Module 7
Reporting and Analyzing
Nonowner Financing
QUESTIONS
Q7-1. Current liabilities are obligations that require payment within the coming year or
operating cycle, whichever is longer.
Generally, current liabilities are normally settled with use of existing current assets
or operating cash flows.
Q7-2. An accrual is the recognition of an event in the financial statements even though
no actual transaction has occurred. Accruals can involve both liabilities (and
expenses) and assets (and revenues).
Accruals are vital to the fair presentation of the financial condition of a company
as they impact both the recognition of revenue and the matching of expense.
Q7-3. The coupon rate is the rate specified on the face of the bond. It is used to compute
the amount of cash interest paid to the bond holder. The market rate is the rate of
return expected by investors that purchase the bonds. The market rate determines
the market price of the bond. It incorporates expectations about the relative
riskiness of the borrower and the rate of inflation. In general, there is an inverse
relation between the bond’s market rate and the bond’s market price.
Q7-4. Bonds sold at face (par) value earn an effective interest rate equal to the bonds’
coupon rate. Bonds sold at a discount causes the effective interest rate to be higher
than the coupon rate. Bonds sold at a premium causes the effective interest rate to
be lower than the coupon rate.
Q7-5. Bonds are reported at historical cost, that is, the face amount plus (minus)
unamortized premium (discount). The market price of the bonds varies inversely
with the level of interest rates and fluctuates continuously. Differences between the
market price of a bond and its carrying amount represent unrealized gains and
losses. These unrealized gains (losses) are not reflected in the financial statements
(although they are disclosed in the footnotes). They must be recognized upon
repurchase of the bonds, the point at which they become “realized.”
The recognition of the gain (loss) on the redemption results from the use of
historical costing for bonds. The gain (loss) that is reported upon redemption will be
offset by correspondingly lower (higher) interest payments in the future. The present
©Cambridge Business Publishers, 2006
Solutions Manual, Module 7
1
value of these future interest payments, as well as the present value of the difference
between the current face amount of the bond and the former face amount, are not
recognized. These present values exactly offset the reported gain (loss), and no
“real” gain (loss) has been realized.
Q7-6. Debt ratings reflect the relative riskiness of the borrowing company. This riskiness
relates to the probability of default (e.g., not repaying the principal and interest when
due). Higher (greater quality) debt ratings result in higher market prices for the
bonds and a correspondingly lower effective interest rate for the issuer. Lower
(lesser quality) debt ratings result in lower market prices for the bonds and a
correspondingly higher effective interest rate for the issuer.
Q7-7B. Reporting a gain or loss on bond redemption results from use of historical cost
accounting. The gain or loss that is reported at redemption is offset by the present
value of lower (higher) interest payments in the future. The present value of those
future interest payments, as well as the present value of the difference between the
current face amount of the bond and the former face amount, are not recognized in
the financial statements, and no “real” economic gain or loss occurs.
©Cambridge Business Publishers, 2006
2
Financial Accounting for MBAs, 2nd Edition
MINI-EXERCISES
M7-8 (10 minutes)
Transaction or event
Cash
Noncash
Liabi+
=
Asset
Assets
lities
Interest expense 24
Interest payable 24
To accrue interest
at December 31*
Income
Statement
Balance Sheet
+
Contrib. Retained Revenues Expenses
+
capital
Earnings
-24
24
-24
Interest
Payable
Interest
Expense
* ($7,200  0.08  15/365)
M7-9 (15 minutes)
a. Accounts Payable, $110,000 (current liability).
b. Not recorded as a liability; an accountable transaction has not yet
occurred.
c. Estimated Liability for Product Warranty, $2,200 (current liability).
d. Bonuses Payable, $30,000 (current liability)—computed as $600,000×5%.
This liability must be reported since its payment is “probable” and can be
“estimated.”
M7-10 (10 minutes)
a. Boston Scientific is offering bonds with a coupon (stated) rate of 4.25%
when the market rate (yield) is higher (4.349%). In order to obtain this
expected rate of return, the bonds sell at a discount price of 99.476
(99.476% of par).
b. The first bond matures in 2011 while the second matures in 2017. There
is, generally, a higher rate (yield) expected for a longer maturity.
