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Debt Financing
Chapter 12
Intermediate Accounting 16E
Prepared by: Sarita Sheth | Santa Monica College
COPYRIGHT 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

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.

Time Line of Business Issues Involved with Long-Term Debt

Notes

Mortgage

Bond Payable Payable

+/ISSUE the debt PAY ACCOUNT interest for the specific aspects of the type of debt RETIRE the debt

CHOOSE the method of financing

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 LiabilitiesPaid within one year or the operating cycle, whichever is longer. Noncurrent Liabilities- Not paid within one year or the operating cycle, whichever is longer.

Stop and Think

Look at Exhibit 12-3. The 2004 current ratio of McDonalds is only 0.81. How will McDonalds most likely meet its current obligations as they come due?

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 long1. Management not intend to term basis shouldmust be reported as a refinance the obligation on a longcurrent liability term basis. FASB Statement No. 6 requires that both of 2. Management must the following conditions be demonstrate an ability to met before a short-term obligation refinance the obligation. may be properly excluded from the current liability classification:

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 entry to record a date. Example journal balance sheet mortgage payment: For a long-term obligation, this Interest Expense 2,000 amount is the present value of the future paymentsPayable made. Mortgage to be 57 The division of these payments into Cash 2,057 interest and principal components is a process called loan amortization.

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 companys 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.

Market Price of Bonds

Yield

8%
Bond Stated Interest Rate 10%

Premium

10%

Face Value

12%

Discount

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 $100,000 4,000 Effective interest rate, 10% per year (5% per semiannual period) $49,849
Total present value (market price) of bond $87,538

Stop and Think

In computing the market price for bonds, what is the only thing for which the stated rate of interest is used?

Issuance of Bonds
Issuers Books
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

Investors Books
100,000 100,000 4,000 4,000

Bonds Cash 4,000

Cash 4,000 Interest Revenue Cash 4,000 Interest Revenue

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).
Issuers Books Jan. 1 Cash Discount on Bonds Payable Bonds Payable 87,538 12,462 100,000

Investors Books
Jan. 1 Bond Investment Cash 87,538 87,538

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).
Issuers Books
Jan. 1 Cash 107,106 Prem. on Bonds Payable 7,106 Bonds Payable 100,000 Investors Books Jan. 1 Bond Investment Cash 107,106 107,106

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.
Issuers Books

Mar. 1

Bond Investment 101,333 Bonds Payable 100,000 $100,000 x 0.08 x 2/12 Interest Payable 1,333 Interest Expense Interest Payable Cash 2,667 1,333
4,000

July 1

$100,000 x 0.08 x 4/12

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.
Investors Books
Mar. 1 Bond Investment Interest Receivable Cash 100,000 1,333 101,333

July 1

Cash Interest Receivable Interest Revenue

4,000
1,333 2,667

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

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 issuers books and the investors books.
Issuers Books July 1 Interest Expense 4,623 Disc on Bonds 6 months $12,462/120 xPayable Cash Interest Expense 4,623 Disc on Bonds Payable Cash 623 4,000 623 4,000

Dec 31

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 issuers books and the investors books.

Investors Books
July 1 Cash Bond Investment Interest Revenue Interest Receivable Bond Investment Interest Revenue 4,000 623 4,623 4,000 623 4,623

Dec 31

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 issuers books and the investors books.
Issuers Books July 1 Interest Expense $7,106/120 on6Bonds Payable Premium x months Cash Interest Expense Premium on Bonds Payable Cash 3,645 355 4,000 3,645 355

Dec 31

4,000

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 issuers books and the investors books.

Investors Books
July 1 Cash Bond Investment Interest Revenue 4,000 355 3,645 4,000 355 4,623

Dec 31 Interest Receivable Bond Investment Interest Revenue

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 One

Effective rate for semiannual period Stated rate per semiannual period Interest amount ($87,538 x 0.05) Interest payment ($100,000 x 0.04) Discount amortization

5% 4% $4,377 4,000 $ 377

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 period Stated rate per semiannual period Interest amount ($87,915 x 0.05) Interest payment ($100,000 x 0.04) Discount amortization $87,538 + $377

5% 4% $4,396 4,000 $ 396

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%.
Period One

Effective rate for semiannual period Stated rate per semiannual period Interest payment ($100,00 x 0.04) Interest amount ($107,106 x 0.35) Discount amortization

3.5 % 4% $4,000 3,749 $ 251

Effective Interest Method Discount

Consider again the $100,000, 8%, 10-year bonds sold for $107,106. The effective rate for the bonds is 7%.
Period Two

Effective rate for semiannual period Stated rate per semiannual period Interest payment ($100,00 x 0.04) Interest amount ($106,855 x 0.35) Discount amortization
$107,106 - $251

3.5 % 4% $4,000 3,740 $ 260

Effective-Interest Method Premium

A
B

D
(D C) Prem.

