Fa4e Sm Ch09

Chapter 9 Reporting and Analyzing Liabilities Learning Objectives – coverage by question MiniExercises LO1 – Identify and account for current operating liabilities. LO2 – Describe and account for current nonoperating (financial) liabilities. LO3 – Explain and illustrate the pricing of long-term nonoperating liabilities. LO4 – Analyze and account for financial statement effects of longterm nonoperating liabilities. LO5 – Explain how solvency ratios and debt ratings are determined and how they impact the cost of debt.

Exercises

Problems

Cases and Projects

38 - 40, 49

59

61

21

49

59

22, 31, 32,

42, 43,

34 - 37

45 - 48, 50

18, 19, 21, 22, 25, 30

23, 24, 26 - 29, 31, 34 - 36

23, 30, 32

41, 42, 44 - 50

43

51 - 60

60, 61

51 - 58

60, 61

51

60, 61

©Cambridge Business Publishers, 2014 Solutions Manual, Chapter 9

9-1

DISCUSSION QUESTIONS Q9-1.

Current liabilities are obligations that require payment within the coming year or operating cycle, whichever is longer. Generally, current liabilities are normally settled with use of existing current assets or operating cash flows.

Q9-2.

If a company fails to take a cash discount that is offered by a supplier, it is effectively paying a penalty for taking additional time to pay the account payable. Depending on the size of the discount, this penalty (an implicit interest rate) can be quite high. The net-of-discount method records the inventory at the purchase cost less the discount. If the discount is lost, the extra cost is treated as part of interest expense for the period. This has two benefits: (1) the lost discount is not capitalized as part of the cost of inventory, and (2) the lost discount is highlighted, which is useful information that may be helpful in managing accounts payable.

Q9-3.

An accrual is the recognition of an event in the financial statements even though no actual transaction has occurred. Accruals can involve both liabilities (and expenses) and assets (and revenues). Accruals are vital to the fair presentation of the financial condition of a company as they impact both the recognition of revenue and the matching of expense.

Q9-4.

The coupon rate is the rate specified on the face of the bond. It is used to compute the amount of cash interest paid to the bond holder. The market rate is the rate of return expected by investors that purchase the bonds. The market rate determines the market price of the bond. It incorporates expectations about the relative riskiness of the borrower and the rate of inflation. In general, there is an inverse relation between the bond’s market rate and the bond’s market price.

Q9-5.

Bonds sold at face (par) value earn an effective interest rate equal to the bonds’ coupon rate. Bonds are sold at a discount when the effective interest rate is higher than the coupon rate. Bonds are sold at a premium when the effective interest rate is lower than the coupon rate.

Q9-6.

Bonds are reported at historical cost, that is, the face amount plus (minus) unamortized premium (discount). The market price of the bonds varies inversely with the level of interest rates and fluctuates continuously. Differences between the market price of a bond and its carrying amount represent unrealized gains and losses. These unrealized gains (losses) are not reflected in the financial statements (although they are disclosed in the footnotes). They must be recognized upon repurchase of the bonds, the point at which they become ―realized.‖ continued next page

©Cambridge Business Publishers, 2014 9-2

Financial Accounting, 4th Edition

continued

If the bonds are refunded (that is, replaced with new bonds reflecting current market values and interest rates), the gain (or loss) that is recognized in the current period will be offset by correspondingly higher (lower) interest payments in the future. The present value of the future interest payments, along with the present value of the difference between the face amount of the new bond and the former face amount, exactly offset the reported gain (loss). Q9-7.

Debt ratings reflect the relative riskiness of the borrowing company. This riskiness relates to the probability of default (e.g., not repaying the principal and interest when due). Higher (greater quality) debt ratings result in higher market prices for the bonds and a correspondingly lower effective interest rate for the issuer. Lower (lesser quality) debt ratings result in lower market prices for the bonds and a correspondingly higher effective interest rate for the issuer.

Q9-8.

Reported gains or losses on bond redemption result from changes in the market price of the bonds and the use of historical cost accounting. Because bonds are typically reported at historical cost, fluctuations in bond prices are not recognized until they are realized when the bonds are redeemed or refunded. If the bonds are refunded (new bonds are issued), the gain or loss is offset by the present value of lower (higher) future interest payments on the new bond issue.

Q9-9.

(a) Term loan – a loan that matures on a single, pre-specified date (b) Bonds payable – the liability account used to record the face value of bonds issued by a company (c) Serial bonds – bonds that mature in installments rather than on one date (d) Call provision – the right for the bond issuer to repurchase the debt, before it matures, at a predetermined price. (e) Convertible bonds – bonds that can be converted into some other asset (typically common stock) at the option of the bondholder (f) Face value – the predetermined amount (typically $1,000) that must be repaid when a bond matures (g) Nominal rate – the rate specified on the face of the bond that determines the periodic interest (coupon) payment (h) Bond discount – the difference between the face value of the bond and the market price when the price is lower than the face value; recorded as a contra-liability (i) Bond premium – the difference between the market price of a bond and the face value when the market price is higher than the face value; recorded as an adjunct-liability (j) Amortization of premium or discount – the periodic reduction of the balance in the premium or discount account recorded each time interest expense is accrued; equal to the difference between the accrued interest and the coupon payment (or payable) ©Cambridge Business Publishers, 2014

Solutions Manual, Chapter 9

9-3

Q9-10. The advantages of issuing bonds are (1) the interest payments are limited to the predetermined amount specified on the bond; (2) the interest is tax deductible; (3) bondholders do not have a vote when it comes to electing directors and managing the company; (4) the additional financial leverage created when bonds are issued increases profits in good years. The disadvantages of bonds include (1) bonds must be repaid while common stock is issued with an indefinite life; (2) bondholders can impose restrictive covenants in the loan indenture; (3) the additional financial leverage created when bonds are issued decreases profits in lean years. Q9-11. $3,000,000 x [.98 + (.09 x 3/12)] = $3,007,500 Q9-12. The contract rate (or stated rate or coupon rate) determines the periodic coupon payment. If this rate is not equal to the rate required by the market, the bond price is adjusted to the present value of the cash payments from the bond discounted at the applicable market rate of interest. If the market rate is higher than the coupon rate, then the periodic coupon payments are insufficient and the bond will be priced lower than the face value (a discount). If the market rate is lower than the coupon rate, then the periodic coupon payments will be higher than required by the market, and the bond will sell for a premium. Q9-13. When the bonds mature, the book value of the bonds will be equal to the face value. Over the life of the bonds, the change in the book value of the bonds will be equal to face value less the market value at the time that the bonds are issued. Q9-14. When the effective interest method is used to amortize a bond discount or premium, the effective rate is multiplied by the net balance in bonds payable (bonds payable plus/minus the premium or discount). If the bond is issued at a discount, the balance increases over the life of the bond; the interest expense will increase as the balance increases. If the bond is issued at a premium, the balance decreases over the life of the bond; the interest expense will decrease as the balance decreases. Q9-15. Bonds payable is presented in the balance sheet net of any discount or plus any premium. Q9-16. The loss is the difference between the retirement value and the book value of the bond: 101% x $200,000 – $197,600 = $4,400. Q9-17. Each payment includes both interest on the outstanding balance and repayment of the principal. As each payment is made, the principal balance is reduced. As a consequence, the interest component of the payment is smaller each period.



