Solution manual intermediate accounting 15e by stice ch10

Chapter 10 187 CHAPTER 10 QUESTIONS The major components included in the FASB’s definition of liabilities are as follows: (a) A liability is a result of past transactions or events (b) A liability involves a probable future transfer of assets or services (c) A liability is the obligation of a particular entity All of these components should be present before a liability is recorded In addition, the amount of the liability must be measurable in order to report it on the balance sheet a An executory contract is one in which performance by both parties is still in the future Only an exchange of promises is made at the initiation of the contract Common examples include labor contracts and purchase orders b The definition of liability states in part that a liability should be the result of a past transaction or event Similar concepts in previous definitions used by accounting bodies have excluded executory contracts from inclusion as liabilities However, the accounting methods currently accepted for leases, for example, essentially recognize liabilities before performance by either party to the lease contract Thus, the FASB apparently does not feel that its definition excludes the possibility of recording executory contracts as liabilities Current liabilities are claims arising from operations that must be satisfied with current assets within operating cycle or within year, whichever is longer Nonoperating cycle claims are classified as current if they must be paid within year from the balance sheet date Noncurrent liabilities are liabilities whose liquidation will not require the use of current assets to satisfy the obligation within year Generally, liabilities should be reported at their net present values rather than at the amounts that eventually will be paid The use of money involves a cost in the form of interest that should be recognized whether or not such cost is expressly stated under the terms of the debt agreement A debt of $10,000 due years from now has a present value less than $10,000, unless interest is charged on the $10,000 at a reasonable rate Some companies include short-term borrowing as a permanent aspect of their overall financing mix In such a case, the company often intends to renew, or roll over, its short-term loans as they become due As a result, a short-term loan can take on the nature of a long-term debt because, with the refinancing, the cash payment to satisfy the loan is deferred into the future As of the date the financial statements are issued, if a company has either already done the refinancing or has a firm agreement with a lender to refinance a short-term loan, the loan is classified in the balance sheet as a longterm liability A line of credit is a negotiated arrangement with a lender in which the terms are agreed to prior to the need for borrowing When a company finds itself in need of money, an established line of credit allows the company access to funds immediately without having to go through the credit approval process In reporting long-term debt obligations, the emphasis is on reporting what the real economic value of the obligation is today, not what the total debt payments will be in the future The sum of the future cash payments to be made on a long-term debt is not a good measure of the actual economic obligation Because the cash outflows associated with a long-term liability extend far into the future, presentvalue concepts must be used to properly value the liability 188 Chapter 10 For each payment, a portion is interest and the remainder is applied to reduce the principal To compute the amount attributable to principal, the outstanding loan balance is multiplied by the monthly interest rate The result is the interest portion of the payment Subtracting this amount from the total payment gives the amount applied to reduce the principal a Secured bonds have specific assets pledged as security for the issue Unsecured bonds, frequently referred to as debenture bonds, are not protected by the pledge or mortgage of specific assets b Collateral trust bonds are secured by stocks and bonds owned by the borrowing corporation There is no specific pledge of property in the case of debenture bonds, the issue being secured only by the general credit of the company c Convertible bonds may be exchanged at the option of the bondholder for other securities of the corporation in accordance with the provisions of the bond contract Callable bonds may be redeemed by the issuing company before maturity at a specified price d Coupon bonds are not recorded in the name of the owner, and title passes with delivery of the bond Interest is paid by having the bondholder clip the coupons attached to the bonds and present these for payment on the interest dates Registered bonds call for the registry of the bondholder’s name on the books of the corporation Transfer of title to these bonds is accomplished by surrender of the old bond certificates to the transfer agent, who records the change in ownership and issues new certificates to the buyer Interest checks are periodically prepared and mailed to the holders of record e Municipal bonds are issued by governmental units, including state, county, and local entities The proceeds are used to finance expenditures such as school construction, utility lines, and road construction The bonds normally sell at lower interest rates than other f bonds because of the favorable tax treatment given to the holders of the bonds for the interest received Because the interest revenue is not taxed by the federal government, these bonds are frequently referred to as tax-exempt securities Corporate bonds are issued by corporations as a means of financing their long-term needs Corporations usually have a choice of raising long-term capital through issuing bonds or stock Bonds have a fixed interest rate while stock pays its return through declared dividends The holders of corporate bonds must pay federal income taxes on interest revenue received Term bonds mature as a lump sum on a single date Serial bonds mature in installments on various dates 10 The market rate of interest is the rate prevailing in the market at the moment The stated rate of interest is the rate printed on the face of the bonds This is also known as the contract rate The effective or yield rate of interest is the same as the market rate at date of issuance (purchase) and is the actual return on the purchase price received by the investor and incurred by the issuer The market rate fluctuates during the life of the bonds in accordance with economywide changes in expectations about future inflation and with the changing financial condition of the company; the stated rate remains the same Although the effective rate remains the same for the individual bond investor or the borrowing corporation over the life of the issue, this rate will vary from one bondholder to another when the securities are acquired at different times and prices 11 APB Opinion No 21 recommends the use of the effective-interest method of amortization for bond premiums and discounts Because the effective-interest method adjusts the stated interest rate to the effective rate, it is theoretically more accurate than the straight-line method It was therefore designated by the APB as the preferred method of amortization The straight-line method may be used if the interim results of using it not differ materially from the resulting amortization Chapter 10 using the effective-interest method The total amortization will, of course, be the same under either method over the life of the bond 189 12 Three ways bonds may be retired prior to maturity are as follows: (a) Bonds may be redeemed by purchasing them on the open