E
($100,000+ D)

($100,000 x 04) (E x 0.035) (A B) # Payment Int. Exp. Amort.

Prem.

Unamort.
$7,106

Bond

Book

$107,106

Effective-Interest Method Premium

A
B

D
(D C) Prem.

E
($100,000+ D)

($100,000 x 04) (E x 0.035) (A B) # Payment Int. Exp. $3,749 Amort. $251

Prem.

Unamort.
$7,106 6,855

Bond

Book

1 $4,000

$107,106 106,855

$107,106 x 0.035

Effective-Interest Method Premium

A
B

D
(D C) Prem.

E
($100,000+ D)

($100,000 x 04) (E x 0.035) (A B) # Payment Int. Exp. $3,749 $3,740 Amort. $251 $260

Prem.

Unamort.
$7,106 6,855 6,595

Bond

Book

1 $4,000 2 $4,000

$107,106 106,855 106,595

$106,855 x 0.035

Effective-Interest Method Premium

A
B

D
(D C) Prem.

E
($100,000+ D)

($100,000 x 04) (E x 0.035) (A B) # 1 2 3 4 5 Payment Int. Exp. $4,000 $4,000 $4,000 $4,000 $4,000 $3,749 $3,740 $3,731 $3,721 $3,712 Amort. $251 $260 $269 $279 $288

Prem.

Unamort.
$7,106 6,855 6,595 6,326 6,047 5,759

Bond

Book

$107,106 106,855 106,595 106,326 106,047 105,759

Straight-Line vs. EffectiveInterest Amortization Methods

Insert exhibit 12-7

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?

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.
Carry value of bonds, 1/1/02 Issuers Books Investors Books Redemption price Feb. 1 Bonds Payable bond redemption 100,000 Feb. 1 Cash Gain on 97,000 $97,700 97,000 $ 700

Discount on Bonds Loss on Sale ofBonds Pay. Cash Bond InvestmentExtraordinary Gain on Triad Inc. Bond Redemption

700

2,300 97,000

97,700 700

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

Cash 525,000 Par value Bonds Payable 500,000 Selling price of bond without Premium on Bonds Payable 25,000
conversion feature

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

Accounting for Conversion

Investors Books Nov. 1 Investment in HiTec Co. Common Stock 10,400 Investment in HiTec Co. Bonds Gain on Conversion of HiTec Co. Bonds

9,850

550

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.

Accounting for Conversion

Issuers Books
Nov. 1 Bonds Payable 10,000 Loss on Conversion of Bonds 550 Common Stock, $1 par 400 Paid-In Capital in Excess of Par Value 10,000 Discount on Bonds Payable 150

Off-Balance-Sheet Financing
Off-Balance-Sheet-Financing- procedures to avoid disclosing all debt on the balance sheet in order to make the companys 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 Firms 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 companys overall ability to repay its debts. Formula: total liabilities total assets. Times Interest Earned- shows a companys 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 debtors financial difficulties grants a concession to the debtor that it would not otherwise consider. (SFAS 15.2)

Asset Swap Debtor

FMV Asset < debt? Yes Remove debt and asset from books. No Not a troubled debt restructure.

Restructuring Gain = Debt FMV Asset

Disposal Gain/Loss = FMV Asset Book Value of Asset

Equity Swap Debtor

FMV Equity < debt? Yes No Not a troubled debt restructure.

Remove debt and asset from books and record new equity. Restructuring Gain =Debt FMV Equity

Asset or Equity Swap Creditor

FMV Asset > loan? Yes

Not a troubled debt restructure.

No

Remove loan from books and record asset at FMV.

Restructure Loss = Loan FMV Asset

Modification of Terms Debtor

Total future payments < debt book value?

No

Yes

Reclassify the debt and amortize using effective interest method. Interest rate is the implicit rate.

Recognize gain on restructuring. Write-down debt to sum of future cash flows. Record all future payments as principal payments.