chap 008

Chapter 08 - Sources of Capital: Debt

CHAPTER 8SOURCES OF CAPITAL: DEBT

Changes from Twelfth Edition

Updated from Twelfth Edition. Two new cases – Persistent Learning and Kim Park – have been added. Stone Industries has been dropped.

Approach

Students sometimes are confused about the nature of bonds, since they have heard the term linked with equity in “stocks and bonds” and know that there are bond exchanges and quoted daily prices. Hybrid securities such as convertible debentures or redeemable preferreds exacerbate any confusion. However, once students understand the nature of bonds, they find the accounting fairly straightforwardwith the notable exception of discount/premium amortization using the compound interest method (as opposed to the easy, but conceptually incorrect, straight-line method). I feel that it is desirable to teach the Appendix’s present value concepts at this point, but it is feasible to omit this topic and introduce it as the beginning of the coverage of capital budgeting.

Cases

Norman Corporation (A) describes several problems relating to contingencies and other liability accounting issues.

Paul Murray enables students to practice future value and present value problems in an everyday context.

Joan Holtz (D) deals with several matters we have recently seen mentioned in the business press (or on TV, in one instance), including debt-for-equity swaps.

Leasing Computers at Persistent Learning requires students to choose between entering into a capital or operating lease.

Kim Park raises a number of issues encountered when accounting for liabilities.

Additional Cases

The observant instructor can augment or update Joan Holtz (D) with new issues as they crop up in The Wall Street Journal and elsewhere. (The folks on Wall Street are quite good about generating new accounting issues for us with their latest “creative” financing instruments.)

Problems

Problem 8-1

Time zero investment = $750,000 x .630 = $472,500

Proof

$472,500 x (1.08 x 1.08 x 1.08 x 1.08 x 1.08 x 1.08) = $749,798

Difference due to use of tables (Table A)

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Problem 8-2

CD price Year 10 = $14 / .676 = $20.71

CD price Year 25 = $14 / .375 = $37.33

CD price Year 50 = $14 / .141 = $99.29

Problem 8-3

(1) Trust fund at time zero = $100,000 x .397 = $39,700

(2) End of Year 1 payment = $4,000 x .926 = $ 3,704End of Year 2 payment = $4,500 x .857 = $ 3,857End of Year 3 payment = $5,000 x .794 = $ 3,970End of Year 5 payment = $6,000 x .735 = $ 4,410

Total loan $15,941

(1) Present value of $3,100 / year for three years at 6 percent (least amount you will accept today) = $3,100 x 2.673 = $8,286

Proof

YearBeginning Balance

Ending Balance Before Payment Payment

1 $8,286 $8,783 $3,1002 5,683 6,024 3,1003 2,924 3,100 3,100

(4) Present value at beginning of year 3 of $3,000 received annually for 9 years (assuming “through year 11” means to the end of year 11) discounted at 12 percent per year = $3,000 x 5.328 = $15,984.

Present value of $15,984 received two years hence, discounted at 12 percent = $15,984 x .797 = $12,739.

Problem 8-4

YearBeginning Balance

Ending Balance Before Payment Payment

1 $164,440 $184,173 40,0002 144,173 161,473 40,0003 121,473 136,050 40,0004 96,050 107,576 40,0005 67,576 75,685 40,0006 35,685 39,967 39,967

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Problem 8-5

(1) W&H Company’s 2010 financial statements should disclose the IRS suit, if material. The company should include in its 2006 financial statements a provision for a payment of at least $270,000 to the IRS.

(2) The full loss should be included in the company’s 2010 financial statements.

(3) The suit should be disclosed in the 2010 financial statements, if material. A comment can be made that if an adverse finding is reached by the court, insurance should offset part of the damage payment. A contingency loss provision is not needed at this time.

(4) If the company has received formal notification of an intent to sue, it should be disclosed in its 2010 financial statements. The company might indicate it believes any claim against the company is without merit.

Problem 8-6April 1, 2008

dr. Cash....................................................................................................................................................................................................260,000cr. Bonds Payable.................................................................................................................................................................................250,000

Bond Premium................................................................................................................................................................................10,000October 1, 2008

dr. Interest Expense.................................................................................................................................................................................10,000cr. Cash 10,000

dr. Bond Premium...................................................................................................................................................................................500cr. Interest Expense..............................................................................................................................................................................500

December 31, 2009dr. Interest Expense.................................................................................................................................................................................2,500

cr. Interest Payable 2,500dr. Bond Premium...................................................................................................................................................................................250

cr. Interest Expense..............................................................................................................................................................................250April 1, 2009dr. Interest Expense 2,500

cr. Interest Payable (10,000 x 3/12)

2,500

dr. Bond Premium 250cr. Interest Expense (1,000 x 3/12)

250

Same as above (assume straight-line amortization of bond premium).

