ch12- Debt Financing

8/3/2019 ch12- Debt Financing

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COPYRIGHT 2007

Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western aretrademarks used herein under license.

Debt Financing

Chapter 12

S t I c e | S t I c e | S k o u s e n

Intermediate Accounting

16E

Prepared by: Sarita Sheth | Santa Monica College


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Learning Objectives

1. Understand the various classification andmeasurement issues associated with debt.

2. Account for short-term debt obligations,including those expected to be refinanced,and describe the purpose of lines of credit.

3. Apply present value concepts to theaccounting for long-term debts such asmortgages.

4. Understand the various types of bonds,compute the price of a bond issue, andaccount for the issuance, interest, andredemption of bonds.


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Time Line of Business IssuesInvolved with Long-Term Debt

ISSUE

the debt

Notes

Payable

Mortgage

Payable

Bond

CHOOSE

themethod offinancing

PAY

interest

+/-RETIRE

the debt

ACCOUNT

for thespecific

aspects ofthe type of

debt


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Definition of Liabilities

The obligation of a particular entity totransfer assets or provide services.Must be the result of past

transactions or events.Probable transfer of assets (or

services) must be in the future.


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Classification of Liabilities

Current Liabilities-Paid within oneyear or the

operating cycle,whichever is longer.

NoncurrentLiabilities- Not paid

within one year orthe operating cycle,whichever is longer.


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Stop and Think

Look at Exhibit 12-3. The2004 current ratio of

McDonalds is only0.81. How willMcDonalds most likely

meet its current

obligations as they comedue?


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Measurement of Liabilities

For measurement purposes, liabilitiescan be divided into three categories:

1. Liabilities that are definite inamount.

2. Estimated liabilities.

3. Contingent liabilities.


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Accounting for Short-Term Debt

Short-Term obligations are due withinone year or an operating cycle.

Account Payable-the amount due forthe purchase of materials.

Notes Payablea formal writtenpromise to pay a sum of money in thefuture, also known as a promissorynote.


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Short-Term ObligationsExpected to be Refinanced

A short-term obligation that isexpected to be refinanced on a long-term basis should not be reported as a

current liability FASB Statement No. 6 requires that

both of the following conditions bemet before a short-term obligationmay be properly excluded from thecurrent liability classification:

1. Management must intend torefinancethe obligation on a long-

term basis.

2. Managementmustdemonstrate an ability to

refinancethe obligation.


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An ability to refinance may bedemonstrated by:

Actually refinancing the obligation duringthe period between the balance sheet dateand the date the statements are issued.

Reaching a firm agreement that clearlyprovides for refinancing on a long-termbasis.


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The terms of the refinancing agreementshould be non-cancelable as to all parties.

The terms of the refinancing agreement

should extend beyond the current year. The company should not be in violation ofthe agreement at the balance sheet date orthe date of issuance.

The lender or investor should be financiallycapable of meeting the refinancingrequirements.


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Lines of Credit

Line of credit-is a negotiated arrangementwith a lender in which the terms are agreedto prior to the need for borrowing.

A company with an established line ofcredit can access funds quickly without thered tape.

Once the line of credit is used to borrow

money, the company has a formal liability(current or noncurrent).


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Present Value of Long-TermDebt

A liability should be reported at theamount that would satisfy theobligation on the balance sheet date.

For a long-term obligation, thisamount is the present value of thefuture payments to be made.

The division of these payments intointerest and principal components isa process called loan amortization.

Example journal entry to record a

mortgagepayment:Interest Expense 2,000

Mortgage Payable 57

Cash 2,057


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Types of Loans

Mortgage-a loan backed by an asset thatserves as collateral for the loan.

If the borrower cannot repay the loan, thelender has the legal right to claim the

mortgaged asset and sell it in order torecover the loan amount. Secured loan-similar to a mortgage, a loan

backed by assets as collateral and can be

claimed by the lender if the borrowerdefaults.There is a reduction in risk for the lender with a

secured loan, thus a reduced interest cost forthe borrower.


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Financing with Bonds

Reasons management may choose to issuebonds instead of stock:

1. Present owners remain in control of the

corporation.2. Interest is a deductible expense in arriving at

taxable income; dividends are not.

3. Current market rates of interest may be

favorable relative to stock market prices.4. The charge against earnings for interest may

be less than the amount of dividends thatmight be expected by shareholders.


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Financing with Bonds

Disadvantages and limitations ofissuing debt securities:

1. It is only possible to use debt financingif the company is in satisfactoryfinancial condition.

2. Interest obligations must be paidregardless of the companys earningsand financial position.

3. If a company has losses and is unableto raise cash to pay interest payments,secured debt holders may take legal

action.