market or by exercising the call provision if included in the bond indenture (b) Bonds may be converted or exchanged for other securities (c) Bonds may be refinanced (sometimes called refunded) with the use of proceeds from the sale of a new issue Normally, with the early extinguishment of a debt, a gain or loss must be recognized for the difference between the carrying value of the debt security and the amount paid Before FASB Statement No 145, this gain or loss would have been labeled as an early extinguishment of debt and reported as an extraordinary item on the income statement Now it is typically reported as an ordinary item 13 Callable bonds serve the issuer’s interests because the callability feature enables the issuing corporation to reduce its outstanding indebtedness at any time that it may be convenient or profitable to so 14 Convertible debt securities generally have the following features: (a) An interest rate lower than the issuer could establish for nonconvertible debt (b) An initial conversion price higher than the market value of the common stock at time of issuance (c) A call option retained by the issuer These securities raise many questions as to the nature of the securities Examples of these questions include whether they should be considered debt or equity securities, the valuation of the conversion feature, and the treatment of any gain or loss on conversion 15 Under IFRS 32, the issuance proceeds are allocated between debt and equity for all convertible debt issues Under U.S GAAP, this allocation is done only when the conversion feature is detachable 16 Convertible bonds are securities that may be viewed either as primarily debt or primarily equity If they are viewed as debt, the conversion from debt to equity could be considered a significant economic event for which any difference between current market price for the securities and 190 Chapter 10 their carrying value should be recognized as a gain or loss For the investor, this could be viewed as the exchange of nonmonetary assets For the issuer, this could be viewed as creating a significant difference in the type of ownership being assumed On the other hand, if the convertible bonds are considered as primarily equity securities whose market is responsive to the price of common stock, the exchange of one equity security for another could be considered as not a significant exchange, and under the historical cost concept, it should not give rise to any gain or loss 17 Bond refinancing or refunding means issuing new bonds and applying the proceeds to the retirement of outstanding bonds This may occur either at the maturity of the old bonds or whenever it may be advantageous to retire old bonds by issuing new bonds with a lower interest rate, a more favorable bond contract, or some other benefit 18 Avoiding the inclusion of debt on the balance sheet through the use of offbalance-sheet financing may allow a company to borrow more than otherwise possible due to debt-limit restrictions Also, a strong appearance of a company’s financial position usually enables it to borrow at a lower cost Another possible reason is that companies wish to understate liabilities because inflation has, in effect, understated its assets One of the main problems with offbalance-sheet financing is that many investors and lenders aren’t able to see through the off-balance-sheet borrowing tactics and thereby make ill-informed decisions There is also concern that as these methods of financing gain popularity, the amount of total corporate debt is reaching unhealthy proportions 19 If a special-purpose entity (SPE) is carefully designed, it can be accounted for as an independent company, and any debt that it incurs will not be reported in the balance sheet of its sponsor 20 Companies will, on occasion, join forces with other companies to share the costs and benefits associated with specifically defined projects These joint ventures are often developed to share the risks associated with high-risk projects Because the benefits of these joint ventures are uncertain, companies have the possibility of incurring substantial liabilities with few, if any, assets resulting from their efforts As a result, as is the case with unconsolidated subsidiaries, a joint venture is carefully structured to ensure that the liabilities of the joint venture are not disclosed in the balance sheets of the companies in the partnership Often, both joint venture partners account for the joint venture using the equity method; that is, the liabilities of the joint venture are not included in the balance sheets of the partners 21 ‡Troubled debt restructuring occurs when the investor (creditor) is willing to make significant concessions as to the return from the investment in order to avoid making settlement under adverse conditions, such as bankruptcy This means that if the restructuring involves a significant transaction, the investors (creditors) will almost always report a loss unless they have previously anticipated the loss and have reduced the investment to a value lower than the amount finally determined in the settlement The issuer will report a gain if the restructuring involves a significant transaction ‡ Relates to Expanded Material 22.‡ a A bond restructuring involving an asset swap usually results in a recognition of a loss on the investor’s books and a gain on the issuer’s books The market value of the assets swapped usually determines the amount of gain or loss to be recognized Only if the market value of the retired debt is more clearly determinable would such a value be used b A bond restructuring involving an equity swap similarly results in recognition of gains or losses because the market value of the equity exchanged for the debt is used to record the transaction If the market value of the debt is more clearly Chapter 10 determinable than the market value of the equity, the value of the debt would be used c A bond restructuring involving a modification of terms does not result in recognition of a gain or loss unless the total amount of future cash to be paid, principal plus interest, is less than the 191 carrying value of the debt In that case, the difference between the future cash and the carrying value is recognized as a gain or loss Under this condition, future cash payments are charged to the liability account on the issuer’s books PRACTICE EXERCISES PRACTICE 101 Current assets: Current liabilities: WORKING CAPITAL AND CURRENT RATIO Cash Accounts receivable Total $ 400 1,750 $2,150 Accounts payable Accrued wages payable Deferred sales revenue Bonds payable (to be repaid in months) Total $1,100 250 900 1,000 $3,250 Working capital = Current assets – Current liabilities = $2,150 – $3,250 = ($1,100) Current ratio = Current assets/Current liabilities = $2,150/$3,250 = 0.66 PRACTICE 102 SHORT-TERM OBLIGATIONS EXPECTED TO BE REFINANCED Loan A Loan B Loan C Total PRACTICE 103 Current Liabilities $10,000 15,000 2,500 $27,500 TOTAL COST OF LINE OF CREDIT Credit line commitment fee: $100,000  0.0008  (12/12) = $80 Interest: $70,000  0.064  (8/12) = $2,987 $2,987 + $80 = $3,067 PRACTICE 104 COMPUTATION OF MONTHLY PAYMENTS Business Calculator Keystrokes: PV = $300,000  (1 – 0.10) = $270,000 N = 30 years  12 = 360 I = 7.5/12 = 0.625 FV = (there is no balloon payment associated with the mortgage) PMT = $1,887.88 Noncurrent Liabilities $ 0 17,500 $17,500 PRACTICE 105 PRESENT VALUE OF FUTURE PAYMENTS PMT = $1,887.88 (see the solution to Practice 104) Business Calculator Keystrokes: N = 30 years  12 = 360 – 12 payments made = 348 payments remaining I = 7.5/12 = 0.625 PMT = $1,887.88 FV = (no balloon payment is associated with the mortgage) PV = $267,511 PRACTICE 106 MARKET PRICE OF A BOND N = 20 years  = 40 I = 14/2 = PMT = $1,000  0.10  (1/2) = $50 FV = $1,000 (the face value is paid at the end of 20 years) PV = $733.37 PRACTICE 107 MARKET PRICE OF A BOND N = 10 years  = 20 I = 8/2 = PMT = $1,000  0.13  (1/2) = $65 FV = $1,000 (the face value is paid at the end of 10 years) PV = $1,339.76 PRACTICE 108 ACCOUNTING FOR ISSUANCE OF BONDS Cash 1,030 Premium on Bonds Payable Bonds Payable PRACTICE 109 30 1,000 ACCOUNTING FOR ISSUANCE OF BONDS Cash Discount on Bonds Payable Bonds Payable 920 80 1,000 PRACTICE 1010 BOND ISSUANCE BETWEEN INTEREST DATES Cash 100,750 Bonds Payable Interest Payable [$100,000  0.09  (1/12)] 100,000 750 194 Chapter 10 PRACTICE 1011 STRAIGHT-LINE AMORTIZATION June 30 Interest Expense Discount on Bonds Payable Cash [$100,000  0.08  (6/12)] 4,512.40 512.40 4,000.00 Discount on Bonds Payable = ($100,000  $84,628)/30 = $512.40 December 31 Interest Expense Discount on Bonds Payable Cash [$100,000  0.08  (6/12)] 4,512.40 512.40 4,000.00 PRACTICE 1012 EFFECTIVE-INTEREST AMORTIZATION June 30 Interest Expense ($84,628  0.05) Discount on Bonds Payable Cash [$100,000  0.08  (6/12)] 4,231.40 231.40 4,000.00 Remaining carrying value of bond: $84,628.00 + $231.40 = $84,859.40 December 31 Interest Expense ($84,859.40  0.05) Discount on Bonds Payable Cash [$100,000  0.08  (6/12)] 4,242.97 242.97 4,000.00 Remaining carrying value of bond: $84,859.40 + $242.97 = $85,102.37 PRACTICE 1013 BOND PREMIUMS AND DISCOUNTS ON THE CASH FLOW STATEMENT Sales Interest expense Net income Income Statement $42,000 Adjustments Subtract Amortization of Bond Premium (4,650) $37,350 (350) Direct Method: Cash collected from customers Cash paid for interest Net cash flow from operating activities $42,000 (5,000) $37,000 Indirect Method: Net income Less: Amortization of bond premium Net cash flow from operating activities $37,350 (350) $37,000 Statement of Cash Flows $42,000 (5,000) $37,000 PRACTICE 1014 MARKET REDEMPTION OF BONDS Bonds Payable Loss on Bond Redemption Discount on Bonds Payable Cash 100,000 4,700 Bonds Payable Premium on Bonds Payable Loss on Bond Redemption Cash 100,000 2,000 700 2,000 102,700 102,700 PRACTICE 1015 ACCOUNTING FOR ISSUANCE OF CONVERTIBLE BONDS If the conversion feature is accounted for separately, the journal entry is as follows: Cash Discount on Bonds Payable Bonds Payable Paid-In Capital from Conversion Feature 107,000 2,000 100,000 9,000 If the conversion feature is not accounted for separately, the journal entry is as follows: Cash 107,000 Premium on Bonds Payable Bonds Payable 7,000 100,000 PRACTICE 1016 ACCOUNTING FOR CONVERSION OF CONVERTIBLE BONDS Bonds Payable Loss on Bond Conversion Discount on Bonds Payable Common Stock, $1 par Paid-In Capital in Excess of Par 100,000 11,500 Paid-in capital in excess of par = ($55  $1 par)  2,000 = $108,000 PRACTICE 1017 DEBT-TO-EQUITY RATIO “Debt” = All liabilities Debt-to-equity ratio = $120,000/$90,000 = 1.33 “Debt” = All interest-bearing debt Debt-to-equity ratio = ($10,000 + $70,000)/$90,000 = 0.89 “Debt” = Long-term, interest-bearing debt Debt-to-equity ratio = $70,000/$90,000 = 0.78 PRACTICE 1018 TIMES INTEREST EARNED RATIO 1,500 2,000 108,000 196 Chapter 10 Times interest earned ratio = Earnings before interest and taxes/Interest expense = ($12,000 + $7,500)/$7,500 = 2.60 PRACTICE 1019 DEBT RESTRUCTURING: ASSET SWAP Bonds Payable Premium on Bonds Payable Interest Payable Land Gain on Disposal of Land Gain on Debt Restructuring 100,000 3,000 6,000 64,000 26,000 19,000 PRACTICE 1020 DEBT RESTRUCTURING: EQUITY SWAP Bonds Payable 100,000 Interest Payable 5,000 Discount on Bonds Payable 4,000 Common Stock at Par (10,000 shares  $1) 10,000 Paid-In Capital in Excess of Par ($90,000  $10,000) Gain on Debt Restructuring 11,000 80,000 PRACTICE 1021 DEBT RESTRUCTURING: SUBSTANTIAL MODIFICATION Undiscounted sum of payments to be made: Maturity value Annual interest payments (5  $800) Total $5,000 4,000 $9,000 Because this $9,000 amount is less than the carrying value of $10,800 ($10,000 + $800 in accrued interest), the loan modification is classified as “substantial,” and the following journal entry is made: Interest Payable Loan Payable Gain on Restructuring of Debt Restructured Debt 800 10,000 1,800 9,000 Next year’s interest expense: $0 The implicit interest rate on the loan is now 0% because the terms were modified substantially, necessitating a reduction in carrying value In a case such as this, there is no interest expense in subsequent years, only a reduction in principal as the loan carrying value is reduced 10–58.‡ 2003 Dec 31 Equipment Gain on Sale of Equipment To write up equipment in preparation for debt restructuring Notes Payable Interest Payable Accumulated Depreciation—Equipment Equipment Notes Receivable Gain on Restructuring of Debt To record settlement of debt with Barboza 2003 Dec 31 Notes Payable Cash To record payment to Janeiro 2004 Dec 31 Interest Expense Interest Payable To record accrual of interest owed to Janeiro 2005 Dec 31 Interest Expense Interest Payable Notes Payable Cash To record payment to Janeiro 20,000 20,000 300,000 60,000 40,000 100,000 250,000 50,000 100,000 100,000 12,000* 12,000 12,360* 12,000 400,000 424,360 *Imputed interest rate: $424,360  PVF = $400,000 (rounded); PVF = 0.9426 from Table ll, Appendix B; Interest Rate = 3% (n = 2) or with a business calculator: PV = ($400,000); N = 2; FV = $424,360  I = 3.00% Date Payment † 12/31/03 12/31/03 $100,000 12/31/04 — 12/31/05 424,360 † Before restructuring ‡ Relates to Expanded Material 3% Interest Principal — $12,000 12,360 $100,000 — 412,000 Balance $500,000 400,000 412,000 240 Chapter 10 10–59.‡ Total payment under original terms: Principal due in years $6,000,000 Interest at 11% for years ($6,000,000  0.11  5) 3,300,000 $9,300,000 Total payment under revised terms: Principal due in years $5,525,000 Interest at 8% for years ($5,525,000  0.08  5) 2,210,000 7,735,000 Difference in cash payments $1,565,000 2004 Dec 31 Interest Expense ($6,000,000  0.11  6/12) 330,000 Interest Payable 660,000 Cash 990,000 To record payment of interest Notes Payable 6,000,000 Restructured Debt 6,000,000 To reclassify debt No loss recognized because total payments exceed carrying value of debt 2005 June 30 Interest Expense ($6,000,000  0.06  6/12) Restructured Debt ($221,000 – $180,000) Cash ($5,525,000  0.08  6/12) First semiannual interest payment after restructuring Dec 31 Interest Expense Restructured Debt ($221,000 – $178,770) Cash Second semiannual interest payment after restructuring *($6,000,000 – $41,000)  0.06  6/12 = $178,770 180,000 41,000 221,000 178,770* 42,230 221,000 Note: The implicit interest rate of 6% can be computed as follows: PV = –$6,000,000 (carrying amount of the loan is unchanged because all interest is paid up under the old terms) PMT = $221,000 ($5,525,000 × 0.08 × 6/12) FV = $5,525,000 ($6,000,000 – $475,000) N= 10 (five years remaining; semiannual interest payments) I = ???; the solution is 2.99% The semiannual implicit interest rate is 2.99%, so the annual equivalent is approximately 6% DISCUSSION CASES Discussion Case 10–60 Both leases and pro athletes’ contracts involve the probable future sacrifice of economic benefit by the owner of the team The differences between the two events relate to certainty and measurement, which in turn are dependent on the specific terms of the leases or contracts It is possible that a player may not fulfill contractual obligations due for poor performance or other reasons Thus, a player’s contract might be considered a less-than-probable liability and thereby not require disclosure Regarding measurement, it is generally more difficult to measure the future benefit to be provided by an individual than to measure the benefit provided by a building The future benefit to