Accounting for Liabilities PDF

Ashik sire CHAPTER 12 Sneek: ACCOUNTING FOR LIABILITIES A look at the liability side of the balance sheet of the German cornpany Beru Aktiengesellschaft, Ludwigsburg, dated March 31, 2003, shows how interna- tional standards are changing the reporting of financial information. On this date, the com...

Ashik sire CHAPTER 12 Sneek: ACCOUNTING FOR LIABILITIES A look at the liability side of the balance sheet of the German cornpany Beru Aktiengesellschaft, Ludwigsburg, dated March 31, 2003, shows how interna- tional standards are changing the reporting of financial information. On this date, the company showed one liability this way: Anticipated losses arising from pending transactions 3,285,000 euros Do you believe a liability should be reported for pending transactions? Anticipated losses means they have not yet occurred; pending transactions means the condition that might cause the loss also has not occurred. So where is the liability? Who does the company owe? Where is the obligation? U.S. GAAP provides guidance on this subject. A company can accrue a liability for a contingency only if an obligation has arisen from a past event, if payment is probable, and if a reasonable estimate of the obligation can be made. In short, under U.S. GAAP, companies cannot accrue anticipated future losses today. German accounting, however, is more permissive. Companies are permitted to report liabilities for possible future events. In essence, establishing this general-purpose “liability” provides a buffer for Beru if losses do materialize. If you take a more skeptical view, you might say it lets Beru smooth its income by charging expenses in good years and reducing expenses in bad years. We should note that the story has a happy ending. As indicated earlier in the text, European com- panies switched to International Financial Reporting Standards (IFRS) in 2005. Because IFRS are sim- ilar to U.S. GAAP. liabilities like “Anticipated losses from pending transactions” disappear. Now when we look at Beru’s 2005 financial statements, we find a note stating that it reports as liabilities only obligations arising from past transactions that can be reasonably estimated. Preview of Chapter 12 As our opening story Indicates, investors pay considerable attention to a company’s liabilities, The stock market severely punishes companies with high debt levels and the related impact of higher interest costs on income performance. In this chapter we explain the accounting i99ue9 related to liabilities as follows. ‘ ACCOUNTING FOR LIABILITIES» > , potent a amas a i be nideitlboaadie th f What is @ liability? Issuing bonds Contingencies What is a current liability? Types of bonds Oft-balance-sheet financing Valuation of bonds Presentation and analysis ‘Learning Objectives After studying this chapter, you should be able to: 4 Describe the nature, type, and valuation of current liabilities, i2, } 3. } Identify various types of bond issues. { Describe the accounting valuation for bonds at date of Issuance. 4. Describe the accounting procedures for the extinguishment of debt. | Io, E Identity the criteria used to account for and disclose gain and loss contingencies. Explain the accounting for different types of loss contingencies. x: Explain the reporting of off-balance-sheet financing arrangements. "Indicate how to present and analyze liabilities and _ contingencies. : 610, 625, 628) é Ae KTS we OY Inside Chapter 12 _ What Do the Numbers Mean? | Frequent buyers (p. 611) All about bonds (p, 614) “How's my rating?” (p. 616) Gift cards: Handle with care (p. 626) ' More disclosure, please (p. 633) ‘What's the Principle? (pp. 606, en) p Nf | Convergence Corner (p. 636) Accounting, Analysis, Principles (p. 637) Record current and long-term liabilities. Assoss liquidity and solvency. Apply the definition of a tiability. SSHONONG] CURRENT LIABILITIES WHAT IS A LIABILITY? The question “What is a Jiability7’ is not easy to answer, For example, 1s preferred stock a liability or an ownership claim? The first reaction is to say that preferred stock #5 in fact an ownership claim. If it is, companics should report it as part of stockholders’ equity In fact, preferred stock has many elements of debt as well.! The issuer (and in some cases the holder) often has the right to call the stock within a specific period of tirme— making it sim- ilar to a repayment of principal. The dividend is in many cases almost guaranteed (curm- lative provision)—making it look like interest. As a resem, preferred stock is bat one of many financial instruments that are difficult to classify.” To help resolve some of these controversies, the FASB defined liabilities in its conceptual framework study as “probable future sacrifices of economic benefits WHAT'S THE PRINCIPLE? arising from present obligations of a particular entity to transfer assets or pro- a alsclads Ge épprepriake vide services to other entities in the future as a result of past transactions or classification of specific financiat. | events.” In other words, a liability has three essential characteristics Srttn in aaigie oggeea 1 Itis a present obligation that entails settlement by probable future transfer or use equities. They often use the of cash, goods, or services. conceptual framework definitions os | 2 It is an unavuidable obligation. the basis for resolving controversial classification issues. 