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Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Chapter 14 Bonds and Long-Term Notes AACSB assurance of learning standards in accounting and business education require documentation of outcomes assessment Although schools, departments, and faculty may approach assessment and its documentation differently, one approach is to provide specific questions on exams that become the basis for assessment To aid faculty in this endeavor, we have labeled each question, exercise, and problem in Intermediate Accounting, 7e, with the following AACSB learning skills: Questions AACSB Tag Exercises AACSB Tag 14–1 14–2 14–3 14–4 14–5 14–6 14–7 14–8 14–9 14–10 14–11 14–12 14–13 14–14 14–15 14–16 14–17 14–18 14–19 14–20 14–21 14–22 14–23 14–24 Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking, Communications Reflective thinking Reflective thinking, Communications Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking, Communications Reflective thinking Analytic, Communications Reflective thinking Reflective thinking Reflective thinking Analytic Reflective thinking 14–1 14–2 14–3 14–4 14–5 14–6 14–7 14–8 14–9 14–10 14–11 14–12 14–13 14–14 14–15 14–16 14–17 14–18 14–19 14–20 14–21 14–22 14–23 14–24 14–25 14–26 14–27 14–28 14–29 14–30 14–31 14–32 14–33 14–34 Analytic Analytic Reflective thinking Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Communications Analytic Analytic Diversity Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Communications Brief Exercises 14–1 14–2 14–3 14–4 14–5 14–6 14–7 14–8 14–9 14–10 14–11 14–12 14–13 14–14 Analytic Analytic Reflective thinking Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Reflective thinking Solutions Manual, Vol.2, Chapter 14 CPA/CMA Reflective thinking Reflective thinking Analytic Analytic © The McGraw-Hill Companies, Inc., 2013 14–1 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com CPA/CMA cont Tags 10 11 12 Reflective thinking Analytic Analytic Analytic Analytic Analytic Diversity Diversity Reflective thinking Analytic Reflective thinking Problems 14–1 14–2 14–3 14–4 14–5 14–6 14–7 14–8 14–9 14–10 14–11 14–12 14–13 14–14 14–15 14–16 14–17 14–18 14–19 14–20 14–21 14–22 14–23 14–24 Analytic Analytic Analytic, Communications Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Reflective thinking Analytic Analytic Analytic Analytic © The McGraw-Hill Companies, Inc., 2013 14–2 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com QUESTIONS FOR REVIEW OF KEY TOPICS Question 14–1 Periodic interest is calculated as the effective interest rate times the amount of the debt outstanding during the period This same principle applies to the flip side of the transaction, that is, the creditor’s receivable or investment The approach also is the same regardless of the specific form of the debt, that is, whether in the form of notes, bonds, leases, pensions, or other debt instruments Question 14–2 Long-term liabilities are appropriately reported at their present values The present value of a liability is the present value of its related cash flows—specifically the present value of the face amount of the debt instrument, if any, plus the present value of stated interest payments, if any Both should be discounted to present value at the effective (market) rate of interest at issuance Question 14–3 Bonds and notes are very similar Both typically obligate the issuing corporation to repay a stated amount (e.g., the principal, par value, face amount, or maturity value) at a specified maturity date In return for the use of the money borrowed, the company also agrees to pay interest to the lender between the issue date and maturity The periodic interest is a stated percentage of face amount In concept, bonds and notes are accounted for in precisely the same way Normally a company will borrow cash from a bank or other financial institution by signing a promissory note Corporations, especially medium- and large- sized firms, often choose to borrow cash by issuing bonds and instead of borrowing from a lending institution, it borrows from the public A bond issue, in effect, breaks down a large debt into manageable parts ($1,000 units), which makes it more attractive to individual and corporate investors Also, bonds typically have longer maturities than notes The most common form of corporate debt is bonds Question 14–4 All of the specific promises made to bondholders are described in a bond indenture This formal agreement will specify the bond issue’s face amount, the stated interest rate, the method of paying interest (whether the bonds are registered bonds or coupon bonds), whether the bonds are backed by a lien on specified assets, and whether they are subordinated to other debt The bond indenture also might provide for redemption through a call feature, by serial payments, through sinking fund provisions, or by conversion It also will specify the trustee (usually a commercial bank or other financial institution) appointed by the issuing firm to represent the rights of the bondholders The bond indenture serves as a contract between the company and the bondholder(s) If the company fails to live up to the terms of the bond indenture, the trustee may bring legal action against the company on behalf of the bondholders Solutions Manual, Vol.2, Chapter 