Question

Question: The following information is taken from the 2017 annual report of Bugant, Inc. Bugant’s fiscal year ends December 31 of each year. Bugant’s December 31, 2017, balance sheet is as follows.

Bugant, Inc. Balance Sheet December 31, 2017 Assets Cash \( 450 Inventory 1,800 Total current assets 2,250 Plant and equipment 2,000 Accumulated depreciation (160) Total assets \)4,090 Liabilities Bonds payable (net of discount) \(1,426 Stockholders’ equity Common stock 1,500 Retained earnings 1,164 Total liabilities and stockholders’ equity \)4,090 Note X: Long Term Debt: On January 1, 2016, Bugant issued bonds with face value of \(1,500 and a coupon rate equal to 10%. The bonds were issued to yield 12% and mature on January 1, 2021.

Additional information concerning 2018 is as follows.

1. Sales were \)3,500, all for cash.
2. Purchases were \(2,000, all paid in cash.
3. Salaries were \)700, all paid in cash.
4. Property, plant, and equipment was originally purchased for \(2,000 and is depreciated straight-line over a 25-year life with no salvage value.
5. Ending inventory was \)1,900.
6. Cash dividends of \(100 were declared and paid by Bugant.
7. Ignore taxes.
8. The market rate of interest on bonds of similar risk was 12% during all of 2018.
9. Interest on the bonds is paid semiannually each June 30 and December 31.

Accounting

Prepare a balance sheet for Bugant, Inc. at December 31, 2018, and an income statement for the year ending December 31, 2018. Assume semiannual compounding of the bond interest.

Analysis

Use common ratios for analysis of long-term debt to assess Bugant’s long-run solvency. Has Bugant’s solvency changed much from 2017 to 2018? Bugant’s net income in 2017 was \)550 and interest expense was $169.

Principles

The FASB and the IASB allow companies the option of recognizing in their financial statements the fair values of their long-term debt. That is, companies have the option to change the balance sheet value of their long-term debt to the debt’s fair value and report the change in balance sheet value as a gain or loss in income. In terms of the qualitative characteristics of accounting information (Chapter 2), briefly describe the potential trade-off(s) involved in reporting long-term debt at its fair value.

Short answer

Answer

1. Balance sheet shows total assets and total liabilities and owners’ equity equals $4,638. Net income as per income statement is $648.
2. Debt to asset ratio is greater in 2017 compared to 2018.
3. Management can have a motivation to skew their estimation of the debt's fair value.

Step-by-step solution

Meaning of FASB

FASB is the autonomous, for-profit, private association that develops financial accounting and reporting standards for for-profit and public businesses that follow GAAP.

Explaining the Accounting part

Bugant Inc. Income statement For the year ended December 31, 2018
Sales revenue		$3,500
Expenses
Cost of goods sold	$1,900
Salaries and wages expense	700
Depreciation expense	80
Interest expenseFASB is the autonomous, for-profit, private association that develops financial accounting and reporting standards for for-profit and public businesses that follow GAAP.	172	2,852
Net income		$648

Working notes:

Computation of cost of goods sold

$$\begin{gathered} \mathbf{Cost}\mathbf{of}\mathbf{goods}\mathbf{sold}\mathbf{=}\mathbf{Inventory}\mathbf{+}\mathbf{Purchases}-\mathbf{Ending}\mathbf{inventory} \\ \mathbf{=}\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{800}\mathbf{+}\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{000}-\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{900} \\ \mathbf{=}\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{900} \end{gathered}$$

$$\begin{gathered} \mathbf{Depreciation}\mathbf{expense}\mathbf{=}\frac{\mathbf{Plant}\mathbf{and}\mathbf{equiment}}{\mathbf{Useful}\mathbf{life}} \\ \mathbf{=}\frac{\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{000}}{\mathbf{25}} \\ \mathbf{=}\mathbf{\$}\mathbf{80} \end{gathered}$$

BUGANT, INC. Balance Sheet December 31, 2018
Assets
Cash $978
Inventory 1,900	$2,878
Total Current Assets
Plant and equipment 2,000
Accumulated depreciation (240)	1,760
Total assets	$4,638
Liabilities
Bonds payable	$1,426
Stockholders’ equity
Common stock $1,500
Retained earnings 1,712	3,212
Total liabilities and stockholders’ equity	$4,638

Working notes:

Computation of cash

Cash at the beginning	$450
Cash sales	$3,500
Less: Purchase	(2,000)
Salaries	(700)
Dividend paid	(100)
Interest paid	(172)
Ending balance	$978

Calculation of retained earnings

Opening balance	1,164
Net income	648
Dividend paid	100
Ending balance	1,712

Explaining the analysis part

Analyzing ratios:

	Formula	2018	2017
Debt to asset ratio	Total debt / Total assets	$1448 /$4,660 = 0.31	$1,426 / $4090 = 0.35
Time interest earned ratio.	EBIT / Total interest expense	($648 +$172) / $172 = 4.77	($550 + $168) / $168 =4.25

It's nice that less than one-third of Bugant's funding comes from debt. Additionally, earnings before interest exceed interest expense by more than 4.5 times. Both ratios increased throughout the year.

It should be noted that the problem's interest expense exceeds the business's yearly cash interest payments. The annual interest payment is $150 in cash. Therefore, it could be argued that the time’s interest earned ratio slightly underestimates the company's capacity to pay interest. In essence, the corporation is deferring some interest payments yearly until the bond's maturity date. One would have to doubt the company's capacity to pay its obligation on the maturity date when it approaches, given its existing cash level and poor income.

Explaining the principal part

This could be a classic trade-off between relevance and accurate portrayal. Many believe that when making investment and finance decisions, it is important to consider the fair values of assets and liabilities. On the other hand, management is in charge of determining fair value. There may be incentives for management to skew reported modest value numbers in one direction or another. For instance, changes in the fair value of the debt would be included in the period's net income. Therefore, management can have a motivation to skew their estimation of the debt's fair value. On the other hand, if the corporation does not plan to pay off the debt early, one can argue that the appropriate debt values are not important.