Chapter 14 Bonds and Long-Term Notes 1 Chapter 14 Bonds and Long-Term Notes QUESTIONS FOR REVIEW OF KEY TOPICS Question 14-1 Periodic interest is calculated as the effective interest rate times the amount of the debt outstanding during the period. This same principle applies to the flip side of the transaction, i.e., the creditor’s receivable or investment. The approach also is the same regardless of the specific form of the debt – that is, whether in the form of notes, bonds, leases, pensions, or other debt instruments. Question 14-2 Long-term liabilities are appropriately reported at their present values. The present value of a liability is the present value of its related cash flows – specifically the present value of the face amount of the debt instrument, if any, plus the present value of stated interest payments, if any. Both should be discounted to present value at the effective (market) rate of interest at issuance. Question 14-3 Bonds and notes are very similar. Both typically obligate the issuing corporation to repay a stated amount (e.g., the principal, par value, face amount, or maturity value) at a specified maturity date. In return for the use of the money borrowed, the company also agrees to pay interest to the lender between the issue date and maturity. The periodic interest is a stated percentage of face amount. In concept, bonds and notes are accounted for in precisely the same way. Normally a company will borrow cash from a bank or other financial institution by signing a promissory note. Corporations, especially medium- and large- sized firms, often choose to borrow cash by issuing bonds instead. A bond issue, in effect, breaks down a large debt into manageable parts ($1,000 units). Also, bonds typically have longer maturities than notes. The most common form of corporate debt is bonds. Question 14-4 All of the specific promises made to bondholders are described in a bond indenture. This formal agreement will specify the bond issue’s face amount, the stated interest rate, the method of paying interest (whether the bonds are registered bonds or coupon bonds), whether the bonds are backed by a lien on specified assets, and whether they are subordinated to other debt. The bond indenture also might provide for their redemption through a call feature, by serial payments, through sinking fund provisions, or by conversion. It also will specify the trustee (usually a commercial bank or other financial institution) appointed by the issuing firm to represent the rights of the bondholders. The bond indenture serves as a contract between the company and the bondholder(s). If the company fails to live up to the terms of the bond indenture, the trustee may bring legal action against the company on behalf of the bondholders. 2 Answers to Questions (continued) Question 14-5 All bonds sell at their price plus any interest that has accrued since the last interest date to simplify the process of paying and recording interest. The buyer is asked to pay the seller accrued interest for any time that has elapsed since the last interest date in addition to the price of the bonds so that when a full six months’ interest is paid at the next interest date, the net interest paid/received will be correct for the time the bonds have been held by the investor. Question 14-6 In order for Brandon to sell its bonds that pay only 11.5% stated interest in a 12.25% market the bonds would have to be priced at a discount from face amount. The discount would be the amount that causes the bond issue to be priced to yield the market rate. In other words, an investor paying that price would earn an effective rate of return on the investment equal to the 12.25% market rate. Question 14-7 The price will be the present value of the periodic cash interest payments (face amount x stated rate) plus the present value of the principal payable at maturity. Both interest and principal are discounted to present value at the market rate of interest for securities of similar risk and maturity. Question 14-8 In a strict sense, it’s true that zero-coupon bonds pay no interest. “Zeros” offer a return in the form of a “deep discount” from the face amount. Still, interest accrues at the effective rate times the outstanding balance, but no interest is paid periodically. So, interest on zero-coupon bonds is determined and reported in precisely the same manner as on interest-paying bonds. Under the concept of accrual accounting, the periodic effective interest is unaffected by when the cash actually is paid. Corporations can deduct for tax purposes the annual interest expense, but without cash outflow until the bonds mature. Question 14-9 When bonds are issued at a premium the debt declines each period because the effective interest each period is less than the cash interest paid. The “overpayments” each period reduce the balance owed. This is precisely the opposite of when debt is sold at a discount. In that case, the effective interest each period is more than the cash paid, and the “underpayment” of interest adds to the amount owed. 3 Answers to Questions (continued) Question 14-10 By the effective interest method, interest is recorded each period as the effective market rate of interest multiplied by the outstanding balance of the debt (during the interest period). This simply is an application of the accrual concept, consistent with accruing all expenses as they are incurred. The “unpaid” (or “overpaid”) portion of the effective interest increases (or decreases) the existing liability and is reflected as “amortization” of the discount (or premium). An exception to the conceptually appropriate method of determining interest for bond issues is the straight-line method. Companies are allowed to determine interest indirectly by allocating a discount or a premium equally to each period over the term to maturity if doing so produces results that are not materially different from the interest method. The firm’s decision should be guided by whether the straight-line method would tend to mislead investors and creditors in the particular circumstance. The straight-line method results in a constant dollar amount of interest each period. By the straight-line method, the amount of the discount to be reduced periodically is calculated, and the effective interest is the “plug” figure. By the effective interest method, the dollar amounts of interest vary over the term to maturity because the percentage rate of interest remains constant, but is applied to a changing debt balance. The “straight-line method,” is not an alternative method of determining interest in a conceptual sense, but is an application of the materiality concept. Question 14-11 The prescribed treatment requires a debit to an asset account – "debt issue costs” which is then allocated to expense, usually on a straight-line basis. An appealing alternative would be to reduce the recorded amount of the debt by the debt issue costs. This approach has the appeal of reflecting the effect debt issue costs have on the effective interest rate. Debt issue costs reduce the net cash the company receives from the sale of the financial instrument. A lower net amount is borrowed at the same cost, increasing the effective interest rate. The actual increase in the effective interest rate is reflected in the interest expense if the issue cost is allowed to reduce the premium (or increase the discount) on the debt. This approach also is consistent with the treatment of issue costs when shares of stock are sold. Share issue costs are recorded as a reduction in the amount credited to stock accounts (Chapter 19). Question 14-12 When the stated interest rate is not indicative of the market rate at the time a note is negotiated, the value of the asset (cash or noncash) or service exchanged for the note establishes the market rate. This rate is the implicit rate of interest. If the value of the asset (or service) is not readily determinable, the implicit rate may not be apparent. In that case an appropriate rate should be “imputed” as the rate that would be expected in a similar transaction, under similar circumstances. The economic essence of a transaction should prevail over its outward appearance. The accountant should look beyond the form of this transaction and record its substance. The amount actually paid for the asset is the present value of the cash flows called for by the loan agreement, discounted at the “imputed” market rate. Both the asset acquired and the liability used to purchase it should be recorded at the real cost. 5 Answers to Questions (continued) Question 14-13 In accordance with FAS 150, mandatorily redeemable shares, which the issuing company is obligated to buy back in exchange for cash or other assets, must be reported as liabilities. Question 14-14 When notes are paid in installments, rather than a single amount at maturity, installment payments typically are equal amounts each period. Each payment will include both an amount representing interest and an amount representing a reduction of principal. At maturity, the principal is completely paid. The installment amount is calculated by dividing the amount of the loan by the appropriate discount factor for the present value of an annuity. Determining periodic interest is the same as for a note whose principal is paid at maturity – effective interest rate times the outstanding principal. But the periodic cash payments are larger and there is no lump-sum payment at maturity. Question 14-15 For all long-term borrowings, disclosure should include (a) the fair values, (b) the aggregate amounts maturing, and (c) sinking fund requirements (if any) for each of the next five years. Question 14-16 Regardless of the method used to retire debt prior to its scheduled maturity date, the gain or loss on the transaction is simply the difference between the carrying amount of the debt at that time and the cash paid to retire it. To record the extinguishment the account balances pertinent to the debt are removed from the books. Cash is credited for the amount paid (the call price or market price). The difference between the carrying amount and the reacquisition price is the gain or loss. Question 14-17 Gains and losses are reported as extraordinary items when they are considered to be both unusual and infrequent. In that case they are reported separate from ordinary operations and net of their related income tax effects. Question 14-18 GAAP requires that the entire issue price of convertible bonds be recorded as debt, precisely the same way, in fact, as for nonconvertible bonds. On the other hand, the issue price of bonds with detachable warrants is allocated between the two different securities on the basis of their market values. The difference is based on the relative separability of the debt and equity features of the two securities. In the case of convertible bonds, the two features of the security, the debt and the conversion option, are physically inseparable — the option cannot be exercised without surrendering the debt. But the debt and equity features of bonds with detachable warrants can be separated. Unlike a conversion feature, warrants can be separated from the bonds and can be exercised independently or traded in the market separately from bonds. In substance, two different securities – the bonds and the warrants – are sold as a "package" for a single issue price. 6 Answers to Questions (concluded) Question 14-19 Additional consideration a company provides to induce conversion of convertible debt should be recorded as an expense of the period. It is measured at the fair value of that consideration. This might be cash paid, the market price of stock warrants given, or the market value of additional shares issued due to modifying the conversion ratio. Question 14-20 By definition, a troubled debt restructuring involves some concessions on the part of the creditor (lender). A creditor may feel it can minimize losses by restructuring a debt agreement, rather than forcing liquidation. A troubled debt restructuring takes one of two forms, with the second further categorized for accounting purposes: 1. The debt may be settled at the time of the restructuring, or 2. The debt may be continued, but with modified terms. a. Under the modified terms, total cash to be paid is less than the carrying amount of the debt. b. Under the modified terms, total cash to be paid exceeds the carrying amount of the debt. Question 14-21 Pratt has a gain of $2 million (the difference between the carrying amount of the debt and the fair value of the property transferred). Pratt also must adjust the carrying amount of the land to its fair value prior to recording its exchange for the debt. Pratt would need to change the recorded amount for the property specified in the exchange agreement from $2 million to the $3 million fair market value. This produces a “gain on disposition of assets” of $1 million. So, Pratt would report two items on its income statement in connection with the troubled debt restructuring: (1) a $2 million gain on troubled debt restructuring and (2) a “gain on disposition of assets” of $1 million. Question 14-22 (a) When the total future cash payments are less than the carrying amount of the debt, the difference is recorded as a gain to the debtor at the date of restructure. No interest is recorded thereafter. All subsequent cash payments produce reductions of principal. (b) When the total future cash payments exceed the carrying amount of the debt, no reduction of the existing debt is necessary and no entry is required at the time of the debt restructuring. The accounting objective is to determine the new (lower) effective interest and to record interest expense for the remaining term of the loan at that new, lower rate. 7 BRIEF EXERCISES Brief Exercise 14-1 $30,000,000 x 6% x 3/12 = $450,000 face annual fraction of the accrued amount rate annual period interest Brief Exercise 14-2 Interest $ 2,000,000 ¥ x 23.11477* = $46,229,540 Principal $80,000,000 x 0.30656** = 24,524,800 Present value (price) of the bonds $70,754,340 ¥ [5÷2] % x $80,000,000 * present value of an ordinary annuity of $1: n=40, i=3% ** present value of $1: n=40, i=3% Brief Exercise 14-3 The price will be the present value of the periodic cash interest payments (face amount x stated rate) plus the present value of the principal payable at maturity. Both interest and principal are discounted to present value at the market rate of interest for securities of similar risk and maturity. When the stated rate and the market rate are the same, the bonds will sell at face value, $75 million in this instance. Brief Exercise 14-4 Interest $ 2,500,000 ¥ x 27.35548* = $ 68,388,700 Principal $100,000,000 x 0.45289** = 45,289,000 Present value (price) of the bonds $113,677,700 ¥ [5÷2] % x $100,000,000 * present value of an ordinary annuity of $1: n=40, i=2% ** present value of $1: n=40, i=2% 8 Brief Exercise 14-5 Interest will be the effective rate times the outstanding balance: 4% x $82,218,585 = $3,288,743 Brief Exercise 14-6 Interest will be the effective rate times the outstanding balance: June 30 Interest expense (2% x $69,033,776) ................................ 