1 chapter chapter 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

2 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.” 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.

3 Types of Liabilities Liabilities that are definite in amount.Liabilities that are definite in amount. Estimated liabilities.Estimated liabilities. Contingent liabilities.Contingent liabilities. Liabilities that are definite in amount.Liabilities that are definite in amount. Estimated liabilities.Estimated liabilities. Contingent liabilities.Contingent liabilities.

4 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.

5 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.

6 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 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

7 Accounting for Short-Term Debt 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.

8 Accounting for Short-Term Debt Obligations

9 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.

10 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-Term Debt Obligations An ability to refinance may be demonstrated by:

11 oThe terms of the refinancing agreement should be noncancelable as to all parties. oThe terms of the refinancing agreement should extend beyond the current year. oThe company should not be in violation of the agreement at the balance sheet date or the date of issuance. oThe lender or investor should be financially capable of meeting the refinancing requirements. Accounting for Short-Term Debt Obligations

12 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.

13 Present value of $100 paid in five years discounted at 10 percent: Today1234Future PV=$62.09$100 Discount at 10% Present Value of $1

14 The Present Value of the Annuity of $1 Present value of five equal payments of $100 discounted at 10 percent: Today12345 $100 PV=$

15 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.

16 Payment Interest Amount Applied to Remaining Date Amount Expense Reduce Principal Balance 1/1/05$200,000 2/1/05$2,057$2,000$57199,943 3/1/052,0571, ,885 4/1/052,0571, ,827 5/1/052,0571, ,768 6/1/052,0571, ,709 PV of Long-Term Debt $200,000 x.12 x 1/12

17 Payment Interest Amount Applied to Remaining Date Amount Expense Reduce Principal Balance 1/1/05$200,000 2/1/05$2,057$2,000$57199,943 3/1/052,0571, ,885 4/1/052,0571, ,827 5/1/052,0571, ,768 6/1/052,0571, ,709 2/1/05 Interest Expense2,000 Mortgage Payable57 Cash2,057 PV of Long-Term Debt

18 Secured Loan A secured loan is a loan backed by certain assets as collateral.

19 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. Fargo, Inc. Paid to the bearer of this bond $10,000 at 8 percent annually on January 1 and July 1. $10,000

20 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.

21  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

22 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 BondsContinuedContinued

23 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. ContinuedContinued

24 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.

25 Market Price of BondsBondStatedInterestRate10% 8%Premium 10 10% FaceValue Face Value 12%Discount Yield

26 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?

27 Market Price of Bonds 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 $100,0004,000 Effective interest rate, 10% per year (5% per semiannual period)$49,849 Total present value (market price) of bond$87,538

28 Bond Issued at Par on Interest Date Issuer’s Books Jan. 1Cash100,000 Bonds Payable100,000 July 1Interest Expense4,000 Cash4,000 Dec. 31Interest Expense4,000 Cash4,000

29 Bond Issued at Par on Interest Date Investor’s Books Jan. 1Bond Investment100,000 Cash100,000 July 1Cash4,000 Interest Revenue4,000 Dec. 31Cash4,000 Interest Revenue4,000

30 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). Effective rate, 10% $100,000 8% Later Slide

31 Issuer’s Books Jan. 1Cash87,538 Discount on Bonds Payable12,462 Bonds Payable100,000 Bond Issued at a Discount on Interest Date Investor’s Books Jan. 1Bond Investment87,538 Cash87,538

32 Bond Issued 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). Effective rate,7% $100,000 8%

33 Issuer’s Books Jan. 1Cash107,106 Prem. on Bonds Payable7,106 Bonds Payable100,000 Bond Issued at a Premium on Interest Date Investor’s Books Jan. 1Bond Investment107,106 Cash107,106

34 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. Effective rate,8% $100,000 8%

35 Issuer’s Books Bonds Issued at Par Between Interest Dates Mar. 1Cash101,333 Bonds Payable100,000 Interest Payable1,333 July 1Interest Expense 2,667 Interest Payable1,333 Cash4,000 $100,000 x 0.08 x 4/12 $100,000 x 0.08 x 2/12

36 Investor’s Books Bonds Issued at Par Between Interest Dates Mar. 1Bond Investment100,000 Interest Receivable1,333 Cash101,333 July 1Cash 4,000 Interest Receivable1,333 Interest Revenue2,667

37 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.slide 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.slide Straight-Line Amortization— Discount Issuer’s Books July 1Interest Expense4,623 Disc. on Bonds Payable623 Cash4,000 Dec. 31Interest Expense 4,623 Disc. On Bonds Payable623 Interest Payable4,000 $12,462/120 x 6 months