Problem 8-7

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(1) dr. Cash....................................................................................................................................................................................................14,700,000Bond Discount....................................................................................................................................................................................300,000

cr. Bonds Payable.................................................................................................................................................................................15,000,000

(2) dr. Issurance Cost (asset).........................................................................................................................................................................250,000Cash....................................................................................................................................................................................................7,999,600

cr. Bond Payable..................................................................................................................................................................................7,000,000Bond Premium................................................................................................................................................................................999,600Cash.................................................................................................................................................................................................250,000

Cash received equals sum of:

PV 15 annual interest payments ($80 x 7,000) discounted at 6.5 percent (9.41)..............................................................................................................................................................$5,269,600PV principal payment ($7,000,000) in year 15 discounted at 6.5 percent (.390).............................................................................................................................................................. 2,730,000

$7,999,600(3) dr. Cash....................................................................................................................................................................................................4,658,250

Bond Discount......................................................................................................................................................................................341,750cr. Bond Payable..................................................................................................................................................................................5,000,000

Cash received equals sum of:

PV 20 semiannual interest payments ($350,000 / 2) discounted at 4 percent (13.590 - Table B).........................................................................................................................................$2,378,250PV principal payment ($5,000,000) in period 20 discounted at 4 percent (.456 - Table A).................................................................................................................................................2,280,000

$4,658,250Problem 8-8

January 1, 2008dr. Cash....................................................................................................................................................................................................4,750,000

Bond Discount....................................................................................................................................................................................250,000cr. Bonds Payable.................................................................................................................................................................................5,000,000

January 1, 2013dr. Bonds Payable....................................................................................................................................................................................5,000,000

Loss on BondRedemption........................................................................................................................................................................................375,000

cr. Cash.................................................................................................................................................................................................5,250,000Bond Discount.................................................................................................................................................................................125,000

Problem 8-9

January 1, 1982dr. Cash 4,120,000

Bond IssuanceCost (asset).........................................................................................................................................................................................80,000

cr. Bonds Payable.................................................................................................................................................................................4,000,000Cash.................................................................................................................................................................................................80,000Bond Premium................................................................................................................................................................................120,000

January 1, 2002

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dr. Bonds Payable 4,000,000Bond Premium 24,000Bond RedemptionExpense 75,000Loss on BondRedemption 312,000

cr. Cash 4,395,000Bond Issuance Cost 16,000

CasesCase 8-1: Norman Corporation (A) *

Note: This case has been updated from the Twelfth Edition.

Norman Corporation (A) allows students to practice dealing with various types of liabilities. If students have had little previous experience identifying when future, possible obligations are and are not accounting liabilities, you may wish to begin with a general discussion of the criteria for recording accounting liabilities. Following this, each of the items in Norman Corporation (A) can be discussed. Students should be encouraged to identify what accounting choice they made, to explain why they made this choice including explaining, where appropriate, how the item met or failed to meet the criteria for a liability, and to state the impact of their choice on the financial statements.

Answers to Question 1

1. In order to recognize an expense related to this contingency, it must be feasible to make an estimate of at least the minimum amount of loss. In this case, no such estimate is available, so no amount should be recorded. In fact, some will argue that it is not clear that a liability has been incurred. The existence of the suit should be disclosed in a note to the financial statements, however.

2. This lawsuit differs from the one above in that the lawyers are able to make an estimate of the loss. The $50,000 should be shown as an expense (rather than a debit directly to Retained Earnings), with a resulting $20,000 (40 percent) decrease in income taxes. (This may raise the question of the treatment of deferred taxes since this item would not be a tax-deductible expense in 2010; it is for this reason that students are asked not to consider detailed income tax consequences, nor to adjust the balance sheet.) In any event, showing this as a “Reserve for Contingencies” in the owner’s equity section of the balance sheet is no longer considered an acceptable practice; the credit should be to Contingent Liabilities or, better, Estimated Loss from Lawsuit.

3. Future maintenance costs are no more a liability than are, say, future salaries or materials purchases. Norman’s treatment of maintenance is an example of “income smoothing,” which is not in accordance with generally accepted accounting principles, and which is particularly frowned on by the Financial Accounting Standards Board. The expense charge should be $44,000, increasing net income and Retained Earnings by $16,000 and reducing noncurrent liabilities by the same amount.

*This teaching note was prepared Robert N. Anthony. Copyright © Robert N. Anthony.

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4.