14 © The McGraw-Hill Companies, Inc., 2013 14–3 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 14–5 In order for Brandon to sell its bonds that pay only 11.5% stated interest in a 12.25% market, the bonds would have to be priced at a discount from face amount The discount would be the amount that causes the bond issue to be priced to yield the market rate In other words, an investor paying that price would earn an effective rate of return on the investment equal to the 12.25% market rate Question 14–6 The price will be the present value of the periodic cash interest payments (face amount times stated rate) plus the present value of the principal payable at maturity Both interest and principal are discounted to present value at the market rate of interest for securities of similar risk and maturity Question 14–7 In a strict sense, it’s true that zero-coupon bonds pay no interest “Zeros” offer a return in the form of a “deep discount” from the face amount Still, interest accrues at the effective rate times the outstanding balance, but no interest is paid periodically So, interest on zero-coupon bonds is determined and reported in precisely the same manner as on interest-paying bonds Under the concept of accrual accounting, the periodic effective interest is unaffected by when the cash actually is paid Corporations can deduct for tax purposes the annual interest expense, but without cash outflow until the bonds mature Question 14–8 When bonds are issued at a premium, the debt declines each period because the effective interest each period is less than the cash interest paid The “overpayments” each period reduce the balance owed This is precisely the opposite of when debt is sold at a discount In that case, the effective interest each period is more than the cash paid, and the “underpayment” of interest adds to the amount owed © The McGraw-Hill Companies, Inc., 2013 14–4 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 14–9 By the effective interest method, interest expense is recorded each period as the effective market rate of interest multiplied by the outstanding balance of the debt (during the interest period) This simply is an application of the accrual concept, consistent with accruing all expenses as they are incurred The difference between the interest expense and the interest paid increases (or decreases) the existing bond liability and is reflected as “amortization” of the discount (or premium) An exception to the conceptually appropriate method of determining interest for bond issues is the straight-line method Companies are allowed to determine interest indirectly by allocating a discount or a premium equally to each period over the term to maturity if doing so produces results that are not materially different from the effective interest method The firm’s decision should be guided by whether the straight-line method would tend to mislead investors and creditors in the particular circumstance The straight-line method results in a constant dollar amount of interest expense each period By the straight-line method, the amount of the discount to be reduced periodically is calculated, and the effective interest is the “plug” figure By the effective interest method, the dollar amounts of interest vary over the term to maturity because the percentage rate of interest remains constant, but is applied to a changing debt balance The “straight-line method” is not an alternative method of determining interest in a conceptual sense, but is an application of the materiality concept Question 14–10 The prescribed treatment requires a debit to an asset account—"debt issue costs”—which is then allocated to expense, usually on a straight-line basis An appealing alternative would be to reduce the recorded amount of the debt by the debt issue costs This approach has the appeal of reflecting the effect debt issue costs have on the effective interest rate Debt issue costs reduce the net cash the company receives from the sale of the financial instrument A lower net amount is borrowed at the same cost, increasing the effective interest rate The actual increase in the effective interest rate is reflected in the interest expense if the issue cost is allowed to reduce the premium (or increase the discount) on the debt This approach also is consistent with the treatment of issue costs when shares of stock are sold Share issue costs are recorded as a reduction in the amount credited to stock accounts (see Chapter 18) Solutions Manual, Vol.2, Chapter 14 © The McGraw-Hill Companies, Inc., 2013 14–5 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 14–11 When the stated interest rate is not indicative of the market rate at the time a note is negotiated, the value of the asset (cash or noncash) or service exchanged for the note establishes the market rate This rate is the implicit rate of interest If the value of the asset (or service) is not readily determinable, the implicit rate may not be apparent In that case an appropriate rate should be “imputed” as the rate that would be expected in a similar transaction, under similar circumstances The economic essence of a transaction should prevail over its outward appearance The accountant should look beyond the form of this transaction and record its substance The amount actually paid