1,380,676 Discount on bonds payable (difference) ................. 180,676 Cash (1.5% x $80,000,000) ....................................... 1,200,000 December 31 Interest expense (2% x [$69,033,776 + 180,676]) .......... 1,384,289 Discount on bonds payable (difference) ................. 184,289 Cash (1.5% x $80,000,000)....................................... 1,200,000 $1,380,676 + 1,384,289 = $2,764,965 Brief Exercise 14-7 Interest will be a plug figure: $80,000,000 - 69,033,776 = $10,966,224 discount $10,966,224 / 40 semiannual periods = $274,156 reduction each period June 30 Interest expense (to balance) ............................................. 1,474,156 Discount on bonds payable (difference) ................. 274,156 Cash (1.5% x $80,000,000) ....................................... 1,200,000 December 31 Interest expense (to balance) ............................................. 1,474,156 Discount on bonds payable (difference) ................. 274,156 Cash (1.5% x $80,000,000) ....................................... 1,200,000 $1,474,156 + 1,474,156 = $2,948,312 9 Brief Exercise 14-8 Interest will be the effective rate times the outstanding balance: June 30 Cash (1.5% x $80,000,000) .......................................... 1,200,000 Discount on investment in bonds (difference) ........... 180,676 Interest revenue (2% x $69,033,776) ............................ 1,380,676 December 31 Cash (1.5% x $80,000,000) .......................................... 1,200,000 Discount on investment in bonds (difference) ........... 184,289 Interest revenue (2% x [$69,033,776 + 180,676]) ...... 1,384,289 Brief Exercise 14-9 Interest $6,000¥ x 2.72325 * = $ 16,340 Principal $300,000 x 0.86384 ** = 259,152 Present value (price) of the note $275,492 ¥ 2% x $300,000 * present value of an ordinary annuity of $1: n=3, i=5% ** present value of $1: n=3, i=5% Equipment (price determined above) ................................ 275,492 Discount on notes payable (difference) .......................... 24,508 Notes payable (face amount) ...................................... 300,000 10 Brief Exercise 14-10 $300,000 ÷ 2.72325 = $110,163 amount (from Table 4) installment of loan n=3, i=5% payment Helpful, but not required: Cash Effective Decrease in Outstanding Dec.31 Payment Interest Balance Balance 5% x Outstanding Balance Balance Reduction 300,000 1 110,163 .05 (300,000) = 15,000 95,163 204,837 2 110,163 .05 (204,837) = 10,242 99,921 104,917 3 110,163 .05(104,917) = 5,246 104,917 0 Interest expense (5% x ($300,000 – [$110,163 – 5% x $300,000])) 10,242 Note payable (difference) ............................................... 99,921 Cash (payment determined above) ................................. 110,163 Brief Exercise 14-11 ($ in millions) Bonds payable (face amount) ..................................... 60.0 Loss on early extinguishment (to balance) ................. 3.2 Discount on bonds (given) ..................................... 2.0 Cash ($60,000,000 x 102%) ..................................... 61.2 11 Brief Exercise 14-12 The issue price of bonds with detachable warrants is allocated between the two different securities on the basis of their market values. ($ in millions) Cash (102% x $60 million) ...................................................... 61.2 Discount on bonds payable (difference) ................................ 1.8 Bonds payable (face amount) ............................................. 60.0 Paid-in capital – stock warrants outstanding ($5 x 10 warrants x 60,000 bonds) ...................................... 3.0 Brief Exercise 14-13 GAAP requires that the entire issue price of convertible bonds be recorded as debt, precisely the same way, in fact, as for nonconvertible bonds. ($ in millions) Cash (102% x $60 million) ...................................................... 61.2 Premium on bonds payable (difference) ............................ 1.2 Bonds payable (face amount) ............................................. 60.0 12 EXERCISES Exercise 14-1 Requirement 1 $100 million x 12% x 2/12 = $2 million face annual fraction of the accrued amount rate annual period interest Requirement 2 ($ in millions) Cash ($99 million plus accrued interest) .................................... 101 Discount on bonds ($100 million – $99 million) ...................... 1 Bonds payable (face amount) ............................................. 100 Interest payable (accrued interest determined above) ............. 2 13 Exercise 14-2 The DD Corp. bonds are appropriately priced to yield the market rate of interest. The GG Corp. bonds are slightly underpriced at the stated price and therefore are the most attractive. The BB Corp. bonds are slightly overpriced at the stated price and therefore are the least attractive. Bonds should be priced to yield the market rate, 10% in this case. When this rate is used to price the bonds, we get the prices shown below. Presumably, the market rate changed since the underwriters priced two of the bond issues. BB Corp. bonds: Interest $ 5,500,000 ¥ x 17.15909 * = $ 94,374,995 Principal $100,000,000 x 0.14205 ** = 14,205,000 Present value (price) of the bonds $108,579,995 ¥ [11÷2] % x $100,000,000 * present value of an ordinary annuity of $1: n=40, i=5% ** present value of $1: n=40, i=5% DD Corp. bonds: Interest $ 5,000,000 ¥ x 17.15909 * = $ 85,795,450 Principal $100,000,000 x 0.14205 ** = 14,205,000 Present value (price) of the bonds $100,000,450 Note: The result differs from $100,000,000 only because the present value factors in any present value table are rounded. Because the stated rate and the market rate are the same, the true present value is $100,000,000. ¥ [10÷2] % x $100,000,000 * present value of an ordinary annuity of $1: n=40, i=5% ** present value of $1: n=40, i=5% GG Corp. bonds: Interest $ 4,500,000 ¥ x 17.15909 * = $77,215,905 Principal $100,000,000 x 0.14205 ** = 14,205,000 Present value (price) of the bonds $91,420,905 ¥ [9÷2] % x $100,000,000 * present value of an ordinary annuity of $1: n=40, i=5% ** present value of $1: n=40, i=5% 14 Exercise 14-3 1. Maturity Interest paid Stated rate Effective (market) rate 10 years annually 10% 12% Interest $100,000 ¥ x 5.65022 * = $565,022 Principal $1,000,000 x 0.32197 ** = 321,970 Present value (price) of the bonds $886,992 ¥ 10% x $1,000,000 * present value of an ordinary annuity of $1: n=10, i=12% ** present value of $1: n=10, i=12% 2. Maturity Interest paid Stated rate Effective (market) rate 10 years semiannually 10% 12% Interest $50,000 ¥ x 11.46992 * = $573,496 Principal $1,000,000 x 0.31180 ** = 311,800 Present value (price) of the bonds $885,296 ¥ 5% x $1,000,000 * present value of an ordinary annuity of $1: n=20, i=6% ** present value of $1: n=20, i=6% 3. Maturity Interest paid Stated rate Effective (market) rate 10 years semiannually 12% 10% Interest $60,000 ¥ x 12.46221 * = $ 747,733 Principal $1,000,000 x 0.37689 ** = 376,890 Present value (price) of the bonds $1,124,623 ¥ 6% x $1,000,000 * present value of an ordinary annuity of $1: n=20, i=5% ** present value of $1: n=20, i=5% 4. Maturity Interest paid Stated rate Effective (market) rate 20 years semiannually 12% 10% Interest $60,000 ¥ x 17.15909 * = $1,029,545 Principal $1,000,000 x 0.14205 ** = 142,050 Present value (price) of the bonds $1,171,595 ¥ 6% x $1,000,000 * present value of an ordinary annuity of $1: n=40, i=5% ** present value of $1: n=40, i=5% 15 Exercise 14-3 (concluded) 5. Maturity Interest paid Stated rate Effective (market) rate 20 years semiannually 12% 12% Interest $60,000 ¥ x 15.04630 * = $902,778 Principal $1,000,000 x 0.09722 ** = 97,220 Present value (price) of the bonds $999,998 actually, $1,000,000 if PV table factors were not rounded ¥ 6% x $1,000,000 * present value of an ordinary annuity of $1: n=40, i=6% ** present value of $1: n=40, i=6% 16 Exercise 14-4 1. Price of the bonds at January 1, 2006 Interest $4,000,000¥ x 11.46992 * = $45,879,680 Principal $80,000,000 x 0.31180 ** = 24,944,000 Present value (price) of the bonds $70,823,680 ¥ 5% x $80,000,000 * present value of an ordinary annuity of $1: n=20, i=6% ** present value of $1: n=20, i=6% 2. January 1, 2006 Cash (price determined above) ...................................... 70,823,680 Discount on bonds (difference) .................................. 9,176,320 Bonds payable (face amount) .................................. 80,000,000 3. June 30, 2006 Interest expense (6% x $70,823,680) ................................ 4,249,421 Discount on bonds payable (difference) ................. 249,421 Cash (5% x $80,000,000) ......................................... 4,000,000 4. December 31, 2006 Interest expense (6% x [$70,823,680 + 249,421]) ............ 4,264,386 Discount on bonds payable (difference) ................. 264,386 Cash (5% x $80,000,000) ......................................... 4,000,000 17 Exercise 14-5 1. January 1, 2006 Interest $4,000,000¥ x 11.46992 * = $45,879,680 Principal $80,000,000 x 0.31180 ** = 24,944,000 Present value (price) of the bonds $70,823,680 ¥ 5% x $80,000,000 * present value of an ordinary annuity of $1: n=20, i=6% ** present value of $1: n=20, i=6% Bond investment (face amount) .................................. 80,000,000 Discount on bond investment (difference) ............. 9,176,320 Cash (price determined above) .................................. 70,823,680 2. June 30, 2006 Cash (5% x $80,000,000) ............................................. 4,000,000 Discount on bond investment (difference) ..................... 249,421 Interest revenue (6% x $70,823,680) ............................ 4,249,421 3. December 31, 2006 Cash (5% x $80,000,000) ............................................. 4,000,000 Discount on bond investment (difference) ................. 264,386 Interest revenue (6% x [$70,823,680 + 249,421]) ........ 4,264,386 18 Exercise 14-6 1. Price of the bonds at January 1, 2006 Interest $16,000,000¥ x 11.46992 * = $183,518,720 Principal $320,000,000 x 0.31180 ** = 99,776,000 Present value (price) of the bonds $283,294,720 ¥ 5% x $320,000,000 * present value of an ordinary annuity of $1: n=20, i=6% ** present value of $1: n=20, i=6% 2. Liability at December 31, 2006 Bonds payable (face amount) ..................................... $320,000,000 Less: discount .......................................................... 36,705,280 Initial balance, January 1, 2006 ............................... $283,294,720 June 30, 2006 discount amortization ....................... 997,683* Dec. 31, 2006 discount amortization ....................... 1,057,544** December 31, 2006 net liability .............................. $285,349,947 3. Interest expense for year ended December 31, 2006 June 30, 2006 interest expense ................................ $16,997,683* Dec. 31, 2006 interest expense ................................ 17,057,544** Interest expense for 2006 ......................................... $34,055,227 4. Statement of cash flows for year ended December 31, 2006 Myriad would report the cash inflow of $283,294,720*** from the sale of the bonds as a cash inflow from financing activities in its statement of cash flows. The $32,000,000 cash interest paid *, ** is cash outflow from operating activities because interest is an income statement (operating) item. 19 Exercise 14-6 (concluded) Calculations: January 1, 2006*** Cash (price determined above) ...................................... 283,294,720 Discount on bonds (difference) .................................. 36,705,280 Bonds payable (face amount) .................................. 320,000,000 June 30, 2006* Interest expense (6% x $283,294,720) .............................. 16,997,683 Discount on bonds payable (difference) ................. 997,683 Cash (5% x $320,000,000)........................................ 16,000,000 December 31, 2006** Interest expense (6% x [$283,294,720 + 997,683]) .......... 17,057,544 Discount on bonds payable (difference) ................. 1,057,544 Cash (5% x $320,000,000)........................................ 16,000,000 20 Exercise 14-7 1. Price of the bonds at June 30, 2006 Interest $58,500¥ x 15.04630 * = $880,209 Principal $900,000 x 0.09722 ** = 87,498 Present value (price) of the bonds $967,707 ¥ 6.5% x $900,000 * present value of an ordinary annuity of $1: n=40, i=6% ** present value of $1: n=40, i=6% 2. June 30, 2006 Cash (price determined above) ...................................... 967,707 Bonds payable (face amount) .................................. 900,000 Premium on bonds (difference) .............................. 67,707 3. December 31, 2006 Interest expense (6% x $967,707) ..................................... 58,062 Premium on bonds payable (difference) .................... 438 Cash (6.5% x $900,000) ........................................... 58,500 4. June 30, 2007 Interest expense (6% x [$967,707 – 438]) ......................... 58,036 Premium on bonds payable (difference) .................... 464 Cash (6.5% x $900,000) ........................................... 58,500 21 Exercise 14-8 1. Price of the bonds at January 1, 2006 Interest $7,500,000¥ x 13.76483 * = $103,236,225 Principal $150,000,000 x 0.17411 ** = 26,116,500 Present value (price) of the bonds $129,352,725 ¥ 5% x $150,000,000 * present value of an ordinary annuity of $1: n=30, i=6% ** present value of $1: n=30, i=6% 2. January 1, 2006 Cash (price determined above) ................................ 129,352,725 Discount on bonds (difference) ............................ 20,647,275 Bonds payable (face amount) ............................ 150,000,000 3. June 30, 2006 Interest expense ($7,500,000 + $688,243) ........................ 8,188,243 Discount on bonds payable ($20,647,275 ÷ 30) ........ 688,243 Cash (5% x $150,000,000)........................................ 7,500,000 4. December 31, 2013 Interest expense ($7,500,000 + $688,243) ........................ 8,188,243 Discount on bonds payable ($20,647,275 ÷ 30) ........ 688,243 Cash (5% x $150,000,000)........................................ 