14 Long-Term Liabilities CONCEPTS FOR ANALYSIS 14
CONCEPTS FOR ANALYSIS
CA14-1 (Bond Theory: Balance Sheet Presentations, Interest Rate, Premium) On January 1, 2017, Nichols Company issued for $1,085,800 its 20-year, 11% bonds that have a maturity value of $1,000,000 and pay interest semiannually on January 1 and July 1.
The following are three presentations of the long-term liability section of the balance sheet that might be used for these bonds at the issue date…
Instructions
(a) Discuss the conceptual merit(s) of each of the date-of-issue balance sheet presentations shown above for these bonds.
(b) Explain why investors would pay $1,085,800 for bonds that have a maturity value of only $1,000,000.
(c) Assuming that a discount rate is needed to compute the carrying value of the obligations arising from a bond issue at any date during the life of the bonds, discuss the conceptual merit(s) of using for this purpose:
(1) The coupon or nominal rate.
(2) The effective or yield rate at date of issue.
(d) If the obligations arising from these bonds are to be carried at their present value computed by means of the current market rate of interest, how would the bond valuation at dates subsequent to the date of issue be affected by an increase or a decrease in the market rate of interest?
(AICPA adapted)
CA14-2 (Bond Theory: Price, Presentation, and Redemption) On March 1, 2017, Sealy Company sold its 5-year, $1,000 face value, 9% bonds dated March 1, 2017, at an effective annual interest rate (yield) of 11%. Interest is payable semiannually, and the first interest payment date is September 1, 2017. Sealy uses the effective-interest method of amortization. The bonds can be called by Sealy at 101 at any time on or after March 1, 2018.
Instructions
(a) (1) How would the selling price of the bond be determined?
(2) Specify how all items related to the bonds would be presented in a balance sheet prepared immediately after the bond issue was sold.
(b) What items related to the bond issue would be included in Sealy’s 2017 income statement, and how would each be determined?
(c) Would the amount of bond discount amortization using the effective-interest method of amortization be lower in the second or third year of the life of the bond issue? Why?
(d) Assuming that the bonds were called in and redeemed on March 1, 2018, how should Sealy report the redemption of the bonds on the 2018 income statement?
(AICPA adapted)
CA14-3 WRITING (Bond Theory: Amortization and Gain or Loss Recognition)
Part I: The appropriate method of amortizing a premium or discount on issuance of bonds is the effective-interest method.
Instructions
(a) What is the effective-interest method of amortization and how is it different from and similar to the straight-line method of amortization?
(b) How is amortization computed using the effective-interest method, and why and how do amounts obtained using the effective-interest method differ from amounts computed under the straight-line method?
Part II: Gains or losses from the early extinguishment of debt that is refunded can theoretically be accounted for in three ways:
1. Amortized over remaining life of old debt.
2. Amortized over the life of the new debt issue.
3. Recognized in the period of extinguishment.
Instructions
(a) Develop supporting arguments for each of the three theoretical methods of accounting for gains and losses from the early extinguishment of debt.
(b) Which of the methods above is generally accepted and how should the appropriate amount of gain or loss be shown in a company’s financial statements?
(AICPA adapted)
CA14-4 WRITING (Off-Balance-Sheet Financing) Matt Ryan Corporation is interested in building its own soda can manufacturing plant adjacent to its existing plant in Partyville, Kansas. The objective would be to ensure a steady supply of cans at a stable price and to minimize transportation costs. However, the company has been experiencing some financial problems and has been reluctant to borrow any additional cash to fund the project. The company is not concerned with the cash flow problems of making payments, but rather with the impact of adding additional long-term debt to its balance sheet.
The president of Ryan, Andy Newlin, approached the president of the Aluminum Can Company (ACC), its major supplier, to see if some agreement could be reached. ACC was anxious to work out an arrangement, since it seemed inevitable that Ryan would begin its own can production. The Aluminum Can Company could not afford to lose the account.
After some discussion, a two-part plan was worked out. First, ACC was to construct the plant on Ryan’s land adjacent to the existing plant. Second, Ryan would sign a 20-year purchase agreement. Under the purchase agreement, Ryan would express its intention to buy all of its cans from ACC, paying a unit price which at normal capacity would cover labor and material, an operating management fee, and the debt service requirements on the plant. The expected unit price, if transportation costs are taken into consideration, is lower than current market. If Ryan did not take enough production in any one year and if the excess cans could not be sold at a high enough price on the open market, Ryan agrees to make up any cash shortfall so that ACC could make the payments on its debt. The bank will be willing to make a 20-year loan for the plant, taking the plant and the purchase agreement as collateral. At the end of 20 years, the plant is to become the property of Ryan.
Instructions
(a) What are project financing arrangements using special-purpose entities?
(b) What are take-or-pay contracts?
(c) Should Ryan record the plant as an asset together with the related obligation?
(d) If not, should Ryan record an asset relating to the future commitment?
(e) What is meant by off-balance-sheet financing?
CA14-5 ETHICS (Bond Issue) Donald Lennon is the president, founder, and majority owner of Wichita Medical Corporation, an emerging medical technology products company. Wichita is in dire need of additional capital to keep operating and to bring several promising products to final development, testing, and production. Donald, as owner of 51% of the outstanding stock, manages the company’s operations. He places heavy emphasis on research and development and long-term growth. The other principal stockholder is Nina Friendly who, as a nonemployee investor, owns 40% of the stock. Nina would like to deemphasize the R &
D functions and emphasize the marketing function to maximize short-run sales and profits from existing products. She believes this strategy would raise the market price of Wichita’s stock.
All of Donald’s personal capital and borrowing power is tied up in his 51% stock ownership. He knows that any offering of additional shares of stock will dilute his controlling interest because he won’t be able to participate in such an issuance. But,
Nina has money and would likely buy enough shares to gain control of Wichita. She then would dictate the company’s future direction, even if it meant replacing Donald as president and CEO.
The company already has considerable debt. Raising additional debt will be costly, will adversely affect Wichita’s credit rating, and will increase the company’s reported losses due to the growth in interest expense. Nina and the other minority stockholders express opposition to the assumption of additional debt, fearing the company will be pushed to the brink of bankruptcy. Wanting to maintain his control and to preserve the direction of “his” company, Donald is doing everything to avoid a stock issuance and is contemplating a large issuance of bonds, even if it means the bonds are issued with a high effective-interest rate.
Instructions
(a) Who are the stakeholders in this situation?
(b) What are the ethical issues in this case?
(c) What would you do if you were Donald?