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Accounting for Bonds

There are three main considerationsin accounting for bonds:

1. Recording the issuance or purchase.

2. Recognizing the applicable interestduring the life of the bonds.

3. Accounting for the retirement of bonds

either at maturity or prior to thematurity date.


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Nature of Bonds

Bond Certificates-commonly referredto as bonds are issued indenominations of $1,000.

Face Value-the amount that will bepaid on a bond at maturity date. Alsoknown as par value or maturity value.

Bond indenture-a group contractbetween the corporation and thebondholders.


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Types of Bonds

Term bonds- Bonds that mature in onelump sum on a specified future date.

Serial bonds- Bonds that mature in a seriesof installments at future dates.

Collateral trust bonds- Bonds usuallysecured by stocks and bonds of othercorporations owned by the issuingcompany.

Unsecured (debenture) bonds- Bonds forwhich no specific collateral has beenpledged.


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Types of Bonds

Registered bonds- Bonds for which theissuing company keeps a record of thenames and addresses of all bondholders

and pays interest only to those individualswhose names are on file.

Bearer (coupon) bonds- Unregistered bondsfor which the issuer has no record of

current bondholders, but instead paysinterest to anyone who can show evidenceof ownership.


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Types of Bonds

Zero-interest bonds-Bonds that do not bearinterest but instead are sold at significantdiscounts.

Junk bond-High-risk, high-yield bondsissued by companies in a weak financialcondition.

Commodity-backed bonds-Bonds that maybe redeemed in terms of commodities.

Callable bonds-Bonds for which the issuerreserves the right to pay the obligation priorto the maturity date.


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Market Price of Bonds

Bond discount-The difference betweenthe face value and the sales pricewhen bonds are sold below their face

value. Bond premium-The difference between

the face value and the sales price

when bonds are sold above their facevalue.


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BondStatedInterest

Rate

10%

8% Premium

10% Face Value

12% Discount

Yield


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Ten-year, 8% bonds of $100,000 are to be sold on the bondissue date. On that date, the effective interest rate for

bonds of similar quality and maturity is 10%, compoundedsemiannually.

Part 1 Present value of principle (maturity value):

Maturity value of bond after 10 years(20 semiannual periods) $100,000

Effective interest rate = 10% per year(5% per semiannual period) $37,689

Part 2: Present value of 20 interest payments:

Semiannual payment, 4% of $100,000 4,000

Effective interest rate, 10% per year(5% per semiannual period) $49,849

Total present value (market price) of bond $87,538


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Stop and Think

In computing themarket price forbonds, what is

the only thingfor which thestated rate of

interest isused?


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Issuance of Bonds

1/1 Cash 100,000Bonds Payable 100,000

7/1 Interest Expense 4,000Cash 4,000

12/31 Interest Expense 4,000

Cash 4,000

Issuers Books

Investors Books

Cash 4,000

Interest Revenue 4,000

Bonds 100,000Cash 100,000

Cash 4,000Interest Revenue 4,000


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Bond Issued at a Discount onInterest Date

On January 1, $100,000, 8%, 10-year bondswere issued for $87,538 (which provided an

effective interest rate of 10% to theinvestor).

Issuers Books

Jan. 1 Cash 87,538Discount on Bonds Payable 12,462

Bonds Payable 100,000

Investors Books

Jan. 1 Bond Investment 87,538Cash 87,538


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Bond Issue at a Premium onInterest Date

On January 1, $100,000, 8%, 10-year bondswere issued for $107,106 (which provided aneffective interest rate of 7% to the investor).

Issuers Books

Jan. 1 Cash 107,106Prem. on Bonds Payable 7,106Bonds Payable 100,000

Investors Books

Jan. 1 Bond Investment 107,106Cash 107,106


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Bonds Issued at Par BetweenInterest Dates

On March 1, $100,000, 8%, 10-year bonds wereissued to yield 8 %. Interest for two months

has accrued on the bonds.

Issuers BooksMar. 1 Bond Investment 101,333

Bonds Payable 100,000Interest Payable 1,333

July 1 Interest Expense 2,667Interest Payable 1,333

Cash 4,000

$100,000 x 0.08 x 4/12

$100,000 x 0.08 x 2/12


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Bonds Issued at Par BetweenInterest Dates

Investors Books

Mar. 1 Bond Investment 100,000Interest Receivable 1,333

Cash 101,333

July 1 Cash 4,000Interest Receivable 1,333Interest Revenue 2,667

On March 1, $100,000, 8%, 10-year bondswere issued to yield 8 %. Interest for two

months has accrued on the bonds.


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When Bonds are Issued at aPremium or Discount:

The market acts to adjust the statedinterest rate to a market or effective interestrate.

