Hello, I need help with the following case:

Sarah Banker sat at her desk, feeling very displeased. Banker Industries had just reported very poor results for the third quarter of 2017 and the outlook for the rest of the year was looking pretty negative.

Sarah turned to her computer and looked up the Banker Industries stock. She saw that the stock had fallen another 50 cents today, totally 3 dollars in the last month. In despair, she picked up her phone, about to call the company's financial advisor when she had a thought. She turned back to her computer, looked up the Banker Industries bonds, and saw that the company's bonds were also losing money. They were only worth $750 each now, and Banker Industries has to pay $1,000 to redeem them.

For the next few hours, all Sarah could think about was the bond value. The more she thought about it, the less he felt it was Banker Industries that had lost. Suddenly, Sarah had a great idea to generate additional income for Banker Industries. She called in her assistant, Marie, and described her idea, which was to buy back all of the company's bonds at $750, thus making $250 on each bond.

Marie returned to her desk and began to calculate the expected cash volatility of Banker Industries as of late December, when Sarah wanted to repurchase the bonds. It became obvious that Banker Industries did not have $3 million to use for the repurchase; in fact, the company barely had $300,000.

Walking into Sarah's office, Marie informed her of the cash position and waited for her reaction. Instead, Sarah smiled at Marie and told her the rest of the plan: "I wondered how long it would take you to realize that; but I've already decided we can achieve my objective by selling some new bonds to buy back the old ones. In fact, we are going to sell $4 million worth of new bonds so we can finally do the plant expansion that I've been planning for the last two years."

Marie pointed out that the new issue would sell at the same price as the old issue, but Sarah responded: "No, I've already talked with the bank and they suggested we issue a 10% coupon bond[1] for late December, when the expected interest rate will still be 10%. That will net us $4,000,000 exactly. Funny thing was, they said that if we made them 12% bonds, we would get $4,498,000. That would mean an additional $498,000 profit so, all in all, we could make over $1.5 million on that issue. That's not bad for one morning's work, is it?"

Marie agreed with the plan, but something was bothering her, which she told Sarah: "Something that's bothering me is that the figure on the balance sheet for the existing bonds is not $4,000,000 but about $3,749,000. There is a footnote, but that didn't help me understand the balance sheet number at all. I don't understand why it's not the full $4 million; after all, that's what we have to pay back, isn't it?"

"Let me have a look," said Sarah. "You are right, I know these accountants have funny ways of doing things, but this really seems way out to me."

"That's going to cut our profit down to $749,000 on the repurchase," Marie stated. "Oh, well, I guess we have to go with the 12% issue and make do with nearly $1.2 million in profit," chuckled Sarah.

Questions

1. (a) How would you explain to Sarah and Marie the $3,749,000 on the balance sheet?

(b) How would you explain the $4,000,000 issue price of the 10% bond and the $4,498,000 issue of the 12% bond? (No detailed calculations are necessary.)

2. (a) If you choose to issue the 10% bonds, what amount would you treat as a gain on the repurchase? Why?

(b) If you choose to issue the 12% bonds, what amount would you treat as a gain on the repurchase? Why?

(c) How would you account for the purchase of the existing bonds and the issuance of 12% bonds? Give the journal entries and the long-term debt portion of the balance sheets for Banker Industries as of December 31, 2017 and 2018. Assume that old bonds were repurchased for $3,000,000 and the new bonds (12% coupon rate) were issued at $4,498,000 on January 1, 2018. Ignore income taxes.

3. What will be the effect on the cash account for the years 2018, 2019, and 2020?