M7-11 (10 minutes)
Amount paid to retire bonds ($200,000 x 101%) ..................
Book value of retired bonds, net of $2,400 unamortized
discount....................................................................................
Loss on bond retirement ........................................................
$202,000
197,600
$ 4,400
©Cambridge Business Publishers, 2006
Solutions Manual, Module 7
3
The recognition of the loss on the redemption results from the use of
historical costing. The loss that is reported upon redemption will be offset by
correspondingly lower interest payments in the future. The present value of
these future interest payments, as well as the present value of the difference
between the current face amount of the bond and the former face amount,
are not recognized. These present values will exactly offset the reported loss
and no “real” loss has been realized.
M7-12 (10 minutes)
a. The $2,616 indicates that BMY has bonds maturing that will require
payment in the amount of $2,616 million during that time period.
b. BMY will need to pay off the bonds when they mature. This will result in
a cash outflow that must come from operating activities if the bonds
cannot be refinanced prior to maturity.
M7-13 (10 minutes)
a. Gain on Bond Retirement: In the other (nonoperating) revenues and
expenses section unless it meets the tests for extraordinary treatment
(e.g., unusual and infrequent)
b. Discount on Bonds Payable: Deduction from Bonds Payable; thus, a
(contra) long-term liability in the balance sheet (e.g., it is netted in the
presentation of long-term liabilities).
c. Mortgage Notes Payable: Long-term liability in the balance sheet.
d. Bonds Payable: Long-term liability in the balance sheet.
e. Bond Interest Expense: In other (nonoperating) revenues and expenses
section of income statement.
f. Bond Interest Payable: Current liability in the balance sheet.
g. Premium on Bonds Payable: Addition to Bonds Payable; thus, part of a
long-term liability in the balance sheet (e.g., it is included in the
presentation of long-term liabilities).
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
M7-14 (15 minutes)
a. Financial ratios used in bond covenants are typically designed to
protect the bond holders against actions by management that they feel
would be detrimental to their interests. These might include restrictions
against the impairment of liquidity, restrictions on the amount of
financial leverage the company can employ, and restrictions on the
payment of dividends. In addition, bond holders usually impose various
covenants prohibiting the acquisition of other companies or the
divestiture of business segments without their consent. All of these
covenants, by design, restrict management in its actions.
b. Management, facing imminent default in one or more of its bond
covenants, may be pressured into taking actions in order to avoid such
default. These may include, for example, operational actions, such as
reduction of R&D or advertising in order to improve profitability, or
leaning on the trade or reduction of receivables (via early payment
incentives) and inventories (by marketing promotions or delaying
restocking) in order to boost cash balances. Actions may also include
fraudulent accounting measures, such as improper recognition of
revenues or delayed recognition of expenses.
c. Restricted assets, such as cash or securities, should not be considered
as general assets in our analysis of liquidity as they are not available to
management for general corporate uses.
M7-15 (15 minutes)
($ 000s)
Bonds 400
Premium 27
Cash
412
Gain on bond
Redemption 15
To retire bonds at
103, remove the
unamortized
premium and
report gain on
bond retirement
Income
Statement
Balance Sheet
Transaction or event
Cash
Noncash
Liabi+
=
Asset
Assets
lities
+
Contrib. Retained Revenues Expenses
+
capital
Earnings
-400
-412
Bonds
Payable
-27
Premium
15
15
Gain on
Bond Retirement
Gain on
Bond Retirement
on Bonds
$412,000 = $400,000 x 1.03
$27,000 = Unamortized premium is 32,000 - $5,000
©Cambridge Business Publishers, 2006
Solutions Manual, Module 7
5
M7-16 (15 minutes)
($ 000s)
Bonds
250
Loss on Redemption 9.5
Discount
Cash
7
252.5
Income
Statement
Balance Sheet
Transaction or event
Cash
Noncash
Liabi+
=
Asset
Assets
lities
To retire bonds at
101, remove the -252.5
unamortized
discount and
report loss on
bond retirement
+
Contrib. Retained Revenues Expenses
+
capital
Earnings
-250
Bonds
Payable
7
Discount
- 9.5
- 9.5
Loss on
Bond Retirement
Loss on
Bond Retirement
on Bonds
$252,500 = $250,000 x 1.01
$7,000
= Unamortized discount is $10,000 - $3,000
M7-17 (10 minutes)
Nissim:
$18,000  0.10  40/365
=
$197.26
Klein:
$14,000  0.09  18/365
=
62.14
Bildersee:
$16,000  0.12  12/365
=
63.12
$322.52
M7-18 (10 minutes)
a. Financial leverage is one of the ratios that is used by bond rating
companies in the determination of credit ratings. Generally, the higher
(lower) the financial leverage, the lower (higher) the bond rating.
