1. Classification of Debt and Measurement Issues

Transcription

1 Chapter 12 Debt Financing 1. Classification and measurement issues associated with debt 2. Accounting for short-term debt 3. Accounting for long-term debt (mortgages) 4. Understand the various types of bonds 5. Compute the price of a bond issue 6. Accounting for the issuance, interest, and redemption of bonds 12-1

2 1. Classification of Debt and Measurement Issues The FASB defined liabilities as probable future sacrifices of economic benefits arising from present obligations to a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. The FASB is currently considering a revision of this liability definition. 12-2

3 Definition of Liabilities A liability is a result of past transactions or events. Thus a liability is not recognized until incurred. This part of the definition excludes contractual obligations from an exchange of promises if performance by both parties is still in the future. Such contracts are referred to as executory contracts. 12-3

4 Classification of Liabilities For reporting purposes liabilities are usually classified as current or noncurrent. If a liability arises in the course of an entity s normal operating cycle, it is considered current if current assets are used to satisfy the obligation within one year or one operating cycle, whichever period is longer. 12-4

5 Classification of Liabilities The classification of a liability as current or noncurrent can impact significantly a company s ability to raise additional funds. When debt classified as noncurrent will mature within the next year, the liability should be reported as a current liability. The distinction between current and noncurrent is important because of the impact on a company s current ratio. 12-5

6 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 The measurement of liabilities always involves some uncertainty because a liability, by definition, involves a future outflow of resources. 12-6

7 2. Accounting for Short-Term Debt The term account payable usually refers to the amount due for the purchase of materials by a manufacturing company or the purchase of merchandise by a wholesaler or retailer. Accounts payable are not recorded when purchase orders are placed but instead when legal title to the goods passes to the buyer. 12-7

8 Short-Term Debt In most cases, debt is evidenced by a promissory note, which is a formal written promise to pay a sum of money in the future, and is usually reflected on the debtor s books as Notes Payable. Notes issued to trade creditors for the purchase of goods or services are called trade notes payable. 12-8

9 Short-Term Debt Nontrade notes payable include notes issued to banks or to officers and stockholders for loans to the company. If a note has no stated rate of interest, or if the stated rate is unreasonable, then the face value of the note would be discounted to the present value to reflect the effective rate of interest implicit in the note. 12-9

10 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. This applies to the currently maturing portion of a long-term debt and to all other short-term obligations except those arising in the normal course of operations that are due in customary terms

11 Short-Term Obligations Expected to be Refinanced According to FASB ASC Topic 470 (Debt), both of the following conditions must be met before a short-term obligation can 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

12 Short-Term Obligations Expected to be Refinanced Concerning the second point, the ability to refinance may be demonstrated by either of the following: a) Actually refinancing the obligation during the period between the balance sheet date and the date the statements are issued. b) Reaching a firm agreement that clearly provides for refinancing on a long-term basis

13 Short-Term Obligations Expected to be Refinanced If a $400,000 long-term note is issued to partially refinance $750,000 of short-term obligations, only $400,000 of the shortterm debt can be excluded from current liabilities. If the obligation is paid prior to the actual refinancing but before the issuance of the financial statements, the obligation should be included in current liabilities

14 Short-Term Obligations Expected to be Refinanced According to IAS 1, for the obligation to be classified as long term the refinancing must take place by the balance sheet date, not the later date when the financial statements are finalized. Under the international standard postbalance-sheet date events are NOT considered when determining whether a refinanceable obligation is reported as current or noncurrent

15 Lines of Credit A line of credit is a negotiated arrangement with a lender in which the terms are agreed to prior to the need for borrowing. Please read the example in the textbook on page

16 Lines of Credit The line of credit itself is not a liability. However, once the line of credit is used to borrow money, the company has a formal liability that will be reported as either a current or a long-term liability. Maintaining a line of credit is not costless. Banks typically charge a small amount, a fraction of 1% per year