MINI EXERCISES M9-18. (15 minutes) a. 11/15

11/23

Inventory (+A) Accounts payable (+L)

6,076

Accounts payable (-L) Cash (-A)

6,076

6,076

6,076

$6,076 = $6,200 x 0.98.

b. + 11/15

Inventory (A) 6,076

-

11/23

+

Cash (A)

Accounts Payable (L) 6,076 6,076

+ 11/15

6,076

11/23

c. [($6,200 - $6,076)/$6,076] x [365/(30-10)] = 37.24%. (With interest compounding, the annual rate of interest r can be solved from (1+r)(20/365)=1.02. The value that solves this relationship is r = 43.5%.)


9-5

M9-19. (15 minutes) a. 1/20

2/15

Inventory (+A) Accounts payable (+L)

12,250

Accounts payable (-L) Interest expense, discounts lost (+E, -SE) Cash (-A)

12,250 250

12,250

12,500

$12,250 = $12,500 x 0.98. b. + 1/20

Inventory (A) 12,250

-

2/15

+

Cash (A)

12,500

2/15

Accounts Payable (L) 12,250 12,250

+ 1/20

+ Interest Expense, Discounts Lost (E) 2/15 250

-

c. [($12,500- $12,250)/$12,250] x [365/(60-15)] = 16.55%. (With interest compounding, the annual rate of interest r can be solved from (1+r)(45/365)=1.02. The value that solves this relationship is r = 17.4%.) M9-20. (10 minutes) a. Interest expense (+E,-SE)…………………… Interest payable (+L)…………………….

24 24

b. -

Interest Payable (L)

+

24

+

a.

a.

Interest Expense (E)

-

24

c. Transaction

Cash Asset

Balance Sheet Noncash LiabilContrib. + = + + Assets ities Capital

Accrued $24 interest on note payable

=

+24 Interest Payable

Income Statement Earned capital -24 Retained Earnings

Revenues - Expenses = -

+24 Interest Expense

Net Income -24

=



M9-21. (15 minutes) a. Accounts Payable, $110,000 (current liability). b. Not recorded as a liability; an accountable transaction has not yet occurred. c. Estimated liability for product warranty, $2,200 (current liability). d. Bonuses Payable, $30,000 (current liability)—computed as $600,000  5%. This liability must be reported since its payment is ―probable‖ and can be ―estimated.‖

M9-22. (10 minutes) a. Boston Scientific is offering bonds with a coupon (stated) rate of 4.25% when the market rate (yield) is higher (4.349%). In order to obtain this expected rate of return, the bonds sell at a discount price of 99.476 (99.476% of par). b. The first bond matures in 2011 while the second matures in 2017. There is, generally, a higher rate (yield) expected for a longer maturity.

M9-23. (10 minutes) Amount paid to retire bonds ($200,000 x 101%).............................................. $202,000 Book value of retired bonds, net of $2,400 unamortized discount ................... 197,600 Loss on bond retirement .................................................................................. $ 4,400

M9-24. (10 minutes) a. The $597 million indicates that BMY has bonds maturing that will require payment in the amount of $597 million in 2013. b. BMY will need to pay off the bonds when they mature. This will result in a cash outflow that must come from operating activities if the bonds cannot be refinanced prior to maturity. However, most of BMY’s long-term debt matures more than 5 years after the financial statement date (December 31, 2011). Thus, BMY’s nearterm cash needs for covering long-term debt should not place a significant burden on the company’s operations.


9-7

M9-25 (10 minutes) a. Gain on Bond Retirement: In the other (nonoperating) revenues and expenses section unless it meets the tests for extraordinary treatment (e.g., unusual and infrequent) b. Discount on Bonds Payable: Deduction from Bonds Payable; thus, a (contra) long-term liability in the balance sheet (e.g., it is netted in the presentation of long-term liabilities). c. Mortgage Notes Payable: Long-term liability in the balance sheet. d. Bonds Payable: Long-term liability in the balance sheet. e. Bond Interest Expense: In other (nonoperating) revenues and expenses section of income statement. f. Bond Interest Payable: Current liability in the balance sheet. g. Premium on Bonds Payable: Addition to Bonds Payable; thus, part of a long-term liability in the balance sheet (e.g., it is included in the presentation of long-term liabilities). h. Loss on Bond Retirement: In the other (nonoperating) revenues and expenses section unless it meets the tests for extraordinary treatment (e.g., unusual and infrequent)

M9-26. (10 minutes) a. Restrictive loan covenants are typically designed to protect the bond holders against actions by management that they feel would be detrimental to their interests. These covenants might include restrictions against the impairment of liquidity, restrictions on the amount of financial leverage the company can employ, and restrictions on the payment of dividends. In addition, bond holders usually impose various covenants prohibiting the acquisition of other companies or the divestiture of business segments without their consent. All of these covenants, by design, restrict management in its actions. b. Management, facing imminent violation of one or more of its bond covenants, may be pressured into taking actions in order to avoid default. These may include, for example, foregoing profitable investments, reduction of discretionary spending such as R&D or advertising in order to improve profitability, missing opportunities to take cash discounts and other methods of ―leaning on the trade,‖ or reduction of receivables (via early payment incentives) and inventories (by marketing promotions or delaying restocking) in order to boost cash balances. Actions may also include questionable accounting measures, such as improper recognition of revenues or delayed recognition of expenses. continued next page ©Cambridge Business Publishers, 2014 9-8


M9-26. concluded c. When evaluation solvency, analysts should compare a company’s position relative to its restrictive covenants. A company pay appear solvent, but in fact may be in close proximity to a restrictive covenant. Also, analysts should be aware of the potential effect that restrictive covenants can have management decisions (see the answer to requirement b). Restricted assets, such as cash or securities, should not be considered as general assets in an analysis of the firm’s liquidity or solvency because they are not available to management for general corporate uses.

