Chapter 21, Problem 21.15P

Integrating problem; bonds; lease transactions; lessee and lessor; statement of cash flow effects

• LO21–3, LO21–5, LO21–6

Digital Telephony issued 10% bonds, dated January 1, with a face amount of $32 million on January 1, 2018. The bonds mature in 2028 (10 years). For bonds of similar risk and maturity the market yield is 12%. Interest is paid semiannually on June 30 and December 31. Digital recorded the issue as follows:

Cash	28,329,472
Discount on bonds	3,670,528
Bonds payable	32,000,000

Digital also leased switching equipment to Midsouth Communications, Inc., on September 30, 2018. Digital purchased the equipment from MDS Corp. at a cost of $6 million. The five-year lease agreement calls for Midsouth to make quarterly lease payments of $391,548, payable each September 30, December 31, March 31, and June 30, with the first payment on September 30, 2018. Digital’s implicit interest rate is 12%.

Required:

1. 1. What would be the amount(s) related to the bonds that Digital would report in its statement of cash flows for the year ended December 31, 2018, if Digital uses the direct method? The indirect method?
2. 2. What would be the amounts related to the lease that Midsouth would report in its statement of cash flows for the year ended December 31, 2018?
3. 3. What would be the amounts related to the lease that Digital would report in its statement of cash flows for the year ended December 31, 2018?
4. 4. Assume MDS manufactured the equipment at a cost of $5 million and that Midsouth leased the equipment directly from MDS. What would be the amounts related to the lease that MDS would report in its statement of cash flows for the year ended December 31, 2018?

To determine

Statement of cash flows: This statement reports all the cash transactions which are responsible for inflow and outflow of cash, and result of these transactions is reported as ending balance of cash at the end of reported period.

Journal: Journal is the method of recording monetary business transactions in chronological order. It records the debit and credit aspects of each transaction to abide by the double-entry system

Rules of Debit and Credit:

Following rules are followed for debiting and crediting different accounts while they occur in business transactions:

• Debit, all increase in assets, expenses and dividends, all decrease in liabilities, revenues and stockholders’ equities.
• Credit, all increase in liabilities, revenues, and stockholders’ equities, all decrease in assets, expenses.

To Determine: The amount which the Company D would report as cash related to bonds during the reporting period, using direct and indirect method.

Explanation of Solution

Company D would report $23,329,472 as cash inflow from the sale of bonds, under the financing activities, in doth the methods.

The payment of interest by bondholders is considered as operating activity, as this is an interest being paid on the loan taken by the company. Hence it is considered as an expense and recorded as operating activity.

Calculate the interest payable on bonds.

Date	Account Title	Debit ($)	Credit ($)
06.30.18	Interest expense  (1)	$1,699,768
	Discount on bonds payable  (3)		$99,768
	Cash   (2)		$1,600,000
	(To record the amount of interest to be paid)
12.31.18	Interest expense   (4)	$1,705,754
	Discount on bonds payable  (5)		$105,754
	Cash   (2)		$1,600,000
	(To record the amount of interest to be paid)

Table (1)

Explanation:

• Interest expense decreases the stockholder's equity; hence debit the interest expense account.
• Discount on bonds payable is a liability which is increased; hence credit the discount on bonds payable.
• Cash is being paid, cash is an asset which is being decreased; hence credit the cash account.

Working Note:

Calculate the interest expense.

$\begin{array}{c}\text{Interest expense = 6\%}\times \text{Value of Bonds}\\ \text{= 6\%}\times \$28,329,472\\ =\$1,699,768\end{array}$ (1)

Calculate the Cash paid.

$\begin{array}{c}\text{Cash Paid = 5\%}\times \text{Value of Bonds}\\ \text{= 5\%}\times \$32,000,000\\ =\$1,600,000\end{array}$ (2)

Calculate the discount on bonds payable.

$\begin{array}{c}\text{Discount on bonds payable = Interest expense}-\text{Cash paid}\\ \text{= }\$1,699,768-\$1,600,000\\ =\$99,768\end{array}$ (3)

Calculate the interest expense.

