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©Cambridge Business Publishers, 2011

Solutions Manual, Chapter 9 9-1

Chapter 9

Reporting and Analyzing Liabilities

Learning Objectives – coverage by question

Mini-exercises

Exercises Problems Cases

LO1 – Identify and account for current operating liabilities.

18, 22, 30 36, 37, 38, 49 61

LO2 – Describe and account for current nonoperating (financial) liabilities.

18 49 61

LO3 – Explain and illustrate the pricing of long-term nonoperating liabilities.

19, 28, 29,

31, 34, 35

40, 43, 44,

45, 46, 47,

48, 50

51, 52, 53,

54, 55, 56,

57, 58, 59, 60

62, 63

LO4 – Analyze and account for financial statement effects of long-term nonoperating liabilities.

17, 20, 21,

23, 24, 25,

26, 31, 33, 34

39, 42, 43,

44, 45, 47,

48, 49, 50

51, 52, 53,

54, 55, 56,

57, 58

61, 62, 63

LO5 – Explain how solvency ratios and debt ratings are determined and how they impact the cost of debt.

20, 27, 32 41 51 62, 63


Financial Accounting, 3rd Edition 9-2

QUESTIONS

Q9-1. Current liabilities are obligations that require payment within the coming year or operating cycle, whichever is longer.

Generally, current liabilities are normally settled with use of existing current assets or operating cash flows.

Q9-2. An accrual is the recognition of an event in the financial statements even though no actual transaction has occurred. Accruals can involve both liabilities (and expenses) and assets (and revenues).

Accruals are vital to the fair presentation of the financial condition of a company as they impact both the recognition of revenue and the matching of expense.

Q9-3. The coupon rate is the rate specified on the face of the bond. It is used to compute the amount of cash interest paid to the bond holder. The market rate is the rate of return expected by investors that purchase the bonds. The market rate determines the market price of the bond. It incorporates expectations about the relative riskiness of the borrower and the rate of inflation. In general, there is an inverse relation between the bond’s market rate and the bond’s market price.

Q9-4. Bonds sold at face (par) value earn an effective interest rate equal to the bonds’ coupon rate. Bonds are sold at a discount when the effective interest rate is higher than the coupon rate. Bonds are sold at a premium when the effective interest rate is lower than the coupon rate.

Q9-5. Bonds are reported at historical cost, that is, the face amount plus (minus) unamortized premium (discount). The market price of the bonds varies inversely with the level of interest rates and fluctuates continuously. Differences between the market price of a bond and its carrying amount represent unrealized gains and losses. These unrealized gains (losses) are not reflected in the financial statements (although they are disclosed in the footnotes). They must be recognized upon repurchase of the bonds, the point at which they become “realized.”

If the bonds are refunded (that is, replaced with new bonds reflecting current market values and interest rates), the gain (or loss) that is recognized in the current period will be offset by correspondingly higher (lower) interest payments in the future. The present value of the future interest payments, along with the present value of the difference between the face amount of the new bond and the former face amount, exactly offset the reported gain (loss).



Q9-6. Debt ratings reflect the relative riskiness of the borrowing company. This riskiness relates to the probability of default (e.g., not repaying the principal and interest when due). Higher (greater quality) debt ratings result in higher market prices for the bonds and a correspondingly lower effective interest rate for the issuer. Lower (lesser quality) debt ratings result in lower market prices for the bonds and a correspondingly higher effective interest rate for the issuer.

Q9-7. Reported gains or losses on bond redemption result from changes in the market price of the bonds and the use of historical cost accounting. Because bonds are typically reported at historical cost, fluctuations in bond prices are not recognized until they are realized when the bonds are redeemed or refunded. If the bonds are refunded (new bonds are issued), the gain or loss is offset by the present value of lower (higher) future interest payments on the new bond issue.

Q9-8. (a) Term loan – a loan that matures on a single, pre-specified date

(b) Bonds payable – the liability account used to record the face value of bonds issued by a company

(c) Serial bonds – bonds that mature in installments rather than on one date

(d) Call provision – the right for the bond issuer to repurchase the debt, before it matures, at a predetermined price.

(e) Convertible bonds – bonds that can be converted into some other asset (typically common stock) at the option of the bondholder

(f) Face value – the predetermined amount (typically $1,000) that must be repaid when a bond matures

(g) Nominal rate – the rate specified on the face of the bond that determines the periodic interest (coupon) payment

(h) Bond discount – the difference between the face value of the bond and the market price when the price is lower than the face value; recorded as a contra-liability

(i) Bond premium – the difference between the market price of a bond and the face value when the market price is higher than the face value; recorded as an adjunct-liability

(j) Amortization of premium or discount – the periodic reduction of the balance in the premium or discount account recorded each time interest expense is accrued; equal to the difference between the accrued interest and the coupon payment (or payable)



Q9-9. The advantages of issuing bonds are (1) the interest payments are limited to the predetermined amount specified on the bond; (2) the interest is tax deductible; (3) bondholders do not have a vote when it comes to electing directors and managing the company; (4) the additional financial leverage created when bonds are issued increases profits in good years. The disadvantages of bonds include (1) bonds must be repaid while common stock is issued with an indefinite life; (2) bondholders can impose restrictive covenants in the loan indenture; (3) the additional financial leverage created when bonds are issued decreases profits in lean years.

Q9-10. $3,000,000 x [.98 + (.09 x 3/12)] = $3,007,500 Q9-11. The contract rate (or stated rate or coupon rate) determines the periodic

coupon payment. If this rate is not equal to the rate required by the market, the bond price is adjusted to the present value of the cash payments from the bond discounted at the applicable market rate of interest. If the market rate is higher than the coupon rate, then the periodic coupon payments are insufficient and the bond will be priced lower than the face value (a discount). If the market rate is lower than the coupon rate, then the periodic coupon payments will be higher than required by the market, and the bond will sell for a premium.

Q9-12. When the bonds mature, the book value of the bonds will be equal to the

face value. Over the life of the bonds, the change in the book value of the bonds will be equal to face value less the market value at the time that the bonds are issued.

Q9-13. When the effective interest method is used to amortize a bond discount or

premium, the effective rate is multiplied by the net balance in bonds payable (bonds payable plus/minus the premium or discount). If the bond is issued at a discount, the balance increases over the life of the bond; the interest expense will increase as the balance increases. If the bond is issued at a premium, the balance decreases over the life of the bond; the interest expense will decrease as the balance decreases.

