Chapter 12 Debt Financing - WordPress.com 12 Debt Financing 12-2 1. Classification of Debt and Measurement Issues The FASB defined liabilities as “probable future sacrifices of economic

12-1

1. Classification and measurement issues

associated with debt

2. Accounting for short-term debt

3. Accounting for long-term debt (mortgages)

4. Understand the various types of bonds

5. Compute the price of a bond issue

6. Accounting for the issuance, interest, and

redemption of bonds

Chapter 12 Debt Financing

12-2

1. Classification of Debt and Measurement

Issues

The FASB defined liabilities as “probable

future sacrifices of economic benefits

arising from present obligations to a

particular entity to transfer assets or

provide services to other entities in the

future as a result of past transactions or

events.”

The FASB is currently considering a

revision of this liability definition.

(continued)

12-3

Definition of Liabilities

• A liability is a result of past transactions

or events. Thus a liability is not recognized

until incurred.

• This part of the definition excludes

contractual obligations from an exchange

of promises if performance by both parties

is still in the future. Such contracts are

referred to as executory contracts.

12-4

Classification of Liabilities

• For reporting purposes liabilities are

usually classified as current or noncurrent.

• If a liability arises in the course of an

entity’s normal operating cycle, it is

considered current if current assets are

used to satisfy the obligation within one

year or one operating cycle, whichever

period is longer.

(continued)

12-5

• The classification of a liability as current or

noncurrent can impact significantly a

company’s ability to raise additional funds.

• When debt classified as noncurrent will

mature within the next year, the liability

should be reported as a current liability.

• The distinction between current and

noncurrent is important because of the

impact on a company’s current ratio.

(continued)

Classification of Liabilities

12-6

Measurement of Liabilities

1. Liabilities that are definite in amount

2. Estimated liabilities

3. Contingent liabilities

For measurement purposes, liabilities can be

divided into three categories:

The measurement of liabilities always

involves some uncertainty because a liability,

by definition, involves a future outflow of

resources.

12-7

2. Accounting for Short-Term Debt

• The term account payable usually refers to

the amount due for the purchase of

materials by a manufacturing company or

the purchase of merchandise by a

wholesaler or retailer.

• Accounts payable are not recorded when

purchase orders are placed but instead

when legal title to the goods passes to the

buyer.

12-8

Short-Term Debt

• In most cases, debt is evidenced by a

promissory note, which is a formal written

promise to pay a sum of money in the

future, and is usually reflected on the

debtor’s books as Notes Payable.

• Notes issued to trade creditors for the

purchase of goods or services are called

trade notes payable.

(continued)

12-9

Short-Term Debt

• Nontrade notes payable include notes

issued to banks or to officers and

stockholders for loans to the company.

• If a note has no stated rate of interest, or if

the stated rate is unreasonable, then the

face value of the note would be discounted

to the present value to reflect the effective

rate of interest implicit in the note.

12-10

Short-Term Obligations

Expected to be Refinanced

• A short-term obligation that is expected to

be refinanced on a long-term basis should

not be reported as a current liability.

• This applies to the currently maturing

portion of a long-term debt and to all other

short-term obligations except those arising

in the normal course of operations that are

due in customary terms.

(continued)

12-11

According to FASB ASC Topic 470

(Debt), both of the following conditions

must be met before a short-term

obligation can be properly excluded from

the current liability classification.

1. Management must intend to refinance

the obligation on a long-term basis.

2. Management must demonstrate an

ability to refinance the obligation.



(continued)

12-12

Concerning the second point, the ability to

refinance may be demonstrated by either of

the following:



a) Actually refinancing the obligation during

the period between the balance sheet

date and the date the statements are

issued.

b) Reaching a firm agreement that clearly

provides for refinancing on a long-term

basis. (continued)

12-13



• If a $400,000 long-term note is issued to

partially refinance $750,000 of short-term

obligations, only $400,000 of the short-

term debt can be excluded from current

liabilities.