$\begin{array}{c}\text{Interest expense = 6\%}\times \left(\text{Value of Bonds+Discount on Bonds payable}\right)\\ \text{= 6\%}\times \left(\$28,329,472+\$99,768\right)\\ =\text{6\%}\times \$28,429,240\\ =\$1,705,754\end{array}$ (4)

Calculate the discount on bonds payable.

$\begin{array}{c}\text{Discount on bonds payable = Interest expense}-\text{Cash paid}\\ \text{= }\$1,705,754-\$1,600,000\\ =\$105,754\end{array}$ (5)

Under the direct method, the interest would be reduced as an expense under operating activity. However under indirect method, the discount on the bonds payable would be added to net income as the interest of $1,600,000 would be reduced while calculating the net income.

To determine

The amount which the Company M would report as cash related to lease during the reporting period.

Explanation of Solution

Company M would report $6 million as an investment with a lease, and note it as non cash transaction in the disclosure notes of the financial statement.

Calculate the Present Annuity Value:

As per table 6, present value for

Number of leases payables: 20 $\left(5\text{ years}\times \text{4 installment every year}\right)$;

Interest rate: 3% $\left(12\%÷4\right)$;

Of annuity due for $1 are 15.3238.

$\begin{array}{c}\text{Lease = Installment }\times \text{ Annuity value}\\ \text{= }\$391,548\times 15.32380\\ = \$6,000,000\end{array}$ (6)

The amount related to the asset value reported by Company M is shown below.

Date	Account Title	Debit ($)	Credit ($)
09.30.18	Right-of-use asset  (6)	$6,000,000
	Lease payable		$6,000,000
	(To record the amount to be paid for the asset)

Table (2)

Explanation:

• Right-to-use asset is being purchased, this increases the assets; hence debit the Right-of-use asset.
• Lease payable is a liability, as the liability is increased; credit the lease payable account.

The amount of lease payable by Company M is shown below.

Date	Account Title	Debit ($)	Credit ($)
09.30.18	Lease payable	$391,548
	Cash		$391,548
	(To record the amount of lease payable)

Table (3)

Explanation:

• Lease payable is a liability, as the liability is reduced; debit the lease payable account.
• Cash is being paid, cash is an asset which is being reduced; hence credit the cash account.

The amount related to lease reported by Company M is shown below.

Date	Account Title	Debit ($)	Credit ($)
12.31.18	Interest expense (7)	$168,254
	Lease payable  (8)	$223,294
	Cash		$391,548
	(To record the amount of interest to be recorded by Company M)

Table (4)

Explanation:

• Interest expense decreases the stockholder's equity; hence debit the interest expense account.
• Lease payable is a liability, as the liability is reduced; debit the lease payable account.
• Cash is being paid, cash is an asset which is being reduced; hence credit the cash account.

Working Note:

Calculate the interest expense.

$\begin{array}{c}\text{Interest expense = 6\%}\times \left(\text{Cost of Asset }-\text{Lease payable}\right)\\ \text{= 6\%}\times \left(\$6,000,000-\$391,548\right)\\ =6\text{\%}\times \$5,608,452\\ =\$168,254\end{array}$ (7)

Calculate the lease payable.

$\begin{array}{c}\text{Lease payable = Cash installment }-\text{Interest expense}\\ \text{=\$391,548 }-\text{\$168,254}\\ \text{=\$223,294}\end{array}$ (8)

The amount of depreciation provided by Company M is shown below.

Date	Account Title	Debit ($)	Credit ($)
	Amortization expense (9)	$300,000
	Right-of-use asset		$300,000
	(To record the depreciation for the asset)

Table (5)

Explanation:

• Amortization expense is a contra asset being debited.
• Right-to-use asset is being depreciated, this decreases the value of assets; hence credit the Right-of-use asset.

Working Note:

Calculate the amortization expense.

$\begin{array}{c}\text{Amortization expense = Cost of asset }÷\text{Useful life of asset }\\ \text{= }\$6,000,000÷\text{ 5 years }\times \frac{1}{4}\\ =\frac{\$1,200,000}{4}\\ =\$300,000\end{array}$ (9)

Company M, shall report the following things in the statement of cash flow:

• Amount of Lease payable $614,842 ($391,548 + 223,294), as financing activity.
• Interest expense $168,254, as operating activity.
• Amortization expense being a non-cash transaction is not recorded.