5. The bond discount should be subtracted from the related liability, rather than being shown as an asset. The company has, in effect, borrowed only $80,000, but at an effective interest rate that is higher than 5 percent. Not enough information is given to calculate the effective rate; this is part of the optional question if students have been required to read the Appendix. It will not owe the $100,000 until the issue matures, at which time the bond discount will have been amortized, and the liability amount will be $100,000. The method of recording does make a difference because it affects total assets and total liabilities amounts and the debt/equity ratio. It does not affect income. (The stockholder’s motive for having the transaction arranged in this way probably was the belief that the $20,000 would be taxed at the lower capital gains rate when the issue matured; this belief probably was incorrect.)

6. This transaction was handled correctly. The amortization of bond discount is, in effect, a part of the true interest expense and is shown as an expense on the income statement. The statement about Retained Earnings is a red herring. Most statement users would prefer to have interest expense shown as a separate income statement line item rather than lumped into a broader category.

7. There are two issues here: whether the $500 should have been capitalized as a deferred charge rather than expensed; and, if expensed, whether included as a nonoperating item. While the deferred charge approach in general is the correct one, in this case an exception could probably be made on the ground that the difference between the correct approach and immediate expensing is immaterial. Although at one time the “nonoperating income and expenses” caption was used to aggregate such things as dividend income and interest expenses, this is no longer the case. APB-9 and APB-30 (discussed in Chapter 10) essentially equate “nonoperating” items to “extraordinary” items, for which specific criteria exist. This does not, however, preclude a company from reporting the net amount of financial revenues (e.g., dividend income) and expenses (interest, bank fees) as a line item in the calculation of pretax income from continuing operations. In the condensed income statement given in Exhibit 1, then, if this $500 is expensed, it should be included in the total for operating expenses.

8. From Chapter 8, we know clearly that this is a capital lease, since one criterion that requires capital lease treatment is transfer of title to the lessee at the end of the lease. Thus, the $35,000 value of the car should have been capitalized as an asset on January 2, 2010, and a $35,000 credit for capital lease obligations made. Assuming straight-line depreciation, one-fifth of the asset amount ($7,000) should be charged as depreciation expense in 2010. Note that the depreciation charge is based on useful life, not the lease term or ACRS schedules. If the student has been required to cover the appendix, enough information is given to calculate the interest rate of the lease, which is 8 percent (see below). Thus the $13,581 first-year payment is divided between $2,800 interest expense (.08 * $35,000) and $10,781 reduction of capital lease obligations.

Answer to Optional Question 2

We are told to assume that the $100,000 (par value) bond with a 5 percent coupon rate in item 4 of Question 1 involves 15 year-end annual interest payments of $5,000 ($100,000 * 0.05). (The payments are assumed to be annual, at year-end, rather than the more realistic semiannual, so that students not having PV calculators can use the text’s appendix tables.) Tables A and B and a rate of 8 percent results in a present value of $5,000 * 8.559 = $42,795 for interest payments plus $100,000 * 0.315 = $31,500, or a total of $74,295; since the investor paid $80,000, the yield rate is less than 8 percent.

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Trying 6 percent, we get PV = ($5,000 * 9.712) + ($100,000 * 0.417) = $90,260; so we know the yield is between 6 and 8 percent. Using 7 percent and linear interpolation in Tables A and B. we have PV = ($5,000 * 9.135) + ($100,000 * .366) = $82,275. (The mathematically inclined student will realize that linear interpolation for 7.0 percent will result in the average of the two PVs we found for 6 and 8 percent, except for rounding.) I accept 7 percent as a perfectly adequate answer. Those with calculators will come up with 7.23.

As for the correctness of the $784 first-year bond discount amortization, the calculation is as follows: Since the bond proceeds were $80,000 and the true yield was 7.23 percent, then Year 1 net interest should be $80,000 * 0.0723 = $5,784. But the stated (cash) interest payment is $5,000; thus the remaining $784 of interest expense is amortization of bond discount. Ms. Fuller’s calculation was correct.

Answer to Optional Question 3

The interest rate is determined by finding the value in Table B equal to $35,000 divided by the annual payments of $13,581 for a period of 3 years ($35,000 divided by $13,581 = 2.577). The interest rate is 8 percent. The amortization schedule:

Year Beg. Bal. Payment InterestPrincipal Reduction

1 $35,000 $13,581 $2,800 $10,7812 24,219 13,581 1,938 11,6433 2,576 13,581 1,006 12,575

($1 rounding error)

I use this schedule to generate journal entries for the lease payment and then show the asset depreciation entries, which are based on the useful life of five years.

Case 8-2: Paul Murray *

Note: This case is unchanged from the Twelfth Edition.

