Debt Financing (Part Two)

Debt Financing (Part Two)
Intermediate Accounting,17E Debt Financing (Part Two) ACC 202 A/B

OBJECTIVE 5 Understand the effective interest method in calculation of the amortized cost for bonds

Effective-Interest Method
Interest accrues on an outstanding debt at a constant percentage of the debt each period. Interest each period is recorded as the effective market rate of interest multiplied by the outstanding balance of the debt (during the interest period).

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 $

Issuer’s Books July 1 Interest Expense 4,377 Discount on Bonds Payable 377 Cash 4,000 Investor’s Books July 1 Cash 4,000 Bond Investment 377 Interest Revenue 4,377

Assume the $100,000, 8%, 10-year bonds is sold for $107,106, based on an effective interest rate of 7%. Bond balance (carrying value) at beginning of first period $107,106 Effective rate per semiannual period 3.5% Stated rate per semiannual period 4% Interest payment based on face value and stated rate ($100,00 × 0.040) ,000 Interest amount based on carrying value and effective rate ($107,106 × .035) ,749 Premium amortization $

Interest is recorded as expense to the issuer and revenue to the investor. For the first six-month interest period the amount is calculated as follows: $107, × (7% ÷ 2) = $3,749 Outstanding Balance Effective Rate Effective Interest

First Interest payment
Effective-Interest Method First Interest payment Issuer’s Books July 1 Interest Expense 3,749 Premium on Bonds Payable 251 Cash 4,000 Investor’s Books July 1 Cash 4,000 Bond Investment 251 Interest Revenue 3,749

The bond indenture calls for semiannual interest payments of only $4,000 – the stated rate (4%) times the face value of $100,000. The difference (e.g. $251 for interest payment 1) decreases the liability for the Issuer and the investment balance for the Investor.

When Financial Statements Are Prepared Between Interest Dates
On 1/1/09, Masterwear Industries issues $700,000 face value bonds to United Intergroup. The market interest rate is 14%. The bonds have the following terms: Face Value of Each Bond = $1,000 Maturity Date = 12/31/11 (3 years) Stated Interest Rate = 12% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/09 Present value (price) of the bond = 666,633 (Part One Slide 12-22) Assume Masterwear and United both have September 30th year-ends and effective interest method is used.

Masterwear - Issuer 7% × $666,633 6% × $700,000 United - Investor Left click on the button to go to Slide (Part One).

The bond indenture calls for semiannual interest payments of only $42,000 – the stated rate (6%) times the face value of $700,000. The difference ($4,664) increases the liability and is reflected as a reduction in the discount (a valuation account).

Amortization Schedule - Discount
6% × $700,000 7% × $666,633 $46,664 – 42,000 $666, ,664

Amortization Schedule - Discount
$48,544 is rounded to cause outstanding balance to be exactly $700,000 on 12/31/11.

Year-end is on September 30, 2009, before the second interest date of December 31, so we must accrue interest for 3 months from June 30 to September 30. Masterwear - Issuer United - Investor

OBJECTIVE 6 Understand the accounting treatment for extinguishment of debt

BUT Extinguishment of Debt Prior to Maturity
Debt retired at maturity results in no gains or losses. BUT Debt retired before maturity may result in an gain or loss on extinguishment. Cash Proceeds – Book Value = Gain or Loss

Extinguishment of Debt Prior to Maturity
Bonds may be redeemed by the issuer by purchasing the bonds on the open market or by exercising the call provision (if available). A call provision gives the issuer the option of retiring bonds prior to maturity. The inclusion of call provisions in a bond agreement is a feature favoring the issuer. The company is in a position to terminate the bond agreement and eliminate future interest charges whenever its financial position make such action feasible.

Extinguishment of Debt Prior to Maturity
Bonds may be converted, that is, exchanged for other securities. Bonds may be refinanced by using the proceeds from the sale of a new bond issue to retire outstanding bonds.