be provided by a leased building remains relatively constant while the benefit from an individual player can vary a great deal Investors and creditors would prefer more information to less If sports franchises are locked into longterm player contracts, investors and creditors would want that information disclosed as it would affect their assessment of future cash flows of the organization Discussion Case 10–61 Critics of the FASB for not requiring discounting of all future obligations argue that the time value of money concept is appropriate for all long-term liabilities These critics argue that the time value of money is especially important in relation to deferred taxes because of the uncertainty associated with future payment of those taxes Why the FASB requires discounting with some long-term liabilities but not with others is unclear If liabilities must be retired with future dollars, then the use of discounting seems appropriate The FASB is currently studying this matter Discussion Case 10–62 a Reclassification of the note payable is permitted only if one of the following conditions is met: (1) the refinancing must actually take place during the period between year-end and the date the balance sheet is issued or (2) a definite agreement for refinancing is reached prior to issuance of the balance sheet It is not enough to indicate that such refinancing will probably take place b Compensated absences must be accrued wherever possible, even though estimates are required Class discussion could include exploration of how estimates might be made when the variables mentioned by the controller are present It is not necessary that specific employees be identified for the liability Overall averages may be used to help compute an amount to be recorded Discussion Case 10–63 This case allows for general discussion of the issues involved in accounting for bonds The primary issues are as follows: (1) Accounting for the issuance price The discussion here might note that issuers generally record a discount or a premium as a contra or adjunct account to Bonds Payable, while investors generally record bond investments at cost (with no contra or adjunct account involved) The discount or premium involved is an adjustment of the stated rate of interest to the effective or yield rate of interest The reason Startup received less than $100,000 upon sale of the bonds is that investors demanded a yield of 12% rather than the 10% stated rate The amount of the discount can be computed as follows: PV of $100,000 at 6% for periods [$100,000  0.5919 (Table ll, Appendix B)] $59,190 PV of $5,000 annuity at 6% for periods [$5,000  6.8017 (Table IV, Appendix B)] 34,009 Issuance price $93,199 Discount = Face – Issuance Price = $100,000 – $93,199 = $6,801 or with a business calculator: FV = $100,000; N = 9; I = 6%  PV = $59,190 242 Chapter 10 or with a business calculator: PMT = $5,000; N = 9; I = 6%  PV = $34,008 The discount will be amortized over the life of the bonds and effectively increases the amount of interest expense for Startup from the stated 10% to the effective rate of interest of 12% It should also be noted that if bonds are sold between interest dates, the issuer will require the purchaser to pay the bond price plus accrued interest The accrued interest will be paid back at the first interest payment date In this case, the bonds were sold on an interest payment date (2) Accounting for the applicable interest expense during the life of the bonds Here the discussion should contrast the straight-line method of amortizing discount or premium with the effectiveinterest method The effective-interest method is the more theoretically correct method and is generally required by GAAP Using the effective-interest method, the journal entries for 2004 to record the bonds issued by Startup would be as follows: July Cash Discount on Bonds Payable Bonds Payable 93,199 6,801 Dec 31 Bond Interest Expense Discount on Bonds Payable Interest Payable 100,000 5,592* 592 5,000 *$93,199  0.12  6/12 = $5,592 (3) Accounting for the eventual retirement of the bonds It should be noted that if the bonds are held to maturity, any discount or premium will have been amortized totally Only the bonds payable will need to be removed from the books by paying the face value of the bonds in cash If the bonds are retired early, any unamortized discount or premium must be written off as well as the bonds payable, and the difference between the cash paid to retire the bonds and the carrying value of the bonds must be recorded as a gain or loss on retirement Assuming early retirement of the Startup Company bonds on July 1, 2006, after paying the interest due on July 1, 2006, and assuming use of straight-line amortization, the loss on retirement would be computed as follows: Cash paid at retirement ($100,000  1.02) Carrying value of bonds at 7/1/06: Bonds payable Less: Unamortized discount Loss on retirement $102,000 $100,000 3,778* 96,222 $ 5,778 *$6,801 ÷ 54 months = $125.94/mo amortization  30 months left to maturity = $3,778 (rounded) The retirement entry would be Bonds Payable Loss on Early Retirement of Bonds Discount on Bonds Payable Cash 100,000 5,778 3,778 102,000 Discussion Case 10–64 There is such a high yield on disaster bonds because of the high risk involved and the difficulty in gathering information to reduce that risk As one large corporate bond investment manager put it, “We’d have to become experts in meteorology.” Anyone who has watched the evening news for tomorrow’s weather knows how difficult it is to predict the elements Discussion Case 10–65 This case centers on the nature of convertible securities Biggs, the company accountant, assumes that the conversion is not a significant economic transaction that establishes new values Under the historical cost system, no entries are made for value changes unless a significant transaction occurs Biggs’ position assumes that when the convertible debentures were issued, the potential for conversion was included in the transfer price Thus, the proceeds could be regarded as consideration received for the stock Because the debenture and the conversion privilege are inseparably linked into one document, no separation can be made between the debt and equity portions of the security at the time of issuance When conversion occurs, the same historical cost transfer price is used to record the conversion from debt to equity No gain or loss can be recorded, so the argument goes, because there is no pure debt “cost” figure to compare with the current market price Robinson’s position assumes that a significant economic transaction has occurred and that the market value of the equity given up should govern the value used for the conversion Because 8,000 shares of common stock are issued in the conversion, the total market value of the stock would be $112,000 (8,000  $14), and the entry would be: Loss on Conversion of Bonds Bonds Payable Discount on Bonds Payable Common Stock Paid-ln Capital in Excess of Par 14,500 100,000 2,500 8,000 104,000 This position can be defended as being in accordance with the substance of APB Opinion No 29, “Accounting for Nonmonetary Exchanges.” No reference is made in the opinion to convertible bonds; however, the opinion does specify that market values should be used to value the majority of exchanges Because market values are available in this case, the equity could be reported at that value and a loss recognized for any difference between the carrying value of the liability and the market price of the equity Ashworth’s position is that the market value of the debentures should govern the conversion value The difference between the carrying value of $97.50 and the current market value of $104.00 is the loss that should be recognized The entry to reflect this position would be as follows: Loss on Conversion of Bonds Bonds Payable Discount on Bonds Payable Common Stock Paid-ln Capital in Excess of Par 6,500 100,000 2,500 8,000 96,000 Usually, the market prices of the debt security and the equity security would be more closely correlated than they are in this case However, in the circumstances described, the existence of the call price of 103 tends to dampen the market value of debentures If bondholders felt the market value of the stock was realistic and assessed positively the long-term prospects for the stock, they would probably convert their bonds before the company could place a call on the debentures The existence of the call price and the corresponding close relationship between the call price and the current market price of the debenture reflect a more realistic value for the conversion than does the stock price The case discussion could focus on the difference in entries under the three positions and the theoretical arguments presented for each Because the standard-setting boards have not directly commented on this area, there is much room for differences of opinion Practice tends to favor the position of Biggs 244 Chapter 10 Discussion Case 10–66 When a firm is being considered as a takeover target, large amounts of debt on the balance sheet tend to make the firm less attractive Companies that require substantial cash flows to service debt are not viewed as desirable acquisitions Firms that buy other companies often incur debt to make the acquisition and use the cash flows of the purchased company to service the debt Debt may offer the advantage of being of a limited duration While stock ownership allows one to hold a stake in the company into the foreseeable future, bonds will eventually be retired Deferred interest allows companies incurring debt to postpone any cash outflows associated with that debt for a certain period of time Thus, firms can incur debt and not be required to make interest payments for several years The disadvantage to deferred interest is that the proceeds from the bond sale are less because of the reduced cash flow to investors Interest rate resets are an attractive feature for purchasers of bonds because they almost guarantee a high return If the market value of the bonds declines, the interest rate reset provision increases the interest payments associated with the bond, thereby increasing the bond’s value As mentioned in item (1), firms with large amounts of debt are not attractive as takeover targets because of the cash flow required to service the debt In the case of Interco, the board of directors incurred large amounts of debt and used a portion of the debt proceeds as a special dividend to stockholders Discussion Case 10–67 The purpose of debt covenants is to require management to operate the company in such a way as to reduce the risk to bondholders The Circle K covenants, for example, place limits on the amount of dividends that may be paid to shareholders and require a certain level of net worth The covenants ensure that the interests of bondholders will be considered when management decisions are made The $5 million payment sets aside funds to compensate parties to the sales and leaseback transactions should the company be unable to complete its obligations associated with the transaction The requirement to place $5 million in escrow will not improve the cash flow position of the firm However, it will provide assurance to the parties to the sales and leaseback transactions that, should the company fail, some money is available as compensation Discussion Case 10–68 Although the use of current values using market interest rates for assets has been discussed for many years, the application of the same theory to liabilities is not well understood If a company has an outstanding liability and interest rates rise, the current value of the security representing the liability will fall That is, the fixed interest rate on the security, compared to the increased market rate will be reflected in a lower security value If an investor reduces the asset value to reflect this decline and recognizes a loss, some would argue that a creditor should be able to reduce the liability to reflect what could happen if the creditor refinanced the debt and was able to retire the debt for less than maturity value To the creditor, this would represent a gain Many financial institutions claim a relationship between their assets and liabilities that suggests this symmetry of treatment Of course, if interest rates fall, the value of the security would rise to reflect the favorable security values relative to the market rates and a loss would occur FASB Statement No 115 (discussed in Chapter 14) addressed the issue of allowing for liability gains to offset asset losses but rejected the extension at this time as being beyond the scope of the statement (paragraph 56) Discussion Case 10–69 The ability to move large amounts of debt off the balance sheets of many large corporations is troublesome to many financial statement users If 50% or more of the ownership in the newly formed corporations is retained by the parent company, a consolidation would be required and the debt would remain on the balance sheet However, if less than 50% of the stock is retained, consolidation is not required Often control is still maintained at a stock ownership of less than 50% (Coca-Cola retained 49% of the stock of Coca-Cola Enterprises), but current GAAP does not require consolidation unless the stock ownership is 50% or more As noted in Chapter 14, this issue is one of several being considered by FASB as it considers the entire area of consolidations and control Factors other than stock ownership should be considered when deciding whether consolidation is appropriate Discussion Case 10–70 Under the provision of FASB Statement No 140, a liability is removed from the balance sheet if and only if either (a) the debtor pays the creditor and is relieved of its obligation for the liability or (b) the debtor is legally released from bearing the primary obligation under the liability either judicially or by the creditor The key concept here is that a debtor must continue to report a liability as long as the debtor bears a legal obligation Because in-substance defeasance does not eliminate a debtor’s legal obligation to continue to service the debt, the transaction is not accounted for as a debt extinguishment Discussion Case 10–71 ‡ The discussion of this case will give instructors the opportunity to explore the impact GAAP can have on the informational content of financial statements The facts are based on a real case that occurred in the early 1970s The company was Aranco, Inc The auditors in the case agreed with the company and allowed it to transfer the amount carried in the bond liability account to preferred stock They reported this in their audit report as an exception to GAAP as specified by the APB but indicated that under the circumstances, they felt the alternative accounting treatment was preferred Since this case occurred, the FASB has issued Statement No 15, “Accounting by Debtors and Creditors for Troubled Debt Restructuring.” In this statement, an equity swap, such as the one described in this case, is to be accounted for at the fair market values of the debt or equity involved This statement solidifies the earlier position of the profession and would make it even more difficult to justify a departure from GAAP However, the reporting of a gain in the midst of poor operating conditions does result in strange financial statements Alternative reporting systems may be necessary to more clearly distinguish between this type of gain and other more common operating