3 The transaction or other event creating the obligation has already occurred Because liabilities involve future disbursements of assets or services, one of their most important features is the date on which they are payable. A company must sat- isfy currently maturing obligations in the ordinary course of business to continue operating Liabilities with a more distant due date do not, as a rule, represent a claim on the company’s current resources, They are therefore in a slightly different category. This feature gives mse to the basic division of liabilities into two categories: current liabilities and long-term debt. WHAT IS A CURRENT LIABILITY? Recall that current assets are cash or other assets that companies reasonably expect to con- vert into cash, sell, or consume in operations within a single operating cycle eo within a | year (if the company completes more than one cycle per year) Current liabilities are “obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets, or the ereation of other current } Describe the nature, type, and valuation of | current Sebthiee; "This illustration is not just a theoretical exervise. In practicg, a numnder of preferred stock issues have all the characteristics of a debt instrument, except that they are called and legally classified pre- ferred stock. In some cases, the IRS has even pernitted gompanies to twat the dividend payments as interest expense for tax purposes “The FASB has addressed this issue in part in “Accowaling for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” Statemeat of Financial Accounting Standardy No, 150 (Norwalk, Conn: FASB, 2003) Elements of Financial Statements of Business Baterprises,” Statement of Pinancial Accounting Con- cepts No, 6 (Stamford, Conn. VASB, 1980). The PASBK and IASB hability definitions are similar. The Boards are working on a joint conceptual framework project, which will likely change the def- inition of a liability (and assets.) See Anup: fash org/project(conceptual_ framework. shtml for the cur rent status of this project 606 What Is a Curront Liabit,? linbilities.’* This definition has gained wide acceptance because il recognizes operating cy- cles of varying lengths in different industries. This definition also considers the important relationship between current assets and current liabilities The operating cycle is the period of time elapsing between the acquisition of goods and services involved in the manufacturing process and the final cash realization resulting from sales and subsequent collections. Industries that manufacture products requiring an aging process, and certain capital-intensive industries, have an operating cycle of consid- erably more than one year. On the other hand, most retail and service establishments have several operating cycles within a year. Here are some typical current liabilities: Accounts payable. 6 Income taxes payable (discussed in Notes payable. Chapter 15). Current maturities of long-terin debt. 7 Employee-related liabilities (discussed Dividends payable. in Chapter 16). Unearned revenues. ark ons — In practice, companies usually record and report current liabilities at their full maturity value. Because of the short time periods involved, frequently less than one year, usually only a sinall difference exists between the present value of a current liability and its maturity value. The slight overstatement of liabilities that results from carrying current liabilities at maturity value is accepted as immaterial.