2A Double-Edged SwordA company’s capital structure refers to the mix of debt and equity it uses to finance its operations.A company’s use of debt to increase earnings by investing borrowed money in assets that generate profits that are greater than the after-tax cost of the debt and using those excess profits to increase the return on equity for the company’s shareholders is financial leverage.Financial liabilities are contractual obligations that require one entity to deliver cash or another financial asset to another party and normally result from the firm raising cash for operating and investing activities.
3Why Do Companies Issue Long-Term Financing Liabilities? Debt financing may be the only available source of funds.Debt financing typically has a lower cost of capital than equity.Debt financing offers an income tax advantage.Debt does not carry voting rights.Debt financing offers the opportunity for financial leverage.
4Bonds Payable: Terminology Bond: A debt instrument in which a company agrees to pay the holder the face value at the maturity date and usually to pay periodic interest on the face value at a specified rate.Face Value (or Par Value): The amount of money that the issuer agrees to pay at maturity.Maturity Date: The date on which the issuer of a financial liability agrees to pay the face value to the holder.Contract Rate (Stated, Face, or Nominal Rate): The rate at which the issuer of the bond agrees to pay interest each period until maturity.Bond Certificate: A legal document that provides evidence of ownership and specifies the face value, the annual interest rate, the maturity date, and other characteristics of the bond issue.Bond Indenture: A document (contract) that defines the rights of the bondholders.
6The Bond Issue Process When a company issues bonds, it must: Receive approval from regulatory authoritiesSet the terms of the bond issueMake a public announcement of its intent to sell the bonds on a particular date and print the bond certificatesThe selling price is based on the terms of the bond issue (such as the stated rate of interest and the length of time to maturity) and factors such as the general bond market condition, the relative risk of the bonds, and the expected state of the economy.The effective rate (yield) is the market rate at which the bonds are actually sold.
7How is the Issue Price of Bonds Payable Computed? (Slide 1 of 3) The selling price of the bond is determined by summing the present value of the principal and interest payments discounted at the effective interest (yield) rate.Three alternatives are possible for a company selling bonds:At Par: Purchasers of the bonds pay the face value of the bonds.At a Discount: Purchasers of the bonds pay an amount less than the face value of the bonds.At a Premium: Purchasers of the bonds pay an amount greater than the face value of the bonds.
9Bond Issued between Interest Payment Dates When a company sells bonds between interest dates, the company normally will collect from the investors both the selling price and the interest accrued on the bonds from the interest payment date prior to the date of sale.
10Amortizing Discounts and Premiums The Interest Expense on the company’s income statement must show an amount based on the effective interest rate and the book value of the bonds.The effective interest expense amount is computed as follows:Interest Expense = Effective Interest Rate × Book Value atBeginning of PeriodA portion of bond discount or premium is amortized, and this amortization is the difference between the amount of interest expense and the cash payment.This process is known as the effective interest method (interest method) of amortization.
11Straight-Line MethodThe simplest method of amortization is the straight- line method.The discount or premium to interest expense is amortized in equal amounts each period during the life of the bond.
12Effective Interest Method The book value (carrying value) of the bond issue at any time is its face value plus any unamortized premium or minus any unamortized discount.The discount or premium amortization is the difference between the interest expense computed under the effective interest method and the cash payment.The relationship among the interest paid, interest expense, and the amortization is shown below:
13Bond Issue CostsBond issue costs (such as legal and accounting fees, printing costs, or registration fees) are recorded as an asset and amortized over the life of the bond issue by the straight-line method.
14Accruing Bond Interest Frequently companies issue bonds with interest payment dates that differ from the fiscal year. In such cases, the company must accrue interest and recognize partial period amortization of premiums or discounts.
15Extinguishment of Liabilities The agreement between the bondholders and the issuing company always includes a specified maturity date.On this date, the company agrees to repay the face value of the bonds to the bondholders.On the maturity date after the last payment is recorded, any premium or discount on bonds payable is fully amortized.At this point, the book value of the bonds is equal to the maturity value.
16Bonds Retired Prior to Maturity (Slide 1 of 2) A call provision included in a long-term financial instrument gives the issuing company the option to recall and repay the debt prior to maturity.Because the call price is generally set above the issue price, a loss occurs when the company recalls the debt.An alternative method of retiring bonds prior to their maturity is for the company to purchase them on the open market, if they are traded.
