Question

1. On January 1, Year 1, Blaze Mining Enterprises purchases an existing coal mine. Blaze expects to operate the min for four years, after which it is legally required to dismantle the mine. Blaze estimates that it will pay $500,000 at the beginning of Year 5 to dismantle the mine. What would be the balance of the Asset Retirement Obligation (ARO) at the end of Year 2? Blaze Mining has an incremental borrowing rate of 7%.

2. On January 1, 2017, Gary Co. sold to Casey Corp. $800,000 of its 10% bonds for $708,236 to yield 12%. Interest is payable semiannually on January 1 and July 1. What will be the cash outlay for interest 2018? What will be the interest expense for the year ended 12/31/2018?

3. On January 1, 2017, Casey Co. sold property to Larry Co. There was no established exchange price for the property, and Larry gave Casey a $4,000,000 zero-interest bearing note payable in 5 equal annual installments of $800,000 with the first payment due December 31, 2017. The prevailing rate of interest for a note of this type is 9%. The present value of the note at 9% was $2,884,000 at January 1, 2017. Assuming that Larry has a calendar year end fiscal year, how much interest expense should Larry Co. report for the year ended December 31, 2018 related to this note?

Answer 1

1. Asset retirment obligation is the amount that is required to restore the property to its original condition. It is usually incurred at a future point of time when the contractual term for commercial exploitation of the property expires.

Computation of Asset Retirement Obligation (ARO) at the end of year 2:

The future value of the ARO at the beginning of year 5 or at the end of year 4 is $500,000

Therefore the present value of ARO at the end of year 2 is obtained by discounting the estimated cash outflow 2 times with the incremental borrowing rate. [Since the fv of the estimated expenditure is 2 years a head of the end of year 2]

PV of ARO at the end of year 2

= $500,000 * 1 / (1 + 0.07)²  [since given that incremental borrowing rate is 7% or 0.07]

= $500,000 * 1 / (1.07)²

⁼ $500,000 * 0.87343

= $436,719.36 (approx.)

2. Cash outlay of interest:

Cash outlay of interest is but the amount of interest actualy paid in cash to the bond holder. It is derived by simply multiplying the coupon rate with the face valur of the bond.

Therefore cash outlay of interest

= $800,000 * 5% * 2

= $80,000

Note: Since the coupon is payable semi-annually, the coupon rate is computed as 10% / 2 = 5%

Interest Expense:

Interest expense is computed by adding the amortized value of discount on issue of bond to the actual interest outlay as per the requirement of GAAP. In the given question, the bond having face value of $800,000 is issued at a cost of $708,236 thereby offering a discount of $91,764. Now along with the actual cash outlay of interest [i.e., $800,000 * 5% = $40,000], a portion of amortized discount will also be accounted for as interest expense for the period as per the GAAP.

Computation:

The interest expense is computed by multiplying the carrying amount of bond with the yield.

Therefore Interest expense (for first half)= $708,206 * 12% / 2 [since coupon is paid semi-annualy]

= $708,206 * 6%

= $42,492.36

The resultant $42,492.36 includes $40,000 (being cash outlay of interest) and rest of the amount i.e., $2,492.36 is the amortized value of discount.

Now for computation of interest expense for the second half of the year, we should include the amortized value of discount to the carrying amount of the bond and then should be multiplied by semi-annual yield.

Therfore revised carrying amount of the bond = $708,236 + $2,492

= $710,728

The interest expense for second half = $710,728 * 12% / 2

= $710,728 * 6%

= $42,643.68

Total interest expense for year 2018 => $42,643.68 + $42,492.36

= $85,136 (approx)