1. COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks 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

2. Learning Objectives 1.Understand the various classification and measurement 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 the accounting for long-term debts such as mortgages. 4.Understand the various types of bonds, compute the price of a bond issue, and account for the issuance, interest, and redemption of bonds.

3. Time Line of Business Issues Involved with Long-Term Debt ISSUE the debt Notes Payable Mortgage Payable Bond CHOOSE the method of financing Bond PAY interest +/- RETIRE the debt ACCOUNT for the specific aspects of the type of debt

4. Definition of Liabilities The obligation of a particular entity to transfer assets or provide services. – Must be the result of past transactions or events. – Probable transfer of assets (or services) must be in the future.

5. Classification of Liabilities Current Liabilities- Paid within one year or the operating cycle, whichever is longer. Noncurrent Liabilities- Not paid within one year or the operating cycle, whichever is longer.

6. Stop and Think Look at Exhibit 12-3. The 2004 current ratio of McDonald’s is only 0.81. How will McDonald’s most likely meet its current obligations as they come due?

7. Measurement of Liabilities For measurement purposes, liabilities can be divided into three categories: 1.Liabilities that are definite in amount. 2.Estimated liabilities. 3.Contingent liabilities.

8. Accounting for Short-Term Debt Short-Term obligations are due within one year or an operating cycle. Account Payable -the amount due for the purchase of materials. Notes Payable – a formal written promise to pay a sum of money in the future, also known as a promissory note.

9. 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 FASB Statement No. 6 requires that both of the following conditions be met before a short-term obligation may 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.

10. Short-Term Obligations Expected to be Refinanced An ability to refinance may be demonstrated by: –Actually refinancing the obligation during the period between the balance sheet date and the date the statements are issued. –Reaching a firm agreement that clearly provides for refinancing on a long-term basis.

11. Short-Term Obligations Expected to be Refinanced The terms of the refinancing agreement should 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 of the agreement at the balance sheet date or the date of issuance. The lender or investor should be financially capable of meeting the refinancing requirements.

12. Lines of Credit Line of credit- is a negotiated arrangement with a lender in which the terms are agreed to prior to the need for borrowing. A company with an established line of credit can access funds quickly without the “red tape”. Once the line of credit is used to borrow money, the company has a formal liability (current or noncurrent).

13. Present Value of Long-Term Debt A liability should be reported at the amount that would satisfy the obligation on the balance sheet date. For a long-term obligation, this amount is the present value of the future payments to be made. The division of these payments into interest and principal components is a process called loan amortization. Example journal entry to record a mortgage payment: Interest Expense2,000 Mortgage Payable 57 Cash2,057

14. Types of Loans Mortgage- 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. Secured loan- similar to a mortgage, a loan backed by assets as collateral and can be claimed by the lender if the borrower defaults. –There is a reduction in risk for the lender with a secured loan, thus a reduced interest cost for the borrower.

15. Financing with Bonds Reasons management may choose to issue bonds 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 that might be expected by shareholders.

16. Financing with Bonds Disadvantages and limitations of issuing debt securities: 1.It is only possible to use debt financing if the company is in satisfactory financial condition. 2.Interest obligations must be paid regardless of the company’s earnings and financial position. 3.If a company has losses and is unable to raise cash to pay interest payments, secured debt holders may take legal action.

17. Accounting for Bonds 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 the retirement of bonds either at maturity or prior to the maturity date.

18. Nature of Bonds Bond Certificates- commonly referred to as bonds are issued in denominations of $1,000. Face Value- the amount that will be paid on a bond at maturity date. Also known as par value or maturity value. Bond indenture- a group contract between the corporation and the bondholders.

19. Types of Bonds Term bonds- Bonds that mature in one lump sum on a specified future date. Serial bonds- Bonds that mature in a series of installments at future dates. Collateral trust bonds- Bonds usually secured by stocks and bonds of other corporations owned by the issuing company. Unsecured (debenture) bonds- Bonds for which no specific collateral has been pledged.

