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Chapter 14: Q.14-3CE (page 768)

Question: Describe how a company would classify debt that includes covenants. What conditions must exist in order to depart from the normal rule?

Short Answer

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Answer

An obligation that comprises covenants should be grouped under non-current liability. The conditions that must occur so as to depart from the normal rule include covenant violation as well as non-conformity with the covenant within an upcoming year.

Step by step solution

01

Meaning of Debt covenants

Debt covenants are defined as a sort of prohibition or word included in the debt contract that is created to safeguard the interests of the borrowers. It comprises items like working capital ratio, leverage ratios, dividend payout ratio, or the prohibition of borrowing of greater priority debt.

02

Classification of debt with covenants

A debt may need regular conformity with borrower covenants. Violation of covenants may provide a borrower the right to demand instant disbursement of the debt. A debt liability should be grouped as non-current.

03

Circumstances that exist in order to depart from the rule

A debt liability should be grouped as non-current, except if there has been a covenant violation that provides the borrower the right to call the debt, and it is possible that the business will not be able to adhere to the covenant in the upcoming 12 months. If both the conditions take place, then debt is to group as a current liability.

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Most popular questions from this chapter

McCormick Corporation issued a 4-year, \(40,000, 5% note to Greenbush Company on January 1, 2017, and received a computer that normally sells for \)31,495. The note requires annual interest payments each December 31. The market rate of interest for a note of similar risk is 12%. Prepare McCormick’s journal entries for (a) the January 1 issuance and (b) the December 31 interest.

Distinguish between the following interest rates for bonds payable:

(a)Yield rate

(b) Nominal Rate

(c) Stated rate

(d) Market rate

(e) Effective rate

On December 31, 2017, American Bank enters into a debt restructuring agreement with Barkley Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, \(3,000,000 note receivable by the following modifications:

  1. Reducing the principal obligation from \)3,000,000 to \(2,400,000.
  2. Extending the maturity date from December 31, 2017, to January 1, 2021.
  3. Reducing the interest rate from 12% to 10%.

Barkley pays interest at the end of each year. On January 1, 2021, Barkley Company pays \)2,400,000 in cash to American Bank.

Instructions

  1. Will the gain recorded by Barkley be equal to the loss recorded by American Bank under the debt restructuring?
  2. Can Barkley Company record a gain under the term modification mentioned above? Explain.
  3. Assuming that the interest rate Barkley should use to compute interest expense in future periods is 1.4276%, prepare the interest payment schedule of the note for Barkley Company after the debt restructuring.
  4. Prepare the interest payment entry for Barkley Company on December 31, 2019.
  5. What entry should Barkley make on January 1, 2021?

Coldwell, Inc. issued a \(100,000. 4-years, 10% note at face value to Flint Hills Bank on January 1, 2017, and received \)100,000 cash. The note requires annual interest payments each December 31. Prepare Coldwell’s journal entries to record (a) the issuance of the note and (b) the December 31 interest payment.

Question: (Debtor/Creditor Entries for Continuation of Troubled Debt with New Effective Interest)

Crocker Corp. owes D. Yaeger Corp. a 10-year, 10% note in the amount of \(330,000 plus \)33,000 of accrued interest. The note is due today, December 31, 2017. Because Crocker Corp. is in financial trouble, D. Yaeger Corp. agrees to forgive the accrued interest, \(30,000 of the principal, and to extend the maturity date to December 31, 2020. Interest at 10% of revised principal will continue to be due on 12/31 each year.

Assume the following present value factors for 3 periods.

Single sum

0.93543

0.93201

0.92589

0.92521

0.92184

0.91514

Ordinary annuity of 1

2.86989

2.86295

2.85602

2.84913

2.84226

2.82861

Instructions

(a) Compute the new effective-interest rate for Crocker Corp. following restructure. (Hint: Find the interest rate that establishes approximately \)363,000 as the present value of the total future cash flows.)

(b) Prepare a schedule of debt reduction and interest expense for the years 2017 through 2020.

(c) Compute the gain or loss for D. Yaeger Corp. and prepare a schedule of receivable reduction and interest revenue for the years 2017 through 2020.

(d) Prepare all the necessary journal entries on the books of Crocker Corp. for the years 2017, 2018, and 2019.

(e) Prepare all the necessary journal entries on the books of D. Yaeger Corp. for the years 2017, 2018, and 2019.
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