17 3. Accounting for Long-Term Debt (Mortgages) A mortgage is 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. Mortgages are generally payable in equal installments; a portion of each payment represents interest on the unpaid mortgage balance

18 Present Value of Long-Term Debt On January 1, 2013, Crystal Michae purchases a house for $250,000 and makes a down payment of $50,000. The remainder is financed with a 12%, 30-year mortgage payable at a rate of $2,057 monthly. The interest rate is compounded monthly, and the first payment is due on February 1,

19 Present Value of Long-Term Debt As the mortgage payments are made, each monthly payment of $2,057 must be divided between principal and interest. On February 1, the interest is $2,000 ($200,000 1/ ), or 1% a month, and the balance of $57 is applied to the principal. In March, the interest is $1,999, 1% of $199,943 ($200,000 $57), and the pattern continues monthly. This loan (or mortgage) amortization is shown in Slide

20 12-20

21 Present Value of Long-Term Debt If Crystal were to maintain a set of personal financial records, she would make the following journal entry on February 1: Interest Expense 2,000 Mortgage Payable 57 Cash 2,057 A secured loan is similar to a mortgage in that it is a loan back by certain assets as collateral

22 4. Various Types of Bonds The long-term financing of a corporation is accomplished either thorough the issuance of long-term debt instruments, usually bonds or notes, or through the sale of additional stock. The issuance of bonds or notes instead of stock may be preferred by management and stockholders for the reasons shown on Slide

23 Financing with Bonds 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 expected dividends

24 Understand the Bonds Conceptually, bonds and long-term notes are similar types of debt instruments. The trust indenture (the bond contract) associated with bonds generally provides more extensive detail than the contract terms of a note, often including restrictions on the payment of dividends or incurrence of additional debt

25 Accounting Issues of 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 retirement of bonds either at maturity or prior to the maturity date 12-25

26 Nature of Bonds Bond certificates, commonly referred to simply as bonds, are frequently issued in denominations of $1,000. The amount printed on the bond is the face value, par value, or maturity value of the bond. The group contract between the corporation and the bondholders is known as the bond indenture

27 Issuers of Bonds Bonds and similar debt instruments are issued by private corporations, the U.S. government, state, county, and local governments, school districts, and government-sponsored organizations. Debt securities issued by state, county, and local governments and their agencies are collectively referred to as municipal debt

28 Types of Bonds Bonds that mature on a single date are called term bonds. Bonds that mature in installments are referred to as serial bonds. Secured bonds offer protection to investors by providing some form of security, such as a mortgage on real estate or the pledge of other collateral

29 Types of Bonds A collateral trust bond is usually secured by stocks and bonds of other corporations owned by the issuing company. Unsecured bonds (frequently termed debenture bonds) are not protected by the pledge of any specific assets. Registered bonds call for the registry of the owner s name on the corporation books

30 Types of Bonds Bearer bonds, or coupon bonds, are not recorded in the name of the owner; title to these bonds passes with delivery. Zero-interest bonds or deep-discount bonds do not bear interest. Instead, these securities sell at a significant discount. High-risk, high-yield bonds issued by companies that are heavily in debt or otherwise in weak financial condition are referred to as junk bonds

31 Types of Bonds Junk bonds are issued in at least three types of circumstances. 1. They are issued by companies that once had high credit ratings but have fallen on hard times. 2. They are issued by emerging growth companies. 3. They are issued by companies undergoing restructuring, often in conjunction with a leverage buyout

32 Types of Bonds Convertible bonds provide for their conversion into some other security at the option of the bondholder. Commodity-backed bonds may be redeemable in terms of commodities, such as oil or precious metals. Bond indentures frequently give the issuing company the right to call and retire the bonds prior to maturity. Such bonds are termed callable bonds

33 Types of Bonds Mortgage-backed bonds, in many cases, are just a special form of secured bonds. The underlying collateral for these bonds is the collection of mortgages owned by the issuing entity

