3216
REV: JUNE 21, 2010
WILLIAM J. BRUNS
TEACHING NOTE
Lyons Document Storage Corporation:
Bond Accounting
Substantive Issues Raised
Rene Cook has just been given the assignment to analyze the possible refunding of bonds in 2009
previously issued in 1999 when interest rates were much higher. Because market interest rates had
fallen between the time the bonds were issued and 2009, refunding the bonds will necessitate
recognition of a significant loss. On the other hand, interest payments on new 2009 bonds would be
much lower in all subsequent periods.
The case requires students to understand the nature of a bond contract and to isolate the cash
flows when the bond is issued, during each interest period, and when the bond is finally retired at the
end of its life. The case also provides a clear illustration of the impact of changing interest rates on
interest payments, interest expense, and whether buyers of bonds will purchase at a discount or
premium. It also can be used to illustrate the idea that the value of any financial security can be
computed at any time as the present value of its future cash flows.
Pedagogical Objectives
To prepare this case for discussion and to understand it, students will either need present value or
bond tables, a financial calculator, or personal computer software to calculate the present value of
interest and principal payments.
Students should begin by understanding how investors determined the amount to pay for the
original bonds when issued in 1999. TN Exhibit 1 shows the calculation which students will make.
The important lesson here is that the bond contract spelled out the cash that would be paid by Lyons,
the bond issuer. Investors then used their desired interest rate to determine what they would pay for
the bonds. That, in turn, fixed the yield rate at 9.0% annual interest, but it did not change the amount
of the interest payments promised in the initial contract. Once the cash payments for interest and
, 3216 | Teaching Note—Lyons Document Storage Corporation: Bond Accounting
repayment of principal were determined, finding the amount of liability for the bonds at the time of
issue merely required discounting each of the cash payments back to the present to get the present
value of the bond issue to investors.
The second part of question 1 invites students to confirm the amount of liability for long-term
debt shown amongst the liabilities and shareholders’ equity at the end of 2006 and 2007 as shown in
Exhibits 1 and 2 of the case. TN Exhibit 2 shows how students can confirm the amount of the
liability at the end of each year. Students may be tempted to think that the liabilities at the end of
2006 and 2007 are $9,658,590 and $9,692,611 respectively, but the payments of $400,000 due on
January 2 have become current liabilities and are shown there on the balance sheet.
At the final part of that question, I like to ask students to confirm the market price of the
outstanding bonds now that the effective interest rate has fallen to 6%. Not only does this illustrate
that the value of any financial security can be computed as the present value of its future cash flows,
it also illustrates that the loss on these bonds has already occurred. TN Exhibit 3 shows the
calculations of the net present value at 6% paid semiannually.
The market value of the existing bonds should be $11,541,503 or approximately $1154 per bond. If
these bonds were refunded with a new $10 million issue, the company will have a cash flow hit of
$1,541,503. See TN Exhibit 4. This is an important number because it is also exactly equal to the
present value of the savings from the new bond issue. In other words, economically, this decision is a
wash. The loss on refunding the bonds is exactly equal to the present value of the interest savings
from the new bonds. In essence the market has already revalued these bonds at 6% and the decision
to replace them with an alternative 6% issue does not have much economic significance.
Similarly, the option to issue $11.542 million new bonds can be analyzed on an NPV basis. See TN
Exhibit 5. While this allows the company to avoid a current cash flow hit, it obviously just pushes
the problem into the future in the form of a larger principal value upon maturity.
Having gone way out of the way to demonstrate that this economic decision is a wash, there is
much fertile ground in pointing out that the accounting does not see it that way. This is a great
opportunity to point out that accounting results are often out of sync with economics because of
accountants' insistence on the historical cost principal. From an accounting standpoint, this company
is positioned to report a large loss in the current year, offset by several years of reduced interest
expense in the future.
There is a movement toward "fair value" accounting, under which the company would actually
revalue these bonds on their balance sheet as the interest rate changes. If that were to be the case, this
company's economic loss would have already been recorded, and then the accounting treatment
would be consistent with economics. (See TN Exhibits 6 and 7, which illustrate the effects of issuing
bonds of $10 million or $11.54 million.)
In thinking about the amount of bonds to be issued, students should consider the following issues:
the reported loss on redemption on the 1999 bonds is going to be a problem. There has to be some
way to make this look sensible in Lyons Document Storage’s financial reports. Perhaps one way to
accomplish this would be to include explanatory material on market conditions in 1999 and the
reasons that Lyons was forced to issue the $10 million debt in the first place. The obvious advantages
of refunding the bonds now that interest rates are lower could also be explained.
