1 chapter chapter 10 – debt financing 1.understand the various classification and measurement...

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chapterchapter 10 – Debt Financing

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.

5. Explain various types of off-balance-sheet financing, and understand the reasons for this type of financing.

6. Analyze a firm’s debt position using ratios

Objectives

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Definition of Liabilities

The FASB has defined liabilities as “probable future sacrifices of economic benefits arising from present

obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of

past transaction or events.”

The FASB has defined liabilities as “probable future sacrifices of economic benefits arising from present

obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of

past transaction or events.”

• Current Liabilities: Paid within one year or the operating cycle, whichever is longer.

• Noncurrent Liabilities: Not paid within one year or the

operating cycle, whichever is longer.

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Types of Liabilities

• Liabilities that are Liabilities that are definite in amount.definite in amount.

• Estimated liabilities.Estimated liabilities.

• Contingent liabilities.Contingent liabilities.

• Liabilities that are Liabilities that are definite in amount.definite in amount.

• Estimated liabilities.Estimated liabilities.

• Contingent liabilities.Contingent liabilities.

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Liabilities Definite in Amount

Record liability at face amount. Classify as short- or long-term based on when

debt will be repaid. Short-term debt to be refinanced can be

classified as long-term if:– management intends to refinance on a long-term

basis.– management can demonstrate an ability to

refinance.

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Estimated Liabilities

• Refundable deposits: Report estimated amount to be refunded as a liability.

• Warranties: Report estimated future expenditures as a liability.

• Premium offers/gift certificates: Report estimated value of redeemed offers as a liability.

Items that will require definite future resource outflow, but the actual amount of the

obligation cannot be established currently.

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Contingent Liabilities

A contingent liability results when there is a potential liability which depends on the outcome of

an uncertain event E.g. pending lawsuit

A contingent liability results when there is a potential liability which depends on the outcome of

an uncertain event E.g. pending lawsuit

If the potential liability is reasonably possible, then disclose

possible liability in a note

If the potential liability is probable and amount can be reasonably estimated, then

recognize in the financial statements

If the potential liability is remote, then do nothing

7Accounting for Short-TermDebt Obligations

• Accounts Payable: The amount due for the purchase of materials by a manufacturing company or merchandise by a wholesaler or retailer.

• Notes Payable: A formal written promise to pay a certain amount of money at a specified future date.


A short-term obligation that is expected to be refinanced on a long-term basis should not be reported as a current liability.

FASB Statement No. 6 requires that both of the following conditions be met before a short-term obligation may be properly excluded from the current liability classification.

1. Management must intend to refinance the obligation on a long-term basis.

2. Management must demonstrate an ability to refinance the obligation.

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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.

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.

Accounting for Short-TermDebt Obligations

An ability to refinance may be demonstrated by:

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o The terms of the refinancing agreement should be noncancelable as to all parties.

o The terms of the refinancing agreement should extend beyond the current year.

o The company should not be in violation of the agreement at the balance sheet date or the date of issuance.

o The lender or investor should be financially capable of meeting the refinancing requirements.

Accounting for Short-TermDebt Obligations

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Line 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.

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• Present value of $100 paid in five years discounted at 10 percent:

Today 1 2 3 4 Future

PV=$62.09 $100

Discount at 10%Discount at 10%

Present Value of $1

14The Present Value of the Annuity of $1

Present value of five equal payments of $100 discounted at 10 percent:

Today 1 2 3 4 5$100$100$100$100$100

PV=$379.08

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PV of Long-Term Debt

On January 1, 2005, Crystal Michae purchases a house for $250,000 and makes

a down payment of $50,000. The remainder is financed through a mortgage

on the house. The mortgage is for ten years and carries an annual interest rate of 12 percent, with payments of $2,057 due

monthly. The first payment is due on February 1, 2005.

On January 1, 2005, Crystal Michae purchases a house for $250,000 and makes

a down payment of $50,000. The remainder is financed through a mortgage

on the house. The mortgage is for ten years and carries an annual interest rate of 12 percent, with payments of $2,057 due

monthly. The first payment is due on February 1, 2005.