b. Higher credit ratings on bond issues result in a lower yield expected by
bond purchasers and a higher bond price realized by the company.
M7-19 (15 minutes)
a. Selling price of 9% bonds discounted at 8%
Present value of principal repayment ($500,000 × 0.45639a)
Present value of interest payments ($22,500 × 13.59033b)
Selling price of bonds
$228,195
305,782
$533,977
a
Table 1, 20 periods at 4%
Table 2, 20 periods at 4%.
b
©Cambridge Business Publishers, 2006
6
Financial Accounting for MBAs, 2nd Edition
b. Selling price of 9% bonds discounted at 10%
Present value of principal repayment ($500,000 × 0.37689a)
Present value of interest payments ($22,500 × 12.46221b)
Selling price of bonds
$188,445
280,400
$468,845
a
Table 1, 20 periods at 5%
Table 2, 20 periods at 5%.
b
M7-20 (15 minutes)
a. Selling price of zero coupon bonds discounted at 8%
Present value of principal repayment ($500,000 × 0.45639a)
$228,195
a
Table 1, 20 periods at 4%
b. Selling price of zero coupon bonds discounted at 10%
Present value of principal repayment ($500,000 × 0.37689a)
$188,445
a
Table 1, 20 periods at 5%
M7-21 (15 minutes)
Transaction
Balance Sheet
Income Statement
Noncash
Retained Revenues – Expenses
Cash
Contrib.
+
= Liabilities +
+
Capital
Assets
Earnings
Asset
a. Purchases $300 of
inventory on credit
b. Sells $300 of
inventory on credit
for $420
c. Records $300 cost
of sales with
transaction b
d. $300 cash paid to
settle accounts
payable from a
e. $420 cash received
from accounts
receivable in b
+ 300
+ 300
Inventory
Accounts
Payable
+ 420
+ 420
+ 420
Accounts
Receivable
Retained
Earnings
Sales
- 300
- 300
– 300
Inventory
Retained
Earnings
Cost of
Goods Sold
- 300
- 300
Accounts
Payable
+ 420
- 420
Accounts
Receivable
©Cambridge Business Publishers, 2006
Solutions Manual, Module 7
7
M7-22 (30 minutes)
a.
Data Inputs into Excel
1/1/2005
1/1/2015
9.00%
8.00%
$100
2
1
Settlement date
Maturity date
Percent semiannual coupon
Percent yield
Redemption value
Frequency is semiannual (see above)
actual/actual basis
Price:
Percent of
Sale
Par
Proceeds
106.7951632 $533,975.82
b.
