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Chapter 12

End-of-Chapter Materials

 

 

[h1]M. Problems

P12-1.  Suggested solution:

1. Financial leverage quantifies the relationship between the relative level of a firm’s debt and its equity base. Financial leverage offers investors the opportunity to increase their return on equity when the business performs well but in so doing exposes them to an increased risk of loss and bankruptcy.
2. The function of debt rating agencies is to provide investors with an independent evaluation of the riskiness of debt securities and in so doing assist them in making informed investment decisions.
3. Financial liabilities are contractual obligations to deliver cash or other financial assets to another party.
4. Companies sell notes directly to the investing public to reduce interest costs. They do this by decreasing or eliminating the spread charged by financial intermediaries.

 

P12-2.  Suggested solution:

1. Companies may be motivated to keep debt off the balance sheet so as to improve key financial ratios and free up borrowing capacity.
2. Examples of obligations that were previously off-balance-sheet but now have to be recognized include: i) those emanating from derivative contracts; ii) special-purpose entities; iii) decommissioning costs; and iv) finance leases.

 

P12-3.  Suggested solution:

a.	Proposal one		Proposal two
Estimated EBIT		$300,000		$300,000
Less: Interest	$2,000,000 × 4%	80,000	$3,000,000 × 4%	120,000
Income before taxes		220,000		180,000
Income taxes	$220,000 × 30%	66,000	$180,000 × 30%	54,000
Net income after taxes		$154,000		$126,000
ROE (Net income / Market value of  equity)	$154,000 / $2,000,000	7.7%	$126,000 / $1,000,000	12.6%
b. Proposal two results in the higher of the two estimated ROEs (Proposal two ROE 12.6% > proposal one ROE 7.7%)
c. The primary benefit to the shareholders of adopting proposal two is the higher envisaged return. Drawbacks to increased financial leverage include a heightened risk of loss if estimates are not realized and an increased risk of bankruptcy.

 

 

P12-4.  Suggested solution:

1. A bond indenture is the contract that outlines the terms of the bond, including the maturity date; rate of interest and interest payment dates; security pledged; and financial covenants.
2. A covenant is the borrower’s promise to restrict certain activities. There are both positive and negative covenants. A positive covenant is one where the borrower promises to do something, e.g., maintain a current ratio in excess of 2:1. A negative covenant is one in which the borrower pledges not to do something, e.g., will not pay dividends without the lender’s prior consent.
3. Companies issue bonds for reasons that include reducing the cost of borrowing and accessing large amounts of capital.
4. Corporations usually engage an investment bank to underwrite (sell) the bonds on its behalf on either a firm commitment or a best-efforts basis. The more common method is the firm commitment underwriting, where the investment bank guarantees the borrower a price for the bonds. Another arrangement is the best-efforts approach, where the broker agrees to try to sell as much of the issue as possible to investors.

 

P12-5.  Suggested solution:

• Callable bonds permit the issuing company to “call” for the bonds to be redeemed before maturity.
• Convertible bonds can be exchanged or “converted” for other securities in the corporation, usually ordinary shares.
• Debentures are unsecured bonds.
• Real-return bonds provide protection against inflation. While the mechanics differ slightly across issues, the basic premise is that the principal owed is indexed to inflation; thus, at maturity the principal is repaid at the inflated amount.
• Perpetual bonds are bonds that never mature.
• Secured bonds are bonds backed by specific collateral such as a mortgage on real estate.
• Serial bonds are bonds issued at the same time that mature at regular intervals, rather than all on the same date.
• Stripped (zero-coupon) bonds are bonds that do not pay interest. Stripped bonds are sold at a discount and mature at face value.

P12-6.  Suggested solution:

Most non-current financial liabilities are initially valued at fair value minus debt issue costs. Fair value is determined by, in order of preference: using active market values; referencing recent similar transactions; and employing discounted cash flow analysis. The debt and equity components of compound financial instruments must be separately valued.

After issuance, most non-current financial liabilities are measured at amortized cost using the effective interest method. The effective interest method charges the original premium or discount, and debt issue costs to interest expense over the life of the liability.

The one exception to the foregoing is financial liabilities at fair value through profit and loss, commonly referred to as held-for-trading financial liabilities. Held-for-trading liabilities are valued initially and subsequently at fair value. All transaction costs are expensed. Changes in market value are reported on the income statement.

 

P12-7.  Suggested solution:

a.	The fair value of the note is determined using discounted cash flow analysis.
	§  PVFA(0.5%, 36) = 1/0.005 – 1/0.005(1.005)36 = 32.8710 §  PV of the note = $1,000 × PVFA(0.5%, 36) = $1,000 x 32.8710 = $32,871
	Or using a BAII PLUS financial calculator
	§  36N, 0.50 I/Y, 1,000 PMT, CPT PV PV = –32,871 (rounded)
	Dr. Automobile		32,871
	Cr. Notes payable				32,871
b.		Dr. Interest expense [$32,871 × 0.50% = $164 (rounded)]		164
		Cr. Notes payable*				164
		Dr. Notes payable*		1,000
		Cr. Cash				1,000
		*May be combined

 

P12-8.  Suggested solution:

a.	The fair value of the note is determined using discounted cash flow analysis.
		Value of principal	= $10,000 / 1.043			$8,890
		Value of coupons	= $200 × PVFA(4%,3)	= $200 × 2.77509		555
		Total				$9,445
	Using a BAII PLUS financial calculator
	§  3 N, 4 I/Y, 10000 FV, 200 PMT, CPT PV   PV = –9,445 (rounded)
	Dr. Office furniture				9,445
	Cr. Notes payable						9,445
b.		Dr. Interest expense [$9,445 × 4% = $378 (rounded)]			378
		Cr. Cash						200
		Cr. Notes payable						178

 

P12-9.  Suggested solution:

Part a
The market rate of interest for similar transactions is 0.5% per month (6%/12 = 0.5) as established by Simply’s independent offer of financing. The present value of the consideration given up and hence the potential purchase price is:
Option i.	$40,000
Option ii.	$39,445
Option iii.	$39,708
Option ii.
§  PVFA(0.5%, 36) = 1/0.005 – 1/0.005(1.005)36 = 32.8710 §  Payments = $43,200/36 = $1,200 §  PV of the note = $1,200 × PVFA(0.5%, 36) = $1,200 x 32.8710 = $39,445
Using a BAII PLUS financial calculator
§  36N, 0.50 I/Y, 1200 PMT, CPT PV PV = –39,445 (rounded)
Option iii.
§  PVFA(0.75%, 36) = 1/0.0075 – 1/0.0075(1.0075)36 = 31.4468 §  Required payment = $38,000/31.4468 = 1,208 (rounded) §  PV of the note = $1,208 × PVFA(0.5%, 36) = $1,208 x 32.8710 = $39,708 (rounded)
Using a BAII PLUS financial calculator
§  36N, 0.75 I/Y, +/-38000 PV, CPT PMT PMT = 1,208 (rounded)
§   36N, 0.5 I/Y, 1208 PMT, CPT PV PV = –39,708 (rounded)
The best offer is option ii. as Simply can acquire the vehicle for a cash equivalent price of $39,445.