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Payment Interest Amount Applied to RemainingDate Amount Expense Reduce Principal Balance

1/1/05 $200,0002/1/05 $2,057 $2,000 $57 199,9433/1/05 2,057 1,999 58 199,8854/1/05 2,057 1,999 58 199,8275/1/05 2,057 1,998 59 199,7686/1/05 2,057 1,998 59 199,709


$200,000 x .12 x 1/12

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Payment Interest Amount Applied to RemainingDate Amount Expense Reduce Principal Balance

1/1/05 $200,0002/1/05 $2,057 $2,000 $57 199,9433/1/05 2,057 1,999 58 199,8854/1/05 2,057 1,999 58 199,8275/1/05 2,057 1,998 59 199,7686/1/05 2,057 1,998 59 199,709

2/1/05 Interest Expense 2,000Mortgage Payable 57

Cash 2,057


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Secured Loan

Secured Loan

A secured loan is a loan backed by certain assets as

collateral.

A secured loan is a loan backed by certain assets as

collateral.

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Financing With Bonds

A bond is a contract between a borrower and a lender in which the borrower

promises to pay a specified amount of interest for each period the bond is

outstanding and repay the principal at the maturity date.

A bond is a contract between a borrower and a lender in which the borrower

promises to pay a specified amount of interest for each period the bond is

outstanding and repay the principal at the maturity date. Fargo, Inc.

Paid to the bearer of this bond $10,000 at 8 percent annually on

January 1 and July 1.

$10,000

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Financing With Bonds

Reasons that management and stockholders may prefer to issue bonds or notes instead of stock:1) Present owners remain in control of the

corporation.

2) Interest is deductible for tax purposes; 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.

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Face value: The amount that will be paid on a bond at the maturity date.

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.

Nature of Bonds

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• 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

ContinuedContinuedContinuedContinued

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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.

ContinuedContinuedContinuedContinued

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• 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.

Types of Bonds.

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Market Price of Bonds

BondBondStatedStatedInterestInterest

RateRate10%10%

8%8% PremiumPremium

1010% FaceFace ValueValue

12%12% DiscountDiscount

Yield

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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.

What is the issue price?

What is the issue price?

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Market Price of BondsPart 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 $100,0004,000

Effective interest rate, 10% per year

(5% per semiannual period)$49,849

Total present value (market price) of bond $87,538

28Bond Issued atPar on Interest Date

Issuer’s BooksIssuer’s BooksIssuer’s BooksIssuer’s Books

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

July 1 Interest Expense 4,000Cash 4,000

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

29Bond Issued atPar on Interest Date

Investor’s BooksInvestor’s BooksInvestor’s BooksInvestor’s Books

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

July 1 Cash 4,000Interest Revenue 4,000

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

30Bond Issued ata 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).

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).

Effective Effective rate, 10%rate, 10%

$100,000

8%

Later Slide

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

Bonds Payable 100,000

Bond Issued ata Discount on Interest Date


Jan. 1 Bond Investment 87,538Cash

87,538

32Bond Issued ata 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).

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).

Effective Effective rate,7%rate,7%

$100,000

8%

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

Bond Issued ata Premium on Interest Date


Jan. 1 Bond Investment 107,106Cash

107,106

34Bonds 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.

On March 1, $100,000, 8%, 10-year bonds were issued to yield 8 %. Interest for two

months has accrued on the bonds.

Effective Effective rate,8%rate,8%

$100,000

8%

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Bonds Issued at Par Between Interest Dates

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

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

Cash 4,000$100,000 x 0.08 x 4/12$100,000 x 0.08 x 4/12

$100,000 x 0.08 x 2/12$100,000 x 0.08 x 2/12

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Bonds Issued at Par Between Interest Dates

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

Cash 101,333

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

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On an earlier slide, $100,000 of 8% bonds were issued at $87,538 (a discount of $12,462).

