CHAPTER 8

SOURCES OF CAPITAL: DEBT

Changes from Eleventh Edition
Updated from Eleventh Edition
Approach
Students sometimes are confused about the nature of bonds, since they have heard the term linked with
equity in stocks and bonds and know that there are bond exchanges and quoted daily prices !ybrid
securities such as convertible debentures or redeemable preferreds exacerbate any confusion !owever,
once students understand the nature of bonds, they find the accounting fairly straightforwardwith the
notable exception of discount"premium amorti#ation using the compound interest method $as opposed to
the easy, but conceptually incorrect, straight%line method& ' feel that it is desirable to teach the
(ppendix)s present value concepts at this point, but it is feasible to omit this topic and introduce it as the
beginning of the coverage of capital budgeting
Cases
Norman Corporation (A) describes several problems relating to contingencies and other liability
accounting issues
Stone Industries, Inc, is a complicated fact situation, raising issues about accounting for bond discount
and premium and the significance of the accounting numbers
Paul Murray enables students to practice future value and present value problems in an everyday context
Joan Holtz (D) deals with several matters we have recently seen mentioned in the business press $or on
*+, in one instance&, including debt%for%equity swaps
Additional Cases
*he observant instructor can augment or update Joan Holtz (D) with new issues as they crop up in Te
!all Street Journal and elsewhere $*he folks on ,all street are quite good about generating new
accounting issues for us with their latest creative financing instruments&
Problems
Problem 8-1
*ime #ero investment - ./01,111 x 231 - .4/5,011
6roof
.4/5,011 x $718 x 718 x 718 x 718 x 718 x 718& - ./49,/98
:ifference due to use of tables $*able (&
Problem 8-2
;: price <ear 71 - .74 " 2/2 - .51/7
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Accountin"# Te$t and Cases %&e ' Instructor(s Manual Antony)Ha*+ins)Mercant
;: price <ear 50 - .74 " 3/0 - .3/33
;: price <ear 01 - .74 " 747 - .9959
Problem 8-3
$7& *rust fund at time #ero - .711,111 x 39/ - .39,/11
$5& End of <ear 7 payment - .4,111 x 952 - . 3,/14
End of <ear 5 payment - .4,011 x 80/ - . 3,80/
End of <ear 3 payment - .0,111 x /94 - . 3,9/1
End of <ear 0 payment - .2,111 x /30 - . 4,471
*otal loan .70,947
$7& 6resent value of .3,711 " year for three years at 2 percent $least amount you will accept today& -
.3,711 x 52/3 - .8,582
6roof
Year
Beginning
Balance
Ending Balance
Before Payment Payment
7 .8,582 .8,/83 .3,711
5 0,283 2,154 3,711
3 5,954 3,711 3,711
$4& 6resent value at beginning of year 3 of .3,111 received annually for 9 years $assuming through year
77 means to the end of year 77& discounted at 75 percent per year - .3,111 x 0358 - .70,984
6resent value of .70,984 received two years hence, discounted at 75 percent - .70,984 x /9/ -
.75,/39
Problem 8-
Year
Beginning
Balance
Ending Balance
Before Payment Payment
7 .724,441 .784,7/3 41,111
5 744,7/3 727,4/3 41,111
3 757,4/3 732,101 41,111
4 92,101 71/,0/2 41,111
0 2/,0/2 /0,280 41,111
2 30,280 39,92/ 39,92/
Problem 8-!
$7& ,=! ;ompany)s 5112 financial statements should disclose the '>S suit, if material *he company
should include in its 5112 financial statements a provision for a payment of at least .5/1,111 to the
'>S
$5& *he full loss should be included in the company)s 5112 financial statements
$3& *he suit should be disclosed in the 5112 financial statements, if material ( comment can be made
that if an adverse finding is reached by the court, insurance should offset part of the damage payment
( contingency loss provision is not needed at this time
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$4& 'f the company has received formal notification of an intent to sue, it should be disclosed in its 5112
financial statements *he company might indicate it believes any claim against the company is
without merit
Problem 8-"
(pril 7, 5118
dr ;ash 521,111
cr @onds 6ayable 501,111
@ond 6remium 71,111
Actober 7, 5118
8%2 Entries at 75%37%18
dr 'nterest Expense 71,111
cr ;ash 71,111
dr @ond 6remium 7,111
cr 'nterest Expense 7,111
(pril 7, 5119
dr 'nterest Expense 5,011
cr 'nterest 6ayable
$71,111 x 3"75&
5,011
dr @ond 6remium 501
cr 'nterest Expense
$7,111 x 3"75&
501
Same as above $assume straight%line amorti#ation of bond premium&
Problem 8-#
$7& dr ;ash 74,/11,111
@ond :iscount 311,111
cr @onds 6ayable 70,111,111
$5& dr 'ssurance ;ost $asset& 501,111
;ash /,999,211
cr @ond 6ayable /,111,111
@ond 6remium 999,211
;ash 501,111
;ash received equals sum ofB
6+ 70 annual interest payments $.81 x /,111&
discounted at 20 percent $947& .0,529,211
6+ principal payment $./,111,111& in year 70
discounted at 20 percent $391& 5,/31,111
./,999,211
$3& dr ;ash 4,208,501
@ond :iscount 347,/01
cr @ond 6ayable 0,111,111
;ash received equals sum ofB
6+ 51 semiannual interest payments $.301,111 "
5& discounted at 4 percent $73091 % *able @& .5,3/8,501
6+ principal payment $.0,111,111& in period 51
discounted at 4 percent $402 % *able (& 5,581,111
.4,208,501
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Accountin"# Te$t and Cases %&e ' Instructor(s Manual Antony)Ha*+ins)Mercant
Problem 8-8
Canuary 7, 5118
dr ;ash 4,/01,111
@ond :iscount 501,111
cr @onds 6ayable 0,111,111
Canuary 7, 5173
dr @onds 6ayable 0,111,111
Doss on @ond
>edemption 3/0,111
cr ;ash 0,501,111
@ond :iscount 750,111
Problem 8-$
Canuary 7, 7985
dr ;ash 4,751,111
@ond 'ssuance
;ost $asset& 81,111
cr @onds 6ayable 4,111,111
;ash 81,111
@ond 6remium 751,111
Canuary 7, 5115
dr @onds 6ayable 4,111,111
@ond 6remium 54,111
@ond >edemption
Expense /0,111
Doss on @ond
>edemption 375,111
cr ;ash 4,390,111
@ond 'ssuance ;ost 72,111
Cases
Case 8-1: Norman Corporation (A)
*
%oteB Tis case as 1een updated 2rom te 3le4ent 3dition
Eorman ;orporation $(& allows students to practice dealing with various types of liabilities 'f students
have had little previous experience identifying when future, possible obligations are and are not
accounting liabilities, you may wish to begin with a general discussion of the criteria for recording
accounting liabilities Following this, each of the items in Eorman ;orporation $(& can be discussed
Students should be encouraged to identify what accounting choice they made, to explain why they made
this choice including explaining, where appropriate, how the item met or failed to meet the criteria for a
liability, and to state the impact of their choice on the financial statements
Ans&ers to '(estion 1
G
*his teaching note was prepared >obert E (nthony ;opyright ? >obert E (nthony
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7 'n order to recogni#e an expense related to this contingency, it must be feasible to make an estimate of
at least the minimum amount of loss 'n this case, no such estimate is available, so no amount should