Redemption by Purchase of Bonds in the Market
Trident, Inc.’s $100,000, 8% bonds are not held to maturity. They are redeemed on February 1, 2011, at 97,000. 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, 2/1/11 $97,700 Redemption price 97,000 Gain on bond redemption $ Issuer’s Books Feb. 1 Bonds Payable 100,000 Discount on Bonds Payable 2,300 Cash 97,000 Gain on Bond Redemption 700 (continues)

Redemption by Purchase of Bonds in the Market
Investor’s Books Feb. 1 Cash 97,000 Loss on Sale of Bonds Bond Investment— Trident Inc. 97,700

Redemption by Exercise
of Call Provision On July 1, 2002, Ball Corporation issued for US$900,000, 1,000 (Bond quantities) of its 9%, US$1,000 callable bonds. The bonds are dated July 1, 2002, and mature on July 1, Interest is payable semiannually on January 1 and July 1. Bell uses the straight-line method of amortizing bond discount. The bonds can be called by the issuer at 102% at any time after June 30, On July 1, 2009, Ball called in all of the bonds and retired them.

of Call Provision What is the amount of loss which Ball should report on this early extinguishment of debt for the year ended December 31, 2008? The bonds payable ($1,000 x 1,000 = $1,000,000) were issued at a discount of $100,000 [($1,000 x 1,000) - $900,000] on 7/1/01. The bonds are called at 102%, 7 years later on 7/1/09. Since the bonds were due in 10 years, 7/10 of the discount (7/10 x $100,000 or $70,000) would have been amortized by 7/1/08.

of Call Provision Therefore, the balance in the bond discount account is $30,000 ($100,000 - $70,000), and the carrying amount of the debt is $970,000 ($1,000,000 - $30,000). The loss on the retirement is the difference between the $1,020,000 x 1.02) and the $970,000 carrying amount, or $50,000.

Bond Refinancing Cash for the retirement of a bond issue is frequently raised through the “sale of a new issue” and is referred to as bond refinancing. When refinancing before the maturity date of the old issue, the Opinions of the Accounting Principles Board (“APB”) selected the immediate recognition of a gain or loss for all early extinguishment of debt.

OBJECTIVE 7 Understand the accounting treatment for convertible bonds

Convertible Bonds Some bonds may be converted into common stock at the option of the holder. When bonds are converted the issuer updates interest expense and amortization of discount or premium to the date of conversion. The bonds are reduced and shares of common stock are increased. Bonds into Stock

Convertible Bonds Convertible debt securities usually have the following features: An interest rate lower than the issuer could establish for nonconvertible debt An initial conversion price higher than the market value of the common stock at time of issuance A call option retained by the issuer Convertible debt gives both the issuer and the holder advantages.

Convertible Bonds – Advantages to an issuer
An issuer is able to obtain financing at a lower interest rate because of the value of the conversion feature to the holder. Because of the call provision, an issuer is in a position to exert influence on the holders to exchange the debt for equity securities if stock values increase. The issuer has had the use of relatively low interest rate financing if stock values do not increase.

Convertible Bonds – Advantages to an issuer
The holder has a debt instrument that, barring default, ensures the return of investment plus a fixed return and, at the same times, offers an option to transfer his or her interest to equity capital should such transfer become attractive.

Convertible Bonds – Induced Conversion
Companies sometimes try to induce conversion of their bonds into stock. One way to induce conversion is through a “call” provision. When the specified call price is less than the conversion value of the bonds (the market value of the shares), calling the convertible bonds provides bondholders with incentive to convert. Bondholders will choose the shares rather than the lower call price.

Accounting for convertible debt issuance when the conversion feature is nondetachable
Differences of opinion exist as to whether convertible debt securities should be treated by an issuer solely as debt or whether part of the proceeds received from the issuance of debt should be recognized as equity capital. One view holds that the debt and the conversion privilege are inseparately connected, and, therefore, the debt and equity portions of a security should not be separately valued. A holder cannot sell part of the instrument and retain the other.

