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Early Retirement of Bonds in Financial Accounting

After bonds are sold to investors, they are often subsequently traded (bought and sold) among investors. The market value of bonds that are traded among investors varies from day to day as prevailing interest rates rise and fall. This occurs because the bond contract specifies a set of cash payments to be made to bondholders, and the present value of a given set of future cash flows changes whenever there is a change in the rates used to make the present value calculations. For example, market interest rates on corporate bonds fell dramatically in the 1990s and as a result the value of existing bonds increased substantially. If monetary authorities begin to tighten money and increase interest rates in subsequent years, the market value of existing bonds will again decline.

Fluctuations in the market prices of outstanding bonds do not result in additional cash inflows and outflows for the issuing company. Consistent with the historical cost principle, the reported value of bonds in the financial statements of the issuing company is not revised to reflect changes in market interest rates and market prices of the outstanding bonds. For this reason, changes in market rates of interest may motivate firms to buy back their outstanding bonds prior to their scheduled maturity dates. If market rates of interest have changed subsequent to the issuance of the bonds, then the current market prices of the bonds may differ substantially from values shown on the books of the issuing firm. If the firm does repurchase its own bonds, any difference between the reported value and the repurchase price must be recognized as an extraordinary gain or loss by the issuer when the transaction is completed.

To illustrate this point, assume that Marley Company issued bonds at par early in 2000, and that interest rates have risen subsequently. When interest rates rise, the market values of outstanding bonds decline because the remaining cash payments (principal and interest coupons) are discounted by lenders at higher rates. If we assumethat Marley repurchases bonds with a $100 million reported value at a market value of $85 million, the firm would report a gain of $15 million:

This transaction would be recognized in Marley’s financial statements in the following way:

The financial reporting of such gains or losses upon early retirement of bonds has been a matter of sharp debate. Managers argue that in cases where bonds are retired at less than their reported values, there is an economic gain to the firm; liabilities have been eliminated for less than their reported values and net assets have been increased. Analysts and accounting policy makers, on the other hand, observe that managers are able to decide whether and when to repurchase outstanding bonds, and for this reason have considerable control over the time periods in which the resulting gains or losses are recognized. Case syudy 8.1 shows the composition of long-term debt for a major company that has debt issued at a variety of different interest rates.

Case Study 8.1

Kerr McGee Corporation, a global energy and chemical company, includes the following information in a footnote describing the long-term debt reported in its 1997 financial statements:

Required

a. Why do the interest rates differ among the various debt issues reported by Kerr McGee?

b. Why is the information concerning the due dates of Kerr McGee’s debt useful to the analyst?

c. Note that the coupon rates and effective interest rates differ for several of Kerr McGee’s debt issues. Based on the information provided above, which of these issues was sold at a discount? Which was sold at a premium?

d. Assume that the market rate of interest on similar debt is 10 percent at the balance sheet date (December 31, 1997). If so, would the market values of the first two issues listed above be greater or less than their book values? Explain.

e. Based on your answer to part d, if Kerr McGee’s management wished to report a gain on early debt retirement, which of the issues would be retired?

Solution

a. The primary reason that interest rates differ among debt issues is that interest rates prevailing in financial markets change over time. Consequently, some debt is issued when interest rates in general are relatively high, and other debt is issued when interest rates in general are relatively low.

In addition, interest rates may differ because of the features of individual debt issues. For example, Kerr McGee’s sinking fund debentures have a relatively low interest rate (8 1/2%). A sinking fund debenture requires that the company makes periodic payments to a fund that is earmarked to repay the debt at maturity. This feature is usually attractive to investors, so lenders are willing to accept a lower rate of interest.

b. The information about the maturity dates of Kerr McGee’s outstanding debt is useful to the analyst in predicting the firm’s future cash flows. The company must generate sufficient cash to retire the debt from operating cash flows and/or from additional borrowings and shareholders’ investments.

c. The effective interest rate on the debentures due October 15, 2027 is 7.01%, which is below the coupon rate of 7.125%, implying that this issue was sold at a premium. Conversely, the effective interest rate on the debentures due November 1, 2011, is 14.25%, which is above the coupon rate of 7%, implying that this issue was sold at a discount.

d. A market rate of interest of 10% would exceed the 7.01% effective rate of the issue due October 15, 2027, so this issue would have a market price that is below its book value. Conversely, a market rate of interest of 10% would be less than the 14.25% effective rate of the issue due November 1, 2011, so this issue would have a market price that is above its book value.

e. In order to report a gain, management would retire the issue due October 15, 2027. The reported gain would be the difference between the book value and the (lower) market value of the issue.

Managers can use bond repurchases as a means of “smoothing”fluctuations in income. For example, in periods of poor operating performance, managers can improve reported income merely by repurchasing outstanding bonds with market values below their reported values. Moreover, firms that retire bonds early often issue additional bonds in order to replace the retired debt. This practice has the appearance of “paper shuffling” because the firm’s debt position is essentially unchanged, but substantial gains have been included in income. Also, because firms must issue new debt at higher interest rates in order to retire older debt bearing lower interest rates, future periods will report higher interest expenses and lower net income.

In response to this issue, the FASB requires that material gains and losses from the early retirement of debt be reported as extraordinary items on the income statement. Recall from our discussion of the income statement in Chapter, “The Income Statement,” that extraordinary gains and losses are reported in a separate section of the income statement, separate from the calculation of the firm’s income from ongoing or recurring operations. This separation is useful to financial statement users who want to assess the firm’s ability to generate profit from its ongoing operations in future periods.

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