be recorded 'n fact, some will argue that it is not clear that a liability has been incurred *he
existence of the suit should be disclosed in a note to the financial statements, however
5 *his lawsuit differs from the one above in that the lawyers are able to make an estimate of the loss
*he .01,111 should be shown as an expense $rather than a debit directly to >etained Earnings&, with a
resulting .51,111 $41 percent& decrease in income taxes $*his may raise the question of the treatment
of deferred taxes since this item would not be a tax%deductible expense in 5112H it is for this reason
that students are asked not to consider detailed income tax consequences, nor to adIust the balance
sheet& 'n any event, showing this as a >eserve for ;ontingencies in the owner)s equity section of
the balance sheet is no longer considered an acceptable practiceH the credit should be to ;ontingent
Diabilities or, better, Estimated Doss from Dawsuit
3 Future maintenance costs are no more a liability than are, say, future salaries or materials purchases
Eorman)s treatment of maintenance is an example of income smoothing, which is not in accordance
with generally accepted accounting principles, and which is particularly frowned on by the Financial
(ccounting Standards @oard *he expense charge should be .44,111, increasing net income and
>etained Earnings by .72,111 and reducing noncurrent liabilities by the same amount
4 *he bond discount should be subtracted from the related liability, rather than being shown as an asset
*he company has, in effect, borrowed only .81,111, but at an effective interest rate that is higher than
0 percent Eot enough information is given to calculate the effective rateH this is part of the optional
question if students have been required to read the (ppendix 't will not owe the .711,111 until the
issue matures, at which time the bond discount will have been amorti#ed, and the liability amount will
be .711,111 *he method of recording does make a difference because it affects total assets and total
liabilities amounts and the debt"equity ratio 't does not affect income $*he stockholder)s motive for
having the transaction arranged in this way probably was the belief that the .51,111 would be taxed at
the lower capital gains rate when the issue maturedH this belief probably was incorrect&
0 *his transaction was handled correctly *he amorti#ation of bond discount is, in effect, a part of the
true interest expense and is shown as an expense on the income statement *he statement about
>etained Earnings is a red herring Jost statement users would prefer to have interest expense shown
as a separate income statement line item rather than lumped into a broader category
2 *here are two issues hereB whether the .011 should have been capitali#ed as a deferred charge rather
than expensedH and, if expensed, whether included as a nonoperating item ,hile the deferred charge
approach in general is the correct one, in this case an exception could probably be made on the
ground that the difference between the correct approach and immediate expensing is immaterial
(lthough at one time the nonoperating income and expenses caption was used to aggregate such
things as dividend income and interest expenses, this is no longer the case (6@%9 and (6@%31
$discussed in ;hapter 71& essentially equate nonoperating items to extraordinary items, for which
specific criteria exist *his does not, however, preclude a company from reporting the net amount of
financial revenues $eg, dividend income& and expenses $interest, bank fees& as a line item in the
calculation of pretax income from continuing operations 'n the condensed income statement given in
Exhibit 7, then, if this .011 is expensed, it should be included in the total for operating expenses
/ From ;hapter /, we know clearly that this is a capital lease, since one criterion that requires capital
lease treatment is transfer of title to the lessee at the end of the lease *hus, the .30,111 value of the
car should have been capitali#ed as an asset on Canuary 5, 5112, and a .30,111 credit for capital lease
obligations made (ssuming straight%line depreciation, one%fifth of the asset amount $./,111& should
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Accountin"# Te$t and Cases %&e ' Instructor(s Manual Antony)Ha*+ins)Mercant
be charged as depreciation expense in 5112 Eote that the depreciation charge is based on useful life,
not the lease term or (;>S schedules 'f the student has been required to cover the appendix, enough
information is given to calculate the interest rate of the lease, which is 8 percent $see below& *hus the
.73,087 first%year payment is divided between .5,811 interest expense $18 G .30,111& and .71,/87
reduction of capital lease obligations
Ans&er to )ptional '(estion 2
,e are told to assume that the .711,111 $par value& bond with a 0 percent coupon rate in item 4 of
Kuestion 7 involves 70 year%end annual interest payments of .0,111 $.711,111 G 110& $*he payments
are assumed to be annual, at year%end, rather than the more realistic semiannual, so that students not
having 6+ calculators can use the text)s appendix tables& *ables ( and @ and a rate of 8 percent results in
a present value of .0,111 G 8009 - .45,/90 for interest payments plus .711,111 G 1370 - .37,011, or a
total of ./4,590H since the investor paid .81,111, the yield rate is less than 8 percent
*rying 2 percent, we get 6+ - $.0,111 G 9/75& L $.711,111 G 147/& - .91,521H so we know the yield is
between 2 and 8 percent Using / percent and linear interpolation in *ables ( and @ we have 6+ -
$.0,111 G 9730& L $.711,111 G 322& - .85,5/0 $*he mathematically inclined student will reali#e that
linear interpolation for /1 percent will result in the average of the two 6+s we found for 2 and 8 percent,
except for rounding& ' accept / percent as a perfectly adequate answer *hose with calculators will come
up with /53
(s for the correctness of the ./84 first%year bond discount amorti#ation, the calculation is as followsB
Since the bond proceeds were .81,111 and the true yield was /53 percent, then <ear 7 net interest should
be .81,111 G 11/53 - .0,/84 @ut the stated $cash& interest payment is .0,111H thus the remaining ./84
of interest expense is amorti#ation of bond discount Js Fuller)s calculation was correct
Ans&er to )ptional '(estion 3
*he interest rate is determined by finding the value in *able @ equal to .30,111 divided by the annual
payments of .73,087 for a period of 3 years $.30,111 divided by .73,087 - 50//& *he interest rate is 8
percent *he amorti#ation scheduleB
Year Beg* Bal* Payment +nterest
Principal
,ed(ction
7 .30,111 .73,087 .5,811 .71,/87
5 54,579 73,087 7,938 77,243
3 5,0/2 73,087 7,112 75,0/0
$.7 rounding error&
' use this schedule to generate Iournal entries for the lease payment and then show the asset depreciation
entries, which are based on the useful life of five years
Case 8-2: Stone Industries, Inc.