The decision about whether to issue $10 million or $11.54 million hinges on whether Lyons has
additional cash that will be required to pay off the old bonds. If Lyons has $1.54 million in cash
which is idle or earning a low rate of return, then issuing $10 million in bonds would appear to be the
appropriate choice. On the other hand, if $1.54 million in cash can be used in some high-return
2
REV: JUNE 21, 2010
WILLIAM J. BRUNS
TEACHING NOTE
Lyons Document Storage Corporation:
Bond Accounting
Substantive Issues Raised
Rene Cook has just been given the assignment to analyze the possible refunding of bonds in 2009
previously issued in 1999 when interest rates were much higher. Because market interest rates had
fallen between the time the bonds were issued and 2009, refunding the bonds will necessitate
recognition of a significant loss. On the other hand, interest payments on new 2009 bonds would be
much lower in all subsequent periods.
The case requires students to understand the nature of a bond contract and to isolate the cash
flows when the bond is issued, during each interest period, and when the bond is finally retired at the
end of its life. The case also provides a clear illustration of the impact of changing interest rates on
interest payments, interest expense, and whether buyers of bonds will purchase at a discount or
premium. It also can be used to illustrate the idea that the value of any financial security can be
computed at any time as the present value of its future cash flows.
Pedagogical Objectives
To prepare this case for discussion and to understand it, students will either need present value or
bond tables, a financial calculator, or personal computer software to calculate the present value of
interest and principal payments.
Students should begin by understanding how investors determined the amount to pay for the
original bonds when issued in 1999. TN Exhibit 1 shows the calculation which students will make.
The important lesson here is that the bond contract spelled out the cash that would be paid by Lyons,
the bond issuer. Investors then used their desired interest rate to determine what they would pay for
the bonds. That, in turn, fixed the yield rate at 9.0% annual interest, but it did not change the amount
of the interest payments promised in the initial contract. Once the cash payments for interest and
, 3216 | Teaching Note—Lyons Document Storage Corporation: Bond Accounting
repayment of principal were determined, finding the amount of liability for the bonds at the time of
issue merely required discounting each of the cash payments back to the present to get the present
value of the bond issue to investors.
The second part of question 1 invites students to confirm the amount of liability for long-term
debt shown amongst the liabilities and shareholders’ equity at the end of 2006 and 2007 as shown in
Exhibits 1 and 2 of the case. TN Exhibit 2 shows how students can confirm the amount of the
liability at the end of each year. Students may be tempted to think that the liabilities at the end of
2006 and 2007 are $9,658,590 and $9,692,611 respectively, but the payments of $400,000 due on
January 2 have become current liabilities and are shown there on the balance sheet.
At the final part of that question, I like to ask students to confirm the market price of the
outstanding bonds now that the effective interest rate has fallen to 6%. Not only does this illustrate
that the value of any financial security can be computed as the present value of its future cash flows,
it also illustrates that the loss on these bonds has already occurred. TN Exhibit 3 shows the
calculations of the net present value at 6% paid semiannually.
The market value of the existing bonds should be $11,541,503 or approximately $1154 per bond. If
these bonds were refunded with a new $10 million issue, the company will have a cash flow hit of
$1,541,503. See TN Exhibit 4. This is an important number because it is also exactly equal to the
present value of the savings from the new bond issue. In other words, economically, this decision is a
wash. The loss on refunding the bonds is exactly equal to the present value of the interest savings
from the new bonds. In essence the market has already revalued these bonds at 6% and the decision
to replace them with an alternative 6% issue does not have much economic significance.
Similarly, the option to issue $11.542 million new bonds can be analyzed on an NPV basis. See TN
Exhibit 5. While this allows the company to avoid a current cash flow hit, it obviously just pushes
the problem into the future in the form of a larger principal value upon maturity.
Having gone way out of the way to demonstrate that this economic decision is a wash, there is
much fertile ground in pointing out that the accounting does not see it that way. This is a great
opportunity to point out that accounting results are often out of sync with economics because of
accountants' insistence on the historical cost principal. From an accounting standpoint, this company
is positioned to report a large loss in the current year, offset by several years of reduced interest
expense in the future.
There is a movement toward "fair value" accounting, under which the company would actually
revalue these bonds on their balance sheet as the interest rate changes. If that were to be the case, this
company's economic loss would have already been recorded, and then the accounting treatment
would be consistent with economics. (See TN Exhibits 6 and 7, which illustrate the effects of issuing
bonds of $10 million or $11.54 million.)
In thinking about the amount of bonds to be issued, students should consider the following issues:
the reported loss on redemption on the 1999 bonds is going to be a problem. There has to be some
way to make this look sensible in Lyons Document Storage’s financial reports. Perhaps one way to
accomplish this would be to include explanatory material on market conditions in 1999 and the
reasons that Lyons was forced to issue the $10 million debt in the first place. The obvious advantages
of refunding the bonds now that interest rates are lower could also be explained.
The decision about whether to issue $10 million or $11.54 million hinges on whether Lyons has
additional cash that will be required to pay off the old bonds. If Lyons has $1.54 million in cash
which is idle or earning a low rate of return, then issuing $10 million in bonds would appear to be the
appropriate choice. On the other hand, if $1.54 million in cash can be used in some high-return
2