Period
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
Interest
21,359.03
21,313.39
21,265.93
21,216.57
21,165.23
21,111.84
21,056.31
20,998.56
20,938.51
20,876.05
20,811.09
20,743.53
20,673.27
20,600.21
20,524.21
20,445.18
20,362.99
20,277.51
20,188.61
20,096.15
Premium
Cash Paid Amortization
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
22,500.00
1,140.97
1,186.61
1,234.07
1,283.43
1,334.77
1,388.16
1,443.69
1,501.44
1,561.49
1,623.95
1,688.91
1,756.47
1,826.73
1,899.79
1,975.79
2,054.82
2,137.01
2,222.49
2,311.39
2,403.85
Premium
Balance
33,975.82
32,834.85
31,648.24
30,414.17
29,130.74
27,795.97
26,407.81
24,964.12
23,462.68
21,901.19
20,277.24
18,588.33
16,831.86
15,005.14
13,105.34
11,129.56
9,074.74
6,937.73
4,715.24
2,403.85
0.00
Carrying
Amount
533,975.82
532,834.85
531,648.24
530,414.17
529,130.74
527,795.97
526,407.81
524,964.12
523,462.68
521,901.19
520,277.24
518,588.33
516,831.86
515,005.14
513,105.34
511,129.56
509,074.74
506,937.73
504,715.24
502,403.85
500,000.00
©Cambridge Business Publishers, 2006
8
Financial Accounting for MBAs, 2nd Edition
EXERCISES
E7-23 (15 minutes)
a.
Total expected failures from units sold (69,000 × 0.02) ..........
Failures accounted for thus far .................................................
Total future failures expected ....................................................
Average cost per failure .............................................................
Total expected future warranty costs .......................................
Current warranty liability ............................................................
Additional warranty cost liability required ...............................
1,380
1,000
380
 $50
$19,000
$10,000
$ 9,000
The product warranty liability must be increased by $9,000 to cover the
additional expected repair costs. Additional warranty expense of $9,000 must
be recorded in the income statement when the liability account is increased.
b. The warranty liability should be equal, at all times, to the expected dollar
cost of repairs. Analysis issues relate to whether the warranty liability
exists and, if so, is it at the correct amount. Understating (overstating) the
accrual overstates (understates) current period income at the expense
(benefit) of future income.
E7-24 (20 minutes)
Number
1.
2.
3.
4.
Accounting Treatment
Neither record nor disclose (neither probably nor even reasonably
possible)
Record a current liability for the note, no liability for interest until
incurred
Disclose in a footnote (at least reasonably possible)
Record warranty liability on balance sheet and recognize expense
in income statement (costs are probable and reasonably
estimable).
E7-25 (15 minutes)
The company must accrue the $25,000 of wages that have been earned even
though these wages will not be paid until the first of next month. The
required accounting accrual will:
 increase wages payable by $25,000 on the balance sheet
 increase wages expense by $25,000 in the income statement
©Cambridge Business Publishers, 2006
Solutions Manual, Module 7
9
Failure to make this accounting accrual (called adjusting entry) would
understate liabilities, overstate income, and overstate stockholders’ equity.
©Cambridge Business Publishers, 2006
10
Financial Accounting for MBAs, 2nd Edition
E7-26 (25 minutes)
a.
Selling price of $300,000, 15-year, 10% semiannual bonds discounted at 8%:
Present value of principal repayment ($300,000 × 0.30832) ............. $ 92,496
Present value of interest payments ($15,000 × 17.29203) ................ 259,380
Selling price of bonds ........................................................................... $351,876
b.
Cash
Asset
(1)
Cash 351,876
Bond payable 300,000
Premium
51,876
Balance Sheet
Noncash
+
= Liabilities
Assets
351,876
Income Statement
Contrib. Retained Revenues - Expenses
+
+
capital
Earnings
351,876
Bond Payable, Net
Interest expense 14,075
Premium
925
Cash
15,000
Interest expense 14,038
Premium
962
Cash
15,000
(2)i
- 15,000
-14,075
- 925
Bond Payable, Net
(3)ii
- 15,000
Bond Interest
Expense
-14,038
- 962
-14,075
Bond Payable, Net
-14,038
Bond Interest
Expense
i
$300,000 x 0.10 x 6/12 = $15,000 cash payment; 0.04 x $351,876 = $14,075 interest
expense; the difference is the bond premium amortization, a reduction of the carrying
amount of the bond.
ii
0.04 x ($351,876  $925) = $14,038 interest expense. The difference between this amount
and the cash payment of $15,000 is the premium amortization, a reduction of the
carrying amount of the bond.