*
*
*his teaching note was prepared by >obert E (nthony ;opyright ? >obert E (nthony
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%oteB Tis case is uncan"ed 2rom te 3le4ent 3dition
Approach
*his case is intended to give the students further insight into the relationship between bond terms and the
market price for a given bond ' stress that a bond is a company)s 'AU held by the bondholder, with its
terms unchangeable once the bond is issued *hus, as market interest rates fluctuate over the life of the
bond, the value $market price& of the bond must fluctuate so that the rate of return on the bond can adIust
to market conditions, because the issuer can gain if market interest rate increases subsequent to the
issuance of a bond, thus driving down the market price of the bond so that repurchase can take place at
less than the bond)s book value *he case permits discussion of how such a gain should be reported to
shareholders
*he instructor needs to be on guard not to let the class get bogged down in computational details that
obscure the purpose of the case 'n particular, two complications exist that can lead to confusion about
what are the right numbers First, some students will use calculators with present value routines,
whereas other will use *ables ( and @ of the textH this will cause rounding errors $especially where
interpolation is needed if the tables are used& Jore important, some students will reali#e that the bonds in
question involve 51 semiannual payments, which is not exactly the same as 71 annual payments of double
the amount Jore specifically, the bonds now outstanding are properly described as having a 0 percent
couponH but semiannual .50 payments are not equivalent to annual .01 payments For example, had the
initial issuance price been $contrary to fact& .7,111 per bond, a bond with .01 annual $year%end& payments
has a yield of exactly 01 percent, but with .50 semiannual payments the yield is 01250 percent <ou may
wish to set groundrules in your assignment sheet to avoid confusion *he calculations in this note were
done with a calculator and assumed semiannual interests paymentsH in some cases ' show more significant
figures than the problem Iustifies so that you have a clear check on results using a calculator 'f the market
rate is said in the case to be 7 percent, then the rate used for each semiannual period was M even though
this is not exactly correct conceptually, it is consistent with most calculators) instruction manuals about
how to handle such problems
Calculations
( @onds issued on Canuary 7, 51x1, when the market rate is said to have been 2 percentB
E6+ $at 3N per half year& of each bond)s cash flowsB
'nterest payments, 51 payments of .50 .3/7,93/
6rincipal repayment, end of 51 periods 003,2/2
Jarket value .950,273
6roceeds $ignoring issuance costs&, 4,111 bondsB .3,/15,405
Ariginal issuance discount $.4,111,111 par&B .59/,048 $.950,273 x 4,111 -
.3,/15,405&
Bond -isco(nt Amorti.ation /ched(le
Period
Beginning
Boo0 1al(e
+nterest
E2pense +nterest Paid
-isco(nt
Amorti.*
Ending
Boo0 1al(e
7 .3,/15,405 .777,1/4 .711,111 .77,1/4 .3,/73,052
5 3,/73,052 777,412 .711,111 77,412 3,/54,935
3 3,/54,935 777,/48 .711,111 77,/48 3,/32,281
4 3,/32,281 775,711 .711,111 75,711 3,/48,/81
0 3,/48,/81 775,423 .711,111 75,423 3,/27,543
2 3,/27,543 775,83/ .711,111 75,83/ 3,//4,181
From this table, one can verify the amounts shown in Eote 7 of Exhibit 7 of the case for the bond)s
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Accountin"# Te$t and Cases %&e ' Instructor(s Manual Antony)Ha*+ins)Mercant
book value as of :ecember 37, 51x1 and 51xl $end of periods 5 and 4 in above table&H .3,/50
thousand and .3,/49 thousand, respectively Eote also that the unamorti#ed discount at :ecember 37,
51x5, is .550,951 $.4,111,111 % .3,//4,181&
@ @onds with 75 percent coupon rate issued on :ec 37, 51x5 $or Canuary 7, 51x3, which is the same
date in accounting&, when market rate was 71 percent
E6+ $at 0N per half year& of each bond)s cash flowsB
'nterest payments, 51 payments of .21 ./4/,/33
$21 x 75425571&
6rincipal repayment, end of 51 periods 3/2,889
$7,111 x 3/2889&
Jarket value .7,754,255
6roceeds $ignoring issuance costs&, 4,111 bondsB .4,498,488
Ariginal issuance discount $.4,111,111 par&B .498,488
$'n the table that follows, ' use .4,498,111 because that is the amount used in the case body and in
Kuestion 3&
Bond Premi(m Amorti.ation /ched(le
Period
Beginning
Boo0 1al(e
+nterest
E2pense +nterest Paid
Premi(m
Amorti.*
Ending
Boo0 1al(e
7 .4,498,111 .554,911 .541,111 .70,711 .4,485,911
5 4,485,911 554,740 541,111 70,800 4,42/,140
3 4,42/,140 553,305 541,111 72,248 4,401,39/
4 4,401,39/ 555,051 541,111 7/,481 4,435,97/
Comments on '(estions
7 a *here is no single explanation of the .3,/49,111H the table shown above explains how this
amount is calculated ' try to stress that bond accounting is such that $7& at the time of issuance,
;ash and @onds 6ayable $net& increase by the same amount $proceeds per bond, ignoring
issuance costs&H $5& at maturity, ;ash and @onds 6ayable decrease by the same amount $.7,111
per bond&H and $3& the amorti#ation of discount or premium, using the compound interest method,
systematically changes the @onds 6ayable amount from the amount of proceeds to the amount of
the face value, and does so in a way such that the interest rate reflected in the issuer)s bond
interest expense is constant throughout the life of the bond
b (t the time of proposed refunding of the old bonds, the market interest rate is said to be 71
percent *hus, a 71 percent coupon bond should have a market value equal to its face valueB if one
invests .7,111 now at 71 percent, gets .711 cash inflow for each of the next 71 years, and gets
his"her .7,111 back at the end of 71 years, then the return on the investment is exactly 71 percent
An the other hand, if the .7,111 investment pays .751 cash per year, then the return is higher than
71 percent $75 percent, to be precise&H thus, the market will drive up the amount of initial
investment $price& until the return $if held to maturity& equals the market return *his would be an
issuance price of .7,750 $.7,754255& per bond, as calculated above Jultiplied by 4,111 bonds,
the total $rounded& is .4,498,111
5 a ;alculation of the gainB since the book value at :ecember 37, 51x5, is .3,//4,181 $end of period
2 in above table& and the expected reacquisition cost is .3,111,111, then the gain on retirement of
the bonds is .//4,181 $*he Iournal entry is given in the answer to question 5c& <ou may wish to
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?&,,- Mc.ra*/Hill)Ir*in Capter 0
discuss at this point how this profit $as Stone and Edwards refer to it in the case& should be
reported ' find that few students have noted that the answer is in the footnote to the text section
on >efunding a @ond 'ssue, and hence it usually can be discussed as an issue $Even if a
student quickly gives the F(S@)s answer, the probable rationale for it can still be discussed& (s
noted there, in most instances the gain $or loss& on refunding is reported separately from
operating income *hus the validity of Stone)s and Edwards)s mouth%watering anticipation of the
stock market)s reaction to Stone)s reporting increased profits is dubious *he separate reporting
shows the book%balancing result of a questionable financial decision $refinancing 0%percent
debt&, but does not enhance ongoing income results 'n fact, ongoing results will be worse
because of higher interest expense on the new bonds $'ncidentally, it is unlikely that a company
could buy back all of a bond issue at the market price stated for smaller trades&
b *he gain on the retirement of the old bonds is the same, irrespective of the vehicle used as the
source of funds to finance the retirement
c ' am pu##led as to why the !arvard casewriter used a Canuary 7, 51x3, refunding date but asked
for :ecember 37, 51x5, balance sheet information <ou may wish to clarify this on your course
assignment sheet (s shown in the table above, Iust prior to retirement at the end of 51x5, the old
bond issue will have a net book value of .3,//4,181, reflecting unamorti#ed discount $after the
year%end adIusting entry& of .550,951 *he Iournal entry to retire this bond, assuming the cash
required was .3,111,111 is as followsB
dr @onds 6ayable 4,111,111
cr ;ash 3,111,111
@ond :iscount 550,951
Oain on @ond >etirement //4,181
*he entry recording issuance of the 75 percent coupon bond with proceeds of .4,498,111 would
be as followsB
dr ;ash 4,498,111
cr @onds 6ayable 4,111,111
@ond 6remium 498,111
*he long%term debt line of the balance sheet will show .4,498,111, the sum of the face amount
and unamorti#ed premium
't may be useful to point out the net effect of the refunding by collapsing the above two Iournal
entries into oneB
dr ;ash 7,498,111
cr @ond :iscount"6remium /53,951
Oain on @ond >etirement //4,181
*hus, ;ash went up by .7,498,111, liabilities increased by ./53,951, and >etained Earnings went
up by .//4,181 !ence, the current ratio will be altered $improved& by this transaction
Ane year later, part of the premium on the new bond will have been amorti#ed (s shown in the
table above $end of period 5&, the net book value of the bond at :ecember 37, 51x3, will be
.4,42/,140
3 *aking the casewriter)s wording of question 5c literally, there will be a net increase in cash on
Canuary 7, 51x3, of .7,498,111 Every six months, starting with Cune 31, 51x3, Stone)s cash flow
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Accountin"# Te$t and Cases %&e ' Instructor(s Manual Antony)Ha*+ins)Mercant
would decrease by .741,111, relative to what it would have been without refunding the original
bondsB the old bonds had a semiannual interest payment of .711,111 $4,111 bonds P .50& and
the new ones have a semiannual payment of .541,111 $4,111 bonds P .21& ;ombining the
initial .7,498,111 cash increase and six net decreases of .741,111, by :ecember 37, 51x0, the
company will still be .208,111 ahead in net cash flow associated with its bonds
$!arnin"B *he instructor should seriously consider whether it is desirable to carry the discussion
any further, given that generally students have not had prior exposure to a finance course when
studying this case& !owever, taking a longer term perspective, would the firm really gain by such
a refinancing, as the refunding accounting procedures would indicateQ Ar has the company
actually hurt itself by incurring additional interest expense and .741,111 additional cash outflow
for each of the next seven yearsQ
*he answer is that, in real present value terms, nothing of economic significance has occurred
$ignoring the transaction costs associated with the refunding& 'f Stone issued Iust enough 75
percent bonds to raise the .3,111,111 necessary to retire the old bonds $.3,111,111".7,754255 -
5,228 bonds&, it simply would have exchanged differing cash flow patterns that have the same
present value $.3,111,111& when discounted at the going market rateH yet the accounting for the
refunding would still have shown a gain of .//4,181 *his is because although bonds are reported
at net present values on the balance sheet, the discount rate used to calculate the E6+ is the one
prevailing at the time of issuance, not the market rate at the time of the balance sheet date *he
:ecember 37, 51x5, present value per bond using a 3 percent discount rate per semiannual period
is .943051, or a total of .3,//4,181 for the 4,111 bonds @ut if a discount rate of 0 percent per
semiannual period were applied to the bond)s remaining cash flows, the present value per bond
would be ./05034, which the casewriter for simplicity rounded down to ./01 for a total market
value of .3,111,111 $*he present value would be ./01 if a semiannual rate of 013 percent were
used& *he reported .//4,181 gain, then, is Iust the difference between the E6+ of the bond)s
remaining cash flows discounted at the rate of the time of issuance and the E6+ when these flows
are discounted at the current market rate *hus, if bonds were carried at current values, such a
refunding would report no gain, Iust the transaction costs associated with carrying out the
refunding Stone is actually experiencing a profit from its old bonds, in that the interest costs