7,500,000 [Using the straight-line method, each interest entry is the same.] 22 Exercise 14-9 1. January 1, 2006 Interest $7,500,000¥ x 13.76483 * = $103,236,225 Principal $150,000,000 x 0.17411 ** = 26,116,500 Present value (price) of the bonds $129,352,725 ¥ 5% x $150,000,000 * present value of an ordinary annuity of $1: n=30, i=6% ** present value of $1: n=30, i=6% Bond investment (face amount) .............................. 150,000,000 Discount on bond investment (difference) ......... 20,647,275 Cash (price determined above) .............................. 129,352,725 2. June 30, 2006 Cash (5% x $150,000,000) ........................................... 7,500,000 Discount on bond investment ($20,647,275 ÷ 30) ......... 688,243 Interest revenue ($7,500,000 + $688,243) .................... 8,188,243 3. December 31, 2013 Cash (5% x $150,000,000) ........................................... 7,500,000 Discount on bond investment ($20,647,275 ÷ 30) ......... 688,243 Interest revenue ($7,500,000 + $688,243) .................... 8,188,243 [Using the straight-line method, each interest entry is the same.] 23 Exercise 14-10 1. January 1, 2006 Cash (price given) .................................................. 739,814,813 Discount on bonds (difference) ............................. 60,185,187 Bonds payable (face amount) ............................. 800,000,000 2. June 30, 2006 Interest expense (6% x $739,814,813) ........................ 44,388,889 Discount on bonds payable (difference) ............ 388,889 Cash (5.5% x $800,000,000) ................................ 44,000,000 3. December 31, 2006 Interest expense (6% x [$739,814,813 + 388,889]) .... 44,412,222 Discount on bonds payable (difference) ............ 412,222 Cash (5.5% x $800,000,000) ................................ 44,000,000 24 Exercise 14-11 1. Price of the bonds at January 1, 2006 Interest $22,500¥ x 6.46321 * = $145,422 Principal $500,000 x 0.67684 ** = 338,420 Present value (price) of the bonds $483,842 ¥ 4.5% x $500,000 * present value of an ordinary annuity of $1: n=8, i=5% ** present value of $1: n=8, i=5% 2. January 1, 2006 Cash (price determined above) ........................... 483,842 Discount on bonds (difference) ....................... 16,158 Bonds payable (face amount) ....................... 500,000 3. Amortization schedule Cash Effective Increase in Outstanding Interest Interest Balance Balance 4.5% x Face Amount 5% x Outstanding Balance Discount Reduction 483,842 1 22,500 .05 (483,842) = 24,192 1,692 485,534 2 22,500 .05 (485,534) = 24,277 1,777 487,311 3 22,500 .05 (487,311) = 24,366 1,866 489,177 4 22,500 .05 (489,177) = 24,459 1,959 491,136 5 22,500 .05 (491,136) = 24,557 2,057 493,193 6 22,500 .05 (493,193) = 24,660 2,160 495,353 7 22,500 .05 (495,353) = 24,768 2,268 497,621 8 22,500 .05 (497,621) = 24,879* 2,379 500,000 180,000 196,158 16,158 * rounded. 25 Exercise 14-11 (concluded) 4. June 30, 2006 Interest expense (5% x $483,842) ....................... 24,192 Discount on bonds payable (difference) ...... 1,692 Cash (4.5% x $500,000) ................................ 22,500 5. December 31, 2009 Interest expense (5% x $497,621) ....................... 24,879* Discount on bonds payable (difference) ...... 2,379 Cash (4.5% x $500,000) ................................ 22,500 Bonds payable ..................................................... 500,000 Cash .......................................................... 500,000 * rounded value from table 26 Exercise 14-12 1. February 1, 2006 Cash (price given) ............................................ 731,364 Discount on bonds (difference) ....................... 68,636 Bonds payable (face amount) ....................... 800,000 2. July 31, 2006 Interest expense (5% x $731,364 ) ...................... 36,568 Discount on bonds payable (difference) ...... 568 Cash (4.5% x $800,000) ................................ 36,000 3. December 31, 2006 Interest expense (5/6 x 5% x [$731,364 + 568]) . 30,497 Discount on bonds payable (difference) ...... 497 Interest payable (5/6 x 4.5% x $800,000) ....... 30,000 4. January 31, 2007 Interest expense (1/6 x 5% x [$731,364 + 568]) . 6,100* Interest payable (from adjusting entry) .............. 30,000 Discount on bonds payable (difference) ...... 100 Cash (4.5% x $ * rounded 27 Exercise 14-13 1. March 1, 2006 Cash (price given) ............................................ 294,000 Discount on bonds (difference) ....................... 6,000 Bonds payable (face amount) ....................... 300,000 2. August 31, 2006 Interest expense ($21,000 + 150) ........................ 21,150 Discount on bonds payable ($6,000 ÷ 40) ... 150 Cash (7% x $300,000) ................................... 21,000 3. December 31, 2006 Interest expense (4/6 x $21,150) .......................... 14,100 Discount on bonds payable (4/6 x $150) ..... 100 Interest payable (4/6 x $21,000) ................... 14,000 4. February 28, 2007 Interest expense (2/6 x $21,150) .......................... 7,050 Interest payable (4/6 x $21,000) ....................... 14,000 Discount on bonds payable (2/6 x $150) ..... 50 Cash (7% x $300,000) .................................. 21,000 Exercise 14-14 1. b 2. c 3. d 28 Exercise 14-15 Requirement 1 Interest $24,000¥ x 2.40183 * = $ 57,644 Principal $600,000 x 0.71178 ** = 427,068 Present value (price) of the bonds $484,712 ¥ 4% x $600,000 * present value of an ordinary annuity of $1: n=3, i=12% ** present value of $1: n=3, i=12% Operational assets (price determined above) ............................ 484,712 Discount on notes payable (difference) ................................. 115,288 Notes payable (face amount) .............................................. 600,000 Requirement 2 Cash Effective Increase in Outstanding Interest Interest Balance Balance 4% x Face Amount 12% x Outstanding Balance Discount Reduction 484,712 1 24,000 .12 (484,712) = 58,165 34,165 518,877 2 24,000 .12 (518,877) = 62,265 38,265 557,142 3 24,000 .12 (557,142) = 66,858* 42,858 600,000 72,000 187,288 115,288 * rounded. Requirement 3 Interest expense (market rate x outstanding balance) ................. 58,165 Discount on notes payable (difference) ............................. 34,165 Cash (stated rate x face amount) ........................................... 24,000 Interest expense (market rate x outstanding balance) ................. 62,265 Discount on notes payable (difference) ............................. 38,265 Cash (stated rate x face amount) ........................................... 24,000 Interest expense (market rate x outstanding balance) .................... 66,858 Discount on notes payable (difference) ............................. 42,858 Cash (stated rate x face amount) ........................................... 24,000 Notes payable ...................................................................... 600,000 Cash (stated rate x face amount) ........................................... 600,000 29 Exercise 14-16 1. January 1, 2006 Operational assets .............................................................. 4,000,000 Notes payable .................................................................. 4,000,000 2. Amortization schedule $4,000,000 ÷ 3.16987 = $1,261,881 amount (from Table 4) installment of loan n=4, i=10% payment Cash Effective Decrease in Outstanding Dec.31 Payment Interest Balance Balance 10% x Outstanding Balance Balance Reduction 2006 1,261,881 .10 (4,000,000) = 400,000 861,881 3,138,119 2007 1,261,881 .10 (3,138,119) = 313,812 948,069 2,190,050 2008 1,261,881 .10 (2,190,050) = 219,005 1,042,876 1,147,174 2009 1,261,881 .10 (1,147,174) = 114,707* 1,147,174 0 5,047,524 1,047,524 4,000,000 * rounded. 3. December 31, 2006 Interest expense (10% x outstanding balance) .............................. 400,000 Note payable (difference) ...................................................... 861,881 Cash (payment determined above) ........................................ 1,261,881 4. December 31, 2008 Interest expense (10% x outstanding balance) .............................. 219,005 Note payable (difference) ...................................................... 1,042,876 Cash (payment determined above) ........................................ 1,261,881 30 Exercise 14-17 Bonds payable (face amount) ..................................... 90,000,000 Loss on early extinguishment (to balance) ................. 4,800,000 Discount on bonds (given) ..................................... 3,000,000 Cash ($90,000,000 x 102%) ..................................... 91,800,000 31 Exercise 14-18 Requirement 1 Gless (Issuer) Cash (101% x $12 million) ........................................... 12,120,000 Convertible bonds payable (face amount) .............. 12,000,000 Premium on bonds payable (difference) ................. 120,000 Century (Investor) Investment in convertible bonds (10% x $12 million) . 1,200,000 Premium on bond investment (difference) .................... 12,000 Cash (101% x $1.2 million) ...................................... 1,212,000 Requirement 2 Gless (Issuer) Interest expense ($540,000 - $6,000) ................................ 534,000 Premium on bonds payable ($120,000 ÷ 20) .............. 6,000 Cash (4.5% x $12,000,000) ....................................... 540,000 Century (Investor) Cash (4.5% x $1,200,000) ............................................ 54,000 Premium on bond investment ($12,000 ÷ 20) ......... 600 Interest revenue ($54,000 - $600) ................................. 53,400 [Using the straight-line method, each interest entry is the same.] Requirement 3 Gless (Issuer) Convertible bonds payable (10% of the account balance) 1,200,000 Premium on bonds payable (($120,000 - [$6,000 x 11]) x 10%) .......................... 5,400 Common stock ([1,200 x 40 shares] x $1 par) ........... 48,000 Paid-in capital – excess of par (to balance) ............ 1,157,400 Century (Investor) Investment in common stock ........................................ 1,205,400 Investment in convertible bonds (account balance) .. 1,200,000 Premium on bond investment ($12,000 - [$600 x 11]) 5,400 32 Exercise 14-19 Requirement 1 ($ in millions) Limbaugh (Issuer) Cash (104% x $30 million) ...................................................... 31.2 Discount on bonds payable (difference) ................................ 3.6 Bonds payable (face amount) ............................................. 30.0 Paid-in capital – stock warrants outstanding ($8 x 20 warrants x [$30,000,000 ÷ $1,000] bonds) ............... 4.8 Interstate (Investor) Investment in stock warrants ($4.8 million x 20%) ................ 0.96 Investment in bonds (20% x $30 million) ............................... 6.00 Discount on bonds (difference) ......................................... 0.72 Cash (104% x $30 million x 20%) ........................................ 6.24 Requirement 2 ($ in millions) Limbaugh (Issuer) Cash (20% x 30,000 bonds x 20 warrants x $60) ......................... 7.20 Paid-in capital – stock warrants outstanding ($4.8 million x 20%) ....................................................... 0.96 Common stock (20% x 30,000 x 20 shares x $10 par) ............ 1.20 Paid-in capital – excess of par (to balance) ....................... 6.96 Interstate (Investor) Investment in common stock (to balance) ............................. 8.16 Investment in stock warrants ($4.8 million x 20%) ............ .96 Cash (20% x 30,000 x 20 warrants x $60) .............................. 7.20 33 Exercise 14-20 1. National Equipment Transfer Corporation Cash (priced at par) .......................................... 200,000,000 Bonds payable (face amount) ....................... 200,000,000 IgWig Cash (99% x $350 million) ................................ 346,500,000 Discount on notes (difference) ........................ 3,500,000 Notes payable (face amount) ........................ 350,000,000 2. National Equipment Transfer Corporation Interest expense .................................................. 7,460,000 Cash ([7.46% ÷ 2] x $200 million ) ................. 7,460,000 IgWig Interest expense ([6.56% ÷ 2] x $346,500,000) . 11,365,200 Discount on bonds payable (difference) ...... 60,200 Cash ([6.46% ÷ 2] x $350 million ) ................ 11,305,000 34 Exercise 14-21 Requirement 1 The error caused both 2004 net income and 2005 net income to be overstated, so retained earnings is overstated by a total of $85,000. Also, the note payable would be understated by the same amount. Remember, the entry to record interest is: Interest expense ................................................................................. xxx Note payable (difference) .......................................................... xxx Cash .................................................................................... xxx So, if interest expense is understated, the reduction in the note will be too much, causing the balance in that account to be understated. Requirement 2 Retained earnings (overstatement of 2004-05 income) .................. 85,000 Note payable (understatement determined above) ..................... 85,000 Requirement 3 The financial statements that were incorrect as a result of the error would be retrospectively restated to report the correct interest amounts, income, and retained earnings when those statements are reported again for comparative purposes in the current annual report. A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share. 35 Exercise 14-22 The 2006 interest expense is overstated by the extra interest recorded in February. Similarly, retained earnings is overstated the same amount because 2005 interest expense was understated when the accrued interest was not recorded. To correct the error: Retained earnings ........................................................... 61,000 Interest expense ($73,200 – $12,200*) ....................... 61,000 *$73,000 x 1/6 2006 adjusting entry: Interest expense (5/6 x $73,200) ................................. 61,000 Discount on bonds payable (5/6 x $1,200).............. 1,000 Interest payable (5/6 x $72,000) .............................. 60,000 ENTRIES THAT SHOULD HAVE BEEN RECORDED: 2005 adjusting entry: Interest expense (5/6 x $73,200) ............................................. 61,000 Discount on bonds payable (5/6 x $1,200) ......................... 1,000 Interest payable (5/6 x $72,000) ......................................... 60,000 February 1, 2006: Interest expense (1/6 x $73,200) ............................................. 12,200 Interest payable (5/6 x $72,000) ............................................. 60,000 Discount on bonds payable (1/6 x $1,200) ......................... 200 Cash ( giv 36 Exercise 14-23 1. a. Because the bonds sold for more than their face value, they were sold at a premium. The premium adjusted the yield of the bonds to the effective rate (presumably, the market rate). 