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CHAPTER 8 SOURCES OF CAPITAL: DEBT Changes from Eleventh Edition Updated from Eleventh Edition Approach Students sometimes are confused about the nature of bonds, since they have heard the term linked with equity in “stocks and bonds” and know that there are bond exchanges and quoted daily prices. Hybrid securities such as convertible debentures or redeemable preferreds exacerbate any confusion. However, once students understand the nature of bonds, they find the accounting fairly straightforward with the notable exception of discount/premium amortization using the compound interest method (as opposed to the easy, but conceptually incorrect, straight-line method). I feel that it is desirable to teach the Appendix’s present value concepts at this point, but it is feasible to omit this topic and introduce it as the beginning of the coverage of capital budgeting. Cases Norman Corporation (A) describes several problems relating to contingencies and other liability accounting issues. Stone Industries, Inc., is a complicated fact situation, raising issues about accounting for bond discount and premium and the significance of the accounting numbers. Paul Murray enables students to practice future value and present value problems in an everyday context. Joan Holtz (D) deals with several matters we have recently seen mentioned in the business press (or on TV, in one instance), including debt-for-equity swaps. Additional Cases The observant instructor can augment or update Joan Holtz (D) with new issues as they crop up in The Wall Street Journal and elsewhere. (The folks on Wall street are quite good about generating new accounting issues for us with their latest “creative” financing instruments.)

Problems Problem 8-1 Time zero investment = $750,000 x .630 = $472,500 Proof $472,500 x (1.08 x 1.08 x 1.08 x 1.08 x 1.08 x 1.08) = $749,798 Difference due to use of tables (Table A) Problem 8-2 CD price Year 10 = $14 / .676 = $20.71

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CD price Year 25 = $14 / .375 = $37.33 CD price Year 50 = $14 / .141 = $99.29 Problem 8-3 (1) Trust fund at time zero = $100,000 x .397 = $39,700 (2) End of Year 1 payment = $4,000 x .926 End of Year 2 payment = $4,500 x .857 End of Year 3 payment = $5,000 x .794 End of Year 5 payment = $6,000 x .735 Total loan

= $ 3,704 = $ 3,857 = $ 3,970 = $ 4,410 $15,941

(1) Present value of $3,100 / year for three years at 6 percent (least amount you will accept today) = $3,100 x 2.673 = $8,286 Proof Year 1 2 3

Beginning Balance $8,286 5,683 2,924

Ending Balance Before Payment $8,783 6,024 3,100

Payment $3,100 3,100 3,100

(4) Present value at beginning of year 3 of $3,000 received annually for 9 years (assuming “through year 11” means to the end of year 11) discounted at 12 percent per year = $3,000 x 5.328 = $15,984. Present value of $15,984 received two years hence, discounted at 12 percent = $15,984 x .797 = $12,739. Problem 8-4 Year 1 2 3 4 5 6

Beginning Balance $164,440 144,173 121,473 96,050 67,576 35,685

Ending Balance Before Payment $184,173 161,473 136,050 107,576 75,685 39,967

Payment 40,000 40,000 40,000 40,000 40,000 39,967

Problem 8-5 (1) W&H Company’s 2006 financial statements should disclose the IRS suit, if material. The company should include in its 2006 financial statements a provision for a payment of at least $270,000 to the IRS. (2) The full loss should be included in the company’s 2006 financial statements. (3) The suit should be disclosed in the 2006 financial statements, if material. A comment can be made that if an adverse finding is reached by the court, insurance should offset part of the damage payment. A contingency loss provision is not needed at this time. 2

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(4) If the company has received formal notification of an intent to sue, it should be disclosed in its 2006 financial statements. The company might indicate it believes any claim against the company is without merit.

Problem 8-6 April 1, 2008 dr. Cash.................................................................................................................................................................. 260,000 cr. Bonds Payable............................................................................................................................................... 250,000 Bond Premium.............................................................................................................................................. 10,000 October 1, 2008 8-6 Entries at 12-31-08 dr. Interest Expense............................................................................................................................................... 10,000 cr. Cash 10,000 dr. Bond Premium................................................................................................................................................. 1,000 cr. Interest Expense............................................................................................................................................. 1,000 April 1, 2009 dr. Interest Expense 2,500 cr. Interest Payable 2,500 (10,000 x 3/12) dr. Bond Premium 250 cr. Interest Expense 250 (1,000 x 3/12) Same as above (assume straight-line amortization of bond premium). Problem 8-7 (1)

dr. Cash..................................................................................................................................................................... 14,700,000 Bond Discount..................................................................................................................................................... 300,000 cr. Bonds Payable.................................................................................................................................................. 15,000,000

(2)

dr. Issurance Cost (asset).......................................................................................................................................... 250,000 Cash..................................................................................................................................................................... 7,999,600 cr. Bond Payable.................................................................................................................................................... 7,000,000 Bond Premium.................................................................................................................................................. 999,600 Cash.................................................................................................................................................................. 250,000 Cash received equals sum of:

PV 15 annual interest payments ($80 x 7,000) discounted at 6.5 percent (9.41)......................................................................................................................................... $5,269,600 PV principal payment ($7,000,000) in year 15 discounted at 6.5 percent (.390)......................................................................................................................................... 2,730,000 $7,999,600 (3) dr. Cash..................................................................................................................................................................... 4,658,250 Bond Discount....................................................................................................................................................... 341,750 cr. Bond Payable.................................................................................................................................................... 5,000,000 Cash received equals sum of:

PV 20 semiannual interest payments ($350,000 / 2) discounted at 4 percent (13.590 - Table B)..................................................................................................................... $2,378,250 PV principal payment ($5,000,000) in period 20 discounted at 4 percent (.456 - Table A)............................................................................................................................. 2,280,000 $4,658,250 3