for the asset is the present value of the cash flows called for by the loan agreement, discounted at the “imputed” market rate Both the asset acquired and the liability used to purchase it should be recorded at the real cost Question 14–12 Mandatorily redeemable shares, which the issuing company is obligated to buy back in exchange for cash or other assets, must be reported as liabilities Question 14–13 When notes are paid in installments, rather than a single amount at maturity, installment payments typically are equal amounts each period Each payment will include both an amount representing interest and an amount representing a reduction of principal At maturity, the principal is completely paid The installment amount is calculated by dividing the amount of the loan by the appropriate discount factor for the present value of an annuity Determining periodic interest is the same as for a note whose principal is paid at maturity— effective interest rate times the outstanding principal But the periodic cash payments are larger and there is no lump-sum payment at maturity Question 14–14 For all long-term borrowings, disclosure should include (a) the fair values, (b) the aggregate amounts maturing, and (c) sinking fund requirements (if any) for each of the next five years Question 14–15 Regardless of the method used to retire debt prior to its scheduled maturity date, the gain or loss on the transaction is simply the difference between the carrying amount of the debt at that time and the cash paid to retire it To record the extinguishment, the account balances pertinent to the debt are removed from the books Cash is credited for the amount paid (the call price or market price) The difference between the carrying amount and the reacquisition price is the gain or loss Question 14–16 Gains and losses are reported as extraordinary items when they are considered to be material and both unusual and infrequent In that case, they are reported separate from ordinary operations and net of their tax effects © The McGraw-Hill Companies, Inc., 2013 14–6 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 14–17 GAAP requires that the entire issue price of convertible bonds be recorded as debt, precisely the same way, in fact, as for nonconvertible bonds On the other hand, the issue price of bonds with detachable warrants is allocated between the two different securities on the basis of their market values The difference is based on the relative separability of the debt and equity features of the two securities In the case of convertible bonds, the two features of the security, the debt and the conversion option, are physically inseparable—the option cannot be exercised without surrendering the debt But the debt and equity features of bonds with detachable warrants can be separated Unlike a conversion feature, warrants can be separated from the bonds and can be exercised independently or traded in the market separately from bonds In substance, two different securities—the bonds and the warrants—are sold as a "package" for a single issue price Question 14–18 Additional consideration a company provides to induce conversion of convertible debt should be recorded as an expense of the period It is measured at the fair value of that consideration This might be cash paid, the market price of stock warrants given, or the market value of additional shares issued due to modifying the conversion ratio Question 14–19 Rising interest rates, other factors remaining the same, cause prices of fixed-rate securities to fall For the investor in these securities, the price decline represents a loss; but for Cordova Tools, the debtor, the decline in the value of the liability is a gain If Cordova has elected the fair value option for the bonds, it will report the gain on change in the fair value of the bonds in its income statement Question 14–20 Under International Financial Reporting Standards, unlike U.S GAAP, convertible debt is divided into its liability and equity elements If a company prepares its financial statements according to IFRS, it accounts for convertible bonds it issues for $12.5 million by separating the $12.5 million into two parts Effectively, the company is selling two securities—(1) bonds and (2) an option to convert to stock—for one package price The bonds represent a liability; the option is shareholders’ equity It would record the fair value of the bonds as the liability and the remaining difference between the fair value of the convertible bonds, $12.5 million, and the fair value of the bonds as equity If the fair value of the bonds cannot be determined from an active trading market, that value can be calculated as the present value of the bonds’ cash flows, using the market rate of interest Question 14–21 All bonds sell at their price plus any interest that has accrued since the last interest date to simplify the process of paying and recording interest The buyer is asked to pay the seller accrued interest for any time that has elapsed since the last interest date in addition to the price of the bonds so that when a full six months’ interest is paid at the next interest date, the net interest paid/received will be correct for the time the bonds have been held by the investor Solutions Manual, Vol.2, Chapter 14 © The McGraw-Hill Companies, Inc., 