* Accounts Payable Accounts payable, or trade accounts payable, are balances owed to others for goods, sup- plies, or services purchased on open account. Accounts payable arise because of the time lag between the receipt of services or acquisition of title to assets and the payment for them. The terms of the sale (e.g., 2/10, n/30 or 1/10, E.O.M.) usually state this period of extended credit, commonly 30 to 60 days. Most companies design their accounting systems to record liabilities for purchases of goods upon receipt of the goods (or more practically, upon receipt of invoices). Frequently there is some delay in recording the goods and the related liability on the books. If title has passed to the purchaser before receipt of the goods, the company should record the trans- action at the time of title passage. A company must pay special attention to transactions occurring near the end of one accounting period and at the beginning of the neat. It needs to ascertain that the record of goods received (the inventory) agrees with the liability (ac- counts payable), and that it records both in the proper period. Measuring the amount of an account payable poses no particular difficulty. The invoice received from the creditor specifies the due date and the exact outlay in money that is nec- essary to settle the account. The only calculation that may be necessary concerns the amount of cash discount. See Chapter 9 for illustrations of entries related to accounts payable and purchase discounts. Notes Payable Notes payable are written promises to pay a certain sum of money on a specified tuture date. They may arise from purchases, financing, or other transactions. Some industries require notes (often referred to as trade notes payable) as part of the sales/purchases 4Commitice on Accounting Procedure, American Vastitute of Certified Public Agcountants, “Accounting Research and Terminology Bulletins,” Final Edition (New York: AICPA, 1961), po 21. SAPB Opinion No. 21, “Interest on Receivables and Payables,” specifically exempts from preseat value measurements those payables arising from transactions with suppliers in the normal course of business that do not exceed approximately one year. rnapter 12 = Accounting for Liabilities transaction in liew of the normal extension of open account credit. Notes payable to banks or loan companies generally arise from cash loans. Companies may classify notes as short- term or long-term, depending on the payment due date, Notes may also be interest-bearing or zero-interest-bearing. Interest-Bearing Note Issued Assume that Castle National Bank agrees to lend $100,000 on March 1, 200%, to Land- scape Co. if Landscape signs a $100,000, 6 percent, four-month note. Landscape records the cash received on March | as follows. March 1 ‘ Cash 100,000 Notes Payable 100,000 (To record issuance of 6%, 4-month note to Castle National Bank) If Landscape prepares financial statements semiannually, it needs the following ad- justing entry to recognize interest expense and interest payable of $2,000 ($100,000 x 6% X 4/12) at June 30. June 30 Interest Expense 2,000 Interest Payable 2,000 (To accrue interest for 4 months on Castle National Bank note) If Landscape prepares financial statements monthly, its adjusting entry at the end of each month is $500 ($100,000 X 6% X 1/12). At maturity (July 1), Landscape must pay the face value of the note ($100,000) plus $2,000 interest ($100,000 X 6% X 4/12), Landscape records payment of the note and ac- crued interest as follows. July 1 Notes Payable 100,000 Interest Payable 2,000 Cash 102,000 (To record payment of Castle National Bank interest-bearing note and accrued interest at maturity) Zero-Interest-Bearing Note Issued A company may issue a zero-interest-bearing note instead of an interest-bearing note. A zero-interest-bearing note does not explicitly state an interest rate on the face of the note, However, the lender does charge interest. At maturily the borrower must pay back an amount greater than the cash received at the issuance date. In other words, the borrower receives in cash the present value of the note. The present value equals the face value of the note at maturity minus the interest or discount charged by the lender for the term of the note. In essence, the lender takes its fee “up front” rather than on the date the note matures. ‘To illustrate, assume that Landscape issues a $102,000, 4-month, zero-interest-bearing note to Castle National Bank, The present value of the note is $100,000.° Landscape records this transaction as follows, March 1 Cash 100,000 Discount on Notes Payable 2,000 Notes Payable 102,000 (To record issuance of 4-month, Zero-Interest-bearing note to Castle National Bank) The bank discount rate used ip this example to find the present value 1s 5.96 percent. Whats a Currora , Landscape credits the Notes Payable account for the face value of the note, which is $2,000 more than the actual cash it received. It debits the difference between the cash re- ceived and the face value of the note to Discount on Notes Payable, Discount on Notes Payable is a contra nccount (o Notes Payable, and therefore ty subtracted from Notes Payable on the balance sheet, MHlustration 12-1 shows the balance sheet presentation on March 1, Current liabilities Notes payable 102,000 Less: Discount on notes payable 2,000 100,000 ‘ The amount of the discount, $2,000 in this case, represents