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Problem 8-8

January 1, 2008 dr. Cash.............................................................................................................................................................................. 4,750,000 Bond Discount............................................................................................................................................................... 250,000 cr. Bonds Payable............................................................................................................................................................ 5,000,000 January 1, 2013 dr. Bonds Payable............................................................................................................................................................... 5,000,000 Loss on Bond Redemption................................................................................................................................................................... 375,000 cr. Cash........................................................................................................................................................................... 5,250,000 Bond Discount............................................................................................................................................................ 125,000 Problem 8-9

January 1, 1982 dr. Cash 4,120,000 Bond Issuance Cost (asset).................................................................................................................................................................... 80,000 cr. Bonds Payable............................................................................................................................................................ 4,000,000 Cash........................................................................................................................................................................... 80,000 Bond Premium........................................................................................................................................................... 120,000 January 1, 2002 dr. Bonds Payable 4,000,000 Bond Premium 24,000 Bond Redemption Expense 75,000 Loss on Bond Redemption 312,000 cr. Cash 4,395,000 Bond Issuance Cost 16,000

Cases Case 8-1: Norman Corporation (A)* Note: This case has been updated from the Eleventh Edition. Norman Corporation (A) allows students to practice dealing with various types of liabilities. If students have had little previous experience identifying when future, possible obligations are and are not accounting liabilities, you may wish to begin with a general discussion of the criteria for recording accounting liabilities. Following this, each of the items in Norman Corporation (A) can be discussed. Students should be encouraged to identify what accounting choice they made, to explain why they made this choice including explaining, where appropriate, how the item met or failed to meet the criteria for a liability, and to state the impact of their choice on the financial statements. Answers to Question 1 *

This teaching note was prepared Robert N. Anthony. Copyright © Robert N. Anthony.

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1. In order to recognize an expense related to this contingency, it must be feasible to make an estimate of at least the minimum amount of loss. In this case, no such estimate is available, so no amount should be recorded. In fact, some will argue that it is not clear that a liability has been incurred. The existence of the suit should be disclosed in a note to the financial statements, however. 2. This lawsuit differs from the one above in that the lawyers are able to make an estimate of the loss. The $50,000 should be shown as an expense (rather than a debit directly to Retained Earnings), with a resulting $20,000 (40 percent) decrease in income taxes. (This may raise the question of the treatment of deferred taxes since this item would not be a tax-deductible expense in 2006; it is for this reason that students are asked not to consider detailed income tax consequences, nor to adjust the balance sheet.) In any event, showing this as a “Reserve for Contingencies” in the owner’s equity section of the balance sheet is no longer considered an acceptable practice; the credit should be to Contingent Liabilities or, better, Estimated Loss from Lawsuit. 3. Future maintenance costs are no more a liability than are, say, future salaries or materials purchases. Norman’s treatment of maintenance is an example of “income smoothing,” which is not in accordance with generally accepted accounting principles, and which is particularly frowned on by the Financial Accounting Standards Board. The expense charge should be $44,000, increasing net income and Retained Earnings by $16,000 and reducing noncurrent liabilities by the same amount. 4. The bond discount should be subtracted from the related liability, rather than being shown as an asset. The company has, in effect, borrowed only $80,000, but at an effective interest rate that is higher than 5 percent. Not enough information is given to calculate the effective rate; this is part of the optional question if students have been required to read the Appendix. It will not owe the $100,000 until the issue matures, at which time the bond discount will have been amortized, and the liability amount will be $100,000. The method of recording does make a difference because it affects total assets and total liabilities amounts and the debt/equity ratio. It does not affect income. (The stockholder’s motive for having the transaction arranged in this way probably was the belief that the $20,000 would be taxed at the lower capital gains rate when the issue matured; this belief probably was incorrect.) 5. This transaction was handled correctly. The amortization of bond discount is, in effect, a part of the true interest expense and is shown as an expense on the income statement. The statement about Retained Earnings is a red herring. Most statement users would prefer to have interest expense shown as a separate income statement line item rather than lumped into a broader category. 6. There are two issues here: whether the $500 should have been capitalized as a deferred charge rather than expensed; and, if expensed, whether included as a nonoperating item. While the deferred charge approach in general is the correct one, in this case an exception could probably be made on the ground that the difference between the correct approach and immediate expensing is immaterial. Although at one time the “nonoperating income and expenses” caption was used to aggregate such things as dividend income and interest expenses, this is no longer the case. APB-9 and APB-30 (discussed in Chapter 10) essentially equate “nonoperating” items to “extraordinary” items, for which specific criteria exist. This does not, however, preclude a company from reporting the net amount of financial revenues (e.g., dividend income) and expenses (interest, bank fees) as a line item in the calculation of pretax income from continuing operations. In the condensed income statement given in Exhibit 1, then, if this $500 is expensed, it should be included in the total for operating expenses. 7. From Chapter 7, we know clearly that this is a capital lease, since one criterion that requires capital lease treatment is transfer of title to the lessee at the end of the lease. Thus, the $35,000 value of the car should have been capitalized as an asset on January 2, 2006, and a $35,000 credit for capital lease obligations made. Assuming straight-line depreciation, one-fifth of the asset amount ($7,000) should

