Earnings Management – Long-Term Liabilities Adrenaline Entertainment is struggli

Question

Earnings Management – Long-Term Liabilities

Adrenaline Entertainment is struggling financially and its CFO, David Plesko, is starting to feel the heat. Back on January 1, 2014, Adrenaline Entertainment issued $100 million of 6% bonds, due in 15 years, with interest payable semiannually on June 30 and December 31 each year. The market interest rate on the date of issue was 5%.

It is now the end of 2018, and David has a plan to increase reported net income in 2018. The market interest rate has risen to 9% by the end of 2018. David wants to retire the $100 million, 6% bonds and reissue new 9% bonds instead.

Required:

1.

Show that the bonds originally were issued on January 1, 2014, for $110,465,146.

2.

Calculate the carrying value of the bonds five years later on December 31, 2018.

3.

Calculate the market value of the bonds five years later on December 31, 2018.

4.

Record the early retirement of the bonds on December 31, 2018. Does the transaction increase net income? By how much (ignoring any tax effect)?

5.

Is David Plesko's plan ethical? Do you think investors would agree with David Plesko that the retirement of the 6% bonds and the reissue of 9% bonds is a good idea? Explain why or why not.

1.

Show that the bonds originally were issued on January 1, 2014, for $110,465,146.

2.

Calculate the carrying value of the bonds five years later on December 31, 2018.

3.

Calculate the market value of the bonds five years later on December 31, 2018.

4.

Record the early retirement of the bonds on December 31, 2018. Does the transaction increase net income? By how much (ignoring any tax effect)?

5.

Is David Plesko's plan ethical? Do you think investors would agree with David Plesko that the retirement of the 6% bonds and the reissue of 9% bonds is a good idea? Explain why or why not.

Explanation / Answer

Determine the issue price of the 6%, 15-year, $100,000,000 bonds if the market interest rate is 5% with semiannual interest payments.

Step 1: Calculate the present value of face value of bonds.

Particulars

Amount ($)

Face value of bonds (a)

$100,000,000

PV factor at a semiannual market rate of 2.5% for 30 periods (b)

0.47674

Present value of face value of bonds (a)x(b)

$47,674,000

Working notes:

Calculate semiannual market interest rate

Market Interest rate= 5%

Semiannual market interest rate=market interest rate/2

5%/2= 2.5%

Calculate the number of periods

No. of years=15 years

No. of semiannual payment periods= Number of years X 2= 30 payment periods

Step 2: Calculate present value of interest payment.

Particulars

Amount ($)

Interest payable amount (a)

$3,000,000

PV factor at a semiannual market rate of 2.5% for 30 periods (b)

20.930382

Present value of interest payment (a)x(b)

$62,791,146

Working Notes:

Calculate amount of interest payable.

Face value of bonds = $100,000,000

Stated interest rate = 6%

Semiannual stated interest rate= Stated Interest rate/2

6%/2= 3%

Int. payable= face value of bonds x semiannual int. rate

$100000000 x 3/100 = $3000000

Step 3: Calculate issue price of bonds.

Present value of face value of bonds = $47,674,000 (From step 1)

Present value of interest payment = $62,791,146 (From step 2)

Issue price of bonds = $47674000+$62791146= $110465146

2.

Step 1: Calculate the present value of face value of bonds.

Particulars

Amount ($)

Face value of bonds (a)

$100,000,000

PV factor at a semiannual market rate of 2.5% for 20 periods (b)

0.61027

Present value of face value of bonds (a)x(b)

$61,027,000

Working Notes:

Calculate semiannual market interest rate.

Market interest rate = 5%

5%/2= 2.5%

Calculate the number of periods.

Number of years = 10 years

10 X 2= 20 periods

The due date of 15 year bond is reduced by 5 years hence the number of years is 10 years

Step 2: Calculate present value of interest payment.

Particulars

Amount ($)

Interest payable amount (a)

$3,000,000

PV factor at a semiannual market rate of 2.5% for 20 periods (b)

15.58919

Present value of interest payment (a)x(b)

$46,767,570

Step 3: Calculate carrying value of bonds.

Present value of face value of bonds = $61,027,000 (From step 1)

Present value of interest payment = $46,767,570 (From step 2)

                                Carrying value of bonds= 61027000+46767570=107794570

3.

Step 1: Calculate the present value of face value of bonds.

Particulars

Amount ($)

Face value of bonds (a)

$100,000,000

PV factor at a semiannual market rate of 4.5% for 20 periods (b)

0.41464

Present value of face value of bonds (a)x(b)

$41,464,000

Working Notes:

Calculate semiannual market interest rate.

Market interest rate = 9%

9%/2= 4.5%

Calculate the number of periods.

Number of years = 10 years

10X2= 20 periods

The due date of 15 year bond is reduced by 5 years hence the number of years is 10 years

Step 2: Calculate present value of interest payment.

Particulars

Amount ($)

Interest payable amount (a)

$3,000,000

PV factor at a semiannual market rate of 4.5% for 20 periods (b)

13.00803

Present value of interest payment (a)x(b)

$39,024,090

Step 3: Calculate market value of bonds.

Present value of face value of bonds = $41,464,000 (From step 1)

Present value of interest payment = $39,024,090 (From step 2)

Market value of bonds= $41464000+$39024090=$80488090

4.

Journal entry: Record the following journal entry in the books of AN Entertainment:

Date

Accounts and Explanations

Post Ref.

Debit ($)

Credit ($)

2017

December

31

Bonds Payable (L–)

107,794,570

Gain (E+)

27,306,480

Cash (A–)

80,488,090

(To record early retirement of bonds)

Explanation:

• Bonds Payable is a liability account. The amount has decreased because the liability is paid off. Therefore, debit Bonds Payable account with $107,794,570.

• Gain is an income account. Incomes and gains increase stockholders’ equity account. Therefore, credit Gain account with $27,306,480.

• Cash is an asset account. The amount has decreased because debt is paid; therefore, credit Cash account with $80,488,090.

Working Notes:

Calculate gain or loss on early retirement of bonds.

Redemption price (market value of bonds) = $80,488,090 (From requirement 3)

Carrying value of bonds as on December 31, 2017 = $107,794,570 (From requirement 2)

Gain (loss) on redemption =$107794870-$80488090=$27306480

Transaction increased by $27306480

5.

Ethics:

Mr. D’s plan of retiring the 6% bonds and reissuing the bonds at 9% would be ethical if he discloses the same to the investors and stockholders.

Investors would not agree the idea of Mr. D at retiring the current 6% bonds and reissuing the bonds at 9% for the following reasons:

• Although the reissue of bonds increases the net income by $27,306,480, but the reissue increases the burden of interest payments every year.

• The current 6% bonds require $6,000,000 ($100000000x6%) interest payments every year but the 9% bonds require $9,000,000 ($100000000x9%) interest payments every year.

Particulars

Amount ($)

Face value of bonds (a)

$100,000,000

PV factor at a semiannual market rate of 2.5% for 30 periods (b)

0.47674

Present value of face value of bonds (a)x(b)

$47,674,000

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