E7-27 (20 minutes)
Event
Cash
Asset
Balance Sheet
Income Statement
Noncash
Contrib. Retained Revenues Expenses
+
= Liabilities +
+
Assets
capital
Earnings
(a)
700,000
700,000
(b)1
-50,854
-8,854
-42,000
-42,000
(c)2
-50,854
-9,385
-41,469
-41,469
1
0.06 x $700,000 = $42,000 interest expense. The difference between interest expense and
the cash payment is the reduction of the principle amount of the loan
2
0.06 x ($700,000 - $8,854) = $41,469 interest expense. The difference between interest
expense and the cash payment is the reduction of the principle amount of the loan
©Cambridge Business Publishers, 2006
Solutions Manual, Module 7
11
E7-28 (15 minutes)
Selling price of bonds
Present value of principal repayment ($900,000 × 0.558)
Present value of interest payments ($45,000 × 7.360)
Selling price of bonds
$502,200
331,200
$833,400
E7-29 (15 minutes)
a. Bond rating companies typically utilize financial ratios that are designed
to measure liquidity and solvency. Liquidity is usually measured with
ratios like the current, quick and various operating cash flow to
liabilities ratios. Solvency is typically measured using financial leverage,
times interest earned and various cash flow to financial payments ratios.
b. As bond ratings are reduced (e.g., companies are viewed as increasingly
more risky concerning the probability of default and bankruptcy),
lenders require a higher rate of interest as compensation for the added
risk. At some point, the borrower will be considered to be of sufficiently
low quality that it is no longer considered to be of “investment grade,”
meaning that institutional investors are precluded from investing in
bonds issued by that company. At that point, the range of possible
buyers of its bonds is severely limited and the company may find it
increasingly difficult to access credit markets.
c. Generally, in order to improve its credit ratings, AT&T must improve its
liquidity and cash flow and/or reduce its debt payments (by reducing its
debt). All of these actions, while serving to improve its credit ratings,
entail certain costs that must also be considered. For example,
increasing liquidity by reducing inventories or foregoing capital
expenditures may impact sales and competitive position. Likewise,
reducing debt via the issuance of equity is costly since equity capital is
much more expensive (due to the subordinated position of equity
investors vis-à-vis creditors and the nondeductability of dividends for
tax purposes). AT&T must carefully weigh the benefits of increasing its
credit ratings against the costs entailed in such an action.
©Cambridge Business Publishers, 2006
12
Financial Accounting for MBAs, 2nd Edition
E7-30 (15 minutes)
Event
Balance Sheet
Cash
Asset
(a)
500,000
(b)1
-22,500
(c)2
-303,000
Noncash
+
Assets
Income Statement
Contrib.
Retained Revenues Expenses
= Liabilities +
+
capital
Earnings
500,000
-300,000
-22,500
-22,500
-3,000
-3,000
1
$500,000 x 0.09 x 1/2 = $22,500 interest expense. Since the bonds were sold at par, there
is no discount or premium amortization.
2
Cash required to retire $300,000 of bonds at 101 = $300,000 x 1.01 = $303,000. The
difference between the cash paid and the carrying amount of the bonds is the gain or
loss on the redemption. In this case, the loss is $3,000.
E7-31 (25 minutes)
Selling price of bonds
Present value of principal repayment ($250,000 × 0.41552)
Present value of interest payments ($10,000 × 11.68959)
Selling price of bonds
Event
$103,880
116,896
$220,776
Balance Sheet
Cash
Asset
Noncash
+
Assets
Income Statement
Contrib.