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be charged as depreciation expense in 2006. Note that the depreciation charge is based on useful life, not the lease term or ACRS schedules. If the student has been required to cover the appendix, enough information is given to calculate the interest rate of the lease, which is 8 percent (see below). Thus the $13,581 first-year payment is divided between $2,800 interest expense (.08 * $35,000) and $10,781 reduction of capital lease obligations. Answer to Optional Question 2 We are told to assume that the $100,000 (par value) bond with a 5 percent coupon rate in item 4 of Question 1 involves 15 year-end annual interest payments of $5,000 ($100,000 * 0.05). (The payments are assumed to be annual, at year-end, rather than the more realistic semiannual, so that students not having PV calculators can use the text’s appendix tables.) Tables A and B and a rate of 8 percent results in a present value of $5,000 * 8.559 = $42,795 for interest payments plus $100,000 * 0.315 = $31,500, or a total of $74,295; since the investor paid $80,000, the yield rate is less than 8 percent. Trying 6 percent, we get PV = ($5,000 * 9.712) + ($100,000 * 0.417) = $90,260; so we know the yield is between 6 and 8 percent. Using 7 percent and linear interpolation in Tables A and B. we have PV = ($5,000 * 9.135) + ($100,000 * .366) = $82,275. (The mathematically inclined student will realize that linear interpolation for 7.0 percent will result in the average of the two PVs we found for 6 and 8 percent, except for rounding.) I accept 7 percent as a perfectly adequate answer. Those with calculators will come up with 7.23. As for the correctness of the $784 first-year bond discount amortization, the calculation is as follows: Since the bond proceeds were $80,000 and the true yield was 7.23 percent, then Year 1 net interest should be $80,000 * 0.0723 = $5,784. But the stated (cash) interest payment is $5,000; thus the remaining $784 of interest expense is amortization of bond discount. Ms. Fuller’s calculation was correct. Answer to Optional Question 3 The interest rate is determined by finding the value in Table B equal to $35,000 divided by the annual payments of $13,581 for a period of 3 years ($35,000 divided by $13,581 = 2.577). The interest rate is 8 percent. The amortization schedule: Year 1 2 3

Beg. Bal. $35,000 24,219 2,576

Payment $13,581 13,581 13,581 ($1 rounding error)

Interest $2,800 1,938 1,006

Principal Reduction $10,781 11,643 12,575

I use this schedule to generate journal entries for the lease payment and then show the asset depreciation entries, which are based on the useful life of five years.

Case 8-2: Stone Industries, Inc.* *

This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

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Note: This case is unchanged from the Eleventh Edition. Approach This case is intended to give the students further insight into the relationship between bond terms and the market price for a given bond. I stress that a bond is a company’s “IOU” held by the bondholder, with its terms unchangeable once the bond is issued. Thus, as market interest rates fluctuate over the life of the bond, the value (market price) of the bond must fluctuate so that the rate of return on the bond can adjust to market conditions, because the issuer can gain if market interest rate increases subsequent to the issuance of a bond, thus driving down the market price of the bond so that repurchase can take place at less than the bond’s book value. The case permits discussion of how such a gain should be reported to shareholders. The instructor needs to be on guard not to let the class get bogged down in computational details that obscure the purpose of the case. In particular, two complications exist that can lead to confusion about what are the “right numbers.” First, some students will use calculators with present value routines, whereas other will use Tables A and B of the text; this will cause rounding errors (especially where interpolation is needed if the tables are used). More important, some students will realize that the bonds in question involve 20 semiannual payments, which is not exactly the same as 10 annual payments of double the amount. More specifically, the bonds now outstanding are properly described as having a 5 percent coupon; but semiannual $25 payments are not equivalent to annual $50 payments. For example, had the initial issuance price been (contrary to fact) $1,000 per bond, a bond with $50 annual (year-end) payments has a yield of exactly 5.0 percent, but with $25 semiannual payments the yield is 5.0625 percent. You may wish to set “groundrules” in your assignment sheet to avoid confusion. The calculations in this note were done with a calculator and assumed semiannual interests payments; in some cases I show more significant figures than the problem justifies so that you have a clear check on results using a calculator. If the market rate is said in the case to be 1 percent, then the rate used for each semiannual period was ½ even though this is not exactly correct conceptually, it is consistent with most calculators’ instruction manuals about how to handle such problems. Calculations

A. Bonds issued on January 1, 20x0, when the market rate is said to have been 6 percent: NPV (at 3% per half year) of each bond’s cash flows: Interest payments, 20 payments of $25................................................................................................................. $371,937 Principal repayment, end of 20 periods................................................................................................................. 553,676 Market value.......................................................................................................................................................... $925,613 Proceeds (ignoring issuance costs), 4,000 bonds: $3,702,452 Original issuance discount ($4,000,000 par): $297,548 ($925,613 x 4,000 = $3,702,452)

Bond Discount Amortization Schedule Period 1 2 3 4 5 6

Beginning Book Value $3,702,452 3,713,526 3,724,932 3,736,680 3,748,780 3,761,243

Interest Expense $111,074 111,406 111,748 112,100 112,463 112,837

Interest Paid $100,000 $100,000 $100,000 $100,000 $100,000 $100,000

Discount Amortiz. $11,074 11,406 11,748 12,100 12,463 12,837

Ending Book Value $3,713,526 3,724,932 3,736,680 3,748,780 3,761,243 3,774,080

From this table, one can verify the amounts shown in Note 1 of Exhibit 1 of the case for the bond’s 7

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book value as of December 31, 20x0 and 20xl (end of periods 2 and 4 in above table); $3,725 thousand and $3,749 thousand, respectively. Note also that the unamortized discount at December 31, 20x2, is $225,920 ($4,000,000 - $3,774,080).

B. Bonds with 12 percent coupon rate issued on Dec. 31, 20x2 (or January 1, 20x3, which is the same date in accounting), when market rate was 10 percent. NPV (at 5% per half year) of each bond’s cash flows: Interest payments, 20 payments of $60.............................................................................................................................. $747,733 (60 x 12.462210) Principal repayment, end of 20 periods.............................................................................................................................. 376,889 (1,000 x 376889) Market value...................................................................................................................................................................... $1,124,622 Proceeds (ignoring issuance costs), 4,000 bonds: $4,498,488 Original issuance discount ($4,000,000 par): $498,488 (In the table that follows, I use $4,498,000 because that is the amount used in the case body and in Question 3.)