To determine

The amount which the Company D would report as cash related to lease during the reporting period.

Explanation of Solution

Company D would report $6 million as an investment with a lease, and note it as non cash transaction in the disclosure notes of the financial statement.

The amount related to the asset value reported by Company D is shown below.

Date	Account Title	Debit ($)	Credit ($)
09.30.18	Lease receivable (6)	$6,000,000
	Inventory of equipment		$6,000,000
	(To record the amount to be paid for the asset)

Table (6)

Explanation:

• Lease receivable is an asset, which is increased; hence debit the lease receivable account.
• Inventory of equipment is an asset, which is decreased; credit the inventory of equipment account.

The amount of lease payable by Company D is shown below.

Date	Account Title	Debit ($)	Credit ($)
09.30.18	Cash	$391,548
	Lease receivable		$391,548
	(To record the amount of lease payable)

Table (7)

Explanation:

• Cash is received, cash is an asset which is being increased; hence debit the cash account.
• Lease receivable is an asset which is being reduced; hence credit the lease receivable account.

The amount related to lease reported by Company D is shown below.

Date	Account Title	Debit ($)	Credit ($)
12.31.18	Cash	$391,548
	Lease receivable		$223,294
	Interest revenue (10)		$168,254
	(To record the amount of interest to be recorded by Company D)

Table (8)

Explanation:

• Cash is received, cash is an asset which is being increased; hence debit the cash account.
• Lease receivable is an asset which is being reduced; hence credit the lease receivable account.
• Interest revenue increases the stockholder's equity; hence credit the interest revenue account

Working Note:

Calculate the interest revenue.

$\begin{array}{c}\text{Interest revenue = 6\%}\times \left(\text{Cost of Asset }-\text{Lease payable}\right)\\ \text{= 6\%}\times \left(\$6,000,000-\$391,548\right)\\ =6\text{\%}\times \$5,608,452\\ =\$168,254\end{array}$ (10)

Company D, shall report the following things in the statement of cash flow:

• Amount of Lease receivable $614,842 ($391,548 + 223,294), as cash inflow from financing activity.
• Interest revenue $168,254, as cash inflow from operating activity.

To determine

The amount which the Company MD would report as cash related to lease during the reporting period, assuming that Company M leased the machine from Company MD directly for $5 millions.

Explanation of Solution

Company MD would report $5 million as an investment with a lease, and note it as non cash transaction in the disclosure notes of the financial statement.

The amount related to the asset value reported by Company MD is shown below.

Date	Account Title	Debit ($)	Credit ($)
09.30.18	Lease receivable (6)	$6,000,000
	Cost of goods sold	$5,000,000
	Sales revenue		$6,000,000
	Inventory of equipment		$5,000,000
	(To record the amount to be paid for the asset)

Table (9)

Explanation:

• Lease receivable is an asset, which is increased; hence debit the lease receivable account.
• Cost of goods sold, is an asset which is being increased; hence debit the cash account.
• Sales revenue increases the stockholder's equity; hence credit the sales revenue account.
• Inventory of equipment is an asset, which is decreased; credit the inventory of equipment account.

The amount of lease payable by Company MD is shown below.

Date	Account Title	Debit ($)	Credit ($)
09.30.18	Cash	$391,548
	Lease receivable		$391,548
	(To record the amount of lease payable)

Table (10)

Explanation:

• Cash is received, cash is an asset which is being increased; hence debit the cash account.
• Lease receivable is an asset which is being reduced; hence credit the lease receivable account.

The amount related to lease reported by Company D is shown below.

Date	Account Title	Debit ($)	Credit ($)
12.31.18	Cash	$391,548
	Lease receivable		$223,294
	Interest revenue (10)		$168,254
	(To record the amount of interest to be recorded by Company D)

Table (11)

Explanation:

• Cash is received, cash is an asset which is being increased; hence debit the cash account.
• Lease receivable is an asset which is being reduced; hence credit the lease receivable account.
• Interest revenue increases the stockholder's equity; hence credit the interest revenue account.