2. d. The annual interest cash outlay is $70,000 (7% nominal rate x $1,000,000), or $35,000 each semiannual period. Interest expense is less than $35,000, however, because the bonds were originally issued at a premium. That premium should be amortized over the life of the bond. Thus, interest expense for the first 6 months is $31,884 [$1,062,809 x 6% x (6 months / 12 months)], and premium amortization is $3,116 ($35,000 - $31,884). 3. b. A bond liability is shown at its face value (maturity value), minus any related discount, or plus any related premium. Thus, a bond issued at a premium is shown at its maturity value plus the unamortized portion of the premium. The premium account is sometimes called an adjunct account because it is shown as an addition to another account. Exercise 14-24 Land ($450,000 – $325,000) ........................................ 125,000 Gain on disposition of assets ............................... 125,000 Note payable (face amount) ........................................ 600,000 Accrued interest payable (11% x $600,000)................ 66,000 Gain on troubled debt restructuring (difference) .... 216,000 Land (fair market value) .......................................... 450,000 37 Exercise 14-25 Analysis: Carrying amount: $12 million + $1.2 million = $13,200,000 Future payments: ($1 million x 2) + $11 million = 13,000,000 Gain to debtor $ 200,000 1. January 1, 2006 Accrued interest payable (10% x $12,000,000) ........... 1,200,000 Note payable ($13 million – $12 million)* ................ 1,000,000 Gain on troubled debt restructuring ..................... 200,000 * Establishes a balance in the note account equal to the total cash payments under the new agreement. 2. December 31, 2007 Note payable ............................................................ 1,000,000 Cash (revised “interest” amount) ............................... 1,000,000 Note: No interest should be recorded after the restructuring. All subsequent cash payments result in reductions of principal. 3. December 31, 2008 Note payable ............................................................ 1,000,000 Cash (revised “interest” amount) ............................... 1,000,000 Note payable ............................................................ 11,000,000 Cash (revised principal amount) ................................ 11,000,000 38 Exercise 14-26 Analysis: Carrying amount: $240,000 + (10% x $240,000) = $264,000 Future payments: ($11,555 x 3) + $240,000 = (274,665) Interest $ 10,665 The discount rate that “equates” the present value of the debt ($264,000) and its future value ($274,665) is the effective rate of interest: $264,000 ÷ $274,665 = .961 – the Table 2 value for n = 2, i = ? In row 2 of Table 2, the value .961 is in the 2% column. So, this is the new effective interest rate. A financial calculator will produce the same rate. To simplify the record keeping, it may be desirable to combine the two debt accounts – the note and the accrued interest – into a single account: 1. January 1, 2006 Accrued interest payable (10% x $240,000)................ 24,000 Note payable (original debt) ....................................... 240,000 Note payable (present carrying amount) .................... 264,000 2. December 31, 2006 Interest expense (2% x $264,000) ............................... 5,280 Note payable ........................................................ 5,280 [Unpaid interest is accrued at the effective rate times the carrying amount of the debt.] 3. December 31, 2007 Interest expense (2% x [$264,000 + 5,280]) ................. 5,385* Note payable ........................................................ 5,385 *rounded After adding accrued interest for each year, the balance of the note account is equal to the amount scheduled to be paid at maturity. Note payable ($264,000 + 5,280 + 5,385) ..................... 274,665 Cash ([$11,555 x 3] + $240,000) ............................... 274,665 39 PROBLEMS Problem 14-1 Requirement 1 Interest $2,500,000¥ x 15.04630 * = $37,615,750 Principal $50,000,000 x 0.09722 ** = 4,861,000 Present value (price) of the bond s $42,476,750 ¥ 5% x $50,000,000 * present value of an ordinary annuity of $1: n=40, i=6% ** present value of $1: n=40, i=6% Cash (price determined above) ...................................... 42,476,750 Discount on bonds (difference) .................................. 7,523,250 Bonds payable (face amount) .................................. 50,000,000 Requirement 2 Interest $ 2,500,000 x 18.40158 * = $46,003,950 Principal $50,000,000 x 0.17193 ** = 8,596,500 Present value (price) of the bonds $54,600,450 * present value of an ordinary annuity of $1: n=40, i=4.5% ** present value of $1: n=40, i=4.5% Cash (price determined above) ...................................... 54,600,450 Premium on bonds (difference) .............................. 4,600,450 Bonds payable (face amount) .................................. 50,000,000 Requirement 3 Investment in bonds (face amount) .................................. 50,000,000 Premium on bond investment ................................. 4,600,450 Cash (price calculated above) .................................... 54,600,450 40 Problem 14-2 1. Liabilities at September 30, 2006 Bonds payable (face amount) ..................................... $160,000,000 Less: discount .......................................................... 20,000,000 Initial balance, March 1, 2006 ................................. $140,000,000 June 30, 2006 discount amortization ....................... 266,667* Sept. 30, 2006 discount amortization ...................... 208,000** Sept. 30, 2006 net bonds payable ............................ $140,474,667 Interest payable ** ................................................... $4,000,000 2. Interest expense for year ended September 30, 2006 June 30, 2006 interest expense ................................ $5,600,000* September 30, 2006 interest expense ...................... 4,208,000** Interest expense for fiscal 2006 ............................... $9,808,000 3. Statement of cash flows for year ended September 30, 2006 Baddour would report the cash inflow of $140,000,000*** from the sale of the bonds as a cash flow from financing activities in its statement of cash flows. The accrued interest portion of the cash receipt was paid on June 30 and is part of the cash outflow from operating activities (below). The $8,000,000 cash interest paid * is a cash outflow from operating activities because interest is an income statement (operating) item. 41 Problem 14-2 (concluded) Calculations: March 1, 2006*** Cash ($140 million plus accrued interest) ....................... 142,666,667 Discount on bonds (difference) .................................. 20,000,000 Bonds payable (face amount) .................................. 160,000,000 Interest payable ($160 million x 10% x 2/12) ............ 2,666,667 June 30, 2006* Interest expense (6% x $140,000,000 x 4/6) ..................... 5,600,000 Interest payable (balance) .......................................... 2,666,667 Discount on bonds payable (difference) ................. 266,667 Cash (5% x $160,000,000)........................................ 8,000,000 September 30, 2006** Interest expense (6% x [$140,000,000 + 266,667] x 3/6 ) 4,208,000 Discount on bonds payable (difference) ................. 208,000 Interest payable (5% x $160,000,000 x 3/6) .............. 4,000,000 42 Problem 14-3 Requirement 1 Cash Effective Increase in Outstanding Interest Interest Balance Balance 4.5% x Face Amount 5% x Outstanding Balance 96,768 1 4,500 .05 (96,768) = 4,838 338 97,106 2 4,500 .05 (97,106) = 4,855 355 97,461 3 4,500 .05 (97,461) = 4,873 373 97,834 4 4,500 .05 (97,834) = 4,892 392 98,226 5 4,500 .05 (98,226) = 4,911 411 98,637 6 4,500 .05 (98,637) = 4,932 432 99,069 7 4,500 .05 (99,069) = 4,953 453 99,522 8 4,500 .05 (99,522) = 4,978* 478 100,000 36,000 39,232 3,232 * rounded. Requirement 2 Cash Recorded Increase in Outstanding Interest Interest Balance Balance 4.5% x Face Amount Cash plus Discount Reduction $3,232 ÷ 8 96,768 1 4,500 (4,500 + 404) = 4,904 404 97,172 2 4,500 (4,500 + 404) = 4,904 404 97,576 3 4,500 (4,500 + 404) = 4,904 404 97,980 4 4,500 (4,500 + 404) = 4,904 404 98,384 5 4,500 (4,500 + 404) = 4,904 404 98,788 6 4,500 (4,500 + 404) = 4,904 404 99,192 7 4,500 (4,500 + 404) = 4,904 404 99,596 8 4,500 (4,500 + 404) = 4,904 404 100,000 36,000 39,232 3,232 43 Problem 14-3 (continued) Requirement 3 (effective interest) Interest expense (5% x $98,226) ....................................... 4,911 Discount on bonds payable (difference) ................. 411 Cash (4.5% x $100,000) ........................................... 4,500 (straight-line) Interest expense ($4,500 + 404) ........................................ 4,904 Discount on bonds payable ($3,232 ÷ 8) ................ 404 Cash (4.5% x $100,000) ........................................... 4,500 Requirement 4 By the straight-line method, a company determines interest indirectly by allocating a discount or a premium equally to each period over the term to maturity. This is allowed if doing so produces results that are not materially different from the interest method. The decision should be guided by whether the straight-line method would tend to mislead investors and creditors in the particular circumstance. Allocating the discount or premium equally over the life of the bonds by the straight-line method results in an unchanging dollar amount of interest each period. By the straight-line method, the amount of the discount to be reduced periodically is calculated, and the effective interest is the “plug” figure. Unchanging dollar amounts like these are not produced when the effective interest approach is used. By that approach, the dollar amounts of interest vary over the term to maturity because the percentage rate of interest remains constant, but is applied to a changing debt balance. Remember that the “straight-line method,” is not an alternative method of determining interest in a conceptual sense, but is an application of the materiality concept. The appropriate application of GAAP, the effective interest method, is by-passed as a practical expediency in situations when doing so has no “material” effect on the results. 44 Problem 14-3 (concluded) Requirement 5 The amortization schedule in requirement 1 gives us the answer: $9,864. The outstanding debt balance after the June 30, 2008, interest payment (line 5) is the present value at that time ($98,637) of the remaining payments. Since $10,000 face amount of the bonds is 10% of the entire issue, we take 10% of the table amount. This can be confirmed by calculating the present value: Interest $450¥ x 2.72325 * = $1,225 Principal $10,000 x 0.86384 ** = 8,638 Present value (price) of the bonds $9,864 (rounded) ¥ 4.5% x $10,000 * present value of an ordinary annuity of $1: n=3, i=5% ** present value of $1: n=3, i=5% 45 Problem 14-4 Requirement 1 $8,000,000 (outstanding balance at maturity) Requirement 2 $6,627,273 (outstanding balance at sale date) Requirement 3 20 years (40 semiannual periods) Requirement 4 At the effective interest rate (By the alternative straight-line approach, interest would be the same amount each period) Requirement 5 8% [($320,000 ÷ $8,000,000) x 2] Requirement 6 10% [($331,364 ÷ $6,627,273) x 2] Requirement 7 $12,800,000 ($320,000 x 40) Requirement 8 $14,172,727 ($12,800,000 + [$8,000,000 – $6,627,273]) (Total cash interest plus the discount) 46 Problem 14-5 Requirement 1 Interest $3,600,000¥ x 6.46321 * = $23,267,556 Principal $80,000,000 x 0.67684 ** = 54,147,200 Present value (price) of the bonds $77,414,756 ¥ 4.5% x $80,000,000 * present value of an ordinary annuity of $1: n=8, i=5% ** present value of $1: n=8, i=5% Requirement 2 (a) Cromley Cash Effective Increase in Outstanding Interest Interest Balance Balance 4.5% x Face Amount 5% x Outstanding Balance Discount Reduction 77,414,756 1 3,600,000 .05 (77,414,756) = 3,870,738 270,738 77,685,494 2 3,600,000 .05 (77,685,494) = 3,884,275 284,275 77,969,769 3 3,600,000 .05 (77,969,769) = 3,898,488 298,488 78,268,257 4 3,600,000 .05 (78,268,257) = 3,913,413 313,413 78,581,670 5 3,600,000 .05 (78,581,670) = 3,929,084 329,084 78,910,754 6 3,600,000 .05 (78,910,754) = 3,945,538 345,538 79,256,292 7 3,600,000 .05 (79,256,292) = 3,962,815 362,815 79,619,107 8 3,600,000 .05 (79,619,107) = 3,980,893* 380,893 80,000,000 28,800,000 31,385,244 2,585,244 * rounded. 47 Problem 14-5 (continued) (b) Barnwell Cash Effective Increase in Outstanding Interest Interest Balance Balance 4.5% x Face Amount 5% x Outstanding Balance Discount Reduction 77,415 1 3,600 .05 (77,415) = 3,871 271 77,686 2 3,600 .05 (77,686) = 3,884 284 77,970 3 3,600 .05 (77,970) = 3,899 299 78,269 4 3,600 .05 (78,269) = 3,913 313 78,582 5 3,600 .05 (78,582) = 3,929 329 78,911 6 3,600 .05 (78,911) = 3,946 346 79,257 7 3,600 .05 (79,257) = 3,963 363 79,620 8 3,600 .05 (79,620) = 3,980 * 380 80,000 28,800 31,385 2,585 *rounded Requirement 3 February 1, 2006 (Cromley) Cash (price determined above) ................................. 77,414,756 Discount on bonds (difference) ............................. 2,585,244 Bonds payable (face amount) ............................. 80,000,000 February 1, 2006 (Barnwell) Bond investment (face amount) ............................. 80,000 Discount on bond investment (difference) ........ 2,585 Cash (price paid) ................................................ 77,415 48 Problem 14-5 (continued) Requirement 4 July 31, 2006 (Cromley) Interest expense (from schedule) ................................ 3,870,738 Discount on bonds payable (from schedule) ..... 270,738 Cash (from schedule) ......................................... 3,600,000 July 31, 2006 (Barnwell) Cash (from schedule) .............................................. 3,600 Discount on investment (from schedule) ................... 271 Interest revenue (from schedule) ............................. 3,871 December 31, 2006 (Cromley) Interest expense (5/6 x $3,884,275) ............................. 3,236,896 Discount on bonds payable (5/6 x $284,275) ..... 236,896 Interest payable (5/6 x $3,600,000) ..................... 3,000,000 December 31, 2006 (Barnwell) Interest receivable (5/6 x $3,600) .......................... 3,000 Discount on investment (5/6 x $284) .................... 237 Interest revenue (5/6 x $3,884) ............................... 3,237 January 31, 2007 (Cromley) Interest expense (1/6 x $3,884,275) ............................. 647,379 Interest payable (from adjusting entry above) ............. 3,000,000 Discount on bonds payable (1/6 x $284,275) ..... 