Exercises E12-1. Finding The Issue Price (LO 12-2) : Education

Financial Reporting and Analysis (8th Ed.
)
Chapter 12 Solutions
Financial Instruments and Liabilities
Exercises
Exercises
E12-1. Finding the issue price (LO 12-2)

(AICPA adapted)
We know that the bonds were priced to yield 8% when the contract interest
rate was only 6%. Since the yield is higher than the contract interest rate, we
know the bonds were sold at a discount, and we must use the yield to
maturity to find interest expense and the price of the bond.
Face value $100,000

Years to maturity 10
Stated interest rate 6%
Yield to maturity 8%
Present value of principal

($100,000 at 4% for 20 periods: 0.45639) $45,639
Interest payments (3% of $100,000) 3,000
Present value of interest payments

(Annuity of $3,000 for 20 periods at 4%: _40,771
13.59033)
Bond issue (selling) price 7/1/X1

(Present value of the bond) $86,410
12-1
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Education.
E12-2. Determining market price following a change in interest rate (LO 12-2)
Now we’ve moved one year closer to the maturity date. So, two aspects of
the calculation in E12-1 will have changed: The yield to maturity is now 10%
(or 5% per period), and there are 18 periods to maturity.

($100,000 at 5% for 18 periods: 0.41552) $41,552
Present value of interest payments

(Annuity of $3,000 for 18 periods at 5%: _35,069
11.68959)
Bond market price 7/1/X2

(Present value of the bond) $76,621
12-2
Education.
E12-3. Finding the discount at Issuance (LO 12-2)
To find the amount of amortization on July 1, 20X1 we first need to know the
book value of the bond on that date. Since this is the first interest payment
date, the beginning-of-period book value is the same as the original issue
(selling) price, which is the face value less any discount (or plus any
premium). With this knowledge, we can find the interest payable and the
interest expense using the effective and stated interest rates respectively, as
is done below.
Market Rate 14%

Contractual Rate, payable semiannually 12%
Face Value $500,000
Discount ($52,970)
Issue Price of Bond on January 1, 20X1 $447,030
Semiannual:
7/1/X1 Interest expense (7% of $447,030) 31,292
7/1/X1 Interest payment (6% of $500,000) 30,000
7/1/X1 Amortization $ 1,292
Use a calculator or an Excel spreadsheet to determine the $447,030 issue

price, and thus the $52,970 discount ($500,000 face minus $447,030 issue
price).
12-3
Education.
E12-4. Determining a bond’s balance sheet value (LO 12-2)
(AICPA adapted)
Even though the bonds pay interest only annually on December 31, the
June 30 balance sheet would still need to reflect interest accrued since the
issue date:
DR Interest expense $23,475

CR Interest payable $22,500
CR Bond discount 975
Interest expense is $23,475 = $469,500 x 10% x 1/2 year, interest payable is

$22,500 = $500,000 x 9% x 1/2 year, and the amortization is the difference
between these two amounts.
The June 30 book value of the bond is $470,475 or the original issue price of
$469,500 plus the $975 discount amortization.
12-4
Education.
E12-5. Calculating gain or loss at early retirement (LO 12-3)
(AICPA adapted)
The gain (or loss) on bond extinguishment can be computed as follows:
Reacquisition price ($1,020,000

Face value 1,000,000
Unamortized premium 78,000
Book value of bonds 5/1/X3 1,078,000
Gain on extinguishment of debt $58,000
The reacquisition price is the cash paid out by Davis to reacquire its bonds.
Since it is less than the book value of the bonds, the company realizes a gain
on the retirement of its debt.
12-5
Education.
E12-6. Amortizing a premium (LO 12-2)
(AICPA adapted)
To find the amount of unamortized premium on June 30, 20X2, we first need
to find the interest expense for 20X2 (6% of the June 30, 20X1, book value,
6% of $105,000).
Interest Interest Premium

Date Payment Expense Amortization Book Value
6/30/X1 105,000
6/30/X2 7,000 6,300 700 104,300
The carrying (or book) value of the bond on June 30, 20X2, is $104,300. We
know that the face value of the bond is $100,000 and the book value is
$104,300; the difference between the face value and book value of the bond
must be the unamortized premium. So Webb should report $4,300 of
unamortized premium in its June 30, 20X2, balance sheet.
12-6
Education.
E12-7. Zero coupon bond (LO 12-2)
Requirement 1:
These bonds have a face value of $250 million, a zero coupon rate, a
market yield rate of 12%, and mature in 20 years. The issue price is:

($250 million at 12% for 20 periods) $25,916,691
Present value of interest payment

(Annuity of zero for 20 periods at 12%)
0
Bond issue price 1/1/20X1
(Present value of the bond) $25,916,691
Alternatively, using PV tables: $250 million x 0.10367 = $25,917,500
If the market interest rate is instead 12% semi-annually (6% each period for
40 periods), then the bond issue price would be $24,305,547.
Alternatively, using PV tables: $250 million x .09722 = $24,305,000
Requirement 2:
How much interest expense would the company record on the bonds in
20X1? Although the bonds don’t pay interest, an expense would still be
recorded:
Expense = $25,916,691 x 12% = $3,110,003

Alternatively, $25,917,500 x 12% = $3,110,000
Requirement 3:
Interest expense in 20X2 would be:
Expense =( $25,916,691 + $3,110,003) x 12% = $3,483,203 rounded

Alternatively, ($25,917,500 + $3,110,100) x 12% = $3,483,312
12-7
Education.
E12-8. Floating-rate debt (LO 12-5)
Requirement 1:
The floating interest rate for 20X1, set on January 1 of that year, was 12%
or the LIBOR rate of 6% plus 6% additional interest. The 20X1 interest
payment was $24 million ($12 million every 6 months), or the $200 million
borrowed multiplied by the 12% floating rate for the year.
For 20X2, the floating rate will be 14%, or a LIBOR rate of 8% plus 6%
additional interest. So the company will pay out $28 million ($14 million
every 6 months) in interest that year, or $200 million borrowed multiplied by
the 14% floating rate for the year.
Requirement 2:
The debentures were issued at par for $200 million, so there is no discount
or premium to amortize. Interest expense just equals the required cash
interest payment: $24 million in 20X1 and $28 million in 20X2.
12-8
Education.
E12-9. Identifying incentives for early debt retirement (LO 12-3)
Requirement 1:
We must first determine the book value of the bonds on December 31, 20X1
—almost two years after issuance. That would seem easy because the
bonds were issued at par, but there is a catch: The interest payment due
that day has not yet been paid, so we must bring the books up to date by
first recording accrued interest from July 1 through December 31:
DR Interest expense to December 31 $5,000,000