M9-27. (15 minutes) a. 1/1/2008

1/1/2014

Cash (+A) ……………………………………..... Bonds payable (+L) ………………..…… Bond premium (+L) ………………..……

432,000

Bonds payable (-L) ………………………..….. Bond premium (-L) ……………………..…….. Cash (-A) ………………………………..... Gain on retirement of bonds (+R, +SE)

400,000 27,809

400,000 32,000

412,000 15,809

b. + 1/1/08

-

Cash (A) 432,000 412,000

-

-

1/1/14

1/1/14

Gain on Retirement of Bonds (R) + 15,809 1/1/14

1/1/14

Bonds Payable (L) 400,000 400,000

+

Bond Premium (L) 32,000 27,809

+

1/1/08

1/1/08

c. Transaction

Cash Asset

1/1/08 Issue bonds at a premium.

432,000 Cash

Balance Sheet Noncash Contrib. + = Liabilities + + Assets Capital

Income Statement Earned Capital

Revenues - Expenses =

+400,000 Bonds Payable =

1/1/14 Retired bonds issued on 1/1/08.

Net Income

+32,000 Bonds Payable, net -400,000 Bonds Payable

-412,000 Cash =

+15,809 Retained Earnings

+15,809 Gain on Retirement of Bonds

=

+15,809

-

=

-27,809 Bonds Payable, net


9-9

M9-28. (15 minutes) a. 7/1/2007

7/1/2014

Cash (+A) ……………………………………. Bond discount (+XL, -L) …………….….…. Bonds payable (+L) ………………….. Bonds payable (-L) ………………………… Loss on retirement of bonds (+E, -SE) … Bond discount (-XL, +L) ……….…… Cash (-A) ……………………………….

240,000 10,000 250,000

250,000 9,314 6,814 252,500

b. + 7/1/07

Cash (A) 240,000 252,500

7/1/14

7/1/14

+ Loss on Retirement of Bonds (E) 7/1/14 9,314

+ 7/1/07

Bonds Payable (L) 250,000 250,000

+

Bond Discount (XL) 10,000 6,814

-

7/1/07

7/1/14

c. Transaction 7/1/07 Issue bonds at a discount

Cash Asset


+240,000 Cash


Net Income


7/1/14 Retired bonds issued on 7/1/03


-10,000 Bonds Payable, net -250,000 Bonds Payable

-252,500 Cash

-9,314 Retained Earnings

=

-

=

+9,314 Loss on retirement of Bonds

-9,314

=

+6,814 Bonds Payable, net

M9-29. (10 minutes) Nissim:

$18,000  0.10  40/365

=

$197.26

Klein:

$14,000  0.09  18/365

=

62.14

Bildersee:

$16,000  0.12  12/365

=

63.12 $322.52



M9-30. (10 minutes) a. The Debt-to-Equity ratio (D/E) will likely change, but the direction and amount is difficult to determine from the information given. The increase in outstanding debt by $450 million (-$742.6+$1200.0-$7.4) along with the net share repurchases of $646.9 million ($1163.5-$516.6) and dividend payments of $739.7 million will increase D/E. (The effect of the share repurchases on reported equity is not provided – the $1163.5 million is the market value of the repurchased shares.) Times interest earned will decrease as additional interest cost on new borrowing is added to the denominator. How much of an effect this will have depends on the size of the change in net income. b. Generally, the higher (lower) the firm's solvency measures, the higher (lower) the firm's debt rating. In financial leverage terms, the higher (lower) the firm's leverage the lower (higher) the firm's debt rating. Increasing the amount of debt while decreasing equity may harm General Mills’ debt ratings.

M9-31. (15 minutes) a. Selling price of 9% bonds discounted at 8% Present value of principal repayment ($500,000  0.45639) .................... $228,195 Present value of interest payments ($22,500  13.59033) .................... 305,782 Selling price of bonds ..................................................................................... $533,977 b. Selling price of 9% bonds discounted at 10% Present value of principal repayment ($500,000  0.37689) .................... $188,445 Present value of interest payments ($22,500  12.46221) .................... 280,400 Selling price of bonds ..................................................................................... $468,845

M9-32. (15 minutes) a. Selling price of zero-coupon bonds discounted at 8%: Present value of principal repayment ($500,000  0.45639)

$228,195

b. Selling price of zero coupon bonds discounted at 10%: Present value of principal repayment ($500,000  0.37689)

$188,445

c. Based on the debt-to-equity ratio, financial leverage would increase from 2.0 [=($3 $1)/$1] to 2.19 [=($3 - $1 + $0.188)/$1)


9-11

M9-33. (15 minutes) a. 1.

2.

3.

4.

5.

Inventory (+A) …………………………………. Accounts payable (+L) …………………

300

Accounts receivable (+A) …………………… Sales revenue (+R, +SE) …..…………..

420

Cost of goods sold (+E, -SE) ………………. Inventory (-A) ……………………………

300

Accounts payable (-L) ………………………. Cash (-A) …………………………………

300

Cash (+A) ……………………………………… Accounts receivable (-A) ………………

420

300

420

300

300

300

b. +

Cash (A)

300

5.

2.

4.

420

4.

+ Accounts Receivable (A) 420 420 +

1.

Accounts Payable (L) 300 300

Inventory (A) 300

-

1.

+ 2.

5.

300

Sales Revenue (R) 420

+

+ 3.

Cost of Goods Sold (E) 300

-

3.

c. Transaction

Cash Asset


1. Purchase inventory on account.

+300 Inventory

=

2. Sell inventory on credit.

+420 Accts Rec

=

3. Cost of sales from 2.

-300 Inventory

=

4. Paid cash for inventory purchased in 1. d. Receive cash on receivable from 2.

-300 Cash 420 Cash

= -420 Accts Rec

=



+300 Accounts Payable +420 Retained Earnings -300 Retained Earnings -300 Accounts Payable

+420 Sales

-

=

-

=

Net Income

+420

-

+300 Cost of Goods Sold

-300 =

-

=

-

=



M9-34.(30 minutes)


9-13

M9-35. (15 minutes) a.

Gain on bond retirement

Reported in the income statement under other (nonoperating) income

b.