An alternative view holds that there are two distinct elements in these securities and that each should be recognized in the accounts: The portion of the issuance price attributable to the conversion privilege should be recorded as a credit to Paid-In Capital; The balance of the issuance price should be assigned to the debt.

Assume that 500 ten-year bonds, face value $1,000, are sold at 105, or a total issue price of $525,000 (500 x $1,000 x 1.05). The bonds contain a conversion privilege that provides for exchange of a $1,000 bond for 20 shares of stock, par value $1. The interest rate on the bonds is 8%. 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. The journal entries to record the issuance on the issuer’s books under the two approaches are as follows:

Convertible Bonds Convertible Bonds
Issued with Conversion Feature Nondetachable and Debt and Equity Not Separated Cash 525,000 Bonds Payable 500,000 Premium on Bonds Payable 25,000

Convertible Bonds Issued with Conversion Feature Nondetachable and Debt and Equity Separated Cash 525,000 Discount on Bonds Payable 20,000 Bonds Payable 500,000 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 Issued with Conversion Feature Nondetachable and Debt and Equity Separated Cash 525,000 Discount on Bonds Payable 20,000 Bonds Payable 500,000 Paid-In Capital Arising from Bond Conversion Feature 45,000 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

Accounting for Conversion
When conversion takes place, a special valuation question must be answered: Should the market value of the securities be used to compute a gain or loss on the transaction? Two approaches are possible to account for bond conversions: valuing the transaction at cost (book value of the bonds), or valuing at market (of the stocks or bonds, whichever is more reliable).

Accounting for Conversion (Book Value or Carrying Amount Method)
William, Inc. had outstanding 10%, $1,500,000 face amount convertible bonds maturing on December 31, 2012, on which interest is paid December 31 and June 30. After amortization through June 30, 2008, the unamortized balance in the bond premium account was $45,000. On that date, bonds with a face amount of $750,000 were converted into 30,000 shares of $20 par common stock. William incurred expenses of $15,000 in connection with the conversion. Compute the additional paid-in capital (“APIC”) which William should credit in it’s books (Record the conversion by the book value method).

Under the book value method, the common stock is recorded at the carrying amount of the converted bonds less any conversion expenses. No gain or loss recognized. $750,000 of the $1,500,000 of bonds are converted. The premium relating to these bonds is 750/1,500 of $45,000, or $22,500. Therefore, the carrying amount of the converted bonds is $772,500 ($750,000 + $22,500). The common stock must be recorded at this amount less the conversion expenses ($15,000), or $757,500.

Issuer’s Books Since the par value of the stock issued is $600,000 (30,000 x $20), AIPC is credited for $157,500 ($757,500 - $600,000). The journal entry is Dr. Bond payable $750,000 Dr. Premium on Bond Payable $22,500 Cr. Common stock $600,000 Cr. APIC $157,500 Cr. Cash $15,000

Accounting for Conversion (Market Value Method)
On September 1, 2008, after interest and amortization had been recorded, OK Co. converted $1,100,000 of its 10% convertible bonds into 55,000 shares of $5.5 par common stock. The carrying amount of the bonds on the date of conversion was $1,320,000, and the market value of OK’s common stock was $27.5 per share. Under the market value method, what amount should OK record as a credit to additional paid-in capital?

Under the market value method, a conversion of bonds to common stock is recorded at the market value of either the stock or the bonds, whichever is more reliable. In this case, the market value of OK’s stock is given. The common stock account is credited for the par value of the stock (55,000 x $5.5 = $302,500) and APIC is increased by market value minus par [55,000 x ($27.5 – $5.5) = $1,210,000]. Bonds payable and any related accounts are removed from the books.