CR Interest payable $5,000,000
$5,000,000 = $125 million x 4%
The total book value (including Interest) of the debt on December 31, 20X1,
is $130 million, the $125 million borrowed plus the $5 million of interest
owed for July 1 through December 31.
The market value of the bonds on December 31, 20X1, is: $125 million face
value, 8% coupon rate paid semi-annually, 13 years to maturity, and yield of
12%:

($125 million at 6% for 26 periods) $27,476,254
Present value of interest payment

(Annuity of $5 million for 26 periods at 6%) 65,015,831
Bond present value 12/31/20X1 $92,492,085

Plus the accrued interest of $5 million gives a total market value of the bond
equal to $97,492,085.
The entry to record the debt extinguishment is:
DR Bonds payable $125,000,000

DR Accrued interest payable 5,000,000
CR Cash $97,492,085
CR Gain on retirement of debt 32,507,915
DR Tax expense (@ 21%) $6,826,662

CR Taxes payable $6,826,662
12-9
Education.
Requirement 2:
There are several reasons a company might want to retire debt early: take
advantage of lower interest rates; postpone scheduled principal
repayments; eliminate a conversion feature attached to the debt; improve
the company’s mix of debt and equity capital; or earnings management
using the “paper” gains from debt retirement. However, unless the company
is awash in cash, voluntary retirement is unlikely since the debt would have
to be replaced at a higher (12%) interest cost.
12-10
Education.
E12-10. Early extinguishment of debt (LO 12-2, LO 12-3)
Requirement 1 – Issuance price
Because the coupon and market rates are equal, the bonds will sell for par value, or
$250,000,000. We can check this result by using present value tables as follows.
Payment $ 10,000,000* X pvoa 20,4% 13.59033 $135,903,300
Principal 250,000,000 X pv 20,4% 0.45639 114,097,500
$250,000,800
*$10,000,000 = $250,000,000 par x 8%÷2.
The computed amount does not equal $250,000,000 because the present value
factors are rounded to only five digits. When we use the Excel pv function (or a
financial calculator) with the assumptions of rate=4%, nper=20, pmt=10,000,000,
and fv=250,000,000 without rounding, we obtain the $250,000,000.
Requirement 2 – Bond price at July 1, 20X3
Remaining periods 16
Market rate 6%
Payments per year 2
Payment 10,000,000 X pvoa 16,3.0% 12.56110 125,611,000
Principal 250,000,000 X pv 16,3.0% 0.62317 155,792,500
281,403,500
Requirement 3 – Journal entry if 50% of the bonds are retired on July 1, 20X3
DR Bonds payable - par 125,000,000a

DR Loss on bond retirement 15,701,750c
CR Cash 140,701,750b
a
Par value of $250,000,000 x 50%.
b
Bond price of $281,403,500 x 50%.
c
Bonds payable of $125,000,000 less cash outflow of $140,701,750.
12-11
Education.
E12-11. Fair value option (LO 12-4)
Requirement 1: Book value on January 1, 20X1
The bonds will be shown at the par of $300 million because the coupon rates and
the market rates are the same.
Requirement 2: Journal entries during 20X1
January 1, 20X1
DR Cash 300,000,000
CR Bonds payable 300,000,000
To record bond issuance
December 31, 20X1

DR Interest expense ($300,000,000 x .06) 18,000,000
CR Cash 18,000,000
To record interest expense
DR Fair value adjustment - Bonds payable 53,956,500 *

CR Unrealized gain - Bonds payable 53,956,500
To record change in bond price
After the second journal entry, the bonds payable net of the adjustment will reflect
fair value. The interest expense and unrealized gain would probably netted in one
financing expense line item on the income statement.
*Price adjustment calculation

Remaining periods
9
Market rate 9%
Payments per year 1
Market value (tables)

Payment 18,000,000 x pvoa 9,9.0% 5.99525 107,914,500
Principal 300,000,000 x pv 9,9.0% 0.46043 138,129,000
246,043,500
Market price 246,043,500

Book value at 12/31/20X1 300,000,000
Adjustment (53,956,500)
12-12
Education.
Requirement 3 - Increase in interest rate and deteriorating financial condition
If the increase in interest rate were due to worsening financial health, the credit
would go to Other comprehensive income - Bonds payable unrealized gain.
Consequently, the gain would be part of Other comprehensive income (OCI)
instead of net income
12-13
Education.
E12-12. Noninterest-bearing loan (LO 12-6)
Requirement 1:
The present value of this payment stream, discounted at 9%, is:
Present value of $100,000 at delivery $100,000

Present value of $200,000 in 1 Year 183,486
Present value of $200,000 in 2 Years 168,336
Total present value of payment stream $451,822
$183,486 = $200,000 x 1/(1.09)

$168,336 = $200,000 x 1/(1.09)2
Requirement 2:
The purchase would be recorded at its implied cash price of $451,822 as:
DR Equipment $451,822
CR Cash $100,000
CR Note payable 351,822
Interest expense at 9% per year on the unpaid balance would also be recorded over time.
Requirement 3:
McClelland should purchase from Agri-Products because it has offered the
best price.
12-14
Education.
Financial Reporting and Analysis (8th Ed.)
Problems/Discussion Questions
Problems
P12-1. Imputing interest (LO 12-6)
Requirement 1:
To verify that the imputed interest rate on the dealer’s loan is 6%, compute
the present value of the payment stream using a 6% discount rate and
confirm that that present value is $19,326. Here is a schedule that shows
the present value of the payment stream at 6%:
Present
value
Down payment Payment factor
$2,000 1.00000 $2,000
Year 1 5,000 0.94340 4,717
Year 2 5,000 0.89000 4,450
Year 3 5,000 0.83962 4,198
Year 4 5,000 0.79209 3,960
Present value of payments $19,325
Requirement 2:
Greg has the funds needed to make the down payment, but must borrow
the remaining amount of purchase price. The dealer has offered Greg a 6%
loan, but the bank is only charging 5%. Greg should borrow from the bank
because it is the least expensive source of funds.
12-15
Education.
P12-2. Reporting bonds issued at a discount (LO 12-2)
Requirement 1:
The issuance price of the bonds on July 1, 20X1 is equal to the present value
of the principal repayment plus the present value of the semi-annual interest
payments. Since the bonds pay interest semi-annually, the present value
calculations are based on a twenty-period horizon using a market interest rate
of 5% (i.e., 10%/2).
Present value of the principal repayment:

= $15,000,000 x Present value of $1 to be received in 20 periods at 5%
= $15,000,000 x 0.37689 = $5,653,350
Present value of the interest payments:
= ($15,000,000 x 0.04) x Present value of an ordinary annuity of $1 to be
received for 20 periods at 5%
= $600,000 x 12.46221 = $7,477,326
Price of the bonds:
= $5,653,350 + $7,477,326 = $13,130,676
Requirement 2:
The amortization schedule appears below:
Effective Amortization of Bond Discount for McVay Corp.