Q9-14. Bonds payable is presented in the balance sheet net of any discount or plus

any premium. Q9-15. The loss is the difference between the retirement value and the book value

of the bond: 101% x $200,000 – $197,600 = $4,400. Q9-16. Each payment includes both interest on the outstanding balance and

repayment of the principal. As each payment is made, the principal balance is reduced. As a consequence, the interest component of the payment is smaller each period.



MINI EXERCISES M9-17 (10 minutes)

a. Interest expense (+E,-SE)……………………... 24 Interest payable (+L)……………………... 24 b.

- Interest Payable (L) + + Interest Expense (E) -

24 a. a. 24

c.

Balance Sheet Income Statement

Transaction Cash Asset

+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned capital

Revenues - Expenses = Net

Income Accrued $24 interest

on note payable

= +24

Interest Payable

-24

Retained Earnings

-

+24 Interest Expense

= -24

M9-18 (15 minutes) a. Accounts Payable, $110,000 (current liability).

b. Not recorded as a liability; an accountable transaction has not yet occurred.

c. Estimated liability for product warranty, $2,200 (current liability).

d. Bonuses Payable, $30,000 (current liability)—computed as $600,000 5%. This liability must be reported since its payment is “probable” and can be “estimated.”

M9-19 (10 minutes) a. Boston Scientific is offering bonds with a coupon (stated) rate of 4.25% when

the market rate (yield) is higher (4.349%). In order to obtain this expected rate of return, the bonds sell at a discount price of 99.476 (99.476% of par).

b. The first bond matures in 2011 while the second matures in 2017. There is,

generally, a higher rate (yield) expected for a longer maturity.



M9-20 (10 minutes) Amount paid to retire bonds ($200,000 x 101%) ......................................... $202,000 Book value of retired bonds, net of $2,400 unamortized discount ........... 197,600 Loss on bond retirement ............................................................................... $ 4,400 M9-21 (10 minutes) a. The $45 million indicates that BMY has bonds maturing that will require

payment in the amount of $45 million in 2010. b. BMY will need to pay off the bonds when they mature. This will result in a cash

outflow that must come from operating activities if the bonds cannot be refinanced prior to maturity. However, most of BMY’s long-term debt matures more than 5 years after the financial statement date (December 31, 2008). Thus, BMY’s near-term cash needs for covering long-term debt should not place a significant burden on the company’s operations.

M9-22 (10 minutes)

a. Gain on Bond Retirement: In the other (nonoperating) revenues and expenses section unless it meets the tests for extraordinary treatment (e.g., unusual and infrequent)

b. Discount on Bonds Payable: Deduction from Bonds Payable; thus, a (contra) long-term liability in the balance sheet (e.g., it is netted in the presentation of long-term liabilities).

c. Mortgage Notes Payable: Long-term liability in the balance sheet.

d. Bonds Payable: Long-term liability in the balance sheet.

e. Bond Interest Expense: In other (nonoperating) revenues and expenses section of income statement.

f. Bond Interest Payable: Current liability in the balance sheet.

g. Premium on Bonds Payable: Addition to Bonds Payable; thus, part of a long-term liability in the balance sheet (e.g., it is included in the presentation of long-term liabilities).

h. Loss on Bond Retirement: In the other (nonoperating) revenues and expenses section unless it meets the tests for extraordinary treatment (e.g., unusual and infrequent)



M9-23 (15 minutes)

a. Financial ratios used in bond covenants are typically designed to protect the bond holders against actions by management that they feel would be detrimental to their interests. These might include restrictions against the impairment of liquidity, restrictions on the amount of financial leverage the company can employ, and restrictions on the payment of dividends. In addition, bond holders usually impose various covenants prohibiting the acquisition of other companies or the divestiture of business segments without their consent. All of these covenants, by design, restrict management in its actions.

b. Management, facing imminent default in one or more of its bond covenants, may be pressured into taking actions in order to avoid such default. These may include, for example, operational actions, such as reduction of R&D or advertising in order to improve profitability, or leaning on the trade or reduction of receivables (via early payment incentives) and inventories (by marketing promotions or delaying restocking) in order to boost cash balances. Actions may also include fraudulent accounting measures, such as improper recognition of revenues or delayed recognition of expenses.

c. Restricted assets, such as cash or securities, should not be considered as general assets in an analysis of the firm’s liquidity or solvency because they are not available to management for general corporate uses.



M9-24 (15 minutes) a. 1/1/2004 Cash (+A) ……………………………………..... 432,000 Bonds payable (+L) ………………..…… 400,000 Bond premium (+L) ………………..…… 32,000 1/1/2009 Bonds payable (-L) ………………………..….. 400,000 Bond premium (-L) ……………………..…….. 27,809 Cash (-A) ………………………………..... 412,000 Gain on retirement of bonds (+R, +SE) 15,809 b.

+ Cash (A) - - Bonds Payable (L) +

1/1/04 432,000 400,000 1/1/04 412,000 1/1/09 1/1/09 400,000

- Gain on Retirement of Bonds (R) + - Bond Premium (L) +

15,809 1/1/09 32,000 1/1/04 1/1/09 27,809

c.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital


Income 1/1/04 Issue bonds at

a premium. 432,000

Cash

=

+400,000 Bonds

Payable

+32,000 Bonds

Payable, net

-

=

1/1/09 Retired bonds issued on 1/1/04.

-412,000 Cash

=

-400,000 Bonds

Payable

-27,809 Bonds

Payable, net

+15,809 Retained Earnings

+15,809 Gain on

Retirement of Bonds

-

=

+15,809



M9-25 (15 minutes) a. 7/1/2003 Cash (+A) ……………………………………. 240,000 Bond discount (+XL, -L) …………….….…. 10,000 Bonds payable (+L) ………………….. 250,000 7/1/2009 Bonds payable (-L) ………………………… 250,000 Loss on retirement of bonds (+E, -SE) … 9,314 Bond discount (-XL, +L) ……….…… 6,814 Cash (-A) ………………………………. 252,500 b.


7/1/03 240,000 250,000 7/1/03 252,500 7/1/09 7/1/09 250,000

+ Loss on Retirement of Bonds (E) - + Bond Discount (XL) -

7/1/09 9,314 7/1/03 10,000 6,814 7/1/09

c.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital



a discount +240,000

Cash

=

+250,000 Bonds

Payable

-10,000 Bonds

Payable, net

-

=

7/1/09 Retired bonds issued on 7/1/03

-252,500 Cash

=

-250,000 Bonds

Payable

+6,814 Bonds

Payable, net

-9,314 Retained Earnings

-

+9,314 Loss on

retirement of Bonds

=

-9,314

M9-26 (10 minutes)

Nissim: $18,000 0.10 40/365 = $197.26

Klein: $14,000 0.09 18/365 = 62.14

Bildersee: $16,000 0.12 12/365 = 63.12 $322.52



M9-27 (10 minutes) a. The Debt-to-Equity ratio (D/E) will likely change, but the direction and amount

is difficult to determine from the information given. The increase in outstanding debt by $773.2 million ($946.6+$1,450.0-$1,623.4) along with the net share repurchases of $1,336 million ($2,425.9-$1,089.4) and dividend payments of $529.7 million will increase D/E. (The effect of the share repurchases on reported equity is not provided – the $2,425.9 million is the market value of the repurchased shares.)

Times interest earned will decrease as additional interest cost on new borrowing is added to the denominator. How much of an effect this will have depends on the size of the change in net income.

b. Generally, the higher (lower) the firm's solvency measures, the higher (lower)

the firm's debt rating. In financial leverage terms, the higher (lower) the firm's leverage the lower (higher) the firm's debt rating. Increasing the amount of debt while decreasing equity may harm General Mills’ debt ratings.

M9-28 (15 minutes) a. Selling price of 9% bonds discounted at 8% Present value of principal repayment ($500,000 0.45639) .................... $228,195

Present value of interest payments ($22,500 13.59033) .................... 305,782 Selling price of bonds .................................................................................. $533,977

b. Selling price of 9% bonds discounted at 10% Present value of principal repayment ($500,000 0.37689) .................... $188,445

Present value of interest payments ($22,500 12.46221) .................... 280,400 Selling price of bonds .................................................................................. $468,845 M9-29 (15 minutes) a. Selling price of zero-coupon bonds discounted at 8%:

Present value of principal repayment ($500,000 0.45639) $228,195

b. Selling price of zero coupon bonds discounted at 10%:

Present value of principal repayment ($500,000 0.37689) $188,445 c. Based on the debt-to-equity ratio, financial leverage would increase from 2.0

[=($3 - $1)/$1] to 2.19 [=($3 - $1 + $0.188)/$1)



M9-30 (15 minutes) a. 1. Inventory (+A) …………………………………. 300 Accounts payable (+L) ………………… 300 2. Accounts receivable (+A) …………………… 420 Sales revenue (+R, +SE) …..………….. 420 3. Cost of goods sold (+E, -SE) ………………. 300 Inventory (-A) …………………………… 300 4. Accounts payable (-L) ………………………. 300 Cash (-A) ………………………………… 300 5. Cash (+A) ……………………………………… 420 Accounts receivable (-A) ……………… 300

b.

+ Cash (A) - - Accounts Payable (L) +

300 4. 300 1. 5. 420 4. 300

+ Accounts Receivable (A) - - Sales Revenue (R) +

2. 420 420 2. 420 5. + Inventory (A) - + Cost of Goods Sold (E) -

1. 300 3. 300 300 3.

c.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital


Income 1. Purchase inventory

on account.

+300 Inventory =

+300 Accounts Payable

-

=

2. Sell inventory on credit.

+420 Accts Rec =

+420 Retained Earnings

+420 Sales -

=

+420

3. Cost of sales from 2.

-300 Inventory =

-300 Retained Earnings

-

+300 Cost of

Goods Sold

= -300

4. Paid cash for inventory purchased in 1.

-300 Cash

=

-300 Accounts Payable

-

=

d. Receive cash on receivable from 2.

420 Cash

-420 Accts Rec =

-

=



M9-31 (30 minutes)

a.

Data Inputs into Excel

1/1/2009 Settlement date 12/31/2018 Maturity date

9.00% Percent semiannual coupon 8.00% Percent yield

$100 Redemption value 2 Frequency is semiannual (see above) 1 actual/actual basis

Percent of Par Sale Proceeds Price……… 106.7951632 $533,975.82 b.

Period Interest Cash Paid Premium

Amortization Premium Balance

Carrying Amount

0 33,975.82 533,975.82

1 21,359.03 22,500.00 1,140.97 32,834.85 532,834.85

2 21,313.39 22,500.00 1,186.61 31,648.24 531,648.24

3 21,265.93 22,500.00 1,234.07 30,414.17 530,414.17

4 21,216.57 22,500.00 1,283.43 29,130.74 529,130.74

5 21,165.23 22,500.00 1,334.77 27,795.97 527,795.97

6 21,111.84 22,500.00 1,388.16 26,407.81 526,407.81

7 21,056.31 22,500.00 1,443.69 24,964.12 524,964.12

8 20,998.56 22,500.00 1,501.44 23,462.68 523,462.68

9 20,938.51 22,500.00 1,561.49 21,901.19 521,901.19

10 20,876.05 22,500.00 1,623.95 20,277.24 520,277.24

11 20,811.09 22,500.00 1,688.91 18,588.33 518,588.33

12 20,743.53 22,500.00 1,756.47 16,831.86 516,831.86

13 20,673.27 22,500.00 1,826.73 15,005.14 515,005.14

14 20,600.21 22,500.00 1,899.79 13,105.34 513,105.34

15 20,524.21 22,500.00 1,975.79 11,129.56 511,129.56

16 20,445.18 22,500.00 2,054.82 9,074.74 509,074.74

17 20,362.99 22,500.00 2,137.01 6,937.73 506,937.73

18 20,277.51 22,500.00 2,222.49 4,715.24 504,715.24

19 20,188.61 22,500.00 2,311.39 2,403.85 502,403.85

20 20,096.15 22,500.00 2,403.85 0.00 500,000.00



M9-32 (15 minutes) Verizon’s leverage as measured by its D/E ratio is higher than either Comcast or Sprint (Quest has negative equity). On the other hand, Verizon is in better shape than any of its competitors in terms of its ability to pay the interest on its debt as indicated by its greater TIE ratio. The comparison includes Sprint/Nextel which has a negative operating income. M9-33 (15 minutes) a. Gain on bond retirement Reported in the income statement under other

(nonoperating) income b. Discount on bonds payable Contra-liability netted against bonds payable

under long-term liabilities in the balance sheet

c. Mortgage notes payable Long-term liability in the balance sheet; the amount due within one year would be reported as a current liability

d. Bonds payable Long-term liability in the balance sheet; the amount due within one year would be reported as a current liability

e. Bond interest expense Nonoperating expense reported in the income statement

f. Bond interest payable A current liability in the balance sheet g. Premium on bonds payable Adjunct-liability added to bonds payable

under long-term liabilities in the balance sheet



M9-34 (15 minutes) a. 12/31/10 Cash (+A) ……………………………………..... 700,000 Mortgage note payable (+L) ………….. 700,000 6/30/11 Interest expense (+E, -SE) ………………….. 42,000 Mortgage note payable (-L) …………………. 8,854 Cash (-A) …………………………………. 50,854 12/31/11 Interest expense (+E, -SE) ………………….. 41,469 Mortgage note payable (-L) …………………. 9,385 Cash (-A) …………………………………. 50,854 * $41,469 = ($700,000 – $8,854) x 12%/2.

b. + Cash (A) - - Mortgage Note Payable (L) +

12/31/10 700,000 700,000 12/31/10 50,854 6/30/11 6/30/11 8,854

50,854 12/31/11 12/31/11 9,385

+ Interest Expense (E) -

6/30/11 42,000

12/31/11 41,469

c.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital


Income 12/31/10 Borrow

$700,000 on a 15-year mortgage note payable.

+700,000 Cash

=

+700,000 Mortgage

Note Payable

-

=

6/30/11 Interest payment on note.

-50,854 Cash

=

-8,854 Mortgage

Note Payable


-

+42,000 Interest Expense

=

-42,000


-50,854 Cash

=

-9,385 Mortgage

Note Payable


-


=

-41,469

M9-35 (5 minutes)

$900,000 x 0.55839 + (900,000 x 10%/2) x 7.36009 = $833,755.

$833,755 / $900,000 = 92.6% of par value.



EXERCISES E9-36 (15 minutes) a.

Total expected failures from units sold (69,000 0.02) ................ 1,380

Average cost per failure ................................................................... $50 Total expected future warranty costs ............................................. $69,000

Current warranty liability ................................................................. $10,000 Additional warranty cost liability required ..................................... $ 59,000

The product warranty liability must be increased by $59,000 to cover the expected repair costs, (because the warranty is for a 60-day period, the $10,000 remaining in the liability account represents unused amounts left from prior years’ accruals). Warranty expense of $59,000 must be recorded in the income statement when the liability account is increased.

b. The warranty liability should be equal, at all times, to the expected dollar cost

of repairs. Analysis issues relate to whether the warranty liability exists and, if so, is it at the correct amount. Understating (overstating) the accrual overstates (understates) current period income at the expense (benefit) of future income.

c. The debt-to-equity ratio will increase and the operating cash flow to liabilities

will decrease. The times-interest earned ratio will not be affected. E9-37 (10 minutes) Item Accounting Treatment

a. Neither record nor disclose (neither probable nor reasonably possible)

b. Record a current liability for the note, no liability for interest until incurred

c. Disclose in a footnote (at least reasonably possible)

d. Record warranty liability on balance sheet and recognize expense in income statement (costs are probable and reasonably estimable).



E9-38 (15 minutes) The company must accrue the $25,000 of wages that have been earned by employees even though these wages will not be paid until the first of next month. The required accounting accrual will:

increase wages payable by $25,000 on the balance sheet

increase wages expense by $25,000 in the income statement

Failure to make this accounting accrual (called adjusting entry) would understate liabilities, understate expenses, overstate income, and overstate stockholders’ equity. M9-39 (15 minutes) a. Selling price of bonds:

Present value of principal repayment ($300,000 0.30832) ............. $ 92,496

Present value of interest payments ($16,500 17.29203) ................ 285,318 Selling price of bonds $377,814 b. 1/1/10 Cash (+A) …………………………………….. 377,814 Bond premium (+L) …………………… 77,814 Bonds payable (+L) ……………...…… 300,000 6/30/10 Interest expense (+E, -SE) ………………… 15,113 Bond premium (-L) ……………...………….. 1,387 Cash (-A) ……………………………….. 16,500 12/31/10 Interest expense (+E, -SE) ………………… 15,057 Bond premium (-L) …………………………. 1,443 Cash (-A) ……………………………….. 16,500 * $15,057 = ($377,814 – $1,387) x 8%/2.

c.

+ Cash (A) - - Bonds Payable (L) + 1/1/10 377,814 300,000 1/1/10

16,500 6/30/10 16,500 12/31/10

+ Interest Expense (E) - - Bond Premium (L) + 77,814 1/1/10

6/30/10 15,113 6/30/10 1,387 12/31/10 15,057 12/31/10 1,443



d.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital



a premium. +377,814

Cash

=

+300,000 Bonds

Payable

+77,814 Bonds

Payable, net

-

=

6/30/10 Interest payment on bonds.

-16,500 Cash

=

-1,387 Bonds

Payable, net


-


=

-15,113


-16,500 Cash

=

-1,443 Bonds

Payable, net


-


=

-15,057

E9-40 (10 minutes) Selling price of bonds

Present value of principal repayment ($900,000 0.44230) ................. $398,070

Present value of interest payments ($49,500 9.29498) ...................... 460,102 Selling price of bonds .............................................................................. $858,172 E9-41 (15minutes) a.

Warranty expense (+E, -SE) ……………………. 123.0

Warranty liability (+L)…………………… 123.0

b.

- Accrued Warranty Liability (L) + + Warranty Expense (E) -

60.5 07 bal. 08 cost 125.1 123.0 08 exp. 123.0

55.2 08 bal.

c. 2008: $123.0 / $6,086.1 = 2.0% 2007: $118.8 / $6563.2 = 1.8%. Warranty expense appears to have increased in 2008 as a percentage of sales

revenue.



E9-42 (15 minutes) a. 5/1/10 Cash (+A) ………………………………………... 500,000 Bonds payable (+L) ……………………… 500,000 10/31/10 Interest expense (+E, -SE) …………………… 22,5001 Cash (-A) ………………………………….. 22,500 11/1/11 Bonds payable (-L) ……………………………. 300,000 Loss on retirement of bonds (+E, -SE) ……. 3,000 Cash (-A) ………………………………….. 303,0002

1 $500,000 x 0.09 x 1/2 = $22,500 interest expense. Because the bonds were sold at par,

there is no discount or premium amortization. 2 Cash required to retire $300,000 of bonds at 101 = $300,000 x 1.01 = $303,000. The

difference between the cash paid and the carrying amount of the bonds is the gain or loss on the redemption. In this case, the loss is $3,000. This calculation assumes that the interest was paid on 10/31/11, so accrued interest is not recorded.

b. + Cash (A) - - Bonds Payable (L) +

5/1/010 500,000 500,000 5/1/10 22,500 10/31/10

303,000 11/1/11 11/1/11 300,000

+ Interest Expense (E) - + Loss on Retirement of Bonds (E) - 10/31/10 22,500 11/1/11 3,000

c.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital


Income 5/1/10 Issue bonds. +500,000

Cash

= +500,000

Bonds Payable

-

=

10/31/10Interest payment on bonds.

-22,500 Cash

=


-


= -22,500

11/1/11 Early retirement of bonds.

-303,000 Cash

=

-300,000 Bonds

Payable

-3,000

Retained Earnings

-

+3,000 Loss on

Retirement of Bonds

=

-3,000



E9-43 (25 minutes)

a. Selling price of bonds


Present value of interest payments ($10,000 11.68959) .................... 116,896 Selling price of bonds .............................................................................. $220,776 b. 1/1/10 Cash (+A) ………………………………………. 220,776 Bond discount (+XL, -L) ……………………… 29,224 Bonds payable (+L) …………………….. 250,000 6/30/10 Interest expense (+E, -SE) …………………… 11,039 Bond Discount (-XL, +L) ………….……. 1,039 Cash (-A) ………………………………….. 10,000

$11,039 = $220,776 .05.

12/31/10 Interest expense (+E, -SE) …………………. 11,091 Bond Discount (-XL, +L) …………….…. 1,091 Cash (-A) ………………………………….. 10,000

$11,091 = [$220,776 + $1,039] .05.

c.


10,000 6/30/10 10,000 12/31/10

+ Interest Expense (E) - + Bond Discount (XL) - 1/1/10 29,224

6/30/10 11,039 1,039 6/30/10

12/31/10 11,091 1,091 12/31/10



E9-43—continued. d.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital



a discount. +220,776

Cash

=

+250,000 Bonds

Payable

-29,224 Bonds

Payable, net

-

=


-10,000 Cash

=

+1,039 Bonds

Payable, net


-


=

-11,039


-10,000 Cash

=

+1,091 Bonds

Payable, net


-


=

-11,091

E9-44 (25 minutes)

a. Selling price of bonds:


Present value of interest payments ($36,000 19.79277) .................... 712,540 Selling price of bonds .............................................................................. $879,172

b. 1/1/10 Cash (+A) ………………………………………... 879,172 Bond premium (+L) ……………………… 79,172 Bonds payable (+L) ……………………… 800,000 6/30/10 Interest expense (+E,-SE) ……………………. 35,167 Bond premium (-L) …………….……………… 833 Cash (-A) ………………………………….. 36,000 $35, 167 = $879,172 x .04.

12/31/10 Interest expense (+E,-SE) ……………………. 35,134 Bond premium (-L) …………….……………… 866 Cash (-A) ………………………………….. 36,000 $35,134 = ($879,171 - $833) x .04.



E9-44—continued. c.


36,000 6/30/10 36,000 12/31/10


6/30/10 35,167 6/30/10 833 12/31/10 35,134 12/31/10 866

d.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital



a premium. +879,172

Cash

=

+800,000 Bonds

Payable

+79,172 Bonds

Payable, net

-

=


-36,000 Cash

=

-833 Bonds

Payable, net


-


=

-35,167


-36,000 Cash

=

-866 Bonds

Payable, net


-


=

-35,134



E9-45 (20 minutes)

a. There is an inverse relation between interest rates and bond prices (examine the increasing discount rates as the yield increases in present value tables). Since the bonds now trade at a premium and assuming that Deere’s credit ratings have not changed, we can conclude that interest rates have fallen since the bonds were issued.

b. No, once the bond is initially recorded, neither the coupon rate nor the yield used to compute interest expense is changed. Bonds are recorded at historical cost (like most other balance sheet assets and liabilities). As a result, changes in the general level of interest rates have no effect on interest expense (or the interest payment) that is reflected in the financial statements.

c. Because the bonds trade at a premium in the market, Deere would be paying more to retire the bonds than the amount at which they are carried on its balance sheet. This would result in a loss on the repurchase that would lower current profitability.

d. The face amount of the bonds will be paid at maturity. As a result, the market price of the bonds must also equal their face amount ($200 million) at that time.

E9-46A (20 minutes)

a. 1. $90,000 0.46319 = $41,687

2. $90,000 0.45639 = $41,075

b. $1,000 5.33493 = $5,335

c. $600 17.29203 = $10,375

d. $500,000 0.38554 = $192,770 E9-47 (25 minutes) a. Selling price of bonds

n=40 i=6 pmt=33,000 fv=600,000 Selling price of bonds .............................................................................. $554,860



E9-47—continued. b. 1/1/10 Cash (+A) ………………………………………….. 554,861 Bond discount (+XL, -L) ………………..……… 45,139 Bonds payable (+L) ……………………….. 600,000 6/30/10 Interest expense (+E, -SE) ……………………… 33,292 Bond discount (-XL, +L) ……………….…. 292 Cash (-A) ……………………………………. 33,000 $33,292 = $554,861 .06.

12/31/10 Interest expense (+E, -SE) ……………………… 33,309 Bond discount (-XL, +L) …………….……. 309 Cash (-A) ………….…………………………. 33,000 $33,309 = ($554,861 + $292) .06.

c.


33,000 6/30/10 33,000 12/31/10


6/30/10 33,292 292 6/30/10

12/31/10 33,309 309 12/31/10

d.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital




Cash

=

+600,000 Bonds

payable

-45,140 Bonds

Payable, net

-

=


-33,000 Cash

+292 Bonds

Payable, net


-


-33,292

12/31/10Interest payment on bonds.

-33,000 Cash

=

+309 Bonds

Payable, net


-


=

-33,309



E9-48 (25 minutes) a. Selling price of bonds

Present value of principal repayment ($400,000 0.61391) ....................... $245,564

Present value of interest payments ($26,000 7.72173) ............................ 200,765 Selling price of bonds .................................................................................... $446,329 b. 1/1/10 Cash (+A) ………………………………………... 446,329 Bond premium (+L) ……………………… 46,329 Bonds payable (+L) ……………………… 400,000 6/30/10 Interest expense (+E,-SE) ……………………. 22,316 Bond premium (-L) …………….……………… 3,684 Cash (-A) ………………………………….. 26,000 $22,316 = $446,329 .05. 12/31/10 Interest expense (+E,-SE) ……………………. 22,132 Bond premium (-L) …………….……………… 3,868 Cash (-A) ………………………………….. 26,000 $22,132 = ($446,329 - $3,684) .05.

c.


26,000 6/30/10 26,000 12/31/10


6/30/10 22,316 6/30/10 3,684 12/31/10 22,132 12/31/10 3,868



E9-48—continued. d.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital



a premium. +446,329

Cash

=

+400,000 Bonds

Payable

+46,329 Bonds

Payable, net

-

=


-26,000 Cash

=

-3,684 Bonds

Payable, net


-


=

-22,316


-26,000 Cash

=

-3,868 Bonds

Payable, net


-

+22,132 Interest Expense =

-22,132

E9-49 (10 minutes) Current liabilities: Bond interest payable $ 25,000 Current maturities of long-term debt:

10% bonds payable due 2011, including $15,000 premium 515,000 Total current liabilities $540,000

Long-term debt: 9% bonds payable due 2012, net of $19,000 discount $581,000 Zero coupon bonds payable due 2013 170,500 8% bonds payable due 2015 100,000 Total long-term debt $851,500



E9-50 (20 minutes) a. 12/31/10 Cash (+A) …………………………………………… 500,000 Mortgage note payable (+L) ………………. 500,000 3/31/11 Interest expense (+E, -SE) ………………………. 10,000 Mortgage note payable (-L) ……………………... 8,278 Cash (-A) ……………………………………… 18,278 6/30/11 Interest expense (+E, -SE) ………………………. 9,834 Mortgage note payable (-L) ……………………... 8,444 Cash (-A) ……………………………………… 18,278 $9,834 = ($500,000 – $8,278) x 8%/4.

b.

+ Cash (A) - - Mortgage Note Payable (L) + 12/31/10 500,000 500,000 12/31/10

18,278 3/31/11 3/31/11 8,278

18,278 6/30/11 6/30/11 8,444


3/31/11 10,000

6/30/11 9,834

c.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital




+500,000 Cash

=

+500,000 Mortgage

Note Payable

-

=


-18,278 Cash

=

-8,278 Mortgage

Note Payable


-


=

-10,000


-18,278 Cash

=

-8,444 Mortgage

Note Payable


-

+9,834 Interest Expense =

-9,834



PROBLEMS P9-51 (20 minutes) a.

Hewlett-Packard Dell Inc. - Accrued Warranty Liability (L) + - Accrued Warranty Liability (L) +

2,376 07 bal. 929 07 bal. 3,244 08 exp. 1,180 08 exp.

3,006 1,074

2,614 08 bal. 1,035 08 bal.

Hewlwtt-Packard incurred $3,006 million in warranty repair costs and settlements

in 2008 while Dell, Inc. incurred costs of $1,074 million. b. HP’s ratio of warranty expense to sales was 3.5% in 2008 ($3,244/$91,697) up

from 3.1% in 2007 ($2,604/$84,229). Dell’s ratio was 1.9% both years ($1,180/$61,101 in 2008 and $1,176/$61,133 in 2007). Dell’s warranty expense is lower and more stable relative to sales revenue than that of HP. Possible reasons for this include the following: (1) perhaps Dell products are higher- quality and require fewer repairs than HP products or (2) HP may have a more generous warranty policy than Dell, resulting in more warranty repairs, even if the quality is the same. The increase in HP’s warranty expense as a percent of sales indicates that either (1) warranty costs have gone up, (2) the company underestimated warranty costs in the past and needed to record larger than normal accruals in 2008 to correct the underestimation; or (3) HP is building up a “cookie-jar reserve” by increasing its warranty liability this year.



P9-52 (20 minutes) a. Cash (+A) ………………………………………….. 518,750 Accrued interest payable (+L) …………… 18,750 Bonds payable (+L) ……………………….. 500,000 $18,750 = $500,000 x .09 x 5/12

b. Interest expense (+E, -SE)………………………. 3,750 Accrued interest payable (-L) ………………….. 18,750 Cash (-A) …………………………………….. 22,500 $22,500 = $500,000 x 9%/2

c. Interest expense (+E, -SE) ……………………… 7,500 Accrued interest payable (+L) …………… 7,500 $7,500 = $500,000 x 9% x 2/12

d. Interest expense (+E, -SE) ……………………… 15,000 Accrued interest payable (-L) ………………….. 7,500 Cash (-A) …………………………………….. 22,500

e. Bonds payable (-L) ………………………………. 300,000 Loss on retirement of bonds (+E, -SE) ………. 3,000 Cash (-A) …………………………………….. 303,000

+ Cash (A) - - Bonds payable (L) +

a. 518,750 500,000 a. 22,500 b. 22,500 d. 303,000 e. e. 300,000

+ Interest expense (E) - - Accrued Interest Payable (L) +

18,750 a. b. 3,750 b. 18,750 c. 7,500 7,500 c. d. 15,000 d. 7,500

+ Loss on Retirement of Bonds (E) - e. 3,000





+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned capital


Income a. (10/1/10) Issue

bonds. +518,750

Cash

=

+500,000 Bonds

Payable

+18,750 Interest Payable

-

=

b. (11/1/10 Interest payment on bonds.

-22,500 Cash

=

-18,750 Interest Payable

-3,750

Retained Earnings

-


= -3,750

c. (12/31/10) Accrued interest on bonds.

=


-7,500

Retained Earnings

-


= -7,500

d. (5/1/11) Interest payment on bonds.

-22,500 Cash

=



-


= -15,000

e. 5/1/15 Early retirement of bonds.

-303,000 Cash

=

-300,000 Bonds

Payable


-

+3,000 Loss on

Retirement of Bonds

=

-3,000

P9-53 (15 minutes) a. CVS reports interest expense of $529.8 million on average long-term debt of

$8,203.45 million ([$8,057.2 million + $8,349.7 million]/2) for an average rate of 6.5%. Using interest paid ($573.7 million) instead of interest expense yields 7.0%. See the answer to c below.

b. CVS reports coupon rates of 4.0% to 8.52% so, the average rate seems

reasonable given the information disclosed in the long-term debt footnote. c. Interest paid can differ from interest expense if bonds are sold at a premium or

a discount. It can also differ because of capitalized interest. CVS reported capitalized interest of $27.8 million in 2008 (information not provided in the problem).