 

Part b
(i).	Dr. Automobile	39,708
	Cr. Notes payable		39,708
(ii).	Dr. Interest expense [$39,708 × 0.5% = $199) (rounded)]	199
	Dr. Notes payable ($1,208 – $199)	1,009
	Cr. Cash (from previous payment calculation)		1,208

 

P12-10.  Suggested solution:

a(i). Series A will sell at a discount as the coupon rate is less than the market rate of interest a(ii). Series B will sell at par as the coupon rate equals the market rate of interest a(iii). Series C will sell at a premium as the coupon rate exceeds the market rate of interest

 

b. All series: the principal amount = $1,000,000; the number of payments = 6 × 2 = 12; and the market rate of interest = 6%/2 = 3%
b(i). Coupon interest payment = $1,000,000 × (5%/2) = $25,000 §  PV of coupons = $25,000 × PVFA(3%, 12) = $25,000 × 9.9540 = $248,850 §  PV of principal = $1,000,000/1.0312 = $701,380 §  PV of the note = $248,850 + $701,380 = $950,230 Using a BAII PLUS financial calculator: §  12N, 3 I/Y, 25,000 PMT, 1000000 FV, CPT PV   PV = –950,230 (rounded)
	Journal entry on issue date—Series A
	Dr. Cash	950,230
	Cr. Bonds payable			950,230
b(ii). Coupon interest payment = $1,000,000 × (6%/2) = $30,000 §  PV of coupons = $30,000 × PVFA(3%, 12) = $30,000 × 9.9540 = $298,620 §  PV of principal = $1,000,000/1.0312 = $701,380 §  PV of the note = $298,620 + $701,380 = $1,000,000   Using a BAII PLUS financial calculator: §  12N, 3 I/Y, 30,000 PMT; 1000000 FV, CPT PV   PV = –1,000,000
	Journal entry on issue date—Series B
	Dr. Cash	1,000,000
	Cr. Bonds payable			1,000,000
b(iii). Coupon interest payment = $1,000,000 × (7%/2) = $35,000 §  PV of coupons = $35,000 × PVFA(3%, 12) = $35,000 × 9.9540 = $348,390 §  PV of principal = $1,000,000/1.0312 = $701,380 §  PV of the note = $348,390 + $701,380 = $1,049,770   Using a BAII PLUS financial calculator: §  12N, 3 I/Y, 35,000 PMT; 1000000 FV, CPT PV   PV = –1,049,770 (rounded)
	Journal entry on issue date—Series C
	Dr. Cash		1,049,770
	Cr. Bonds payable				1,049,770

 

P12-11.  Suggested solution:

a. Journal entry on issuance (May 1, 2012)
	Dr. Cash ($1,000,000 + $13,333)	1,013,333
	Cr. Bonds payable			1,000,000
	Cr. Accrued interest payable ($1,000,000 × 4% × 4/12)			13,333
b. Journal entry on interest payment date (June 30, 2012)
	Dr. Accrued interest payable		13,333
	Dr. Interest expense ($1,000,000 × 4% × 2/12)		6,667
	Cr. Cash			20,000
c. Journal entry on interest payment date (Dec. 31, 2012)
	Dr. Interest expense ($1,000,000 × 4%/2)		20,000
	Cr. Cash			20,000

 

P12-12.  Suggested solution:

Determining the effective interest rate for the period using a BAII PLUS financial calculator §  The net proceeds (PV) to Escape are $3,860,000 ($3,900,000 – $40,000);N = 10 (5 × 2); PMT = $80,000 ($4,000,000 × 4% × 6/12) §  10 N, 3860000 +/– PV, 4000000 FV, 80000 PMT, CPT I/Y   I/Y = 2.3978% (rounded)
Spreadsheet
Effective period rate			2.3978%
Date	Interest expense		Interest paid		Discount amortized		Amortized cost
Jan. 1, 2012							$3,860,000	(a)
July 1, 2012	$92,555	(b)	$80,000	(c)	$12,555	(d)	3,872,555	(e)
Jan. 1, 2013	92,856	(f)	80,000		12,856		3,885,411
(a) $3,900,000 – $40,000 = $3,860,000
(b) $3,860,000 × 2.3978% = $92,555
(c) $4,000,000 × 4%/2 = $80,000
(d) $92,555 – $80,000 = $12,555
(e) $3,860,000 + $12,555 = $3,872,555
(f) $3,872,555 × 2.3978% = $92,856

 

a. Journal entry on issuance (Jan. 1, 2012)
	Dr. Cash (Sales proceeds – transaction costs)	3,860,000
	Cr. Bonds payable ($3,900,000 – $40,000)			3,860,000
b. Journal entry on interest payment date (July 1, 2012)
	Dr. Interest expense ($3,860,000 × 2.3978%)		92,555
	Cr. Cash			80,000
	Cr. Bonds payable ($92,555 – $80,000)			12,555
c. Journal entry at year-end (Dec. 31, 2012)
	Dr. Interest expense ($3,872,555 × 2.3978%)		92,856
	Cr. Interest payable			80,000
	Cr. Bonds payable ($92,856 – $80,000)			12,856

 

P12-13.  Suggested solution:

Determining the effective interest rate for the period using a BAII PLUS financial calculator §  The net proceeds (PV) to Australian are $4,180,000 ($4,200,000 – $20,000);  N = 10 (5 × 2); PMT = $80,000 ($4,000,000 × 4% × 6/12) §  10 N, 4180000 +/– PV, 4000000 FV, 80000 PMT, CPT I/Y   I/Y = 1.5117% (rounded)
Spreadsheet
Effective period rate			1.5117%
Date	Interest expense		Interest paid		Premium amortized		Amortized cost
Jan. 1, 2011							$4,180,000	(a)
July 1, 2011	$63,191	(b)	$80,000	(c)	$16,809	(d)	4,163,191	(e)
Jan. 1, 2012	62,937	(f)	80,000		17,063		4,146,128
(a) net sales proceeds $4,200,000 – $20,000
(b) $4,180,000 × 1.5117% = $63,191
(c) $4,000,000 × 4%/2 = $80,000
(d) $80,000 – $63,191 = $16,809
(e) $4,180,000 –  $16,809 = $4,163,191
(f) $4,163,191 × 1.5117% = $62,937

 

a. Journal entry on issuance (Jan. 1, 2011)
	Dr. Cash (Net sales proceeds $4,200,000 – $20,000)	4,180,000
	Cr. Bonds payable				4,180,000
b. Journal entry on interest payment date (July 1, 2011)
	Dr. Interest expense ($4,180,000 × 1.5117%)		63,191
	Dr. Bonds payable ($80,000 – $63,191)		16,809
	Cr. Cash					80,000
c. Journal entry at year-end (Dec. 31, 2011)
	Dr. Interest expense ($4,163,191 × 1.5117%)			62,937
	Dr. Bonds payable ($80,000 – $62,937 )			17,063
	Cr. Interest payable						80,000

 

P12-14.  Suggested solution:

Determining the effective interest rate for the period using a BAII PLUS financial calculator §  The net proceeds (PV) to Really are $1,890,000 ($1,900,000 – $10,000);  N = 10 (5 × 2); PMT = $50,000 ($2,000,000 × 5% × 6/12) §  10 N, 1890000 +/– PV, 2000000 FV, 50000 PMT, CPT I/Y   I/Y = 3.1497% (rounded)
Spreadsheet
Effective period rate			3.1497%
Date	Interest expense		Interest paid		Discount amortized		Amortized cost
Jan. 1, 2012							$1,890,000	(a)
July 1, 2012	$59,529	(b)	$50,000	(c)	$9,529	(d)	1,899,529	(e)
Jan. 1, 2013	59,829	(f)	50,000		9,829		1,909,358
(a) $1,900,000 – $10,000 = $1,890,000
(b) $1,890,000 × 3.1497% = $59,529
(c) $2,000,000 × 5%/2 = $50,000
(d) $59,529 – $50,000 = $9,529
(e) $1,890,000 + $9,529 = $1,899,529
(f) $1,899,529 × 3.1497% = $59,829