are only .711,111 per semiannual period versus .701,111 $.3,111,111 P 0 percent per
semiannual period& if .3,111,111 were raised at the prevailing rate ( decision to refinance is
simply a decision that there may be some benefit to changing the pattern of cash flows associated
with the bondsin this case, trading off higher cash interest payments versus a lower payment at
maturity $since the 4,111 old bonds can be refinanced with a smaller number of new bonds&
'f you do choose to get into all of this, be prepared to deal with student confusion as to why a
company would refund a bond at all @e sure to point out that the refunding example in the text is
$at least implicitly& based on the issuer)s being able to reacquire the bonds at a call price that is
lower than the current market price *his can happen if interest rates fall more, and thus bond
prices rise more, than was reflected in the bond)s call price schedule 'n such a case, the company
truly benefits economically from the refunding $assuming that transaction costs don)t wipe out
the call price%market price differential& <et note the irony that bond accounting procedures will
report a loss when such a refunding takes place, since $in the falling interest rate circumstances
we are assuming& the call price will exceed the price at which the bonds were originally issued
Case 8-3: Pau !urra"
*
%oteB Tis case is uncan"ed 2rom te 3le4ent 3dition
G
*his teaching note was prepared by >obert E (nthony ;opyright ? >obert E (nthony
71
?&,,- Mc.ra*/Hill)Ir*in Capter 0
Approach
,hen encountering a difficult concept, such as the time value of money, students often can get more
involved in trying to master the concept if they can relate it to their everyday lives before trying to apply
it to a business situation *hat is the purpose of this case, which is intended to be used with the (ppendix
to ;hapter 8 $'t can also be used instead at a later time with ;hapter 55 on capital budgeting& Since most
students will have recent experience with tuition, and many may be looking forward to finding new Iobs
and"or having children, these issues should be salient to them
Ans&ers to '(estions
%oteB Students ans*ers may di22er sli"tly, dependin" on *eter te te$t(s ta1les, a calculator, or a
spreadseet pro"ram is used5 6e"innin"/o2/year payments may 1e more realistic, 1ut tey tend to con2use
students since te ta1les and te routines in many calculators and spreadseets are 1ased on year/end
payments5
7uestion %
'f the tables are used, this question will require the student to think through how to come up with a future
value, given that the tables are designed to compute the present value when the future value is known
From the table, we can observe that the present value factor for .7 received 78 years hence is 301 *hus,
6+ - F+ G 6+%factor
6+ - F+ G 301
or 6+ divided by 301 - F+
Since the 6+ of one year)s tuition is .78,111, the F+ of one year)s tuition is .78,111 divided by 301 -
.07,4580/ *he F+ of four years) tuition is 4 G .07,4580/ - .510,/74
*o drive home the impact that a small difference in interest rates makes when compounded over many
years, you may want to examine in class what would happen if the cost of tuition continued to rise at 8N
as Te !all Street Journal reported it had in the past 'n this case, the F+ of one year)s tuition would be
.78,111 divided by 501 - ./5,111, and the F+ of four years) tuition would be 4 G ./5,111 - .588,111
Af course, many students will not have to use the tables but will use calculators or spreadsheets to
calculate the F+ directly
7uestion &
*he investment made at the end of <ear one will earn interest for 7/ years until the end of <ear 78, so its
F+ factor will be 7 divided by 3/7 - 5290 For the payment made at the end of <ear two, the F+ factor
will be 7 divided by 394 - 5038 @y performing similar calculations for the remaining years $see Exhibit
7&, you can then compute that the F+ factor for equal investments $earning 2N& made at the end of each
year is 31919 !ence, for the F+ of the investments to equal .510,/74, each investment must be
.510,/74 divided by 31919 - .2,200 $(gain, for comparison purposes, you might want to show that if
the four year tuition were .588,111 as in the 8N example, this would require annual investments of
.9,378 earning 2N to accumulate the desired amount&
7uestion 8
E2hibit 1
77
Accountin"# Te$t and Cases %&e ' Instructor(s Manual Antony)Ha*+ins)Mercant
Payment 3ade at End of Year4 5(t(re 1al(e 5actor 6 "7
7 7 3/7 - 5290
5 7 394 - 5038
3 7 47/ - 5398
4 7 445 - 5525
0 7 429 - 5735
2 7 49/ - 5175
/ 7 05/ - 7898
8 7 008 - 7/95
9 7 095 - 7289
71 7 25/ - 7090
77 7 220 - 7014
75 7 /10 - 7478
73 7 /4/ - 7339
74 7 /95 - 7523
'0 7 841 - 7791
72 7 891 - 7754
7/ 7 943 - 7121
78 7111
*otal 31919
E2hibit 2
Payment at
End of Year 51 5actor 6 87 51 5actor 6 187 51 5actor 6 7
7 7 5/1 - 3/14 7 798 - 0107 7 073 - 7949
5 7 595 - 3450 7 578 - 408/ 7 034 - 78/3
3 7 370 - 37/0 7 539 - 4784 7 000 - 7815
4 7 341 - 5947 7 523 - 3815 7 0// - 7/33
0 7 328 - 5/7/ 7 591 - 3448 7 217 - 7224
2 7 39/ - 5079 7 379 - 3730 7 250 - 7211
/ 7 459 - 5337 7 301 - 580/ 7 201 - 7038
8 7 423 - 5721 7 382 - 5097 7 2/2 - 74/9
9 7 011 - 5111 7 454 - 5308 7 /13 - 7455
71 7 041 - 7805 7 42/ - 5747 7 /37 - 7328
77 7 083 - 7/70 7 073 - 7949 7 /21 - 7372
75 7 231 - 708/ 7 024 - 7//3 7 /91 - 7522
73 7 287 - 7428 7 257 - 7271 7 855 - 757/
74 7 /30 - 7327 7 283 - 7424 7 800 - 77/1
70 7 /94 - 7509 7 /07 - 7335 7 889 - 7750
72 7 80/ - 772/ 7 852 - 7577 7 950 - 7187
7/ 7 952 - 7181 7 919 - 7711 7 925 - 7141
78 7111 7111 7111
*otal 3/427 40093 50243
(nnual investment to reach
.510, /74 .0,497 .4,075 .8,155
(nnual investment to reach
75
?&,,- Mc.ra*/Hill)Ir*in Capter 0
.588,111 ./,288 .2,37/ .77,537
Case 8-#: $oan %ot& (')
*
%ote4 Tis case is updated 2rom te 3le4ent 3dition
Approach
(s with the earlier Coan !olt# cases, this one enables students to discuss some interesting issues, none of
which requires a full class period *he instructor should be alert to newer situations to augment or
