Question

Quantum Galaxies, Inc.

Quantum Galaxies, Inc. (QGI) was founded in 1997 by three electrical engineering professors to commercialize their research into products that would significantly reduce the size of electronic tools and toys. Due to their teaching and publishing demands, it took them several years to really get the company up and moving. Once the research on the products was complete, they decided to go public in order to raise funds to complete the development. On May 15, 2004, they commenced a public offering. Public markets were strong for technology companies at that time, so they were able to raise $15 million. They used that money to develop physical product prototypes from their previous research.

Once the research was made for the products were ready for market, the company issued bonds to help it finance production, marketing, and distribution, and to acquire the buildings and equipment it needed. The markets were recovering from the burst of the "dot com bubble" several years earlier. So, investors and creditors were again very interested in financing technology companies. Because of that, the company was able to issue 10,000 bonds with a face value of $1,000 each, for a total face value of $10 million, dated July 1, 2005. The bonds are 30-year bonds with a stated rate of 5.97%. They pay interest semiannually on December 31 and June 30. The market rate at the time the bonds were issued had dropped to 5.75% (net of issuance costs) so there was a premium on the bonds. They brought in cash of $10,312,759.

The product introduction was very successful and QGI made good money for many years. In fact, QGI was able to purchase some investments to help fund future growth. But, in the last few years, competitors began to enter the market and the popularity of QGI's products began a steep decline. At the end of 2019, QGI had about $6 million in cash and decided to use about $2 million of that to reignite a new R&D effort. But, for now, revenues are low, the company has been losing money, and the stock price has been dropping. In addition, many of the investment assets saved for future growth have been liquidated to pay for ongoing expenses which exceed the revenues generated. Related to the decline in value of the company, QGI's bonds were trading at only about 40% of face value. Apparently, the public doubted QGI's ability to fulfill the bond obligation when it comes due. In fact, several analysts expressed concern about the company's ability to continue as a going concern.

What nobody in public markets knows is that the company's research team recently made a significant breakthrough. QGI now plans to introduce a new suite of products by the end of the year that it is certain will be very successful.

The CEO, Jessica Frewkin, felt this was a fantastic opportunity for the company to improve its cash flows. She called a special meeting of the Board of Directors and management to describe her "brilliant" idea. They like the idea and the benefits it could bring to the company and its shareholders, but they are concerned about the legal aspects and the proper accounting for the proposed transaction. They assigned Ms. Frewkin to get legal counsel's input and they assigned the CFO, Bart Mellodin, to get professional accounting advice. Mr. Mellodin set up an appointment for your team to meet him in his office on June 3, 2020. You are a senior manager in a public accounting firm, and QGI has been a consulting client of your firm for the last three years. Although your firm does not perform QGI's audit, QGI managers often call you in for assistance with complex accounting issues before presenting them to their auditors.

When you arrive at Mr. Mellodin's office, he greets you all cheerfully and warmly. In fact, you don't remember ever seeing him this happy. He tells you they have a wonderful idea that he believes will make a significant difference for the company. He actually has the entire team sign non-disclosure agreements before he will begin the discussion, even though he knows you are subject to client confidentiality (though not client privilege) rules.

Mr. Mellodin then proceeds to describe AGI's plan. "As you know," he begins, "we currently have $10 million in 30-year bonds that are now 15 years old. We have enough money left, from our profitable years, to buy back three quarters of those bonds for $3 million, based on current market prices, which we don't expect to change by June 30, 2020, which is when we expect to make the bond repurchase effective. That'll save us $4.5 million from face value. But the next part is even better! We expect our new suite of products to be ready for market introduction early next year, which will be a signal to the market that our revenues will increase substantially. Not only will this increase our stock price, but it will also decrease the risk on our bonds. By reducing this risk and restoring confidence for creditors, our bond price will go back up. So, instead of retiring the bonds we repurchase, like companies usually do, we plan to hold them and expect to resell them in the market at full face value! That'll bring in $7.5 million, for an increase in cash of $4.5 million in excess of the amount we will pay to buy them back! Isn't that great? We can use that excess cash to get the products through production and out to the market with an incredible marketing campaign! This will also save us substantial offering costs we would have incurred if we had retired the old bonds and had to go through the process of issuing new bonds."

He further explains that they know there are risks of claims of insider trading or non-compliance with tender offer rules. QGI is having its legal team look into that to try to find a way to make this happen. He wants you to move forward assuming they will be able to conduct this transaction in compliance with all applicable laws.

Part A:

Mr. Mellodin says he knows you will need to do some research to tie things down, but would like you to hold a discussion now and give him your "off-the-top-of-your-head" ideas of what accounting might be done. Specifically, what journal entries are usually made when a company repurchases bonds and retires them; as well as the comparative journal entries they should make when they repurchase bonds with the intent to reissue them. Would the entries be any different? Finally, what would the entries be when the bonds are reissued?

Part B:

After the discussion, Mr. Mellodin said he would now like you to go do research and get back to him in the next few days with a more researched opinion. You'll now go and do research to identify guidance in FASB's Accounting Standards Codification (ASC) and on the internet or other non-authoritative sources to get ideas. Remember, however, that non-authoritative guidance can only help point you in a direction and cannot be used to support your final conclusion. Is your final conclusion consistent with your preliminary discussion? Or different? He would also like to see any examples you might be able to find of any companies buying back their own bonds and holding them for resale.Make journal entries

Part C:

, provide any suggestions you might make to FASB for additional guidance in this area. Do you agree with the guidance that is already there? Is there anything you would change? Anything you would suggest they add?