 

a. Journal entry on issuance (Jan. 1, 2012)
	Dr. Cash (Sales proceeds – transaction costs)	1,890,000
	Cr. Bonds payable ($1,900,000 – $10,000)			1,890,000
b. Journal entry on interest payment date (July 1, 2012)
	Dr. Interest expense ($1,890,000 × 3.1497% = $59,529)		59,529
	Cr. Cash			50,000
	Cr. Bonds payable ($59,529 – $50,000)			9,529
c. Journal entry at year-end (Dec. 31, 2012)
	Dr. Interest expense ($1,899,529 × 3.1497% = $59,829)		59,829
	Cr. Interest payable			50,000
	Cr. Bonds payable ($59,829 – $50,000)			9,829

 

P12-15.  Suggested solution:

The fair value of the bond (sales price) is determined using discounted cash flow analysis where: § N = 20 (10 × 2); PMT = $20,000 ($1,000,000 × 4% × 6/12); I/Y = 1.95% (3.9% /2) Because the discount rate is not a whole number, the annuity factor is not given in a table, so we need to compute it by formula.
Value of principal		= $1,000,000 / 1.019520								$   679,603
Value of coupons		= $20,000 × PVFA(1.95%,20)				= $20,000 × 16.430607				328,612
Total										$1,008,215
Using a BAII PLUS financial calculator
§ 20N, 1.95I/Y, 1000000 FV, 20000 PMT, CPT PV   PV = –1,008,215 (rounded)
Spreadsheet
Effective period rate				1.9500%
Date	Interest expense			Interest paid			Premium amortized		Amortized cost
Jan. 1, 2011									$1,008,215		(a)
Jul. 1, 2011	$19,660		(b)	$20,000	(c)		$340	(d)	1,007,875		(e)
Jan. 1, 2012	19,654		(f)	20,000			346		1,007,529
(a) sales proceeds
(b) $1,008,215 × 1.95% = $19,660
(c) $1,000,000 × 4%/2 = $20,000
(d) $20,000 – $19,660 = $340
(e) $1,008,215 –  $340 = $1,007,875
(f) $1,007,875 × 1.95% = $19,654

 

a. Journal entry on issuance (Jan. 1, 2011)
	Dr. Cash (Sales proceeds)	1,008,215
	Cr. Bonds payable		1,008,215
b. Journal entry at year-end (June 30, 2011)
	Dr. Interest expense	19,660
	Dr. Bonds payable ($20,000 – $19,660)	340
	Cr. Interest payable		20,000
c. Journal entry on interest payment date (July 1, 2011)
	Dr. Interest payable	20,000
	Cr. Cash		20,000
d. Journal entry on interest payment date (Jan. 1, 2012)
	Dr. Interest expense	19,654
	Dr. Bonds payable ($20,000 – $19,654)	346
	Cr. Cash		20,000

 

P12-16.  Suggested solution:

a. Effective period rate = 4%/2 = 2%
Small differences due to rounding
Straight-line method									Effective interest method
Date	Interest expense		Interest paid		Premium amortized		Amortized cost		Date	Interest expense	Interest paid	Premium amortized	Amortized cost
Jan. 1, 2011							$3,109,882	(a)	Jan. 1, 2011				$3,109,882
June 30, 2011	$61,265	(b)	$75,000	(c)	$13,735	(d)	$3,096,147	(e)	June 30, 2011	$62,198	$75,000	$12,802	$3,097,080
Dec. 31, 2011	$61,265		$75,000		$13,735		$3,082,412		Dec. 31, 2011	$61,942	$75,000	$13,058	$3,084,021
June 30, 2012	$61,265		$75,000		$13,735		$3,068,677		June 30, 2012	$61,680	$75,000	$13,320	$3,070,702
Dec. 31, 2012	$61,264		$75,000		$13,736		$3,054,941		Dec. 31, 2012	$61,414	$75,000	$13,586	$3,057,116
June 30, 2013	$61,265		$75,000		$13,735		$3,041,206		June 30, 2013	$61,142	$75,000	$13,858	$3,043,258
Dec. 31, 2013	$61,265		$75,000		$13,735		$3,027,471		Dec. 31, 2013	$60,865	$75,000	$14,135	$3,029,123
June 30, 2014	$61,265		$75,000		$13,735		$3,013,736		June 30, 2014	$60,582	$75,000	$14,418	$3,014,706
Dec. 31, 2014	$61,264		$75,000		$13,736		$3,000,000		Dec. 31, 2014	$60,294	$75,000	$14,706	$3,000,000
	$490,118		$600,000		$109,882					$490,118	$600,000	$109,882
(a) given
(b) $75,000 – $13,735 = $61,265
(c) $3,000,000 × 5%/2 = $75,000
(d) $3,109,882 – $3,000,000 = $109,882; $109,882/8 = $13,735 (rounded)
(e) $3,109,882 – $13,735 = $3,096,147

 

b(i). Cash flow for each of the periods is not affected. Irrespective of the method chosen to account for the amortization of the bond premium, the cash outflow is $75,000 on each interest payment date.

b(ii). The total interest expense over the life of the bond is $490,118 under both the effective interest and straight-line methods.

b(iii). If the straight-line method is chosen, reported profitability will be higher than that under the effective rate method in 2011 and 2012 but lower in 2013 and 2014. (Interest expense is initially lower under the straight-line method; hence, net income will be higher.)

 

P12-17.  Suggested solution:

Determining the effective interest rate for the period using a BAII PLUS financial calculator §  The net proceeds (PV) to Buy Low are $970,000 §  N = 6 (3 × 2); PMT = $25,000 ($1,000,000 × 5% × 6/12) §  6N, 970000 +/– PV, 1000000 FV, 25000 PMT, CPT I/Y   I/Y = 3.0548% (rounded)

 

a. Effective period rate = 3.0548%
Small differences due to rounding
Straight-line method									Effective interest method
Date	Interest expense		Interest paid		Discount amortized		Amortized cost		Date	Interest expense	Interest paid	Discount amortized	Amortized cost
Jan. 1, 2015							$970,000	(a)	Jan. 1, 2011				$970,000
June 30, 2015	$30,000	(b)	$25,000	(c)	$5,000	(d)	$975,000	(e)	June 30, 2011	$29,632	$25,000	$4,632	$974,632
Dec. 31, 2015	$30,000		$25,000		$5,000		$980,000		Dec. 31, 2011	$29,773	$25,000	$4,773	$979,405
June 30, 2016	$30,000		$25,000		$5,000		$985,000		June 30, 2012	$29,919	$25,000	$4,919	$984,323
Dec. 31, 2016	$30,000		$25,000		$5,000		$990,000		Dec. 31, 2012	$30,069	$25,000	$5,069	$989,393
June 30, 2017	$30,000		$25,000		$5,000		$995,000		June 30, 2013	$30,224	$25,000	$5,224	$994,616
Dec. 31, 2017	$30,000		$25,000		$5,000		$1,000,000		Dec. 31, 2013	$30,384	$25,000	$5,384	$1,000,000
	$180,000		$150,000		$30,000					$180,000	$150,000	$30,000
(a) given
(b) $25,000 + $5,000 = $30,000
(c) $1,000,000 × 5%/2 = $25,000
(d) $1,000,000 – $970,000 = $30,000; $30,000/6 = $5,000
(e) $970,000 + $5,000 = $975,000