the cost of borrowing $100,000 for four months, Accordingly, Landscape charges the discount to interest expense over the life of the note, That is, the Discount on Notes Payable balance represents Interest expense chargeable to future periods, Thus, Landscape should not debit Interest Expense for $2,000 at the time of obtaining the loun, Current Maturities of Long-Term Debt PepsiCo reports as a current liability the portion of bonds, mortgage notes, and other long- term indebtedness that matures within the next fiscal year, It categorizes this amount as current maturities of long-term debt, When a company like PepsiCo pays only a part of a long-term debt within the next 12 months, as in the case of serial bonds that it retires through a series of annual installments, it reports the maturing portion of long-term debt as a current Hability and the balance as a long-term debt, However, it excludes long-term debts maturing currently as current liabilities if they are to be: 4 retired by assets accumulated for this purpose that properly have not been shown as current assets, 2 refinanced, or retired from the proceeds of a new debt issue, or 3 converted into capital stock. In these situations, the use of current assets or the creation of other current liabilities does not occur. Therefore, classification as a current liability is inappropriate. A company should disclose the plan for liquidation of such a debt either parenthetically or by a note to the fi- nancial statements. However, a company should classify as a current liability one that is due on demand (callable by the creditor) or will be due on demand within a year (or operating cycle, if longer). Creditors often call liabilities duc to a violation of the debt agreement. For exam- ple, most debt agreements specify that a borrower must maintain a given level of equity to debt, or a minimum amount of working capital. If the company violates such an agreement, it must classify the debt as current because it is a reasonable expectation that the company will use existing working capital to satisfy the debt, Only if a company can show that it is probable that it will cure (satisfy) the violation within the grace period usually given in these agreements can it classify the debt as noncurrent,’ Dividends Payable A cash dividend payable is an amount a corporation owes to ity stockholders as a result of the board of directors’ authorization, At the date of declaration the corporation assumes a liability that places the stockholders in the position of creditors in the amount of dividends ™Chassification of Obligations That Are Callable by the Creditor,” Statement of Financial Accounting Standards No. 78 (Stamford, Conn.: FASH, 1983) ‘ it | Htusteation 12-1 Balance Sheet Prosantation of Dise WHAT'S THE PRINCIPLE? Preterred dividends In arrears do represent a probable future 4 Chapter 12 & Accounting for Liabilities declared, Because companies always pay cash dividends within one year of declara- tion (generally within three months), they classify them as current I ibalities On the other hand, companies do not recognize accumulated but undeclared div- idends on cumulative preferred stock as a liability, Why? Because preferred dividends in arrears are not an obligation until the board of directors authorizes the distnbutyon economic sactifice, but the expected | Of eamnings. Nevertheless, companies should disclose the aynount of cumulative divi- sacrifice does not result from a past | dends unpaid in a note, or show it parenthetically in the capital stuck section, transaction or past event, The Companies also do not recognize dividends payable in the form of additional sacrifice will result from a future | shares of stock as a liability, Such stock dividends (as we discuss in Chapter 13) do event (declaration by the board of directors). Note disclosure improves the predictive value of the financial Statements in this situation. not require future outlays of assets or services. Further, the bourd of directors may recover them at any time prior to issuance. Even so, companies generally report such undistributed stock dividends in the stockholders’ equity section because they repre- sent retained earnings in the process of transfer to paid-in capital. _-‘Uhearned Revenues Hlustration 12-2 Unearned and Earned Revenue Accounts A magazine publisher, such as Golf Digest, receives payment when a customer subseribes lo its magazines. An airline company, such as American Airlines, sells tickets for future Nights, Software companies, like Microsoft, issue coupons that allow customers to upgrade to the next version of their software. How do these companies account for unearned rev- enues that they receive before delivering goods or rendering services? 