47,379 Cash (stated rate x face amount) ........................... 3,600,000 January 31, 2007 (Barnwell) Cash (stated rate x face amount) ............................... 3,600 Discount on bond investment (1/6 x $284) ........... 47 Interest receivable (from adjusting entry above) ... 3,000 Interest revenue (1/6 x $3,884) ............................... 647 49 Problem 14-5 (concluded) July 31, 2007 (Cromley) Interest expense (from schedule) ................................ 3,898,488 Discount on bonds payable (from schedule) ..... 298,488 Cash (from schedule) ......................................... 3,600,000 July 31, 2007 (Barnwell) Cash (from schedule) .............................................. 3,600 Discount on investment (from schedule) ................... 299 Interest revenue (from schedule) ............................. 3,899 December 31, 2007 (Cromley) Interest expense (5/6 x $3,913,413) ............................. 3,261,177 Discount on bonds payable (5/6 x $313,413) ..... 261,177 Interest payable (5/6 x $3,600,000) ..................... 3,000,000 December 31, 2007 (Barnwell) Interest receivable (5/6 x $3,600) .......................... 3,000 Discount on investment (5/6 x $313) .................... 261 Interest revenue (5/6 x $3,913) ............................... 3,261 January 31, 2008 (Cromley) Interest expense (1/6 x $3,913,413) ............................. 652,236* Interest payable (from adjusting entry above) ............. 3,000,000 Discount on bonds payable (1/6 x $313,413) ..... 52,236* Cash (stated rate x face amount) ........................... 3,600,000 January 31, 2008 (Barnwell) Cash (stated rate x face amount) ............................... 3,600 Discount on bond investment (1/6 x $313) ........... 52 Interest receivable (from adjusting entry above) ... 3,000 Interest revenue (1/6 x $3,913) ............................... 652 *rounded 50 Problem 14-6 Requirement 1 April 1, 2006 (Western) Cash ($29,300,000 + [1/12 x 12% x $30,000,000]) ....... 29,600,000 Discount on bonds ($30 million - $29.3 million) ....... 700,000 Bonds payable (face amount) ............................. 30,000,000 Interest payable (1/12 x 12% x $30,000,000) ....... 300,000 April 1, 2006 (Stillworth) Bond investment (face amount) ............................. 30,000 Interest receivable (1/12 x 12% x $30,000) ............. 300 Discount on bond investment ($30,000 - $29,300) 700 Cash ($29,300 + [1/12 x 12% x $30,000]) .............. 29,600 Alternative: Some accountants prefer to credit (debit) interest expense (revenue), rather than interest payable (receivable), when bonds are sold (purchased). April 1, 2006 (Western) Cash ($29,300,000 + [1/12 x 12% x $30,000,000]) ..... 29,600,000 Discount on bonds ($30 million - $29.3 million) ....... 700,000 Bonds payable (face amount) ............................. 30,000,000 Interest expense (1/12 x 12% x $30,000,000) ....... 300,000 April 1, 2006 (Stillworth) Bond investment (face amount) ............................. 30,000 Interest revenue (1/12 x 12% x $30,000) .................... 300 Discount on bond investment ($30,000 - $29,300) 700 Cash ($29,300 + [1/12 x 12% x $30,000]) .............. 29,600 If the alternate entries are used, entries at the next interest date would require simply a debit (credit) to interest expense (revenue) for the full interest. The interest accounts would then reflect the same net debit of five months' interest. 51 Problem 14-6 (continued) Requirement 2 The original maturity of the bonds was 3 years, or 36 months. But since the bonds weren’t sold until one month after they were dated, they are outstanding for only 35 months. Straight-line amortization, then, is $700,000 ÷ 35 months = $20,000 per month for Western (and $700 ÷ 35 months = $20 per month for Stillworth’s investment). August 31, 2006 (Western) Interest expense ($1,800,000 + $100,000 – $300,000) 1,600,000 Interest payable (accrued interest from above) ........... 300,000 Discount on bonds payable ($20,000 x 5 months) 100,000 Cash ($30,000,000 x 12% x 6/12) ........................ 1,800,000 August 31, 2006 (Stillworth) Cash ($30,000 x 12% x 6/12) .................................. 1,800 Discount on investment ($20 x 5 months) ................ 100 Interest receivable (accrued interest from above) . 300 Interest revenue ($1,800 + $100 – $300) ................ 1,600 If alternate method of recording accrued interest is used: August 31, 2006 (Western) Interest expense ($1,800,000 + $100,000) ................. 1,900,000 Discount on bonds payable ($20,000 x 5 months) 100,000 Cash ($30,000,000 x 12% x 6/12) ........................ 1,800,000 August 31, 2006 (Stillworth) Cash ($30,000 x 12% x 6/12) .................................. 1,800 Discount on investment ($20 x 5 months) ................ 100 Interest revenue ($1,800 + $100) ............................ 1,900 52 Problem 14-6 (continued) December 31, 2006 (Western) Interest expense ($1,200,000 + $80,000) .................... 1,280,000 Discount on bonds payable ($20,000 x 4 months) 80,000 Interest payable ($30,000,000 x 12% x 4/12) ....... 1,200,000 December 31, 2006 (Stillworth) Interest receivable ($30,000 x 12% x 4/12) ............. 1,200 Discount on investment ($20 x 4 months) .............. 80 Interest revenue ($1,200 + $80) .............................. 1,280 February 28, 2007 (Western) Interest expense ($1,800,000 + $40,000 – $1,200,000) 640,000 Interest payable (from adjusting entry) ................... 1,200,000 Discount on bonds payable ($20,000 x 2 months) 40,000 Cash ($30,000,000 x 12% x 6/12) ........................ 1,800,000 February 28, 2007 (Stillworth) Cash ($30,000 x 12% x 6/12) ................................... 1,800 Discount on bond investment ($20 x 2 months) ..... 40 Interest receivable (from adjusting entry) ............ 1,200 Interest revenue ($1,800 + $40 – $1,200) .............. 640 August 31, 2007 (Western) Interest expense ($1,800,000 + $120,000) ................. 1,920,000 Discount on bonds payable ($20,000 x 6 months) 120,000 Cash ($30,000,000 x 12% x 6/12) ........................ 1,800,000 August 31, 2007 (Stillworth) Cash ($30,000 x 12% x 6/12) .................................. 1,800 Discount on investment ($20 x 6 months) ................ 120 Interest revenue ($1,800 + $120) ............................ 1,920 December 31, 2007 (Western) Interest expense ($1,200,000 + $80,000) .................... 1,280,000 Discount on bonds payable ($20,000 x 4 months) 80,000 Interest payable ($30,000,000 x 12% x 4/12) ....... 1,200,000 53 Problem 14-6 (continued) December 31, 2007 (Stillworth) Interest receivable ($30,000 x 12% x 4/12) ............. 1,200 Discount on investment ($20 x 4 months) .............. 80 Interest revenue ($1,200 + $80) .............................. 1,280 February 28, 2008 (Western) Interest expense ($1,800,000 + $40,000 – $1,200,000) 640,000 Interest payable (from adjusting entry) ................... 1,200,000 Discount on bonds payable ($20,000 x 2 months) 40,000 Cash ($30,000,000 x 12% x 6/12) ........................ 1,800,000 February 28, 2008 (Stillworth) Cash ($30,000 x 12% x 6/12) ................................... 1,800 Discount on bond investment ($20 x 2 months) ..... 40 Interest receivable (from adjusting entry) ............ 1,200 Interest revenue ($1,800 + $40 – $1,200) .............. 640 August 31, 2008 (Western) Interest expense ($1,800,000 + $120,000) ................. 1,920,000 Discount on bonds payable ($20,000 x 6 months) 120,000 Cash ($30,000,000 x 12% x 6/12) ........................ 1,800,000 August 31, 2008 (Stillworth) Cash ($30,000 x 12% x 6/12) .................................. 1,800 Discount on investment ($20 x 6 months) ................ 120 Interest revenue ($1,800 + $120) ............................ 1,920 December 31, 2008 (Western) Interest expense ($1,200,000 + $80,000) .................... 1,280,000 Discount on bonds payable ($20,000 x 4 months) 80,000 Interest payable ($30,000,000 x 12% x 4/12) ....... 1,200,000 December 31, 2008 (Stillworth) Interest receivable ($30,000 x 12% x 4/12) ............. 1,200 Discount on investment ($20 x 4 months) .............. 80 Interest revenue ($1,200 + $80) .............................. 1,280 54 Problem 14-6 (concluded) February 28, 2009 (Western) Interest expense ($1,800,000 + $40,000 – $1,200,000) 640,000 Interest payable (from adjusting entry) ................... 1,200,000 Discount on bonds payable ($20,000 x 2 months) 40,000 Cash ($30,000,000 x 12% x 6/12) ........................ 1,800,000 Bonds payable .................................................... 30,000,000 Cash ................................................................ 30,000,000 February 28, 2009 (Stillworth) Cash ($30,000 x 12% x 6/12) ................................... 1,800 Discount on bond investment ($20 x 2 months) ...... 40 Interest receivable (from adjusting entry) ............ 1,200 Interest revenue ($1,800 + $40 – $1,200) .............. 640 Cash .................................................................... 30,000 Investment in bonds ....................................... 30,000 55 Problem 14-7 Requirement 1 Interest $16,000,000¥ x 17.15909 * = $274,545,440 Principal $400,000,000 x 0.14205 ** = 56,820,000 Present value (price) of the bonds $331,365,440 ¥ 4% x $400,000,000 * present value of an ordinary annuity of $1: n=40, i=5% ** present value of $1: n=40, i=5% Requirement 2 (a) Cash (price determined above) ................................. 331,365,440 Discount on bonds (difference) ............................. 68,634,560 Bonds payable (face amount) ............................. 400,000,000 (b) Bond investment (face amount) ............................. 400,000 Discount on bond investment (difference) ........ 68,635 Cash (0.1% x $331,365,440) ................................ 331,365 Requirement 3 (a) Interest expense (5% x $331,365,440) ........................ 16,568,272 Discount on bonds payable (difference) ............ 568,272 Cash (4% x $400,000,000)................................... 16,000,000 (b) Cash (4% x $400,000) ............................................ 16,000 Discount on bond investment (difference) ............ 568 Interest revenue (5% x $331,365) ........................... 16,568 Requirement 4 (a) Interest expense (5% x [$331,365,440 + $568,272]) .. 16,596,686 Discount on bonds payable (difference) ............ 596,686 Cash (4% x $400,000,000)................................... 16,000,000 (b) Cash (4% x $400,000) ............................................ 16,000 Discount on bond investment (difference) ............ 597 Interest revenue (5% x [$331,365 + $568]) ............ 16,597 56 Problem 14-8 Requirement 1 Cash (price given) .................................................. 5,795,518 Discount on bonds (difference) ............................. 12,204,482 Bonds payable (face amount) ............................. 18,000,000 Requirement 2 The discount rate that “equates” the present value of the debt ($5,795,518) and its future value ($18,000,000) is the effective rate of interest: $5,795,518 ÷ $18,000,000 = .32197 – the Table 2 value for n = 10, i = ? In row 10 of Table 2, the value .32197 is in the 12% column. So, this is the effective interest rate. A financial calculator will produce the same rate. Requirement 3 Interest expense (12% x $5,795,518) .......................... 695,462 Discount on bonds payable ............................ 695,462 Requirement 4 Interest expense (12% x [$5,795,518 + $695,462]) .... 778,918 Discount on bonds payable ............................ 778,918 Requirement 5 Bonds payable ..................................................... 18,000,000 Cash ................................................................ 18,000,000 57 Problem 14-9 Requirement 1 Land ............................................................................ 600,000 Notes payable (face amount) ...................................... 600,000 Interest expense (12% x $600,000) .................................. 72,000 Cash (12% x $600,000) ............................................... 72,000 Requirement 2 Office equipment (price given) ....................................... 94,643 Discount on notes payable (difference) .......................... 5,357 Notes payable (face amount) ...................................... 100,000 The discount rate that “equates” the present value of the debt ($94,643) and its future value ($100,000 + $6,000) is the effective rate of interest: $94,643 ÷ $106,000 = .8929 – the Table 2 value for n = 1, i = ? In row 1 of Table 2, the value .8929 is in the 12% column. So, this is the effective interest rate. A financial calculator will produce the same rate. PROOF: Interest $6,000¥ x 0.89286 * = $ 5,357 Principal $100,000 x 0.89286 ** = 89,286 Present value (price) of the bonds $94,643 ¥ 6% x $100,000 * present value of an ordinary annuity of $1: n=1, i=12% ** present value of $1: n=1, i=12% Interest expense (12% x $94,643) ................................... 11,357 Discount on note payable (determined above) ............. 5,357 Cash (6% x $100,000) ................................................. 6,000 58 Problem 14-9 (concluded) Not required, but recorded at the same date (may be combined with interest entry): Note payable (face amount) ............................................ 100,000 Cash ......................................................................... 100,000 Requirement 3 $1,000,000 x 2.40183 = $2,401,830 installment (from Table 4) present payments n=3, i=12% value Building (implicit price) .................................................. 2,401,830 Note payable (present value determined above) ............. 2,401,830 Interest expense (12% x $2,401,830) ............................... 288,220 Note payable (difference) ............................................... 711,780 Cash (given) ............................................................... 1,000,000 59 Problem 14-10 Requirement 1 Interest $ 6,000 x 3.79079 * = $ 22,745 Principal $150,000 x 0.62092 ** = 93,138 Present value (price) of the note $115,883 * present value of an ordinary annuity of $1: n=5, i=10% ** present value of $1: n=5, i=10% Equipment (fair market value ) ........................................ 115,883 Discount on notes payable (difference) .......................... 34,117 Note payable (face amount) ........................................ 150,000 Requirement 2 December 31, 2006 Interest expense (10% x $115,883) ........................................ 11,588 Discount on notes payable (difference) ...................... 5,588 Cash (given) ............................................................... 