Approach

When encountering a difficult concept, such as the time value of money, students often can get more involved in trying to master the concept if they can relate it to their everyday lives before trying to apply it to a business situation. That is the purpose of this case, which is intended to be used with the Appendix to Chapter 8. (It can also be used instead at a later time with Chapter 22 on capital budgeting.) Since most students will have recent experience with tuition, and many may be looking forward to finding new jobs and/or having children, these issues should be salient to them.

*This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

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Answers to Questions

Note: Students answers may differ slightly, depending on whether the text’s tables, a calculator, or a spreadsheet program is used. Beginning-of-year payments may be more realistic, but they tend to confuse students since the tables and the routines in many calculators and spreadsheets are based on year-end payments.

Question 1

If the tables are used, this question will require the student to think through how to come up with a future value, given that the tables are designed to compute the present value when the future value is known. From the table, we can observe that the present value factor for $1 received 18 years hence is .350. Thus,

PV = FV * PV-factor PV = FV * .350

or PV divided by .350 = FV

Since the PV of one year’s tuition is $18,000, the FV of one year’s tuition is $18,000 divided by .350 = $51,428.57. The FV of four years’ tuition is 4 * $51,428.57 = $205,714.

To drive home the impact that a small difference in interest rates makes when compounded over many years, you may want to examine in class what would happen if the cost of tuition continued to rise at 8% as The Wall Street Journal reported it had in the past. In this case, the FV of one year’s tuition would be $18,000 divided by .250 = $72,000, and the FV of four years’ tuition would be 4 * $72,000 = $288,000.

Of course, many students will not have to use the tables but will use calculators or spreadsheets to calculate the FV directly.

Question 2

The investment made at the end of Year one will earn interest for 17 years until the end of Year 18, so its FV factor will be 1 divided by .371 = 2.695. For the payment made at the end of Year two, the FV factor will be 1 divided by .394 = 2.538. By performing similar calculations for the remaining years (see Exhibit 1), you can then compute that the FV factor for equal investments (earning 6%) made at the end of each year is 30.909. Hence, for the FV of the investments to equal $205,714, each investment must be $205,714 divided by 30.909 = $6,655. (Again, for comparison purposes, you might want to show that if the four year tuition were $288,000 as in the 8% example, this would require annual investments of $9,318 earning 6% to accumulate the desired amount.)

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Question 3

Exhibit 1Payment Made at End of Year: Future Value Factor @ 6%

1 1 .371 = 2.695 2 1 .394 = 2.538 3 1 .417 = 2.398 4 1 .442 = 2.262 5 1 .469 = 2.132 6 1 .497 = 2.012 7 1 .527 = 1.898 8 1 .558 = 1.792 9 1 .592 = 1.68910 1 .627 = 1.59511 1 .665 = 1.50412 1 .705 = 1.41813 1 .747 = 1.33914 1 .792 = 1.263I5 1 .840 = 1.19016 1 .890 = 1.12417 1 .943 = 1.06018 1.000

Total 30.909

Exhibit 2Payment at End of Year FV Factor @ 8% FV Factor @ 10% FV Factor @ 4%

1 1 .270 = 3.704 1 .198 = 5.051 1 .513 = 1.949 2 1 .292 = 3.425 1 .218 = 4.587 1 .534 = 1.873 3 1 .315 = 3.175 1 .239 = 4.184 1 .555 = 1.802 4 1 .340 = 2.941 1 .263 = 3.802 1 .577 = 1.733 5 1 .368 = 2.717 1 .290 = 3.448 1 .601 = 1.664 6 1 .397 = 2.519 1 .319 = 3.135 1 .625 = 1.600 7 1 .429 = 2.331 1 .350 = 2.857 1 .650 = 1.538 8 1 .463 = 2.160 1 .386 = 2.591 1 .676 = 1.479 9 1 .500 = 2.000 1 .424 = 2.358 1 .703 = 1.42210 1 .540 = 1.852 1 .467 = 2.141 1 .731 = 1.36811 1 .583 = 1.715 1 .513 = 1.949 1 .760 = 1.31612 1 .630 = 1.587 1 .564 = 1.773 1 .790 = 1.26613 1 .681 = 1.468 1 .621 = 1.610 1 .822 = 1.21714 1 .735 = 1.361 1 .683 = 1.464 1 .855 = 1.17015 1 .794 = 1.259 1 .751 = 1.332 1 .889 = 1.12516 1 .857 = 1.167 1 .826 = 1.211 1 .925 = 1.08117 1 .926 = 1.080 1 .909 = 1.100 1 .962 = 1.04018 1.000 1.000 1.000

Total 37.461 45.593 25.643Annual investment to reach.....................................................................................................................................................................$205, 714 $5,491 $4,512 $8,022

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Annual investment to reach.....................................................................................................................................................................$288,000 $7,688 $6,317 $11,231

Case 8-3: Joan Holtz (D) *

Note: This case is updated from the Twelfth Edition.