The periodic interest payments made by the

issuer are not the total interest expense. An adjustment to interest expense

(amortization) associated with the cashpayment is necessary to reflect the effective

interest being incurred on the bonds. There are two methods used to amortize thepremium/ discount:Straight Line MethodEffective Interest Method


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Straight Line AmortizationDiscount

Previously, $100,000 of 8% bonds were issued at$87,538 (a discount of $12,462). Appropriateamortization entries must be made on both the

issuers books and the investors books.

Issuers Books

July 1 Interest Expense 4,623Disc on Bonds Payable 623

Cash 4,000

Dec 31 Interest Expense 4,623Disc on Bonds Payable 623Cash 4,000

$12,462/120 x 6 months


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Straight Line AmortizationDiscount

Investors Books

July 1 Cash 4,000Bond Investment 623


Dec 31 Interest Receivable 4,000Bond Investment 623


Previously, $100,000 of 8% bonds were issued at$87,538 (a discount of $12,462). Appropriateamortization entries must be made on both the



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Straight Line AmortizationPremium

Previously, $100,000 of 8% bonds were issued at$107,106 (a premium of $7,106). Appropriateamortization entries must be made on both the


Issuers Books

July 1 Interest Expense 3,645Premium on Bonds Payable 355

Cash 4,000

Dec 31 Interest Expense 3,645Premium on Bonds Payable 355

Cash 4,000

$7,106/120 x 6 months


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Straight Line AmortizationPremium

Investors Books

July 1 Cash 4,000Bond Investment 355


Dec 31 Interest Receivable 4,000Bond Investment 355Interest Revenue 4,623

Previously, $100,000 of 8% bonds were issued at$107,106 (a premium of $7,106). Appropriateamortization entries must be made on both the



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Effective Interest MethodDiscount

Consider again the $100,000, 8%,10-year bonds sold for $87,538.

The effective rate for the bonds is

10%.

Effective rate for semiannual period 5 %

Stated rate per semiannual period 4 %Interest amount ($87,538 x 0.05) $4,377Interest payment ($100,000 x 0.04) 4,000Discount amortization $ 377

Period One


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Consider again the $100,000, 8%,10-year bonds sold for $87,538.

The effective rate for the bonds is

10%.Period Two

Effective rate for semiannual period 5 %Stated rate per semiannual period 4 %Interest amount ($87,915 x 0.05) $4,396Interest payment ($100,000 x 0.04) 4,000Discount amortization $ 396

$87,538 + $377


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Effective Interest MethodPremium

Consider again the $100,000, 8%,10-year bonds sold for $107,106.The effective rate for the bonds is

7%.

Effective rate for semiannual period 3.5 %

Stated rate per semiannual period 4 %Interest payment ($100,00 x 0.04) $4,000Interest amount ($107,106 x 0.35) 3,749Discount amortization $ 251

Period One


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Period Two

$107,106 - $251

Effective rate for semiannual period 3.5 %

Stated rate per semiannual period 4 %Interest payment ($100,00 x 0.04) $4,000Interest amount ($106,855 x 0.35) 3,740Discount amortization $ 260

Consider again the $100,000, 8%,10-year bonds sold for $107,106.The effective rate for the bonds is

7%.

Effective-Interest Method


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A B C D E

(AB) (DC) ($100,000+ D)($100,000 x 04) (E x 0.035)

Prem. Unamort. Bond# Payment Int. Exp. Amort. Prem. Book

$7,106 $107,106


Premium



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A B C D E

(AB) (DC) ($100,000+ D)($100,000 x 04) (E x 0.035)


$7,106 $107,106


Premium

1 $4,000 $3,749 $251 6,855 106,855

$107,106 x 0.035



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A B C D E

(AB) (DC) ($100,000+ D)($100,000 x 04) (E x 0.035)


$7,106 $107,106


Premium

1 $4,000 $3,749 $251 6,855 106,855

$106,855 x 0.035

2 $4,000 $3,740 $260 6,595 106,595



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A B C D E

(AB) (DC) ($100,000+ D)($100,000 x 04) (E x 0.035)


$7,106 $107,106


Premium

1 $4,000 $3,749 $251 6,855 106,855

2 $4,000 $3,740 $260 6,595 106,5953 $4,000 $3,731 $269 6,326 106,326

4 $4,000 $3,721 $279 6,047 106,047

5 $4,000 $3,712 $288 5,759 105,759


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Straight-Line vs. Effective-Interest Amortization Methods

Insert exhibit 12-7


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Stop & Think

When preparing a bondamortization schedule like the

one that follows, there arecertain numbers within that

schedule that you knowwithout having to do anyelaborate computations.

Which ONE of the followingnumbers can be determinedusing a very simple

computation?

i i h f b i


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Extinguishment of Debt Prior toMaturity

1. Bonds may be redeemedby the issuer bypurchasing the bonds on the open marketor by exercising the call provision (if

available).2. Bonds may be converted, that is,

exchanged for other securities.