6,000 Requirement 3 December 31, 2007 Interest expense (10% x [$115,883 + 5,588]) ........................ 12,147 Discount on notes payable (difference) ...................... 6,147 Cash (given) ............................................................... 6,000 60 Problem 14-11 Requirement 1 $6,074,700 ÷ $2,000,000 = 3.03735 present installment present value value payment table amount This is the Table 4 value for n = 4, i = ? In row 4 of Table 4, the number 3.03735 is in the 12% column. So, 12% is the implicit interest rate. Requirement 2 Machine (fair market value ) ............................................ 6,074,700 Notes payable (present value ) .................................... 6,074,700 Requirement 3 Interest expense (12% x outstanding balance) ....................... 728,964 Notes payable (difference) ............................................. 1,271,036 Cash (given) ............................................................... 2,000,000 Requirement 4 Interest expense (12% x [$6,074,700 – 1,271,036]) .............. 576,440 Note payable (difference) ............................................... 1,423,560 Cash (given) ............................................................... 2,000,000 Requirement 5 $2,000,000 x 3.10245 = $6,204,900 installment (from Table 4) present payment n=4, i=11% value Machine ....................................................................... 6,204,900 Notes payable ........................................................... 6,204,900 61 Problem 14-12 Requirement 1 Interest $5,000¥ x 3.16987 * = $15,849 Principal $100,000 x 0.68301 ** = 68,301 Present value (price) of the note $84,150 ¥ 5% x $100,000 * present value of an ordinary annuity of $1: n=4, i=10% ** present value of $1: n=4, i=10% Operational assets (price determined above) ..................... 84,150 Discount on notes payable (difference) .......................... 15,850 Notes payable (face amount) ...................................... 100,000 Requirement 2 Cash Effective Increase in Outstanding Dec.31 Interest Interest Balance Balance 84,150 2006 5,000 .10 (84,150) = 8,415 3,415 87,565 2007 5,000 .10 (87,565) = 8,757 3,757 91,322 2008 5,000 .10 (91,322) = 9,132 4,132 95,454 2009 5,000 .10 (95,454) = 9,546* 4,546 100,000 20,000 35,850 15,850 * rounded Requirement 3 Interest expense (market rate x outstanding balance) .......... 9,132 Discount on notes payable (difference) ...................... 4,132 Cash (stated rate x face amount) .................................... 5,000 62 Problem 14-12 (concluded) Requirement 4 $84,150 ÷ 3.16987 = $26,547 amount (from Table 4) installment of loan n=4, i=10% payment Requirement 5 Cash Effective Decrease in Outstanding Dec.31 Payment Interest Balance Balance 10% x Outstanding Balance Balance Reduction 84,150 2006 26,547 .10 (84,150) = 8,415 18,132 66,018 2007 26,547 .10 (66,018) = 6,602 19,945 46,073 2008 26,547 .10 (46,073) = 4,607 21,940 24,133 2009 26,547 .10 (24,133) = 2,414* 24,133 0 106,188 22,038 84,150 * rounded Requirement 6 Interest expense (market rate x outstanding balance) .......... 4,607 Note payable (difference) ............................................... 21,940 Cash (payment determined above) ................................. 26,547 63 Problem 14-13 Bonds payable (face amount) ......................................... 800,000 Loss on early extinguishment (to balance) ..................... 13,100 Debt issue costs (7/10 x $3,000) ................................. 2,100 Discount on bonds (7/10 x [$800,000 – $770,000]) ....... 21,000 Cash (given) .............................................................. 790,000 Problem 14-14 Requirement 1 Interest expense (7% x $19,000,000) ..................................... 1,330,000 Discount on bonds payable (difference) .................... 130,000 Cash (6% x $20,000,000) ............................................. 1,200,000 Requirement 2 Bonds payable (face amount) ......................................... 20,000,000 Loss on early extinguishment (to balance) ..................... 1,270,000 Discount on bonds ($1,000,000 – 130,000) .................. 870,000 Cash (redemption price) .............................................. 20,400,000 64 Problem 14-15 2006 July 1 Bond investment (face amount) ...................................... 16,000,000 Discount on bond investment (difference) ................. 300,000 Cash (price paid) ......................................................... 15,700,000 Oct. 1 Bond investment (face amount) ...................................... 30,000,000 Premium on bond investment ..................................... 1,160,000 Interest receivable ($30,000,000 x 12% x 4/12) ................ 1,200,000 Cash ($31,160,000 + $1,200,000) .................................. 32,360,000 Dec. 1 Cash (6% x $30,000,000) ................................................. 1,800,000 Premium on investment* ................................................. 20,000 Interest receivable (from October entry) .......................... 1,200,000 Interest revenue (to balance) .............................................. 580,000 * 10 years – (June-September) = 116 months $1,160,000 ÷ 116 months = $10,000 / month $10,000 x 2 months = $20,000 Dec. 31 Accrued interest Bracecourt Interest receivable ($16,000,000 x 10% x 6/12) ................ 800,000 Discount on bond investment * ................................... 7,500 Interest revenue (to balance) .............................................. 807,500 * 20 years = 240 months $300,000 ÷ 240 months = $1,250 / month $1,250 x 6 months = $7,500 Framm Interest receivable ($30,000,000 x 12% x 1/12) ................ 300,000 Premium on investment ($10,000 x 1 month) ................. 10,000 Interest revenue (to balance) .............................................. 290,000 65 Problem 14-15 (continued) 2007 Jan. 1 Cash (10% x $16,000,000 x 6/12) ....................................... 800,000 Interest receivable (from adjusting entry) .................... 800,000 June 1 Cash (12% x $30,000,000 x 6/12) ....................................... 1,800,000 Premium on investment ($10,000 x 5 months) ............... 50,000 Interest receivable (from adjusting entry) ......................... 300,000 Interest revenue (to balance) .............................................. 1,450,000 July 1 Cash (10% x $16,000,000 x 6/12) ...................................... 800,000 Discount on bond investment ($1,250 x 6 months) ............ 7,500 Interest revenue (to balance) .............................................. 807,500 Sept. 1 Interest receivable (12% x $15,000,000 x 3/12) ................ 450,000 Premium on investment ($10,000 x 3 months x 15/30) .. 15,000 Interest revenue (difference) .............................................. 435,000 Cash ([101% x $15,000,000] + $450,000) ........................... 15,600,000 Loss on sale of investment ** ..................................... 375,000 Bond investment (face amount) .................................. 15,000,000 Premium on bond investment * .............................. 525,000 Interest receivable (12% x $15,000,000 x 3/12) ............ 450,000 * ([$1,160,000 – 20,000 – 10,000 – 50,000 ] x 15/30 ) – $15,000 = $525,000, or [$1,160,000 x 105/116 x 15/30] = $525,000 ** [$15,000,000 + 525,000] – [101% x $15,000,000]) = $375,000 66 Problem 14-15 (continued) Dec. 1 Cash (12% x $15,000,000 x 6 /12) ...................................... 900,000 Premium on investment* ................................................. 30,000 Interest revenue (to balance) .............................................. 870,000 * ($10,000 x 6 months x 15/30) Dec. 31 Accrued interest Bracecourt Interest receivable (10% x $16,000,000 x 6 /12) ................. 800,000 Discount on bond investment ($1,250 x 6 months) ............ 7,500 Interest revenue (to balance) .............................................. 807,500 Framm Interest receivable ($15,000,000 x 12% x 1/12) ................ 150,000 Premium on investment ($10,000 x 1 month x 15/30) .... 5,000 Interest revenue (to balance) .............................................. 145,000 2008 Jan. 1 Cash (10% x $16,000,000 x 6 /12) ...................................... 800,000 Interest receivable (from adjusting entry) .................... 800,000 67 Problem 14-15 (concluded) Feb. 28 Interest receivable (12% x $15,000,000 x 2/12) ................ 300,000 Premium on investment ($10,000 x 2 months x 15/30) .. 10,000 Interest revenue (difference) .............................................. 290,000 Cash ([102% x $15,000,000] + $150,000 + $300,000) .......... 15,750,000 Loss on sale of investment ** ..................................... 195,000 Bond investment (face amount) .................................. 15,000,000 Premium on bond investment * .............................. 495,000 Interest receivable (12% x $15,000,000 x 3/12) ............ 450,000 * $1,160,000 – 20,000 – 10,000 – 50,000 – 15,000 – 525,000 – 30,000 – 5,000 – 10,000 = $495,000, or [$1,160,000 x 99/116 x 15/30] = $495,000 ** [$15,000,000 + 495,000] – [102% x $15,000,000]) = $195,000 Dec. 31 Accrued interest Interest receivable (10% x $16,000,000 x 6 /12) ................ 800,000 Discount on bond investment ($1,250 x 6 months) ............ 7,500 Interest revenue (to balance) .............................................. 807,500 68 Problem 14-16 1. Issuance of the bonds. Cash ($385,000 – 1,500) .................................................. 383,500 Debt issue costs (given) ................................................. 1,500 Discount on bonds payable ($400,000 – 385,000) .............. 15,000 Bonds payable (face amount) ..................................... 400,000 2. December 31, 2006 Interest expense ($20,000 + 750 ) .......................................... 20,750 Discount on bonds payable ($15,000 ÷ 20) ................ 750 Cash (5% x $400,000) ................................................. 20,000 Debt issue expense ($1,500 ÷ 20) ................................... 75 Debt issue costs ....................................................... 75 3. June 30, 2007 Interest expense ($20,000 + 750 ) .......................................... 20,750 Discount on bonds payable ($15,000 ÷ 20) ................ 750 Cash (5% x $400,000) ................................................. 20,000 Debt issue expense ($1,500 ÷ 20) ................................... 75 Debt issue costs ....................................................... 75 4. Call of the bonds Bonds payable (face amount) ......................................... 400,000 Loss on early extinguishment (to balance) ..................... 9,850 Debt issue costs (9/10 x $1,500) ................................. 1,350 Discount on bonds (9/10 x [$400,000 – $385,000]) ....... 13,500 Cash (given) .............................................................. 395,000 69 Problem 14-17 List A List B j_ 1. Effective rate times balance a. Straight-line method h_ 2. Promises made to bondholders b. Discount o_ 3. Present value of interest plus c. Liquidation payments after other present value of principal claims satisfied m_ 4. Call feature d. Name of owner not registered l_ 5. Debt issue costs e. Premium b_ 6. Market rate higher than stated rate f. Checks are mailed directly d_ 7. Coupon bonds g. No specific assets pledged k_ 8. Convertible bonds h. Bond indenture e_ 9. Market rate less than stated rate i. Backed by a lien n_ 10. Stated rate times face amount j. Interest expense f_ 11. Registered bonds k. May become stock g_ 12. Debenture bond l. Legal, accounting, printing i_ 13. Mortgage bond m. Protection against falling rates a_ 14. Materiality concept n. Periodic cash payments c_ 15. Subordinated debenture o. Bond price 70 Problem 14-18 Requirement 1 Bonds payable (face amount) ......................................... 20,000,000 Premium on bonds (20/40 x $6,000,000) ......................... 3,000,000 Gain on early extinguishment (to balance) ................ 2,600,000 Cash ($20,000,000 x 102%) ......................................... 20,400,000 Requirement 2 Bonds payable (face amount) ......................................... 10,000,000 Premium on bonds (10/40 x $6,000,000) ......................... 1,500,000 Gain on early extinguishment (to balance) ................ 1,000,000 Cash (given) .............................................................. 10,500,000 71 Problem 14-19 Requirement 1 ($ in millions) Convertible Bonds – 1993 issue Cash (97.5% x $200 million) ........................................................ 195 Discount on bonds (difference) .................................................. 5 Convertible bonds payable (face amount) .............................. 200 Bonds With Warrants – 1997 issue Cash (102% x $50 million) ........................................................... 51 Discount on bonds payable (difference) ..................................... 3 Bonds payable (face amount) .................................................. 50 Paid-in capital – stock warrants outstanding (given) ............ 4 Requirement 2 ($ in millions) Convertible bonds payable (90% x $200 million) ....................... 180 Discount on bonds payable (90% x $2 million) ...................... 1.8 Common stock (90% x [200,000 x 40 shares] x $1 par) .............. 7.2 Paid-in capital – excess of par (to balance) ............................ 171.0 Convertible bonds payable (10% x $200 million) ....................... 20.0 Loss on early extinguishment (to balance) ................................. .4 Discount on bonds payable (10% x $2 million) ...................... .2 Cash (101% x 10% x $200 million) ........................................... 20.2 Requirement 3 ($ in millions) Convertible bonds payable (90% x $200 million) ....................... 180 Conversion expense (90% x 200,000 bonds x $150) ..................... 27 Discount on bonds payable (90% x $2 million) ...................... 1.8 Common stock (90% x [200,000 x 40 shares] x $1 par) .............. 7.2 Paid-in capital – excess of par (to balance) ............................ 171.0 Cash (90% x 200,000 bonds x $150) .......................................... 27.0 72 Problem 14-19 (concluded) Requirement 4 ($ in millions) Convertible bonds payable (90% x $200 million) ....................... 180.0 Conversion expense (90% x [200,000 x (45 – 40) shares] x $32) ................................. 28.8 Discount on bonds payable (90% x $2 million) ...................... 1.8 Common stock (90% x [200,000 x 45 shares] x $1 par) .............. 8.1 Paid-in capital – excess of par (to balance) ............................ 198.9 Requirement 5 ($ in millions) Cash (40% x 50,000 x 40 warrants x $25) ....................................... 