intermediate accounting,17e stice | stice | skousen 2010 cengage learning powerpoint presented by:...

Intermediate Accounting,17E

Stice | Stice | Skousen

© 2010 Cengage Learning

PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University

Debt Financing

12-2

Definition of LiabilitiesThe 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.”

12-3

Classification of Liabilities• 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

• When debt that has been 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.

Classification of Liabilities

12-5

Measurement of LiabilitiesFor measurement purposes, liabilities can be divided into three categories:1. Liabilities that are definite in

amount2. Estimated liabilities3. Contingent liabilities

12-6

Short-Term Operating Liabilities

• 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.

• No recognition of interest is required.

12-7

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.

• Notes issued to trade creditors for the purchase of goods or services are called trade notes payable.

• Nontrade notes payable include notes issued to banks or to officers and stockholders.

12-8

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.

• The FASB issued Statement No. 6, which contains the authoritative guidelines for classifying short-term obligations expected to be refinanced.

(continues)

12-9

FASB Statement No. 6

(continues)

According to Statement No. 6, 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.

12-10

FASB Statement No. 6Concerning the second point, the ability to refinance may be demonstrated by either of the following:1. Actually refinancing the obligation

during the period between the balance sheet date and the date the statements are issued.

2. Reaching a firm agreement that clearly provides for refinancing on a long-term basis.

12-11

Lines of CreditA line of credit is a negotiated arrangement with a lender in which the terms are agreed to prior to the need for borrowing.

12-12

Present Value of Long-Term Debt

• A mortgage is a loan backed by an asset that serves as collateral for the loan.

• On January 21, 2011, 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.

(continues)

12-13

Present Value of Long-Term Debt

As the $2,057 monthly mortgage payment is made, the interest portion must be recognized. On February 1, the interest is $2,000 ($200,000 × 1/12 × 0.12). The balance, $57, is applied to the principal. On March 1, the interest is $1,999 [$200,000 – $57 (1/12 × 0.12)]. This pattern continues throughout the mortgage.

12-14

Financing with BondsThe issuance of bonds or notes instead of stock may be preferred by management and stockholders for the following reasons:• Present owners remain in control of the

corporation.• Interest is a deductible expense in arriving at

taxable income; dividends are not.• Current market rates of interest may be

favorable relative to stock market prices.• The charge against earnings for interest may be

less than the amount of expected dividends.

12-15

Accounting for 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.

12-16

Accounting for BondsThere are three main considerations in accounting for bonds:1. Recording the issuance or purchase2. Recognizing the applicable interest

during the life of the bonds3. Accounting for retirement of bonds

either at maturity or prior to the maturity date

12-17

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.

12-18

• Debt securities issued by state, county, and local governments and their agencies are collectively referred to as municipal debt.

• Bonds that mature on a single date are called term bonds.

• When bonds mature in installments, they are referred to as serial bonds.

Nature of Bonds

12-19

• 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.

• 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.

Nature of Bonds

12-20

• Registered bonds call for the registry of the owner’s name on the corporation books.

• 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.

Nature of Bonds

12-21

• High-risk, high-yield bonds issued by companies that are heavily in debt or otherwise in a weak financial condition are often called junk bonds.

• Convertible bonds provide for their conversion into some other security at the option of the bondholder.

• Commodity-backed bonds or asset- linked bonds are redeemable in terms of commodities.

Nature of Bonds

12-22

• Bond indentures frequently give the issuing company the right to call and retire the bonds prior to maturity. Such bonds are termed callable bonds.

Nature of Bonds

12-23

Market Price of 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 discount. If the market rate exceeds the stated rate, the bonds will sell at a premium.

• The actual return rate on a bond is known as the market, yield, or effective interest rate.

12-24

BondBondStatedStatedInterestInterest

RateRate10%10%

8%8% PremiumPremium

1010% FaceFace ValueValue

12%12% DiscountDiscount

Yield

Market Price of Bonds

12-25

Market Price of BondsTen-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 12-26).

12-26

Part 1 Present value of principal (maturity value):Maturity value of bonds after 10 years,

or 20 semiannual periods $100,000Effective interest rate: 10% per year,

or 5% per semiannual period $37,689Part 2 Present value of twenty interest

payments:Semiannual payment, 4% of $100,000 $4,000Effective interest rate: 10% per year,

or 5% per semiannual period 49,849Total present value (market price) of bond $87,538

Market Price of Bonds

12-27

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 ($100,000 × 0.08 × 6/12) is payable on January 1 and July 1.