Retained Revenues Expenses
= Liabilities +
+
capital
Earnings
(1)i
220,776
220,776
(2)ii
-10,000
1,039
-11,039
-11,039
(3)iii
-10,000
1,091
-11,091
-11,091
i
The bond is reported at its sale price, which represents the par value of $250,000 less
the discount of $29,224.
ii
The cash paid is the face amount of the bond multiplied by the coupon rate ($250,000 ×
.04 = $10,000). The interest expense is the carrying amount of the bond multiplied by the
discount rate ($220,776 x .05 = $11,039). The difference between the two is the
amortization of the discount, which increases the carrying amount of the bond.
iii
The cash paid is the face amount of the bond multiplied by the coupon rate ($250,000 x
.04 = $10,000). The interest expense is the carrying amount of the bond multiplied by the
discount rate ([$220,776 + $1,039] x .05 = $11,091). The difference between the two is the
amortization of the discount, which increases the carrying amount of the bond.
©Cambridge Business Publishers, 2006
Solutions Manual, Module 7
13
E7-32 (25 minutes)
Selling price of bonds
Present value of principal repayment ($800,000 × 0.20829)
Present value of interest payments ($36,000 × 19.79277)
Selling price of bonds
Event
$166,632
712,540
$879,172
Balance Sheet
Cash
Asset
Noncash
+
Assets
Income Statement
Contrib.
Retained Revenues Expenses
= Liabilities +
+
capital
Earnings
(1)i
879,172
879,172
(2)ii
-36,000
-833
-35,167
-35,167
(3)iii
-36,000
-866
-35,134
-35,134
i
The bond is reported at its sale price, which represents the par value of $800,000 plus
the premium of $79,172.
ii
The cash paid is the face amount of the bond multiplied by the coupon rate ($800,000 x
.045 = $36,000). The interest expense is the carrying amount of the bond multiplied by
the discount rate ($879,172 x .04 = $35,167). The difference between the two is the
amortization of the premium, which decreases the carrying amount of the bond.
iii
The cash paid is the face amount of the bond multiplied by the coupon rate ($800,000
x .045 = $36,000). The interest expense is the carrying amount of the bond multiplied
by the discount rate ([$879,171 - $833] x .04 = $35,134). The difference between the two
is the amortization of the premium, which decreases the carrying amount of the bond.
E7-33 (30 minutes)
a. There is an inverse relation between interest rates and bond prices (just
look at the increasing discount rates as the yield increases in present
value tables). Since the bonds now trade at a premium and assuming
that Abbott Labs’ credit ratings have not changed, we can conclude that
interest rates have fallen since the bonds were issued.
b. No, once the bond is initially recorded, neither the coupon rate nor the
yield used to compute interest expense is changed. Bonds are recorded
at historical cost (like all other balance sheet assets and liabilities,
except marketable securities acquired as passive investments). As a
result, changes in the general level of interest rates have no effect on
the interest expense (or the interest payments) that are reflected in the
financial statements.
©Cambridge Business Publishers, 2006
14
Financial Accounting for MBAs, 2nd Edition
c. Since the bonds trade at a premium in the market, Abbott Labs would be
paying more to retire the bonds than they are carried on its balance
sheet. This would result in a loss on the repurchase that would lower
current profitability.
d. The face amount of the bonds will be paid at maturity. As a result, since
this is the only cash flow that the holders of the bonds will receive, the
market price of the bonds must also equal their face amount at that time.
E7-34A (30 minutes)
a. 1. $90,000 × 0.46319 = $41,687
2. $90,000 × 0.45639 = $41,075
b. $1,000 × 5.33493
=
$5,335
c. $600 × 17.29203
= $10,375
d. $500,000 × 0.38554
= $192,770
E7-35 (25 minutes)
Selling price of bonds
Present value of principal repayment ($600,000 × 0.09722)
Present value of interest payments ($33,000 × 15.04630)
Selling price of bonds
Event
$ 58,332
496,528
$554,860
Balance Sheet
Cash
Asset
Noncash
+
Assets
Income Statement
Contrib.
