Accounting Week 46 Tutorials - CH7, E7.23, P7.26, C7.34; CH8, P8.28, P8.32

1. AccountingP 6011P0148 / PE 6011P0150 Tutorials Amsterdam Business School

2. Contents • CH7: E7.23, P7.26, C7.34 • CH8: P8.28, P8.32 Accounting week 46

3. E7.23 Accounting week 46

4. E7.23 Accounting week 46

5. E7.23 Accounting week 46

6. P7.26 Accounting week 46

7. P7.26 Solution approach: Assuming that the “profile” of lifetime subscribers for Evans Ltd. will be similar to that of current subscribers, an average lifetime membership will last for 40 years. The present value of a lifetime subscription, discounted at 12% for 40 years = ($75 per year revenues foregone * 8.2438) = $618.29 Accounting week 46

8. C7.34 Accounting week 46

9. C7.34 Accounting week 46

10. C7.34 c. The bonds pay a higher than market-rate of interest, so their price will increase. That is, investors are willing to pay more for bonds offering a higher than market interest rate because such an investment will increase their ROI. Since the bonds are a liability to Corless Co. (the issuer), it is likely that the call feature will be exercised so that bonds with a lower interest rate can be issued in the near future. It would not be to the bondholders’ advantage to exercise the conversion feature at this point. Other factors to consider before deciding to call the bonds?1) cost of the call premium, and 2) cost of registration and issuance of a new bond issue; both factors should be considered relative to the remaining term of the outstanding bonds. Note that interest rate expectations are not terribly relevant because the new bond issue will have a fixed interest rate (at or near 7%), and if interest rates continue to drop, the call feature can be exercised on the new bonds as well. Accounting week 46

11. C7.34 d. The market value would be more than the book value of $400,000 because the price of the bonds would increase, as described in item c. This is bad news to Corless Co. because it is paying a higher than market interest rate. Why doesn’t the firm adjust the book value of its liability for the change in market value caused by interest rate movements? That is, why not record the unrealized gain or loss each year as a year-end adjusting entry so that the Bonds Payable account will be marked to market? 1) This would violate the historical cost principle--bonds are initially recorded at their market value at the time of issuance, and the initial amount of discount or premium is amortized over the life of the bond issue (much like the depreciation of the historical cost of long-term assets). Accounting for liabilities should be consistent with the accounting for long-term assets. 2) The going concern concept suggests that, in the end, the bonds will be appropriately valued--the book value will be equal to the face amount at the maturity date, and this is the amount of cash the issuer must ultimately pay to satisfy its obligation. So why keep adjusting the “value” of the Bonds Payable liability up and down if the market adjustments are not going to be realized by the firm. This provides a good opportunity to discuss/reinforce alternative valuation approaches for liabilities (and assets) with emphasis on the historical cost/market value debate. Accounting week 46

12. C7.34 Accounting week 46

13. P8.28 Accounting week 46

14. Accounting week 46

15. P8.32 Accounting week 46

16. Accounting week 46

17. Accounting week 46

18. Accounting week 46