2013 14–7 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (concluded) Question 14–22 By definition, a troubled debt restructuring involves some concessions on the part of the creditor (lender) A creditor may feel it can minimize losses by restructuring a debt agreement, rather than forcing liquidation A troubled debt restructuring takes one of two forms, with the second further categorized for accounting purposes: The debt may be settled at the time of the restructuring, or The debt may be continued, but with modified terms a Under the modified terms, total cash to be paid is less than the carrying amount of the debt b Under the modified terms, total cash to be paid exceeds the carrying amount of the debt Question 14–23 Pratt has a gain of $2 million (the difference between the carrying amount of the debt and the fair value of the property transferred) Pratt also must adjust the carrying amount of the land to its fair value prior to recording its exchange for the debt Pratt would need to change the recorded amount for the property specified in the exchange agreement from $2 million to the $3 million fair value This produces a “gain on disposition of assets” of $1 million So, Pratt would report two items on its income statement in connection with the troubled debt restructuring: (1) a $2 million gain on troubled debt restructuring and (2) a “gain on disposition of assets” of $1 million Question 14–24 (a) When the total future cash payments are less than the carrying amount of the debt, the difference is recorded as a gain to the debtor at the date of restructure No interest is recorded thereafter All subsequent cash payments produce reductions of principal (b) When the total future cash payments exceed the carrying amount of the debt, no reduction of the existing debt is necessary and no entry is required at the time of the debt restructuring The accounting objective is to determine the new (lower) effective interest and to record interest expense for the remaining term of the loan at that new, lower rate © The McGraw-Hill Companies, Inc., 2013 14–8 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com BRIEF EXERCISES Brief Exercise 14–1 $30,000,000 x face amount 6% annual rate x 6/12 = fraction of the annual period $900,000 cash interest Brief Exercise 14–2 Interest $ 2,000,000 ¥ Principal $80,000,000 Present value (price) of the bonds x x 23.11477* 0.30656** = = $46,229,540 24,524,800 $70,754,340 Ơ [5 ữ 2] % x $80,000,000 * Present value of an ordinary annuity of $1: n = 40, i = 3% (Table 4) ** Present value of $1: n = 40, i = 3% (Table 2) Brief Exercise 14–3 The price will be the present value of the periodic cash interest payments (face amount times stated rate) plus the present value of the principal payable at maturity Both interest and principal are discounted to present value at the market rate of interest for securities of similar risk and maturity When the stated rate and the market rate are the same, the bonds will sell at face value, $75 million in this instance Brief Exercise 14–4 Interest $ 2,500,000 ¥ Principal $100,000,000 Present value (price) of the bonds x x 27.35548* 0.45289** = = $ 68,388,700 45,289,000 $113,677,700 ¥ [5 ÷ 2] % x $100,000,000 * Present value of an ordinary annuity of $1: n = 40, i = 2% (Table 4) ** Present value of $1: n = 40, i = 2% (Table 2) Solutions Manual, Vol.2, Chapter 14 © The McGraw-Hill Companies, Inc., 2013 14–9 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 14–5 Interest will be the effective rate times the outstanding balance: 4% x $82,218,585 = $3,288,743 Brief Exercise 14–6 Interest will be the effective rate times the outstanding balance: June 30 Interest expense (2% x $69,033,776) Discount on bonds payable (difference) Cash (1.5% x $80,000,000) December 31 Interest expense (2% x [$69,033,776 + 180,676]) Discount on bonds payable (difference) Cash (1.5% x $80,000,000) 1,380,676 180,676 1,200,000 1,384,289 184,289 1,200,000 Interest expense for the year: $1,380,676 + 1,384,289 = $2,764,965 Brief Exercise 14–7 Interest will be a plug figure: $80,000,000 – 69,033,776 = $10,966,224 discount $10,966,224 ÷ 40 semiannual periods = $274,156 reduction each period June 30 Interest expense (to balance) Discount on bonds payable (difference) Cash (1.5% x $80,000,000) December 31 Interest expense (to balance) Discount on bonds payable (difference) Cash (1.5% x $80,000,000) 1,474,156 274,156 1,200,000 1,474,156 274,156 1,200,000 Interest expense for the year: $1,474,156 + 1,474,156 = $2,948,312 © The McGraw-Hill Companies, Inc., 2013 14–10 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Analysis Case 14–4 Requirement The notice is being placed by the four underwriters listed at the bottom of the notice The purpose is to announce the sale of the bonds described Actually, the sale by Craft Foods already has occurred at this point The underwriters resell the securities to the investing public These are 10-year bonds The stated rate of interest is 7.75%, but the bonds are priced to yield a higher rate, which accounts for the fact they are offered at a discount, 99.57% of face value Requirement In practice, debt securities rarely are priced at a premium in their initial offering The reason is primarily a marketing consideration It’s psychologically more palatable for a security