4 Upon receipt of the advance, debit Cash, and credit a current liability account identi- fying the source of the unearned revenue. 2 Upon earning the revenue, debit the unearned revenue account, and credit an earned revenue account. To illustrate, assume that Allstate University sclls 10,000 season football tickets at $50 each for its five-game home schedule. Allstate University records the sales of season tick- ets as follows. — August 6 Cash £00,000 Unearned Football Ticket Revenue 500,000 (To record sale of 10,000 season tickets) After each game, Allstate University makes the following entry. September 7 Unearned Football Ticket Revenue 100,000 Football Ticket Revenue 100,000 (To record football ticket revenues earned) ™~ Uncarned Football Ticket Revenue is, therefore, unearned revenue. Allstate University would report it as a current liability in the balance sheet. As revenue is earned, a transfer from unearned revenue to earned revenue occurs. Unearned revenue is maternal tor some companies: In the aitline industry, tickets sold for future fights represent almost 50 per- cent of total current liabilities, IMlustration 12-2 shows specific unearned and earned revenue accounts used in selected types of businesses, Account Title Type of Business Unearned Revenue Earned Revenue Airline Unearned Passenger Ticket Revenue Passenger Revenue Magazine publisher Unearned Subscription Revenue Subscription Revenue Hotel Unearned Rental Revenue Rental Revenue Auto dealer Unearned Warranty Revenue Warranty Revenue Retailers Unearned Gilt Card Revenue Sales Revenue Vital le a Carrmeit ¢ ined The balance sheet shoutd report obligations for any Commitments that are redeemable in goods and services, The income statement should report revenues earned during the period Waldo he numbers mean? _____ Numerous companies offer premiums to customers in the form of a promise of future goods or services AS an incentive for purchases today. A premium plan that has widespread adoption is the frequent-fyer progiams used by all major airlines. On the basis of mileage accumnfated, frequent-Ayer members receive discounted ur free airline tickets. Airline custorners can earn miles toward free travel by making long-distance phone calls, staying in hotels, and charging gasoline and groceries on a specified credit card. Those free tickets fepresent an enorinenrs potential liability because people using them may displace paying passengers When airlines first started offering frequent-flycr bonuses, everyone assumed that the anr- lines could accommodate the free-ticket holders with otherwise-empty seats. That rade the ad- ditional cost of the program so minimal that airlines didn’t accrue it or report the small fiabil- ity. But, as more and more paying passengers were crowded off Nights by frequent-fyer awardees, the loss of revenues grew enormously. For example, United Airlines at one time reported a |i- ability of $1.4 billion for advance ticket sales, a good portion of which pertained to free fre- quent-flyer tickets. Although the profession has studied the accounting for this transaction, no authoritative guidelines have been issued. Beyond the Numbers Some companies, like Microsoft report uneamed revenue related to future upgrades of its programs. Briefly discuss how a decline in the level of these unearned revenues can provide a signal about Microsoft's current sales.. ’ The following are selected 2008 transactions of Alston Company Sept. | Borrowed $90,000 by signing a $90,000, 8%, 6-month note. : Oct. 1 Sold 1,000 annual subscriptions to its monthly basketball magazine for $20 each. Instructions a Prepare the necessary annual-adjusting entries for the preceding transactuos at De- cember 31, 2008, b Prepare the entry on March 1, 2009 for payment of the pote aiat tntereot Solution a4 December 31, 2008 Interest Expense ($90,000 x.08 * 4/12) 2400 Interest Payable 2,400 Unearned Subscription Revenue “6.000 Subscription Revenue (1,000 * $20 « M12) §,000 Chapter 12 # Accounting for Liabilities b March 1, 2099 Notes Payatla 99 000 Interest Payable ZAK) Interest Expense ($90,000 » 06 ¥ 2/17) 1,209 Cash 93,650 A ee RL Oe NA a i NE tie le (A Nl OCC DALAL LE LL wt” art] LONG-TERM DEBT 399" Long-term debt consists of probable future sacrifices of economic benefits arising from present obligations that are not payable within a year or the operating cycle of the company, whichever is longer. Bonds payable, long-term notes payable, mortgages payable, pension liabilities, and lease liabilities are examples of long-term debt. A company often incurs long-term debt through a formal process. For example, a cor- poration, per its bylaws, usually requires approval by the board of directors and the stock- holders before it contracts long-term debt arrangements. Generally, long-term note agreements or bond indentures state covenants or restric- tions that protect both Jenders and borrowers. The indenture or agreement often includes the amounts authorized to be issued, interest rate, due date(s), call provisions, property pledged as security, sinking fund requirements, working capital and dividend restrictions, and lim- itations concerning the assumption of additional debt. Companies should describe these stipulations in the body of the financial statements or the notes if important for a complete understanding of the financial position and the results of operations.’ ISSUING BONDS Bonds are the most common type of long-term debt that companies report on the balance sheet. The main purpose of bonds is to borrow for the long term when the amount of cap- ital needed is too large for one lender to supply. By issuing bonds in $100, $1,000, or $10,000 denominations, a company can divide a large amount of Jung-term indebtedness into many small investing units, thus enabling more than one Jender to participate in the loan. (A bond arises from a contract known as a bond indenturegA bond represents a promise to pay: (|) a sum of money at a designated maturity rate, plus {2) periodic interest at a specified rate on the maturity amount (face value). Individual bonds are evidenced by a paper certificate and typically have a $1,000 face value. Companies usually make bond interest payments semiannually, although the interest rate is generally.expressed as ap annual rate. *Although it would scem that these covenants provide adequate protection to the long-term debtholder, many bondholders suffer considerable losses when companies addi more de ot to the cap- ital structure. Consider what can happen to bondholders in leveraged buyouts (LBO»), which are usually led by management. In an LBO of RJR Nabisco, for example, solidly rated 9Y% percent bonds due in 2016 plunged 20 percent in value when management announced the leveraged buy- out. Such a Joss in value occurs because the additional debt added to the cupital structure increases the likelihood of default. Although covenants protect bondholders, interpretations of the covenants can easily differ. : A company may sell an entire bond issue to an investment bank which acts as a sell- ing agent in the process of marketing the bonds. In such arrangements, investment banks may either wederwrite the entire issue by guarantecing a certain sum to the company, thus taking the risk of selling the bonds for whutever price they cun get (a procedure called firm underwriting). Or they may sell the bond issue for a commission on the proceeds of the sale (a procedure called best-effurty underwriting), Alternatively, the issuing company may sell the bonds directly to a large institution, financial or otherwise, without the aid of an underwriter (a private placement). TYPES OF BONDS VV* ny Below, we define some of the more common types of bonds found in practice. “TYRES OF BONDS SECURED AND UNSECURED BONDS. Secured bonds are backed by a pledge of some sort of collateral. For example, mortgage bonds are secured by a claiin on real estate; collateral trust bonds are secured by stocks and bonds of other corporations. Bonds not backed by collateral are unsecured, A debenture bond is unsecured, A so-called junk bond is un- secured and also very risky, and therefore pays a high interest rate. Companies often use junk bonds to finance leveraged. buyouts, TERM, SERIAL BONDS, AND CALLABLE BONDS, Bond i issues ‘that mature on a single date are , called term bonds. Issues that mature in installments are called serial bonds. School or sanitary districts, municipalities, or other local taxing bodies that receive money through a special levy frequently use serially maturing bonds. Callable bonds give the issuer the right to call and retire the bonds prior to maturity. CONVERTIBLE, COMMOD ITY:BACKEO, AND_DEEP DISCOUNT.BONDS. Bonds that are convertible into other securities of a corporation for a specified time after issuance are convertible bonds. Companies have developed two similar types of bonds in an attempt to attract cap- ital ina tight money market—commodity- -backed. bonds and deep discount bonds. Commodity-backed bonds (also called asset-linked bonds) are redeemable in measures of a commodity, such as barrels of oil, tons of coal, or ounces of rare metal. To illus- trate, Sunshine Mining, a silver-mining company, sold two issues of bonds redeemable with either $1,000 in cash-or 50 ounces.of.silver, whichever is greater at maturity, and that have a’ stated interest rate of 84 percent. The accounting problem for such bonds is to project their maturity value; silver has fluctuated between’ Ra and $40 an ounce since the bonds were issued. JCPenney Company sold