12-28

Bonds Issued at Par on Interest Date

Jan. 1 Cash 100,000Bonds Payable 100,000

Issuer’s BooksIssuer’s Books

July 1 Interest Expense 4,000Cash 4,000

Dec. 31 Interest Expense 4,000Interest Payable 4,000

(continues)

12-29

Bonds Issued at Par on Interest Date

Jan. 1 Bond Investment 100,000Cash 100,000

Investor’s BooksInvestor’s Books

July 1 Cash 4,000Interest Revenue 4,000

Dec. 31 Interest Receivable 4,000Interest Revenue 4,000

12-30

Bonds Issued at Discount on Interest Date

Jan. 1 Cash 87,538Discount on Bonds Payable 12,462

Bonds Payable 100,000




12-31

Bonds Issued at Premium on Interest Date

Jan. 1 Cash 107,106Premium on Bonds Payable 7,106Bonds Payable 100,000




12-32

Bonds Issued at Par between Interest Date

Jan. 1 Cash 101,333Bonds Payable 100,000Interest Payable 1,333


July 1 Interest Expense 2,667Interest Payable 1,333

Cash 4,000

(continues)

($100,000 × 0.08 × 2/12)

($100,000 × 0.08 × 4/12)

12-33

Bonds Issued at Par between Interest Date

Jan. 1 Bond Investment 100,000Interest Receivable 1,333

Cash 101,333


July 1 Cash 4,000Interest Receivable 1,333Interest Revenue 2,667

12-34

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.

12-35

Accounting for Bond Interest• When bonds are issued at a

premium or discount, an adjustment is made to periodic interest expense to reflect the effective interest rate incurred on the bonds.

• This periodic adjustment is referred to as bond premium or discount amortization.

12-36

Straight-Line Method• The straight-line method

provides for the recognition of an equal amount of premium or discount amortization each period.

• $100,000, 8%, 10-year bonds were issued on January 1 at a $12,462 discount. Interest is payable on July 1 and December 31.

(continues)

12-37

Straight-Line Method

July 1 Interest Expense 4,623Discount on Bonds Payable 623Cash 4,000


Dec. 31 Interest Expense 4,623Discount on Bonds Payable 623Interest Payable 4,000

(continues)

$12,462/120 × 6 mo. = $623 (rounded)

12-38


July 1 Cash 4,000Bond Investment 623

Interest Revenue 4,623


Dec. 31 Interest Receivable 4,000Bond Investment 623

Interest Revenue 4,623

(continues)

12-39


July 1 Interest Expense 3,645Premium on Bonds Payable 355

Cash 4,000


Dec. 31 Interest Expense 3,645Premium on Bonds Payable 355

Interest Payable 4,000

(continues)

$7,106/120 × 6 mo. = $355 (rounded)

Assume the bonds were sold for $107,106.Reflects effective interest of 7%

12-40


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


Dec. 31 Interest Receivable 4,000Bond Investment 355Interest Revenue 3,645

12-41

Effective-Interest Method• The effective-interest method

of amortization provides for a uniform interest rate based on a changing loan balance.

• Provides for an increasing premium or discount amortization each period.

12-42

Effective-Interest MethodConsider 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 $87,538Effective rate per semiannual period 5%Stated rate per semiannual period 4%Interest amount based on carrying value and effective

rate ($87,538 × 0.05) $ 4,377Interest payment based on face value and stated

rate ($100,00 × 0.040) 4,000Discount amortization $ 377

12-43

Effective-Interest MethodAssume 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 $107,106Effective 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) 4,000Interest amount based on carrying value and effective

rate ($107,106 × .035) 3,749Premium amortization $ 251

12-44

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.

12-45

Redemption by Purchase of Bonds in the Market


Feb. 1 Bonds Payable 100,000Discount on Bonds Pay. 2,300Cash 97,000Gain on Bond Redemption 700

Triad, Inc.’s $100,000, 8% bonds are not held to maturity. They are redeemed on February 1, 2011, at 97. The carrying value of the bonds is $97,700 as of this date. Interest payment dates are January 31 and July 31.

(continues)

Carrying value of bonds, 2/1/11 $97,700Redemption price 97,000Gain on bond redemption $ 700

12-46

Redemption by Purchase of Bonds in the Market


Feb. 1 Cash 97,000Loss on Sale of Bonds 700

Bond Investment— Triad Inc. 97,700

12-47

Convertible Bonds• Convertible debt securities usually

have the following features:1. An interest rate lower than the issuer

could establish for nonconvertible debt2. 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.