Issuer’s Books OK sustained a loss on this redemption of $192,500, as shown in the entry recording the conversion. Dr. Loss on redemption $192,500 Dr. Bond Payable $1,100,000 Dr. Premium on Bond Payable $220,000 Cr. Common stock $302,500 Cr. APIC $1,210,000 $1,320,000 - $1,100,000

Investor’s Books Dr. Investment in OK Co Common stock $1,512,500 Cr. Bond Investment $1,320,000 Cr. Gain on conversion $192,500 (55,000 x $27.5) ($1,100,000 + $220,000)

OBJECTIVE 8 Discuss the use of the fair value option for financial assets and liabilities.

Fair Value Option In 2007, with SFAS No. 159 (“The Fair Value Option for Financial Assets and Financial Liabilities”), the FASB took a bold step toward increased use of fair value by allowing companies a fair value option for the reporting of financial assets and liabilities.  Fair value is defined as the “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

Fair Value Option Is not a forced liquidation or distress sale;
Orderly transaction A sale or transfer by the reporting entity that holds an asset or owes a liability that: Is not a forced liquidation or distress sale; Assumes exposure of the asset or liability to the market for a period prior to the measurement date to facilitate marketing activities that are usual and customary for transactions involving such assets or liabilities.

Fair Value Option Under the provisions of SFAS No. 159, a company has the option to report, at each balance sheet date, any or all of its financial assets and liabilities at their fair values on the balance sheet date. This is a very interesting accounting rule because a company can choose to report some financial assets and liabilities of a certain type at fair value while at the same time continuing to use another basis, such as historical cost, for other financial assets and liabilities of exactly the same type.

Fair Value Option If a company chooses the option to report at fair value, then it reports changes in fair value in its income statement. A company must make the election when the item originates and is not allowed to switch methods once a method is chosen.

Fair Value Option - Example
On July 1, HSA, Inc. issued $200,000 face value, 8% bonds, priced at $180,000 to yield an effective rate of 10% . HSA chose the fair value option for the bonds. Six months later, on December 31, HSA recorded the following interest entry: The December 31 entry reduced the unamortized discount to $19,000 and increased the book value of the liability by $1,000 to $181,000.

Fair Value Option - Example
On December 31, the fair value of the bonds was $183,000. Rather than increasing the bonds payable account itself, we increase it indirectly with a valuation allowance (or contra) account: The $2,000 credit to fair value adjustment will increase the bond credit balance to $183,000. HSA must recognize the unrealized holding loss in the income statement.

OBJECTIVE 9 Understand the conditions under which troubled debt restructuring occurs, and be able to account for troubled debt restructuring.

Troubled Debt Restructuring
Debt restructuring is a process that allows a private or public company – or a sovereign entity – facing cash flow problems and financial distress, to reduce and renegotiate its delinquent debts in order to improve or restore liquidity and rehabilitate so that it can continue its operations. In Statement No. 15, the FASB defined troubled debt restructuring as a situation in which “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.

Troubled debt may be restructured in one of two ways: Settled at time of restructuring. Continued with modified terms.

Accounting for Troubled Debt Restructuring

Troubled Debt Restructuring - Appendix
Settled at time of restructuring. Book value of the debt – Fair value of asset transferred Gain on restructuring Debtor reports ordinary gain or loss on adjustment to fair value of the asset transferred. Thus, a two-step process is used: (1) revalue the noncash asset to fair market value and (2) determine the restructuring gain.

Transfer of Assets in Full Settlement (Asset Swap)
A debtor that transfers assets, such as real estate or inventories, to a creditor to fully settle a payable will recognize two types of gains or losses: A gain or loss on disposal of the asset A gain or loss arising from the concession granted in the restructuring of the debt (continues)

The computation of these gains and/or losses is made as follows: Carrying value of assets being transferred Market value of asset being transferred Carrying value of debt being liquidated Difference represents gain or loss on disposal Difference represents gain on restructuring (continues)

An investor always recognizes a loss on the restructuring due to concessions granted. Carrying value of investment liquidated Market value of asset being transferred Difference represents loss on restructuring

Acer Corp. entered into a troubled debt restructuring agreement with National Bank. National agreed to accept land with a carrying amount of $75,000 and a fair value of $100,000 in exchange for a note with a carrying amount of $150,000. Disregarding income taxes, what amount should Acer report as a gain on restructuring the debt?