20.0 Paid-in capital – stock warrants outstanding (40% x $4 million)1.6 Common stock (40% x 50,000 x 40 shares x $1 par) .................. .8 Paid-in capital – excess of par (to balance) ............................ 20.8 73 Problem 14-20 Requirement 1 ($ in millions) Land ............................................................................. 3 Gain on disposal ..................................................... 3 Note payable ................................................................ 20 Accrued interest payable .............................................. 2 Land ........................................................................ 16 Gain on debt restructuring ....................................... 6 Requirement 2 Analysis: Carrying amount: $20 million + $2 million = $22,000,000 Future payments: ($1 million x 4) + $15 million = 19,000,000 Gain to debtor $ 3,000,000 ($ in millions) (a) January 1, 2006 Accrued interest payable ............................................. 2 Note payable * ............................................................. 1 Gain on debt restructuring ....................................... 3 * establishes a balance in the note account equal to the total cash payments under the new agreement ($20 million – 1 million = $19 million) (b) December 31, 2006, 2007, 2008, and 2009 revised “interest” payments Note payable ................................................................ 1 Cash ......................................................................... 1 Note: No interest expense should be recorded after the restructuring. All subsequent cash payments result in reductions of principal. (c) December 31, 2009 revised principal payment Note payable ................................................................ 15 Cash ..................................................................................... 15 74 Problem 14-20 (continued) Requirement 3 Analysis: Carrying amount: $20,000,000 + $2,000,000 = $22,000,000 Future payments: 27,775,000 Interest $ 5,775,000 Calculation of the new effective interest rate: • $22,000,000 ÷ $27,775,000 = .79208 – the Table 2 value for n = 4, i = ? • In row 4 of Table 2, the number .79209 is in the 6% column. So, this is the new effective interest rate. (a) January 1, 2006 [Since the total future cash payments are not less than the carrying amount of the debt, no reduction of the existing debt is necessary and no entry is required at the time of the debt restructuring.] Amortization Schedule (not required) Cash Effective Increase in Outstanding Dec.31 Interest Interest Balance Balance 6% x Outstanding Balance 22,000,000 2006 0 .06 (22,000,000) = 1,320,000 1,320,000 23,320,000 2007 0 .06 (23,320,000) = 1,399,200 1,399,200 24,719,200 2008 0 .06 (24,719,200) = 1,483,152 1,483,152 26,202,352 2009 0 .06 (26,202,352) = 1,572,648* 1,572,648 27,775,000 0 5,775,000 5,775,000 * rounded 75 Problem 14-20 (concluded) (b) December 31, 2006 Interest expense .................................................. 1,320,000 Interest payable ............................................... 1,320,000 December 31, 2007 Interest expense .................................................. 1,399,200 Interest payable ............................................... 1,399,200 December 31, 2008 Interest expense .................................................. 1,483,152 Interest payable ............................................... 1,483,152 December 31, 2009 Interest expense .................................................. 1,572,648 Interest payable ............................................... 1,572,648 (c) December 31, 2009 revised payment Interest payable ................................................... 7,775,000 Note payable ....................................................... 20,000,000 Cash ................................................................ 27,775,000 76 CASES Communication Case 14-1 Suggested Grading Concepts and Grading Scheme: Content (80% ) 20 Convertible bonds Entire proceeds of the bond issue should be allocated to the debt and the related premium or discount accounts. 20 Bonds with detachable warrants Proceeds of their sale should be allocated between the debt and the warrants. Basis of allocation is their relative fair values. Relative values are usually determined by the price at which the respective instruments are traded in the open market. Portion of the proceeds assigned to the warrants should be accounted for as paid-in capital. 20 Reasons why all the proceeds of convertible bonds should be allocated to the debt The option is inseparable from the debt: no way to retain one right while selling the other. The valuation presents practical problems: would be subjective. 20 Arguments that accounting for convertible debt should be the same as for debt issued with detachable stock purchase warrants Convertible debt has features of both debt and shareholders’ equity, and separate recognition should be given to the fundamental elements at the time of issuance. Difficulties in separating the relative values of the features are not insurmountable. Bonus (5) Other relevant arguments not mentioned above 80-85 points Writing (20%) 5 Terminology and tone appropriate to the audience (CFO). 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English. Word selection. Spelling. Grammar. 77 Real World Case 14-2 Requirement 1 ($ in millions) Cash (price given) ....................................................... 968 Discount on notes (difference) ................................... 832 Notes payable (face amount) ................................... 1,800 Requirement 2 Fiscal Decrease Outstanding Year-end Cash Interest Expense in Balance Balance 1997 968 1998 0 0.03149 (968) = 30 30 998 1999 0 0.03149 (998) = 31 31 1,030 2000 0 0.03149 (1,030) = 32 32 1,062 2001 0 0.03149 (1,062) = 33 33 1,096 2002 0 0.03149 (1,096) = 35 35 1,130 2003 0 0.03149 (1,130) = 36 36 1,166 2004 0 0.03149 (1,166) = 37 37 1,203 2005 0 0.03149 (1,203) = 38 38 1,240 2006 0 0.03149 (1,240) = 39 39 1,280 2007 0 0.03149 (1,280) = 40 40 1,320 2008 0 0.03149 (1,320) = 42 42 1,361 2009 0 0.03149 (1,361) = 43 43 1,404 2010 0 0.03149 (1,404) = 44 44 1,449 2011 0 0.03149 (1,449) = 46 46 1,494 2012 0 0.03149 (1,494) = 47 47 1,541 2013 0 0.03149 (1,541) = 49 49 1,590 2014 0 0.03149 (1,590) = 50 50 1,640 2015 0 0.03149 (1,640) = 52 52 1,691 2016 0 0.03149 (1,691) = 53 53 1,745 2017 0 0.03149 (1,745) = 55 55 1,800 78 Case 14-2 (concluded) Requirement 3 In a strict sense, zero-coupon debt pays no interest. “Zeros” offer a return in the form of a “deep discount” from the face amount. In fact, though, interest accrues at the effective rate (3.149% in this case) times the outstanding balance ($968 million during 1998), even though no interest is paid periodically. Interest on zero- coupon debt is determined and reported in precisely the same manner as on interest-paying debt. Under the concept of accrual accounting, the periodic effective interest is unaffected by when the cash actually is paid. Corporations can even deduct for tax purposes the annual interest expense. So, for 1998, HP’s earnings were reduced by $30 million (.03149 x $968) and increased by the tax savings from being able to deduct the $30 million. If the tax rate was 35%, that savings would have been 35% x $30, or $10.5 million, and the net decrease in earnings would have been $19.5 million ($30 – 10.5). Requirement 4 From the amortization schedule, we can see that the book value of the debt at the end of 2002 was $1,130 million. Requirement 5 The journal entry Hewlett-Packard used to record the early extinguishment of debt in 2002, assuming the purchase was made at the end of the year was: Notes payable (given) ........................................... 257 Discount (calculated below) ................................ 96 Gain on the early extinguishment of debt (to balance) 34 Cash (given) ...................................................... 127 Calculations: $257 / $1,800 = 14.28% of notes were repurchased 14.28% x $1,130 = $161 million book value of notes repurchased $257 – 161 = $96 million discount on notes repurchased 79 Communication Case 14-3 You may wish to suggest to your students that they consult the FASB 1990 Discussion Memorandum, “Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both,” which sets forth the most common arguments on the issues in this case. Or, you may prefer that they think for themselves and approach the issue from scratch. There is no right or wrong answer. Both views can and often are convincingly defended. The process of developing and synthesizing the arguments will likely be more beneficial than any single solution. Each student should benefit from participating in the process, interacting first with his or her partner, then with the class as a whole. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Arguments brought out in the FASB DM include the following: 80 Case 14-3 (continued) Arguments Supporting View 1: 1. Those who favor accounting for convertible debt as entirely a liability until it is either converted or repaid argue that a convertible bond offers the holder two mutually exclusive choices. The holder cannot both redeem the bond for cash at maturity and convert it into common stock. They contend that the accounting before conversion or other settlement should reflect only the issuer's current position as a borrower and the holder's current position as a creditor. Until the conversion option is exercised, the bondholder is entitled to receive, and the enterprise is obligated to pay, only the periodic interest payments. If the option has not been exercised at the date the bonds mature, the issuer is obligated to pay the face amount, not to issue stock to the holder. Advocates of accounting for convertible debt according to its governing characteristics argue that a convertible bond is a single instrument, not two. To account for it as two instruments would not be representationally faithful. (par. 295) 2. Supporters of the first alternative generally also are concerned about the ability to measure reliably the components of convertible debt because neither is separately traded. They conclude that because the market does not determine a separate value for the conversion option, any value attributed to it would be subjective. Opinion 14 cited "the uncertain duration of the right to obtain the stock and the uncertainty as to the future value of the stock obtainable upon conversion" as factors further complicating valuation of the conversion option. (par. 296) 3. Supporters of that view argue that factors other than the conversion feature typically affect the pricing of convertible debt and therefore may complicate an attempt to allocate the proceeds from issuance between the straight debt and the conversion feature. For example, convertible bonds generally have covenants that are less restrictive than those for nonconvertible bonds on matters such as issuing more debt, maintaining specified financial ratios, paying large dividends on common stock, and establishing sinking funds. Less restrictive covenants may result in some reduction in market value and a corresponding increase in yield, which would complicate valuing the debt component of a convertible bond by comparing it with nonconvertible bonds with similar terms issued by enterprises with comparable credit ratings (par. 297). 81 Case 14-3 (continued) 4. Moreover, no cash payment from holder to issuer is required when a convertible bond is converted; the bond itself represents the consideration received by the issuing enterprise for the stock into which the bond is converted. Thus, the price paid by the holder upon conversion effectively depends on the market price of the bond at the time of conversion. Those who would account for convertible debt as entirely a liability argue that the absence of a fixed cash price for which a bondholder obtains an equity interest complicates an attempt to value the straight debt and conversion feature components (par. 298). Arguments Supporting View 2: 1. Those who favor separate recognition of the liability and equity components of convertible debt argue that to ignore the existence of the conversion feature in recognizing the issuance of the bond results in overstating the liability and understating the interest expense. The effect of the conversion feature is to lower the rate for otherwise comparable straight debt (par. 333). 2. The higher interest expense recognized if the components are separately recognized than if all of the proceeds of issuance are recorded as a liability reflects the fact that an enterprise that issues debt at less than its face amount pays an effective interest rate that is higher than the coupon rate. The lower reported interest expense that results if the convertible debt is accounted for as entirely a liability leads those who support separate accounting to argue that failure to attribute a portion of the proceeds to the conversion option, thereby overstating the amount of the enterprise's liability, does not faithfully represent the economics of the transaction between the enterprise and the bondholder (par. 334). 3. Supporters of separate accounting contend that accounting for convertible debt as entirely a liability impairs comparability between enterprises. If convertible debt is reported as entirely a liability, an enterprise with a relatively high credit rating that issues nonconvertible debt appears to have a higher cost of borrowing than a company with a lower credit rating that issues convertible debt because inclusion of the conversion feature lowers the nominal interest rate significantly (par. 335). 82 Case 14-3 (concluded) 4. Those who support separate recognition of the liability and equity components of convertible debt point to the different values assigned by the market to convertible and nonconvertible debt with like terms as evidence of the inherent value of the conversion feature. They argue that accounting for a convertible bond as if it were entirely a debt instrument fails to recognize and display appropriately the obligation to issue stock, that is, the option embedded in convertible debt. The conversion feature has essentially the same economic value as the call on stock represented by a separately traded call option or warrant. The fact that the conversion feature cannot be sold separately does not justify ignoring its existence (par. 336). 