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