3. Bonds may be refinancedby using the

proceeds from the sale of a new bondissue to retire outstanding bonds.

E i i h f D b P i


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Extinguishment of Debt Prior toMaturity

Triad, Inc.s $100,000, 8% bonds are notheld to maturity. They are redeemed on

February 1, 2007, at 97. The carrying valueof the bonds is $97,700 as of this date.

Interest payment dates are January 31 andJuly 31.

Issuers Books

Feb. 1 Bonds Payable 100,000Discount on Bonds Pay. 2,300Cash 97,000Extraordinary Gain on

Bond Redemption 700

Carry value of bonds, 1/1/02 $97,700Redemption price 97,000

Gain on bond redemption $ 700

Investors Books

Feb. 1 Cash 97,000Loss on Sale of Bonds 700

Bond Investment-Triad Inc. 97,700


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Convertible Bonds

Convertible debt securities usuallyhave the following features:

1. An interest rate lower than the issuer

could establish for nonconvertible debt.2. An initial conversion price higher thanthe market value of the common stockat time of issuance.

3. A call option retained by the issuer Convertible debt gives both the

issuer and the holder advantages.


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Convertible Bonds

Assume that 500 ten-year bonds,face value $1,000, are sold at 105($525,000). The bonds contain a

conversion privilege that provides forexchange of a $1,000 bond for 20

shares of stock, par value $1.


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Convertible Bonds

Debt and Equity Not Separated

Cash 525,000Bonds Payable 500,000

Premium on Bonds Payable 25,000

Debt and Equity Separated

Cash 525,000Discount on Bonds Payable 20,000Bonds Payable 500,000Paid-In Capital Arising from

Bond Conversion Feature 45,000

Par valueSelling price of

bond withoutconversionfeature


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Accounting for Conversion

Investors Books

Nov. 1 Investment in HiTec Co.Common Stock 10,400

Investment in HiTecCo. Bonds 9,850

Gain on Conversion ofHiTec Co. Bonds 550

The investor may choose not to recognize again or a loss. If so the investor would debitInvestment in HiTec Co. Common Stock for

&9,850.


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Accounting for Conversion

Issuers Books

Nov. 1 Bonds Payable 10,000Loss on Conversion of

Bonds 550Common Stock, $1 par 400Paid-In Capital in Excess

of Par Value 10,000

Discount on Bonds Payable 150


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Off-Balance-Sheet Financing

Off-Balance-Sheet-Financing-procedures toavoid disclosing all debt on the balancesheet in order to make the companysfinancial position look stronger.

Common techniques used:Leases

Unconsolidated subsidiaries

Variable interest entities (VIEs)

Joint ventures

Research and development arrangements

Project financing arrangements

A l i Fi D bt


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Analyzing a Firms DebtPosition

Debt-to-Equity Ratio-measures the relationshipbetween the debt and equity of an entity.

Formula: total debt total stockholders equity

Debt Ratio- indicates a companys overall ability torepay its debts.

Formula: total liabilities total assets.

Times Interest Earned- shows a companys ability

to meet interest payments.Formula: income before interest expense and income

taxes interest expense for the period.

Di l i D bt i th Fi i l


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Disclosing Debt in the FinancialStatements

Companies may want to disclose additionalinformation about long-term debt in thenotes like:Nature of the liabilities

Maturity dates Interest rates

Methods of liquidation

Conversion privileges

Sinking fund requirementsBorrowing restrictions

Assets pledged,

Dividend limitations


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Troubled Debt Restructuring

Troubled debt restructuring exists onlyif the creditor for economic or legal

reasons related to the debtorsfinancial difficulties grants a

concession to the debtor that it would

not otherwise consider. (SFAS 15.2)

Asset Swap


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No Not a troubleddebt restructure.

Disposal Gain/Loss= FMV AssetBook

Value of Asset

Asset SwapDebtor

FMV Asset< debt?

Yes

Remove debt andasset from books.

Restructuring Gain= DebtFMV Asset

Equity Swap


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YesRemove debt and

asset from books andrecord new equity.

Equity SwapDebtor

FMV Equity< debt?

No Not a troubleddebt restructure.

Restructuring Gain=DebtFMV Equity

Asset or Equity Swap


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Asset or Equity SwapCreditor

FMV Asset> loan?

Yes Not a troubleddebt

restructure.

Remove loanfrom books andrecord asset at

FMV.

No

Restructure Loss =

LoanFMV Asset

Modification of Terms


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Recognize gain onrestructuring.

Write-down debt tosum of future cash

flows.Record all future

payments as

principal payments.

NoTotal futurepayments < debt

book value?

Modification of TermsDebtor

Reclassify thedebt and amortize

using effectiveinterest method.Interest rate is

Yes

ch12- Debt Financing

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