Discount on bonds payable

Contra-liability netted against bonds payable under long-term liabilities in the balance sheet

c.

Mortgage notes payable

Long-term liability in the balance sheet; the amount due within one year would be reported as a current liability

d.

Bonds payable

Long-term liability in the balance sheet; the amount due within one year would be reported as a current liability

e.

Bond interest expense

Nonoperating expense reported in the income statement

f.

Bond interest payable

A current liability in the balance sheet

g.

Premium on bonds payable

Adjunct-liability added to bonds payable under long-term liabilities in the balance sheet

M9-36. (15 minutes) a. 12/31/13

6/30/14

12/31/14

Cash (+A) …………………………………….. 700,000 Mortgage note payable (+L) …………..

700,000

Interest expense (+E, -SE) ………………….. Mortgage note payable (-L) …………………. Cash (-A) ………………………………….

42,000 8,854

Interest expense (+E, -SE) ………………….. Mortgage note payable (-L) …………………. Cash (-A) ………………………………….

41,469 9,385

50,854

50,854

* $41,469 = ($700,000 – $8,854) x 12%/2.

continued next page



M9-36. concluded b. + 12/31/13

Cash (A) 700,000

50,854 50,854

+ 6/30/14 12/31/14

Interest Expense (E) 42,000 41,469

-

6/30/14 12/31/14

Mortgage Note Payable (L) + 700,000 12/31/13 6/30/14 8,854 12/31/14 9,385

-

c. Transaction 12/31/13 Borrow $700,000 on a 15-year mortgage note payable. 6/30/14 Interest payment on note. 12/31/14 Interest payment on note.

Cash Asset


+700,000 Cash

-50,854 Cash

-50,854 Cash



+700,000 Mortgage = Note Payable -8,854 Mortgage = Note Payable -9,385 Mortgage = Note Payable

-

-42,000 Retained Earnings -41,469 Retained Earnings

-

-

Net Income

=

+42,000 Interest Expense +41,469 Interest Expense

-42,000 = -41,469 =

M9-37. (5 minutes) $900,000 x 0.55839 + (900,000 x 10%/2) x 7.36009 = $833,755. $833,755 / $900,000 = 92.6% of par value.


9-15

EXERCISES E9-38. (15 minutes) a. Total expected failures from units sold (69,000  0.02) ......................

1,380

Average cost per failure ...................................................................... Total expected future warranty costs ..................................................

 $50 $69,000

Current warranty liability ..................................................................... Additional warranty cost liability required............................................

$10,000 $ 59,000

The product warranty liability must be increased by $59,000 to cover the expected repair costs, (because the warranty is for a 60-day period, the $10,000 remaining in the liability account represents unused amounts left from prior years’ accruals). Warranty expense of $59,000 must be recorded in the income statement when the liability account is increased. b. The warranty liability should be equal, at all times, to the expected dollar cost of repairs. Analysis issues relate to whether the warranty liability exists and, if so, is it at the correct amount. Understating (overstating) the accrual overstates (understates) current period income at the expense (benefit) of future income. c. The debt-to-equity ratio will increase and the operating cash flow to liabilities will decrease. The times-interest earned ratio will not be affected.

E9-39. (10 minutes) Item

Accounting Treatment

a.

Neither record nor disclose (neither probable nor reasonably possible)

b.

Record a current liability for the note, no liability for interest until incurred

c.

Disclose in a footnote (at least reasonably possible)

d.

Record warranty liability on balance sheet and recognize expense in income statement (costs are probable and reasonably estimable).



E9-40. (15 minutes) The company must accrue the $25,000 of wages that have been earned by employees even though these wages will not be paid until the first of next month. The required accounting accrual will: 

increase wages payable by $25,000 on the balance sheet



increase wages expense by $25,000 in the income statement

Failure to make this accounting accrual (called adjusting entry) would understate liabilities, understate expenses, overstate income, and overstate stockholders’ equity.

M9-41. (15 minutes) a. Selling price of bonds: Present value of principal repayment ($300,000  0.30832) .................. $ 92,496 Present value of interest payments ($16,500  17.29203) ........... 285,318 Selling price of bonds $377,814 b. 1/1/14

6/30/14

Cash (+A) …………………………………….. Bond premium (+L) …………………… Bonds payable (+L) ……………...……

377,814 77,814 300,000

Interest expense (+E, -SE) ………………… Bond premium (-L) ……………...………….. Cash (-A) ………………………………..

15,113 1,387 16,500

12/31/14 Interest expense (+E, -SE) ………………… Bond premium (-L) …………………………. Cash (-A) ………………………………..

15,057 1,443 16,500

* $15,057 = ($377,814 – $1,387) x 8%/2.

c. + 1/1/14

Cash (A) 377,814

16,500 16,500

+ 6/30/14 12/31/14


-

Bonds Payable (L) 300,000

+

Bond Premium (L) 77,814 1,387 1,443

+

1/1/10

6/30/10 12/31/10 -

6/30/14 12/31/14

1/1/10

continued next page ©Cambridge Business Publishers, 2014 Solutions Manual, Chapter 9

9-17

M9-41. concluded d. Balance Sheet Transaction 1/1/14 Issue bonds at a premium.

Cash Asset

+

Income Statement

Noncash Contrib. = Liabilities + + Assets Capital

+377,814 Cash

Earned Capital


+300, Payable =

6/30/14 Interest payment on bonds. 12/31/14 Interest payment on bonds.

-16,500 Cash -16,500 Cash

-

+77,814 Bonds Payable, net -1,387 = Bonds Payable, net -1,443 = Bonds Payable, net


-

-

=


-15,113 = -15,057 =

E9-42. (10 minutes) Selling price of bonds Present value of principal repayment ($900,000  0.44230) .................... $398,070 Present value of interest payments ($49,500  9.29498) ......................... 460,102 Selling price of bonds ................................................................................ $858,172

E9-43. (15minutes) a. Warranty expense (+E, -SE) ……………………. Warranty liability (+L)……………………

123.0 123.0

b. -

Accrued Warranty Liability (L) + 60.5 07 bal. 08 cost 125.1 123.0 08 exp. 55.2 08 bal.

+

Warranty Expense (E)

-

123.0

c. 2008: $123.0 / $6,086.1 = 2.0% 2007: $118.8 / $6563.2 = 1.8%. Warranty expense appears to have increased in 2008 as a percentage of sales revenue.