5. In the 21 years since Opinion 14 was issued, the idea that many financial instruments may be broken down into more fundamental components, which then may be traded separately, has been embraced by the Wall Street community. The cash flows from instruments that have generally not been thought of as containing different components, such as government bonds, have been unbundled and recombined. Those who support separate accounting for the fundamental components of convertible debt argue that separate accounting would be consistent with the current economic environment. They contend that it is neither necessary nor appropriate to wait until the components of a financial instrument like convertible debt, which so obviously has both liability and equity characteristics, are physically separated to give accounting recognition to the existence of the separate components (par. 337). 83 Analysis Case 14-4 Requirement 1 The notice is being placed by the four underwriters listed at the bottom of the notice. The purpose is to announce the sale of the bonds described. Actually, the sale by Craft Foods already has occurred at this point. The underwriters resell the securities to the investing public. These are ten-year bonds. The stated rate of interest is 7.75%, but the bonds are priced to yield a higher rate, which accounts for the fact they are offered at a discount, 99.57% of face value. Requirement 2 In practice, debt securities rarely are priced at a premium in their initial offering. The reason is primarily a marketing consideration. It’s psychologically more palatable for a security salesperson to approach a customer with an issue that is offered at a discount off its face value and that provides a return greater than its stated rate than one which is priced above its face value and provides a return less than its stated rate. Requirement 3 The accounting considerations for Craft Foods are to recognize the liability and related debt issue costs, as well as to record interest expense semiannually over the ten-year term to maturity at the effective rate of interest. The bonds were recorded at their selling price: $750,000,000 x 99.57 = $746,775,000 (Bonds payable at face, discount of $3,225,000). Craft Foods also recorded debt issue costs in a separate account to be amortized over the term to maturity (probably straight-line). We do not know the amount of those costs. It also is not apparent exactly when the sale by Craft Foods was made to the underwriters and therefore the amount of any accrued interest. Any accrued interest would be recorded as interest payable to be paid at the first interest date as part of the first semiannual interest payment. 84 Judgment Case 14-5 Obviously, no rational lender will lend money without interest. The zero interest loan described actually does implicitly bear interest. The amount and rate of interest can be inferred from either the market rate of interest at the time for this type of transaction or from the fair value of the asset being sold. The case information provides no information about either, other than that the stated price of the asset is higher than prices for this model Mr. Wilde had seen elsewhere. If we knew, for instance, that the market rate of interest at the time for this type of transaction is 8%, we would assume that’s the effective interest rate and could calculate the price of the equipment as follows: $17,000 x 10.57534 = $179,781 installment (from Table 4) actual payment n=12, i=2.0% price Both the asset acquired and the liability used to purchase it should be recorded at the real cost, $179,781. Similarly, if we knew the cash price of the equipment is $185,430, then we could calculate the effective rate of interest as follows: The discount rate that “equates” the present value of the debt ($185,430) and the installment payments ($17,000) is the effective rate of interest: $185,430 ÷ $17,000 = 10.9076: the Table 4 value for n = 12, i = ? In row 12 of Table 4, the value 10.90751 is in the 1.5% column. Since payments are quarterly, this equates to a 1.5 x 4 = 6% annual rate. So, 6% is the effective interest rate. A financial calculator will produce the same rate. In any case, Mr. Wilde will not avoid interest charges with this offer. Interest expense must be recorded at the effective rate, 8% in our first scenario, and 6% in the second. 85 Judgment Case 14-6 Although not specifically discussed in the chapter, concepts studied in this and other chapters provide the logic for addressing the situation described. (APB 21 also addresses this type of situation.) The company's accountant is incorrect in valuing the note at $200,000. The note should be valued at the present value of the receivable using the prevailing market rate and the difference between the present value and the cash given is regarded as an addition to the cost of products purchased during the contract term. In this case, the note would be valued at $136,602, computed as follows: PV = $200,000 x .68301 PV of $1: n=4, i=10% (from Table 2) PV = $136,602 The journal entry to record the initial transaction is as follows Note receivable (above) .................................. 136,602 Prepaid inventory (difference) ........................ 63,398 Cash ............................................................ 200,000 Interest revenue is recognized over the 4-year life of the note using the effective interest rate of 10%. Accrued interest will increase the receivable valuation to $200,000. Prepaid inventory is credited and inventory is debited as inventory is purchased, thus increasing the cost of inventory from the prices paid to market value. 86 Communication Case 14-7 The critical question that student groups should address is the valuation of the note receivable. In this case, there is a correct answer. The note should be valued at the present value of $300,000 using the appropriate market rate of interest. The difference between present value and the $300,000 should be accounted for by Pastel as prepaid advertising. Interest revenue over the life of the note will be recognized using the effective rate. As advertising services are provided by the radio station, advertising expense is debited and prepaid advertising credited. It is important that each student actively participate in the process of arriving at a solution. Domination by one or two individuals should be discouraged. Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction. 87 Analysis Case 14-8 1.a. The 11% bonds were issued at a premium (more than face amount). Although the bonds provide for the payment of interest of 11% of face amount, this rate was more than the prevailing or market rate for bonds of similar quality at the time the bonds were issued. Thus, the bonds must sell at a premium to yield 9%. b. The amount of interest expense would be higher in the first year of the life of the bond issue than in the second year of the life of the bond issue. According to the effective interest method of amortization, the 9% effective interest rate is applied to a declining bond carrying amount, and results in a lower interest expense in each successive year. 2. a. Gain or loss on early extinguishment of debt should be determined by comparing the net carrying amount of the bonds at the date of extinguishment with the reacquisition price. If the net carrying amount exceeds the reacquisition price, a gain results. If the net carrying amount is less than the reacquisition price, a loss results. In this case, a gain results. The bonds were issued at a premium; therefore, the carrying amount of the bonds at the date of extinguishment must exceed face amount. Thus, the net carrying amount exceeds the reacquisition price. b. Brewster should report a gain on the early extinguishment in net income for 2006. 88 Case 14-8 (concluded) 3. a. Net income is not affected by conversion under the book value method. The book value method views the convertible bonds as possessing substantial characteristics of equity capital. The conversion represents the completion of a prior transaction (the issuance of the convertible debt), not the culmination of an earning process. b. A gain or loss results, and thus net income is affected by conversion under the market value method when market value differs from the carrying amount of the convertible bonds. The market value method views the convertible bonds primarily as debt whose conversion was a significant economic transaction. The conversion represents the culmination of an earning process. The market value method views the market value of the common stock at the date of the conversion to be the proper measurement at which to carry the common stock. 89 Ethics Case 14-9 Discussion should include these elements. Facts: Inducing a bond conversion is a common method of indirectly issuing stock, though typically not for the purpose of enhancing profits. Reported performance will increase. Company managers stand to benefit from the change. Ethical Dilemma: Should Hunt Manufacturing enter into these transactions primarily for “window dressing” rather than for economic reasons? Who is affected? Meyer Barr Other managers Bondholders Hunt’s auditors Shareholders Potential shareholders The employees Other creditors 90 Judgment Case 14-10 Requirement 1 The debt to equity ratio is computed by dividing total liabilities by total shareholders' equity. The ratio summarizes the capital structure of the company as a mix between the resources provided by creditors and those provided by owners. For example, a ratio of 2.0 means that twice as many resources (assets) have been provided by creditors as those provided by owners. In general, debt increases risk. Debt places owners in a subordinate position relative to creditors because the claims of creditors must be satisfied first in case of liquidation. In addition, debt requires payment, usually on specific dates. Failure to pay debt interest and principal on a timely basis may result in default and perhaps even bankruptcy. Other things being equal, the higher the debt to equity ratio, the higher the risk. The type of risk this ratio measures is called default risk because it presumably indicates the likelihood a company will default on its obligations. IGF’s debt to equity ratio is not particularly high – in fact it’s less than the industry average. Requirement 2 Debt also can be used to enhance the return to shareholders. This concept is known as leverage. If a company earns a return on borrowed funds in excess of the cost of borrowing the funds, shareholders are provided with a total return greater than what could have been earned with equity funds alone. This desirable situation is called “favorable financial leverage.” Unfortunately, leverage is not always favorable. Sometimes the cost of borrowing the funds exceeds the returns they generate. This illustrates the typical risk-return tradeoff faced by shareholders. Debt to equity ratio = Total liabilities Shareholders' equity = $2,414 $2,931 = 0.82 Industry average = 1.0 91 Case 14-10 (continued) IGF has experienced favorable leverage, as demonstrated by calculating and comparing the return on assets and the return on shareholders’ equity for 2006: The debt to equity ratio is not particularly high, but the debt the company does have has been used to shareholders’ advantage. The return on equity is greater than the return on assets. In fact, it may be that debt is being under-utilized by IGF. More debt might increase the potential for return, but the price would be higher risk. This is a fundamental tradeoff faced by virtually all firms when trying to settle on the optimal capital structure. Requirement 3 Creditors generally demand interest payments as compensation for the use of their capital. Failure to pay interest as scheduled may cause several adverse consequences including bankruptcy. Therefore, another way to measure a company's ability to pay its obligations is by comparing interest payments with cash flow generated from operations. The times interest earned ratio does this by dividing income before subtracting interest expense or income tax expense by interest expense. Rate of return on = Net income assets Average total assets = $487 [$5,345 + 4,684] / 2 = 9.7% Rate of return on = Net income shareholders' equity Average shareholders' equity = $487 [$2,931 + 2,671] / 2 = 17.4% 92 Case 14-10 (concluded) Two points about this ratio are important. First, because interest is deductible for income tax purposes, income before interest and taxes is a better indication of a company's ability to pay interest than is income after interest and taxes (i.e., net income). Second, income before interest and taxes is a rough approximation for cash flow generated from operations. The primary concern of decision-makers is, of course, the cash available to make interest payments. In fact, this ratio often is computed by dividing cash flow generated from operations by interest payments. IGF’s fixed charges are covered over 15 times, far exceeding the industry norm. The interest coverage ratio seems to indicate an ample safety cushion for creditors, particularly when considered in conjunction with their debt-equity ratio. There seems also to be considerable room for additional borrowing in the event the firm wanted to increase its leverage in an attempt to further enhance the return to shareholders. Times interest earned = Net income + interest + taxes Interest = $487 + 54 + 316 $54 = 15.9 times Industry average = 5.1 times 93 Real World Case 14-11 The following is from Procter and Gamble’s annual report. The responses to the questions will vary depending on the date of the 10-K accessed. 2004 2003 Requirement 3 ($ in millions) Total Current Liabilities $22,147 $12,358 Long-term Debt 12,554 11,475 Deferred Income Taxes 2,261 1,396 Other Noncurrent Liabilities 2,808 2,291 Total $39,770 $27,520 Total debt has increased by 45%. Requirement 4 Total debt $39,770 $27,520 Shareholders’ Equity $17,278 $16,186 Total debt 39,770 27,520 Shareholders’ Equity 17,278 16,186 Ratio 2.30 1.70 The debt to equity ratio has increased by 35% since last year. Requirement 5 The vast majority is in the form of notes. Aggregate required payments of maturities of long-term debt for the next five fiscal years (generally increasing) are as follows: Dollars in Millions 2005 2006 2007 2008 2009 Required payments $1,518 $2,625 $1,433 $972 $1,150 The current portion of long-term debt is $1,518 million and $1,093 in 2004 and 2003, respectively. No short-term debt is classified as long-term in 2004. It would be classified as long-term if the company intended to refinance any currently maturing debt on a long-term basis and could demonstrate the ability to do so. Solution Manual for Intermediate Accounting David J. Spiceland, James F. Sepe, Lawrence A. Tomassini 9780072994025, 9780072524482
Download
Close
Close