Period 1 2 3 4

Bond Premium Amortization Schedule Beginning Interest Premium Book Value Expense Interest Paid Amortiz. $4,498,000 $224,900 $240,000 $15,100 4,482,900 224,145 240,000 15,855 4,467,045 223,352 240,000 16,648 4,450,397 222,520 240,000 17,480

Ending Book Value $4,482,900 4,467,045 4,450,397 4,432,917

Comments on Questions 1. a. There is no single explanation of the $3,749,000; the table shown above explains how this amount is calculated. I try to stress that bond accounting is such that (1) at the time of issuance, Cash and Bonds Payable (net) increase by the same amount (proceeds per bond, ignoring issuance costs); (2) at maturity, Cash and Bonds Payable decrease by the same amount ($1,000 per bond); and (3) the amortization of discount or premium, using the compound interest method, systematically changes the Bonds Payable amount from the amount of proceeds to the amount of the face value, and does so in a way such that the interest rate reflected in the issuer’s bond interest expense is constant throughout the life of the bond. b. At the time of proposed refunding of the old bonds, the market interest rate is said to be 10 percent. Thus, a 10 percent coupon bond should have a market value equal to its face value: if one invests $1,000 now at 10 percent, gets $100 cash inflow for each of the next 10 years, and gets his/her $1,000 back at the end of 10 years, then the return on the investment is exactly 10 percent. On the other hand, if the $1,000 investment pays $120 cash per year, then the return is higher than 10 percent (12 percent, to be precise); thus, the market will drive up the amount of initial investment (price) until the return (if held to maturity) equals the market return. This would be an issuance price of $1,125 ($1,124.622) per bond, as calculated above. Multiplied by 4,000 bonds, the total (rounded) is $4,498,000. 2. a. Calculation of the gain: since the book value at December 31, 20x2, is $3,774,080 (end of period 6 in above table) and the expected reacquisition cost is $3,000,000, then the gain on retirement of the bonds is $774,080. (The journal entry is given in the answer to question 2.c) You may wish to

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discuss at this point how this “profit” (as Stone and Edwards refer to it in the case) should be reported. I find that few students have noted that the answer is in the footnote to the text section on “Refunding a Bond Issue,” and hence it usually can be discussed as an issue. (Even if a student quickly gives the FASB’s answer, the probable rationale for it can still be discussed.) As noted there, in most instances the gain (or loss) on refunding is reported separately from operating income. Thus the validity of Stone’s and Edwards’s mouth-watering anticipation of the stock market’s reaction to Stone’s reporting increased profits is dubious. The separate reporting shows the “book-balancing” result of a questionable financial decision (refinancing 5-percent debt), but does not enhance ongoing income results. In fact, ongoing results will be worse because of higher interest expense on the new bonds. (Incidentally, it is unlikely that a company could buy back all of a bond issue at the market price stated for smaller trades.) b. The gain on the retirement of the old bonds is the same, irrespective of the vehicle used as the source of funds to finance the retirement. c. I am puzzled as to why the Harvard casewriter used a January 1, 20x3, refunding date but asked for December 31, 20x2, balance sheet information. You may wish to clarify this on your course assignment sheet. As shown in the table above, just prior to retirement at the end of 20x2, the old bond issue will have a net book value of $3,774,080, reflecting unamortized discount (after the year-end adjusting entry) of $225,920. The journal entry to retire this bond, assuming the cash required was $3,000,000 is as follows:

dr. Bonds Payable..................................................................................................................................... 4,000,000 cr. Cash.................................................................................................................................................. 3,000,000 Bond Discount.................................................................................................................................. 225,920 Gain on Bond Retirement................................................................................................................. 774,080 The entry recording issuance of the 12 percent coupon bond with proceeds of $4,498,000 would be as follows:

dr. Cash..................................................................................................................................................... 4,498,000 cr. Bonds Payable.................................................................................................................................. 4,000,000 Bond Premium.................................................................................................................................. 498,000 The long-term debt line of the balance sheet will show $4,498,000, the sum of the face amount and unamortized premium. It may be useful to point out the net effect of the refunding by collapsing the above two journal entries into one:

dr. Cash..................................................................................................................................................... 1,498,000 cr. Bond Discount/Premium.................................................................................................................. 723,920 Gain on Bond Retirement................................................................................................................. 774,080 Thus, Cash went up by $1,498,000, liabilities increased by $723,920, and Retained Earnings went up by $774,080. Hence, the current ratio will be altered (improved) by this transaction. One year later, part of the premium on the new bond will have been amortized. As shown in the table above (end of period 2), the net book value of the bond at December 31, 20x3, will be $4,467,045. 3. Taking the casewriter’s wording of question 2.c. literally, there will be a net increase in cash on January 1, 20x3, of $1,498,000. Every six months, starting with June 30, 20x3, Stone’s cash flow

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would decrease by $140,000, relative to what it would have been without refunding the original bonds: the old bonds had a semiannual interest payment of $100,000 (4,000 bonds @ $25) and the new ones have a semiannual payment of $240,000 (4,000 bonds @ $60). Combining the initial $1,498,000 cash increase and six net decreases of $140,000, by December 31, 20x5, the company will still be $658,000 ahead in net cash flow associated with its bonds. (Warning: The instructor should seriously consider whether it is desirable to carry the discussion any further, given that generally students have not had prior exposure to a finance course when studying this case.) However, taking a longer term perspective, would the firm really gain by such a refinancing, as the refunding accounting procedures would indicate? Or has the company actually hurt itself by incurring additional interest expense and $140,000 additional cash outflow for each of the next seven years? The answer is that, in “real” present value terms, nothing of economic significance has occurred (ignoring the transaction costs associated with the refunding). If Stone issued just enough 12 percent bonds to raise the $3,000,000 necessary to retire the old bonds ($3,000,000/$1,124.622 = 2,668 bonds), it simply would have exchanged differing cash flow patterns that have the same present value ($3,000,000) when discounted at the going market rate; yet the accounting for the refunding would still have shown a gain of $774,080. This is because although bonds are reported at net present values on the balance sheet, the discount rate used to calculate the NPV is the one prevailing at the time of issuance, not the market rate at the time of the balance sheet date. The December 31, 20x2, present value per bond using a 3 percent discount rate per semiannual period is $943.520, or a total of $3,774,080 for the 4,000 bonds. But if a discount rate of 5 percent per semiannual period were applied to the bond’s remaining cash flows, the present value per bond would be $752.534, which the casewriter for simplicity rounded down to $750 for a total market value of $3,000,000. (The present value would be $750 if a semiannual rate of 5.03 percent were used.) The reported $774,080 gain, then, is just the difference between the NPV of the bond’s remaining cash flows discounted at the rate of the time of issuance and the NPV when these flows are discounted at the current market rate. Thus, if bonds were carried at current values, such a refunding would report no gain, just the transaction costs associated with carrying out the refunding. Stone is actually experiencing a “profit” from its old bonds, in that the interest costs are only $100,000 per semiannual period versus $150,000 ($3,000,000 @ 5 percent per semiannual period) if $3,000,000 were raised at the prevailing rate. A decision to refinance is simply a decision that there may be some benefit to changing the pattern of cash flows associated with the bonds in this case, trading off higher cash interest payments versus a lower payment at maturity (since the 4,000 old bonds can be refinanced with a smaller number of new bonds). If you do choose to get into all of this, be prepared to deal with student confusion as to why a company would refund a bond at all. Be sure to point out that the refunding example in the text is (at least implicitly) based on the issuer’s being able to reacquire the bonds at a call price that is lower than the current market price. This can happen if interest rates fall more, and thus bond prices rise more, than was reflected in the bond’s call price schedule. In such a case, the company truly benefits economically from the refunding (assuming that transaction costs don’t wipe out the call price-market price differential). Yet note the irony that bond accounting procedures will report a loss when such a refunding takes place, since (in the falling interest rate circumstances we are assuming) the call price will exceed the price at which the bonds were originally issued. Case 8-3: Paul Murray* Note: This case is unchanged from the Eleventh Edition. *

This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

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Approach When encountering a difficult concept, such as the time value of money, students often can get more involved in trying to master the concept if they can relate it to their everyday lives before trying to apply it to a business situation. That is the purpose of this case, which is intended to be used with the Appendix to Chapter 8. (It can also be used instead at a later time with Chapter 22 on capital budgeting.) Since most students will have recent experience with tuition, and many may be looking forward to finding new jobs and/or having children, these issues should be salient to them. Answers to Questions Note: Students answers may differ slightly, depending on whether the text’s tables, a calculator, or a spreadsheet program is used. Beginning-of-year payments may be more realistic, but they tend to confuse students since the tables and the routines in many calculators and spreadsheets are based on year-end payments. Question 1 If the tables are used, this question will require the student to think through how to come up with a future value, given that the tables are designed to compute the present value when the future value is known. From the table, we can observe that the present value factor for $1 received 18 years hence is .350. Thus,

or

PV = FV * PV-factor PV = FV * .350 PV divided by .350 = FV

Since the PV of one year’s tuition is $18,000, the FV of one year’s tuition is $18,000 divided by .350 = $51,428.57. The FV of four years’ tuition is 4 * $51,428.57 = $205,714. To drive home the impact that a small difference in interest rates makes when compounded over many years, you may want to examine in class what would happen if the cost of tuition continued to rise at 8% as The Wall Street Journal reported it had in the past. In this case, the FV of one year’s tuition would be $18,000 divided by .250 = $72,000, and the FV of four years’ tuition would be 4 * $72,000 = $288,000. Of course, many students will not have to use the tables but will use calculators or spreadsheets to calculate the FV directly. Question 2 The investment made at the end of Year one will earn interest for 17 years until the end of Year 18, so its FV factor will be 1 divided by .371 = 2.695. For the payment made at the end of Year two, the FV factor will be 1 divided by .394 = 2.538. By performing similar calculations for the remaining years (see Exhibit 1), you can then compute that the FV factor for equal investments (earning 6%) made at the end of each year is 30.909. Hence, for the FV of the investments to equal $205,714, each investment must be $205,714 divided by 30.909 = $6,655. (Again, for comparison purposes, you might want to show that if the four year tuition were $288,000 as in the 8% example, this would require annual investments of $9,318 earning 6% to accumulate the desired amount.) Question 3 Exhibit 1

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Payment Made at End of Year: 1 2 3 4 5 6 7 8 9 10 11 12 13 14 I5 16 17 18

Anthony/Hawkins/Merchant

Future Value Factor @ 6% 2.695 1  .371 = 2.538 1  .394 = 2.398 1  .417 = 2.262 1  .442 = 2.132 1  .469 = 2.012 1  .497 = 1.898 1  .527 = 1.792 1  .558 = 1.689 1  .592 = 1.595 1  .627 = 1.504 1  .665 = 1.418 1  .705 = 1.339 1  .747 = 1.263 1  .792 = 1.190 1  .840 = 1.124 1  .890 = 1.060 1  .943 = 1.000 Total 30.909 Exhibit 2

Payment at End of Year FV Factor @ 8% FV Factor @ 10% FV Factor @ 4% 1 3.704 5.051 1.949 1  .270 = 1  .198 = 1  .513 = 2 3.425 4.587 1.873 1  .292 = 1  .218 = 1  .534 = 3 3.175 4.184 1.802 1  .315 = 1  .239 = 1  .555 = 4 2.941 3.802 1.733 1  .340 = 1  .263 = 1  .577 = 5 2.717 3.448 1.664 1  .368 = 1  .290 = 1  .601 = 6 2.519 3.135 1.600 1  .397 = 1  .319 = 1  .625 = 7 2.331 2.857 1.538 1  .429 = 1  .350 = 1  .650 = 8 2.160 2.591 1.479 1  .463 = 1  .386 = 1  .676 = 9 2.000 2.358 1.422 1  .500 = 1  .424 = 1  .703 = 10 1.852 2.141 1.368 1  .540 = 1  .467 = 1  .731 = 11 1.715 1.949 1.316 1  .583 = 1  .513 = 1  .760 = 12 1.587 1.773 1.266 1  .630 = 1  .564 = 1  .790 = 13 1.468 1.610 1.217 1  .681 = 1  .621 = 1  .822 = 14 1.361 1.464 1.170 1  .735 = 1  .683 = 1  .855 = 15 1.259 1.332 1.125 1  .794 = 1  .751 = 1  .889 = 16 1.167 1.211 1.081 1  .857 = 1  .826 = 1  .925 = 17 1.080 1.100 1.040 1  .926 = 1  .909 = 1  .962 = 18 1.000 1.000 1.000 Total 37.461 45.593 25.643 Annual investment to reach............................................................................................................................................................. $205, 714 $5,491 $4,512 $8,022