Net Income


E9-44. (15 minutes) a. Cash (+A) ………………………………………... Bonds payable (+L) ………………………

5/1/13

10/31/13 Interest expense (+E, -SE) …………………… Cash (-A) ………………………………….. 11/1/14 Bonds payable (-L) ……………………………. Loss on retirement of bonds (+E, -SE) ……. Cash (-A) …………………………………..

500,000 500,000 22,5001 22,500 300,000 3,000 303,0002

1

$500,000 x 0.09 x 1/2 = $22,500 interest expense. Because the bonds were sold at par, there is no discount or premium amortization.

2

Cash required to retire $300,000 of bonds at 101 = $300,000 x 1.01 = $303,000. The difference between the cash paid and the carrying amount of the bonds is the gain or loss on the redemption. In this case, the loss is $3,000. This calculation assumes that the interest was paid on 10/31/14, so accrued interest is not recorded.

b. + 5/1/13

Cash (A) 500,000

-

22,500 303,000 + 10/31/13

10/31/10 11/1/11

Interest Expense (E) 22,500

-


11/1/14

+ 5/1/13

300,000

+ Loss on Retirement of Bonds (E) 11/1/14 3,000

c. Transaction 5/1/10 Issue bonds.

Cash Asset


+500,000 Cash

=

10/31/10Interest payment on bonds.

-22,500 Cash

=

11/1/11 Early retirement of bonds.

-303,000 Cash

=


+500,000 Bonds Payable

-300,000 Bonds Payable



Net Income

=

+22,500 Interest = Expense +3,000 Loss on = Retirement of Bonds

-22,500

-

-3,000


9-19

E9-45. (25 minutes) a. Selling price of bonds Present value of principal repayment ($250,000  0.41552) ............... $103,880 Present value of interest payments ($10,000  11.68959) .................. 116,896 Selling price of bonds .......................................................................... $220,776 b. 1/1/13

6/30/13

Cash (+A) ………………………………………. Bond discount (+XL, -L) ……………………… Bonds payable (+L) ……………………..

220,776 29,224

Interest expense (+E, -SE) …………………… Bond Discount (-XL, +L) ………….……. Cash (-A) …………………………………..

11,039

250,000

1,039 10,000

$11,039 = $220,776  .05.

12/31/13 Interest expense (+E, -SE) …………………. Bond Discount (-XL, +L) …………….…. Cash (-A) …………………………………..

11,091 1,091 10,000

$11,091 = [$220,776 + $1,039]  .05.

c. + 1/1/13

+ 6/30/13 12/31/13

Cash (A) 220,776 10,000 10,000 Interest Expense (E)

-

-


+ 1/1/13

6/30/13 12/31/13 -

+ 1/1/13

11,039 11,091

Bond Discount (XL) 29,224 1,039 1,091

6/30/13 12/31/13

d. Transaction 1/1/10 Issue bonds at a discount.

Cash Asset


+220,776 Cash


-10,000 Cash -10,000 Cash

-29,224 Bonds Payable, net +1,039 = Bonds Payable, net +1,091 = Bonds Payable, net

-


-

-

=


-11,039 = -11,091 =


Net Income





E9-46. (25 minutes) a. Selling price of bonds: Present value of principal repayment ($800,000  0.20829) ............... $166,632 Present value of interest payments ($36,000  19.79277) .................. 712,540 Selling price of bonds .......................................................................... $879,172 b. Cash (+A) ………………………………………... Bond premium (+L) ……………………… Bonds payable (+L) ………………………

879,172

6/30/14 Interest expense (+E,-SE) ……………………. Bond premium (-L) …………….……………… Cash (-A) …………………………………..

35,167 833

1/1/14

79,172 800,000

36,000

$35,167 = $879,172 x .04.

12/31/14 Interest expense (+E,-SE) ……………………. Bond premium (-L) …………….……………… Cash (-A) …………………………………..

35,134 866 36,000

$35,134 = ($879,171 - $833) x .04.

c. + 1/1/14

Cash (A) 879,172

36,000 36,000

+


+ 1/1/14

Bond Premium (L) 79,172 6/30/14 833 12/31/14 866

+ 1/1/14

6/30/14 12/31/14


6/30/14 12/31/14

-

-

35,167 35,134

-

d. Balance Sheet Transaction 1/1/14 Issue bonds at a premium.

Cash Asset

+


+879,172 Cash


-36,000 Cash -36,000 Cash

Net Income




+79,172 Bonds Payable, net -833 = Bonds Payable, net -866 = Bonds Payable, net

-


-

-

=


-35,167 = -35,134 =


9-21

E9-47. (20 minutes) a. There is an inverse relation between interest rates and bond prices (examine the increasing discount rates as the yield increases in present value tables). Since the bonds now trade at a premium and assuming that Deere’s credit ratings have not changed, we can conclude that interest rates have fallen since the bonds were issued. b. No, once the bond is initially recorded, neither the coupon rate nor the yield used to compute interest expense is changed. Bonds are recorded at historical cost (like most other balance sheet assets and liabilities). As a result, changes in the general level of interest rates have no effect on interest expense (or the interest payment) that is reflected in the financial statements. c. Because the bonds trade at a premium in the market, Deere would be paying more to retire the bonds than the amount at which they are carried on its balance sheet. This would result in a loss on the repurchase that would lower current profitability. d. The face amount of the bonds will be paid at maturity. As a result, the market price of the bonds must also equal their face amount ($200 million) at that time.

E9-48. (25 minutes) a. Selling price of bonds Present value of principal repayment ($600,000  0.09722) ............... $ 58,332 Present value of interest payments ($33,000  15.04630) .................. 496,528 Selling price of bonds .......................................................................... $554,860 b. Cash (+A) ………………………………………….. Bond discount (+XL, -L) ………………..……… Bonds payable (+L) ………………………..

554,860 45,140

6/30/13 Interest expense (+E, -SE) ……………………… Bond discount (-XL, +L) ……………….…. Cash (-A) …………………………………….

33,292

1/1/13

600,000

292 33,000

$33,292 = $554,860  .06.

12/31/13 Interest expense (+E, -SE) ……………………… Bond discount (-XL, +L) …………….……. Cash (-A) ………….………………………….