the first publicly marketed long: term. debt recurtten in the United States that do not bear interest. These deep-discount bonds, also referred to as zero-interest debenture bonds, | are ‘sold at a discount that provides the buyer's total interest payoff at maturity, REGISTERED AND BEARER (COUPON) BONDS. Bonds issued in the name of the owner are rey: istered bonds, They require surrender of the certificate and issuance of a new cectifi- cate to Con) ete a a sale, A bearer or coupon hond, however, i is not recorded in the name of the owner and may be transferred from one owner to another by mere delivery. INCOME AND REVENUE BONDS, Income bonds pay No Interest unless the issuing company is profitable,. Revenue bonds pay it interest fiom specified reventie sources. Aupouts, school districts, countics, foll- road authoritic s, and governmental bodies most frequently ‘issue'r revenue bonds, - A Chapter 12 » eR” ae ae ee ee ee SOR ? All About Bonds How do investors monitor their bund investments? One way js to review the bond betings found in the ewspaper oF Lunline Corporate hond frvtings show fhe gonigon | {inte eres f) rate, mati hatucsty date, and last price However, because corporate bonds are more a tevely held by hor ge inwtu- tional investors, the hstings also indicate the current yield and the volume tracked Corporate honed listings would lvok like those below “ ‘a qe @% 4 RS A Coupon Price: Yield: Volume Maturity Highlow | Hightow [ o fm) 6.000 102.190 5439 11/15/2034 95.370 an s+) om 23.525 96 A206 872) wanenenaers 86 781 9779 923,972 (mew ‘oe Issuer BellSouth Corp General Motors Cop 07/15/2033 The companies issuing the bunds are listed m the first column, in this case, a telecomme- nications Company BellSouth Corp., and the automaker General Motors Corp... lnumediately after the names is a colygnn with the interest rate paid by the bond as a percentage of its gar yalue, with its maturit y date beluw, The BellSouth bonds, for example, pay § percent and ma- ture on November 15, 2034. The General Motors bonds pay quite a bit More at 8 375 at 8 375 percent The BeliSouth bonds have a current yield of 6.3 percent based on its closing low price ow price of 95.310. pet $1,000. The high/low prices are based on trading in a five-day period, i in which the volume traded on the exchange amounted to $23,125 million. For General Motors, at the high price of 96.426, its bonds yield 8.721 percent. The GM bonds had volume of nearly $ $1 bilison, oan Also, as indicated in the chapter, interest rates and the bond's term to m matunty have 3 real effect on bond prices, For example, an increase jn interest rates will fead to a decline ta bond yalues. Similarly, a decrease in interest rates will lead to a rise in bond Values. The data repo ported below, based on three different bond funds, demonstrates these relationships between interest rate changes and bond values. Bond Price Changes in Response to 1% Interest 1% faterest Interest Rate Changes Rate Increase Rate Decrease Short-term fund (2-5 years) 15% +2 9% Intermediate-term fund (5 years) ~ = —--- _ -5% _————— +5% Long-term fund (10 years) lyn 10% ———-— + 10% Data source: The Vanguard Group. Another factor that affects bond prices is the call feature, which decreases the value of the bond. Investors must be rewarded forthe risk that the issuer will call the boo af interest mies decline, which forces the investor to reinvest al lower ower fates. Source: The Bond Market Association (ws. investinginbonds com) (2¢cessed March 2007). Beyond the Numbers Some bonds are convertible. That is, the bondholders have the option to exchange their beads for common shares, which could be quite valuable for the bonds issued by 9 growth company. What effect does a conversion have on the coupoa rate of a bond? SS EL ESL SELES SLL ALUATION OF BONDS PAYABLE—DISCOUNT AND PREMIUM The selling price of a bond issue is set by the supply und demand of buyers and sellers, relative risk, market conditions, and the state of the economy. The iavestment community values a bond at the present-value of its future cash Flows, which consist of (1) interest and (2) principal. The rate ised to compute the present value of these cash flows is the interes! Valuation of Bonds Payable-—Discount and Prariye§ rate that provides an acceptable return on an investment commensurate with the issuer's risk characteristics. (The interest rate written in the terms of the bond indenture (and often printed on the bond certificate) is known as the stated, coupon, or nominal rate{The issuer of the bonds sets this rate, expressed as a percentage Of the face Value. The rate is also called the par value, principal amount, or maturity value of the bonds. If the rate employed by the investment community (buyers) differs