supplant any of those described in the case (lso many of these issues tend eventually to result in an
F(S@, (';6(, or SE; pronouncement Since seldom will a beginning student be aware of these
pronouncements, they do not preclude continuing to use a part of this case, and then revealing at the end
of that part)s discussion whether the accounting rule%making body reached the same conclusion as the
class did
Comments on '(estions
7 *he question is equivalent to asking, what is the future value of .711 invested at 71 percent
compound interest, 75/ years $78/9 % 5112& from nowQ *he answer is .711 $771&
75/
- .78,122,111
,e subsequently read that the man, after giving his town officials a good scare, did not pursue the
matter further, becausehad he prevailedit would have bankrupted the town
5 a For a future value of .7,111 received 8 years hence, and a 70 percent discount rate, the present
value is .35/H so, yes, the yield was 70 percent $*his result can be gotten using a calculator, or
by noting in (ppendix *able ( that the 8 yr, 70N 6+ factor is 135/&
b *he discount is .7,111 % 35/ - .2/3H using straight%line amorti#ation, that is .2/3 divided by 8 -
.84750"bond"yr, resulting in annual tax savings of .84750 G 141 - .3320 $Subsequent to the
writing of the case, the US *reasury reduced, but did not eliminate, the tax deductibility of
original issue discount, so these #ero%coupon bonds became less attractive& *hus, the bond issuer
contemplates the following cash flow patternB
*ime Rero L .35/
<ears 7%8 L .3320"yr
End of year 8 % .7,111
$(ctually, straight%line discount amorti#ation is not permitted, but we wanted to keep the
calculations as simple as possible& ,e need to make the sum of the 6+s of the eight%year stream
and negative future flow equal .35/, ie, find the rate that gives an E6+ of #ero @y trial and
error, this rate can be found to be approximately 80 percent $( calculator shows it to be 823
percent&
c ,ith 70 percent bonds issued for par, the net%of%tax interest payment stream is simply .701 $7%
141& - .91"bond"yr for 8 years 'f one makes a calculation like the one for part $b&, but with
*ime Rero in flow equal to .7,111 $instead of .35/& and the annual outflows equal to .91
$instead of .3320 annual inflows&, the rate giving an E6+ of #ero $remember the <ear 8 .7,111
outflow, as well& is 91 percent $(ctually, trial%and%error or calculators aren)t needed hereH once
the .91"year amount is determined, the rate of 91 percent is also determined, since .91 divided
by .7,111 - 91 percent *he student who quickly reali#es this understands the meaning of a
true return on investment of 91 percent& *hus, from the standpoint of the bondholder, ignoring
taxes, the yield on either bond is 70N, but the cost to the issuer of the #ero%coupon bond is lower
G
*his teaching note was prepared by >obert E (nthony ;opyright ? >obert E (nthony
73
Accountin"# Te$t and Cases %&e ' Instructor(s Manual Antony)Ha*+ins)Mercant
(ctually, #ero%coupon bonds are generally purchased by tax%exempt institutions, so this
comparison ignoring taxes is valid !owever, for taxable bondholder entities, the #ero%coupon
bond discount amorti#ation is taxable as ordinary interest income 'n the early 7981s, #ero%
coupon bond mutual funds have sprung up for use by '>(s
3 (lthough the text describes refunding a bond issue, it does not explicitly describe early
extinguishment of debt (ctually, refunding a bond issue is Iust a special case of early
extinguishmentB the proceeds to retire the current debt come from a new debt issue 'n the debt%for%
equity swap we)re considering, the substance of the transaction is the same as if the company issued
shares and then used the cash proceeds to buy its bonds on the open marketH in effect, the company is
simply paying an investment banker to do this on the company)s behalf $'n practice, an investment
banker would be used to market newly issued common stock, whatever the intended use of the
proceeds& @ut in fact, a company is motivated in the debt%for%equity swap to use the investment
banker as an intermediary because the tax laws are such that if the company handled the transactions
on its own, it would pay taxes on the difference between the repurchase cost of the bonds and their
balance sheet carrying value, irrespective of the source of the funds used to repurchase the bonds Af
course, we do not expect students to be aware of this anomaly in the tax lawbut they might well
surmise it, since, again, the substance is the same whether the transaction is handled by the company
or by an investment banker
(s to whether the company has really earned its gain on the swap will be debated by the students
'n the Exxon example given, ask for Iournal entries to reflect the transaction *hese will beB
dr @onds 6ayable /5 million
cr ;apital Stock 43 million
cr Q 59 million
*o what account should the hanging credit of .59 million be madeQ 'f it were made to ;apital
Stock, the value of the consideration for the stock $ie, bonds plus investment banker)s fee worth a
total of .43 million& would be overstated Ar if @onds 6ayable is debited for only .43 million $which
is equivalent to making the hanging credit to @onds 6ayable&, then the actual retirement of a ./5
million obligation is not reflected *hus, by process of elimination, the .59 million has to be credited
to >etained Earnings 'n fact, the same treatment cited in the text for bond refunding, coming from
AP6/&9 and :AS6/;, applies here, with the gain shown as an extraordinary item $described in ;hapter
71& on the income statement, rather than bring a direct credit to >etained Earnings $ie, rather than
not being flowed through the income statement& *he effect of this treatment is to reward the
company $through higher reported earnings& for being savvy enough to retire its debt early when the
debt)s market price was depressed
:iscussion of this technique should also bring out that the swap improves the company)s debt"equity
ratio and interest coverage $times interest earned& *he price the company pays for this is possible
dilution of earnings per share resulting from the additional shares outstanding !owever, as the