 

b. Journal entry on issuance (Jan. 1, 2015) – both methods
	Dr. Cash	970,000
	Cr. Bonds payable			970,000
c. Journal entry on interest payment date (June 30, 2015) – straight-line
	Dr. Interest expense (from spreadsheet)		30,000
	Cr. Bonds payable			5,000
	Cr. Cash			25,000
d. Journal entry on interest payment date (June 30, 2015) – effective interest
	Dr. Interest expense (from spreadsheet)		29,632
	Cr. Bonds payable			4,632
	Cr. Cash			25,000
e.  Journal entry on retirement of bonds (Dec. 31, 2017) – both methods
	Dr. Bonds payable		1,000,000
	Cr. Cash			1,000,000

 

1. The straight-line and effective interest methods are different approaches of allocating discounts and premiums to interest expense over the life of the bonds. The choice of methods does not affect a company’s cash flow, as the coupon payment (the cash outflow) remains the same. Moreover, total interest expense over the life of the bond is the same. Initial interest expense will be higher under the straight-line method for bonds issued at a discount and lower for bonds issued at a premium. IFRS believes that the effective interest method is conceptually superior as a uniform interest rate is used to calculate interest expense over the life of the bond. It thus provides for better matching of expenses than does the straight-line method. The Accounting Standards for Private Enterprises permits the use of the straight-line method as it is easy to use and period results do not usually differ materially from those obtained under the effective interest method.

 

P12-18.  Suggested solution:

1. Offsetting is the practice of showing the net amount of related assets and liabilities on the balance sheet, rather than showing the components separately. Offsetting is allowed only when the entity has both a legally enforceable right to offset the asset and liability and intends to settle on a net basis. The principal benefit to offsetting is that it may improve key financial ratios making it easier to meet restrictive covenants. Moreover, it may free up borrowing capacity.
2. In-substance defeasance is an arrangement where funds sufficient to satisfy a liability are placed in trust with a third party to pay directly to the creditor at maturity. Defeasance arrangements qualify for offsetting only if the creditor formally confirms that the entity is no longer liable for the indebtedness.

 

P12-19.  Suggested solution:

a. Journal entry for open market purchase and retirement (Apr. 1, 2013)
	Dr. Bonds payable		1,000,000
	Dr. Interest expense ($1,000,000 × 6% × 3/12)		15,000
	Cr. Cash			984,736
	Cr. Gain on bond redemption ($1,000,000 + $15,000 – $984,736)			30,264
b. Journal entry for calling the bonds (Aug. 1, 2014)
	Dr. Bonds payable	500,000
	Dr. Interest expense ($500,000 × 6% × 1/12)	2,500
	Dr. Loss on bond redemption ($507,500 – $500,000 – $2,500)	5,000
	Cr. Cash ($500,000 × 101% + $2,500)			507,500
c. Journal entry on retirement of the bonds (Dec. 31, 2016)
	Dr. Bonds payable ($5,000,000 – $1,000,000 – $500,000)	3,500,000
	Cr. Cash			3,500,000

 

P12-20.  Suggested solution:

There are a number of ways to approach this question, but NPV (net present value) analysis is normally used. Adler’s cash position has not changed—they raised $3,441,000 using this money to pay out the old bond issue.

 

The present value of the old bond issue is determined by the repurchase price – $3,441,000. This is confirmed by using a BAII PLUS financial calculator. 5N, 4000000 FV, 180000* PMT, 8 I/Y, CPT PV   PV = 3,441,000 (rounded). The present value of the new bond issue is determined by the issue price – $3,441,000. This is confirmed by using a BAII PLUS financial calculator. 5N, 3441000 FV, 275280** PMT, 8 I/Y, CPT PV   PV = 3,441,000.

*$4,000,000 × 4.5% = $180,000; **$3,441,000 × 8% = $275,280

The net cash inflow was $0, as 100% of the sale proceeds of the new issue were used to retire the old issue. This coupled with the fact that the present value of the old and new indebtedness is the same means that Adler is not any better off than previously. When taxation and transaction costs are considered, the company will be worse off.

 

P12-21.  Suggested solution:

a. Journal entry on issuance (March 1, 2011)
	Dr. Cash ($5,315,703 + $50,000)	5,365,703
	Cr. Bonds payable (given)		5,315,703
	Cr. Interest expense ($5,000,000 × 6% × 2/12)		50,000
b. Journal entry on interest payment date (July 1, 2011)
	Dr. Interest expense ($74,420* + $50,000)	124,420
	Dr. Bonds payable ($150,000 – $124,420)	25,580
	Cr. Cash		150,000
	*[$5,315,703 × (4.2%/2) × (4/6) = $74,420 (rounded)]
c. Journal entry on reacquisition of the bonds (July 1, 2011)
	Dr. Loss on bond redemption ($5,400,000 – $5,290,123)	109,877
	Dr. Bonds payable ($5,315,703 – $25,580)	5,290,123
	Cr. Cash		5,400,000

 

P12-22.  Suggested solution:

Determining the effective interest rate for the period using a BAII PLUS financial calculator §  The net proceeds (PV) are $9,990,000 ($10,500,000 – $400,000 – $200,000);  N = 12 (6 × 2); PMT = $200,000 ($10,000,000 × 4% × 6/12) §  12N, 9900000 +/– PV, 10000000 FV, 200000 PMT, CPT I/Y   I/Y = 2.0951% (rounded)
Spreadsheet
Effective period rate			2.0951%
Small differences due to rounding
Date	Interest expense		Interest paid		Discount amortized		Amortized cost
Jan. 1, 2013							$9,900,000	(a)
June 30, 2013	$207,416		$200,000	(b)	$7,416	(c)	9,907,416	(d)
Dec. 31, 2013	207,572		200,000		7,572		9,914,988
June 30, 2014	207,730		200,000		7,730		9,922,718
Dec. 31, 2014	207,892		200,000		7,892		9,930,610
June 30, 2015	208,057		200,000		8,057		9,938,668
Dec. 31, 2015	208,226		200,000		8,226		9,946,894
Jan. 1, 2016	Redeem and derecognize 40% of the outstanding bonds						–3,978,758
							$5,968,136
June 30, 2016	125,039		120,000		5,039		5,973,175
Dec. 31, 2016	125,145		120,000		5,145		5,978,320
June 30, 2017	125,253		120,000		5,253		5,983,573
Dec. 31, 2017	125,363		120,000		5,363		5,988,935
June 30, 2018	125,475		120,000		5,475		5,994,410
Dec. 31, 2018	125,590		120,000		5,590		6,000,000
(a) The net sale proceeds of the bonds ($10,500,000 – $400,000 – $200,000 = $9,900,000)
(b) $10,000,000 × 4%/2 = $200,000
(c) $207,416 – $200,000 = $7,416
(d) $9,900,000 + $7,416 = $9,907,416

 

a. Journal entry on issuance (Jan. 1, 2013)
	Dr. Cash (Sales proceeds – transaction costs)		9,900,000
	Cr. Bonds payable ($10,500,000 – $400,000 – $200,000)			9,900,000
b. Journal entry on interest payment date (Dec. 31, 2015)
	Dr. Interest expense (from spreadsheet)	208,226
	Cr. Cash			200,000
	Cr. Bonds payable			8,226
c. Journal entry on reacquisition of the bonds (Jan. 1, 2016)
	Dr. Loss on bond redemption ($4,040,000 – $3,978,758)	61,242
	Dr. Bonds payable (from spreadsheet)	3,978,758
	Cr. Cash ($4,000,000 × 101%)			4,040,000
d. Journal entry on retirement of the bonds (Dec. 31,2018)
	Dr. Bonds payable	6,000,000
	Cr. Cash			6,000,000

 

P12-23.  Suggested solution:

Using a BAII PLUS financial calculator
Situation 1	12N, 6I/Y, 10000000 FV, 700000 PMT, CPT PV   PV = –10,838,384 (rounded)
Situation 2	12N, 12I/Y, 20000000 FV, 2000000 PMT, CPT PV   PV = –17,522,250 (rounded)
Situation 3	8N, 14I/Y, 40000000 FV, 4800000 PMT, CPT PV   PV = –36,288,909 (rounded)

 

a. Journal entry on issuance (Jan. 1, 2011)
Situation 1	Dr. Cash (Sales proceeds)	10,838,384
	Cr. Bonds payable		10,838,384
Situation 2	Dr. Cash (Sales proceeds)	17,522,250
	Cr. Bonds payable		17,522,250
Situation 3	Dr. Cash (Sales proceeds)	36,288,909
	Cr. Bonds payable		36,288,909
b. Journal entry at year-end (Dec. 31, 2011)
Situation 1	Dr. Interest expense	647,321
	Dr. Bonds payable	52,679
	Cr. Cash		700,000
1.     Calculate the outstanding balance at the beginning of period 2: 11N, 6I/Y, 10000000 FV, 700000 PMT, CPT PV   PV = –10,788,687 (rounded) 2.     Use the balance to determine interest expense: 10,788,687 × 12% / 2 = $647,321
Situation 2	Dr. Interest expense	2,102,670
	Cr. Bonds payable		102,670
	Cr. Cash		2,000,000
	$17,522,250 × 12% = $2,102,670
Situation 3	Dr. Interest expense	5,080,447
	Cr. Bonds payable		280,447
	Cr. Cash		4,800,000
	$36,288,909 × 14% = $5,080,447
c. Journal entry on retirement (Jan. 1, 2015)
Situation 3	Dr. Bonds payable*	37,669,030
	Dr. Loss on retirement	2,330,970
	Cr. Cash		40,000,000
*Calculate the outstanding balance at the beginning of period 5: 4N, 14I/Y, 40000000 FV, 4800000 PMT, CPT PV   PV = –37,669,030 (rounded)

 

P12-24.Suggested solution:

a. Spreadsheet
Effective period rate			7.2000%
Small differences due to rounding
Date	Interest expense			Interest paid			Discount amortized		Amortized cost
Dec. 1, 2016									$2,838,944	(a)
June 30, 2017	$194,236	(b)		$180,000	(c)		$14,236	(d)	2,853,180	(e)
June 30, 2018	205,429			180,000			25,429		2,878,609
June 30, 2019	207,260			180,000			27,260		2,905,868
July 1, 2019	Book value of bonds purchased ($2,905,868/3)								$968,623	(f)
July 1, 2019									1,937,245
June 30, 2020	139,482			120,000	(g)	19,482			$1,956,727	(h)
(a) The sale price of the bonds
(b) ($180,000 × 5/12 = $75,000); [($2,838,944 × 7.20% × 7/12) + $75,000 = $194,236]
(c) $3,000,000 × 6% = $180,000
(d) $194,236 – $180,000 = $14,236
(e) $2,838,944 + $14,236 = $2,853,180
(f) $1,000,000 of the $3,000,000 in bonds are redeemed so 1/3 of the liability is removed from the books
(g) $180,000 × 2/3 = $120,00 or $2,000,000 × 6% = $120,000
(h) this is the amount to be derecognized

 

b. Journal entry on issuance (Dec. 1, 2016)
	Dr. Cash ($2,838,944 + $75,000)	2,913,944
	Cr. Bonds payable (given)			2,838,944
	Cr. Interest expense ($3,000,000 × 6% × 5/12)			75,000
c. Journal entry on interest payment date (June 30, 2017)
	Dr. Interest expense (from spreadsheet)		194,236
	Cr. Bonds payable			14,236
	Cr. Cash			180,000
d. Journal entry on interest payment date (June 30, 2019)
	Dr. Interest expense (from spreadsheet)		207,260
	Cr. Bonds payable			27,260
	Cr. Cash			180,000
e.  Journal entry on reacquisition of the bonds (July 1, 2019)
	Dr. Bonds payable (from spreadsheet)		968,623
	Cr. Cash (given)			950,000
	Cr. Gain on bond redemption ($968,623 – $950,000)			18,623
f. Journal entry on interest payment date (June 30, 2020)
	Dr. Interest expense (from spreadsheet)		139,482
	Cr. Bonds payable			19,482
	Cr. Cash			120,000
g.  Journal entry on reacquisition of the bonds (July 1, 2020)
	Dr. Loss on bond redemption ($2,040,000 – $1,956,727)		83,273
	Dr. Bonds payable (from spreadsheet)		1,956,727
	Cr. Cash ($2,000,000 × 102%)			2,040,000

 

P12-25.  Suggested solution:

a.
(i). Journal entry on issuance (July 1, 2014)
	Dr. Cash (Sales proceeds)	5,040,000
	Cr. Bonds payable ($5,040,000 – $40,000)			5,000,000
	Cr. Cash (Sales commission)			40,000
(ii). Journal entry on reacquisition of the bonds (July 31, 2017)
	Dr. Interest expense ($3,000,000 × 6% × 1/12)		15,000
	Dr. Bonds payable		3,000,000
	Dr. Loss on redemption of bonds ($3,075,000 – $3,000,000 – $15,000)		60,000
	Cr. Cash ($3,000,000 × 102% + $15,000)			3,075,000
(iii). Journal entry on interest payment date (Dec. 31, 2017)
	Dr. Interest expense ($2,000,000 × 6% × 4/12)		40,000
	Dr. Accrued interest payable ($2,000,000 × 6% × 2/12)*		20,000
	Cr. Cash ($2,000,000 × 6% × 6/12)			60,000
	* Inuvialuit does not use reversing entries
(iv). Journal entry on retirement of the bonds (March 31, 2018)
	Dr. Bonds payable		2,000,000
	Dr. Interest expense ($2,000,000 × 6% × 3/12)		30,000
	Cr. Cash			1,980,000
	Cr. Gain on retirement of bonds ($2,000,000 + $30,000 – $1,980,000)			50,000

 

1. The most likely reason why the company was able to repurchase its bonds at a discount on March 31, 2018 is that the market interest rate for similar bonds had increased and was then greater than the 6% coupon rate on Inuvialuit bonds. The decline in the market price of the company’s bonds may have also been attributable to a perceived increase in the probability of default by the market and/or one or more of the debt rating agencies downgrading the rating on the bond.