• If the obligation is paid prior to the actual

refinancing but before the issuance of the

financial statements, the obligation should

be included in current liabilities.

(continued)

12-14



• According to IAS 1, for the obligation to be

classified as long term the refinancing must

take place by the balance sheet date, not

the later date when the financial statements

are finalized.

• Under the international standard post-

balance-sheet date events are NOT

considered when determining whether a

refinanceable obligation is reported as

current or noncurrent.

12-15

Lines of Credit

A line of credit is a negotiated arrangement

with a lender in which the terms are agreed to

prior to the need for borrowing.

(continued)

Please read the example in the

textbook on page 12-12.

12-16

Lines of Credit

• The line of credit itself is not a liability.

However, once the line of credit is used to

borrow money, the company has a formal

liability that will be reported as either a

current or a long-term liability.

• Maintaining a line of credit is not costless.

Banks typically charge a small amount, a

fraction of 1% per year.

(continued)

12-17

3. Accounting for Long-Term Debt (Mortgages)

• A mortgage is a loan backed by an asset

that serves as collateral for the loan.

• If the borrower cannot repay the loan, the

lender has the legal right to claim the

mortgaged asset and sell it in order to

recover the loan amount.

• Mortgages are generally payable in equal

installments; a portion of each payment

represents interest on the unpaid mortgage

balance. (continued)

12-18

Present Value of

Long-Term Debt

• On January 1, 2013, Crystal Michae

purchases a house for $250,000 and

makes a down payment of $50,000. The

remainder is financed with a 12%, 30-year

mortgage payable at a rate of $2,057

monthly.

• The interest rate is compounded monthly,

and the first payment is due on February 1,

2013.

(continued)

12-19

• As the mortgage payments are made, each

monthly payment of $2,057 must be divided

between principal and interest. On February

1, the interest is $2,000 ($200,000 × 1/12

× 0.12), or 1% a month, and the balance of

$57 is applied to the principal.

• In March, the interest is $1,999, 1% of

$199,943 ($200,000 – $57), and the pattern

continues monthly. This loan (or mortgage)

amortization is shown in Slide 12-20.

Present Value of

Long-Term Debt

(continued)

12-20 12-20 (continued)

12-21

Present Value of

Long-Term Debt

If Crystal were to maintain a set of personal

financial records, she would make the

following journal entry on February 1:

Interest Expense 2,000

Mortgage Payable 57

Cash 2,057

A secured loan is similar to a mortgage in

that it is a loan back by certain assets as

collateral.

12-22

• The long-term financing of a corporation is

accomplished either thorough the

issuance of long-term debt instruments,

usually bonds or notes, or through the

sale of additional stock.

• The issuance of bonds or notes instead of

stock may be preferred by management

and stockholders for the reasons shown

on Slide 12-23.

(continued)

4. Various Types of Bonds

12-23

Financing with Bonds

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 expected

dividends.

12-24

Understand the Bonds

• Conceptually, bonds and long-term notes

are similar types of debt instruments.

• The trust indenture (the bond contract)

associated with bonds generally provides

more extensive detail than the contract

terms of a note, often including

restrictions on the payment of dividends

or incurrence of additional debt.

(continued)

12-25

There are three main considerations in

accounting for bonds:

1. Recording the issuance or purchase

2. Recognizing the applicable interest during

the life of the bonds

3. Accounting for retirement of bonds either at

maturity or prior to the maturity date

Accounting Issues of Bonds

12-26

Nature of Bonds

• Bond certificates, commonly referred to

simply as bonds, are frequently issued in

denominations of $1,000.

• The amount printed on the bond is the face

value, par value, or maturity value of the

bond.

• The group contract between the corporation

and the bondholders is known as the bond

indenture.

12-27

• Bonds and similar debt instruments are

issued by private corporations, the U.S.

government, state, county, and local

governments, school districts, and

government-sponsored organizations.