preceding Iournal entries illustrate, there is really no cash generated by the deal, except in future years
to the extent that dividends on the new shares are less than were the interest payments on the retired
bonds 'nterestingly, the (ssociated 6ress correspondent who wrote the article on which ' based this
problem did not understand that, because she indicates that the company ends up with some tax%free
cash that can be used for capital improvements
4 *he airlines $as of late 5110& were carrying a relatively small liability for earned but unused frequent
flier mileage credits Jost airlines had set up provisions for the future cost of frequent flier usage (n
alternative approach would require a revenue deferral approach ( portion of revenue applicable to
74
?&,,- Mc.ra*/Hill)Ir*in Capter 0
each original ticket sold would be deferred until the free tickets expected to be awarded were issued
and used (ssuming the percentage deferred was, say 0 percent, the Iournal entry for a .411 original
ticket would beB
dr ;ash 411
cr *icket >evenue 381
:eferred >evenue 51
*his approach implies that when a traveler buys a ticket, he"she in effect is buying that trip and a
piece of some future free trip, the revenue for which has not yet been earned 't)s not clear to me
why an approach analogous to warranty expense accounting $crediting the full amount of revenue,
.411, then also debiting (ward 6rogram Expense and crediting Future (ward ;osts for .51& wouldn)t
make more senseH the bottom line impact would be the same as the above, however
*he amount of the revenue deferral $or ex%post establishment of a liability for previously earned free
tickets& is certainly a fu##y issue, especially as the airlines begin to place restrictions on when free
tickets can be used (n airline might argue that, with restrictions, the free tickets are Iust filling
otherwise empty seats, so the cost to the airline is minimal (lso, some awards go unused (ccording
to Te !all Street Journal, some airlines are quietly hoping the '>S will ease their problem by
swiftly moving to tax%free tickets as income, which would drastically cut the number of people
redeeming their awards
*he F(S@ permits the use of either the cost reserve or revenue deferral method
0 *his item raises a number of interesting issues, and it illustrates how, depending on which accounting
principle one emphasi#es, a different accounting method may appear more appropriate in a specific
situation *his item also can be used to illustrate how accounting standards change and evolve over
time and the roles played by two key standard%setting bodies in the US, the SE; and the F(S@
( key issue is whether the purchase of the electronics product and the extended warranty contract
should be viewed as one transaction or two, and which alternative represents the best matching of
revenues and expenses Since such a high proportion of customers purchase the extended warranty
contract, particularly in the case of high ticket items, many would argue that it is, in substance, a
single transaction 'n fact, as illustrated by the example in the case, retailers frequently make most of
their profits on the extended warranty contract, not on the sale of the product
7
*herefore, the retailers
must view the sale of the electronics product and the extended warranty as a single transactionH
otherwise, they would not be willing to earn such a low $or nonexistent& margin on the sale of the
electronics product *he counter%argument is that customers do, in fact, have a choice of whether to
purchase the extended warranty contract or not, and many do not
'f you view the purchase as a single transaction, then (lternative @ represents the best matching 'f
you view it as two distinct transactions, then (lternative ( represents the best matching
(nother principle which can be discussed is conservatism ;learly, (lternative ( is the most
conservative as it defers the recognition of the most revenueH none of the warranty revenue is
recogni#ed at the date of the sale of the product 'nstead, the extended warranty revenue is recogni#ed
ratably over the life of the extended warranty contract (lternative @ which recogni#es all of the
warranty revenue on the date the product is sold, and (lternative ;, which recogni#es some of the
warranty on the date the product is sold, are clearly less conservative
7
6usiness !ee+ indicated that with retailers slashing prices to lure customers, service plans had become even more important, as
the revenues from extended warranties were one way to withstand the never%ending price wars 6usiness !ee+ quoted
(udio"+ideo (ffiliates ;hairman Stuart >ose, (nyone making money now, it)s probably 711N from warranties SElectronics
Stores Oet a ;ruel Shock, 6usiness !ee+, Canuary 74, 7997, page 45:T
70
Accountin"# Te$t and Cases %&e ' Instructor(s Manual Antony)Ha*+ins)Mercant
*he instructor can also raise the issue of performance under the extended warranty contractB ,hen
has the retailer performed what is required to earn income under the warranty contractQ ;learly, there
is some requirement for the retailer to perform, that is, to provide repair or replacement under the
extended warranty contract, during the life of the contract !owever, it can also be argued that the
reliability of these electronics products is high enough that, in most cases, the retailer will never have
to provide any service at all *his is one factor that makes these contracts so profitableB customers are
willing to purchase them in case there is a problem with the unit they have purchased but, in fact, in
most instances there will be no problem at all *he performance criterion argues for deferring at least
some warranty contract revenue to be recogni#ed over the life of the contract, but does it necessarily
mean that all warranty contract revenue should be deferredQ 'f deferring all extended warranty
contract revenue does not seem necessary, then (lternative ; may appear most appropriate
;learly, an argument for each of the three alternatives can be made and supported using the
accounting principles and sound reasoning
*he three alternatives will have different effects on the financial statements