 

P12-26.  Suggested solution:

a(i). The fair value of the bond is determined using discounted cash flow analysis where: § FV = $5,000,000; N = 120 (10 × 12); I/Y = 0.3% (3.6%/12): § PV = $5,000,000 / 1.003120 = $3,490,262.
Using a BAII PLUS financial calculator
§ 120 N, 0.3 I/Y, 5000000 FV, CPT PV   PV = –3,490,262 (rounded)
Issue
Dr. Cash					3,490,262
Cr. Bonds payable						3,490,262
The fair value of the bond (the repurchase price) is determined using the market rate of interest to discount the future value: § FV = $2,000,000; N = 54 [(10 × 12) – (5.5 × 12)]; I/Y = 0.4% (4.8%/12) The net book value of the bond is determined using the original effective rate interest to discount the future value: § FV = $2,000,000; N = 54 [(10 × 12) – (5.5 × 12)]; I/Y = 0.3% (3.6%/12)
§  Fair value = $2,000,000/1.00454 = $1,612,165 §  Book value = $2,000,000/1.00354 = $1,701,295
Using a BAII PLUS financial calculator
§ 54 N, 0.4 I/Y, 2000000 FV, CPT PV   PV = –1,612,165 (rounded) is the fair value
§ 54 N, 0.3 I/Y, 2000000 FV, CPT PV   PV = –1,701,295 (rounded) is the book value
Repurchase
Dr. Bonds payable (from above)					1,701,295
Cr. Gain on repurchase of  bonds ($1,701,295 – $1,612,165)						89,130
	Cr. Cash (from above)					1,612,165
a(ii).
Issue
Dr. Cash ($2,000,000 + $10,000)					2,010,000
Cr. Interest expense ($2,000,000 × 6%/12)						10,000
Cr. Bonds payable						2,000,000
Interest payment
Dr. Interest expense					120,000
Cr. Cash ($2,000,000 × 6%)						120,000
a(iii). The fair value of the bond (sales price) is determined using discounted cash flow analysis: § N = 6 (3 × 2); PMT = $75,000 ($3,000,000 × 5% × 6/12); I/Y = 2.25% (4.5%/2)
Value of principal			= $3,000,000 / 1.02256				$2,625,073
Value of coupons			= $75,000 × PVFA(2.25%, 6)	= $75,000 × 5.5545			416,588
Total							$3,041,661
Using a BAII PLUS financial calculator
§ 6N, 2.25I/Y, 3000000 FV, 75000 PMT, CPT PV   PV = –3,041,659 (rounded)
Dr. Cash					$3,041,659
Cr. Bonds payable						$3,041,659

 

b.
Spreadsheet
Date	Interest expense		Interest paid		Premium amortized		Amortized cost
Jan. 1, 2016							$3,041,659	(a)
June 30, 2016	$68,437	(b)	$75,000	(c)	$6,563	(d)	3,035,096	(e)
Dec. 31, 2016	68,290		75,000		6,710		3,028,386
June 30, 2017	68,139		75,000		6,861		3,021,525
Dec. 31, 2017	67,984		75,000		7,016		3,014,509
June 30, 2018	67,826		75,000		7,174		3,007,335
Dec. 31, 2018	67,665		75,000		7,335		3,000,000
(a) issue price
(b) $3,041,659 × 2.25% = $68,437
(c) $3,000,000 × 5%/2 = $75,000
(d) $75,000 – $68,437 = $6,563
(e) $3,041,659 – $6,563 = $3,035,096

 

P12-27.  Suggested solution:

a. Determining the interest rate for the period using a BAII PLUS financial calculator §  The net proceeds (PV) to Candoit are $9,772,469 ($9,972,469– $200,000);  N = 10 (5 × 2); PMT = $150,000 ($10,000,000 × 3% × 6/12) §  10 N, 9772469 +/– PV, 10000000 FV, 150000 PMT, CPT I/Y   I/Y = 1.75%

b. Using a BAII PLUS financial calculator

Net book value at March 16, 2016: §  When the bonds were issued on March 15, 2014, they were five-year bonds (10 period bonds). It is now two years later, so three years (six periods) remain. §  6N, 1.75 I/Y, 10000000 FV, 150000 PMT, CPT PV  PV = –9,858,775 (rounded) Net book value at September 16, 2016: §  When the bonds were issued on March 15, 2014, they were five-year bonds (10 period bonds). It is now 2½ years later, so 2½ years (five periods) remain. §  5N, 1.75 I/Y, 10000000 FV, 150000 PMT, CPT PV  PV = –9,881,304 (rounded)

 

Spreadsheet
Small differences due to rounding
Date	Interest expense		Interest paid		Discount amortized		Amortized cost
Mar. 15, 2014							$9,772,469	(a)
Sept. 15, 2014	$171,018	(b)	$150,000	(c)	$21,018	(d)	9,793,487	(e)
Mar. 15, 2015	171,386		150,000		21,386		9,814,874
Sept. 15, 2015	171,760		150,000		21,760		9,836,634
Mar. 15, 2016	172,141		150,000		22,141		9,858,775	(f)
Sept. 15, 2016	172,529		150,000		22,529		9,881,304	(g)
Mar. 15, 2017	172,923		150,000		22,923		9,904,226
Sept. 15, 2017	173,324		150,000		23,324		9,927,550
Mar. 15, 2018	173,732		150,000		23,732		9,951,283
Sept. 15, 2018	174,147		150,000		24,147		9,975,430
Mar. 15, 2019	174,570		150,000		24,570		10,000,000
(a) net proceeds from issue – $9,972,469 – $200,000 = $9,772,469
(b) $9,772,469 × 1.75% = $171,018
(c) $10,000,000 × 3.0%/2 = $150,000
(d) $171,018 – $150,000 = $21,018
(e) $9,772,469 + $21,018 = $9,793,487
(f) the outstanding balance as at March 15, 2016 equals that determined using the financial calculator approach
(g) the outstanding balance as at Sept. 15, 2016 equals that determined using the financial calculator approach

 

c. The market rate of interest was lower on the date of repurchase than on the date of issue. When the bonds were issued, they were sold at a discount as the market rate of interest was higher than the coupon rate. At date of repurchase, they sold at par implying that the market rate of interest equalled the coupon rate. Hence, the market rate has declined.

d. The repurchase did not result in an economic gain for either Candoit or the investor. The cash paid to redeem the bond was equal to the present value of the future cash flow streams discounted at the market rate of interest on the date of redemption. More simply, there was not an economic gain or loss because the company reacquired the bonds at their fair market value. The loss on redemption suffered by Candoit (and the offsetting gain realized by the investor) were due to the change in the market value when interest rates declined.