17Bonds Retired Prior to Maturity (Slide 2 of 2) A defeasance is a way to extinguish a liability, whereby a debit is legally released from being the primary obligator of the liability. This situation arises when:An affiliated company agrees to become the primary obligator for the bondsThe issuing company transfers a sufficient amount of assets into a legally separate entity to be used for bond retirement at maturityThe parent company derecognizes the liability from its balance sheet, recognizes a reduction in an investment account, and reports a gain or loss on the transaction, if appropriate.
18How Do We Account for Bonds with Equity Characteristics? Stock warrants (also called stock rights) give holders the option to purchase a specific number of common shares at a predetermined price for a period of time.A conversion right allows bondholders to exchange bonds for common equity shares at a predetermined exchange ratio.The bondholder has acquired a dual set of rights:The right to receive interest and principal repayments on the bondThe right to acquire common stock, either by exercising the warrants and purchasing shares or by exchanging bonds for shares, and to participate in future dividends and future appreciation of the market value of the company’s common stock
19Bonds Issued with Detachable Stock Warrants GAAP requires that a portion of the proceeds of bonds issued with detachable stock warrants be allocated to the stock warrants.The allocation is made as follows:
20Convertible Bonds (Slide 1 of 2) Why do companies issue convertible bonds?The company wants to increase its equity capital at a later date and decides that the issuance of convertible bonds is the way to do so.The company wants to increase its debt and finds the conversion feature necessary to make the bonds sufficiently marketable at a reasonable interest rate.Current GAAP requires companies to treat the proceeds from the issuance of convertible debt solely as debt.The two approaches that bondholders may use when converting bonds into common stock are the book value method and the market value method.
22Convertible Bonds (Slide 2 of 2) Book Value Method: A method of recording bond conversion where the shareholders’ equity is recorded at book value of the convertible bonds on the date of conversion, and no gain or loss is recorded.Market Value Method: A method of recording bond conversion where the shareholders’ equity is recorded at the market value of the shares issued on the date of conversion, and a gain or loss is recorded.
23Induced ConversionsTo induce conversion, the company may add a “sweetener” to the convertible bond issue so that the conversion privileges are changed or additional consideration is paid to the bondholder.The changed terms (privileges) may involve a reduction of the original conversion price resulting in the following:Issuance of additional shares of common stockIssuance of warrants or other securities not included in the original conversion termsPayment of cash to bondholders who convert during the specified time period
24Convertible Bonds that May Be Settled with a Cash Payment A cash or partial cash settlement usually occurs when the bond has an artificially low interest rate and an attractive conversion feature.
25Long-Term Notes Payable A long-term note is economically similar to a debenture bond because it represents a future obligation of the borrower to repay debt in more than a year. In many cases, no collateral backs the note.Long-term notes generally require payments of interest on the borrowed funds.In some commercial arrangements, the long-term notes will not require explicit interest payments.These lending arrangements are sometimes used to maintain favorable customer, supplier, or employee relations or to ensure future services.GAAP requires the borrower to record the note payable at its present value and to use the effective interest method to record the interest expense.
26Notes Payable Issued for Cash When the interest rate agreed to in a note is not fair, an accountant may need to use an imputed interest rate, which is an estimated interest rate based on the rate that an independent borrower and an independent lender would negotiate for a similar transaction under comparable terms and conditions.Accounting standards require interest to be imputed in the following situations:When a note is non-interest-bearing or no interest rate is statedWhen an interest rate is stated but the interest rate is unrealistically low
27Notes Payable Exchanged for Property, Goods, or Services When a note is exchanged solely for property, goods, or services in exchange for property, goods, or services in an external transaction, GAAP says that the stated rate of interest should be presumed fair.This presumption can be overcome only if:no interest is stated, orstated rate of interest is clearly unreasonable, orface value of the note is materially different from the cash sales price of the property, goods, or services, or the fair value of the note, at the date of the transaction.
28Disclosure of Long-Term Liabilities Companies’ balance sheets often disclose the book value of the liability net of any premiums or discounts and do not separately disclose the premiums or discounts.Cash paid for interest is included in the operating activities section of the statement of cash flows.A company must close the various characteristics of its long term debt. It normally does so in the notes to its financial statements.