gains and losses Without this special treatment, readers could misinterpret the reported income Instructors may wish to explore possible variations with their students ‡ Relates to Expanded Material 246 Chapter 10 SOLUTIONS TO STOP & THINK Stop & Think (p 572): The 2001 current ratio of McDonald’s is only 0.81; does this mean that McDonald’s will not be able to meet its current obligations as they come due? Explain The current ratio is just one indicator of a company’s ability to meet its current obligations Another indicator is the ability of the company to generate operating cash flow In fact, from a conceptual standpoint, current obligations are satisfied with normal ongoing operating cash flow rather than through the liquidation of a company’s existing current assets Because McDonald’s has the ability to generate a stable stream of operating cash flow, it is still able to meet its current obligations even though its current ratio is 0.81 Stop & Think (p 584): In computing the market price for bonds, what is the only thing the stated rate of interest is used for? Do not confuse the market and the stated rates The stated rate is used only for computing the amount of the interest payments The market rate is used for computing the present value amounts of the principal and interest payments Stop & Think (p 590): When preparing a bond amortization schedule like the one illustrated below, there are certain numbers within that schedule that you know without having to any elaborate computations Identify what those numbers represent There are quite a few things you know about a bond amortization schedule before you actually prepare it in detail First, you know the amount of the periodic interest payments Second, you know that the bond’s initial carrying value is equal to its present value on the day it was sold (its market value) Third, you know that the bond’s carrying value at the end of the life of the bond is going to be equal to the face value of the bond Stop & Think (p 607): How can there be a gain or loss on disposal but only a gain on restructuring? The gain or loss on disposal of an asset is computed by comparing the carrying value with its market value The market value could be more than or less than book value Regarding the restructuring, there can be a gain only for the debtor Remember what we are doing here: getting the creditor to forgive the debt That means the debtor will be able to retire debt at less than its carrying value The debtor is getting a good deal—and this good deal is classified as a gain SOLUTIONS TO STOP & RESEARCH Stop & Research (p 572): Compare the current ratios in Exhibit 10–3 to each company’s current ratio in its most recent annual report Do you note any systematic pattern in how those current ratios have changed over time? Explain SOLUTION: Comparing the ratios in Exhibit 10–3 to the ratios for the same companies in 1998 reveals an interesting pattern Coca-Cola Delta Air Lines Dow Chemical IBM McDonald’s Microsoft Wal-Mart 2001 0.85 0.56 1.27 1.21 0.81 3.56 1.04 1998 0.74 0.50 1.18 1.15 0.52 2.32 1.26 Six of the seven companies reported an increase in current ratio from 1998 to 2001 This probably reflects the economic uncertainty during that three-year interval As a result of the uncertainty, all of the companies (except Wal-Mart, which seems to well no matter what the condition of the overall economy) felt the need to have a little bit more liquidity cushion Stop & Research (p 600): What has the FASB done about the accounting for special-purpose entities since this chapter was written? (Hint: Visit the FASB’s Web site at http:// www.fasb.org.) An example of the FASB’s response to the criticism of SPE accounting in the wake of the Enron scandal is as follows: On Wednesday, May 22, 2002, at 9:30 a.m., the FASB held an “Open Meeting of the Financial Accounting Standards Board” with the number one item on the agenda being as follows: “Consolidations: interpretive guidance for certain situations The Board will continue its discussion of a draft of a proposed Interpretation of FASB Statement No 94, Consolidation of All Majority-Owned Subsidiaries, and Accounting Research Bulletin No 51, Consolidated Financial Statements, that would address issues related to identifying and accounting for special-purpose entities.” 248 Chapter 10 SOLUTION TO NET WORK EXERCISE Net Work Exercise (p 582): The Bonds Online Web site provides free information about bonds, links to other bond-related Web sites, and the chance to establish an account for bond trading For example, through the Bonds Online Web site, one can learn about corporate bonds, municipal bonds, treasury bonds, zero-coupon bonds, and bond ratings The Bond Professor provided a response to the following question: “What is your overall opinion of convertible bonds in today’s market?” “While I personally haven’t done much with converts in recent years, I have a warm place in my heart for them One of my early jobs was as a convert analyst and loan arranger at to 10% margin Our clients really were swingers back in the early 1960s My first articles were on converts I view converts as essentially a substitute for annuity If you like a stock then you should check to see if it has a convertible affiliated with it If so, then get the terms of the convert and make an analysis Does it offer a satisfactory potential return for the risk? Is it nearly as good as the common or is it overpriced? Some of the things to check are the conversion premium; call provisions; conversion premium recovery period; estimated value as a straight bond, i.e one without a conversion option Check out the conversion features to see if there is a step-up in the conversion price or does the conversion option expire shortly I would also look at the size of the issue, as I prefer (others may have different views) issues of at least $100 million outstanding and listing on the NYSE Some may leave out the NYSE listing and say an OTC issue is okay In looking at LYONS or similar zero coupon converts the conventional premium recovery period isn’t applicable, as the bonds don’t pay current interest With a LYON, if the stock doesn’t move then the conversion premium is steadily increasing You may also want to check out usable bonds These are straight bonds that can be used in lieu of cash on the exercise of warrants These two together make a synthetic convert An article in the Financial Analysts Journal for Jan/Feb 1996 says in part: ‘From 1962 through September 1994, convertible bonds returned more than low-grade bonds but at a higher standard deviation of return After adjusting for bond and stock market movements, convertible bonds outperformed low-grade bonds, but not at commonly accepted statistical levels of significance Convertible bonds are more sensitive to stock market movements and less sensitive to bond market movements than low-grade bonds Given the additional equity call option embedded in convertible bonds, they should behave more like stocks and less like bonds In addition, like low-grade bonds, convertible bonds display a strong January effect Good luck with your converts Don’t forget that there are convertible preferred issues Remember, if you like the stock, check to see if there is a convert Investigate before you invest.’” SOLUTIONS TO BOXED ITEMS Will IBM Be Around in 100 Years? (pp 586–587) Low interest rates have created a market that encourages companies to lock in the low rates for long periods of time Even though investors’ risk in such bonds is high and interest rates are low, investors are willing to invest in such bonds from quality companies even with an interest rate that is only slightly higher than the rate on U.S Treasury bonds The primary disadvantage to the issuer of very-long-term