from the stated rate, the present value of the bonds computed by the buyers (and the current purchase price) will differ from the face value of the bonds. The difference hetween the face value and the present value of the bonds is either a discount or premium:” If the bonds sell for lesy than face value, they sell at a discount, If the bonds sell for more than face value, they sell ata premium, The rate of interest the bondholders actually earn is called the effective yield or the mar- ket rate. If bonds sell at a discount, the effective yield exceeds the stated rate, Conversely, if bonds sell at a premium, the effective yield is lower than the stated rate. While a bond is outstanding, several variables affect its price, most notably the market rate of interest. There is an inverse relationship between the market interest rate and the price of the bond. Here we consider an example to illustrate the computation of the present value of a bond issue (Assume that ServiceMaster issues $100,000 in bonds, due in five years with 9 percent interest payable annually at year-end. At the time of issue, the market rate for such bonds is 11 percent. The following time diagram depicts both the interest and the princi- pal cash flows, e PY $100,000 Principal i= 11% PV-OA $9,000 $9,000 $9,000 $9,000. $9,000 Interest : ; Ni Sed aes ee 4 5 oY Oe an - i < 3 uk Leen 7 , SLE The actual principal and interest cash flows are discounted at an I! percent rate for five periods as shown in Illustration 12-3. Present value of the principal:. , $100,000 x.59345 (Appendix A, Table 2) $59,345.00 Present value of the interest payments: : $9,000 x 3.69590 (Appendix A, Table 4) 33,263.10 Present value (selling price) of the bonds yer $92,608.10 By paying $92,608.10 at the date of issue, investors realize an effective rate or yield of LL percent over the five-year term of the bonds, These bonds would sell at a. discount of $7,391.90 ($100,000 — $92,608.10). The price at which the bonds sell is typically stated as a percentage of the face or par value of the bonds, For example, the ServiceMaster bonds sold for 92.6 (92.6% of par). If ServiceMaster had received $102,000, then the bonds sold for 102 (102% of par). *Until the 1950s corporations commonly issued bonds with low, even-percentage Coupons (such as 4 percent) to demonstrate their financial solidity. Frequently, large discounts resulted, More recently, it has become acceptable to set the stated rate of interest on bonds in rather precise amounts (such as 10.65 percent). Companies usually attempt to align the stated’ rate as closely as possible with the market or effective rate at the time of issue. Coupon Rete Ve. onuectie Describe the | | accounting valuation for bonds at dats of issuance. of bits & Ulustration 12-3 Present Value Computation of Bond Selling at a Discount Chapter 12 = Accounting for Liabilities When bonds sell below face value, it means that investors demand a rate of interest higher than the stated rate, Usually this occurs because the investors can earn a greater rate on altemative iivestments of equal risk. They cannot change the stated rate, so they refuse to pay face value for the bonds. Thus, by changing the amount invested, they alter the ef- fective rate of return. The investors receive interest at the stated rate computed on the face value, but they actually carn at an effective rate that exceeds the stated rate because they paid less than face value for the bonds. Whatdo the numbers mean? “How's My Rating?” Two major publication companies, Moody's Investors Service and Standard & Poors Cor- poration, issue quality ratings on every public debt issue. The following table summarizes the ratings issued by Standard & Poor's, along with historical default rates on bonds with different ratings. As expected, bonds receiving the highest quality rating of AAA have the lowevt histor- ical default rates. Bonds rated below BBB, which ate considered below investment grade (“junk bonds”), experience default rates ranging from 20 to 50 percent. Original rating AAA AA A BBB BB B ccc Detault rate* 052% 131 2.32 6.64 19.52 35.76 54.3% *Percentage of defaults by issuers recently rated by Standard & Poor's, based on rating they were initially assigned. Data source: Standard & Poor's Corp. Debt ratings reflect credit quality. The market closely monitors these ratings when deter- mining the required yield and pricing of bonds at issuance and in periods after issuance, espe- cially if a bond's rating is upgraded or downgraded. Data on recent downgrades suggest that the number of “fallen angels” (downgraded debt) is on the rise. (Issuers) — Par Bonds Affected [J Number of Issuers (US$ Billion) < ee Lar 606 80 70 50 : 40 30] 20}- 10} -: Rae Fi i ‘ ee. 2001 2002 2 1998 199 4 2000 ‘