33,309 309 33,000

$33,309 = ($554,860 + $292)  .06.

continued next page



E9-48. concluded c. + 1/1/13

+ 6/30/13 12/31/13

Cash (A) 554,860 33,000 33,000 Interest Expense (E)

-

-


+ 1/1/10

Bond Discount (XL) 45,140 292 309

+ 1/1/13

6/30/13 12/31/13 -

33,292 33,309

6/30/13 12/31/13

d. At December 31, 2013 (after the coupon payment recorded in b) the book value of the bonds would be $554,860 + $292 + $309 = $555,461. The market value would be $600,000 X 1.01 = $606,000. Thus, a fair value adjustment of $50,539 (=$606,000-$555,461) would be recorded as follows: 12/31/13 Loss due to adjustment of bonds to fair value (+E, -SE) Fair value adjustment (+L) ……………….….

50,539 50,539

e. Coupon payments ($33,000 X 2) …………… Discount amortization ($292 + $309) ……… Total interest expense ……………………….. Fair value adjustment ………………………... Total effect on income (deduction) ………..

$66,000 601 66,601 50,539 $117,140

E9-49. (10 minutes) Current liabilities: Bond interest payable Current maturities of long-term debt: 10% bonds payable due 2014, including $15,000 premium Total current liabilities

515,000 $540,000

Long-term debt: 9% bonds payable due 2015, net of $19,000 discount Zero coupon bonds payable due 2016 8% bonds payable due 2018 Total long-term debt

$581,000 170,500 100,000 $851,500

$ 25,000


9-23

E9-50. (20 minutes) a. 12/31/13 Cash (+A) …………………………………………… Mortgage note payable (+L) ……………….

500,000

Interest expense (+E, -SE) ………………………. Mortgage note payable (-L) ……………………... Cash (-A) ………………………………………

10,000 8,278

Interest expense (+E, -SE) ………………………. Mortgage note payable (-L) ……………………... Cash (-A) ………………………………………

9,834 8,444

3/31/14

6/30/14

500,000

18,278

18,278

$9,834 = ($500,000 – $8,278) x 8%/4.

b. + 12/31/13

Cash (A) 500,000

18,278 18,278

+ 3/31/14 6/30/14


-

3/31/14 6/30/14


-

c. Transaction

Cash Asset


12/31/13 Borrow +500,000 $500,000 on a 10Cash year mortgage note payable. 3/31/14 Interest -18,278 payment on note. Cash

6/30/14 Interest payment on note.

-18,278 Cash

+500,000 Mortgage Note Payable -8,278 Mortgage = Note Payable -8,444 Mortgage = Note Payable


=



-

-

Net Income

= +10,000 Interest Expense +9,834 Interest Expense

-10,000 = -9,834 =



PROBLEMS P9-51. (20 minutes) a. -

Hewlett-Packard Accrued Warranty Liability (L) + 2,447 10 bal. 2,657 11 exp.

2,653

-

Dell Inc. Accrued Warranty Liability (L) + 895 10 bal. 1,025 11 exp.

1,032 2,451

11 bal.

888

11 bal.

Hewlwtt-Packard incurred $2,653 million in warranty repair costs and settlements in 2011 while Dell, Inc. incurred costs of $1,032 million. b. HP’s ratio of warranty expense to sales was 3.1% in 2011 ($2,657/$84,757) down slightly from 3.2% in 2010 ($2,689/$84,799). Dell’s ratio was 2.1% both years ($1,005/$49,906 in 2011 and $1,042/$50,002 in 2010). Dell’s warranty expense is lower relative to sales revenue than that of HP. Possible reasons for this include the following: (1) perhaps Dell products are higher- quality and require fewer repairs than HP products or (2) HP may have a more generous warranty policy than Dell, resulting in more warranty repairs, even if the quality is the same. The decrease in HP’s warranty expense as a percent of sales indicates that either (1) warranty costs have gone down, (2) the company overestimated warranty costs in the past and needed to record smaller than normal accruals in 2011 to correct the overestimation; or (3) HP was building up a ―cookie-jar reserve‖ by increasing its warranty liability in past years.


9-25

P9-52. (20 minutes) a. Cash (+A) ………………………………………….. Accrued interest payable (+L) …………… Bonds payable (+L) ………………………..

518,750 18,750 500,000

$18,750 = $500,000 x .09 x 5/12

b. Interest expense (+E, -SE)………………………. Accrued interest payable (-L) ………………….. Cash (-A) ……………………………………..

3,750 18,750 22,500

$22,500 = $500,000 x 9%/2

c. Interest expense (+E, -SE) ……………………… Accrued interest payable (+L) ……………

7,500 7,500

$7,500 = $500,000 x 9% x 2/12

d. Fair value adjustment (+XL, -L) ……………….. Gain from adjustment of bonds to fair value (+R, +SE) ……………………………..

5,000

e. Interest expense (+E, -SE) ……………………… Accrued interest payable (-L) ………………….. Cash (-A) ……………………………………..

15,000 7,500

Bonds payable (-L) ………………………………. Loss on retirement of bonds (+E, -SE) ………. Cash (-A) …………………………………….. Fair value adjustment (-XL, +L) …

300,000 18,000

f.

5,000

22,500

303,000 15,000 continued next page



P9-52. concluded + a.

Cash (A) 518,750

-

-

22,500 22,500 303,000 + b. c. e. d.

Interest expense (E)

b. e. f. -

f.

a.

300,000

-

Accrued Interest Payable (L) + 18,750 b. 18,750 7,500 e. 7,500 + Loss on Retirement of Bonds (E) f. 18,000

3,750 7,500 15,000 Fair Value Adjustment (L) 5,000 15,000

Bonds payable (L) + 500,000

+

a. c.

f. - Gain from Fair Value Adjustment + 5,000

Balance Sheet Transaction

Cash Asset

a. (10/1/13) Issue bonds.

+518,750 Cash

+


Income Statement Earned capital


-22,500 Cash

e. (5/1/14) Interest payment on bonds. f. 5/1/18 Early retirement of bonds.

-22,500 Cash

Net Income


b. (11/1/13) Interest payment on bonds. c. (12/31/13) Accrued interest on bonds. d. (12/31/13) Fair value adjustment

d.