salesperson to approach a customer with an issue that is offered at a discount off its face value and that provides a return greater than its stated rate than one that is priced above its face value and provides a return less than its stated rate Requirement The accounting considerations for Craft Foods are to recognize the liability and related debt issue costs, as well as to record interest expense semiannually over the 10year term to maturity at the effective rate of interest The bonds were recorded at their selling price: $750,000,000 x 99.57 = $746,775,000 (Bonds payable at face, discount of $3,225,000) Craft Foods also recorded debt issue costs in a separate account to be amortized over the term to maturity (probably straight line) We not know the amount of those costs It also is not apparent exactly when the sale by Craft Foods was made to the underwriters and, therefore, the amount of any accrued interest Any accrued interest would be recorded as interest payable to be paid at the first interest date as part of the first semiannual interest payment © The McGraw-Hill Companies, Inc., 2013 14–116 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Judgment Case 14–5 Obviously, no rational lender will lend money without interest The zero-interest loan described actually does implicitly bear interest The amount and rate of interest can be inferred from either the market rate of interest at the time for this type of transaction or from the fair value of the asset being sold The case information provides no information about either, other than that the stated price of the asset is higher than prices for this model Mr Wilde had seen elsewhere If we knew, for instance, that the market rate of interest at the time for this type of transaction is 8%, we would assume that’s the effective interest rate and could calculate the price of the equipment as follows: $17,000 installment payment x 10.57534 (from Table 4) n = 12, i = 2.0% = $179,781 actual price Both the asset acquired and the liability used to purchase it should be recorded at the real cost, $179,781 Similarly, if we knew the cash price of the equipment is $185,430, then we could calculate the effective rate of interest as follows: The discount rate that “equates” the present value of the debt ($185,430) and the installment payments ($17,000) is the effective rate of interest: $185,430 ÷ $17,000 = 10.9076: the Table value for n = 12, i = ? In row 12 of Table 4, the value 10.90751 is in the 1.5% column Since payments are quarterly, this equates to a 1.5 x = 6% annual rate So, 6% is the effective interest rate A financial calculator will produce the same rate In any case, Mr Wilde will not avoid interest charges with this offer Interest expense must be recorded at the effective rate, 8% in our first scenario, and 6% in the second Solutions Manual, Vol.2, Chapter 14 © The McGraw-Hill Companies, Inc., 2013 14–117 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Judgment Case 14–6 Although not specifically discussed in the chapter, concepts studied in this and other chapters provide the logic for addressing the situation described The company's accountant is incorrect in valuing the note at $200,000 The note should be valued at the present value of the receivable using the prevailing market rate and the difference between the present value and the cash given is regarded as an addition to the cost of products purchased during the contract term In this case, the note would be valued at $136,602, computed as follows: PV = $200,000 x 68301 PV of $1: n = 4, i = 10% (from Table 2) PV = $136,602 The journal entry to record the initial transaction is as follows: Note receivable (above) Prepaid inventory (difference) Cash 136,602 63,398 200,000 Interest revenue is recognized over the four-year life of the note using the effective interest rate of 10% Accrued interest will increase the receivable valuation to $200,000 Prepaid inventory is credited and inventory is debited as inventory is purchased, thus increasing the cost of inventory from the prices paid to market value © The McGraw-Hill Companies, Inc., 2013 14–118 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Communication Case 14–7 The critical question that student groups should address is the valuation of the note receivable In this case, there is a correct answer The note should be valued at the present value of $300,000 using the appropriate market rate of interest The difference between present value and the $300,000 should be accounted for by Pastel as prepaid advertising Interest revenue over the life of the note will be recognized using the effective rate As advertising services are provided by the radio station, advertising expense is debited and prepaid advertising credited It is important that each student actively participate in the process of arriving at a solution Domination by one or two individuals should be discouraged Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction Solutions Manual, Vol.2, Chapter 14 © The McGraw-Hill Companies, Inc., 2013 14–119 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Ethics Case 14–8 Discussion should include these elements Facts: Inducing a bond conversion is a common method of indirectly issuing stock, though typically not for the purpose of enhancing profits Reported performance will increase Company managers stand to benefit from the change Ethical Dilemma: Should Hunt Manufacturing enter into these transactions primarily for “window dressing” rather than for economic reasons? Who is affected? Meyer Barr Other managers Bondholders Hunt’s auditors Shareholders Potential shareholders The employees Other creditors © The McGraw-Hill Companies, Inc., 2013 14–120 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Judgment Case 14–9 Requirement The debt to equity ratio is computed by dividing total liabilities by total shareholders' equity The ratio summarizes the capital structure of the company as a mix between the resources provided by creditors and those provided by owners For example, a ratio of 2.0 means that twice as many resources (assets) have been provided by creditors as those provided by owners Debt to equity ratio = Total liabilities Shareholders' equity = $2,414 $2,931 = 0.82 Industry average = 1.0 In general, debt increases risk Debt places owners in a subordinate position relative to creditors because the claims of creditors must be satisfied first in case of liquidation In addition, debt requires payment, usually on specific dates Failure to pay debt interest and principal on a timely basis may result in default and perhaps even bankruptcy Other things being equal, the higher the debt to equity ratio, the higher the risk The type of risk this ratio measures is called default risk because it presumably indicates the likelihood a company will default on its obligations AGF’s debt to equity ratio is not particularly high—in fact it’s less than the industry average Requirement Debt also can be used to enhance the return to shareholders This concept is known as leverage If a company earns a return on borrowed funds in excess of the cost of borrowing the funds, shareholders are provided with a total return greater than what could have been earned with equity funds alone This desirable situation is called “favorable financial leverage.” Unfortunately, leverage is not always favorable Sometimes the cost of borrowing the funds exceeds the returns they generate This illustrates the typical risk-return tradeoff faced by shareholders Solutions Manual, Vol.2, Chapter 14 © The McGraw-Hill Companies, Inc., 2013 14–121 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 14–9 (continued) AGF has experienced favorable leverage, as demonstrated by calculating and comparing the return on assets and the return on shareholders’ equity for 2013: Rate of return on assets Rate of return on shareholders' equity = Net income Average total assets = $487 [$5,345 + 4,684] ÷ = 9.7% = Net income Average shareholders' equity = $487 [$2,931 + 2,671] ÷ = 17.4% The debt to equity ratio is not particularly high, but the debt the company does have has been used to shareholders’ advantage The return on equity is greater than the return on assets In fact, it may be that debt is being underutilized by AGF More debt might increase the potential for return, but the price would be higher risk This is a fundamental tradeoff faced by virtually all firms when trying to settle on the optimal capital structure Requirement Creditors generally demand interest payments as compensation for the use of their capital Failure to pay interest as scheduled may cause several adverse consequences, including bankruptcy Therefore, another way to measure a company's ability to pay its obligations is by comparing interest payments with cash flow generated from operations The times interest earned ratio does this by dividing income before subtracting interest expense or income tax expense by interest expense © The McGraw-Hill Companies, Inc., 2013 14–122 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 14–9 (concluded) Times interest earned = Net income + interest + taxes Interest = $487 + 54 + 316 $54 = 15.9 times Industry average = 5.1 times Two points about this ratio are important First, because interest is deductible for income tax purposes, income before interest and taxes is a better indication of a company's ability to pay interest than is income after interest and taxes (i.e., net income) Second, income before interest and taxes is a rough approximation for cash flow generated from operations The primary concern of decision makers is, of course, the cash available to make interest payments In fact, this ratio often is computed by dividing cash flow generated from operations by interest payments AGF’s fixed charges are covered over 15 times, far exceeding the industry norm The interest coverage ratio seems to indicate an ample safety cushion for creditors, particularly when considered in conjunction with their debt-equity ratio There seems also to be considerable room for additional borrowing in the event the firm wanted to increase its leverage in an attempt to further enhance the return to shareholders Solutions Manual, Vol.2, Chapter 14 © The McGraw-Hill Companies, Inc., 2013 14–123 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Real World Case 14–10 The following is from Macy’s annual report: January 29, 2011 Requirement Total current liabilities Long-term debt Deferred income taxes Other noncurrent liabilities Total January 30, 2010 ($ in millions) $ 5,065 6,971 1,245 1,820 $15,101 $ 4,462 8,456 1,132 2,597 $16,647 