Suggested Grading Concepts and Grading Scheme:

Content (80% )

20 Convertible bonds

Entire proceeds of the bond issue should be allocated to the debt and the related premium or discount accounts.

20 Bonds with detachable warrants

Proceeds of their sale should be allocated between the debt and the warrants.

Basis of allocation is their relative fair values.

Relative values are usually determined by the price at which the respective instruments are traded in the open market.

Portion of the proceeds assigned to the warrants should be accounted for as equity.

20 Reasons why all the proceeds of convertible bonds should be allocated to the debt

The option is inseparable from the debt: no way to retain one right while selling the other.

The valuation presents practical problems: would be subjective.

20 Arguments that accounting for convertible debt should be the same as for debt issued with detachable stock purchase warrants

Convertible debt has features of both debt and shareholders’

equity, and separate recognition should be given to the

fundamental elements at the time of issuance.

Difficulties in separating the relative values of the features are not insurmountable.

Bonus (5) Other relevant arguments not mentioned above

80-85 points

Writing (20%)

5 Terminology and tone appropriate to the audience (CFO).

6 Organization permits ease of understanding.

Introduction that states purpose.

Paragraphs separate main points.

9 English.

Word selection.

Spelling.

Grammar.

20 points

Real World Case 14-2

Requirement 1

($ in millions)

Cash(price given) 968 Discount on notes (difference) 832 Notes payable (face amount) 1,800

Requirement 2

Fiscal Increase Outstanding

Year-end Cash Interest Expense in Balance Balance

1997							968
1998	0	0.03149	(968)	=	30	30	998
1999	0	0.03149	(998)	=	31	31	1,030
2000	0	0.03149	(1,030)	=	32	32	1,062
2001	0	0.03149	(1,062)	=	33	33	1,096
2002	0	0.03149	(1,096)	=	35	35	1,130
2003	0	0.03149	(1,130)	=	36	36	1,166
2004	0	0.03149	(1,166)	=	37	37	1,203
2005	0	0.03149	(1,203)	=	38	38	1,240
2006	0	0.03149	(1,240)	=	39	39	1,280
2007	0	0.03149	(1,280)	=	40	40	1,320
2008	0	0.03149	(1,320)	=	42	42	1,361
2009	0	0.03149	(1,361)	=	43	43	1,404
2010	0	0.03149	(1,404)	=	44	44	1,449
2011	0	0.03149	(1,449)	=	46	46	1,494
2012	0	0.03149	(1,494)	=	47	47	1,541
2013	0	0.03149	(1,541)	=	49	49	1,590
2014	0	0.03149	(1,590)	=	50	50	1,640
2015	0	0.03149	(1,640)	=	52	52	1,691
2016	0	0.03149	(1,691)	=	53	53	1,745
2017	0	0.03149	(1,745)	=	55	55	1,800

Case 14-2 (concluded)

Requirement 3

In a strict sense, zero-coupon debt pays no interest. “Zeros” offer a return in the form of a “deep discount” from the face amount. In fact, though, interest accrues at the effective rate (3.149% in this case) times the outstanding balance ($968 million during 1998), even though no interest is paid periodically. Interest on zero-coupon debt is determined and reported in precisely the same manner as on interest-paying debt. Under the concept of accrual accounting, the periodic effective interest is unaffected by when the cash actually is paid. Corporations can even deduct for tax purposes the annual interest expense. So, for 1998, HP’s earnings were reduced by $30 million (.03149 x $968) and increased by the tax savings from being able to deduct the $30 million. If the tax rate was 35%, that savings would have been 35% x $30, or $10.5 million, and the net decrease in earnings would have been $19.5 million ($30 – 10.5).

Requirement 4

From the amortization schedule, we can see that the book value of the debt at the end of 2002 was $1,130 million.

Requirement 5

The journal entry Hewlett-Packard used to record the early extinguishment of debt in 2002, assuming the purchase was made at the end of the year was:

Notes payable (given) 257 Discount (calculated below) 96

Gain on the early extinguishment of debt (to balance) 34

Cash(given) 127

Calculations:

$257 / $1,800 = 14.28% of notes were repurchased

14.28% x $1,130 = $161 million book value of notes repurchased

$257 – 161 = $96 million discount on notes repurchased

Communication Case 14-3

You may wish to suggest to your students that they consult the FASB 1990 Discussion Memorandum, “Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both,” which sets forth the most common arguments on the issues in this case. Or, you may prefer that they think for themselves and approach the issue from scratch.

There is no right or wrong answer. Both views can and often are convincingly defended. The process of developing and synthesizing the arguments likely will be more beneficial than any single solution. Each student should benefit from participating in the process, interacting first with his or her partner, then with the class as a whole. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged.

Arguments brought out in the FASB DM include the following:

Case 14-3 (continued)

Arguments Supporting View 1:

1. Those who favor accounting for convertible debt as entirely a liability until it is either converted or repaid argue that a convertible bond offers the holder two mutually exclusive choices. The holder cannot both redeem the bond for cash at maturity and convert it into common stock. They contend that the accounting before conversion or other settlement should reflect only the issuer's current position as a borrower and the holder's current position as a creditor. Until the conversion option is exercised, the bondholder is entitled to receive, and the enterprise is obligated to pay, only the periodic interest payments. If the option has not been exercised at the date the bonds mature, the issuer is obligated to pay the face amount, not to issue stock to the holder. Advocates of accounting for convertible debt according to its governing characteristics argue that a convertible bond is a single instrument, not two. To account for it as two instruments would not be representationally faithful. (par. 295)

