Real World Case 14–2
Requirement 1
($ in millions)
Cash (price given) ………………………………………………. 968
Requirement 2
($ in millions)
Fiscal Increase Outstanding
Year-end Cash Interest Expense in Balance Balance
1997
968
1998
0
0.03149
(968)
=
30
30
998
1999
0
0.03149
(998)
=
31
31
1,030
2000
0
0.03149
(1,030)
=
32
32
1,062
2001
0
0.03149
(1,062)
=
33
33
1,096
2002
0
0.03149
(1,096)
=
35
35
1,130
2003
0
0.03149
(1,130)
=
36
36
1,166
2004
0
0.03149
(1,166)
=
37
37
1,203
2005
0
0.03149
(1,203)
=
38
38
1,240
2006
0
0.03149
(1,240)
=
39
39
1,280
2008
0
0.03149
(1,320)
=
42
42
1,361
2009
0
0.03149
(1,361)
=
43
43
1,404
2010
0
0.03149
(1,404)
=
44
44
1,449
2011
0
0.03149
(1,449)
=
46
46
1,494
2012
0
0.03149
(1,494)
=
47
47
1,541
2013
0
0.03149
(1,541)
=
49
49
1,590
2014
0
0.03149
(1,590)
=
50
50
1,640
2015
0
0.03149
(1,640)
=
52
52
1,691
2016
0
0.03149
(1,691)
=
53
53
1,745
2017
0
0.03149
(1,745)
=
55
55
1,800
14–122 Intermediate Accounting, 8/e
Case 14–2 (continued)
Requirement 3
In a strict sense, zero-coupon debt pays no interest. “Zeros” offer a return in the
form of a “deep discount” from the face amount. In fact, though, interest accrues at
the effective rate (3.149% in this case) times the outstanding balance ($968 million
Requirement 4
Requirement 5
The journal entry Hewlett-Packard used to record the early extinguishment of
debt in 2002, assuming the purchase was made at the end of the year was:
Calculations:
$257 ÷ $1,800 = 14.28% of notes were repurchased
Case 14–2 (concluded)
Requirement 6
The journal entry Hewlett-Packard used to record the extinguishment of debt at its
2017 maturity would be:
Communication Case 14–3
You may wish to suggest to your students that they consult the FASB 1990
Discussion Memorandum, “Distinguishing between Liability and Equity Instruments
and Accounting for Instruments with Characteristics of Both,” which sets forth the
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 accounting
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
14–126 Intermediate Accounting, 8/e
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
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 converted. Thus, the price
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 in
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
3. Supporters of separate accounting contend that accounting for convertible debt as
entirely a liability impairs comparability between enterprises. If convertible debt
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 inherent
14–128 Intermediate Accounting, 8/e
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 from
Analysis Case 14–4
is 7.75%, but the bonds are priced to yield a higher rate, which accounts for the fact
they are offered at a discount, 99.57% of face value.
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 more
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
14–130 Intermediate Accounting, 8/e
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 rate of interest
can be inferred from either the market rate of interest at the time for this type of
Both the asset acquired and the liability used to purchase it should be recorded at
the real cost, $179,781. Similarly, if we knew the cash price of the equipment is
$185,430, then we could calculate the effective rate of interest as follows:
The discount rate that “equates” the present value of the debt ($185,430) and
the installment payments ($17,000) is the effective rate of 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 company‘s
accountant is incorrect in valuing the note at $200,000. The note should be valued at
the present value of the receivable using the prevailing market rate and the difference
between the present value and the cash given is regarded as an addition to the cost of
products purchased during the contract term.
In this case, the note would be valued at $136,602, computed as follows:
The journal entry to record the initial transaction is as follows:
Notes receivable (above) …………………………... 136,602
Interest revenue is recognized over the four-year life of the note using the
effective interest rate of 10%. Accrued interest will increase the receivable valuation
to $200,000.
14–132 Intermediate Accounting, 8/e
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 at the
present value of $300,000 using the appropriate market rate of interest. The
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.
Ethical Dilemma:
Should Hunt Manufacturing enter into these transactions primarily for “window
dressing” rather than for economic reasons?
Who is affected?
Meyer
Barr