$150,000 (Carrying amount of the Note) - ($100,000) (Fair market value of land) $50,000 (Gain on restructuring the debt) Dr. Note payable $150,000 Cr. Land $100,000 Cr. Gain on restructuring the debt $50,000

Assume that Stanley Industries is behind in its interest payments on outstanding bonds of $500,000 and is threatened with bankruptcy proceedings. The carrying value of the bonds on Stanley’s books is $545,000 after deducting the unamortizd discount of $5,000 and adding unpaid interest of $50,000. To settle the debt, Stanley transfers long-term investments it holds in Worth common stock with a carrying value of $350,000 and a current market value of $400,000 to all investors on a pro rata basis.

Asset Swap Example Assume Realty, Inc. holds $40,000 face value of Stanley’s bonds. Because of the troubled financial condition of Stanley Industries, Realty Inc. has previously recognized as a loss a $5,000 decline in the value of the debt and is carrying the investment of $35,000 on its books plus interest receivable of $4,000. The entries for Stanley and Realty are on Slides and (continues)

Stanley Industries (Issuer)
Asset Swap Example Stanley Industries (Issuer) Interest Payable 50,000 Bonds Payable 500,000 Discount on Bonds Payable 5,000 Long-Term Investment—Worth Common Stock 350,000 Gain on Disposal of Worth Common Stock 50,000 Gain on Restructuring of Debt 145,000 Carrying value of Worth common $350,000 Market value of Worth common $400,000 Carrying value of debt liquidated $545,000 $50,000 gain on disposal $145,000 gain from restructuring (continues)

Asset Swap Example Realty Inc. (Investor) Long-Term Investments—Worth
Common Stock 32,000 Loss on Restructuring of Debt 7,000 Bond Investments—Stanley Industries 35,000 Interest Receivable 4,000 Percentage of debt held by Realty Inc.: $40,000/$500,000 = 8% Market value of long-term investment received in settlement of debt: 0.08 × $400,000 = $32,000

Grant of Equity Interest (Equity Swap)
Stanley Industries transfers 20,000 shares of common stock to satisfy the $500,000 face value of the bonds. The par value of the common stock is $1, and the market value at the date of the restructuring is $20 per share. Entries for both parties are shown on Slides and (continues)

Stanley Industries (Issuer)
Grant of Equity Interest (Equity Swap) Stanley Industries (Issuer) Interest Payable 50,000 Bonds Payable 500,000 Discount on Bonds Payable 5,000 Common Stock 20,000 Paid-In Capital in Excess of Par 380,000 Gain on Restructuring the Debt 145,000 20,000 x ($20 - $1) Market value of Worth common $400,000 Carrying value of debt liquidated $545,000 $145,000 gain from restructuring (continues)

Grant of Equity Interest (Equity Swap)
Realty Inc. (Investor) Long-Term Investments—Stanley Common Stock 32,000 Loss on Restructuring of Debt 7,000 Bond Investments—Stanley Industries 35,000 Interest Receivable 4,000 Percentage of debt held by Realty Inc.: $40,000/$500,000 = 8% Market value of long-term investment received in settlement of debt: 0.08 × $400,000 = $32,000

Continued with modified terms. Reduce or delay interest payments. Reduce or delay maturity payment. Accounting treatment depends on a comparison of total cash payments after restructuring with the book value of the original debt.

Continued with modified terms. The sum of the future payments (undiscounted) less than book value of debt. The sum of the future payments (undiscounted) exceeds book value of debt. Debtor reports difference as a gain. All cash payments are reductions in principal. (No interest expense in subsequent periods) New carrying value of the loan equals the undiscounted future payments. No gain reported. Compute new “implicit” interest rate. Record annual interest at new “implicit” interest rate.

