978-1259722660 Chapter 14 Solution Manual Part 14

Case 14–3 (continued)

Arguments Supporting View 1:

1. Those who favor accounting for convertible debt as entirely a liability until it

is either converted or repaid argue that a convertible bond offers the holder

two mutually exclusive choices. The holder cannot both redeem the bond for

cash at maturity and convert it into common stock. They contend that the

2. Supporters of the first alternative generally also are concerned about the

ability to measure reliably the components of convertible debt because neither

is separately traded. They conclude that because the market does not

Case 14–3 (continued)

3. Supporters of that view argue that factors other than the conversion feature

typically affect the pricing of convertible debt and therefore may complicate

an attempt to allocate the proceeds from issuance between the straight debt

and the conversion feature. For example, convertible bonds generally have

4. Moreover, no cash payment from holder to issuer is required when a

convertible bond is converted; the bond itself represents the consideration

received by the issuing enterprise for the stock into which the bond is

Arguments Supporting View 2:

1. Those who favor separate recognition of the liability and equity components

of convertible debt argue that to ignore the existence of the conversion feature

Case 14–3 (continued)

2. The higher interest expense recognized if the components are separately

recognized than if all of the proceeds of issuance are recorded as a liability

reflects the fact that an enterprise that issues debt at less than its face amount

pays an effective interest rate that is higher than the coupon rate. The lower

3. Supporters of separate accounting contend that accounting for convertible

debt as entirely a liability impairs comparability between enterprises. If

4. Those who support separate recognition of the liability and equity components

of convertible debt point to the different values assigned by the market to

convertible and nonconvertible debt with like terms as evidence of the

Case 14–3 (concluded)

5. In the 21 years since the original pronouncement, Opinion 14, was issued (to

the date of this literature), the idea that many financial instruments may be

broken down into more fundamental components, which then may be traded

separately, has been embraced by the Wall Street community. The cash flows

Analysis Case 14–4

Requirement 1

The notice is being placed by the four underwriters listed at the bottom of the

notice. The purpose is to announce the sale of the bonds described. Actually, the

Requirement 2

In practice, debt securities rarely are priced at a premium in their initial

offering. The reason is primarily a marketing consideration. It’s psychologically

Requirement 3

The accounting considerations for Craft Foods are to recognize the liability

and related debt issue costs, as well as to record interest expense semiannually over

the 10-year term to maturity at the effective rate of interest. The bonds were

recorded at their selling price: $750,000,000 x 99.57 = $746,775,000 (Bonds

payable at face, discount of $3,225,000). Craft Foods also recorded the debt issue

Judgment Case 14–5

Obviously, no rational lender will lend money without interest. The

zero-interest loan described actually does implicitly bear interest. The amount and

If we knew, for instance, that the market rate of interest at the time for this

Both the asset acquired and the liability used to purchase it should be recorded

In row 12 of Table 4, the value 10.90751 is in the 1.5% column. Since

In any case, Mr. Wilde will not avoid interest charges with this offer. Interest

Judgment Case 14–6

Although not specifically discussed in the chapter, concepts studied in this and

other chapters provide the logic for addressing the situation described. The

The journal entry to record the initial transaction is as follows:

Interest revenue is recognized over the four-year life of the note using the

Prepaid inventory is credited and inventory is debited as inventory is

Communication Case 14–7

The critical question that student groups should address is the valuation of the

note receivable. In this case, there is a correct answer. The note should be valued

It is important that each student actively participate in the process of arriving

at a solution. Domination by one or two individuals should be discouraged.

Ethics Case 14–8

Discussion should include these elements.

Facts:

Inducing a bond conversion is a common method of indirectly issuing stock,

though typically not for the purpose of enhancing profits.

Reported performance will increase.

Company managers stand to benefit from the change.

Ethical Dilemma:

Should Hunt Manufacturing enter into these transactions primarily for

“window dressing” rather than for economic reasons?

Who is affected?

Meyer

Barr

Other managers

Bondholders

Hunt’s auditors

Shareholders

Potential shareholders

The employees

Other creditors

Judgment Case 14–9

Requirement 1

The debt to equity ratio is computed by dividing total liabilities by total

shareholders’ equity. The ratio summarizes the capital structure of the company as

In general, debt

increases risk. Debt

of liquidation. In addition, debt requires payment, usually on specific dates.

Failure to pay debt interest and principal on a timely basis may result in default and

Requirement 2

Debt also can be used to enhance the return to shareholders. This concept is

known as leverage. If a company earns a return on borrowed funds in excess of the

Debt to equity ratio = Total liabilities

Shareholders’ equity