CHAPTER 8

SOURCES OF CAPITAL: DEBT

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

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

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Anthony/Hawkins/Merchant

CD price Year 25 = $14 / .375 = $37.33

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

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

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

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

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

Payment
$3,100
3,100
3,100

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

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

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

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

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

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

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

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

(2)

dr. Issurance Cost (asset)..........................................................................................................................................

250,000
Cash.....................................................................................................................................................................
7,999,600
cr. Bond Payable....................................................................................................................................................
7,000,000
Bond Premium..................................................................................................................................................
999,600
Cash..................................................................................................................................................................
250,000
Cash received equals sum of:

PV 15 annual interest payments ($80 x 7,000)

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

PV 20 semiannual interest payments ($350,000 /

2) discounted at 4 percent (13.590 - Table B).....................................................................................................................
$2,378,250
PV principal payment ($5,000,000) in period 20
discounted at 4 percent (.456 - Table A).............................................................................................................................
2,280,000
$4,658,250
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Problem 8-8

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

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

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

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

2007 McGraw-Hill/Irwin

Chapter 8

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

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Anthony/Hawkins/Merchant

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

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

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

Interest
$2,800
1,938
1,006

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

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

Case 8-2: Stone Industries, Inc.*

*

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

2007 McGraw-Hill/Irwin

Chapter 8

Note: This case is unchanged from the Eleventh Edition.

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

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

Bond Discount Amortization Schedule

Period
1
2
3
4
5
6

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

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

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

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

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

From this table, one can verify the amounts shown in Note 1 of Exhibit 1 of the case for the bonds
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Anthony/Hawkins/Merchant

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

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

Period
1
2
3
4

Bond Premium Amortization Schedule

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

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

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

2007 McGraw-Hill/Irwin

Chapter 8

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

dr. Bonds Payable.....................................................................................................................................

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

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

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

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Anthony/Hawkins/Merchant

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

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

10

2007 McGraw-Hill/Irwin

Chapter 8

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

or

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

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

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Accounting: Text and Cases 12e Instructors Manual

Payment Made at End of Year:

1
2
3
4
5
6
7
8
9
10
11
12
13
14
I5
16
17
18

Anthony/Hawkins/Merchant

Future Value Factor @ 6%

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

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

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

12

2007 McGraw-Hill/Irwin

$288,000

Chapter 8

$7,688

$6,317

$11,231

Case 8-4: Joan Holtz (D)*

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

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

13

Accounting: Text and Cases 12e Instructors Manual

Anthony/Hawkins/Merchant

Actually, zero-coupon bonds are generally purchased by tax-exempt institutions, so this

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

dr. Bonds Payable.....................................................................................................................................

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

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

14

2007 McGraw-Hill/Irwin

Chapter 8

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

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

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

15

Accounting: Text and Cases 12e Instructors Manual

Anthony/Hawkins/Merchant

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

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

16

2007 McGraw-Hill/Irwin

Chapter 8

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

Business Week, op. cit.

17

Exhibit 1
Financial Statement Impact: Steadily Increasing Sales
Alternative A

Number of units sold

x0
1

xl
2

Alternative B
x2
3

x0
1

x1
2

Alternative C
x2
3

x0
1

xl
2

x2
3

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

Exhibit 2
Financial Statement Impact: Decreasing Sales
Alternative A

Alternative B

Alternative C

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