Question

Digital Telephony issued 10% bonds, dated January 1, with a face amount of $42 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: (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.):

General Journal	Debit	Credit
Cash	37,182,432
Discount on bonds	4,817,568
Bonds payable		42,000,000

Digital also leased switching equipment to Midsouth Communications, Inc., on September 30, 2018. Digital purchased the equipment from MDS Corp. at a cost of $5 million. The five-year lease agreement calls for Midsouth to make quarterly lease payments of $326,290, 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. 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, under the direct method?
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, under the direct method?
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, under the direct method?
4. Assume MDS manufactured the equipment at a cost of $4 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?

Answer 1

Answer 1.

Issue Price of Bond is equal to present value of its maturity price and present value of its related interest payments.

Maturity Price of bond = Face Value = $42,000,000

Bond maturity Time = 10 years

Market interest rate = 12%

Now PVF of 1 for 10 years @ 12% = 0.322

Present value of maturity price = $42,000,000 x 0.322 = $13,524,000

Interest Payment per Six month Period = $42,000,000 x 10% x 1/2 = $2,100,000

In 10 years there will be total 20 six month periods and market interest rate per period will be 6%.

Now PVAF for 20 periods @6% =10.8276

Present value of Future interest payments = $2,100,000 x 10.8276 = $22,737,960

Bond Issue Price = $22,737,960+$13,524,000 = $36,261,960

Direct will record the following amounts related to bond issue in its statement of cash flows under direct method:

$36,261,960 cash inflow under cash from financial activities for issue of bonds.

$4,200,000 cash outflow under cash from financial activities towards interest on bonds.

Answer 2.

As Midsouth leased the equipment from Digital , it will record quarterly lease payments in its cash flow statement.

At the time of Lease – No entry required in cash flow as no cash transaction.

At time of lease payments , interest amount will be recorded as cash outflow from operating activities and principal amount will be recorded as cash outflow from financing activities.

In 2018 Midsouth will pay 2 lease payments i.e on september 30 and december 31.

As equipment was leased on September 30, 2018, the payment on that date will not contain any interest amount.

However lease payment on 31 Dec will contain interest amount of 12% for 3 months on $5 million

Interest amount = 5,000,000 x 12% x3/12 = $150,000

Total Lease payment for Year 2018 = $326,290 x 2 = $652,580

Interest Amount = $150,000

Principal Amount = $652,580 - $150,000 = $502,580

So Midsouth will report Principal Payment of $502,580 as cash outflow under Cash from financing activities and Interest amount of $150,000 as cash outflow under cash from operating activities in Cash Flow Statement for Year 2018.