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Chapter 14: Q19E (page 758)

Fallen Company commonly issues long-term notes payable to its various lenders. Fallen has had a pretty good credit rating such that its effective borrowing rate is quite low (less than 8% on an annual basis). Fallen has elected to use the fair value option for the long-term notes issued to Barclay’s Bank and has the following data related to the carrying and fair value for these notes. Any changes in fair value are due to changes in market rates, not credit risk.

Carrying Value

Fair Value

December 31, 2017

\(54,000

\)54,000

December 31, 2018

44,000

42,500

December 31, 2019

36,000

38,000

Instructions

(a) Prepare the journal entry at December 31 (Fallen’s year-end) for 2017, 2018, and 2019, to record the fair value option for these notes.

(b) At what amount will the note be reported on Fallen’s 2018 balance sheet?

(c) What is the effect of recording the fair value option on these notes on Fallen’s 2019 income?

(d) Assuming that general market interest rates have been stable over the period, does the fair value data for the notes indicate that Fallen’s creditworthiness has improved or declined in 2019? Explain.

Short Answer

Expert verified

(a) No entry needs to be passed for 31/12/2017. At the end of 2018 and 2019, unrealized holding gains/losses were $1,500 and $3,500.

(b) The fair value of $42,500.

(c) Unrealized holding loss of $3,500.

(d) Throughout 2019, Fallen's creditworthiness has increased.

Step by step solution

01

Meaning of Fair value

According to a company's financial statement, the fair value represents the estimated value of its assets and liabilities.Fair market value refers to an item's fair sale value for the buyer and seller.

02

(a) Preparing journal entry

Date

Particulars

Debit ($)

Credit ($)

31/12/2017

No entry

31/12/2018

Notes payable ($44,000−$42,500)

1,500

Unrealized Holdings gain

1,500

31/12/2019

Unrealized Holdings Gain/Loss

3,500

Notes Payable($38,000−$36,000+$1,500)

3,500

Notes: No entry on 31/12/2017 since carrying value = Fair value.

03

(b) Amount to be reported on Fallen’s 2018 balance sheet

The note will be reported at fair value as of Dec 31, 2018, on Fallen's balance sheet.

Hence, the note will report at $42,500

04

(c) Effect of recording the fair value option on these notes on Fallen’s 2019 income

Fallen's net income will decrease by $3,500per the 3rd journal entry since the change in fair value will be deducted from the net income.

05

Explaining whether the fair value data for the notes indicate that Fallen’s creditworthiness has improved or declined in 2019

Fallen's creditworthiness has increased throughout 2019 due to bond investors earning a greater yield than investors in investments with comparable risk. Changes in fallen credit risk should be considered when recording any gains or losses in other comprehensive income.

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Most popular questions from this chapter

On January 1, Martinez Inc. issued \(3,000,000, 11% bonds for \)3,195,000. The market rate of interest for these bonds is 10%. Interest is payable annually on December 31. Martinez uses the effective-interest method of amortizing bond premium. At the end of the first year, Martinez should report bonds payable of:

(a) \(3,185,130. (c) \)3,173,550.

(b) \(3,184,500. (d) \)3,165,000.

What is off-balance sheet financing? Why might a company be interested in using off-balance sheet financing?

On January 1, 2017, Nichols Company issued for \(1,085,800 its 20-year, 11% bonds that have a maturity value of \)1,000,000 and pay interest semiannually on January 1 and July 1. The following are three presentations of the long-term liability section of the balance sheet that might be used for these bonds at the issue date.

1

Bonds payable (maturing January 1, 2037)

\(1,000,000

Unamortized premium on bonds payable

85,800

Total bond liability

\)1,085,800

2

Bonds payable—principal (face value \(1,000,000 maturing January 1, 2037)

\) 142,050a

Bonds payable—interest (semiannual payment \(55,000)

943,750b

Total bond liability

\)1,085,800

3

Bonds payable—principal (maturing January 1, 2037)

\(1,000,000

Bonds payable—interest (\)55,000 per period for 40 periods)

2,200,000

Total bond liability

\(3,200,000

aThe present value of \)1,000,000 due at the end of 40 (6-month) periods at the yield rate of 5% per period

bThe present value of \(55,000 per period for 40 (6-month) periods at the yield rate of 5% per period.

Instructions

(a) Discuss the conceptual merit(s) of each of the date-of-issue balance sheet presentations shown above for these bonds.

(b) Explain why investors would pay \)1,085,800 for bonds that have a maturity value of only $1,000,000.

(c)Assuming that a discount rate is needed to compute the carrying value of the obligations arising from a bond issue at any date during the life of the bonds, discuss the conceptual merit(s) of using for this purpose: (1) The coupon or nominal rate. (2) The effective or yield rate at date of issue.

(d)If the obligations arising from these bonds are to be carried at their present value computed by means of the current market rate of interest, how would the bond valuation at dates subsequent to the date of the issue be affected by an increase or a decrease in the market rate of interest?

On December 31, 2017, Hyasaki Corporation has the following account balance:

Bonds payable, due January 1, 2026 \(2,000,000

Discount on bonds payable \) 88,000

Interest payable $ 80,000

Show how the above accounts should be presented on the December 31, 2017, balance sheet, including the proper classifications.

Using the same information as in E14-22 and E14-24, answer the following questions related to American Bank (creditor).

Instructions

  1. Compute the loss American Bank will suffer under this new term modification. Prepare the journal entry to record the loss on American’s books.
  2. Prepare the interest receipt schedule for American Bank after the debt restructuring.
  3. Prepare the interest receipt entry for American Bank on December 31, 2018, 2019, and 2020.
  4. What entry should American Bank make on January 1, 2021?
See all solutions

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