Appropriate amortization entries must be made on both the issuer’s books and the investor’s books.

On an earlier slide, $100,000 of 8% bonds were issued at $87,538 (a discount of $12,462).

Appropriate amortization entries must be made on both the issuer’s books and the investor’s books.

Straight-Line Amortization—Discount


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

Dec. 31 Interest Expense 4,623Disc. On Bonds Payable 623Interest Payable 4,000

$12,462/120 x 6 months$12,462/120 x 6 months$12,462/120 x 6 months$12,462/120 x 6 months

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July 1 Cash 4,000Bond Investment 623

Interest Revenue 4,623

Dec. 31 Interest Receivable 4,000Bond Investment 623

Interest Revenue 4,623

Straight-Line Amortization—Discount

39Straight-Line Amortization—Premium

In Slide 42, $100,000 of 8% bonds were issued at $107,106. Appropriate

amortization entries must be made on both the issuer’s books and the investor’s books.

In Slide 42, $100,000 of 8% bonds were issued at $107,106. Appropriate

amortization entries must be made on both the issuer’s books and the investor’s books.


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

$7,106/120 x 6 months$7,106/120 x 6 months$7,106/120 x 6 months$7,106/120 x 6 months

40Straight-Line Amortization—Premium


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

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

41Effective-Interest Method—Discount

Consider again the $100,000, 8%, 10-year bonds sold for

$87,538. The effective rate for the bonds is 10%.

Consider again the $100,000, 8%, 10-year bonds sold for


Effective rate for semiannual period 5 %Stated rate per semiannual period 4 %Interest amount ($87,538 x 0.05) $4,377Interest payment ($100,000 x 0.04) 4,000Discount amortization $ 377

42Effective-Interest Method—Discount

Effective rate for semiannual period 5 %Stated rate per semiannual period 4 %Interest amount ($87,915 x 0.05) $4,396Interest payment ($100,000 x 0.04) 4,000Discount amortization $ 396

Second PeriodSecond PeriodSecond PeriodSecond Period

$87,538 + $377$87,538 + $377$87,538 + $377$87,538 + $377

43Effective-Interest Method—Premium

Now consider the $100,000, 8%, 10-year bonds sold for


Now consider the $100,000, 8%, 10-year bonds sold for


Effective rate for semiannual period 3.5 %Stated rate per semiannual period 4.0 %Interest payment ($100,000 x 0.04) $4,000Interest amount ($107,106 x 0.35) 3,749Premium amortization $ 251

44Effective-Interest Method—Premium

Effective rate for semiannual period 3.5 %Stated rate per semiannual period 4.0 %Interest payment ($100,000 x 0.04) $4,000Interest amount ($106,855 x 0.035) 3,740Discount amortization $ 260

Second PeriodSecond PeriodSecond PeriodSecond Period

$107,106 $107,106 –– $251 $251$107,106 $107,106 –– $251 $251

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A B C D E

(A – B) (D – C) ($100,000 + D)

($100,000 x 04)

(E x 0.035)

Prem. Unamort. Bond # Payment Int. Exp. Amort. Prem. Book

$7,106 $107,106

Effective-Interest Method—Premium

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A B C D E

(A – B) (D – C) ($100,000 + D)

($100,000 x 04)

(E x 0.035)


$7,106 $107,106


1 $4,000 $3,749 $251 6,855 106,855

$107,106 x 0.035$107,106 x 0.035

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A B C D E

(A – B) (D – C) ($100,000 + D)

($100,000 x 04)

(E x 0.035)


$7,106 $107,106


$106,855 x 0.035$106,855 x 0.035

1 $4,000 $3,749 $251 6,855 106,8552 $4,000 $3,740 $260 6,595 106,595

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A B C D E

(A – B) (D – C) ($100,000 + D)

($100,000 x 04)

(E x 0.035)


$7,106 $107,106


1 $4,000 $3,749 $251 6,855 106,8552 $4,000 $3,740 $260 6,595 106,5953 $4,000 $3,731 $269 6,326 106,3264 $4,000 $3,721 $279 6,047 106,0475 $4,000 $3,712 $288 5,759 105,759

49Extinguishment 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).