Annual investment to reach............................................................................................................................................................. 12

©2007 McGraw-Hill/Irwin

$288,000

Chapter 8

$7,688

$6,317

$11,231

Case 8-4: Joan Holtz (D)* Note: This case is updated from the Eleventh Edition. Approach As with the earlier Joan Holtz cases, this one enables students to discuss some interesting issues, none of which requires a full class period. The instructor should be alert to newer situations to augment or supplant any of those described in the case. Also many of these issues tend eventually to result in an FASB, AICPA, or SEC pronouncement. Since seldom will a beginning student be aware of these pronouncements, they do not preclude continuing to use a part of this case, and then revealing at the end of that part’s discussion whether the accounting rule-making body reached the same conclusion as the class did. Comments on Questions 1. The question is equivalent to asking, what is the future value of $100 invested at 10 percent compound interest, 127 years (1879 - 2006) from now? The answer is $100 (1.10) 127 = $18,066,000. We subsequently read that the man, after giving his town officials a good scare, did not pursue the matter further, because had he prevailed it would have bankrupted the town. 2. a. For a future value of $1,000 received 8 years hence, and a 15 percent discount rate, the present value is $327; so, yes, the yield was 15 percent. (This result can be gotten using a calculator, or by noting in Appendix Table A that the 8 yr., 15% PV factor is 0.327.) b. The discount is $1,000 - 327 = $673; using straight-line amortization, that is $673 divided by 8 = $84.125/bond/yr., resulting in annual tax savings of $84.125 * 0.40 = $33.65. (Subsequent to the writing of the case, the U.S. Treasury reduced, but did not eliminate, the tax deductibility of original issue discount, so these zero-coupon bonds became less attractive.) Thus, the bond issuer contemplates the following cash flow pattern: Time Zero + $327 Years 1-8 + $33.65/yr. End of year 8 - $1,000 (Actually, straight-line discount amortization is not permitted, but we wanted to keep the calculations as simple as possible.) We need to make the sum of the PVs of the eight-year stream and negative future flow equal $327, i.e., find the rate that gives an NPV of zero. By trial and error, this rate can be found to be approximately 8.5 percent. (A calculator shows it to be 8.63 percent.) c. With 15 percent bonds issued for par, the net-of-tax interest payment stream is simply $150 (10.40) = $90/bond/yr. for 8 years. If one makes a calculation like the one for part (b), but with Time Zero in flow equal to $1,000 (instead of $327) and the annual outflows equal to $90 (instead of $33.65 annual inflows), the rate giving an NPV of zero (remember the Year 8 $1,000 outflow, as well) is 9.0 percent. (Actually, trial-and-error or calculators aren’t needed here; once the $90/year amount is determined, the rate of 9.0 percent is also determined, since $90 divided by $1,000 = 9.0 percent. The student who quickly realizes this understands the meaning of a “true” return on investment of 9.0 percent.) Thus, from the standpoint of the bondholder, ignoring taxes, the yield on either bond is 15%, but the cost to the issuer of the zero-coupon bond is lower. *

This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

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Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

Actually, zero-coupon bonds are generally purchased by tax-exempt institutions, so this comparison ignoring taxes is valid. However, for taxable bondholder entities, the zero-coupon bond discount amortization is taxable as ordinary interest income. In the early 1980s, zerocoupon bond mutual funds have sprung up for use by IRAs. 3. Although the text describes refunding a bond issue, it does not explicitly describe early extinguishment of debt. Actually, refunding a bond issue is just a special case of early extinguishment: the proceeds to retire the current debt come from a new debt issue. In the “debt-forequity swap” we’re considering, the substance of the transaction is the same as if the company issued shares and then used the cash proceeds to buy its bonds on the open market; in effect, the company is simply paying an investment banker to do this on the company’s behalf. (In practice, an investment banker would be used to market newly issued common stock, whatever the intended use of the proceeds.) But in fact, a company is motivated in the debt-for-equity swap to use the investment banker as an intermediary because the tax laws are such that if the company handled the transactions on its own, it would pay taxes on the difference between the repurchase cost of the bonds and their balance sheet carrying value, irrespective of the source of the funds used to repurchase the bonds. Of course, we do not expect students to be aware of this anomaly in the tax law but they might well surmise it, since, again, the substance is the same whether the transaction is handled by the company or by an investment banker. As to whether the company has “really earned” its gain on the swap will be debated by the students. In the Exxon example given, ask for journal entries to reflect the transaction. These will be:

dr. Bonds Payable..................................................................................................................................... 72 million cr. Capital Stock 43 million cr. ? 29 million To what account should the “hanging credit” of $29 million be made? If it were made to Capital Stock, the value of the consideration for the stock (i.e., bonds plus investment banker’s fee worth a total of $43 million) would be overstated. Or if Bonds Payable is debited for only $43 million (which is equivalent to making the “hanging credit” to Bonds Payable), then the actual retirement of a $72 million obligation is not reflected. Thus, by process of elimination, the $29 million has to be credited to Retained Earnings. In fact, the same treatment cited in the text for bond refunding, coming from APB-26 and FASB-4, applies here, with the gain shown as an extraordinary item (described in Chapter 10) on the income statement, rather than bring a direct credit to Retained Earnings (i.e., rather than not being flowed through the income statement). The effect of this treatment is to “reward” the company (through higher reported earnings) for being savvy enough to retire its debt early when the debt’s market price was depressed. Discussion of this technique should also bring out that the swap improves the company’s debt/equity ratio and interest coverage (times interest earned). The price the company pays for this is possible dilution of earnings per share resulting from the additional shares outstanding. However, as the preceding journal entries illustrate, there is really no cash generated by the deal, except in future years to the extent that dividends on the new shares are less than were the interest payments on the retired bonds. Interestingly, the Associated Press correspondent who wrote the article on which I based this problem did not understand that, because she indicates that the company ends up with some tax-free cash that can be used for capital improvements.