34 5. Pricing Bonds The amount of interest paid on bonds is a specified percentage of the face value. This percentage is termed the stated rate, or contract rate. If the stated rate exceeds the market rate, the bonds will sell at a bond premium. If the stated rate is less than the market, the bonds will sell at a bond discount. The actual return rate on a bond is known as the market, yield, or effective interest rate

35 Market Price of Bonds Yield 8% Premium Bond Stated Interest Rate 10% 10% Face Value 12% Discount 12-35

36 Market Price of Bonds Ten-year, 8% bonds of $100,000 are to be sold on the bond issue date. The effective interest rate for bonds of similar quality and maturity is 10%, compounded semiannually. The computation of the market price of the bonds may be divided into two parts (as shown in Slide 12-37)

37 Market Price of Bonds Part 1 Present value of principal (maturity value): Maturity value of bonds after 10 years, or 20 semiannual periods $100,000 Effective interest rate: 10% per year, or 5% per semiannual period $37,689 Part 2 Present value of twenty interest payments: Semiannual payment, 4% of $100,000 $4,000 Effective interest rate: 10% per year, or 5% per semiannual period 49,849 Total present value (market price) of bond $87,

38 6. Accounting for Bonds Bonds may be sold directly to investors by the issuer or they may be sold in the open market through security exchanges or through investment bankers. Bonds issued or acquired in exchange for noncash assets or services are recorded at the fair value of the bonds unless the value of the exchanged assets or services is more clearly determinable

39 Issuance of Bonds Each of the bond situations in the following slides will be illustrated using the following data: $100,000, 8%, 10-year bonds are issued; semiannual interest of $4,000 ($100, /12) is payable on January 1 and July

40 Bonds Issued at Par on Interest Date Issuer s Books Jan. 1 Cash 100,000 Bonds Payable 100,000 July 1 Interest Expense 4,000 Cash 4,000 Dec. 31 Interest Expense 4,000 Interest Payable 4,

41 Bonds Issued at Par on Interest Date Investor s Books Jan. 1 Bond Investment 100,000 Cash 100,000 July 1 Cash 4,000 Interest Revenue 4,000 Dec. 31 Interest Receivable 4,000 Interest Revenue 4,

42 Bonds Issued at Discount on Interest Date The bonds were issued on January 1 but the effective rate of interest was 10%, requiring recognition of a discount of $12,462 ($100,000 $87,538)

43 Bonds Issued at Discount on Interest Date Issuer s Books Jan. 1 Cash 87,538 Discount on Bonds Payable 12,462 Bonds Payable 100,000 Investor s Books Jan. 1 Bond Investment 87,538 Cash 87,

44 Bonds Issued at Premium on Interest Date The bonds were issued on January 1 but the effective rate of interest was 7%, requiring recognition of a premium of $7,

45 Bonds Issued at Premium on Interest Date Issuer s Books Jan. 1 Cash 107,106 Premium on Bonds Payable 7,106 Bonds Payable 100,000 Investor s Books Jan. 1 Bond Investment 107,106 Cash 107,

46 Bonds Issued at Par between Interest Date Issuer s Books Mar. 1 Cash 101,333 Bonds Payable 100,000 Interest Payable 1,333 ($100, /12) July 1 Interest Expense 2,667 Interest Payable 1,333 Cash 4,000 ($100, /12) 12-46

47 Bonds Issued at Par between Interest Date Investor s Books Mar. 1 Bond Investment 100,000 Interest Receivable 1,333 Cash 101,333 July 1 Cash 4,000 Interest Receivable 1,333 Interest Revenue 2,

48 Bond Issuance Costs The issuance of bonds normally involves bond issuance costs to the issuer for legal services, printing and engraving, taxes, and underwriting. In Statement of Financial Accounting Concepts No.3, the FASB stated that deferred charges such as bond issuance costs fail to meet the definition of assets