Approach

As with the earlier Joan Holtz cases, this one enables students to discuss some interesting issues, none of which requires a full class period. The instructor should be alert to newer situations to augment or supplant any of those described in the case. Also many of these issues tend eventually to result in an FASB, AICPA, or SEC pronouncement. Since seldom will a beginning student be aware of these pronouncements, they do not preclude continuing to use a part of this case, and then revealing at the end of that part’s discussion whether the accounting rule-making body reached the same conclusion as the class did.

Comments on Questions

1. The question is equivalent to asking, what is the future value of $100 invested at 10 percent compound interest, 127 years (1883 – 2010) from now? The answer is $100 (1.10)127 = $18,066,000. We subsequently read that the man, after giving his town officials a good scare, did not pursue the matter further, becausehad he prevailedit would have bankrupted the town.

2. a. For a future value of $1,000 received 8 years hence, and a 15 percent discount rate, the present value is $327; so, yes, the yield was 15 percent. (This result can be gotten using a calculator, or by noting in Appendix Table A that the 8 yr., 15% PV factor is 0.327.)

b. The discount is $1,000 - 327 = $673; using straight-line amortization, that is $673 divided by 8 = $84.125/bond/yr., resulting in annual tax savings of $84.125 * 0.40 = $33.65. (Subsequent to the writing of the case, the U.S. Treasury reduced, but did not eliminate, the tax deductibility of original issue discount, so these zero-coupon bonds became less attractive.) Thus, the bond issuer contemplates the following cash flow pattern:

Time Zero + $327Years 1-8 + $33.65/yr.End of year 8 - $1,000

(Actually, straight-line discount amortization is not permitted, but we wanted to keep the calculations as simple as possible.) We need to make the sum of the PVs of the eight-year stream and negative future flow equal $327, i.e., find the rate that gives an NPV of zero. By trial and error, this rate can be found to be approximately 8.5 percent. (A calculator shows it to be 8.63 percent.)

*This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

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c. With 15 percent bonds issued for par, the net-of-tax interest payment stream is simply $150 (1-0.40) = $90/bond/yr. for 8 years. If one makes a calculation like the one for part (b), but with Time Zero in flow equal to $1,000 (instead of $327) and the annual outflows equal to $90 (instead of $33.65 annual inflows), the rate giving an NPV of zero (remember the Year 8 $1,000 outflow, as well) is 9.0 percent. (Actually, trial-and-error or calculators aren’t needed here; once the $90/year amount is determined, the rate of 9.0 percent is also determined, since $90 divided by $1,000 = 9.0 percent. The student who quickly realizes this understands the meaning of a “true” return on investment of 9.0 percent.) Thus, from the standpoint of the bondholder, ignoring taxes, the yield on either bond is 15%, but the cost to the issuer of the zero-coupon bond is lower. Actually, zero-coupon bonds are generally purchased by tax-exempt institutions, so this comparison ignoring taxes is valid. However, for taxable bondholder entities, the zero-coupon bond discount amortization is taxable as ordinary interest income. In the early 1980s, zero-coupon bond mutual funds have sprung up for use by IRAs.

3. Although the text describes refunding a bond issue, it does not explicitly describe early extinguishment of debt. Actually, refunding a bond issue is just a special case of early extinguishment: the proceeds to retire the current debt come from a new debt issue. In the “debt-for-equity swap” we’re considering, the substance of the transaction is the same as if the company issued shares and then used the cash proceeds to buy its bonds on the open market; in effect, the company is simply paying an investment banker to do this on the company’s behalf. (In practice, an investment banker would be used to market newly issued common stock, whatever the intended use of the proceeds.) But in fact, a company is motivated in the debt-for-equity swap to use the investment banker as an intermediary because the tax laws are such that if the company handled the transactions on its own, it would pay taxes on the difference between the repurchase cost of the bonds and their balance sheet carrying value, irrespective of the source of the funds used to repurchase the bonds. Of course, we do not expect students to be aware of this anomaly in the tax lawbut they might well surmise it, since, again, the substance is the same whether the transaction is handled by the company or by an investment banker.