4. The airlines (as of late 2005) were carrying a relatively small liability for earned but unused frequent flier mileage credits. Most airlines had set up provisions for the future cost of frequent flier usage. An alternative approach would require a revenue deferral approach. A portion of revenue applicable to

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Chapter 8

each original ticket sold would be deferred until the free tickets expected to be awarded were issued and used. Assuming the percentage deferred was, say 5 percent, the journal entry for a $400 original ticket would be:

dr. Cash....................................................................................................................................... 400 cr. Ticket Revenue.................................................................................................................... 380 Deferred Revenue................................................................................................................ 20 This approach implies that when a traveler buys a ticket, he/she in effect is buying that trip and a “piece” of some future “free” trip, the revenue for which has not yet been earned. It’s not clear to me why an approach analogous to warranty expense accounting (crediting the full amount of revenue, $400, then also debiting Award Program Expense and crediting Future Award Costs for $20) wouldn’t make more sense; the “bottom line” impact would be the same as the above, however. The amount of the revenue deferral (or ex-post establishment of a liability for previously earned free tickets) is certainly a fuzzy issue, especially as the airlines begin to place restrictions on when free tickets can be used. An airline might argue that, with restrictions, the free tickets are just filling otherwise empty seats, so the cost to the airline is minimal. Also, some awards go unused. According to The Wall Street Journal, some airlines are “quietly hoping” the IRS will ease their problem by swiftly moving to tax-free tickets as income, which would drastically cut the number of people redeeming their awards. The FASB permits the use of either the cost reserve or revenue deferral method. 5. This item raises a number of interesting issues, and it illustrates how, depending on which accounting principle one emphasizes, a different accounting method may appear more appropriate in a specific situation. This item also can be used to illustrate how accounting standards change and evolve over time and the roles played by two key standard-setting bodies in the U.S., the SEC and the FASB. A key issue is whether the purchase of the electronics product and the extended warranty contract should be viewed as one transaction or two, and which alternative represents the best matching of revenues and expenses. Since such a high proportion of customers purchase the extended warranty contract, particularly in the case of high ticket items, many would argue that it is, in substance, a single transaction. In fact, as illustrated by the example in the case, retailers frequently make most of their profits on the extended warranty contract, not on the sale of the product. 1 Therefore, the retailers must view the sale of the electronics product and the extended warranty as a single transaction; otherwise, they would not be willing to earn such a low (or nonexistent) margin on the sale of the electronics product. The counter-argument is that customers do, in fact, have a choice of whether to purchase the extended warranty contract or not, and many do not. If you view the purchase as a single transaction, then Alternative B represents the best matching. If you view it as two distinct transactions, then Alternative A represents the best matching. Another principle which can be discussed is conservatism. Clearly, Alternative A is the most conservative as it defers the recognition of the most revenue; none of the warranty revenue is recognized at the date of the sale of the product. Instead, the extended warranty revenue is recognized ratably over the life of the extended warranty contract. Alternative B. which recognizes all of the warranty revenue on the date the product is sold, and Alternative C, which recognizes some of the warranty on the date the product is sold, are clearly less conservative. 1

Business Week indicated that with retailers slashing prices to lure customers, service plans had become even more important, as the revenues from extended warranties were one way to withstand the never-ending price wars. Business Week quoted Audio/Video Affiliates Chairman Stuart Rose, “Anyone making money now, it’s probably 100% from warranties.” [“Electronics Stores Get a Cruel Shock,” Business Week, January 14, 1991, page 42D.]

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Anthony/Hawkins/Merchant

The instructor can also raise the issue of performance under the extended warranty contract: When has the retailer performed what is required to earn income under the warranty contract? Clearly, there is some requirement for the retailer to perform, that is, to provide repair or replacement under the extended warranty contract, during the life of the contract. However, it can also be argued that the reliability of these electronics products is high enough that, in most cases, the retailer will never have to provide any service at all. This is one factor that makes these contracts so profitable: customers are willing to purchase them in case there is a problem with the unit they have purchased but, in fact, in most instances there will be no problem at all. The performance criterion argues for deferring at least some warranty contract revenue to be recognized over the life of the contract, but does it necessarily mean that all warranty contract revenue should be deferred? If deferring all extended warranty contract revenue does not seem necessary, then Alternative C may appear most appropriate. Clearly, an argument for each of the three alternatives can be made and supported using the accounting principles and sound reasoning. The three alternatives will have different effects on the financial statements. 2 First consider the situation where sales are growing steadily (See Ex. 1). Alternative B will produce the highest revenue and net income, as all extended warranty revenue and profit are recognized immediately. The balance sheet will also show the largest retained earnings and there will be no deferred revenue liability. Alternative C will show the second highest revenue and net income, as some of the revenue and most of the income from the extended warranty contract will be recognized immediately. The balance sheet will thus show the second highest retained earnings; there will be a deferred revenue liability that will increase each year because we have assumed steadily growing sales. Alternative A will show the lowest revenue and the lowest net income, as all of the extended warranty revenues and the associated high warranty profits are deferred. On the balance sheet, Alternative A will show the smallest retained earnings and the largest deferred revenue liability. Of course, the net effect on the cash flow statement is the same for each of the three alternatives. A lower net income will be adjusted by a higher deferred revenue to reveal the same impact on cash. The story changes if the sales decline (See Ex. 2). In this situation, Alternative A will eventually show the highest revenue because it deferred the most extended warranty contract revenue, and it will show the highest net income because of the deferral of these very high margin contracts. Net income decreases much more gradually under Alternative A than under the other alternatives. Alternative B will show the most precipitous drop in sales and net income because there is no carryover of the very profitable extended warranty contracts to cushion the fall. The accounting standards for extended warranty contracts have changed and evolved over time. Initially, retailers had considerable latitude in choosing the method they considered most appropriate. In 1989, the SEC staff moved to limit this latitude when they indicated that partial recognition Alternative C should be used.3 Subsequently, the FASB issued a Technical Bulletin requiring retailers to delay recognition of extended warranty revenue and income until the warranty period expired (Alternative A). 4 This pattern of accounting standard evolution is not uncommon: a situation arises that regulators may consider misleading or abusive; the SEC steps in with a “quick fix” and the FASB, with its larger staff and open standard-setting process, follows with a (perhaps) more thorough alternative that the SEC agrees to accept. This process is consistent with that seen in other controversial issues, such as accounting for the effects of inflation. When the change to delayed recognition of extended warranty revenue and income (Alternative A) 2

