ACC 318 Module 2 Long-Term Debt Assignment Example

Ten Million Dollars at Six Percent When the Market Wants Seven: Pricing, Amortizing and Calling a Bond Issue

[Student Name]

Southern New Hampshire University

ACC 318: Intermediate Accounting II

Module Two Assignment

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Ten Million Dollars at Six Percent When the Market Wants Seven: Pricing, Amortizing and Calling a Bond Issue

Introduction

To open four new parks, a composite chain of indoor trampoline and adventure parks in Texas and Oklahoma issued $10,000,000 of five-year bonds on January 1. The bonds pay interest of 6 percent a year, in two semiannual payments of $300,000, and can be called at 101 after two years. By the time the bonds were sold, market rates for similar companies had risen to 7 percent, so investors would only buy them at a discount. This assignment computes the issue price, prepares the effective interest amortization table, records the related entries and analyzes a call three years later when rates fall.

Issue Price

Investors pay for a bond only what its promised payments are worth today at the yield they require (Kieso et al., 2019). Because interest is paid semiannually, the calculation uses ten periods and a rate of 3.5 percent per period.

Table 1. Issue Price

That $415,830 should not be read as money lost on the sale; it is extra borrowing cost, settled in the final repayment, since the company hands back $10,000,000 for $9,584,170 it actually received. The effective interest method spreads that extra cost over the life of the bonds, so that each period's expense reflects the 7 percent the market actually charged.

The size of the discount follows directly from the rate gap. Each semiannual payment is $300,000, while investors wanted $350,000 on every $10,000,000 lent, a shortfall of $50,000 per period. Discounting ten shortfalls of $50,000 at 3.5 percent gives $415,830, the same discount computed in Table 1. Seen this way, investors are simply paying less up front to make up for the interest the coupon does not provide.

Amortization Table

Table 2. Effective Interest Amortization, 3.5 Percent per Period

Interest expense rises each period because it is computed on a carrying value that grows as the discount is amortized. The final period's interest is reduced by $2 to bring the carrying value exactly to face, a rounding adjustment that should always be disclosed in a working paper so a reviewer does not chase it. Total interest expense of $3,415,830 equals the $3,000,000 of cash interest plus the $415,830 discount, confirming the table.

Journal Entries

At issuance, Cash rises by $9,584,170, a contra-liability for the $415,830 discount is opened and Bonds Payable is recorded at the full $10,000,000 face. On June 30, it debits Interest Expense for $335,446 and credits Discount on Bonds Payable for $35,446 and Cash for $300,000. On December 31, the entry is the same in form, with interest expense of $336,687 and discount amortization of $36,687.

On the first December 31 balance sheet the company shows Bonds Payable of $10,000,000 less the unamortized discount of $343,697, a carrying value of $9,656,303, as a long-term liability. Under current GAAP, any debt issue costs would also be deducted from the carrying value rather than shown as an asset; this issue had none, because the bonds were placed privately with two insurers.

Calling the Bonds After Three Years

By the end of the third year, market rates for the company's credit had fallen to 5 percent, and a bank offered a term loan at that rate. The company called the bonds at 101 immediately after the sixth interest payment.

Table 3. Loss on Extinguishment

To record the call, the full $10,000,000 face leaves the Bonds Payable account, the $283,652 loss is recognized, the $183,652 of discount still on the books is written off and $10,100,000 of cash goes out. It belongs among continuing results, typically under other expense; it is not an unusual item simply because it is large.

Two disclosures accompany the call. The notes should describe the extinguishment, the call price and the source of refinancing, and the statement of cash flows should show the $10,100,000 repayment as a financing outflow and the new bank loan as a financing inflow. Because the loss is a noncash adjustment to the carrying value plus the premium paid in cash, under the indirect method the company adds back $283,652 in operating activities so that the full payment appears only once, under financing.

Why Call at a Loss?

An accounting loss of $283,652 sounds like a reason not to call, but the decision turns on future cash flows. The remaining bonds would cost $300,000 every six months for two more years. A $10,100,000 bank loan at 5 percent would cost about $252,500 per half year, saving about $47,500 per period, or about $190,000 over two years before discounting, against a call premium of $100,000. The rest of the reported loss is the unamortized discount, a cost already incurred economically that the accounting simply recognizes all at once. Graham and Harvey (2001) found that financial managers report timing debt issues to interest rate movements, and refinancing when rates fall is the mirror image. The covenants matter too: Chava and Roberts (2008) showed that covenant violations shift control to lenders and reduce investment, and the new bank loan carries looser covenants than the bond indenture, a benefit the loss calculation does not capture.

Conclusion

The 6 percent bonds sold for $9,584,170 because the market demanded 7 percent. The effective interest method spreads the $415,830 discount over ten periods, and the carrying value reaches $9,816,348 after three years. Calling the bonds at 101 then produces a $283,652 loss, but refinancing at 5 percent recovers much of it and loosens the company's covenants.

References

Chava, S., & Roberts, M. R. (2008). How does financing impact investment? The role of debt covenants. The Journal of Finance, 63(5), 2085-2121. https://doi.org/10.1111/j.1540-6261.2008.01391.x

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2019). Intermediate accounting (17th ed.). Wiley.