[Market Interest Rate of 5% (semi-annual)]
(a) (b) (c) (d) (e)
Amortization of Discount on B/P
Interest Bond Discount (Beginning Balance Carrying Amount
Expense Cash Payment ($15,000,000
Date (0.05 x e) (Fixed) (a - b) minus c) minus d)
7/1/X1 $1,869,324.00 $13,130,676.00
12/31/X1 $656,533.80 $600,000.00 $56,533.80 1,812,790.20 13,187,209.80
6/30/X2 659,360.49 600,000.00 59,360.49 1,753,429.71 13,246,570.29
12/31/X2 662,328.51 600,000.00 62,328.51 1,691,1014.20 13,308,898.80
6/30/X3 665,444.94 600,000.00 65,444.94 1,625,656.26 13,374,343.74
12-16
Education.
Requirement 3:
The journal entries for the first four interest payments are:
12/31/20X1:
DR Interest expense $656,533.80

CR Cash $600,000.00
CR Discount on bonds payable 56,533.80
6/30/20X2:

CR Cash $600,000.00
12/31/20X2:

CR Cash $600,000.00
6/30/20X3:

CR Cash $600,000.00
Requirement 4:
The balance sheet presentation at 12/31/20X1 would be:
Bonds payable $15,000,000.00

Less: Discount on bonds payable 1,812,790.20
Carrying amount of bonds payable $13,187,209.80

Less: Discount on bonds payable 1,691,101.20
12-17
Education.
P12-3. Reporting bonds issued at a premium (LO 12-2)
Requirement 1:
The issuance price of the bonds on January 1, 20X1, is equal to the present
value of the principal repayment plus the present value of the semi-annual
interest payments. Since the bonds pay interest semi-annually, the present
value calculations are based on a twenty-period horizon using a market
interest rate of 3% (i.e., 6%/2).

= $25,000,000 x 0.55368 = $13,842,000
= ($25,000,000 x 0.04) x Present value of an ordinary annuity of $1 to

be received for 20 periods at 3%
= $1,000,000 x 14.87747 = $14,877,470
Issue price of the bonds:
= $13,842,000 + $14,877,470 = $28,719,470
Requirement 2:
The amortization schedule appears below:
Effective Amortization of Bond Premium for Fleetwood Inc.

[Market interest rate of 3% (semi-annual)]
(a) (b) (c) (d) (e)
Amortization Premium on B/P Carrying
Interest of Bond (Beginning Amount
Expense Cash Payment Premium Balance ($25,000,000
Date (0.03 x e) (Fixed) (b - a) minus c) plus d)
1/1/X1 $3,719,470.00 $28,719,470.00
6/30/X1 $861,584.10 $1,000,000.00$138,415.90 3,581,054.10 28,581,054.10
12/31/X1 857,431.62 1,000,000.00142,568.38 3,438,485.72 28,438,485.72
6/30/X2 853,154.57 1,000,000.00146,845.43 3,291,640.29 28,291,640.29
12/31/X2 848,749.21 1,000,000.00151,250.79 3,140,389.50 28,140,389.50
12-18
Education.
Requirement 3:
The journal entries for the first four interest payments are:
6/30/20X1:

DR Premium on bonds payable 138,415.90
CR Cash $1,000,000.
12/31/20X1:

CR Cash $1,000,000.
6/30/20X2:

CR Cash $1,000,000.
12/31/20X2:

CR Cash $1,000,000.
Requirement 4:

Plus: Premium on bonds payable 3,438,485.72

Plus: Premium on bonds payable 3,140,389.50
12-19
Education.
P12-4. Analyzing installment note and imputed interest (LO 12-3)
Requirement 1:
To verify that the imputed interest rate on the installment note is 10%, we
compute the present value of the payment stream using a 10% discount rate
and confirm that that present value is $6,340. Here is a schedule that shows
the present value of the payment stream at 10%:
Present value
Down payment Payment factor
$0 1,00000 $0
December 31, 20X1 2,000 0.90909 1,818
December 31, 20X2 2,000 0.82645 1,653
December 31, 20X3 2,000 0.75132 1,503
December 31, 20X4 2,000 0.68301 1366
Present value of payments $6,340
Requirement 2:
The following journal entry would be made on January 1, 20X1 to record the
purchase:
DR Equipment $6,340
CR Installment note payable $6,340
Requirements 3 and 4:
The following schedule shows interest expense and the loan balance for each
year:
Balance at Interest Loan Balance at

start of year at 10% payment end of year
20X1 $6,340 $634 $2,000 $4,974
20X2 $4,974 $497 $2,000 $3,471
20X3 $3,471 $347 $2,000 $1,818
20X4 $1,818 $182 $2,000 $0
Interest expense for 20X1 would be $634 and the loan balance at year-end
would be $4,974. Interest expense for 20X2 would be $497 and the loan
balance at year-end would be $3,471. All amounts are rounded to the nearest
dollar.
12-20
Education.
P12-5. Understanding the Fair Value Option (LO 12-4)
Requirement 1:
Mason would make the following entry to record the borrowing and initial
purchase of its corporate bond investment:
January 1, 20X1:
DR Cash $500,000
CR Loan payable $500,000
DR Marketable securities—Corporate bonds $500,000

CR Cash $500,000
As described in more detail in Chapter 17, Mason Manufacturing would make

the following entries to record the fair value of its corporate bond investment
at the end of each quarter. Unrealized holding losses and gains reflect the
fair value change over the period, and flow to the income statement each
quarter. The Market adjustment account is a marketable securities contra-
asset and flows to the balance sheet so that the investment is carried at fair
value.
March 31, 20X1:
DR Unrealized holding loss $50,000

CR Market adjustment—Corporate bonds $50,000
June 30, 20X1:
DR Marketable adjustment—Corporate bonds $30,000

CR Unrealized holding gain $30,000
September 30, 20X1:
DR Marketable adjustment—Corporate bonds $30,000

December 31, 20X1:

CR Market adjustment—Corporate bonds $25,000
12-21
Education.
Requirement 2:
Ignoring interest, the carrying value of the loan under conventional historical
cost accounting would be $500,000 at the end of each quarter. The reason is
that changes in loan (i. e., debt) fair value are ignored under conventional
historical cost accounting for debt.
Requirement 3:
If Mason elects to use the fair value option for debt permitted by ASC Topic
825, the loan’s carrying value would be reset to its fair value each quarter.
The entries to do so are:
March 31, 20X1:
DR Market adjustment—Loan payable $35,000

June 30, 20X1:

CR market adjustment—Loan payable $28,000
September 30, 20X1:

CR Market adjustment—Loan payable $11,000
December 31, 20X1:
DR Market adjustment—Loan payable $9,000