bonds, such as IBM or Disney, is that if rates go lower, they would end up paying a higher rate of interest than the market rate However, the probability of lower rates was perceived by IBM and Disney as being low enough that the issuance of bonds is worth the small risk An economist for Moody’s Investors Service Inc stated that investors in the Disney bonds will need to have “a lot of confidence in the longevity of Mickey Mouse.” The Disney issue will provide investors with a fixed return for 100 years, assuming, of course, that Disney remains in business that long Another reason for investors’ interest in such long-term bonds, as stated by one investor, is to lengthen the average maturity of their bond holdings in order to counterbalance short-term holdings The Largest U.S Corporate Bond Issue Ever (pp 594–595) The effective interest rate on U.S corporate bonds is higher than the rate on U.S Treasury securities because the corporate bonds are riskier The higher rate represents the risk premium that U.S corporations must pay investors in order to get the investors to lend money to them instead of to the U.S government The interest rate on U.S Treasury securities is often referred to as the riskfree rate Investors buy bonds instead of, or in addition to, stocks because even though the yield on bonds is generally lower than the expected yield on stocks, this is balanced by the fact that there is less risk associated with bonds than with stocks Bondholders receive their required cash payments before any cash can be distributed to stockholders Junk bonds are high-risk, high-yield bonds issued by companies whose credit ratings place them in the “below investment grade” category The RJR Holdings bond issue was made in connection with a leveraged buyout of RJR Nabisco 250 Chapter 10 COMPETENCY ENHANCEMENT OPPORTUNITIES Deciphering 10–1 (The Walt Disney Company) The largest liability in Disney’s 2001 balance sheet is long-term “borrowings” totaling $8,940 million Disney’s total borrowings in 2000 and 2001 are as follows: Current portion Other borrowings Total borrowings 2001 2000 $ 829 8,940 $ 9,769 $2,502 6,959 $ 9,461 Total borrowings increased by only 3.3% in 2001 [($9,769  $9,461)/$9,461] The current ratios in 2001 and 2000 are 1.13 and 0.90, respectively Thus, the decrease in shortterm borrowing led to an increase in Disney’s current ratio In Note 5, we see that U.S dollar notes and debentures constituted 91.3% of Disney’s total borrowings in 2001 Deciphering 10–2 (Boston Celtics) Deferred Game Revenues results when the Celtics receive cash in advance of a service being provided This liability represents the portion of season ticket payments that has been received by the Celtics but which has not yet been earned through the playing of games In some cases when athletes negotiate their contracts, the contract stipulates that a portion of the current year’s salary be paid in the future, often after the player has retired This amount is included as a liability because it relates to the current (or past) period’s performance This account does not represent amounts to be paid in the future for future years’ performances Total assets as of June 30, 2001 were $26,161,019 ($31,231,706 + $50,000,000 + $5,182,821  $60,253,508) Because total partners’ capital is a negative amount, we can see that total liabilities are in excess of total assets The amount of recorded assets is just half of the amount owed on the $50 million note As noted, the partners’ capital account shows a deficit of $60 million However, these numbers are based on the reported assets and liabilities The reputation, name, and membership in the NBA of the Boston Celtics are all assets that are not reported in the balance sheet at current market value However, as lenders consider making loans to the Celtics, they consider these economic assets Thus, the company is able to continue to function even though reported liabilities are in excess of reported assets Deciphering 10–3 (Hewlett-Packard & Compaq) Hewlett-Packard’s current ratio in 2001 is 1.53 Compaq’s current ratio in 2001 is 1.19 Thus, HP appears to be the more liquid of the two companies HP’s debt-to-equity ratio is 1.34 when debt is defined as total liabilities Compaq’s ratio is 1.13 using the same definition Thus, HP has more debt relative to stockholders’ equity For HP, current liabilities are 75.0% of total liabilities For Compaq, current liabilities are 88.6% of total liabilities It appears that HP has more long-term debt in its financing mix Hewlett-Packard has a larger retained earnings balance primarily because it has been in business a lot longer than Compaq HP was making calculators long before Compaq was a dream in its founder’s mind Deciphering 10–4 (Philip Morris) Philip Morris’s current ratio for the year is 0.84 [$17,275/($20,141 + $512)] The computation is made a little more complex because Philip Morris reports its liabilities (and assets) in two segments, consumer products and financial services Because Philip Morris has two distinct segments, it breaks down its assets and liabilities into these two segments so that users of the financial statements can determine how the company has allocated its assets and the liabilities associated with those assets Many large companies with multiple segments provide similar disclosure For example, both Ford and General Motors, with an automobile segment and a financing segment, the same thing In many cases, this disclosure is in the notes to the financial statements a Using only long-term debt in the computation, Philip Morris’s debt-to-equity ratio is 0.95 [($17,159 + $1,492)/$19,620] b Using all the liabilities, the company’s debt-to-equity ratio is 3.33 ($65,348/$19,620) The big difference in the two numbers results from Philip Morris having a lot of liabilities other than just long-term debt The first question one should ask when interpreting a debt-to-equity ratio is, what is the definition of debt being used? Deciphering 10–5 (H J Heinz Company) A Eurodollar note is a U.S dollar-denominated note that is not a domestic note A domestic note is any note issued under the control of U.S banking or other regulatory authorities Initially, these types of notes were primarily issued by European banks; hence, they were called Eurodollar notes However, the term is more general and represents any U.S dollar-denominated note outside the jurisdiction of U.S authorities, whether issued by a European, Asian, South American, African, or Australian bank A company may have debt denominated in foreign currency for a variety of reasons Perhaps a subsidiary of the company is located in a foreign country and the interest rates in that country make it advantageous to issue debt there Some countries place restrictions on investment by outsiders, and as a result, funding must come from within the country In addition, companies use other currencies to hedge obligations or to protect themselves from currency risks or interest rate changes As you can see from the note, H J Heinz will need to come up with more than $1.0 billion in the year 2021 to pay off debt that is maturing in that year Rather than pay the debt in 2021, the company may refinance the debt with additional debt issues SAMPLE CPA EXAM QUESTIONS The correct answer is c Since the bonds were issued at 109, or 109% of the face amount of $1,000,000, the total proceeds were $1,090,000 The bonds included 50,000 detachable stock purchase warrants with a value of $4 each for a total of $200,000 The remainder of the proceeds, or $890,000, were attributed to the bonds This results in a discount on bonds of $1,000,000  $890,000, or $110,000 This solution assumes that the value of the bonds without the warrants cannot be separately determined