20. Types of Bonds Registered bonds- Bonds for which the issuing company keeps a record of the names and addresses of all bondholders and pays interest only to those individuals whose names are on file. Bearer (coupon) bonds- Unregistered bonds for which the issuer has no record of current bondholders, but instead pays interest to anyone who can show evidence of ownership.

21. Types of Bonds Zero-interest bonds- Bonds that do not bear interest but instead are sold at significant discounts. Junk bond- High-risk, high-yield bonds issued by companies in a weak financial condition. Commodity-backed bonds- Bonds that may be redeemed in terms of commodities. Callable bonds- Bonds for which the issuer reserves the right to pay the obligation prior to the maturity date.

22. Market Price of Bonds Bond discount- The difference between the face value and the sales price when 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 face value.

23. Market Price of Bonds BondStatedInterestRate10% 8%Premium 10 10% FaceValue Face Value 12%Discount Yield

24. Market Price of Bonds Ten-year, 8% bonds of $100,000 are to be sold on the bond issue date. On that date, the effective interest rate for bonds of similar quality and maturity is 10%, compounded semiannually. 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 $100,0004,000 Effective interest rate, 10% per year (5% per semiannual period)$49,849 Total present value (market price) of bond $87,538

25. Stop and Think In computing the market price for bonds, what is the only thing for which the stated rate of interest is used?

26. Issuance of Bonds 1/1 Cash 100,000 Bonds Payable 100,000 7/1 Interest Expense 4,000 Cash 4,000 12/31 Interest Expense 4,000 Cash 4,000 Issuer’s Books Investor’s Books Cash4,000 Interest Revenue 4,000 Bonds 100,000 Cash 100,000 Cash 4,000 Interest Revenue 4,000

27. Bond Issued at a Discount on Interest Date On January 1, $100,000, 8%, 10-year bonds were issued for $87,538 (which provided an effective interest rate of 10% to the investor). Issuer’s Books Jan. 1Cash87,538 Discount on Bonds Payable12,462 Bonds Payable100,000 Investor’s Books Jan. 1Bond Investment87,538 Cash87,538

28. Bond Issue at a Premium on Interest Date On January 1, $100,000, 8%, 10-year bonds were issued for $107,106 (which provided an effective interest rate of 7% to the investor). Issuer’s Books Jan. 1Cash107,106 Prem. on Bonds Payable7,106 Bonds Payable100,000 Investor’s Books Jan. 1Bond Investment107,106 Cash107,106

29. Bonds Issued at Par Between Interest Dates On March 1, $100,000, 8%, 10-year bonds were issued to yield 8 %. Interest for two months has accrued on the bonds. Issuer’s Books Mar. 1 Bond Investment 101,333 Bonds Payable 100,000 Interest Payable 1,333 July 1 Interest Expense 2,667 Interest Payable 1,333 Cash 4,000 $100,000 x 0.08 x 4/12 $100,000 x 0.08 x 2/12

30. Bonds Issued at Par Between Interest Dates Investor’s Books Mar. 1Bond Investment100,000 Interest Receivable1,333 Cash101,333 July 1Cash 4,000 Interest Receivable1,333 Interest Revenue2,667 On March 1, $100,000, 8%, 10-year bonds were issued to yield 8 %. Interest for two months has accrued on the bonds.

31. 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. The periodic interest payments made by the issuer are not the total interest expense. An adjustment to interest expense ( amortization ) associated with the cash payment is necessary to reflect the effective interest being incurred on the bonds. There are two methods used to amortize the premium/ discount: –Straight Line Method –Effective Interest Method

32. Straight Line Amortization Discount Previously, $100,000 of 8% bonds were issued at $87,538 (a discount of $12,462). Appropriate amortization entries must be made on both the issuer’s books and the investor’s books. Issuer’s Books July 1 Interest Expense 4,623 Disc on Bonds Payable 623 Cash 4,000 Dec 31 Interest Expense 4,623 Disc on Bonds Payable 623 Cash 4,000 $12,462/120 x 6 months

33. Straight Line Amortization Discount Investor’s Books July 1Cash 4,000 Bond Investment623 Interest Revenue4,623 Dec 31 Interest Receivable4,000 Bond Investment623 Interest Revenue4,623 Previously, $100,000 of 8% bonds were issued at $87,538 (a discount of $12,462). Appropriate amortization entries must be made on both the issuer’s books and the investor’s books.

34. Straight Line Amortization Premium Previously, $100,000 of 8% bonds were issued at $107,106 (a premium of $7,106). Appropriate amortization entries must be made on both the issuer’s books and the investor’s books. Issuer’s Books July 1 Interest Expense 3,645 Premium on Bonds Payable 355 Cash 4,000 Dec 31 Interest Expense 3,645 Premium on Bonds Payable 355 Cash 4,000 $7,106/120 x 6 months

35. Straight Line Amortization Premium Investor’s Books July 1Cash 4,000 Bond Investment355 Interest Revenue3,645 Dec 31 Interest Receivable4,000 Bond Investment355 Interest Revenue4,623 Previously, $100,000 of 8% bonds were issued at $107,106 (a premium of $7,106). Appropriate amortization entries must be made on both the issuer’s books and the investor’s books.

36. Effective Interest Method Discount 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 period5% Stated rate per semiannual period4% Interest amount ($87,538 x 0.05)$4,377 Interest payment ($100,000 x 0.04) 4,000 Discount amortization$ 377 Period One

37. Effective Interest Method Discount 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 period5% Stated rate per semiannual period4% Interest amount ($87,915 x 0.05)$4,396 Interest payment ($100,000 x 0.04) 4,000 Discount amortization$ 396 $87,538 + $377

38. Effective Interest Method Premium 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 period3.5% Stated rate per semiannual period4% Interest payment ($100,00 x 0.04)$4,000 Interest amount ($107,106 x 0.35) 3,749 Discount amortization$ 251 Period One

39. Effective Interest Method Discount Period Two $107,106 - $251 Effective rate for semiannual period3.5% Stated rate per semiannual period4% Interest payment ($100,00 x 0.04)$4,000 Interest amount ($106,855 x 0.35) 3,740 Discount amortization$ 260 Consider again the $100,000, 8%, 10-year bonds sold for $107,106. The effective rate for the bonds is 7%.

40. A B C D E (A – B) (D – C)($100,000+ D)($100,000 x 04) (E x 0.035) Prem.Unamort.Bond #PaymentInt. Exp.Amort.Prem.Book $7,106$107,106 Effective-Interest Method— Premium

41. A B C D E (A – B) (D – C)($100,000+ D)($100,000 x 04) (E x 0.035) Prem.Unamort.Bond #PaymentInt. Exp.Amort.Prem.Book $7,106$107,106 Effective-Interest Method— Premium 1$4,000$3,749$2516,855 106,855 $107,106 x 0.035

42. A B C D E (A – B) (D – C)($100,000+ D)($100,000 x 04) (E x 0.035) Prem.Unamort.Bond #PaymentInt. Exp.Amort.Prem.Book $7,106$107,106 Effective-Interest Method— Premium 1$4,000$3,749$2516,855 106,855 $106,855 x 0.035 2$4,000$3,740$2606,595 106,595

43. A B C D E (A – B) (D – C)($100,000+ D)($100,000 x 04) (E x 0.035) Prem.Unamort.Bond #PaymentInt. Exp.Amort.Prem.Book $7,106$107,106 Effective-Interest Method— Premium 1$4,000$3,749$2516,855 106,855 2$4,000$3,740$2606,595 106,595 3$4,000$3,731$2696,326 106,326 4$4,000$3,721$2796,047 106,047 5$4,000$3,712$2885,759 105,759

44. Straight-Line vs. Effective- Interest Amortization Methods Insert exhibit 12-7

45. Stop & Think When preparing a bond amortization schedule like the one that follows, there are certain numbers within that schedule that you know without having to do any elaborate computations. Which ONE of the following numbers can be determined using a very simple computation?

46. 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.