As to whether the company has “really earned” its gain on the swap will be debated by the students. In the Exxon example given, ask for journal entries to reflect the transaction. These will be:

dr. Bonds Payable....................................................................................................................................................................................72 millioncr. Capital Stock 43 millioncr. ? 29 million

To what account should the “hanging credit” of $29 million be made? If it were made to Capital Stock, the value of the consideration for the stock (i.e., bonds plus investment banker’s fee worth a total of $43 million) would be overstated. Or if Bonds Payable is debited for only $43 million (which is equivalent to making the “hanging credit” to Bonds Payable), then the actual retirement of a $72 million obligation is not reflected. Thus, by process of elimination, the $29 million has to be credited to Retained Earnings. In fact, the same treatment cited in the text for bond refunding, coming from APB-26 and FASB-4, applies here, with the gain shown as an extraordinary item (described in Chapter 10) on the income statement, rather than bring a direct credit to Retained Earnings (i.e., rather than not being flowed through the income statement). The effect of this treatment is to “reward” the company (through higher reported earnings) for being savvy enough to retire its debt early when the debt’s market price was depressed.

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Discussion of this technique should also bring out that the swap improves the company’s debt/equity ratio and interest coverage (times interest earned). The price the company pays for this is possible dilution of earnings per share resulting from the additional shares outstanding. However, as the preceding journal entries illustrate, there is really no cash generated by the deal, except in future years to the extent that dividends on the new shares are less than were the interest payments on the retired bonds. Interestingly, the Associated Press correspondent who wrote the article on which I based this problem did not understand that, because she indicates that the company ends up with some tax-free cash that can be used for capital improvements.

4. The airlines (as of late 2005) were carrying a relatively small liability for earned but unused frequent flier mileage credits. Most airlines had set up provisions for the future cost of frequent flier usage. An alternative approach would require a revenue deferral approach. A portion of revenue applicable to each original ticket sold would be deferred until the free tickets expected to be awarded were issued and used. Assuming the percentage deferred was, say 5 percent, the journal entry for a $400 original ticket would be:

dr. Cash....................................................................................................................................................................................................400cr. Ticket Revenue................................................................................................................................................................................380

Deferred Revenue............................................................................................................................................................................20

This approach implies that when a traveler buys a ticket, he/she in effect is buying that trip and a “piece” of some future “free” trip, the revenue for which has not yet been earned. It’s not clear to me why an approach analogous to warranty expense accounting (crediting the full amount of revenue, $400, then also debiting Award Program Expense and crediting Future Award Costs for $20) wouldn’t make more sense; the “bottom line” impact would be the same as the above, however.

The amount of the revenue deferral (or ex-post establishment of a liability for previously earned free tickets) is certainly a fuzzy issue, especially as the airlines begin to place restrictions on when free tickets can be used. An airline might argue that, with restrictions, the free tickets are just filling otherwise empty seats, so the cost to the airline is minimal. Also, some awards go unused. According to The Wall Street Journal, some airlines are “quietly hoping” the IRS will ease their problem by swiftly moving to tax-free tickets as income, which would drastically cut the number of people redeeming their awards.

The FASB permits the use of either the cost reserve or revenue deferral method.

5. This item raises a number of interesting issues, and it illustrates how, depending on which accounting principle one emphasizes, a different accounting method may appear more appropriate in a specific situation. This item also can be used to illustrate how accounting standards change and evolve over time and the roles played by two key standard-setting bodies in the U.S., the SEC and the FASB.

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6.

A key issue is whether the purchase of the electronics product and the extended warranty contract should be viewed as one transaction or two, and which alternative represents the best matching of revenues and expenses. Since such a high proportion of customers purchase the extended warranty contract, particularly in the case of high ticket items, many would argue that it is, in substance, a single transaction. In fact, as illustrated by the example in the case, retailers frequently make most of their profits on the extended warranty contract, not on the sale of the product.1 Therefore, the retailers must view the sale of the electronics product and the extended warranty as a single transaction; otherwise, they would not be willing to earn such a low (or nonexistent) margin on the sale of the electronics product. The counter-argument is that customers do, in fact, have a choice of whether to purchase the extended warranty contract or not, and many do not.

If you view the purchase as a single transaction, then Alternative B represents the best matching. If you view it as two distinct transactions, then Alternative A represents the best matching.

Another principle which can be discussed is conservatism. Clearly, Alternative A is the most conservative as it defers the recognition of the most revenue; none of the warranty revenue is recognized at the date of the sale of the product. Instead, the extended warranty revenue is recognized ratably over the life of the extended warranty contract. Alternative B. which recognizes all of the warranty revenue on the date the product is sold, and Alternative C, which recognizes some of the warranty on the date the product is sold, are clearly less conservative.