Retained Revenues Expenses
= Liabilities +
+
capital
Earnings
(1)i
554,860
554,860
(2)ii
-33,000
292
-33,292
-33,292
(3)iii
-33,000
309
-33,309
-33,309
i
The bond is reported at its sale price, which represents the par value of $600,000 less
the discount of $45,140.
ii
The cash paid is the face amount of the bond multiplied by the coupon rate ($600,000 ×
.055 = $33,000). The interest expense is the carrying amount of the bond multiplied by
©Cambridge Business Publishers, 2006
Solutions Manual, Module 7
15
the discount rate ($554,860 × .06 = $33,292. The difference between the two is the
amortization of the discount, which increases the carrying amount of the bond.
iii
The cash paid is the face amount of the bond multiplied by the coupon rate ($600,000 ×
.055 = $33,000). The interest expense is the carrying amount of the bond multiplied by
the discount rate ([$554,860 + $292] × .06 = $33,309). The difference between the two is
the amortization of the discount, which increases the carrying amount of the bond.
E7-36 (25 minutes)
Selling price of bonds
Present value of principal repayment ($400,000 × 0.61391) .............
Present value of interest payments ($26,000 × 7.72173) ..................
Selling price of bonds ...........................................................................
Event
Balance Sheet
Cash
Asset
(1)i
$245,564
200,765
$446,329
Noncash
+
Assets
446,329
Income Statement
Contrib.
Retained Revenues Expenses
= Liabilities +
+
capital
Earnings
446,329
Bond Payable, Net
(2)ii
- 26,000
- 3,684
-22,316
Bond Payable, Net
(3)iii
- 26,000
- 3,868
Bond Payable, Net
-22,316
Bond Interest
Expense
-22,132
-22,132
Bond Interest
Expense
1 2
The bond is reported at its sale price, which represents the par value of $400,000 plus
the premium of $46,329.
2
The cash paid is the face amount of the bond multiplied by the coupon rate ($400,000 ×
.065 = $26,000). The interest expense is the carrying amount of the bond multiplied by
the discount rate ($446,329 × .05 = $22,316). The difference between the two is the
amortization of the premium, which decreases the carrying amount of the bond.
3
The cash paid is the face amount of the bond multiplied by the coupon rate ($400,000 ×
.065 = $26,000). The interest expense is the carrying amount of the bond multiplied by
the discount rate ([$446,329 - $3,684] × .05 = $22,132). The difference between the two
is the amortization of the premium, which decreases the carrying amount of the bond.
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
PROBLEMS
P7-37 (15 minutes)
a. There is an inverse relation between bond price and effective yield. All
of Lockheed’s bonds are selling at a substantial premium (119.002% to
137.654% of par). These premia will cause the effective yields to be less
than the coupon rates if purchased at these prices.
b. Yes, at the maturity increases from 2009 to 2029, the yield increases
from 3.976% to 5.666%. There is generally an increasing yield as the
maturity of the bond lengthens.
P7-38 (15 minutes)
a. CVS reports interest expense of $53.9 million on average long-term debt
of 1,094.7 million ([$1,076.3 million + $1,113.1 million]/2) for an average
rate of 4.9%.
b. CVS reports coupon rates of 3.875% to 8.52% (the latter is on $163.2
million vs. $300 million for the lower rates). So, the average rate seems
reasonable given the information disclosed in the long-term debt
footnote.
c. Interest paid can differ from interest expense if the bonds are sold at a
premium or a discount.
P7-39 (50 minutes)
a. Net income is $142 million. Transitory items in the income statement
follow ($ millions):
1. Merger integration costs .............................................................. $ 54
2. Restructuring and other charges.................................................
949
3. Reversals of reserves no longer required ..................................
(34)
4. Impairment losses on businesses to be sold .............................
541
5. Net gain on sales of investments and businesses, net .............
(315)
b. Major components of the $969 million charge for 2000 are ($ millions)
1. Merger-related expenses .............................................................. $ 54
2. Asset shutdowns of excess capacity and cost reduction ........
824
3. Masonite legal reserves ................................................................
125
4. Reversals of reserves no longer required ..................................
(34)
Total ................................................................................................ $ 969
©Cambridge Business Publishers, 2006
Solutions Manual, Module 7
17
P7-39—concluded
c.