As before, unrealized holding gains and losses flow to the income statement.
The Market adjustment account flows to the balance sheet as a contra-liability
so that the loan is carried at fair value each quarter. Notice that unrealized
gains on Mason Manufacturing’s loan payable partially offset unrealized
losses on its corporate bond investments.
Requirement 4:
Proponents of the fair value option for debt argue that this offset feature
(described in Requirement 3) helps to insulate the income statement from
artificial volatility when inter-corporate investments are financed with loans.
Critics of the fair value option claim that the entries in Requirement 3 mask
the fact that Mason continues to owe the full amount borrowed ($500,000)
despite temporary fluctuations in debt fair value.
P12-6. Fair value option and retiring debt early (LO 12-2, LO 12-3, LO 12-4)
Requirement 1: Bond price at issuance

12-22
Education.
Because the coupon rate and the market rate are the same, the bonds will be
sold at par, $75,000,000. One can check the bond price by using the present
value tables. There is a small difference due to rounding.
Market value - tables

Paymen
t 3,000,000* x pvoa 20,4% 13.59033 40,770,990
Principal 75,000,000 x pv 20,4% 0.45639 34,229,250
75,000,240
$3,000,000 = $75,000,000 x 8% ÷ 2.
Requirement 2: Journal entries during 20X1
January 1, 20X1
DR Cash 75,000,000
CR Bonds payable 75,000,000
To record bond issuance
June 30, 20X1

CR Cash 3,000,000
December 31, 20X1

CR Cash 3,000,000
DR Unrealized loss - Bonds payable 10,314,780 *

CR Fair value adjustment - Bonds payable 10,314,780
After the second journal entry, the bonds payable net of the adjustment
will reflect fair value. The interest expense and unrealized gain would
probably be netted in one financing expense line item on the income
statement.
12-23
Education.
*Price adjustment calculation
Market rate 6%
Payments per year 2
Fair value (tables)

Payment 3,000,000 x pvoa 18, 3% 13.75351 41,260,530
Principal 75,000,000 x pv 18, 3% 0.58739 44,054,250
85,314,780
Fair value at 12/31/20X1 85,314,780

Book value at 12/31/20X1 75,000,000
Adjustment-credit 10,314,780
Requirement 3: General rates remain at 6% but Tango's rate is 10%
June 30, 20X2

CR Cash 3,000,000
December 31, 20X2

CR Cash 3,000,000
DR Fair value adjustment - Bonds payable 893,730 a

CR Unrealized gain - Bonds payable 893,730
DR Fair value adjustment (credit risk) - Bonds payable 17,549,490b

CR OCI - Bonds payable gain (credit risk)
17,549,490
12-24
Education.
a
Price adjustment that effects net income
The fair value changes because there are fewer payments remaining.
Remaining periods 1
6
Market rate 6%
Payments per year 2
Fair value (tables)

Payment 3,000,000 x pvoa 16, 3% 12.56110 37,683,300
Principal 75,000,000 x pv 16, 3% 0.62317 46,737,750
84,421,050
Fair value at 12/31/20X2 using 6% 84,421,050

Fair value at 12/31/20X1 using 6% 85,314,780
Adjustment – debit (893,730)
This adjustment will decrease the book value of the bond.
b
Price adjustment that affects OCI
Market rate 10%
Payments per year 2
Fair value (tables)

Payment 3,000,000 x pvoa 16, 5% 10.8377 32,513,310
7
Principal 75,000,000 x pv 16, 5% 0.45811 34,358,250
66,871,560
Fair value at 12/31/X2 using 10% 66,871,560

Fair value at 12/31/X2 using 6% 84,421,050
Adjustment – debit (17,549,490)
Check of bond payable book value

Bonds payable at issuance price 75,000,000
Fair value adjustment (10,314,780 less 9,421,050
893,730)
Fair value at 6% 84,421,050
Fair value adjustment (credit risk) (17,549,490)
Fair value at 10% 66,871,560
12-25
Education.
Requirement 4 - Bond retirement on 1/1/20X3
DR Bonds payable 75,000,000

DR Fair value adjustment - Bonds payable 9,421,050
CR Fair value adjustment (credit risk) - Bonds payable 17,549,490
CR Cash 66,871,560
DR OCI - Bonds payable gain (credit risk) 17,549,490

CR Gain on bond retirement 17,549,490
To transfer gain from AOCI
Requirement 5 - Bond retirement on 1/1/20X3 (no fair value option)
DR Bonds payable 75,000,000

CR Cash 66,871,560
CR Gain on bond retirement 8,128,440
The gain is lower because the debt had not been increased to fair value in prior years.
12-26
Education.
P12-7. Fair value option (LO 12-4)
Requirement 1:
The bonds were issued on January 1, 20X1 at par, so the proceeds received
by Kahn were equal to the face value ($500 million) of the bonds. There was
no discount or premium to amortize. Interest expense for 20X1 and each
year thereafter is $30 million ($500 million x 6% annual interest). Because
the bonds were issued at par and there was no discount or premium to
amortize, the carrying value on January 1, 20X5 is $500 million.
Requirement 2:
Using a market interest rate of 12%, the market value of the bonds on
January 1, 20X5 is $363,807,304.
Requirement 3:
Let’s illustrate the effect of escalating credit risk using the results in
Requirements 1 and 2. Investors who believe on January 1, 20X1 that
Kahn’s credit risk is accurately captured by the 6% stated interest rate will be
willing to pay par value ($500 million) for the bonds. As the chapter explains,
if investors believed that Kahn’s credit risk was higher than that implied by
6%, the bonds would be issued for an amount less than par value and the
effective (market) interest rate would be higher than 6%.
Now, let’s jump forward in time. If investors still believed on January 1, 20X5
that Kahn’s credit risk is accurately captured by the 6% stated interest rate,
they will continue to price the bonds at par value ($500 million). [You should
verify this fact.] On the other hand, if investors perceive that Kahn’s credit
risk has increased, the fair value of the bonds will decline to reflect the higher
likelihood of nonpayment. Investors who believe that Kahn’s credit risk is
accurately captured by a 12% interest rate will assign a value of only $363.8
million (rounded) to the bonds. Under this scenario, the value to investors of
Kahn’s has declined in the marketplace because the perceived risk of
nonpayment by Kahn has increased.
Requirement 4:
Kahn elected to use the fair value option in accounting for its debt, and thus
recorded the following journal entry:
DR Fair value adjustment -Bonds $2.7 billion