• Debt securities issued by state, county, and

local governments and their agencies are

collectively referred to as municipal debt.

Issuers of Bonds

12-28

Types of Bonds

• Bonds that mature on a single date are

called term bonds.

• Bonds that mature in installments are

referred to as serial bonds.

• Secured bonds offer protection to investors

by providing some form of security, such as

a mortgage on real estate or the pledge of

other collateral.

(continued)

12-29

• A collateral trust bond is usually secured by

stocks and bonds of other corporations

owned by the issuing company.

• Unsecured bonds (frequently termed

debenture bonds) are not protected by the

pledge of any specific assets.

• Registered bonds call for the registry of the

owner’s name on the corporation books.

Types of Bonds

(continued)

12-30

• Bearer bonds, or coupon bonds, are not

recorded in the name of the owner; title to

these bonds passes with delivery.

• Zero-interest bonds or deep-discount

bonds do not bear interest. Instead, these

securities sell at a significant discount.

• High-risk, high-yield bonds issued by

companies that are heavily in debt or

otherwise in weak financial condition are

referred to as junk bonds.

Types of Bonds

(continued)

12-31

Types of Bonds

Junk bonds are issued in at least three types of

circumstances.

1. They are issued by companies that once had

high credit ratings but have fallen on hard

times.

2. They are issued by emerging growth

companies.

3. They are issued by companies undergoing

restructuring, often in conjunction with a

leverage buyout.

(continued)

12-32

• Convertible bonds provide for their

conversion into some other security at the

option of the bondholder.

• Commodity-backed bonds may be

redeemable in terms of commodities, such

as oil or precious metals.

Types of Bonds

• Bond indentures frequently give the issuing

company the right to call and retire the bonds

prior to maturity. Such bonds are termed

callable bonds. (continued)

12-33

• Mortgage-backed bonds, in many cases,

are just a special form of secured bonds.

The underlying collateral for these bonds

is the collection of mortgages owned by

the issuing entity.

Types of Bonds

12-34

5. Pricing Bonds

• The amount of interest paid on bonds is a

specified percentage of the face value. This

percentage is termed the stated rate, or

contract rate.

• If the stated rate exceeds the market rate, the

bonds will sell at a bond premium. If the stated

rate is less than the market, the bonds will sell

at a bond discount.

• The actual return rate on a bond is known as

the market, yield, or effective interest rate.

(continued)

12-35

Bond

Stated

Interest

Rate

10%

8% Premium

10% Face Value

12% Discount

Yield

Market Price of Bonds

(continued)

12-36

• Ten-year, 8% bonds of $100,000 are to be

sold on the bond issue date. The effective

interest rate for bonds of similar quality and

maturity is 10%, compounded semiannually.

• The computation of the market price of the

bonds may be divided into two parts (as

shown in Slide 12-37).


(continued)

12-37

Part 1 Present value of principal (maturity value):

Maturity value of bonds after 10 years,

or 20 semiannual periods $100,000

Effective interest rate: 10% per year, or 5% per semiannual

period $37,689

Part 2 Present value of twenty interest

payments:

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

Effective interest rate: 10% per year,

or 5% per semiannual period 49,849

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


(continued)

12-38

6. Accounting for Bonds

• Bonds may be sold directly to investors by

the issuer or they may be sold in the open

market through security exchanges or

through investment bankers.

• Bonds issued or acquired in exchange for

noncash assets or services are recorded at

the fair value of the bonds unless the value

of the exchanged assets or services is

more clearly determinable.

(continued)

12-39

Each of the bond situations in the following

slides will be illustrated using the following

data: $100,000, 8%, 10-year bonds are

issued; semiannual interest of $4,000

($100,000 × 0.08 × 6/12) is payable on

January 1 and July 1.