Total
Second quarter.............$ 71
Fourth quarter .............. 753
Total ..............................$824
Asset write-downs Severance charges
$ 40
$ 31
536
217
$576
$248
d. Additional Masonite legal reserves of $125 million (pre-tax).
e. Write-down of the book value of investment in subsidiary companies.
f. This item means that IP had created a reserve over one or more prior years
that created a liability on its balance sheet and reduced its income and
equity by the same amount. IP’s current disclosure indicates that its
previous accrual(s) was over-stated and should now be reversed. The
reversal reduces the liability on the balance sheet and increases income
and equity by the amount of that reversal.
g. Accruals are adjustments to the balance sheet that do not impact current cash
flows, but do relate to a future inflow or outflow of cash. For example,
restructuring accruals are usually comprised of (i) write-offs of some or all of
the carrying amount of an asset (e.g., inventories, plant assets, goodwill), and
(ii) liabilities for costs relating to the future severance of employees. Typically,
only the severance portion of the expense is related to a future cash outflow.
Specifically, the asset write-down indicates reduced cash flow expectations
relating to the asset and the severance accrual is usually paid in cash within a
year after the liability is created. Consequently, accruals are useful to
investors in assessing current company performance and in predicting future
performance.
GAAP requires companies to faithfully represent their financial condition—not
to be overly conservative in the estimation of accruals, nor to underestimate
them so as to boost current income. To be sure, estimation of future cash
flows is subject to error, and the flexibility afforded companies under GAAP to
conduct this estimation process creates the opportunity to misrepresent
income. In general, however, accruals have proved to be a reliable predictor of
future cash flows and are recognized as such by the market in the pricing of
securities.
Analysts must be aware of the potential for abuse in the accrual process and
must critically assess their reasonableness. For example, anecdotal evidence
suggests that companies tend to group accruals into one year, known as the
“big bath,” in order to establish “reserves” on the balance sheet which can be
used in later periods to increase earnings. The net effect of this process is to
shift earnings from the current period into one or more future periods. The
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
grouping of accruals into a single period, especially if accompanied by a
change in senior management, should be critically evaluated and scrutinized.
©Cambridge Business Publishers, 2006
Solutions Manual, Module 7
19
P7-40 (50 minutes)
a. The total face amount is $1,696,248,000. The unamortized discount at
year-end 2002 is $13,013,000, resulting in a net amount of $1,683,235,000
reported on Southwest’s balance sheet (specifically, $130,454,000 as a
current liability and the remainder as a long-term liability).
The scheduled maturities of this indebtedness are: $130 million in 2003,
$207 million in 2004, $142 million in 2005, $542 million in 2006, $114
million in 2007, and $561 million thereafter.
Analysts monitor these scheduled maturities to look for excessive
amounts coming due in any one year that might present a cash flow
problem if the indebtedness cannot be refinanced.
b. The remaining portion could be the amortization of the discount. Interest
expense is equal to cash paid plus discount amortization (or less
premium amortization). Note that Southwest Airlines’ footnote only
reports the net discount—meaning that actual gross discounts and
premium are much higher with varying amortization periods.
c. Credit rating companies look for the amount of indebtedness in relation
to the operating cash flow and asset size of the company. This is
because cash flow is the primary source of repayment of the bonds and
assets serve as a secondary source (collateral) in the event of default.
We would also look at the usual profitability ratios, especially for longterm debt, and the usual ratios for long-term credit worthiness.
d. The market value of these notes’ is $385,000,000 × 1.11631 =
$429,779,350.
The difference between the current trading price of $429,779,350 and its
face amount is $44,779,350. Yet we know that notes are reported at
historical cost (face value – unamortized discount or + unamortized
premium). The current market value of the notes is, therefore, not
reflected in the balance sheet.
If Southwest would repurchase these notes, the difference would be
reported as a loss in its income statement. This is because it would pay
more than the notes’ carrying value on the balance sheet to retire them.
Since the notes have risen in value subsequent to their issuance, the
general level of interest rates have declined. (Another possibility is that
Southwest’s credit rating has improved while the general interest rate
has not.)
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition