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CHAPTER 12 Debt Financing
A.Definition of liabilities
1. Must be the result of past transactions or events.
: Thus, contractual obligations from an exchangeof promises if performance by both parties is stillin the future are not recognized as liabilities.
2. Probable transfer of assets (or services) must bein the future
B.Classification of Liabilities
Current Liabilities
1. Payable within 1 year
2. Reported at maturity value
Non Current Liabilities
C. Measurement of Liabilities
1. Liabilities that are definite in amount:2. Estimated liabilities:3. Contingent liabilities:
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D. Accounting for a bond
There are three main considerations in accounting
for bonds:
1. The issuance of bonds2. Interest during the life of the bonds.3. The retirement of bonds either at maturity or prior
to the maturity date.
The Issuance of bonds
1. Bonds sell at price plus accrued interest.2. Bonds are typically stated in terms of a
percentage of face value.(e.g., a bond at 97 or a bond at 103)
3. Bond discounts are recorded as contra accountsto Bonds Payable (Issuer) and Investment in
Bonds (Investor).4. Bond premiums represent adjunct accounts whichincrease Bonds Payable (Issuer) and Investmentin Bonds (Investor).
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Bond Sold at Face Amount
On January 1, 2009, Masterwear Industries issued
$700,000 of 12% bonds. Interest of $42,000 is payablesemiannually on June 30 and December 31. The bondsmature in three years [an unrealistically short maturity toshorten the illustration]. The bond was sold at faceamount.
At Issuance (January 1)
Masterwear (Issuer)
Dr. Cash
Cr. Bonds payable (face amount)
* Bond payable is always recorded at
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Determining the Selling Price Bonds Sold at a Discount
On January 1, 2009, Masterwear Industries issued$700,000 of 12% bonds, dated January 1. Interest ispayable semiannually on June 30 and December 31. Thebonds mature in threeyears. The market yield for bondsof similar risk and maturity is 14%.
Present value (price) of the bonds:Present Values
Interest $42,000 x 4.76654 * = $200,195
Principal $700,000 x 0.66634 ** = 466,438
Present value (price) of the bonds $666,633
* present value of an ordinary annuity of $1: n=6, i=7%(Table IV)
** present value of $1: n=6, i=7% (Table II)
Because interest is paid semiannually, the PV calculationsuse: (a) semiannual market rate (7%), and (b) 6 (3 x 2) semi-annualperiods.
Masterwear (Issuer)
(Dr) Cash (price calculated above)
(Dr) Discount on bonds payable (difference)
(Cr) Bonds payable (face amount)
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Determining the Selling Price Bonds Sold at a Premium
On January 1, 2009, Masterwear Industries issued$700,000 of 12% bonds, dated January 1. Interest ispayable semiannually on June 30 and December 31. Thebonds mature in threeyears. The market yield for bondsof similar risk and maturity is 10%.
Present value (price) of the bonds:Present Values
Interest $42,000 x 5.07569 * = $213,179Principal $700,000 x 0.74622 ** = 522,354
Present value (price) of the bonds $735,533
* present value of an ordinary annuity of $1: n=6, i=5%(Table IV)
** present value of $1: n=6, i=5% (Table II)
Because interest is paid semiannually, the PV calculationsuse: (a) semiannual market rate (5%), and (b) 6 (3 x 2) semi-annualperiods.
Masterwear (Issuer)
(Dr) Cash (price calculated above)
(Cr) Premium on bonds payable (difference)
(Cr) Bonds payable (face amount)
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Debt Issue Costs
o Include legal and accounting fees, printing fees, andregistration and underwriting fees.
o Debt issue costs are amortized to expense over theterm to maturity.
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Interest (When Bonds are Issued at a Premium orDiscount)
1. The periodic interest payments made by the issuerare not the total interest expense.
2. An adjustment to interest expense (amortization)associated with the cash payment is necessary toreflect the effective interest being incurred on thebonds.