Future payments (undiscounted) excess the book value of debt Assume the interest rate on the Stanley Industries bonds is reduced from 10% to 7%, the maturity date is extended from three to five years from the restructuring date, and the past interest due of $50,000 is forgiven. The total future payments to be made after this restructuring are as follows:

Future payments (undiscounted) excess the book value of debt Maturity value of bonds $500,000 Interest – 0.07 x $500,000 x 5 years ,000 Total payments to be made after restructuring $675,000 Because the $675,000 exceeds the carrying value of $545,000 [($500,000 - $5,000) + $50,000], no gain is recognized on the books of Stanley Industries at the time of restructuring.

Future payments (undiscounted) excess the book value of debt If the total future payments are greater than the carrying amount of the debt (principal plus unpaid interest), the excess is recognized as future interest expense using a newly computed implicit interest rate. The total carrying value of the restructured debt is not changed and no gain is recognized.

Future payments (undiscounted) excess the book value of debt To illustrate the computation of an implicit interest rate, the initial restructuring of Stanley Industries described above will be used. The question to be answered is what rate of interest will equate the total future payments of $675,000 to the present carrying value of $545,000. Interest is paid and compounded semiannually.

Future payments (undiscounted) excess the book value of debt Business Calculator Keystrokes PV = -$545,000 (this is the carrying value of the loan, enter as a negative number) PMT = $17,500 ($500,000 x 0.07 x 6/12) FV = $500,000 (amount to be paid in a lump sum at the loan maturity date) N = 10 (the total loan term is 5 years; interest payments are semiannual) I = ??? The solution returned by the calculator is 2.47% for each 6-month period.

Future payments (undiscounted) excess the book value of debt Using this rate, the recorded interest expense for the first six months would be $13,462, or 2.47% of $545,000. Because the actual cash payment for interest is $17,500, the carrying value of the debt will decline by $4,038 ($17,500 - $13,462). The interest expense for the second semiannual period will be less than for the first period because of the decrease in the carrying value of the debt [($545,000 - $4,038) x = $13,362 interest expense]. These computations are the same as those required in applying the effective-interest method amortization described earlier.

Future payments (undiscounted) excess the book value of debt The entries to record the restructuring on Stanley’s books and the first two interest payments would be as follows: Bond Payable……………………………….$500,000 Interest Payable………………………………$50,000 Discount on Bonds Payable…………………………....$5,000 Restructuring Debt…………………………………….$545,000

Future payments (undiscounted) excess the book value of debt The entries to record the restructuring on Stanley’s books and the first two interest payments would be as follows: Interest Expense……………………………$13,462 Restructured Debt……………………………$4,038 Cash……………………………………………………$17,500 Interest Expense……………………………$13,362 Restructured Debt………………………..….$4,138

Future payments (undiscounted) is less than the book value of debt However, if, in addition to the preceding changes, $200,000 of maturity value is forgiven, the future payments would be reduced as follows: Maturity value of bonds ($500,000 - $200,000) $300,000 Interest – 0.07 x $300,000 x 5 years ,000 Total payments to be made after restructuring $405,000

Future payments (undiscounted) is less than the book value of debt Now the carrying value exceeds the future payments by $140,000 ($545,000 – $405,000), and this gain would be recognize by Stanley as follows: Interest Payable………………………….$50,000 Bonds Payable………………….………$500,000 Discount on Bonds Payable………………………..$5,000 Restructured Debt………………………………..$405,000 Gain on Restructuring of Debt…………………..$140,000

Future payments (undiscounted) is less than the book value of debt In this case, the carrying value must be reduced to the cash to be realized and a gain recognized for the difference. All interest payments in the future are offset directly to the debt account. No interest expense will be recognized in the future because of the extreme concessions made in the restructuring.

Chapter 12 The End

Debt Financing (Part Two)

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