 

P12-28.  Suggested solution:

a. The fair value of the bond at time of issue is determined using discounted cash flow analysis.   The book value of the bond at the time of repurchase is determined using discounted cash flow analysis using the original effective rate of interest to discount the remaining cash flow stream. As at date of redemption, there are 5 years (10 periods) left to maturity.
Using a BAII PLUS financial calculator (issue)
§ 24N (12 × 2), 3 I/Y (6%/2), 140,000 PMT ($4,000,000 × 7%/2); 4000000 FV, CPT PV PV = –4,338,711 (rounded)
Issue
Dr. Cash	4,338,711
Cr. Bonds payable			4,338,711
Using a BAII PLUS financial calculator (repurchase – book value)
§ 10 N (5 × 2), 3 I/Y (6%/2), 140,000 PMT ($4,000,000 × 7%/2); 4000000 FV, CPT PV         PV = –4,170,604 (rounded)
Redemption
Dr. Bonds payable	4,170,604
Cr. Gain on redemption of bonds ($4,170,604 – 4,080,000)			90,604
Cr. Cash ($4,000,000 × 102)			4,080,000
b. The fair value of the bond at time of issue is determined using discounted cash flow analysis.   The fair market value of the bond at the time of repurchase is determined using discounted cash flow analysis using the current effective rate of interest (6%/2 = 3%) to discount the remaining cash flow stream. As at date of redemption, there are 4½ years (nine periods) left to maturity.   The book value of the bond at the time of repurchase is determined using discounted cash flow analysis using the original effective rate of interest to discount the remaining cash flow stream. As at date of redemption, there are 4½ years (nine periods) left to maturity.
Using a BAII PLUS financial calculator (issue)
§ 16 N (8 × 2), 3.25 I/Y (6.5/2), 150000 PMT, 6000000 FV, CPT PV PV = –5,445,404 (rounded)
Issue
Dr. Cash	5,445,404
Cr. Bonds payable		5,445,404
Using a BAII PLUS financial calculator (redemption)
market value: § 9 N (4½ × 2), 3 I/Y (6/2), 150000 PMT, 6000000 FV, CPT PV   PV = –5,766,417 (rounded)
book value: § 9 N (4½ × 2), 3.25 I/Y (6.5/2), 150000 PMT, 6000000 FV, CPT PV PV = –5,653,674 (rounded)
Repurchase
Dr. Bonds payable (book value)	5,653,674
Dr. Loss on repurchase of bonds ($5,766,417 –$5,653,674)	112,743
Cr. Cash (market value)		5,766,417

 

P12-29.  Suggested solution:

Disclosures regarding an entity’s indebtedness should cover essential aspects including:

• The nature of contingent liabilities
• A summary of the accounting policies used to determine the measurement basis of valuing liabilities, e.g. amortized cost
• Pertinent details of the indebtedness including collateral pledged and call or conversion privileges
• The fair value of each class of financial liability and how this was determined, e.g., discounted cash flow analysis. This information need not be provided for financial instruments whose carrying value reasonably approximates the carrying value, e.g., trade payables
• Total interest expense on liabilities other than those valued at fair value through profit and loss
• A schedule that details the contractual maturity dates of financial liabilities
• The nature and extent of risks arising from financial liabilities, including credit risk, liquidity risk, and market risk
• Details of any obligations in default, including the carrying amount of loans in default at statement date and whether the default was remedied before the financial statements were issued

 

P12-30.  Suggested solution:

a(i). The fair value of the note is determined using discounted cash flow analysis. The market rate suggested by the bank has been used to discount the obligation. List prices are not necessarily a reliable indicator of the asset’s fair market value. § PV = $10,500 / 1.06 = $9,906
Using a BAII PLUS financial calculator
§ 1 N, 6 I/Y, 10500 FV, CPT PV   PV = –9,906 (rounded)
	Dr. Office furniture		9,906
	Cr. Notes payable (furniture)			9,906
a(ii). The fair value of the note is determined using discounted cash flow analysis as the interest rate in the note is less than the market rate. § PV = $1,040 × PVFA(8%,3) = $1,040 × 2.5771 = $2,680
Using a BAII PLUS financial calculator
§ 3 N, 8 I/Y, 1040 PMT, CPT PV   PV = –2,680 (rounded)
	Dr. Office equipment ($2,680 + $500)		3,180
	Cr. Notes payable (equipment)			2,680
	Cr. Cash			500
a(iii).		Dr. Cash	10,000
		Cr. Notes payable (bank)		10,000
a(iv).		Dr. Interest expense ($9,906 × 6% × 365/365)	594
		Cr. Notes payable (furniture)		594
		Dr. Interest expense ($2,680 × 8% × 334/365)	196
		Cr. Notes payable (equipment)		196
		Dr. Notes payable (bank)	10,000
		Dr. Interest expense ($10,000 × 6% × 302/365)  (# days – include the day issued but not the day paid off)	496
		Cr. Cash ($10,000 + $496)		10,496
a(v).		Dr. Notes payable (furniture) ($9,906 + $594)	10,500
		Cr. Common shares		10,500

 

1. SSBC disclosure relative to the outstanding liabilities would include:

• that the liabilities are carried at amortized cost
• details of the indebtedness including the collateral pledged
• the fair value of each class of financial liability and how this was determined
• total interest expense
• a schedule that details the contractual maturity dates of financial liabilities
• the nature and extent of risks arising from financial liabilities, including credit, liquidity, and market risk

[h1]N. Mini-Cases

Case 1.  Suggested solution:

 

Accounting Issues

This memo presents a review of the accounting issues associated with the long-term debt issued by JCI and its share capital as well as explores the issue of the company’s cash flow.

 

Stock-indexed bond payable

On March 1, 2012, JCI issued long-term, 5%, stock-indexed bonds payable for $6 million. This bond, the principal repayment of which is indexed to the TSX Composite, bears the risk that the principal repayment will increase or decrease due to factors beyond the control of management. This factor makes valuation a key issue for this bond as it represents a contingent settlement provision. What is not clear here is whether the company originally elected to value the financial liability at fair value through profit or loss or at amortized cost. This needs to be determined as it will affect how the liability is accounted for.

 

If the liability is valued at fair value through profit or loss, then the bond would be reported at fair value on the balance sheet with the change in value from the previous balance sheet date being reported as a gain or loss on the income statement. Immediate recognition provides better matching and reflects the risk of the instrument.

 

If the liability is valued at amortized cost using the effective interest method, this would eliminate any earnings fluctuations due to revaluations caused by factors unrelated to the business. There is a presumption, however, that when the amortized cost method is used that the entity can reliably estimate the future cash flows related to the financial instrument. It may be difficult for the company to meet this test as this requires that they estimate the change in the TSX Composite Index six years forward.

 

The manner in which the liability should be classified is a matter of professional judgment. JCI should disclose the interest rate, maturity date, amount outstanding, and the terms of the debt in the notes to the financial statements.

 

Share capital

JCI’s share capital includes 1 million 8% Class A preference shares redeemable at the holder’s option on or after August 10, 2016. These Class A preference shares have some characteristics of a liability instrument (the holder has the right to require the issuer to redeem the share), even if the legal form is equity.

 

It is not clear whether the dividends on these shares are cumulative or non-cumulative and further investigation needs to be undertaken to determine this. If the dividends are cumulative, the entire $7 million should be classified as a liability with any dividends being classified as an interest expense. If, however, the dividends are non-cumulative the shares are a compound financial instrument with the liability component being the present value of the redemption amount. Dividends paid relate to the equity component and represent a distribution of profit and loss.

 

Cash flow issues

JCI seems to have very few guaranteed sources of income and a very low level of short-term revenue. As well, the Brazilian debt may be subject to currency fluctuations and restrictions, making the cash flow from this loan extremely uncertain. To compound this problem, JCI seems to have a fairly high debt load (with the associated interest payments) and high operating expenses.

 

We need to carefully consider JCI’s cash flow situation and what actions JCI would take if the company found itself short of operating cash. We should obtain representations from management as to which investments it would liquidate if cash flow needs arose. This assessment may affect the accounting treatment of certain investments (such as their classification as short term or long term). We should assess whether the value of the liquidated investments would cover JCI’s cash flow needs. If we conclude that JCI is likely to run into serious cash flow difficulties, there may be a need to include a going-concern note in the financial statements or modify our audit report.