Total debt has decreased by about 9% Requirement Total debt Shareholders’ equity $15,101 5,530 $16,647 4,653 Total debt Shareholders’ equity 15,101 5,530 16,647 4,653 2.73 3.58 Ratio The debt to equity ratio decreased by 24% since last year © The McGraw-Hill Companies, Inc., 2013 14–124 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 14–10 (concluded) Requirement The vast majority is in the form of notes Aggregate required payments of maturities of long-term debt for the next five fiscal years are as follows: Dollars in Millions Required payments 2012 2013 2014 2015 2016 $1,098 $121 $461 $718 $1,105 There is no obvious pattern in the amount of payments due over the next five years No short-term debt is classified as long term at January 29, 2011 It would be classified as long term if the company intended to refinance any currently maturing debt on a long-term basis and could demonstrate the ability to so Requirement FASB ASC 470–10–45–14: “Debt–Overall–Other Presentation Matters–Intent and Ability to Refinance on a Long-Term Basis” Macys could report the debt as noncurrent if the company had the intent and ability to refinance on a long-term basis: Intent and Ability to Refinance on a Long-Term Basis 45-14 A short-term obligation shall be excluded from current liabilities if the entity intends to refinance the obligation on a long-term basis and the intent to refinance the short-term obligation on a long-term basis is supported by an ability to consummate the refinancing demonstrated in either of the following ways: a Post-balance-sheet-date issuance of a long-term obligation or equity securities After the date of an entity's balance sheet but before that balance sheet is issued or is available to be issued (as discussed in Section 855-10-25), a long-term obligation or equity securities have been issued for the purpose of refinancing the short-term obligation on a long-term basis If equity securities have been issued, the short-term obligation, although excluded from current liabilities, shall not be included in owners' equity Solutions Manual, Vol.2, Chapter 14 © The McGraw-Hill Companies, Inc., 2013 14–125 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 14–10 (concluded) b Financing agreement Before the balance sheet is issued or is available to be issued (as discussed in Section 855-10-25), the entity has entered into a financing agreement that clearly permits the entity to refinance the short-term obligation on a long-term basis on terms that are readily determinable The agreement does not expire within one year (or operating cycle from the date of the entity's balance sheet and during that period the agreement is not cancelable by the lender or the prospective lender or investor (and obligations incurred under the agreement are not callable during that period) except for violation of a provision with which compliance is objectively determinable or measurable For purposes of this Subtopic, violation of a provision means failure to meet a condition set forth in the agreement or breach or violation of a provision such as a restrictive covenant, representation, or warranty, whether or not a grace period is allowed or the lender is required to give notice Financing agreements cancelable for violation of a provision that can be evaluated differently by the parties to the agreement (such as a material adverse change or failure to maintain satisfactory operations) not comply with this condition No violation of any provision in the financing agreement exists at the balance sheet date and no available information indicates that a violation has occurred thereafter but before the balance sheet is issued or is available to be issued or, if one exists at the balance sheet date or has occurred thereafter, a waiver has been obtained The lender or the prospective lender or investor with which the entity has entered into the financing agreement is expected to be financially capable of honoring the agreement © The McGraw-Hill Companies, Inc., 2013 14–126 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Analysis Case 14–11 Requirement Earnings are not affected by conversion under the book value method On the other hand, a gain or loss is recorded and thus earnings are affected by conversion if the market value method is used and the market value differs from the book value of the convertible bonds In this case, the $6 million fair value of the common stock is higher than the book value of the bonds because the book value would be some amount less than the face amount of 20% x $25 million A loss would be recorded for the difference, reducing earnings Requirement The 7% bonds were issued at a discount (less than face amount) We know this because the stated rate was less than the prevailing or market rate for bonds of similar risk and maturity at the time the bonds were issued Thus, the bonds would have to be sold at a discount for them to yield 8% Requirement The amount of interest expense would be less in the first year of the term to maturity than in the second year of the life of the bond issue That’s because the 8% effective interest rate is applied to an increasing bond carrying amount, and results in higher interest expense in each successive year Requirement We determine gain or loss on early extinguishment of debt by