the carrying amount (CA) of the debt (principal plus unpaid interest) and the total future payments (TFP). If the TFP are greater than the CA, the excess is recognized as future interest expense using a newly computed effective rate and no gain is recognized. If the CA is greater than the TFP, the excess is recognized as a gain, and no future interest expense is recognized. In this case, the CA ($1,000,000 principal + $40,000 accrued interest = $1,040,000) exceeds the TFP ($950,000 + 30,000 = $980,000), so the excess ($1,040,000 - $980,000 = $60,000) is recognized as a gain.
Ace Corp. entered into a troubled debt restructuring agreement with National Bank. National agreed to accept land with a carrying amount of $75,000 and a fair value of $100,000 in exchange for a note with a carrying amount of $150,000. Disregarding income taxes, what amount should Ace report as a gain on restructuring the debt?
The gain on restructuring the debt would be the difference between the carrying amount of the note received and the FMV of the land given. The amount that Ace should report as gain in its income statement is
- $150,000 CV of note
- – 100,000 FMV of land
- $ 50,000 Gain on restructuring the debt
Which of the following statements is true?
- All financial assets and financial liabilities must be valued at fair value.
- No financial assets or financial liabilities can be valued at fair value.
- Debt modifications may be valued at fair value.
- Debt modifications must be valued at fair value.
Debt modifications may be valued at fair value.
An election can be made to value certain financial assets or financial liabilities at fair value. Modification of debt is eligible for such valuation. However, the fair value election is not a requirement.