Effective Interest Method
The amount of interest to be recognized each periodis computed at a uniform interest rate (the market /effective rate)
The amount paid is determined by stated rate(coupon rate)
Difference between the amount paid and thecompound interest expense is reflected asamortization of discount or premium
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DETERMINING INTEREST The Effective Interest Method
Continuing Example of Masterwear Industries:$700,000 of 12% bonds; Market yield of 14%
AMORTIZATION SCHEDULE DISCOUNT
Cash Effective Increase OutstandingInterest Interest in Balance Balance
6% x Face 7% x O/S Debt Disct Reduction
1/01/09 666,633
6/30/09 42,000 .07(666,633) = 46,664 4,664 671,297
12/31/09 42,000 .07(671,297) = 46,991 4,991 676,288
6/30/10 42,000 .07(676,288) = 47,340 5,340 681,628
12/31/10 42,000 .07(681,628) = 47,714 5,714 687,342
6/30/11 42,000 .07(687,342) = 48,114 6,114 693,456
12/31/11 42,000 .07(693,456) = 48,544* 6,544 700,000
252,000 285,367 33,367
*Rounded
At the First Interest Date (June 30)
Masterwear (Issuer)
(Dr) Interest expense (market rate x carrying value.)
(Cr) Discount on bonds payable (difference)(Cr) Cash (stated rate x face amount)
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Straight-Line Method
the recognition of an equal amount of
premium or discount amortization for eachperiod
The amount paid is determined by statedrate (coupon rate)
Interest expense is the balanced amount of
the amount paid and the recognition ofpremium or discount
3. Both methods result in the same amount of totalinterest expense over the life of the bond.
4. Interest expense is increased by discountamortization and decreased by premiumamortization.
5. If an accounting period ends between interest dates,interest should be accrued.
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Determining InterestThe Straight-Line Method
Continuing Example of Masterwear Industries:$700,000 of 12% bonds; Market yield of 14%
Under the straight-line method, the discount would be allocatedequally to the 6 semiannual periods (3 years):
Discount: $700,000 - $666,633 = $33,367
At Each of the Six Interest Dates
Masterwear (Issuer)
(Dr)Interest expense (to balance)
(Cr)Discount on bonds payable(discount 6 periods)
(Cr)Cash (stated rate x face amount)
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Extinguishment of Debt Prior to Maturity
When debt is retired prior to maturity, a gain or lossmust be recognized for the difference between the
carrying value of the debt and the amount to satisfythe obligation
Extinguishment of Debt Prior to Maturity
Feb. 1
(Dr) Bonds Payable (Face value) 100,000
(Cr) Discount on Bonds Payable 2,300
(Cr) Cash (The amount Triad paid) 97,000(Cr) Gain in Bond Redemption 700(The balance)
Note: Discount = The difference between the face andcarrying value
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Triad, Inc.s $100,000, 8% bonds are not held tomaturity. They are redeemed on February 1, 2010, at97. The carrying value of the bonds is $97,700 as of thisdate. Interest payment dates are January 31 and July31.
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Convertible Bonds
Bonds that provide for their conversion into some othersecurity at the option of the bondholder
Generally they are permitted to be exchanged forcommon stock
There are two ways to account for the issuance ofconvertible bonds
Debt and equity not separated (U.S. GAAP) Debt and equity separated
Convertible Bonds (Detachable)
The Issuer of the bonds and the stock warrants isrequired to allocate the joint issuance price betweendebt and equity instrument.
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Convertible Bonds Issuance
500 ten-year bonds, face value $1,000, are sold at 105, or
a total issue price of $525,000 (500$1,000 1.05). Thebonds contain a conversion privilege that provides forexchange of a $1,000 bond for 20 shares of stock, parvalue $1. The interest rate on the bonds is 8%. It isestimated that without the conversion privilege, the bondswould sell at 96.
- Debt and equity not separated
Cash 525,000Bonds Payable 500,000Premium on Bonds Payable 25,000
Debt and equity separated
Cash 525,000Discount on Bonds Payable 20,000
Bonds Payable 500,000Paid-In Capital Arising fromBond Conversion Feature equity>>> 45,000
Note: Discount on bonds payable = $500,000 * (100%-96%) w/o 96% * 500,000=$480,000
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U.S. GAAP vs. IASB
U.S. GAAP:
Despite of theoretical support for the separation ofdebt and equity, common practice follows FASBASC Section 470-20-25, which designates all ofthe proceeds as belonging to the bond alone: nonseparation between debt and equity
IASB: IAS 32 No distinction between Nondetachable vs.
Detachable Proceeds should be allocated to debt and equity:
Separation between debt and equity
Accounting for Conversion
Should we recognize gain and loss as the part of theconversion process or not?
If convertible security is viewed as equity, then theconversion is not significant transaction: no gainor loss is recognized
If convertible security is viewed as debt, then theconversion would seem to be a significanttransaction: gain or loss recognized
Recognizing gain or loss would seem to bereasonable, but no recognition of gain or loss iswidespread practice.