2. Supporters of the first alternative generally also are concerned about the ability to measure reliably the components of convertible debt because neither is separately traded. They conclude that because the market does not determine a separate value for the conversion option, any value attributed to it would be subjective. Opinion 14 cited "the uncertain duration of the right to obtain the stock and the uncertainty as to the future value of the stock obtainable upon conversion" as factors further complicating valuation of the conversion option. (par. 296)

3. Supporters of that view argue that factors other than the conversion feature typically affect the pricing of convertible debt and therefore may complicate an attempt to allocate the proceeds from issuance between the straight debt and the conversion feature. For example, convertible bonds generally have covenants that are less restrictive than those for nonconvertible bonds on matters such as issuing more debt, maintaining specified financial ratios, paying large dividends on common stock, and establishing sinking funds. Less restrictive covenants may result in some reduction in market value and a corresponding increase in yield, which would complicate valuing the debt component of a convertible bond by comparing it with nonconvertible bonds with similar terms issued by enterprises with comparable credit ratings (par. 297).

Case 14-3 (continued)

4. Moreover, no cash payment from holder to issuer is required when a convertible bond is converted; the bond itself represents the consideration received by the issuing enterprise for the stock into which the bond is converted. Thus, the price paid by the holder upon conversion effectively depends on the market price of the bond at the time of conversion. Those who would account for convertible debt as entirely a liability argue that the absence of a fixed cash price for which a bondholder obtains an equity interest complicates an attempt to value the straight debt and conversion feature components (par. 298).

Arguments Supporting View 2:

1. Those who favor separate recognition of the liability and equity components of convertible debt argue that to ignore the existence of the conversion feature in recognizing the issuance of the bond results in overstating the liability and understating the interest expense. The effect of the conversion feature is to lower the rate for otherwise comparable straight debt (par. 333).

2. The higher interest expense recognized if the components are separately recognized than if all of the proceeds of issuance are recorded as a liability reflects the fact that an enterprise that issues debt at less than its face amount pays an effective interest rate that is higher than the coupon rate. The lower reported interest expense that results if the convertible debt is accounted for as entirely a liability leads those who support separate accounting to argue that failure to attribute a portion of the proceeds to the conversion option, thereby overstating the amount of the enterprise's liability, does not faithfully represent the economics of the transaction between the enterprise and the bondholder (par. 334).

3. Supporters of separate accounting contend that accounting for convertible debt as entirely a liability impairs comparability between enterprises. If convertible debt is reported as entirely a liability, an enterprise with a relatively high credit rating that issues nonconvertible debt appears to have a higher cost of borrowing than a company with a lower credit rating that issues convertible debt because inclusion of the conversion feature lowers the nominal interest rate significantly (par. 335).

Case 14-3 (concluded)

4. Those who support separate recognition of the liability and equity components of convertible debt point to the different values assigned by the market to convertible and nonconvertible debt with like terms as evidence of the inherent value of the conversion feature. They argue that accounting for a convertible bond as if it were entirely a debt instrument fails to recognize and display appropriately the obligation to issue stock, that is, the option embedded in convertible debt. The conversion feature has essentially the same economic value as the call on stock represented by a separately traded call option or warrant. The fact that the conversion feature cannot be sold separately does not justify ignoring its existence (par. 336).

5. In the 21 years since Opinion 14 was issued (to the date of this literature), the idea that many financial instruments may be broken down into more fundamental components, which then may be traded separately, has been embraced by the Wall Street community. The cash flows from instruments that have generally not been thought of as containing different components, such as government bonds, have been unbundled and recombined. Those who support separate accounting for the fundamental components of convertible debt argue that separate accounting would be consistent with the current economic environment. They contend that it is neither necessary nor appropriate to wait until the components of a financial instrument like convertible debt, which so obviously has both liability and equity characteristics, are physically separated to give accounting recognition to the existence of the separate components (par. 337).

Analysis Case 14-4

Requirement 1

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 ten-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 2

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 which is priced above its face value and provides a return less than its stated rate.

Requirement 3

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 ten-year 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 do 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.

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 x 10.57534 = $179,781 installment (from Table 4) actual payment n=12, i=2.0% 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 4 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 4 = 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.

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) 136,602 Prepaid inventory (difference) 63,398 Cash 200,000

Interest revenue is recognized over the 4-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.

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.

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

Judgment Case 14-9

Requirement 1

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 2

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.

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 2011:

Rate of return on ₌ Net income assets Average total assets ₌ $487 [$5,345 + 4,684] / 2 = 9.7%

Rate of return on ₌ Net income shareholders' equity Average shareholders' equity ₌ $487 [$2,931 + 2,671] / 2 = 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 under-utilized 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 3

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.

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.

Real World Case 14-10

The following is from Macy’s annual report:

January 31,

2009 2008

Requirement 3 ($ in millions)

Total Current Liabilities $5,126 $5,360

Long-term Debt 8,733 9,087

Deferred Income Taxes 1,119 1,446

Other Noncurrent Liabilities 2,521 1,989

Total $17,499 $17,882

Total debt has decreased by less than 1%.

Requirement 4

Total debt $17,499 $17,882

Shareholders’ Equity $4,646 $9,907

Total debt 17,499 17,882

Shareholders’ Equity 4,646 9,907

Ratio 3.77 1.80

The debt to equity ratio more than doubled since last year.

Case 14-10 (concluded)

Requirement 5

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 2010 2011 2012 2013 2014

Required payments $238 $662 $1,663 $138 $508

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 31, 2009. 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 do so.

Requirement 6

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: