Page 610 - Accounting Principles (A Business Perspective)

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An accounting perspective:

Business insight

Companies sometimes invest in the bonds of other companies. According to FASB Statement No.
115 (covered in Chapter 14), investments in these bonds fall into three categories—trading
securities, available-for-sale securities, or held-to-maturity securities. The bonds would be
classified as trading securities if they were acquired principally for the purpose of selling them in
the near future. If the bonds were to be held for a longer period of time, but not until maturity, they
would be classified as available-for-sale securities. Bonds that will be held to maturity are classified
as held-to-maturity securities. All trading securities are current assets. Available-for-sale securities

are either current assets or long-term assets, depending on how long management intends to hold
them. Discounts and premiums on bonds classified as trading and available-for-sale securities are
not amortized because management does not know how long they will be held. Held-to-maturity
securities are long-term assets. Discounts and premiums on bonds classified as held-to-maturity
securities are amortized by the holder of the bonds in the same manner as for the issuer of the
bonds. Further discussion of investments in bonds is reserved for an intermediate accounting
course.

Analyzing and using the financial results—Times interest earned ratio
The times interest earned ratio (or interest coverage ratio) indicates the ability of a company to meet
required interest payments when due. We calculate the ratio as follows:
Income before interest also taxesIBIT
Time interest earned ratio=
Interest expense
Income before interest and taxes (IBIT), also called "earnings before interest and taxes (EBIT)", is the
numerator because there would be no income taxes if interest expense is equal to or greater than IBIT. To find IBIT
when the income statement is not complex, take net income and add back interest expense and taxes. However, in
complex situations, when there are discontinued operations, changes in accounting principle, extraordinary items,

interest revenue, and/or other similar items, analysts often use "operating income" to represent IBIT. The higher
the ratio, the more comfortable creditors feel about receiving interest payments in the future.

An ethical perspective:
Rawlings furniture company

The Rawlings brothers inherited 300,000 shares (30 per cent) of the common stock of the Rawlings
Furniture Company from their father, who had founded the company 55 years earlier. One brother
served as president of the company, and the other two brothers served as vice presidents. The
company, which produced a line of fine furniture sold nationwide, earned an average of USD 4
million per year. Located in Jamesville, New York, USA, the company had provided steady

Accounting Principles: A Business Perspective 611 A Global Text