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Giant Utility Company
Author(s):
Menon, Krishnagopal
Functional Area(s):
   Financial Accounting
Setting(s):
   For Profit
Difficulty Level: Beginner
Pages: 1
Teaching Note: Available. 
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First Page and the Assignment Questions:

Ron Giant, CEO of Giant Utility Company, walked into his CFO's office one day with a disturbed look on his face.

I've just been looking at today's Wall Street Journal, and I can't believe what's happening to our bond prices. We're having a great year as far as profits are concerned, but the prices of our bonds just keep tumbling. What's going on?

Before Sally Line, the CFO, could get a word in, Mr. Giant continued, Actually, I've been meaning to ask you some questions about our bonds, and now may be as good a time as any." Sally didn't think so, but she kept her thoughts to herself.

We issued a thousand bonds on January 1, last year [1997]. I can understand selling each bond for $463, even though we’ll pay $1,000 on each when they mature on December 31, 2006. After all, the bonds carry no interest. But why did we show interest expense on these bonds last year?
And then there are the 2,000 bonds we issued at the beginning of 1996. You told me that the market rate was 12 percent at the time, but we pay only 10 percent on these bonds. And I’ve noticed that the value on our books keeps going up even though the market price keeps going down. Now, these bonds are going to mature at the end of 2002. By that time they’ll probably be worth next to nothing if the price keeps sliding. I'm really tempted to buy them back early. I must admit, though, that I'm quite confused about the way you are accounting for our bonds. And I consider myself to be a pretty smart guy.

Sally wanted to respond to Ron's last comment, but she bit her tongue just in time.

Assignment

  1. What did Giant Utility show as interest expense on the zero-coupon bonds in 1997? What should the company show as interest expense in 1998?
  2. Assume that the 2002 bonds pay interest annually. Assume, also, that they were issued on January 1, 1996 and carry a par value of $1000 each. Compute interest expense on these bonds for 1996, 1997 and 1998. How should these bonds be disclosed on the balance sheets on December 31, 1996 and 1997?
  3. If the market rate of interest on December 31, 1996 were 14%, at what price do you think the bonds would have been being traded at the time? How does this affect the valuation of the 2002 bonds on the balance sheet? If Giant Utility were to buy the bonds back at the market price would it show as a gain or loss?