The correct answer is a Upon calling the 600 bonds at 102, Dome will pay $612,000 to retire the bonds The carrying value of the bonds is the face value of $600,000 plus the unamortized premium of $65,000 for a total of $665,000 The difference is a gain on early extinguishment of debt equal to $53,000 252 Chapter 10 Writing Assignment: I like these “no interest” bonds Recall that traditional bonds consist of two parts: a lump sum distribution and an annuity Each of these parts is valued by the market when determining the market price of bonds While not having to make semiannual interest payments is appealing to a firm from a cash flow perspective, the lack of interest payments also reduces the market value of the bond Because there is no annuity associated with a zero-interest bond, the market will reduce the price of the bond accordingly Thus, the proceeds from a zero-interest bond are often much less than those received from the sale of more traditional debt instruments Zero-interest bonds: Lump sum payment: Table II, 10%, 10 periods (0.3855  $100,000) Deferred-interest bonds: Lump sum payment: Table II, 10%, 10 periods Deferred interest payments: Table II, 10%, period (0.5645  $10,000) $5,645 Table II, 10%, period (0.5132  $10,000) 5,132 Table II, 10%, period (0.4665  $10,000) 4,665 Table II, 10%, period (0.4241  $10,000) 4,241 Table II, 10%, period 10 (0.3855  $10,000) 3,855 Present value of bond Traditional bonds: Lump sum payment: Table II, 10%, 10 periods Interest payments: Table IV, 10%, 10 periods (6.1446  $10,000) Present value of bond $38,550 $38,550 23,538 $62,088 $38,550 61,446 $99,996 As illustrated by this example, the interest terms associated with a debt instrument can significantly affect the debt’s market value Bonds that pay interest require periodic outflows of cash in the form of interest, while zero-interest bonds require a large cash outflow only when the bonds are redeemed Zero-interest bonds are attractive because the cash outflow is often far into the future However, as the maturity date nears, firms often find themselves unprepared to make the cash payment necessary to retire the debt Research Project: Foreign debt—why and how? The objective of this project is to get students to realize that companies obtain debt financing using a variety of sources Bond markets exist in numerous countries and U.S companies are actively involved in the debt markets of foreign countries Students will have to go beyond the textbook in order to address the issues raised in this assignment Finance texts, international business texts, advanced accounting texts, and/or professors in each of these areas might be of help as students address these questions A company might have some of its loans denominated in foreign currencies for a variety of reasons First, some countries are reluctant to allow large multinational corporations to business in their countries without using local financing It helps the company establish good local relations if it uses local financial institutions as much as possible Also, many foreign subsidiaries of U.S multinationals are relatively self-contained, meaning that almost all operating, investing, and financing activities are handled locally Sometimes a multinational gets foreign currency financing because the interest rate is low Finally, foreign currency financing is a way for a multinational company to hedge, or protect itself, again fluctuations in the value of foreign currencies For example, if a U.S company has assets denominated in Thai baht, and the baht decreases in value, then the company will have lost money However, if the company has an equal amount of loans denominated in Thai baht, the loss from the decrease in the value of the Thai baht assets will be offset by the gain from the decrease in value of the Thai baht liabilities This is called a hedge and results in the U.S company being immune to the effects of exchange rate changes, either up or down The Debate: Rules for ratios The purpose of this exercise is to require students to think of the pros and cons associated with requiring ratios to be computed in a certain way Requiring the debt-to-equity ratio to be computed in a predefined way would have advantages, but what way should that be—include only long-term debt or include all liabilities? Students should walk away from the debate realizing that a burden is placed on the user of financial statement information to understand how information was compiled and computed Rather than mandate a computation, it is probably wiser to encourage users to ask the right questions when using financial statement information Ethical Dilemma: Keeping our debt covenants Debt covenants exist to protect the interests of debtholders In some cases, these debt covenants might cause managers to make decisions that are not in the best long-term interest of the company In this case, the Larsen brothers are asking you to manipulate the current ratio, not for a business purpose, but instead to ensure that debt covenants are not violated Now, one could argue that it is in the best interest of the company to comply with the debt covenants and if it takes a little accounting magic to so, then so be it Students should realize that accounting information is used for a variety of purposes and that tracking profits and losses is only one purpose Financial statements are also used to protect the interests of many parties, debtholders in this case Preparers of financial statements must keep the interests of these other users in mind as they prepare financial statements Cumulative Spreadsheet Analysis See Cumulative Spreadsheet Analysis solutions CD-ROM, provided with this manual Internet Search The following numbers are from the 2001 financial statements of each company a b c d e f (in millions) Total assets Total liabilities Total long-term debt Total assets of finance subsidiary Total liabilities of finance subsidiary Long-term debt of finance subsidiary General Electric $495,023 434,984 79,806 425,484 392,627 79,091 General Motors $323,969 303,516 163,912 193,759 177,345 153,186 Ford $276,543 268,085 167,035 188,224 175,105 153,543 The following computations illustrate the impact of the finance subsidiaries on the reported leverage position of General Electric, General Motors, and Ford: Overall debt ratio (Total liabilities/Total assets) Debt ratio without the finance subsidiary Debt ratio of finance subsidiary alone Overall long-term debt divided by equity Long-term debt divided by equity without finance subsidiary Long-term debt divided by equity of finance subsidiary alone General Electric 87.9% 60.9% 92.3% General Motors 93.7% 96.9% 91.5% Ford 96.9% 105.3% 93.0% 1.33 8.01 19.75 0.03 2.66 -2.89 2.41 9.33 11.70 Each of the companies has a very high debt ratio In addition, in each case, the large majority of the company’s long-term debt is associated with the finance subsidiary It is interesting to note that for both General Motors and Ford, the automotive segments (the remainder of the business after the finance subsidiary is removed) also have very high debt ratios In fact, for Ford, the automotive segment has negative equity ... to as debenture bonds, are not protected by the pledge or mortgage of specific assets b Collateral trust bonds are secured by stocks and bonds owned by the borrowing corporation There is no specific... redeemed by the issuing company before maturity at a specified price d Coupon bonds are not recorded in the name of the owner, and title passes with delivery of the bond Interest is paid by having... Because the interest revenue is not taxed by the federal government, these bonds are frequently referred to as tax-exempt securities Corporate bonds are issued by corporations as a means of financing