P9-54 (25 minutes) a. 6/1/10 Cash (+A) ……………………………………. 824,000 Accrued interest payable (+L) ……. 24,000 Bonds payable (+L) ………………… 800,000 $24,000 = $800,000 x .09 x 4/12

b. 9/1/10 Interest expense (+E, -SE) ……………..… 12,000 Accrued interest payable (-L) ……………. 24,000 Cash (-A) ……………………………… 36,000 $36,000 = $800,000 x 9%/2

c. 12/31/10 Interest expense (+E, -SE) ………………… 24,000 Accrued interest payable (+L) ……. 24,000

d. 3/1/11 Interest expense (+E) ……………………… 12,000 Accrued interest payable (-L) ……………. 24,000 Cash (-A) ……………………………… 36,000

e. 3/1/11 Bonds payable (-L) ………………………… 200,000 Loss on retirement of bonds (+E, -SE) … 2,000 Cash (-A) …………………………….. 202,000


a. 824,000 36,000 b. 800,000 a. 36,000 d. 202,000 e. e. 200,000

+ Interest Expense (E) - - Accrued Interest Payable (L) +

b. 12,000 b. 24,000 24,000 a. c. 24,000 d. 24,000 24,000 c. d. 12,000

+ Loss on Retirement of Bonds (E) - e. 2,000





+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital


Income a. (7/1/10) Issue

bonds. +824,000

Cash

=

+800,000 Bonds

Payable


-

=

b. (9/1/10) Interest payment on bonds.

-36,000 Cash

=



-


= -12,000

c. (12/31/10) Accrued interest on bonds.

=



-


= -24,000

d. (3/1/11) Interest payment on bonds.

-36,000 Cash

=



-


= -12,000

e. 3/1/11 Early retirement of bonds.

-202,000 Cash

=

-200,000 Bonds

Payable

-2,000

Retained Earnings

-

+2,000 Loss on

Retirement of bonds

=

-2,000

P9-55 (20 minutes) a.

Period Interest expense

Cash interest

paid Discount

amortization Discount balance

Bond payable net

0 $41,292 $678,708 1 $40,722 $39,600 $1,122 $40,170 $679,830 2 $40,790 $39,600 $1,190 $38,980 $681,020

$40,722 = $678,708 x 12%/2. $40,790 = $679,830 x 12%/2.

b. 12/31/10 Cash (+A) ………………………………….. 678,708 Bond discount (+XL) ……………………. 41,292 Bonds payable (+L) ……………….. 720,000 6/30/11 Interest expense (+E,-SE) ………………. 40,722 Bond discount (-XL) ……………….. 1,122 Cash (-A) …………………………….. 39,600 12/31/11 Interest expense (+E,-SE) ………………. 40,790 Bond discount (-XL) ……………….. 1,190 Cash (-A) …………………………….. 39,600



c. + Cash (A) - - Bonds Payable (L) +

12/31/10 678,708 720,000 12/31/10 39,600 6/30/11 39,600 12/31/11


6/30/11 40,722 1,122 6/30/11

12/31/11 40,790 1,190 12/31/11

d.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Retained Earnings


Income 12/31/10 Issue bonds

at a discount. +678,708

Cash

=

+720,000 Bonds

Payable

-41,292 Bonds

Payable, net

-

=


-39,600 Cash

=

+1,122 Bonds

Payable, net


-


=

-40,722


-39,600 Cash

=

+1,190 Bonds

Payable, net


-


=

-40,790



P9-56 (20 minutes) a.

Period Interest expense

Cash interest

paid Discount

amortization Discount balance

Bond payable net

0 $43,230 $206,770 1 $8,271 $7,500 $771 $42,459 $207,541 2 $8,302 $7,500 $802 $41,657 $208,343

$8,271= $206,770 x 8%/2. $8,302 = $207,541 x 8%/2.

b. 4/30/10 Cash (+A) …………………….……….………..…… 206,770 Bond discount (+XL, -L) …………………………. 43,230 Bonds payable (+L) …….…………………… 250,000 10/31/10 Interest expense (+E, -SE) ………………..….….. 8,271 Bond discount (-XL, +L) ……………………. 771 Cash(-A) ……………………………………….. 7,500 12/31/10 Interest expense (+E, -SE) ………………..….….. 2,767 Bond discount (-XL, +L) ……………………. 267 Accrued interest payable (+L) …………….. 2,500 4/30/11 Interest expense (+E, -SE) …………………...….. 5,535 Accrued interest payable (-L) ………..….………. 2,500 Bond discount (-XL, +L) ……………………. 535 Cash(-A) ……………………………………….. 7,500 c.


7,500 10/31/10 7,500 4/30/11

+ Interest Expense (E) - + Bond Discount (XL) - 4/30/10 43,230 10/31/10 8,271 771 10/31/10

12/31/10 2,767 267 12/31/10

4/30/11 5,535 535 4/30/11

- Accrued Interest Payable (L) + 2,500 12/31/10

4/30/11 2,500



d.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital




Cash

=

+250,000 Bonds

Payable

-43,230 Bonds

Payable, net

-

=


-7,500 Cash

=

+771 Bonds

Payable, net

-8,271

Retained Earnings

-


=

-8,271

12/31/10 Accrued interest on bonds.

=

+267 Bonds

Payable, net

+2,500 Accrued Interest Payable


-


=

-2,767


-7,500 Cash

=

+535 Bonds

Payable, net

-2,500 Accrued Interest Payable


-


=

-5,535



P9-57 (20 minutes)

a. Payment x 12.46221 = $500,000; Payment = $500,000/12.46221 = $40,121. b. 12/31/10 Cash (+A) ………………………………………..…… 500,000 Mortgage note payable (+L) ………………… 500,000 6/30/11 Interest expense (+E, -SE) ………………………… 25,000 Mortgage note payable (-L) ………………………. 15,121 Cash (-A) …………………………………..…… 40,121 * $25,000 = $500,000 x 10%/2 12/31/11 Interest expense (+E, -SE) ……………………….… 24,244 Mortgage note payable (-L) ……………………….. 15,877 Cash (-A) …………………………………..…… 40,121 $24,244 = ($500,000 – $15,121) x 10%/2.

c.


