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MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell

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Chapter 3

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Financing Decisions - Debt Topics –Characteristics of debt securities –Cash interest versus effective interest –Effective interest overview –Computation of effective interest –Accounting for long-term bonds payable

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–Application of effective interest method to bonds payable –Example illustrating effective interest method –Notes payable –Hybrid securities –Convertible debt –Debt-like characteristics of preferred stock

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Characteristics of Debt Securities Security –Claims against specific asset (secured) –General claims against all assets (unsecured) Maturity –Have a definite maturity date –May be callable earlier at the borrowers discretion

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Convertibility –Normally, debt is not convertible into other securities. –Debt securities, particularly bonds, may be convertible into common stock at holders discretion. –Bonds may be issued with detachable warrants, which allow the holder to purchase common stock at predetermined prices.

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Interest payment characteristics –In general, debt has a fixed maturity value (principal) and a stated interest rate. –Maturity value (principal) also is referenced as face value or par value.

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Cash Interest Cash Interest Paid by Debtor –Multiply maturity value times the stated interest rate (as printed on the instrument) Example: On January 1, 2004, the Liu Co. issued $10,000,000 of 10 year, 8% bonds due January 1, 2014, with interest to be paid annually on January 1. (Liu will disburse cash interest of $800,000 each year, on January 1, starting on January 1, 2005.)

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Effective Interest Overview Effective Interest – The market rate of interest for debt (on the date of transaction), being a function of economy- wide conditions and borrower-specific risk factors. Components –Underlying real rate of return –Inflation premium –Risk premium

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Effective Interest: Computation Mathematics of Finance (in general) is based on five variables: n = Number of interest payment periods P = Principal (present value) - the amount being borrowed MV = Maturity (future) value of the debt R = Rent (generic term) payments on rented capital, i.e., the interest payment per period (n) and...

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i = Interest (or market) rate per period (also known as the effective rate per period) Note: Investors compare investment opportunities by comparing respective rates of return available, by calculating effective rates per year. For example, a stated rate of 8%, compounded semiannually equates to an effective rate per year of 8.16%.

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Of course, payments ( R ), representative of the cash interest payments over n periods, may be arranged as either: Ordinary annuity payments (payments at the end of each period), or Annuity due payments (payments at the beginning of each period).

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Typically, if three of the variable factors are given (known), financial calculators aid in easily deriving the other two; an example relating to bonds (where four givens are needed), follows. The focus of such problems is very often the effective interest rate being earned per period or per year.

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The Present Value of a bond investment, i.e., an investors bid price (also known as the market, sales, or issue price of a bond) is equal to The present value of future cash interest annuity PLUS the present value of the future maturity value, both discounted by using the current market rate of interest for similar debts.

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EXAMPLE: On January 1, 2004, the Liu Co. issued $10,000,000 of 10 year, 8% bonds due January 1, 2015, with interest paid annually on January 1. Given that the market price (sales price) of the bonds is $9,358,234 (rounded to nearest dollar), solve for the effective interest rate per year, i. PV = $9,358,234; MV = $10,000,000 n = 10; R = $800,000 ($10,000,000 × 8%) i = ? = 9%

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Accounting for Long-term Bonds Payable At Issuance –Bonds payable are recorded by the debtor at the issue (sale) price, by reflecting any... Premium situation: bonds issued at greater amount than maturity value (risk low) Discount situation: bonds issued at lesser amount than maturity value (risk high) –Book value (or carrying value) = The face value plus/minus any premium/discount

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–If bonds are issued between interest payment dates, the buyer also pays the issuer accrued interest from the last interest payment date to date of issuance. (*) –At the next interest payment date, the issuer pays the entire amount due for a full interest payment period. (*) This principle applies to any acquisition of bonds from any seller, just as it applied to the original issuer involved. This traditional procedure is fair to all. Why?

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After Issuance –After issuance, bond accounting uses the effective interest method, which emphasizes the interest expense per period. Premium/discount amortization per period is the difference between interest expense calculation and cash interest paid (or payable).

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Application of Effective Interest Method Calculated on a per period basis with... n = number of interest payments to be made (i.e., periods during the life of the debt security)

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Computation: Beginning of the period carrying (book) value ×Historical effective interest rate at time of issuance × appropriate time frame = Interest expense –Interest paid (or payable) =Premium/discount amortization for the period

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EXAMPLE: Apply effective interest method after calculating the effective interest rate per period. Facts: On January 1, 2004, the Faulconer Co. issued (for $4,550,000) the following bond: $4,000,000 of 7-year, 8% bonds, due January 1, 2011; interest is paid semiannually (on July 1 and January 1) each year. Faulconer incurred $75,000 in transactions costs. Note: Any bond issue costs are recorded separately and amortized over the life of the bond.

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Solution: The effective interest rate = 2.8% per semiannual period; a 5.6%, compounded semiannually stated rate. Documentation: n = 14; (7=year bonds × 2 semiannual periods) R = interest payment per period = $160,000; ($4,000,000 × 8% × one-half year) PV (present value) = purchase price = $4,550,000 MV in the future = face value = $4,000,000 i per n = ? = 2.8% THEN...

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Faulconer Co.: Computation of Interest Expense, First Semiannual Period Beginning carrying value (1/1/04)$4,550,000 Effective interest rate per n 2.8% Interest expense (1/1/04 – 6/30/04)127,400 Interest payable (1/1/04 – 6/30/04) 160,000 Premium amortization = $ 32,600 Thus, ending carrying value on 6/30/04 = $4,550,000 - $32,600 = $4,517,400

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Faulconer Co. Financial Statement Information For six months ended June 30, 2004 Statement of Cash Flows Operating activities (No Effect as of June 30(*)] Income Statement Interest expense - bonds$127,400 (*) Interest will be paid on July 1.

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Balance Sheet Current Liabilities Interest payable$ 160,000 Long-term Liabilities Bonds payable$4,000,000 Premium 517,400$4,517,400

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Partial Bond Amortization Schedule Faulconer Co. Effective Interest Amortization Table – Bond Premium Date 4% Cash Interest 2.8% Eff. Interest Expense* Premium Amort. Book Value of Debt 1/1/04$4,550,000 7/1/04160,000127,40032,6004,517,400 1/1/05160,000126,48733,5134,483,887 7/1/05160,000125,54934,4514,449,436 *Beginning Book Value × 2.8% effective interest rate

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Accounting for Notes Payable Normally issued for cash, but may be issued for non-cash consideration (e.g., goods and services). Apply the effective interest method if issued for a premium/discount (rare).

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Notes payable, as compared to bonds, are more likely to be issued at face value, but may be issued at a premium or discount –If stated and market interest rates are equal, the note is issued at face value, and no premium or discount occurs. –This happens because the borrower and lender have typically agreed to base the notes terms to reflect the market rate of interest on the date of the transaction.

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Hybrid Securities Hybrid securities are securities that have both debt-like and equity-like characteristics. Examples –Convertible debt incorporates an option to acquire common stock. Total FMV is attributed to the debt feature.

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–Debt incorporating detachable warrants (Warrants may be tendered to acquire common stock.) The FMV of the debt security is allocated between debt features and the equity features, preferably based on the relative separate FMVs of the debt and warrants (if practical).

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Convertible Debt EXAMPLE: On January 1, 2004, the Lopez Co. issued at face value of $5,000,000 of 8-year, 10% convertible debentures, due January 1, 2012. Interest is paid annually on December 31. Each $1,000 bond is convertible into 30 shares of Lopezs $10 par common stock at the option of the holder. On January 1, 2006 (after payment of the December 31, 2005, interest payment), all bonds were converted to common stock. The balance sheet presentation just before and just after the conversion is as follows:

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Lopez Co. Balance Sheet Before conversion Long-term liabilities Bonds payable$5,000,000 After conversion Stockholders Equity Common Stock (1)$1,500,000 Additional paid-in capital (2)$3,500,000

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Documentation (1)5,000 bonds × 30 shares = 150,000 shares; 150,000 shares × $10 par = $1,500,000 (2)$5,000,000 book value of debt – $1,500,000 par value of stock

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FAQs? What would be the impact on the journal entry if the FMV of the common stock in the above example at the time of conversion was $25 per share? $35 per share? How would premiums/discounts affect it? Give it a shot!

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Debt-like Characteristics of Preferred Stock Preferred stock and convertible preferred stock are equity securities with some debt- like features: –Like debt holders, preferred shareholders have priority in liquidation over common stockholders. (Note: Debt holders have priority in liquidation over all shareholders).

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–Stated dividend preference per period is somewhat similar to a stated interest rate. –If preferred stock is cumulative and current period dividends are not declared, then dividends in arrears is somewhat similar to interest payable. –Note: Neither debt holders nor preferred stockholders vote.

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End of Chapter 3

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