The instructor can also raise the issue of performance under the extended warranty contract: When has the retailer performed what is required to earn income under the warranty contract? Clearly, there is some requirement for the retailer to perform, that is, to provide repair or replacement under the extended warranty contract, during the life of the contract. However, it can also be argued that the reliability of these electronics products is high enough that, in most cases, the retailer will never have to provide any service at all. This is one factor that makes these contracts so profitable: customers are willing to purchase them in case there is a problem with the unit they have purchased but, in fact, in most instances there will be no problem at all. The performance criterion argues for deferring at least some warranty contract revenue to be recognized over the life of the contract, but does it necessarily mean that all warranty contract revenue should be deferred? If deferring all extended warranty contract revenue does not seem necessary, then Alternative C may appear most appropriate.

Clearly, an argument for each of the three alternatives can be made and supported using the accounting principles and sound reasoning.

The three alternatives will have different effects on the financial statements.2 First consider the situation where sales are growing steadily (See Ex. 1). Alternative B will produce the highest revenue and net income, as all extended warranty revenue and profit are recognized immediately. The balance sheet will also show the largest retained earnings and there will be no deferred revenue liability. Alternative C will show the second highest revenue and net income, as some of the revenue and most of the income from the extended warranty contract will be recognized immediately. The balance sheet will thus show the second highest retained earnings; there will be a deferred revenue liability that will increase each year because we have assumed steadily growing sales.

1 Business Week indicated that with retailers slashing prices to lure customers, service plans had become even more important, as the revenues from extended warranties were one way to withstand the never-ending price wars. Business Week quoted Audio/Video Affiliates Chairman Stuart Rose, “Anyone making money now, it’s probably 100% from warranties.” [“Electronics Stores Get a Cruel Shock,” Business Week, January 14, 1991, page 42D.]2 In the discussion of effects on the financial statements, it will be assumed that margins on products and extended warranty contracts remain constant. Any effect of the three alternatives on taxes (expense, liability, deferred tax) will be ignored.

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Alternative A will show the lowest revenue and the lowest net income, as all of the extended warranty revenues and the associated high warranty profits are deferred. On the balance sheet, Alternative A will show the smallest retained earnings and the largest deferred revenue liability. Of course, the net effect on the cash flow statement is the same for each of the three alternatives. A lower net income will be adjusted by a higher deferred revenue to reveal the same impact on cash.

The story changes if the sales decline (See Ex. 2). In this situation, Alternative A will eventually show the highest revenue because it deferred the most extended warranty contract revenue, and it will show the highest net income because of the deferral of these very high margin contracts. Net income decreases much more gradually under Alternative A than under the other alternatives. Alternative B will show the most precipitous drop in sales and net income because there is no carryover of the very profitable extended warranty contracts to cushion the fall.

The accounting standards for extended warranty contracts have changed and evolved over time. Initially, retailers had considerable latitude in choosing the method they considered most appropriate. In 1989, the SEC staff moved to limit this latitude when they indicated that partial recognitionAlternative Cshould be used.3 Subsequently, the FASB issued a Technical Bulletin requiring retailers to delay recognition of extended warranty revenue and income on a straight line-basis over the warranty period (Alternative A).4 This pattern of accounting standard evolution is not uncommon: a situation arises that regulators may consider misleading or abusive; the SEC steps in with a “quick fix” and the FASB, with its larger staff and open standard-setting process, follows with a (perhaps) more thorough alternative that the SEC agrees to accept. This process is consistent with that seen in other controversial issues, such as accounting for the effects of inflation.

When the change to delayed recognition of extended warranty revenue and income (Alternative A) was announced, it was expected to have a significant effect on the financial results of major electronics retailers. According to Business Week:

Circuit City Stores, Inc., the biggest U.S. consumer-electronics chain, with $2.4 billion in sales and 185 stores, expects that the revision in warranty accounting will cut 25 cents a share from earnings for the year. That’s roughly 16% of fiscal 1991’s estimated profit of $1.55 a share. And, because it prefers not to drag out the change over several years, Circuit City also plans to take a one-time charge to account for warranty sales in prior years. That will cost an additional $1.15 a share. Although the charges won’t affect actual cash flow, they will all but wipe out stated earnings.5

3 SEC and Highland Superstores, Inc., March 1989.4 FASB Technical Bulletin No. 90-1, “Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts,” December 1990.5 Business Week, op. cit.

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Exhibit 1Financial Statement Impact: Steadily Increasing Sales

Alternative A Alternative B Alternative C

x0 xl x2 x0 x1 x2 x0 xl x2

Number of units sold 1 2 3 1 2 3 1 2 3

Revenues:...............................................................................................................................................................................................................................................................................