40,121 6/30/11 6/30/11 15,121

40,121 12/31/11 12/31/11 15,877


6/30/11 25,000

12/31/11 24,244

d.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital




+500,000 Cash

=

+500,000 Mortgage

Note Payable

-

=


-40,121 Cash

=

-15,121 Mortgage

Note Payable


-


=

-25,000


-40,121 Cash

=

-15,877 Mortgage

Note Payable


-


=

-24,244



P9-58 (20 minutes) a. Payment x 16.35143 = $950,000; Payment = $950,000/16.35143 = $58,099. b. 12/31/10 Cash (+A) ………………………………………..…… 950,000 Mortgage note payable (+L) ………………… 950,000 3/31/11 Interest expense (+E, -SE) ………………………… 19,000* Mortgage note payable (-L) ………………………. 39,099 Cash (-A) …………………………………..…… 58,099 * $19,000 = $950,000 x 8%/4 6/30/11 Interest expense (+E, -SE) ………………………… 18,218* Mortgage note payable (-L) ………………………. 39,881 Cash (-A) …………………………………..…… 58,099 * $18,218 = ($950,000 – $39,099) x 8%/4.

c.


58,099 3/31/11 3/31/11 39,099

58,099 6/30/11 6/30/11 39,881


3/31/11 19,000

6/30/11 18,218

d.



+ Noncash Assets

= Liabil-ities

+ Contrib. Capital

+ Earned Capital




+950,000 Cash

=

+950,000 Mortgage

Note Payable

-

=

3/31/11 Payment on note.

-58,099 Cash

=

-39,099 Mortgage

Note Payable


-


=

-19,000

6/30/11 Payment on

note. -58,099

Cash

=

-39,881 Mortgage

Note Payable


-


=

-18,218



P9-59 (20 minutes) a. 1. $90,000 x 0.54703 = $49,233

2. $90,000 x 0.53997* = $48,597 (*0.53997 = 1.045-14)

3. $90,000 x 0.53632** = $48,269 (**0.5632 = 1.0225-28) b. $1,000 x 4.21236 = $4,212 c. $2,400 x 15.24696 = $36,593 d. $500,000 x 0.38554 = $192,770 e. $2,500 x 11.46992 + $85,000 x 0.31180 = $55,178 P9-60 (20 minutes) a. $7,000 x 4.17725 = $29,241. b. $7,000 x 4.32194 = $30,254. c. $29,241 x 0.23939 = $7,000. d. $6,000 x 1.69005 = $10,140. e. $500 x 21.24339 = $10,622.



CASES C9-61 (50 minutes) a. The $1,300 million reported in short-term liabilities means that this face

amount will come due in 2009 and needs to be paid or refunded with new debt. The amount of debt needed to be either paid or refunded with a new issue is important because it implies required uses of cash unless refunding is available. The note reveals that, in October 2008, PBG issued $1,300 million of 6.95% senior notes due in 2014 and the proceeds were used to pay off the 7% notes due in February 2009. At the end of 2008, both debt issues appeared on PBG’s balance sheet.

b. The 98.919 price indicates that each $1,000 bond would sell for $989.19. Each

$1,000 bond still returns $70 of interest per year. The result is that the investor's return is increased. The lower bond price reflects an increase in market interest rates.

c. The first covenant indicates an upper limit on borrowing. The debt to EBITDA

ratio is an additional constraint on the level of debt. The third covenant restricts new borrowing secured by the pledge of specific assets of the firm. All of these covenants restrict the firm's freedom to borrow.

d. Bond discount arises when a bond is sold at less than par. Sale below par

occurs when the market interest rate exceeds the coupon rate for the issue. The result is that the issuer receives less money but the interest payment remains at the coupon rate. The amortization of the bond discount results in an increase in the firm's interest expense. The initial discount is reported as a debit contra account to the outstanding bond's face value. The discount is amortized over time reflected by a credit to it and a debit to interest expense.



C9-62 (50 minutes)

a. From the firm's view, it is useful to know the maturity dates in order to complete the firm's cash budget and to be able to plan for any refunding or additional cash needs if refunding is not an option. This information is also useful to analysts as that they consider the firms solvency and debt capacity as indicators of the firm's health and ability to implement its strategy.

b. Several factors can cause a difference between interest expense and interest

paid. Some of a firm's accrued interest may have been capitalized to assets under construction. In addition, bonds issued at a discount will result in interest expense that is greater than interest paid, while bonds issued at a premium will lead to interest expense that is less than cash interest paid.

c. Several ratios discussed in this chapter may be useful in assessing a firm’s

riskiness include the firm's debt-to-equity ratio and its time interest earned. Credit rating companies look for the amount of indebtedness in relation to the operating cash flow and asset size of the company. This is because cash serves as the primary source of debt repayment and assets serve as a backup source, in the event of default. Other factors such as profitability measures, an examination of the firm's closeness to its debt covenants, the state of the firm's sales and industry health should also be considered.

d. $374.57 million. If the notes originally sold at par, the difference between the

$385 million issue price and the current $374.57 million value would not be reflected in the firm's current financial statements. (The firm could report the market value in a note if it wished.) Repurchase of the issue at the current market price would eliminate the debt of $385 million for a cash payment of $374.57 million and a gain on redemption equal to the difference. The 97.29 price tells us that market rate of interest for the risk level associated with this debt issue has increased. An alternative explanation would be that Southwest's credit rating has declined since the notes were issued.

e. Cash (+A) ………..………………………..……...… 297 Bond discount (+XL) …....……....……....…….... 3 5¾% Notes payable, due 2016 (+L) …....… 300



C9-63 (20 minutes) a. The gain results from the difference between the book value of the debt

($3,000,000) and the current redemption (market) value ($1,900,000). The gain would be reported in the income statement under other (nonoperating) income. The source of the gain should be adequately disclosed in the notes.

b. Currently, Foster is paying 8% interest on the $3,000,000 of long-term debt, or

$240,000 per year. Under the proposed refinancing, Foster would pay 16%, or $480,000. The refinancing would generate an additional $1,100,000 in cash. However, because interest costs are increasing by $240,000 per year ($480,000 - $240,000), Foster is effectively borrowing the additional $1,100,000 at a rate of almost 22% ($240,000 / $1,100,000). As such, Foster would be paying in the future (in the form of higher interest costs) for a one-time boost in current earnings.

c. The potential ethical conflict exists because Foster’s president is concerned

that his job might be dependent on producing short-term earnings. Because of this, he might be tempted to accept this proposal and boost current earnings at the cost of lower earnings in future years. This thinking is misguided because, given adequate disclosure, analysts and investors would be able to identify and discount the source of the earnings boost. The most serious unethical act would be to try to hide (or obfuscate) the bond refinancing with inadequate disclosure.

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