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

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.

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.

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.

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.

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.

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.

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.

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.

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).

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

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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

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.

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.

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

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

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.

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

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)