5
First consider the
situation where sales are growing steadily $See E2* 1& (lternative @ will produce the highest revenue
and net income, as all extended warranty revenue and profit are recogni#ed immediately *he balance
sheet will also show the largest retained earnings and there will be no deferred revenue liability
(lternative ; will show the second highest revenue and net income, as some of the revenue and most
of the income from the extended warranty contract will be recogni#ed immediately *he balance sheet
will thus show the second highest retained earningsH there will be a deferred revenue liability that will
increase each year because we have assumed steadily growing sales
(lternative ( will show the lowest revenue and the lowest net income, as all of the extended warranty
revenues and the associated high warranty profits are deferred An the balance sheet, (lternative (
will show the smallest retained earnings and the largest deferred revenue liability Af course, the net
effect on the cash flow statement is the same for each of the three alternatives ( lower net income
will be adIusted by a higher deferred revenue to reveal the same impact on cash
*he story changes if the sales decline $See E2* 2& 'n this situation, (lternative ( will eventually show
the highest revenue because it deferred the most extended warranty contract revenue, and it will show
the highest net income because of the deferral of these very high margin contracts Eet income
decreases much more gradually under (lternative ( than under the other alternatives (lternative @
will show the most precipitous drop in sales and net income because there is no carryover of the very
profitable extended warranty contracts to cushion the fall
*he accounting standards for extended warranty contracts have changed and evolved over time
'nitially, retailers had considerable latitude in choosing the method they considered most appropriate
'n 7989, the SE; staff moved to limit this latitude when they indicated that partial
recognition(lternative ;should be used
3
Subsequently, the F(S@ issued a Tecnical 6ulletin
requiring retailers to delay recognition of extended warranty revenue and income until the warranty
period expired $(lternative (&
4
*his pattern of accounting standard evolution is not uncommonB a
situation arises that regulators may consider misleading or abusiveH the SE; steps in with a quick
fix and the F(S@, with its larger staff and open standard%setting process, follows with a $perhaps&
more thorough alternative that the SE; agrees to accept *his process is consistent with that seen in
other controversial issues, such as accounting for the effects of inflation
,hen the change to delayed recognition of extended warranty revenue and income $(lternative (&
5
'n the discussion of effects on the financial statements, it will be assumed that margins on products and extended warranty
contracts remain constant (ny effect of the three alternatives on taxes $expense, liability, deferred tax& will be ignored
3
SE; and !ighland Superstores, 'nc, Jarch 7989
4
:AS6 Tecnical 6ulletin No5 <,/%, (ccounting for Separately 6riced Extended ,arranty and 6roduct Jaintenance ;ontracts,
:ecember 7991
72
?&,,- Mc.ra*/Hill)Ir*in Capter 0
was announced, it was expected to have a significant effect on the financial results of maIor
electronics retailers (ccording to 6usiness !ee+B
;ircuit ;ity Stores, 'nc, the biggest US consumer%electronics chain, with .54 billion in sales
and 780 stores, expects that the revision in warranty accounting will cut 50 cents a share from
earnings for the year *hat)s roughly 72N of fiscal 7997)s estimated profit of .700 a share (nd,
because it prefers not to drag out the change over several years, ;ircuit ;ity also plans to take a
one%time charge to account for warranty sales in prior years *hat will cost an additional .770 a
share (lthough the charges won)t affect actual cash flow, they will all but wipe out stated
earnings
0
0
6usiness !ee+, op cit
7/
E2hibit 1
Financial Statement 'mpactB Steadily 'ncreasing Sales
(lternative ( (lternative @ (lternative ;

x1 xl x5 x1 x7 x5 x1 xl x5
Eumber of units sold 7 5 3 7 5 3 7 5 3
>evenuesB
6roduct .5,111 .4,111 .2,111 .5,111 .4,111 .2,111 .5,758 .4,502 .2,384
,arranty $x1& 21 21 21 781 7/ 7/ 78
,arranty $xl& 751 751 321 30 30
,arranty $x5& UUUUU UUUUU 781 UUUUU UUUUU 041 UUUUU UUUUU 05
*otal revenue 5,121 4,781 2,321 5,781 4,321 2,041 5,740 4,318 2,489
;ost of goods sold
6roduct 7,841 3,281 0,051 7,841 3,281 0,051 7,841 3,281 0,051
,arranty $x1& 70 70 70 40 70 70 70
,arranty $x7& 31 31 91 31 31
,arranty $x5& UUUUU UUUUU 40 UUUUU UUUUU 730 UUUUU UUUUU 40
*ota7 cost of goods sold 7,800 3,/50 0,271 7,880 3,//1 0,200 7,800 3,/50 0,271
Eet income 510 400 /01 590 091 880 591 083 8/9
:eferred revenue
x1 751 21 1 %% %% %% 30 78 1
x7 541 751 %% %% %% 29 34
x5 UUUUU UUUUU 321 UU U%% UU U%% UU U%% UUUUU UUUUU %
*otal deferred revenue 751 311 481 1 1 1 30 8/ 738
;umulative increase
in retained earnings 510 221 7,471 590 880 7,//1 591 8/3 7,/05
E2hibit 2
Financial Statement 'mpactB :ecreasing Sales
(lternative ( (lternative @ (lternative ;
<ear x1 x7 x5 x1 x7 x5 x1 x7 x5
Eumber of units sold 3 5 7 3 5 7 3 5 7
>evenues
6roduct .2,11
1
.4,111 .5,11
1
.2,111 .4,11
1
.5,11
1
.2,384 .4,50
2
.5,75
8
,arranty $x1& 781 781 781 041 05 05 05
,arranty $xl& 751 751 321 30 30
,arranty $x5& UUUUU UUUUU 21 UUUUU UUUUU 781 UUUUU UUUUU 7/
*otal revenue 2,781 4,311 5,321 2,041 4,321 5,781 2,432 4,343 5,535
;ost of goods sold
6roduct 0,051 3,281 7,841 0,051 3,281 7,841 0,051 3,281 7,841
,arranty $x1& 40 40 40 730 40 40 40
,arranty $xl& 31 31 91 31 31
,arranty $x5& UUUUU UUUUU 70 UUUUU UUUUU 40 UUUUU UUUUU 70
*otal cost of goods sold 0,020 3,/00 7,931 0,200 3,//1 7,880 0,020 3,/00 7,931
Eet income 270 040 431 880 091 590 8/7 088 315
:eferred revenue
x1 321 781 1 %% %% %% 714 05 1
x7 541 751 %% %% %% 29 34
x5 UUUUU UUUUU 751 UU U%% U UU%% U UU%% UUUUU UUUUU 30
*otal deferred revenue 321 451 541 1 1 1 714 757 29
;umulative increase
in retained earnings 270 l,721 7,091 880 l,4/0 7,//1 8/7 7,409 7,/27