comparing the book value of the bonds at the date of extinguishment with the purchase price If more is paid than the book value, a loss results If less is paid than the book value, a gain results In this case, a loss results The bonds were issued at a discount so the book value of the bonds at the date of extinguishment must be less than the face amount Thus, the reacquisition price is more than the book value Solutions Manual, Vol.2, Chapter 14 © The McGraw-Hill Companies, Inc., 2013 14–127 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Air France-KLM Case Requirement Using IFRS, as Air France does, companies use the “net method” to record notes and other borrowings A discount on notes would be recorded only using the “gross method,” in which a borrowing sold for less than face value is recorded with a contraliability account—Discount The discount is then amortized over the life of the debt Under IFRS, the discount also is amortized over the life of the debt, but credited directly to the note account rather than to a separate discount account Thus, “Amortization of discount” in Sealy’s statement of cash flows does not and would not appear in the corresponding note of Air France Under U.S GAAP, debt issue costs are recorded separately as an asset and then amortized as reported by Sealy A conceptually more appealing treatment, and the one prescribed by IFRS, is to reduce the recorded amount of the debt by the debt issue costs (called transaction costs under IFRS) © The McGraw-Hill Companies, Inc., 2013 14–128 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Air France Case (continued) Requirement From Note 30.2.1, we see that in April 2005, the Air France issued convertible bonds maturing in 15 years The conversion option allows for conversion and/or exchange at any time into new or existing Air France-KLM shares 21,951,219 bonds were issued for a total amount of €450 million Each bond has a nominal value of €20.50 As of March 31, 2011, the conversion ratio is 1.03 Air France-KLM shares for one bond Upon issue of this convertible debt, Air France-KLM recorded a debt of €379 million, corresponding to the present value of future payments of interest and face amount discounted at the rate of a similar bond without a conversion option The option value was evaluated by deducting this debt value from the total nominal amount (i.e., €450 million) and was recorded in equity Under IFRS, convertible debt is divided into its liability and equity elements We achieve separation by measuring the fair value of a similar liability that does not have an associated equity component Air France determined the effective interest rate that bonds similar in all respects, except that they are nonconvertible, would sell for Using that rate as the discount rate, AF determined the present value of future payments of interest and principal (nominal) discounted at the rate of a similar bond without a conversion option to be €379 million So the liability-first separation gives us the following entry: Cash (given) 450 Convertible bonds payable (calculated amount given) 379 Equity—conversion option (to balance) 71 Under U.S GAAP, the entire issue price of convertible debt is recorded as debt: Cash (given) Convertible bonds payable (face amount) Solutions Manual, Vol.2, Chapter 14 450 450 © The McGraw-Hill Companies, Inc., 2013 14–129 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Air France Case (concluded) Requirement If the AF had elected the FVO for all of its debt measured at amortized cost, the fair value adjustment account would have a March 31, 2011, credit balance of €733 million, the difference between the €2,434 + 566 + 2,164 + 5,624 = €10,788 million net book value and the €2,822 + 594 + 2,178 + 5,927 = €11,521 million fair value Requirement International accounting standards are more restrictive than U.S standards for determining when firms are allowed to elect the fair value option for financial assets and liabilities Under IFRS No 39, companies can elect the fair value option only in specific circumstances To avoid misuse, the fair value option is limited to only those financial instruments falling into one of the following categories x A group of financial assets, financial liabilities, or both is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy x The fair value option designation eliminates or significantly reduces an “accounting mismatch” that would otherwise arise if we measured the assets or liabilities or recognized gains and losses on them on different measurement bases Although U.S GAAP guidance indicates that the intent of the fair value option under U.S GAAP is to address these sorts of circumstances, it does not require that those circumstances exist © The McGraw-Hill Companies, Inc., 2013 14–130 Intermediate Accounting, 7e ... Companies, Inc., 2013 14–4 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 14–9 By the effective interest... time the bonds have been held by the investor Solutions Manual, Vol.2, Chapter 14 © The McGraw-Hill Companies, Inc., 2013 14–7 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com... Analytic Analytic Analytic © The McGraw-Hill Companies, Inc., 2013 14–2 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com QUESTIONS FOR REVIEW
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