In the discussion of effects on the financial statements, it will be assumed that margins on products and extended warranty contracts remain constant. Any effect of the three alternatives on taxes (expense, liability, deferred tax) will be ignored. 3 SEC and Highland Superstores, Inc., March 1989. 4 FASB Technical Bulletin No. 90-1, “Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts,” December 1990.

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was announced, it was expected to have a significant effect on the financial results of major electronics retailers. According to Business Week: Circuit City Stores, Inc., the biggest U.S. consumer-electronics chain, with $2.4 billion in sales and 185 stores, expects that the revision in warranty accounting will cut 25 cents a share from earnings for the year. That’s roughly 16% of fiscal 1991’s estimated profit of $1.55 a share. And, because it prefers not to drag out the change over several years, Circuit City also plans to take a one-time charge to account for warranty sales in prior years. That will cost an additional $1.15 a share. Although the charges won’t affect actual cash flow, they will all but wipe out stated earnings.5

5

Business Week, op. cit.

17

Exhibit 1 Financial Statement Impact: Steadily Increasing Sales Alternative A

Number of units sold

x0 1

xl 2

Alternative B x2 3

x0 1

x1 2

Alternative C x2 3

x0 1

xl 2

x2 3

Revenues:..................................................................................................................................................................................................................... Product.................................................................................................................................................................................................................. $2,000 $4,000 $6,000 $2,000 $4,000 $6,000 $2,128 $4,256 $6,384 Warranty (x0)........................................................................................................................................................................................................ 60 60 60 180 17 17 18 Warranty (xl)......................................................................................................................................................................................................... 120 120 360 35 35 Warranty (x2)........................................................................................................................................................................................................ _____ _____ 180 _____ _____ 540 _____ _____ 52 Total revenue................................................................................................................................................................................................................ 2,060 4,180 6,360 2,180 4,360 6,540 2,145 4,308 6,489 Cost of goods sold Product.................................................................................................................................................................................................................. 1,840 3,680 5,520 1,840 3,680 5,520 1,840 3,680 5,520 Warranty (x0)........................................................................................................................................................................................................ 15 15 15 45 15 15 15 Warranty (x1)........................................................................................................................................................................................................ 30 30 90 30 30 Warranty (x2)........................................................................................................................................................................................................ _____ _____ 45 _____ _____ 135 _____ _____ 45 Tota1 cost of goods sold............................................................................................................................................................................................... 1,855 3,725 5,610 1,885 3,770 5,655 1,855 3,725 5,610 Net income................................................................................................................................................................................................................... 205 455 750 295 590 885 290 583 879 Deferred revenue x0........................................................................................................................................................................................................................... 120 60 0 ---35 18 0 x1........................................................................................................................................................................................................................... 240 120 ---69 34 x2........................................................................................................................................................................................................................... _____ _____ 360 __ _-__ _-__ _-_____ _____ Total deferred revenue.................................................................................................................................................................................................. 120 300 480 0 0 0 35 87 138 Cumulative increase in retained earnings............................................................................................................................................................................................... 205 660 1,410 295 885 1,770 290 873 1,752

Exhibit 2 Financial Statement Impact: Decreasing Sales Alternative A

Alternative B

Alternative C

Year x0 x1 x2 x0 x1 x2 x0 x1 x2 Number of units sold............................................................................................................................................................................ 3 2 1 3 2 1 3 2 1 Revenues Product........................................................................................................................................................................................... $6,00 $4,000 $2,00 $6,000 $4,00 $2,00 $6,384 $4,25 $2,12 0 0 0 0 6 8 Warranty (x0)................................................................................................................................................................................. 180 180 180 540 52 52 52 Warranty (xl).................................................................................................................................................................................. 120 120 360 35 35 Warranty (x2)................................................................................................................................................................................. _____ _____ 60 _____ _____ 180 _____ _____ 17 Total revenue........................................................................................................................................................................................ 6,180 4,300 2,360 6,540 4,360 2,180 6,436 4,343 2,232 Cost of goods sold Product........................................................................................................................................................................................... 5,520 3,680 1,840 5,520 3,680 1,840 5,520 3,680 1,840 Warranty (x0)................................................................................................................................................................................. 45 45 45 135 45 45 45 Warranty (xl).................................................................................................................................................................................. 30 30 90 30 30 Warranty (x2)................................................................................................................................................................................. _____ _____ 15 _____ _____ 45 _____ _____ 15 Total cost of goods sold........................................................................................................................................................................ 5,565 3,755 1,930 5,655 3,770 1,885 5,565 3,755 1,930 Net income........................................................................................................................................................................................... 615 545 430 885 590 295 871 588 302 Deferred revenue x0................................................................................................................................................................................................... 360 180 0 ---104 52 0 x1................................................................................................................................................................................................... 240 120 ---69 34 x2................................................................................................................................................................................................... _____ _____ 120 __ _-- _ __-- _ __-_____ _____ 35 Total deferred revenue.......................................................................................................................................................................... 360 420 240 0 0 0 104 121 69 Cumulative increase in retained earnings........................................................................................................................................................................ 615 l,160 1,590 885 l,475 1,770 871 1,459 1,761