=

=

=

-303,000 Cash =

+18,750 Interest Payable -18,750 Interest Payable +7,500 Interest Payable -5,000 Fair value adjustment -7,500 Interest Payable -300,000 Bonds Payable +15,000 Fair value adjustment

-3,750 Retained Earnings -7,500 Retained Earnings +5,000 Retained Earnings -15,000 Retained Earnings -18,000 Retained Earnings

-

-

=


-3,750 = -7,500 =

+5,000 Gain on FV adjustment

+5,000

+15,000 Interest = Expense +18,000 Loss on Retirement of = Bonds

-15,000

-

-18,000


9-27

P9-53. (15 minutes) a. CVS reports interest expense of $588 million on average debt of $10,035.5 million ([$10,014 million + $10,057 million]/2) for an average rate of 5.9%. Using interest paid ($647 million) instead of interest expense yields 6.5%. See the answer to c below. b. CVS reports coupon rates of 3.25% to 6.6%. In addition, no rates are reported for capital leases, mortgage notes, commercial paper, or the floating rate notes. So, the average rate seems reasonable given the information disclosed in the long-term debt footnote. c. Interest paid can differ from interest expense if bonds are sold at a premium or a discount. It can also differ because of capitalized interest. CVS reported capitalized interest of $37 million in 2011. Thus, CVS apparently amortized $22 million in net bond discounts ($647m -$588m -$37m).

P9-54. (25 minutes) a. 6/1/13

Cash (+A) ……………………………………. Accrued interest payable (+L) ……. Bonds payable (+L) …………………

824,000 24,000 800,000

$24,000 = $800,000 x .09 x 4/12

b. 9/1/13

Interest expense (+E, -SE) ……………..… Accrued interest payable (-L) ……………. Cash (-A) ………………………………

12,000 24,000 36,000

$36,000 = $800,000 x 9%/2

c. 12/31/13

d. 3/1/14

e. 3/1/14

Interest expense (+E, -SE) ………………… Accrued interest payable (+L) …….

24,000

Interest expense (+E) ……………………… Accrued interest payable (-L) ……………. Cash (-A) ………………………………

12,000 24,000

Bonds payable (-L) ………………………… Loss on retirement of bonds (+E, -SE) … Cash (-A) ……………………………..

200,000 2,000

24,000

36,000

202,000 continued next page



P9-54. concluded + a.

+ b. c. d.

Cash (A) 824,000

36,000 36,000 202,000

Interest Expense (E) 12,000 24,000 12,000

b. d. e. -

Bonds Payable (L) + 800,000

e. -

a.

200,000 Accrued Interest Payable (L) b. 24,000 24,000 d. 24,000 24,000

+ a. c.

+ Loss on Retirement of Bonds (E) e. 2,000

Transaction

Cash Asset

a. (7/1/13) Issue bonds.

+824,000 Cash



-36,000 Cash

-202,000 Cash

+24,000 Interest Payable -24,000 Interest Payable +24,000 Interest Payable


-24,000 Interest Payable -200,000 Bonds = Payable


=

= -36,000 Cash

Net Income


b. (9/1/13) Interest payment on bonds. c. (12/31/13) Accrued interest on bonds. d. (3/1/14) Interest payment on bonds. e. 3/1/14 Early retirement of bonds.


=

-

-

=


-12,000 = -24,000 =

+12,000 Interest = Expense +2,000 Loss on = Retirement of bonds

-12,000

-

-2,000


9-29

P9-55. (20 minutes) a. Cash Interest Paid

Interest Expense

Period 0 1 2

$40,722 $40,790

Discount Amortization

$39,600 $39,600

$1,122 $1,190

Discount Balance $41,292 $40,170 $38,980

Bond Payable Net $678,708 $679,830 $681,020

$40,722 = $678,708 x 12%/2. $40,790 = $679,830 x 12%/2.

b. 12/31/13 Cash (+A) ………………………………….. Bond discount (+XL) ……………………. Bonds payable (+L) ………………..

678,708 41,292

Interest expense (+E,-SE) ………………. Bond discount (-XL) ……………….. Cash (-A) ……………………………..

40,722

12/31/14 Interest expense (+E,-SE) ………………. Bond discount (-XL) ……………….. Cash (-A) ……………………………..

40,790

6/30/14

720,000 1,122 39,600 1,190 39,600

c. + 12/31/13

+

Cash (A) 678,708 39,600 39,600

-


+ 12/31/13

6/30/14 12/31/14


6/30/14 12/31/14

-

-

40,722 40,790

+ Bond Discount (XL) 12/31/13 41,292 1,122 1,190

6/30/14 12/31/14

d. Balance Sheet Transaction 12/31/13 Issue bonds at a discount.

Cash Asset

+

Income Statement

Noncash Contrib. Retained = Liabilities + + Assets Capital Earnings

+678,708 Cash

-39,600 Cash -39,600 Cash

Net Income




-41,292 Bonds Payable, net +1,122 = Bonds Payable, net +1,190 = Bonds Payable, net

-


-

-

=


-40,722 = -40,790 =



P9-56. (20 minutes) a. Period 0 1 2

Interest Expense $8,271 $8,302

Cash Interest Paid $7,500 $7,500

Discount Amortization $771 $802

Discount Balance $43,230 $42,459 $41,657

Bond Payable Net $206,770 $207,541 $208,343

$8,271= $206,770 x 8%/2. $8,302 = $207,541 x 8%/2.

b. Cash (+A) …………………….……….………..…… Bond discount (+XL, -L) …………………………. Bonds payable (+L) …….……………………

206,770 43,230

10/31/13 Interest expense (+E, -SE) ………………..….….. Bond discount (-XL, +L) ……………………. Cash(-A) ………………………………………..

8,271

12/31/13 Interest expense (+E, -SE) ………………..….….. Bond discount (-XL, +L) ……………………. Accrued interest payable (+L) ……………..

2,767

4/30/13

4/30/14

Interest expense (+E, -SE) …………………...….. Accrued interest payable (-L) ………..….………. Bond discount (-XL, +L) ……………………. Cash(-A) ………………………………………..

250,000 771 7,500 267 2,500 5,535 2,500 535 7,500

c. + 4/30/13

Cash (A) 206,770

7,500 7,500

+ 10/31/13 12/31/13 4/30/14


-


+ 4/30/13

10/31/13 4/30/14 -

8,271 2,767 5,535

+ Bond Discount (XL) 4/30/13 43,230 771 267 535

10/31/13 12/31/13 4/30/14

-

Accrued Interest Payable (L) + 2,500 12/31/13 4/30/14 2,500

continued next page


9-31

P9-56. concluded d. Balance Sheet Transaction

Cash Asset

+


4/30/13 Issue bonds +206,770 at a discount. Cash




10/31/13 Interest payment on bonds. 12/31/13 Accrued interest on bonds.

-7,500 Cash

=

=

4/30/14 Interest payment on bonds.

Net Income

-7,500 Cash =

-43,230 Bonds Payable, net +771 Bonds Payable, net +267 Bonds Payable, net +2,500 Accrued Interest Payable +535 Bonds Payable, net -2,500 Accrued Interest Payable


-

=


-

-5,535 Retained Earnings

-8,271 = -2,767

=

+5,535 Interest Expense -

-5,535

=

P9-57. (20 minutes) a. Payment x 12.46221 = $500,000; Payment = $500,000/12.46221 = $40,121. b. 12/31/13

6/30/14

Cash (+A) ………………………………………..…… Mortgage note payable (+L) …………………

500,000

Interest expense (+E, -SE) ………………………… Mortgage note payable (-L) ………………………. Cash (-A) …………………………………..……

25,000 15,121

500,000

40,121

* $25,000 = $500,000 x 10%/2

12/31/14

Interest expense (+E, -SE) ……………………….… Mortgage note payable (-L) ……………………….. Cash (-A) …………………………………..……

24,244 15,877 40,121

$24,244 = ($500,000 – $15,121) x 10%/2.

continued next page



P9-57. concluded c. + 12/31/13

+

Cash (A) 500,000 40,121 40,121

6/30/11 12/31/11


6/30/14 12/31/14

-


-

25,000 24,244

d. Transaction 12/31/13 Borrow $500,000 on a 10-year mortgage note payable. 6/30/14 Interest payment on note. 12/31/14 Interest payment on note.

Cash Asset


+500,000 Cash

-40,121 Cash

-40,121 Cash



+500,000 Mortgage = Note Payable -15,121 Mortgage Note Payable -15,877 Mortgage = Note Payable =

-


-

-

Net Income

=


-25,000 = -24,244 =

P9-58. (20 minutes) a. Payment x 16.35143 = $950,000; Payment = $950,000/16.35143 = $58,099. b. 12/31/10 Cash (+A) ………………………………………..…… Mortgage note payable (+L) ………………… 3/31/11


950,000 950,000 19,000* 39,099 58,099

* $19,000 = $950,000 x 8%/4

6/30/11


18,218* 39,881 58,099

* $18,218 = ($950,000 – $39,099) x 8%/4. continued next page ©Cambridge Business Publishers, 2014 Solutions Manual, Chapter 9

9-33

P9-58. concluded c. + 12/31/13

Cash (A) 950,000

58,099 58,099

+


3/31/14 6/30/14

3/31/14 6/30/14

-


-

19,000 18,218

d. Transaction

Cash Asset


12/31/13 Borrow +950,000 $950,000 on a Cash 5-year mortgage note payable. 3/31/14 Payment on -58,099 note. Cash

6/30/14 Payment on note.

-58,099 Cash

+950,000 Mortgage = Note Payable -39,099 Mortgage = Note Payable -39,881 Mortgage = Note Payable




-

-

Net Income

= +19,000 Interest Expense +18,218 Interest Expense

=

=

-19,000

-18,218

P9-59. (10 minutes)

a. BP recorded the $9.2 billion estimate as an expense on its 2010 income statements. This increased the company’s liabilities. b. If BP had prepared its financial statements in accordance with U.S. GAAP, the accrual would most likely have been at the low end of the range -- $6 million, instead of the expected amount (best reliable estimate), or mid-point in the range.



CASES and PROJECTS C9-60. (30 minutes) a. The difference between interest expense and interest paid can be caused by three factors: (1) interest capitalized as part of self constructed assets is paid but not part of interest expense; (2) coupon payments differ from interest expense charged on bonds due to amortization of discounts or premiums; (3) interest payments may not coincide with the fiscal period, thus requiring the company to record accrued interest payable. b. In 2011, Comcast’s debt had a fair value of $45.1 billion while its historical cost was $39.3 billion. Thus, Comcast would report a fair value adjustment as a credit in its balance sheet of $5.8 billion ($45.1 - $39.3). In 2010, the fair value was $34.3 billion and the historical cost was $31.4 billion yielding a credit balance in the fair value adjustment account of $2.9 billion ($34.3 - $31.4). The change in the fair value adjustment from 2010 to 2011 ($2.9 = $5.8 – $2.9) would be recorded as follows: 12/31/11 Loss due to adjustment of bonds to fair value (+E, -SE) Fair value adjustment (+L) ……………….….

2.9 2.9

c. It is likely that Comcast could get a lower interest rate by replacing its 7% debt with a new debt issue. While this would translate into lower future interest costs, it would have an adverse impact on the 2012 income statement. If interest rates have fallen, the market value of Comcast’s 7% notes would have increased. Thus, Comcast would have to either pay a high price to repurchase the notes or pay a call premium, if the loan agreement allows them to call the notes. Either way, Comcast would record a loss on early retirement of the notes. d. Debt-to-equity: $110,163 million/$47,655 million = 2.31 Times interest earned: ($8,207 million + $2,505 million)/$2,505 million = 4.28 Creditors are naturally concerned about the risk of default. The debt-to-equity ratio measures the extent to which a company is relying on debt financing and the higher the ratio, the greater chance of default. In addition, the times interest earned ratio measures the company’s ability to pay the interest on the debt. e. Management may bypass profitable investment projects or cut discretionary expenditures such as R&D or advertising. It may also engage in questionable accounting practices in an attempt to manage the ratios.


9-35

C9-61. (20 minutes) a. The gain results from the difference between the book value of the debt ($3,000,000) and the current redemption (market) value ($1,900,000). The gain would be reported in the income statement under other (nonoperating) income. The source of the gain should be adequately disclosed in the notes. b. Currently, Foster is paying 8% interest on the $3,000,000 of long-term debt, or $240,000 per year. Under the proposed refinancing, Foster would pay 16%, or $480,000. The refinancing would generate an additional $1,100,000 in cash. However, because interest costs are increasing by $240,000 per year ($480,000 $240,000), Foster is effectively borrowing the additional $1,100,000 at a rate of almost 22% ($240,000 / $1,100,000). As such, Foster would be paying in the future (in the form of higher interest costs) for a one-time boost in current earnings. c. The potential ethical conflict exists because Foster’s president is concerned that his job might be dependent on producing short-term earnings. Because of this, he might be tempted to accept this proposal and boost current earnings at the cost of lower earnings in future years. This thinking is misguided because, given adequate disclosure, analysts and investors would be able to identify and discount the source of the earnings boost. The most serious unethical act would be to try to hide (or obfuscate) the bond refinancing with inadequate disclosure.



Fa4e Sm Ch09

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