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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 up to date for both investor and issuer,$9,850) for 400 shares of common stock having a marketprice at the time of the exchange of $26 per share. Theexchange is completed at the interest payment date.
9850 =face value-discount9850=$10,000- =$150
Recognition of gain or loss
Nov. 1
Bonds Payable 10,000Loss on Conversion of Bonds 550Common Stock, $1 par 400Paid-In Capital in Excessof Par Value 10,000Discount on Bonds Payable 150
Note:Market value of stock issued 400 shares * $26 = $10,400(-) Bonds payable = 10,000(-) Discount on bonds payable = 150Loss on conversion of bonds = 550
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No recognition of gain or loss
Nov. 1
Bonds Payable 10,000Common Stock, $1 par 400Paid-In Capital in Excessof Par Value 9,450Discount on Bonds Payable 150
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E. Fair Value Option
1. SFASNo. 159allows a company to report, at each
balance sheet date, any or all of its financial assetsand liabilities at their fair market value on the balancesheet date.
2. Why? The FASB reasoned that the objective is toimprove financial reporting by providing entities withthe opportunity to mitigate volatility in reportedearnings.
Example:
Lily Kay Company has one asset, a Lusvardi CompanyBond that it purchased (on the day it was issued) asinvestment and one liability, one of its own bonds thatLily Kay issued to finance the purchase of Lusvardi
Company Bond investment.
Both bonds have the same terms: $1,000 face value, 20year life, 10% coupon rate, and single interest paymentsmade at the end of each year, 10% of market interestrate when they were issued.
Balance Sheet on the day it purchased Lusvardi
Company Bond
Assets Amount Liability AmountLusvardiCompany Bond
$1,000 Bond PayableEquity
$1,0000
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Case 1: Market interest increases to 12%
a. Investment at fair value & liability at cost
Assets Amount Liability AmountLusvardiCompany Bond
$851 Bond PayableEquity
$1,000($149)*
Unrealized loss $149 = $851- $1,000 =($149)
b. Both investment and liability at fair value
Assets Amount Liability AmountLusvardiCompany Bond
$851 Bond PayableEquity
$8510
No impact on net income
Case 2: Market interest decreases to 8%
a. Investment at fair value & liability at cost
Assets Amount Liability AmountLusvardiCompany Bond
$1,196 Bond PayableEquity
$1,000$196*
Unrealized gain $196 = $1,196- $1,000= $196
b. Both investment and liability at fair value
Assets Amount Liability AmountLusvardiCompany Bond
$1,196 Bond PayableEquity
$1,1960
No impact on net income
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3. To pervent companies from using fair value option toenhance reported earnings selectively, SFAS 159requires a company to designate whether it is usingthe fair value option with respect to a financial asset or
financial liability when the initial transaction to createthe item occurs
F. Off-Balance-Sheet-Financing: procedures to avoiddisclosing all debt on the balance sheet in order to makethe companys financial position look stronger.
1. Operating vs. Capital leases
In excess of 90% of all leases are accounted foroperating leases in which no obligation to makefuture lease payments is reflected in thebalance sheet
2. Unconsolidated subsidiaries FASB statement No. 94 requires all majority-
owned ( greater than 50%) subsidiaries to beconsolidated
Companies still can avoid reporting debtassociated with subsidiaries that are less than50% owned
3. Variable Interest Entities (VIEs), formerly calledSpecial-Purpose Entities (SPEs): no debt would berecorded in sponsors balance sheet.
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Example:
Sponsor Company requires the use of a building
costing $100,000. Sponsor facilitates the establishmentof VIE Company. VIE Company is started with a$10,000 investment from a private investor along with a$90,000 bank loan. VIE then leases the building toSponsor (carefully crafted to qualify as an operatinglease).
- Sponsor companys book
Assets $0 Liability $0
- VIEs Book
Assets Amount Liability AmountBuilding $100,000 Bank Loan
Paid-in-capital
$90,000
10,000
4. Joint venture: 50:50 joint venture will be accountedunder equity method. No debt of joint ventures will berecorded in a parent companys balance sheet
Reasons for Off-Balance-Sheet Financing Allow a company to borrow more than it otherwise
could due to debt-limit restriction Lower borrowing cost, e.g., lower cost of capital
(interest rate)