 

Case 2.  Suggested solution:

 

Report on Accounting Policies

There are a number of users of the financial statements of TPL, each with different interests:

 

1. The shareholders/builders will use the financial statements to assess the profitability of the Company and to determine what cash, if any, should be distributed.
2. Safe-Way will calculate its royalties on the basis of the revenue-recognition policies adopted by the Company.
3. Customers may use the statements to determine the liquidity and viability of the Company before purchasing a warranty.
4. Other builders may rely on the statements before participating in the warranty programs. Their reputations are at stake.
5. The government may use the statements as part of its review of the Company’s operations from time to time.

 

Accordingly, policies for accruals of future warranty costs will be of great importance to all the users and will affect the long-term viability of TPL. Given the number of users and high levels of assurance each requires, statements should be prepared in accordance with generally accepted accounting principles, with the appropriate disclosures.

The most significant accounting policies that must be developed are for warranty liabilities and expenses and for revenue recognition.

Matching the revenues and expenses is the critical issue because the largest portion of cash from warranty sales is received upfront and expenditures will be made on warranty repairs unevenly over the following 10 years.

To the extent that cash reserves are in place to meet future contingencies, interest will be earned on those funds. Policies should be re-evaluated from year to year according to repair experience and potential increases in reserves from investment income.

 

Warranty liabilities and expenses

Future warranty expenses are difficult to estimate because few warranties of 10 years have been offered in the marketplace. Accordingly, data on repair history for warranties longer than one year are not available in the industry. Further complicating estimations is the fact that new builders do not use materials and construction techniques of identical quality, and there are no controls over the builders participating in the plan.

The market-decline provision due to faulty construction is unique in this industry, so no comparable information is available to determine the extent of the risk arising from this coverage.

Despite the problems with warranty cost estimation, an attempt must be made to quantify the estimated future liability by reviewing the repair history of each builder participating in the plan and the nature of the repairs incurred to date. Otherwise, revenue cannot be recognized until the downstream costs can be reliably estimated.

Historical repair data from each builder should be reviewed to properly estimate the current portion of the warranty liability at the balance sheet date. This is particularly important in light of the Company’s liquidity objective.

 

Revenue recognition

Warranties are a service, as opposed to a good, and as such the revenue recognition criteria of paragraphs 20 and 26 of IAS 18 apply:

 

[start BQ]

¶20      When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognised by reference to the stage of completion of the transaction at the end of the reporting period.  The outcome of a transaction can be estimated reliably when all of the following conditions are satisfied:

 

(a)       the amount of revenue can be measured reliably;

(b)       it is probable that the economic benefits associated with the transaction will flow to the entity;

(c)       the stage of completion of the transaction at the end of the reporting period can be measured reliably; and

(d)       the costs incurred for the transaction and the costs to complete the transaction can be measured reliably.

¶26      When the outcome of the transaction involving the rendering of services cannot be estimated reliably, revenue shall be recognised only to the extent of the expenses recognized that are recoverable.

[end BQ]

 

Given that the home warranties cover multiple years, ideally revenue should be recognized over the period of coverage. If this policy is adopted, a straight-line method is probably not appropriate as the reality of warranties for homes is that the majority of claims will occur in the first two years; if there is a problem with construction, it is much more likely to become apparent in the first year than in later years. Hence, revenues should be recognized in a manner that is higher initially and lower later in a manner that reflects the stage of completion of the service provided. It remains, though, that there is insufficient information to reliably estimate the downstream warranty costs; accordingly, as per paragraph 26, TPL can recognize revenue only to the extent that expenses have been incurred and are recoverable. At this point, due to the upfront fee, recoverability is not an issue and as such revenue can be recognized to the extent that expenses have been incurred ($224,000 as per Exhibit I).

 

Other accounting issues

The repairs and rent charged by Safe-Way to TPL and the royalties received by Safe-Way from the Company are related-party transactions. Details of these transactions must be fully disclosed in the financial statements.

 

Case 3.  Suggested solution:

Part a)

1. This is a very common form of presentation. The benefits include: i) that it is easily understandable by even unsophisticated readers—KCI owes $523,973;  ii) the amount reported complies with IAS 39—the liability is initially valued at its fair value less transaction costs; and iii) the form of presentation does not emphasize premiums and discounts. This is the only one of the three proposals that complies with IAS 39. One drawback is that the recorded obligation does not accurately portray the fair value of the debt incurred—$538,973. Moreover, after issue date, the liability will be reported at amortized cost, which does not allow for changes in the fair value of the amount owed due to changes in the market rate of interest.
2. One benefit of this approach is that the presentation accurately portrays the substance of the transaction. KCI owes $500,000 at maturity; the bondholders paid a premium to acquire the bonds as the rate of interest offered by KCI is higher than the market rate, and the company spent $15,000 on bond-issue-related costs. Another benefit is that the excess of proceeds specifically relating to obligation to pay a rate of interest that is higher than the current market rate of interest is shown separately.

This method of presentation does not comply with IAS 39, though, as the transaction costs must be netted against the loan proceeds and expensed over time using the effective interest method. Also, arguably bond issue costs should be expensed as they do not meet the definition of an asset, which is partially described in IAS 38 as a resource from which future economic benefits are expected to flow to the entity. Critics of this approach contend that the expenditure is analogous to installation costs of equipment. While not directly recoverable, they are necessary to prepare the equipment for use and as such should be expensed over time. While debate of this point is likely to continue, IAS 39 explicitly sets out the required accounting treatment for directly attributable transaction costs on liabilities carried at amortized cost. As such, proposal 2 does not comply with IAS 39.

3. The benefits to this form of presentation include that the liability initially recorded accurately depicts the fair value of the obligation undertaken. Also, it appeals to those who contend that the transaction costs should be immediately expensed as they do not provide an enduring economic benefit. The drawback of this proposal is that it does not comply with IAS 39 with respect to the initial measurement of liabilities recorded at amortized cost.

 

Part b)

The effective rate of interest is 2.6870% per period or 5.4462% per annum [PV – 523,973; FV = 500,000; N = 20; PMT = 15,000; CPT I/Y; I/Y = 2.6870 (rounded); (1 + .026870)²– 1 = 5.4462% (rounded)]. The effective rate is used to determine interest expense as it reflects the interest obligation that KCI accepted at the time of issue inclusive of transaction costs. Using the effective interest rate to discount cash outflows results in the book value of the bond at maturity equalling that of the required cash outflow—$500,000. Also, using the effective interest method provides for more accurate matching of interest costs to the outstanding liability.

 

Part c)

When KCI issues the bonds, it is entering into two related but separate obligations. The first is to pay the principal at maturity and the second is to pay interest every six months over the life of the bond. The $500,000 payout is the same as that that would be received by investors purchasing $500,000 of 5% bonds so can be ignored for the balance of this discussion. The difference lies in the series of interest payments—an annuity—that the investor expects to receive. The KCI bonds pay $15,000 every six months whereas bonds that pay the market rate of 5% per annum only pay $12,500 every six months. Clearly, from an investor’s point of view, receiving $15,000 every six months is more desirable than receiving $12,500. Given this, investors are willing to pay more than $500,000 to receive the incremental interest payment. They collectively bid up the price to $538,973 which is the present value of the future cash flows discounted at the market rate of interest.

 

Part d)

Yes, if KCI designates the liability as held for trading my answer to part “a” will change. Specifically, IAS 39 requires that the liability be initially measured at its fair value ($538,973) and that the transaction costs ($15,000) be expensed. This required accounting treatment is consistent with that illustrated in possibility 3.