CR Unrealized holding gain-Bonds $2.7 billion
The fair value adjustment reduces the balance sheet carrying value of the
bonds, and the unrealized holding gain flows to the income statement and
increases reported earnings for the period.
Requirement 5:
12-27
Education.
Opponents of the fair value accounting option for debt point to the counter-
intuitive financial statement result: as a company’s credit risk increases and
the slow march toward bankruptcy ensues, it reports higher earnings because
of the fair value accounting option’s “unrealized holding gain.” This additional
earnings also increases reported stockholders’ equity, yet it is difficult to
believe that shareholders reap economic gains as the company heads to
bankruptcy. Moreover, opponents argue, the company remains legally
obligated to repay the entire amount borrowed (plus interest), not some
smaller amount represented by the debt’s fair value.
12-28
Education.
P12-8. Discount and premium amortization (LO 12-2)
Requirement 1:
The carrying values of both bonds in each of the two years presented is
simply equal to the present value of the principal and interest payments
discounted over the remaining life of the bond. To illustrate, the December
31, 20X3, value of $9,653,550 for the 10% bonds due in 20X5 can be
derived as follows. Note that these bonds pay semi-annual interest of
$500,000 and have four periods until they mature. Present value of the
principal repayment:

= $10,000,000 x 0.7921 = $7,921,000
= $500,000 x Present value of an ordinary annuity of $1 to be received in
4 periods at 6%
= $500,000 x 3.4651 = $1,732,550
Carrying value of the bonds at December 31, 20X3:
= $7,921,000 + $1,732,550 = $9,653,550
In a similar fashion, the December 31, 20X4, value of $10,362,950 for the
10% bonds due in 20X6 can be derived as follows. Note that these bonds
pay semi-annual interest of $500,000 and have four periods until they
mature.

= $10,000,000 x 0.8548 = $8,548,000

4 periods at 4%
= $500,000 x 3.6299 = $1,814,950
= $8,548,000 + $1,814,950 = $10,362,950
12-29
Education.
The December 31, 20X4 carrying value of the 10% bonds due in 20X5 is
equal to the present value of the principal repayment to be received in 2
periods plus the present value of the 2 remaining interest payments
discounted at the original market rate of 6% (i.e., 12%/2).

= $10,000,000 x 0.8900 = $8,900,000

2 periods at 6%
= $500,000 x 1.8334 = $916,700
= $8,900,000 + $916,700 = $9,816,700
The December 31, 20X3, carrying value of the 10% bonds due in 20X6 is
equal to the present value of the principal repayment to be received in 6
periods plus the present value of the 6 remaining interest payments
discounted at the original market rate of 4% (i.e., 8%/2).

= $10,000,000 x 0.7903 = $7,903,000

6 periods at 4%
= $500,000 x 5.2421 = $2,621,050
= $7,903,000 + $2,621,050 = $10,524,050
12-30
Education.
Requirement 2:
The amount of interest expense recognized in 20X4 on the bonds due in
20X5 is equal to the cash interest payment of $1 million ($500,000 on both
June 30 and December 31) plus the amortization of the bond discount
during 20X4. This latter amount is the difference between the carrying value
of the bonds at December 31, 20X3, and December 31, 20X4. Based on the
calculations in part 1, this amount is:
= $9,816,700 - $9,653,550 = $163,150
Total interest expense:
= $1,000,000 + $163,150 = $1,163,150
Requirement 3:
The amount of interest expense recognized in 20X4 on the bonds due in
20X6 is equal to the cash interest payment of $1 million ($500,000 on both
June 30 and December 31) minus the amortization of the bond premium
during 20X4. This latter amount is the difference between the carrying value
of the bonds at December 31, 20X3, and December 31, 20X4. Based on the
calculations in part 1, this amount is:
= $10,524,050 - $10,362,950 = $161,100
Total interest expense:
= $1,000,000 - $161,100 = $838,900
12-31
Education.
P12-9. Reading the Financials (LO 12-1, LO 12-2, LO 12-7)
Requirement 1:
There are two correct solutions to this requirement, depending upon how
you interpret the company’s “14.6% effective rate” disclosure. If this is the
annual effective interest rate then interest expense for the year is found by
multiplying the beginning book value of the debt by its effective interest rate:
Interest expense = $182,700,000 x 14.6% = $26,674,200
Notice that interest expense is different from the cash interest payment,
which can be found by multiplying the debt face value by the stated interest
rate:
Interest payment = $300,000,000 x 7% = $21,000,000
The discount amortization is the difference between the expense and cash
payment shown above, or $5,674,200 = $26,674,200 minus $21,000,000.
The book value change shown on the balance sheet is $5,900,000 (or
$188.6 million minus $182.7 million). The discount amortization should
equal the change in balance sheet book values, but the two numbers differ
here because of rounding in the reported interest rate or in the reported
book values.
An alternative solution is based on the notion that the disclosed “14.6%

effective rate” is meant to be interpreted as meaning a semi-annual effective
rate of 7.3%. In this case, we have to build up the annual interest expense
from two semi-annual calculations:
1. First semi-annual period

Interest payment = $300,000,000 x 3.5% = 10,500,000
Discount amortized = $ 2,837,100
Ending book value of debt (including amortized discount) is now

$185,537,100.
2. Second semi-annual period

Interest payment = $300,000,000 x 3.5 = 10,500,000
Discount = $ 3,044,208
These semi-annual calculations show total interest expense to be

$26,881,308 and the total discount amortization to be $5,881,308.
Requirement 2:
12-32
Education.
There are two ways to compute interest expense on the zero coupon bonds:
Or, since the entire expense is amortized (there’s no cash payment), it is all
added to the debt book value. Consequently, interest expense will equal the
increase in carrying value of the bonds, or:
Interest expense = $267.9 million - $239.2 million = $28.7 million
Requirement 3:
The following entry would have been made on December 31, Year 2, for the
participating mortgages:
DR Interest expense $72.549

CR Cash $71.949
CR Discount on mortgage 0.600
$72.549 = $833.9 x 8.7% and $0.600 = $834.5 - $833.9
Requirement 4:
The zero coupon bonds do not pay cash interest. $21 million was paid out
on the 7% debentures, i.e., $300 million face value times 7%.
12-33
Education.
P12-10. Working backward from an amortization table (LO 12-2)
Requirement 1:
Compute:
 Discount or premium on the sale
Premium = Amount received ($540,554) - Face value ($500,000)

= $40,554
 Semi-annual stated interest rate: ($25,000/$500,000) x 10
 Semi-annual effective interest rate: ($21,622/$540,554) x 10
Requirement 2:
At the time of issuance, the bondholders exchanged today’s cash flow for
tomorrow’s, but with the same present value on a risk-adjusted basis.
Consequently, neither the borrower nor the lender made a profit (or loss) at
the time of the issuance of bonds. Consequently, no gain or loss should be
recorded at that time. The discount/premium merely reflects the difference
between the face value and the price of the bonds, a difference that arises
because the stated interest rate is not equal to the market yield (effective)
rate. Amortizing discounts and premiums over time allows interest expense
to be properly recorded at the true cost of borrowing.
Requirement 3:
It is the present value of an annuity of $25,000 for the next 5 periods plus
the present value of $500,000 to be received at the end of 5 periods, both
discounted at the original semi-annual effective rate of 4%.
Requirement 4:
New price of the bonds on January 1, 20X4, is:
$478,939 = ($25,000 x 4.21236) + ($500,000 x 0.74726)
The economic gain that results from the interest rate increase is:
Book value of the bond = $522,258