12-48

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 BondsIssued with Conversion Feature Nondetachable Issued with Conversion Feature Nondetachable

and Debt and Equity Not Separatedand Debt and Equity Not Separated

Cash 525,000Bonds Payable 500,000Premium on Bonds Payable 25,000

12-49

Convertible Bonds

Cash 525,000Discount on Bonds Payable 20,000

Bonds Payable 500,000Paid-In Capital Arising from Bond Conversion Feature 45,000

Issued with Conversion Feature Nondetachable Issued with Conversion Feature Nondetachable and Debt and Equity Separatedand Debt and Equity Separated

Par value of bonds (500 × $1,000) $500,000Selling price of bonds without conversion feature ($500,000 x 0.96) 480,000Discount on bonds w/o conversion $ 20,000

12-50

Convertible Bonds

Cash 525,000Discount on Bonds Payable 20,000

Bonds Payable 500,000Paid-In Capital Arising from Bond Conversion Feature 45,000

Issued with Conversion Feature Nondetachable Issued with Conversion Feature Nondetachable and Debt and Equity Separatedand Debt and Equity Separated

Total cash received on sale of bonds $525,000Selling price of bonds without conversion feature ($500,000 × 0.96) 480,000Amount applicable to conversion $ 45,000

12-51

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.

12-52

Accounting for ConversionHiTec 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 for 400 shares of common stock having a market value at the time of the exchange of $26 per share.

12-53

Accounting for Conversion

Investment in HiTec Co. Common Stock 10,400

Bond Investment—HiTec Co. 9,850Gain on Conversion of HiTec Co. Bonds 550

Investor’s Books—Gain RecognizedInvestor’s Books—Gain Recognized

Market value of stock issued (400 shares at $26) $10,400Face value of bonds payable $10,000Less unamortized discount 150 9,850Loss to company on conversion of bonds $ 550

12-54

Accounting for ConversionInvestor’s BooksInvestor’s Books

Investment in HiTec Co. Common Stock (carrying value on books) 9,850

Bond Investment—HiTec Co. 9,850

Bonds Payable 10,000Loss on Conversion of Bonds 550

Common Stock, $1 par 400Paid-In Capital in Excess of Par 10,000Discount on Bonds Payable 150


12-55

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 APB selected the immediate recognition of a gain or loss for all early extinguishment of debt.

12-56

Fair Value Option

• SFAS No. 159 allows a company to report, at each balance sheet date, any or all of its financial assets and liabilities at their fair market value on the balance sheet date.

• The FASB reasoned that the objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings.

12-57

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

12-58

LeasesLeases are considered to be either rentals (operating leases) or asset purchases with borrowed money (capital leases). The four classification criteria are as follows:1. Lease transfers ownership2. Lease includes a bargain purchase option3. Lease covers 75% or more of the economic

life of the asset4. Present value of lease payments is 90% or

more of the asset value

12-59

Unconsolidated Subsidiaries• The FASB issued Statement No. 94

in 1987, effectively eliminating one opportunity that companies have used for off-balance-sheet financing.

• Companies are able to avoid recognizing debt associated with subsidiaries that are less than 50% owned by the company.

12-60

Joint Ventures• When companies join forces with other

companies to share the costs and benefits associated with specifically defined projects, it is called a joint venture.

• Because the benefits of joint ventures are uncertain, companies could incur substantial liabilities with few, if any, assets resulting from their efforts.

12-61

Research and Development Arrangements

• These arrangements involve situations in which an enterprise obtains the results of research and development activities funded partially or entirely by others.

• Accounting issue: Is this arrangement, in essence, a means of borrowing to fund research and development or is it simply a contract to do research for others?

12-62

Analyzing a Firm’s Debt Position

The term leverage refers to the relationship between a firm’s debt and assets or its debt and stockholders’ equity. A common measure of a firm’s leverage is the debt-to-equity ratio.

Total LiabilitiesTotal Stockholders’ Equity

Debt-to-Equity Ratio

=

12-63

Analyzing a Firm’s Debt Position

Another measure of a company’s performance relating to debt is the number of times interest is earned. Times interest earned is calculated using the following formula:

Income Before Taxes + Interest ExpenseInterest Expense

Times Interest Earned =

12-64

Accounting for Troubled Debt Restructuring

• A significant accounting problem is created when economic conditions make it difficult for an issuer of long-term debt to make the payments under the terms of the debt instrument.

• The revision of debt terms to avoid bankruptcy proceedings or foreclosure on the debt is referred to as troubled debt restructuring.

12-65

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:1. A gain or loss on disposal of the asset

2. A gain arising from the concession

granted in the restructuring of the debt (continues)

12-66


The computation of these gains and/or losses is made as follows:Carrying value of assets being transferred

Major value of asset being transferred

Carrying value of debt being liquidated

Difference represents gain or loss on disposal

Difference represents gain on restructuring

(continues)

12-67


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

12-68

Modification of Debt Terms

intermediate accounting,17e stice | stice | skousen 2010 cengage learning powerpoint presented by:...

Documents