Product..........................................................................................................................................................................................................................................................................$2,000 $4,000 $6,000 $2,000 $4,000 $6,000 $2,128 $4,256 $6,384

Warranty (x0)................................................................................................................................................................................................................................................................60 60 60 180 17 17 18

Warranty (xl).................................................................................................................................................................................................................................................................120 120 360 35 35

Warranty (x2)................................................................................................................................................................................................................................................................_____ _____ 180 _____ _____ 540 _____ _____ 52

Total revenue.........................................................................................................................................................................................................................................................................2,060 4,180 6,360 2,180 4,360 6,540 2,145 4,308 6,489

Cost of goods sold

Product..........................................................................................................................................................................................................................................................................1,840 3,680 5,520 1,840 3,680 5,520 1,840 3,680 5,520

Warranty (x0)................................................................................................................................................................................................................................................................15 15 15 45 15 15 15

Warranty (x1)................................................................................................................................................................................................................................................................30 30 90 30 30

Warranty (x2)................................................................................................................................................................................................................................................................_____ _____ 45 _____ _____ 135 _____ _____ 45

Tota1 cost of goods sold........................................................................................................................................................................................................................................................1,855 3,725 5,610 1,885 3,770 5,655 1,855 3,725 5,610

Net income.............................................................................................................................................................................................................................................................................205 455 750 295 590 885 290 583 879

Deferred revenue

x0...................................................................................................................................................................................................................................................................................120 60 0 -- -- -- 35 18 0

x1...................................................................................................................................................................................................................................................................................240 120 -- -- -- 69 34

x2..................................................................................................................................................................................................................................................................................._____ _____ 360 -- -- -- _____ _____ --

Total deferred revenue...........................................................................................................................................................................................................................................................120 300 480 0 0 0 35 87 138

Cumulative increasein retained earnings.......................................................................................................................................................................................................................................................205 660 1,410 295 885 1,770 290 873 1,752

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Exhibit 2Financial Statement Impact: Decreasing Sales

Alternative A Alternative B Alternative C

Year x0 x1 x2 x0 x1 x2 x0 x1 x2Number of units sold...............................................................................................................................................................................3 2 1 3 2 1 3 2 1

RevenuesProduct..............................................................................................................................................................................................$6,00

0$4,000 $2,00

0$6,000 $4,000 $2,000 $6,384 $4,256 $2,128

Warranty (x0)....................................................................................................................................................................................180 180 180 540 52 52 52Warranty (xl).....................................................................................................................................................................................120 120 360 35 35Warranty (x2)...................................................................................................................................................................................._____ _____ 60 _____ _____ 180 _____ _____ 17

Total revenue...........................................................................................................................................................................................6,180 4,300 2,360 6,540 4,360 2,180 6,436 4,343 2,232

Cost of goods soldProduct..............................................................................................................................................................................................5,520 3,680 1,840 5,520 3,680 1,840 5,520 3,680 1,840Warranty (x0)....................................................................................................................................................................................45 45 45 135 45 45 45Warranty (xl).....................................................................................................................................................................................30 30 90 30 30Warranty (x2)...................................................................................................................................................................................._____ _____ 15 _____ _____ 45 _____ _____ 15

Total cost of goods sold...........................................................................................................................................................................5,565 3,755 1,930 5,655 3,770 1,885 5,565 3,755 1,930

Net income..............................................................................................................................................................................................615 545 430 885 590 295 871 588 302

Deferred revenuex0......................................................................................................................................................................................................360 180 0 -- -- -- 104 52 0x1......................................................................................................................................................................................................240 120 -- -- -- 69 34x2......................................................................................................................................................................................................_____ _____ 120 __ _-- _ __-- _ __-- _____ _____ 35

Total deferred revenue.............................................................................................................................................................................360 420 240 0 0 0 104 121 69

Cumulative increasein retained earnings...........................................................................................................................................................................615 l,160 1,590 885 l,475 1,770 871 1,459 1,761

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Case 8-4: Leasing Computers at Persistent Learning *

Note: This case is new with the Thirteenth Edition. Please see the printed Instructor’s Resource Manual for the Harvard Teaching Notes.

Case 8-5: Kim Park *

Note: This case is new with the Thirteenth Edition. Please see the printed Instructor’s Resource Manual for the Harvard Teaching Notes.

*This note was prepared by Professor Devin Shanthikumar. Copyright © 2009 President and Fellows of Harvard College. Harvard Business School Teaching Note 109-054.*This note was prepared by Professor David Hawkins, Gregory Miller, and VG Narayanan. Copyright © 2009 President and Fellows of Harvard College. Harvard Business School Teaching Note 110-021.

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