Market value (present value) of debt = 478,939
Economic gain $43,319
Considering just the debt, the company and its shareholders are better off
because of the interest rate increase. The economic gain is the reduced
present value of debt payments (principal plus interest) at the new higher
interest rate. The cash outflow has a lower present value—indicating
bondholders will be receiving a less valuable payment stream.
12-34
Education.
Of course, things get a bit more complicated when the interest rate increase
has a negative impact on the company’s other activities. For example, if the
company sells products to customers on an installment payment plan,
higher interest rates may lead to lower product sales. In addition, we have
presumed that interest rates have increased throughout the economy and
not just for this company.
12-35
Education.
P12-11. Recording floating-rate debt (LO 12-5)
Requirement 1:
Journal entry to record the issuance on January 1, 20X1:
DR Cash $250,000,000
CR Bonds payable $250,000,000
If the bonds were issued at par, the effective (or market) interest rate must
have been equal to the stated rate of “LIBOR + 5.5%”, or 12%, since the
LIBOR was 6.5% at the issue date.
Requirement 2:
Interest expense for 20X1:
Interest rate = LIBOR + 5.5% = 6.50% + 5.50% = 12.0%

Interest expense = 12.0% x $250,000,000 = $30,000,000
DR Interest expense $30,000,000

CR Cash $30,000,000


CR Cash $31,250,000


CR Cash $27,500,000
Requirement 3:
If the only factor influencing the market value of these bonds is the LIBOR,
the bonds will have a market value of $250 million on 12/31/20X3. This is
because the interest rate on the bonds is reset annually so that the present
value of the principal and remaining interest payments always equals $250
million at the new rate.
12-36
Education.
P12-12. Debt-for-debt swaps (LO 12-4, LO 12-8)
Requirement 1:
Since the bonds were originally sold at par, the carrying amount on
December 31, 20X1 is equal to $5,000,000. If this bond issued were retired
in exchange for a bond issue valued at $3,200,000 there would be a pre-tax
gain of $1,800,000. The journal entry to record the exchange would be:
DR Bonds payable (old) $5,000,000

CR Bonds payable (new) $3,200,000
CR Income tax payable (current)* 378,000
CR Gain on debt retirement** 1,422,000
*$378,000 = $1,800,000 x 0.21 **$1,422,000 = $1,800,000 x (1.0 - 0.21)
Requirement 2:
Long-term debt-to-equity ratio after the swap:
= ($7,500,000 - $5,000,000 + $3,200,000) / ($12,500,000 + $1,422,000)

= 40.9%
Requirement 3:
The transaction would increase net income by $1,422,000 (see above).
Requirement 4:
Other ways to avoid the covenant’s violation include: issue additional
common stock, reissue any treasury stock that is being held, make changes
to accounting methods (e.g., depreciation of assets, useful lives, salvage
values, etc.) that are income increasing, and/or exchange common stock for
some outstanding debt.
Requirement 5:
IFRS guidance stipulates that an exchange of financial instruments qualifies
as an extinguishment of debt only if the terms—stated interest rate,
duration, payment schedule, etc.—of the instruments are “substantially”
different. Absent substantial differences in terms, no extinguishment gain or
loss is recorded under IFRS. So, Chain Corporation would be required to
demonstrate that the terms associated with the old 7% coupon bonds and
the new 14% bonds are substantially different.
12-37
Education.
P12-13. Zero coupon bonds (LO 12-2)
Requirement 1:
Korman issued $1.0 billion maturity value zero coupon debentures at a price
of $553.68 per $1,000 maturity value. The total cash proceeds to the
company (ignoring any investment banking fees associated with the
transaction) was:
Cash proceeds = $553.68 x ($1.0 billion / $1,000) = $553,680,000.
Requirement 2:
The present value factor for a 3% yield to maturity over twenty years is
given by:
Present value factor = ¿¿ = 0.553676
which implies an issue price of $553.68 per $1,000 principal amount at

maturity.
Requirement 3:
January 1, 20X0
DR Cash (financing inflow) $553.68 m

CR Zero coupon debentures $553.68 m
To record the issuance of $1b zero coupon debentures at a price of

$553.68 per $1,000 principal amount at maturity. (Note: investment
banking fees—if any—are ignored in this entry.)
12-38
Education.
December 31, 20X0
DR Interest expense (0.03 x $553.68 m)$ 16.610 m

CR Zero coupon debentures $ 16.610 m
To record interest expense for the year at a 3% effective interest rate.
Requirement 4:
Interest rates throughout the economy have declined, making Korman’s 3%
zero coupon debentures even more attractive to investors who then bid up
the price of the company’s debt.
12-39
Education.
P12-14. Comprehensive problem on premium bond (LO 12-2)
The following schedule shows the details for most parts of this question.
Amortization table for 20-year bond with semi-annual interest payments

Bond Principal $20,000,000
Coupon Interest Rate 6.0%
Market Interest Rate 4.0%
Month and Year Issued July-X1
Amortization Table
Bond
Bond Carrying (Premium) Premium Bond Carrying Cost
Payment Amount at Interest Discount (Discount) Amount at Interest Principal
Month/Year Period Start of Period Expense Amortization Balance End of Period Payment Payment
Issue date: $27,917,110 $7,917,110
December-X1 1 $27,917,110 $1,116,684($83,316) $7,833,794 $27,833,794 $1,200,000

$0
June-X2 2 27,833,794 1,113,352 (86,648) 7,747,146 27,747,146 1,200,000
0
December-X2 3 27,747,146 1,109,886 (90,114) 7,657,032 27,657,032 1,200,000
0
June-X3 4 27,657,032 1,106,281 (93,719) 7,563,313 27,563,313 1,200,000
0
December-X3 5 27,563,313 1,102,533 (97,467) 7,465,845 27,465,845 1,200,000
0
June-X4 6 27,465,845 1,098,634(101,366) 7,364,479 27,364,479 1,200,000
0
December-X4 7 27,364,479 1,094,579(105,421) 7,259,058 27,259,058 1,200,000
0
June-X5 8 27,259,058 1,090,362(109,638) 7,149,421 27,149,421 1,200,000
0
December-X5 9 27,149,421 1,085,977(114,023) 7,035,397 27,035,397 1,200,000
0
June-X6 10 27,035,397 1,081,416(118,584) 6,916,813 26,916,813 1,200,000
0
December-X6 11 26,916,813 1,076,673(123,327) 6,793,486 26,793,486 1,200,000
0
June-X7 12 26,793,486 1,071,739(128,261) 6,665,225 26,665,225 1,200,000
0
Requirement 1:
The July 1, 20X1 issue price is $27,917,110.
Requirement 2:
The partial amortization table is shown above.
Requirement 3:
Interest expense and cash interest payment information is given in the
amortization table. The entry for June 30, 20X2 is:

DR Premium on bonds 86,648
CR Cash $1,200,000
The entry for December 31, 20X2 is:

12-40
Education.
DR Premium on bonds 90,114
CR Cash $1,200,000
Requirement 4:
Points to be made include: the company received $27.9 million cash in
exchange for a promise to repay on $20 million in principal and $2.4 million
in interest each year; because more than $20 million was received, the true
interest rate is less than 6% each period; some of each year’s interest
payment is really a payment on the principal; to reflect these facts properly
on the books, interest expense is recorded at the true market rate (4% each
period) and using the true amount owed—book value of the debt including
unamortized premium.
Requirement 5:
From the amortization schedule in Requirement 1, we can see that the book
value of the entire debt issue is $26,665,225 on July 1, 20X7. So, the book
value of 40% of the debt would be $10,666,090 (rounded). If the company
exercised its call provision and retired 40% of the debt (or $8,000,000 face
value) at a price of 105, the following entry would be made:
DR Bonds payable $8,000,000

DR Premium on bonds (0.4 x $6,665,225) 2,666,090
CR Cash $8,400,000
CR Gain on extinguishment of debt 2,266,090
Requirement 6:
If the market yield on the debt is 10%, its market price would be
$22,979,625 and 40% of the debt would have a market value of $9,191,850.
This means that the company paid $791,850 less by calling the debt than it
would have paid buying the debt on the open market.
12-41
Education.
Financial Reporting and Analysis (8th Ed.)
Cases
Cases
C12-1. Century and beyond bonds (LO 12-1, LO 12-2)
Requirement 1: Present value of principal to price
The issue price of Draper’s $200 million century bonds is also $200 million.
The follows from the fact that the market yield (7.5%) exactly equals the
stated interest rate. A financial calculator on Excel spreadsheet is needed to
perform the detailed calculation of how much of the issue price comes from
the promised principal payment vs. interest payments. Here we sketch the
calculation.
To find the principal contribution to issue price, we need to determine the

present value of $200 million to be received 100 years from January 1, 20X1
using the market yield of 7.5% as our discount rate. The present value factor
for a single payment in 100 periods at 7.5% is 0.000723. Multiplying this
factor by the amount of the payment ($200 million) yields a present value of
$145,000 (rounded to the nearest $1,000 dollars). This figure is the dollar
contribution of debt principal to the issue price. To find the relative
(percentage) contribution, just divide the dollar contribution by the issue price
($145,000 / $200,000,000) and you have 0.0725%. In other words, the
principal contributes less than one one-hundredth of a percent to the issue
price.
What about the interest payment stream? Well, interest payments must
contribute the remaining amount of the issue price ($200,000,000 minus
$145,000) or $199.855 million. This represents 99.9275% of the issue price
Requirement 2: Tax savings

The present value of the company’s interest tax deduction is equal to the
present value of the interest payment stream, multiplied by the effective tax
rate of 21%. This tax savings present value is $199.855 million x 21%, or
$41.970 million if interest deductibility spans the entire 100 years.
To find the amount of tax savings lost if only the first 40 years of interest
payments are deductible, we first need to find the present value of the 40
year interest payment stream. Using a financial calculator or Excel
spreadsheet, you can determine that the present value of a 40 period annuity
of $15 million each year—the annual interest payment—at 7.5% is $188.916
million. The tax benefit of this 40-year deduction is $39.672 million ($188.916
million x 21%) in present value terms. This means that restricting the
deductibility of interest to the first 40 years will reduce the present value of the
12-42
Education.
tax savings by only $2.298 million ($41.970 million less $39.672 million), or
roughly 5.5%.
Requirement 3: Issue price at different rates

The market yield (8.5%) is above the stated (coupon) interest rate, and this
means the $200 million century bonds will sell at a discount to their face
value. To find the issue price using a financial calculator or Excel
spreadsheet, you must determine:
a. The present value of the interest payments stream, which is $15 million
each year for 100 years, discounted at 8.5%, or $176.420 million.
b. The present value of the principal payment, which is $200 million due in
100 years, discounted at 8.5%, or $0.057 million.
Combining these two amounts yields an issue price of $176.477 million.
If the market yield is only 6.5%, the issue price becomes $230.713 million,
composed of an interest payment stream worth $230.344 million and a
principal payment worth $0.368 million.
Requirement 4: Ohio State bond

A major source of cash for educational institutions such as The Ohio State
University is tuition paid by students. The primary economic benefit from
issuing century bonds is that Ohio State has access to $500 million cash
immediately rather having to wait until sometime in the future when tuition
payments are actually received. In a sense, the bonds allow Ohio State to
“monetize” its anticipated future tuition payments so that the cash can be
used today. Of course, when those future tuition payments are received
some of the cash collected will be dedicated to repaying the century bond
interest and principal.
Requirement 5: Reason for Treasury or Congress intervention

Both the treasury and Congress are concerned that these bonds do not meet
the definition of debt, and therefore, should not receive the interest deduction
for 100 years. This issue relates to tax fairness. A second issue relates to
funding government operations. The government will receive less in tax
revenue, if companies can deduct the interest in computing taxable income.
However, as Requirement 2 shows, the loss in tax revenue may not be that
high on a single company basis. Congress and the treasury may be
concerned that the loss in tax revenue could be material if more firms were
allowed to issue these types of bonds.
Requirement 6: GAAP treatment

GAAP currently treats century and millennium bonds, as they are described
here, as debt. This may change in the future.
C12-2 Interpreting long-term debt disclosures (LO 12-1, LO 12-7)
Requirement 1:
$1,402 from the balance sheet
12-43
Education.
Requirement 2:
$1,298 from the cash flow statement
Requirement 3:
The difference is $104. This appears to suggest that payment on the note
payable in Note 5 was not made during Year 2, but that it is included in the
current maturities amount of $2,747 as of the end of Year 2.From Note 5:
$2,747 - $1,794 - $416 - $432 = $105  $104 Rounded, where $416 is (4 x
$104) and $432 is (4 x$108).
Requirement 4:
Current portion is $2,747
$1,794
Remaining principal on note
432 4 quarterly installments on industrial development bond
416 4 quarterly installments on note payable
104 see Question #3
____1 Rounding
$2,747
Requirement 5:
Journal entry for March 31:
DR Current installment on mortgage $108

DR Interest expense 49
CR Cash $157
Simple interest = $1,401 x .14 x 1/4 = $49
Requirement 6:
Journal entry for April 30:
DR Current installment on mortgage $1,794

DR Interest expense* 63
CR Mortgage on property $1,794
CR Cash 63
*$1,794 x .14 x 1/4 = $63
12-44
Education.
Requirement 7:
Journal entry for April 30, assuming full payment.
DR Current installment on mortgage $1,794

DR Interest expense 63
CR Cash $1,857
12-45
Education.
C12-3 Dentsply International: Analyzing long-term debt disclosures (LO 12-1,
LO 12-2, LO 12-7)
Requirement 1: Change in amount and composition of debt

The debt amount declined slightly from 2011 to 2012. Individual amount
changes appear to have occurred because of premium or discount
amortization or changes in foreign currency values. Note that the Japanese
debt amount decreased, but the Swiss debt amount increased.
The debt composition changed little from 2011 to 2012. No new debt was
issued. “Other borrowings, various currencies and rates” declined slightly.
Requirement 2: Difference between fair value and book value

At December 31, 2012, the fair value of debt of $1,515.2 million exceeds the
book value of $1,472.9 million. The higher fair value indicates that the
market demands lower interest rates on Dentsply’s debt than was
demanded when Dentsply originally issued the debt.
Requirement 3: Weighted-average interest rate

The weighted-average rate of interest on Dentsply’s long-term debt is
3.01%. To arrive at this figure, multiply the principal balance of each debt
instrument by its corresponding interest rate. Add the resulting amounts and
divide that sum by the total amount of debt outstanding at year-end
($1,472.913 million).
There are two features of this calculation to notice. First, the weighted-
average interest rate is not simply the average of the interest rates reported
in the financial statement note. Each reported interest rate is weighted by
the dollar amount of debt to which it is associated. Second, one category of
long-term debt (“Other borrowings..”) does not have an interest rate shown
in the table. This solutions assumes that Other borrowings have an interest
rate consistent with the weighted-average rate for Dentsply’s other loans
(3.01%).
Requirement 4: Interest expense for 2013

Forecasted interest expense for 2013 is $44.296 million. This amount is
computed as total long-term debt outstanding as of the end of 2012
($1,472.913 million) multiplied by the weighted average interest rate of
3.01%
Requirement 5: Cash payout on debt

The company is obligated to make 2013 cash payments on debt in the
amount of $295.174 million. This figure is the sum the schedule principal
payment ($250.878) shown in the financial statement note plus forecasted
2013 interest expense ($44.296). Any non-cash component to interest
12-46
Education.
expense arising from original issuance discounts and premia has been
ignored for purposes of this calculation since they are small in magnitude.
Requirement 6: Dentsply’s ability to meet its debt obligations

The note indicates that Dentsply should be able to meet its debt obligations.
The fair value of its debt exceeds the debt book value (see part 2). The
2012 cash from operating activities exceeds the 2013 servicing payments
(see part 5). In addition, the 2012 cash from operating activities exceeds
debt maturities for most years except 2016. The note also indicates that
Dentsply has access to credit lines and probably could refinance its debt.
Compare this analysis to the one connected with the Chesapeake Energy
Corporation information in Exhibit 11.10. Chesapeake’s debt fair value was
less than the debt book value, and its cash from operations could not meet
its debt servicing. In addition, Chesapeake had to enter into a troubled debt
restructuring.
12-47
Education.
C12-4. Toys “R” Us: Identifying financial distress and potential bankruptcy (LO
12-2, LO 12-7)
This is a good case with which to get student participation. There are
numerous indicators of financial weakness. They are listed below.
1. Shareholders’ equity is negative.

2. The company has negative cash from operations.
3. The company has had losses in the last two years.
4. Interest expense exceeds operating earnings.
5. The fair value of debt is less than the carrying value of debt. One reason
for this relation would be that the debt is becoming riskier.
6. Most of the debt is due within the next five years.
7. The new debt exchanged for the old debt has higher interest rates (12%
versus 10.375% and 7.375%).
8. The company must operate under severe restrictions because of debt
covenants. For example, it can pay dividends, sell assets, or take on new
debt without permission.
9. It states that “We are dependent on the borrowings provided by the
lenders to support our working capital needs, capital expenditures and to
service debt.”
12-48
Education.

Exercises E12-1. Finding The Issue Price (LO 12-2) : Education

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Exercises E12-1. Finding The Issue Price (LO 12-2) : Education

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Financial Reporting and Analysis (8th Ed.

E12-1. Finding the issue price (LO 12-2)

Face value $100,000

Present value of principal

Interest payments (3% of $100,000) 3,000

Present value of interest payments

Bond issue (selling) price 7/1/X1

Present value of principal

Present value of interest payments

Bond market price 7/1/X2

Market Rate 14%

Issue Price of Bond on January 1, 20X1 $447,030

7/1/X1 Interest payment (6% of $500,000) 30,000

7/1/X1 Amortization $ 1,292

Use a calculator or an Excel spreadsheet to determine the $447,030 issue

DR Interest expense $23,475

Interest expense is $23,475 = $469,500 x 10% x 1/2 year, interest payable is

The gain (or loss) on bond extinguishment can be computed as follows:

Reacquisition price ($1,020,000

Interest Interest Premium

Present value of principal

Present value of interest payment

Expense = $25,916,691 x 12% = $3,110,003

Expense =( $25,916,691 + $3,110,003) x 12% = $3,483,203 rounded

DR Interest expense to December 31 $5,000,000

$5,000,000 = $125 million x 4%

Present value of principal

Present value of interest payment

Bond present value 12/31/20X1 $92,492,085

The entry to record the debt extinguishment is:

DR Bonds payable $125,000,000

DR Tax expense (@ 21%) $6,826,662

Requirement 1 – Issuance price

*$10,000,000 = $250,000,000 par x 8%÷2.

Requirement 2 – Bond price at July 1, 20X3

DR Bonds payable - par 125,000,000a

Requirement 1: Book value on January 1, 20X1

Requirement 2: Journal entries during 20X1

December 31, 20X1

DR Fair value adjustment - Bonds payable 53,956,500 *

*Price adjustment calculation

Market value (tables)

Market price 246,043,500

Present value of $100,000 at delivery $100,000

$183,486 = $200,000 x 1/(1.09)

Present value of the principal repayment:

Effective Amortization of Bond Discount for McVay Corp.

DR Interest expense $656,533.80

DR Interest expense $659,360.49

DR Interest expense $662,328.51

DR Interest expense $665,444.94

Bonds payable $15,000,000.00

The balance sheet presentation at 12/31/20X2 would be:

Bonds payable $15,000,000.00

Present value of the principal repayment:

= $25,000,000 x Present value of $1 to be received in 20 periods at 3%

Present value of the interest payments:

= ($25,000,000 x 0.04) x Present value of an ordinary annuity of $1 to

Issue price of the bonds:

= $13,842,000 + $14,877,470 = $28,719,470

Effective Amortization of Bond Premium for Fleetwood Inc.

DR Interest expense $861,584.10

DR Interest expense $857,431.62