47. Extinguishment of Debt Prior to Maturity Triad, Inc.’s $100,000, 8% bonds are not held to maturity. They are redeemed on February 1, 2007, at 97. The carrying value of the bonds is $97,700 as of this date. Interest payment dates are January 31 and July 31. Issuer’s Books Feb. 1Bonds Payable100,000 Discount on Bonds Pay.2,300 Cash97,000 Extraordinary Gain on Bond Redemption700 Carry value of bonds, 1/1/02$97,700 Redemption price 97,000 Gain on bond redemption$ 700 Investor’s Books Feb. 1Cash 97,000 Loss on Sale of Bonds700 Bond Investment- Triad Inc.97,700

48. 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.

49. 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 for exchange of a $1,000 bond for 20 shares of stock, par value $1.

50. Convertible Bonds Debt and Equity Not Separated Cash525,000 Bonds Payable500,000 Premium on Bonds Payable25,000 Debt and Equity Separated Cash525,000 Discount on Bonds Payable20,000 Bonds Payable500,000 Paid-In Capital Arising from Bond Conversion Feature45,000 Par value – Selling price of bond without conversion feature

51. Accounting for Conversion Investor’s Books Nov. 1Investment in HiTec Co. Common Stock10,400 Investment in HiTec Co. Bonds9,850 Gain on Conversion of HiTec Co. Bonds550 The investor may choose not to recognize a gain or a loss. If so the investor would debit Investment in HiTec Co. Common Stock for &9,850.

52. Accounting for Conversion Issuer’s Books Nov. 1Bonds Payable10,000 Loss on Conversion of Bonds550 Common Stock, $1 par400 Paid-In Capital in Excess of Par Value10,000 Discount on Bonds Payable150

53. Off-Balance-Sheet Financing Off-Balance-Sheet-Financing- procedures to avoid disclosing all debt on the balance sheet in order to make the company’s financial position look stronger. Common techniques used: –Leases –Unconsolidated subsidiaries –Variable interest entities (VIEs) –Joint ventures –Research and development arrangements –Project financing arrangements

54. Analyzing a Firm’s Debt Position Debt-to-Equity Ratio- measures the relationship between the debt and equity of an entity. Formula: total debt ÷ total stockholders’ equity Debt Ratio- indicates a company’s overall ability to repay its debts. Formula: total liabilities ÷ total assets. Times Interest Earned- shows a company’s ability to meet interest payments. Formula: income before interest expense and income taxes ÷ interest expense for the period.

55. Disclosing Debt in the Financial Statements Companies may want to disclose additional information about long-term debt in the notes like: –Nature of the liabilities –Maturity dates –Interest rates –Methods of liquidation –Conversion privileges –Sinking fund requirements –Borrowing restrictions –Assets pledged, –Dividend limitations

56. Troubled Debt Restructuring Troubled debt restructuring exists only if the “creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider.” (SFAS 15.2)

57. No Not a troubled debt restructure. Disposal Gain/Loss = FMV Asset – Book Value of Asset Disposal Gain/Loss = FMV Asset – Book Value of Asset Asset Swap Debtor FMV Asset < debt? Yes Remove debt and asset from books. Restructuring Gain = Debt – FMV Asset

58. Yes Remove debt and asset from books and record new equity. Remove debt and asset from books and record new equity. Equity Swap Debtor FMV Equity < debt? No Not a troubled debt restructure. Restructuring Gain =Debt – FMV Equity Restructuring Gain =Debt – FMV Equity

59. Asset or Equity Swap Creditor FMV Asset > loan? Yes Not a troubled debt restructure. Remove loan from books and record asset at FMV. No Restructure Loss = Loan – FMV Asset Restructure Loss = Loan – FMV Asset

60. Recognize gain on restructuring. Write-down debt to sum of future cash flows. Record all future payments as principal payments. Recognize gain on restructuring. Write-down debt to sum of future cash flows. Record all future payments as principal payments. No Total future payments < debt book value? Modification of Terms Debtor Reclassify the debt and amortize using effective interest method. Interest rate is the implicit rate. Reclassify the debt and amortize using effective interest method. Interest rate is the implicit rate. Yes