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.

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Triad, Inc.’s $100,000, 8% bonds are not held to maturity. They are redeemed on February 1, 2005, at

97. The carrying value of the bonds is $97,700 as of this date.

Interest payment dates are January 31 and July 31.

Triad, Inc.’s $100,000, 8% bonds are not held to maturity. They are redeemed on February 1, 2005, at

97. The carrying value of the bonds is $97,700 as of this date.

Interest payment dates are January 31 and July 31.

Extinguishment of Debt Prior to Maturity

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

Carry value of bonds, 1/1/02 $97,700Redemption price 97,000Gain on bond redemption $ 700


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

Bond Investment— Triad Inc. 97,700


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Convertible Bonds

An interest rate lower than the issuer could establish for

nonconvertible debt

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

An initial conversion price higher than the market value of the common stock at time

of issuance

Convertible debt securities usually have the following features:

A call option retained by the issuer

A call option retained by the issuer

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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. It

is estimated that without the conversion privilege, the bonds

would sell at 96.

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.

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Convertible Bonds

Debt and Equity Not SeparatedDebt and Equity Not SeparatedDebt and Equity Not SeparatedDebt and Equity Not Separated

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

Debt and Equity SeparatedDebt and Equity SeparatedDebt and Equity SeparatedDebt and Equity Separated

Cash 525,000Discount on Bonds Payable 20,000

Bonds Payable 500,000Paid-In Capital Arising from Bond Conversion Feature 45,00050

0,00

0-

(500

,000

x

.96)50

0,00

0-

(500

,000

x

.96)

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Accounting for Conversion

Assume that HiTec Co. offers bondholders 40 shares of HiTec Co. Common stock, $1 par, in exchange for each $1000, 8%

bond held. An investor exchanges bonds of $10,000 (carrying value

as brought up to date for both investor and issuer, $9,850) for

400 shares of common stock having a market price at the time of the exchange of $26 per share.

Assume that HiTec Co. offers bondholders 40 shares of HiTec Co. Common stock, $1 par, in exchange for each $1000, 8%

bond held. An investor exchanges bonds of $10,000 (carrying value

as brought up to date for both investor and issuer, $9,850) for

400 shares of common stock having a market price at the time of the exchange of $26 per share.

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Nov. 1 Investment in HiTec Co. Common Stock 10,400

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

The investor may choose not to recognize a gain or loss. If so, the investor in the above situation would debit Investment in HiTec Co. Common

Stock for $9,850.

The investor may choose not to recognize a gain or loss. If so, the investor in the above situation would debit Investment in HiTec Co. Common

Stock for $9,850.

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Nov. 1 Bonds Payable 10,000Loss on Conversion of Bonds 550

Common Stock, $1 par 400Paid-In Capital in Excess

of Par Value 10,000Discount on Bonds Payable 150


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Off-Balance-Sheet Financing

• Off-Balance-Sheet-Financing: Financing procedures used by companies to avoid disclosing all their debt on the balance sheet in order to make their financial position look stronger.– Leases– Unconsolidated entities– Special-purpose entities (SPEs)– Joint Ventures– Research and development arrangements– Project financing arrangements

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Analyzing a Firm’s Debt Position

• Debt-to-Equity Ratio: A ratio that measures the relationship between the debt and equity of an entity. Formula: total debt ÷ total stockholders’ equity.

• Debt Ratio: An indicator of a company’s overall ability to repay its debts. Formula: total liabilities ÷ total assets.

• Times Interest Earned: An indicator of a company’s ability to meet interest payments. Formula: income before interest expense and income taxes ÷ interest expense for the period.

1 chapter chapter 10 – debt financing 1.understand the various classification and measurement...

Documents

contingent liabilities

liabilities definite

definition of liabilities

noncurrent liabilities

potential liability

possible liability

current liability

contingent liability