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Bond AccountingIn December 2014, Rene Cook sat in her cubicle trying to remember what she had learned in business school about bonds and bond accounting. Ms. Cook, a new CPA and special assistant in a training assignment with the company president, had just met with David Lyons, president of Lyons Document Storage Corporation. Interest rates had fallen over recent years and he had asked her to think about the consequences issuing new bonds at a lower rate of interest and using the proceeds to repurchase the higher coupon rate bonds that are currently outstanding. My Lyons had asked Rene to focus on how much the company’s annual interest payments could be reduced, how reported earnings would be affected, and how the refunding would change the company’s financial position as referenced on the balance sheet, if at all.The CompanyThe Lyons Company was a family business in the stationary supply business until the document storage opportunity appeared in the early 1990’s. Lyons Document Storage Corporation was incorporated in 1993 to compete in the emerging and rapidly growing industry that provides secure, off-site storage of documents for other corporate customers. The demand for storage was fueled by the need for corporations to retain records of sales contracts, employment records, compliance records, and other documents. The convenience of secure storage and easy recovery in professionally managed warehouses appealed to corporate clients that wanted to save space in their more expensive office buildings. At the same time, the stationary supply business was growing more competitive with the entrance of Staples, Office Depot and Office Max.The early 2000’s were difficult for Lyons because there were still differences among management about directions and the company’s future. A large competitor, Iron Mountain, was expanding rapidly in the United States and internationally. When the decision to focus on document storage was made, it was imperative to move quickly to secure storage space and transportation equipment. Management decided to fund the company’s growth by issuing debt rather than by issuing additional equity. Lyons had operated conservatively without any long-term debt until it issued bonds in January of 2005. The bonds issued were $10 million in 20-year bonds, offering a coupon rate of 8%, with interest paid semiannually, and sold to yield the 9% market rate of interest at the time.Current SituationDavid Lyons had told Rene Cook that he felt the time might be ripe to refund the 2005 bond issue and replace it with bonds bearing lower interest rates. He had talked with the company’s investment bankers who had told him that $10 million in new 6% bonds with semiannual interest payments could be issued to provide the company with exactly $10 million, not considering underwriting costs and legal fees that were expected to be nominal. The bonds would pay $300,000 of interest every June 30 and December 31 with a payment of $10 million in principal at the end of 10 years. The new interest payments would be $200,000 less each year than those due on the old bonds, which still had 10 years before they would be paid off. To Lyons, that seemed to offer a saving over the old bonds.The existing bonds had been issued on January 1, 2005 and would be due December 31, 2024. Interest was paid semiannually to holders of the bonds.Beginning her research, Rene reached for her copy of Lyons Document Storage’s 2013 Annual Report. (See Exhibit 1 for the Liabilities section of the 2013 Annual Report.) She was confused as to why the liability for the $10 million bonds was only $9.3 million at the end of 2013.To clarify her understanding, Rene called the company’s controller, Eric Petro, and learned that the 2005 bonds had been issued at a discount. Only about $9.1 million was received when the bonds were issued. For further information, Petro referred Rene to footnote 8 of the company’s 2013 financial statements (Exhibit 2).Next, Rene went to the Internet to determine the market price of the company’s bonds. The current price was shown as 114.88 – reflecting the 6% yield the market for bonds was currently supporting. This meant that each $1,000 bond would have to be repurchased for $1,148.77. The company would have to spend $11.5 million to retire bonds that would be listed on the December 2014 balance sheet at less than $10 million. The resulting loss would shrink the 2015 projected earnings and slow the growth rate in earnings about which David Lyons was so proud. Rene knew this would not make Mr. Lyons happy. However, the lower interest payments associated with the new bonds would help reduce cash outflows in future years.1. There is no indication in this case that the 2005 bonds were “callable”. Assume that the bonds are callable at 102. That is, there is a 2% call premium over par value. What accounting loss would result if the bonds were called at this price? If the bonds were in fact callable, how would this impact your analysis and recommendation?Expert Answer