ACC 422 Week 4 Long-Term Liabilities Example

Borrowing When Rates Were Falling: Pricing a 7% Bond Sold to Yield 6%, Amortizing the Premium, Calling the Issue Early and Watching the Covenants at a Composite Grocery Cooperative

[Student Name]

University of Phoenix

ACC/422: Intermediate Financial Accounting II

Week 4 Assignment

[Instructor Name]

[Date]

The cooperative, its bonds and all figures are composites written for a model paper; accounting rules and research findings come from the sources listed.

A composite grocery cooperative supplies about 180 independent grocery stores with food, household goods and store services. Its members voted to build a new refrigerated distribution center, and the cooperative financed it by selling $10 million of 10-year bonds with a stated rate of 7%, paying interest semiannually on June 30 and December 31. The bonds were priced in January, when the market rate for borrowers with the cooperative's credit rating was 6%. A bond that promises more interest than the market demands is worth more than its face value, and the accounting must explain where the extra money goes. This paper records the bonds from issue to early retirement.

Pricing the Bonds

The price of a bond is the present value of its cash flows at the market rate. With semiannual payments, the rate per period is 3% and there are 20 periods. The $10 million of principal due in 20 periods has a present value factor of 0.55368, about $5,536,800. The 20 interest payments of $350,000 each have an annuity factor of 14.87747, about $5,207,100. The bonds sold for about $10,743,900, a premium of $743,900.

The cooperative paid underwriting and legal costs of $120,000. Under current standards, debt issuance costs are presented as a direct deduction from the carrying amount of the debt (Financial Accounting Standards Board, 2015), so the net carrying value on issue was about $10,623,900. For clarity, the schedule below follows the bonds and premium; the issuance costs are amortized separately as additional interest over the 10 years, $6,000 each period.

Recording Issuance

The cooperative debits cash for $10,623,900 and debt issuance costs, contra to the bonds, for $120,000, and credits bonds payable for $10,000,000 and premium on bonds payable for $743,900.

Amortizing the Premium

The effective-interest method charges interest on what the cooperative really owes. Each period's expense is the opening carrying value multiplied by 3%, the cash paid stays fixed at $350,000 and the gap between those two figures is the slice of premium written off.

On June 30 of the first year, interest expense is $10,743,900 times 3%, or about $322,300. The premium amortized is $27,700, and the carrying value falls to about $10,716,200. On December 31, interest expense is about $321,500, amortization about $28,500 and the carrying value about $10,687,700. Each period, the carrying value moves closer to face value, and interest expense falls slightly. Over the 20 periods, total interest expense would equal the $7 million of cash interest less the $743,900 premium.

Weygandt et al. (2021) explain that the effective-interest method keeps the rate of interest constant on the amount actually owed, which is why it is required when its results differ materially from straight-line amortization.

Calling the Bonds After Five Years

The bond agreement allowed the cooperative to call the bonds at 102 after five years. By then, market rates for similar borrowers had fallen to 4.5%, and the cooperative could refinance more cheaply. It called the bonds on the interest date at the end of year five, after paying that period's interest.

At that date, 10 periods remain. The carrying value of the bonds is the present value of the remaining cash flows at the original 3% per period: $10 million times 0.74409, about $7,440,900, plus $350,000 times 8.53020, about $2,985,600, a total of about $10,426,500. Unamortized issuance costs of $60,000 reduce the net carrying amount to about $10,366,500. The call price is 102% of face, $10,200,000.

Because the cooperative paid less than the net carrying amount, it records a gain on extinguishment of about $166,500. It debits bonds payable for $10,000,000 and premium on bonds payable for about $426,500, credits the issuance cost account for $60,000, credits cash for $10,200,000 and credits the gain. The gain is reported in income; it reflects the fall in interest rates that made the old debt a worse deal for bondholders.

Why the Premium Is Not a Gain

It can look as if the cooperative made $743,900 by selling its bonds above face value. It did not. Investors paid the premium because they will receive $350,000 every six months when the market would have given them only $300,000 on the same principal. The premium is an advance repayment of that extra interest, and amortizing it spreads the benefit over the periods in which the higher coupons are paid. That is also why the premium sits with the liability rather than in equity: it is part of what the cooperative owes, measured at the rate lenders required when the money was raised.

The New Borrowing

To fund the call, the cooperative issued $10.2 million of new 5-year bonds at par at 4.5%. Annual interest cost falls from $700,000 to about $459,000. The gain on the old bonds is not the reason to refinance; the lower future interest is.

Covenants and Disclosure

The bond agreement required the cooperative to keep a ratio of debt to members' equity below 1.5 and to maintain a fixed-charge coverage ratio above 2.0, measured each year. Dichev and Skinner (2002) found that many private lending agreements are written with covenant thresholds set close to borrowers' actual ratios, so violations are common and act as early warnings rather than immediate defaults. The cooperative's controller tracks both ratios quarterly and would negotiate with the trustee before a breach occurred.

The notes to the financial statements disclose the bonds' terms, the call and gain, the maturities of the new debt for each of the next five years, the covenants and the fair value of the debt. Readers use the maturity schedule to see when the cooperative must repay or refinance.

Conclusion

The cooperative's bonds sold at a premium because they paid more than the market rate. The premium reduced interest expense over the time the bonds were outstanding, and the effective-interest method kept that expense proportional to the amount owed. When rates fell, the cooperative called the bonds at 102, recorded a gain against their carrying value and refinanced at a lower rate, while its covenants and disclosures kept lenders informed.

References

Dichev, I. D., & Skinner, D. J. (2002). Large-sample evidence on the debt covenant hypothesis. Journal of Accounting Research, 40(4), 1091-1123. https://doi.org/10.1111/1475-679X.00083

Financial Accounting Standards Board. (2015). Interest, imputation of interest (Subtopic 835-30): Simplifying the presentation of debt issuance costs (Accounting Standards Update No. 2015-03).

Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2021). Accounting principles (14th ed.). Wiley.