49 Accounting for Bond Interest 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. Because the initial premium or discount, the periodic interest payments made over the bond s life by the issuer do not represent the total interest expense involved, an amortization adjustment is made

50 Straight-Line Method The straight-line method provides for the recognition of an equal amount of premium or discount amortization each period. A 10-year, 10% bond issue with a maturity value of $200,000 was sold on the issuance date at 103, the $6,000 premium would be amortized evenly over 120 months until maturity

51 Straight-Line Method To illustrate the accounting for bond interest using straight-line amortization, consider the earlier example of the $100,000, 8%, 10-year bonds issued on January 1. When sold at a $12,462 discount, the appropriate entries to record interest on July 1 and December 31 are shown on Slides and

52 Straight-Line Method Issuer s Books July 1 Interest Expense 4,623 Discount on Bonds Payable 623 Cash 4,000 $12,462/120 6 mo. = $623 (rounded) Dec. 31 Interest Expense 4,623 Discount on Bonds Payable 623 Interest Payable 4,

53 Straight-Line Method Investor s Books July 1 Cash 4,000 Bond Investment 623 Interest Revenue 4,623 Dec. 31 Interest Receivable 4,000 Bond Investment 623 Interest Revenue 4,

54 Straight-Line Method Assume the bonds were sold for $107,106. Issuer s Books July 1 Interest Expense 3,645 Premium on Bonds Payable 355 Cash 4,000 $7,106/120 6 mo. = $355 (rounded) Reflects effective interest of 7% Dec. 31 Interest Expense 3,645 Premium on Bonds Payable 355 Interest Payable 4,

55 Straight-Line Method Investor s Books July 1 Cash 4,000 Bond Investment 355 Interest Revenue 3,645 Dec. 31 Interest Receivable 4,000 Bond Investment 355 Interest Revenue 3,

56 Effective-Interest Method The effective-interest method of amortization uses a uniform interest rate based on a changing loan balance and provides for an increasing premium or discount amortization each period. In order to use this method, the effectiveinterest rate for the bonds must be known

57 Effective-Interest Method 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, ) $ 4,377 Interest payment based on face value and stated rate ($100, ) 4,000 Discount amortization $

58 Effective-Interest Method Assume the $100,000, 8%, 10-year bonds is sold for $107,106, based on an effective interest rate of 7%. The premium amortization for the first 6-month period would be computed as follows: 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, ) 4,000 Interest amount based on carrying value and effective rate ($107, ) 3,749 Premium amortization $

59 Effective-Interest Method The second 6-month period would be computed as follows: Bond balance (carrying value) at beginning of second period ($107,106 $251) $106,855 Effective rate per semiannual period 3.5% Stated rate per semiannual period 4% Interest payment based on face value and stated rate ($100, ) 4,000 Interest amount based on carrying value and effective rate ($106,855 x.035) 3,740 Premium amortization $

60 Interest Payment 12-60

61 Retirement of Bonds at Maturity If the bonds are held to maturity, the discount or premium has been eliminated over the life of the bond. The entry for retiring the bond is straightforward. Assume a $100,000 bond matures on July 1. Issuer s Books July 1 Bonds Payable 100,000 Cash 100,

62 Retirement of Bonds at Maturity Investor s Books July 1 Cash 100,000 Bond Investment 100,000 There is no gain or loss on retirement because the carrying value is equal to the maturity value. Any bonds not presented for payment at their maturity date should be moved to Matured Bonds Payable

63 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

64 Redemption by Purchase of Bonds in the Market Triad, Inc. s $100,000, 8% bonds are not held to maturity. They are redeemed on February 1, 2013, at 97. 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, 2/1/13 $97,700 Redemption Issuer s price Books 97,000 Gain on bond redemption $ 700 Feb. 1 Bonds Payable 100,000 Discount on Bonds Pay. 2,300 Cash 97,000 Gain on Bond Redemption

