Acct 414
Prof. T. Gordon
Fair Value Option Homework Assignments
HW #2
Problem 1 Fair Value Option (similar to illustration in K. Stice’s material posted on web site)
Ryan Marie Company has one asset, a bond issued by Miles Company that Ryan Marie purchased (on the
day it was issued) as an investment. Ryan Marie also has only one liability, one of its own bonds that was
to finance the purchase of the Miles Bond investment. The company had no initial shareholder
investment. Both bonds have the same terms: $1,000 face value, 10-year life, 11% coupon rate, and single
interest payments made at the end of each year. On their issuance dates, both bonds were associated with
a market interest rate of 8%. The company has determined to account for both the bond asset and the bond
liability using the fair value option.
1.
Prepare a balance sheet for Ryan Marie Company as of the date it both purchased the Miles bond
investment and issued its own bonds payable.
2.
On the very next day, the market interest rate with respect to the Miles bond investment had risen
to 13%, and the market interest rate with respect to Ryan Marie’s bond had risen to 11%. Prepare
the company’s balance sheet.
3.
Repeat (2) but this time assume that the market interest rate for the Miles bond had gone down to
6%, and the market interest rate of Ryan Marie bond had increased to 14%.
4.
Repeat (2) but this time assume that the market interest rate for the Miles bond had increased to
14%, and the market interest rate of Ryan Marie bond had gone down to 6%.
Problem 2 – Fair Value Option but a more realistic example (similar to one in ppt slides)
Margaret Inc. has one asset, a bond issued by Mead Company that Margaret Inc. purchased at face value
as an investment (accounted for at fair value as trading security). Margaret Inc. has only one liability, a
bond that was issued at face value to finance the purchase of the Mead Company bond. There is no initial
shareholder investment.
Terms of the bonds
Face value
Coupon rate (annual)
Term
Semiannual interest payment
Yield rate at year end (simple interest)
Mead Company Bond
Investment
$100,000
12%
10 years
$6,000
11%
Margaret Inc. Bond Payable
$100,000
10%
8 years
$5,000
9%
What makes this one different from #1? The balance sheets are prepared a year later instead of “next
day” and the bonds are semiannual. In both cases, the bonds are not actively traded but yield rates for
bonds with similar ratings and maturities are available (level 2 inputs in the fair value hierarchy):
Required:
a. Prepare a balance sheet and income statement for Margaret Company at the END of the first
year assuming that the fair value option was not selected for the bond payable. Hint – do an
income statement first.
b. Prepare a balance sheet and income statement for Margaret Company at the END of the first
year assuming that the fair value option was selected for the bond payable.
c. Prepare a balance sheet and income statement for Margaret Company and the END of the first
year assuming that the fair value option was selected for the bond payable and the bond
investment is accounted for as part of the available for sale securities portfolio (instead of the
trading securities portfolio).
Acct 414
HW #2 (continued)
Page 2
Problem 3. Valuing of Bonds Held as Investment Securities – market values are
available.
Han Company has purchased five corporate bonds as temporary investments. The bond
investments are to be reported in Han’s books at their fair values on the balance sheet date. “Fair
value” is defined as the price that would be received to sell an asset in an orderly transaction
between market participants. Each of the bonds has unique terms, and the bonds are not traded in
active markets, so Han cannot look to quoted market prices to directly determine how much each
bond would bring in a sales transaction. However, Han has assembled the following matrix of
bond price data for actively traded bonds which can be used to indirectly estimate the selling
price of each of Han’s bonds.
Bond Prices (% of par)
Term (in years)
2
5
10
20
AAA
103.85
103.66
101.64
95.66
AA
103.56
102.53
100.29
91.49
Bond Ratings
A
102.71
101.45
99.56
90.00
BBB
102.37
100.17
98.54
89.31
BB
100.29
98.50
91.98
82.06
Han has learned that the selling price of a bond is related to both its term (the number of years
until the bond matures) and by the underlying riskiness of the company that issued the bond.
[Note: Another important valuation variable is the amount of interest paid by the bond. In this
example, that rate is assumed to be the same for all bonds and so is ignored in this analysis.] This
underlying riskiness is represented by the “bond rating” which is a label attached to a bond by a
bond rating agency such as Standard & Poor’s. The rating agency assigns the rating after an
analysis of the bond issuing company’s finances and the strength of its industry. A lower bond
rate (AAA is the highest in the table and BB is the lowest) indicates that rating agency views the
bond issuing company as being more risky. The higher this risk, the lower the bond price if
everything else is held constant. Also, somewhat independent of the underlying riskiness of the
bond issuing company, the longer until a bond matures the more risk is associated with a bond.
Thus, holding all else constant, bonds with longer times to maturity have lower prices.
For the five bonds it purchased, Taraz has determined the time to maturity and has also looked
up the bond rating from Standard & Poor’s. These data for the five bonds are as follows.
Bond 1
Bond 2
Bond 3
Bond 4
Bond 5
Term
15
6
3
18
9
Bond
Rating
AA
BBB
AAA
BB
A
Question: Estimate the fair value of each of the five bonds. Note: The par value of each of
the bonds is $1,000, and the numbers given in the matrix of bond prices are expressed in
terms of a percentage of par value.
ALSO ATTACH SOLUTIONS to textbook exercises E17-19, E17-20 & E17-21