Issuance of Bonds

(continued)

12-40

Bonds Issued at Par

on Interest Date

Jan. 1 Cash 100,000

Bonds Payable 100,000

Issuer’s Books Issuer’s Books

July 1 Interest Expense 4,000

Cash 4,000

Dec. 31 Interest Expense 4,000

Interest Payable 4,000

(continued)

12-41

Jan. 1 Bond Investment 100,000

Cash 100,000

Investor’s Books Investor’s Books

July 1 Cash 4,000

Interest Revenue 4,000

Dec. 31 Interest Receivable 4,000


Bonds Issued at Par

on Interest Date

12-42

Bonds Issued at Discount

on Interest Date

The bonds were issued on January 1 but the

effective rate of interest was 10%, requiring

recognition of a discount of $12,462

($100,000 – $87,538).

(continued)

12-43

Bonds Issued at Discount

on Interest Date

Jan. 1 Cash 87,538

Discount on Bonds Payable 12,462




Cash 87,538


12-44

Bonds Issued at Premium

on Interest Date

• The bonds were issued on January 1 but

the effective rate of interest was 7%,

requiring recognition of a premium of

$7,106.

(continued)

12-45

Jan. 1 Cash 107,106

Premium on Bonds Payable 7,106




Cash 107,106


Bonds Issued at Premium

on Interest Date

(continued)

12-46

Bonds Issued at Par

between Interest Date

Mar. 1 Cash 101,333






Cash 4,000

($100,000 × 0.08 ×

2/12)

($100,000 × 0.08 ×

4/12)

(continued)

12-47

Mar. 1 Bond Investment 100,000

Interest Receivable 1,333

Cash 101,333


July 1 Cash 4,000

Interest Receivable 1,333


Bonds Issued at Par

between Interest Date

12-48

Bond Issuance Costs

• The issuance of bonds normally involves

bond issuance costs to the issuer for

legal services, printing and engraving,

taxes, and underwriting.

• In Statement of Financial Accounting

Concepts No.3, the FASB stated that

“deferred charges” such as bond issuance

costs fail to meet the definition of assets.

12-49

Accounting for Bond Interest

• When bonds are issued at a premium or

discount, the market acts to adjust the

stated interest rate to a market or

effective interest rate.

• Because the initial premium or discount,

the periodic interest payments made over

the bond’s life by the issuer do not

represent the total interest expense

involved, an amortization adjustment is

made.

12-50

• The straight-line method provides for the

recognition of an equal amount of premium

or discount amortization each period.

• A 10-year, 10% bond issue with a maturity

value of $200,000 was sold on the issuance

date at 103, the $6,000 premium would be

amortized evenly over 120 months until

maturity.

Straight-Line Method

(continued)

12-51


• To illustrate the accounting for bond

interest using straight-line amortization,

consider the earlier example of the

$100,000, 8%, 10-year bonds issued on

January 1.

• When sold at a $12,462 discount, the

appropriate entries to record interest on

July 1 and December 31 are shown on

Slides 12-52 and 12-53.

(continued)

12-52


Discount on Bonds Payable 623

Cash 4,000





$12,462/120 × 6 mo. = $623 (rounded)


(continued)

12-53

July 1 Cash 4,000

Bond Investment 623




Bond Investment 623



(continued)

12-54


Premium on Bonds Payable 355

Cash 4,000



Premium on Bonds Payable 355


$7,106/120 × 6 mo. = $355

(rounded)

Assume the bonds were sold for $107,106.

Reflects

effective

interest of

7%


(continued)

12-55

July 1 Cash 4,000

Bond Investment 355




Bond Investment 355



12-56

Effective-Interest Method

• The effective-interest method of

amortization uses a uniform interest rate

based on a changing loan balance and

provides for an increasing premium or

discount amortization each period.

• In order to use this method, the effective-

interest rate for the bonds must be known.

(continued)

12-57

Consider once again the $100,000, 8%, 10-year

bonds sold for $87,539, based on an effective

interest rate of 10%.

Bond balance (carrying value) at beginning of year $87,538

Effective rate per semiannual period 5%

Stated rate per semiannual period 4%

Interest amount based on carrying value and effective

rate ($87,538 × 0.05) $ 4,377

Interest payment based on face value and stated

rate ($100,00 × 0.040) 4,000

Discount amortization $ 377


(continued)

12-58

Assume the $100,000, 8%, 10-year bonds is

sold for $107,106, based on an effective interest

rate of 7%. The premium amortization for the first

6-month period would be computed as follows:

Bond balance (carrying value) at beginning of first period $107,106

Effective rate per semiannual period 3.5%



rate ($100,00 × 0.040) 4,000


rate ($107,106 × .035) 3,749

Premium amortization $ 251


(continued)

12-59

The second 6-month period would be computed

as follows:


Bond balance (carrying value) at beginning of second

period ($107,106 – $251) $106,855

Effective rate per semiannual period 3.5%



rate ($100,00 × 0.040) 4,000


rate ($106,855 x .035) 3,740

Premium amortization $ 260

(continued)

12-60

Interest

Payment

12-60

12-61

Retirement of Bonds at Maturity

If the bonds are held to maturity, the

discount or premium has been eliminated

over the life of the bond. The entry for

retiring the bond is straightforward. Assume

a $100,000 bond matures on July 1.

July 1 Bonds Payable 100,000

Cash 100,000


(continued)

12-62

Retirement of Bonds at Maturity

July 1 Cash 100,000

Bond Investment 100,000


• There is no gain or loss on retirement

because the carrying value is equal to the

maturity value.

• Any bonds not presented for payment at their

maturity date should be moved to Matured

Bonds Payable.

12-63

Extinguishment of Debt

Prior to Maturity

1. Bonds may be redeemed by the issuer by

purchasing the bonds on the open market or

by exercising the call provision (if available).

2. Bonds may be converted, that is,

exchanged for other securities.

3. Bonds may be refinanced by using the

proceeds from the sale of a new bond issue

to retire outstanding bonds.

12-64

Redemption by Purchase

of Bonds in the Market


Feb. 1 Bonds Payable 100,000

Discount on Bonds Pay. 2,300

Cash 97,000

Gain on Bond Redemption 700

Triad, Inc.’s $100,000, 8% bonds are not held to

maturity. They are redeemed on February 1, 2013,

at 97. The carrying value of the bonds is $97,700 as

of this date. Interest payment dates are January 31

and July 31. Carrying value of bonds, 2/1/13 $97,700

Redemption price 97,000

Gain on bond redemption $ 700

(continued)

12-65


Feb. 1 Cash 97,000

Loss on Sale of Bonds 700

Bond Investment—

Triad Inc. 97,700

Redemption by Purchase

of Bonds in the Market

Before the issuance of FASB Statement No.

125 in 1996, early extinguishment of debt

could also be accomplished through in-

substance defeasance.

12-66

Redemption by Exercise

of Call Provision

• A call provision gives the issuer the option

of retiring bonds prior to maturity.

• Frequently, the call must be made on an

interest payment date.

• When bonds are called, the difference

between the amount paid and the bond

carrying value is reported as a gain or a

loss on both the issuer’s and investor’s

books.

12-67

Convertible Bonds

• Convertible debt securities usually have the following features:

1. An interest rate lower than the issuer could establish for nonconvertible debt

2. An initial conversion price higher than the market value of the common stock at time of issuance

3. A call option retained by the issuer

• Convertible debt gives both the issuer and the holder advantages.

(continued)

12-68

Assume that 500 ten-year bonds, face value $1,000, are

sold at 105 ($525,000). The bonds contain a conversion

privilege that provides for exchange of a $1,000 bond

for 20 shares of stock, par value $1. It is estimated that

without the conversion privilege, the bonds would sell at

96. Assume that a separate value of the conversion

feature cannot be determined.

