Thompson Limited (a private company with no published credit rating) completed several transactions during 2011. In January, the company purchased under contract a machine at a total price of $1.2 million, payable over five years with instalments of $240,000 per year with the first payment due January 1, 2011. The seller considered the transaction to be an instalment sale with the title transferring to Thompson at the time of the final payment. If the company had paid cash for the machine, all at the time of the sale, the machine would have cost $1,050,000. The company could have bor- rowed funds from the bank to buy the machine at an interest rate between 7% and 7.5%. It is expected that the machine will last 10 years. On July 1, 2011, Thompson issued $10 million of general revenue bonds priced at 99 with a coupon of 10% payable July 1 and January 1 of each of the next 10 years to a small group of large institutional investors. As a result, the bonds are closely held. The July 1 interest was paid and on December 30 the company transferred $500,000 to the trustee, Holly Trust Limited, for payment of the January 1, 2012 interest.
Thompson purchased $500,000 (face value) of its 6% convertible bonds for $455,000. It expects to resell the bonds at a later date to a small group of private investors. Finally, due to the economic recession, Thompson was able to obtain some government financing to assist with the purchase of some updated technology to be used in the plant. The government provided a $500,000 loan with an interest rate of 1% on December 31, 2011. The company must repay $500,000 in five years: December 31, 2016. Interest pay- ments of $5,000 are due for the next five years, starting on December 31, 201
2. The company could have borrowed a sim- ilar amount of funds for an interest rate of 6% on December 31, 2011.
Instructions
(a) As Thompson’s accountant, prepare journal entries for the machine purchase and the government loan transactions described above. As Thompson is a private company, indicate any differences in treatment that might arise under PE GAAP and IFRS. For any fair value discussions, outline the level of fair value hierarchy that has been used.
(b) Having prepared the balance sheet as at December 31, 2011, you have presented it to the company president. You are asked the following questions about it. Answer these questions by writing a brief paragraph that justifies your treat- ment of the items in the balance sheet.
1. Why is the new machine being valued at $1,050,000 on the books, when we are paying $1.2 million in total? Why has depreciation been charged on equipment being purchased under contract? Title has not yet passed to the com- pany and, therefore, the equipment is not yet our asset. Would it not be more correct for the company to show on the left side of the balance sheet only the amount that has been paid to date instead of showing the full contract price on the left side and the unpaid portion on the right side? After all, the seller considers the transaction an instalment sale.
2. Bond interest is shown as a current liability. Did we not pay our trustee, Holly Trust Limited, the full amount of interest that is due this period?
3. The repurchased bonds (sometimes referred to as treasury bonds) are shown as a deduction from bonds payable issued. Why are they not shown as an asset since they can be sold again? Are they the same as bonds of other com- panies that we hold as investments?
4. What is this government grant showing on the balance sheet? We received a loan, not a grant, since we have to pay it back. Why is the government loan showing substantially less than the $500,000 that we will have to repay?