65 Redemption by Purchase of Bonds in the Market Investor s Books Feb. 1 Cash 97,000 Loss on Sale of Bonds 700 Bond Investment Triad Inc. 97,700 Before the issuance of FASB Statement No. 125 in 1996, early extinguishment of debt could also be accomplished through insubstance defeasance

66 Redemption by Exercise of Call Provision A call provision gives the issuer the option of retiring bonds prior to maturity. Frequently, the call must be made on an interest payment date. When bonds are called, the difference between the amount paid and the bond carrying value is reported as a gain or a loss on both the issuer s and investor s books

67 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

68 Convertible Bonds Issued with Conversion Feature Nondetachable 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. 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. Cash 525,000 Bonds Payable 500,000 Premium on Bonds Payable 25,

69 Convertible Bonds Issued with Conversion Feature Nondetachable 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,

70 Convertible Bonds Issued with Conversion Feature Nondetachable 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, ) 480,000 Amount applicable to conversion $ 45,

71 Convertible Bonds Issued with Conversion Feature Nondetachable The detachable warrants allow the holder to buy shares of stock at a set price. The FASB has expressed a preliminary preference for ultimately requiring the process of all convertible debt issues to be separated into their debt and equity components

72 Accounting for Conversion Debt According to IAS 32 IAS 32 does not differentiate between convertible debt with nondetachable and detachable conversion features. IAS 32 states that for all convertible debt issues, the issuance proceeds should be allocated between debt and equity

73 Accounting for Conversion HiTec Co. offers bondholders 40 shares of HiTec Co. common stock, $1 par, in exchange for each $1,000, 8% bond held. An investor exchanges bonds of $10,000 (carrying value as of the conversion date, $9,850) for 400 shares of common stock having a market value at the time of the exchange of $26 per share. The exchange took place on an interest payment date after interest had been paid and properly recorded

74 Accounting for Conversion When the bondholders exercise their conversion privileges, the value identified with the obligation is transferred to the common stock that replaces it. The conversion is recorded as follows: Bonds Payable 10,000 Common Stock, $1 par 400 Paid-in Capital in Excess of Par 9,450 Discount on Bonds Payable

75 Accounting for Conversion Assume that, as of the issuance date, the fair value of 40 shares of HiTec Co. common stock was substantially below the issuance price of the convertible bonds. The subsequent unexpected conversion is reported as follows: Bonds Payable 10,000 Loss on Conversion of Bonds 550 Common Stock, $1 par 400 Paid-in Capital in Excess of Par 10,000 Discount on Bonds Payable

76 Accounting for Conversion Bonds Payable 10,000 Loss on Conversion of Bonds 550 Common Stock, $1 par 400 Paid-in Capital in Excess of Par 10,000 Discount on Bonds Payable 150 Market value of stock issued (400 shares at $26) $10,400 Face value of bonds payable $10,000 Less unamortized discount 150 9,850 Loss to company on conversion of bonds $

77 Accounting for Conversion Assume the carrying value is the same on the books of the investor as it is on the books of the issuer. Investor s Books Investment in HiTec Co. Common Stock 10,400 Bond Investment HiTec Co. 9,850 Gain on Conversion of HiTec Co. Bonds 550 Market value of stock issued (400 shares at $26) $10,400 Face value of bonds payable $10,000 Less unamortized discount 150 9,850 Loss to company on conversion of bonds $

78 Bond Refinancing Cash for the retirement of a bond is frequently raised through the sale of a new issue and referred to as bond refinancing. Bond refinancing may take place when an issue matures, or bonds may be refinanced prior to their maturity when the interest rate has dropped and the interest savings on a new issue will more than offset the cost of retiring the old issue

79 Bond Refinancing A corporation has outstanding $1,000,000 of 12% bonds callable at 102 with a remaining 10-year term, and similar 10-year bonds can be marketed currently at an interest rate of only 10%. When refinancing takes place before the maturity date of the old issue, the call premium and unamortized discount and issue costs of the original bonds are considered in computing the gain or loss