Issued with Conversion

Feature Nondetachable



Cash 525,000


Premium on Bonds Payable 25,000

(continued)

Convertible Bonds

12-69

Cash 525,000



Paid-In Capital Arising from Bond

Conversion Feature 45,000

Par value of bonds (500 × $1,000) $500,000

Selling price of bonds without

conversion feature ($500,000 x 0.96) 480,000

Discount on bonds w/o conversion $ 20,000

Convertible Bonds

(continued)





12-70

Total cash received on sale of bonds $525,000

Selling price of bonds without

conversion feature ($500,000 × 0.96) 480,000

Amount applicable to conversion $ 45,000

Convertible Bonds

Cash 525,000



Paid-In Capital Arising from Bond

Conversion Feature 45,000





12-71

Convertible Bonds

• The detachable warrants allow the holder

to buy shares of stock at a set price.

• The FASB has expressed a preliminary

preference for ultimately requiring the

process of all convertible debt issues to be

separated into their debt and equity

components.





12-72

Accounting for Conversion Debt

According to IAS 32

• IAS 32 does not differentiate between

convertible debt with nondetachable and

detachable conversion features.

• IAS 32 states that for all convertible debt

issues, the issuance proceeds should be

allocated between debt and equity.

12-73

Accounting for Conversion

• HiTec Co. offers bondholders 40 shares of

HiTec Co. common stock, $1 par, in exchange

for each $1,000, 8% bond held.

• An investor exchanges bonds of $10,000

(carrying value as of the conversion date,

$9,850) for 400 shares of common stock

having a market value at the time of the

exchange of $26 per share. The exchange took

place on an interest payment date after interest

had been paid and properly recorded.

(continued)

12-74


• When the bondholders exercise their

conversion privileges, the value identified with

the obligation is transferred to the common

stock that replaces it. The conversion is

recorded as follows:


Common Stock, $1 par 400

Paid-in Capital in Excess of Par 9,450


(continued)

12-75


• Assume that, as of the issuance date, the fair

value of 40 shares of HiTec Co. common stock

was substantially below the issuance price of

the convertible bonds. The subsequent

“unexpected” conversion is reported as

follows:

(continued)


Loss on Conversion of Bonds 550




12-76


(continued)


Loss on Conversion of Bonds 550




Market value of stock issued (400 shares

at $26) $10,400

Face value of bonds payable $10,000

Less unamortized discount 150 9,850

Loss to company on conversion of bonds $ 550

12-77

Investment in HiTec Co. Common

Stock 10,400

Bond Investment—HiTec Co. 9,850

Gain on Conversion of HiTec Co. Bonds 550


Market value of stock issued (400 shares at $26) $10,400

Face value of bonds payable $10,000

Less unamortized discount 150 9,850

Loss to company on conversion of bonds $ 550


• Assume the carrying value is the same on the

books of the investor as it is on the books of

the issuer.

12-78

Bond Refinancing

• Cash for the retirement of a bond is

frequently raised through the sale of a new

issue and referred to as bond refinancing.

• Bond refinancing may take place when an

issue matures, or bonds may be refinanced

prior to their maturity when the interest rate

has dropped and the interest savings on a

new issue will more than offset the cost of

retiring the old issue.

(continued)

12-79

Bond Refinancing

• A corporation has outstanding $1,000,000 of

12% bonds callable at 102 with a remaining

10-year term, and similar 10-year bonds can

be marketed currently at an interest rate of

only 10%.

• When refinancing takes place before the

maturity date of the old issue, the call

premium and unamortized discount and

issue costs of the original bonds are

considered in computing the gain or loss.

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Chapter 12 Debt Financing - WordPress.com 12 Debt Financing 12-2 1. Classification of Debt and Measurement Issues The FASB defined liabilities as “probable future sacrifices of economic