38 Investor’s Books July 1Cash4,000 Bond Investment623 Interest Revenue4,623 Dec. 31Interest Receivable4,000 Bond Investment623 Interest Revenue4,623 Straight-Line Amortization— Discount

39 Straight-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. Issuer’s Books July 1Interest Expense3,645 Premium on Bonds Payable355 Cash4,000 Dec. 31Interest Expense 3,645 Premium On Bonds Payable355 Interest Payable4,000 $7,106/120 x 6 months

40 Straight-Line Amortization— Premium Investor’s Books July 1Cash4,000 Bond Investment355 Interest Revenue3,645 Dec. 31Interest Receivable4,000 Bond Investment355 Interest Revenue3,645

41 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%. Effective rate for semiannual period5% Stated rate per semiannual period4% Interest amount ($87,538 x 0.05)$4,377 Interest payment ($100,000 x 0.04) 4,000 Discount amortization$ 377

42 Effective-Interest Method— Discount Effective rate for semiannual period5% Stated rate per semiannual period4% Interest amount ($87,915 x 0.05)$4,396 Interest payment ($100,000 x 0.04) 4,000 Discount amortization$ 396 Second Period $87,538 + $377

43 Effective-Interest Method— Premium Now consider the $100,000, 8%, 10-year bonds sold for $107,106. The effective rate for the bonds is 7%. Effective rate for semiannual period3.5% Stated rate per semiannual period4.0% Interest payment ($100,000 x 0.04)$4,000 Interest amount ($107,106 x 0.35) 3,749 Premium amortization$ 251

44 Effective-Interest Method— Premium Effective rate for semiannual period3.5% Stated rate per semiannual period4.0% Interest payment ($100,000 x 0.04)$4,000 Interest amount ($106,855 x 0.035) 3,740 Discount amortization$ 260 Second Period $107,106 – $251

45 A B C D E (A – B)(D – C)($100,000 + D) ($100,000 x 04) (E x 0.035) Prem.Unamort.Bond #PaymentInt. Exp.Amort.Prem.Book $7,106$107,106 Effective-Interest Method— Premium

46 A B C D E (A – B)(D – C)($100,000 + D) ($100,000 x 04) (E x 0.035) Prem.Unamort.Bond #PaymentInt. Exp.Amort.Prem.Book $7,106$107,106 Effective-Interest Method— Premium 1 $4,000$3,749$2516,855106,855 $107,106 x 0.035

47 A B C D E (A – B)(D – C)($100,000 + D) ($100,000 x 04) (E x 0.035) Prem.Unamort.Bond #PaymentInt. Exp.Amort.Prem.Book $7,106$107,106 Effective-Interest Method— Premium $106,855 x $4,000$3,749$2516,855106,855 2 $4,000$3,740$2606,595106,595

48 A B C D E (A – B)(D – C)($100,000 + D) ($100,000 x 04) (E x 0.035) Prem.Unamort.Bond #PaymentInt. Exp.Amort.Prem.Book $7,106$107,106 Effective-Interest Method— Premium 1 $4,000$3,749$2516,855106,855 2 $4,000$3,740$2606,595106,595 3 $4,000$3,731$2696,326106,326 4 $4,000$3,721$2796,047106,047 5 $4,000$3,712$2885,759105,759

49 Extinguishment 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.

50 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

51 Issuer’s Books Feb. 1Bonds Payable100,000 Discount on Bonds Pay.2,300 Cash97,000 Extraordinary Gain on Bond Redemption700 Carry value of bonds, 1/1/02$97,700 Redemption price 97,000 Gain on bond redemption$ 700 Extinguishment of Debt Prior to Maturity

52 Investor’s Books Feb. 1Cash97,000 Loss on Sale of Bonds700 Bond Investment— Triad Inc.97,700 Extinguishment of Debt Prior to Maturity

53 Convertible Bonds 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 Convertible debt securities usually have the following features: A call option retained by the issuer

54 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.

55 Convertible Bonds Debt and Equity Not Separated Cash525,000 Bonds Payable500,000 Premium on Bonds Payable25,000 Debt and Equity Separated Cash525,000 Discount on Bonds Payable20,000 Bonds Payable500,000 Paid-In Capital Arising from Bond Conversion Feature45, ,000- (500,000 x.96)

56 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.

57 Accounting for Conversion Investor’s Books Nov. 1Investment in HiTec Co. Common Stock10,400 Investment in HiTec Co. Bonds9,850 Gain on Conversion of HiTec Co. Bonds550 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.

58 Issuer’s Books Nov. 1Bonds Payable10,000 Loss on Conversion of Bonds550 Common Stock, $1 par400 Paid-In Capital in Excess of Par Value10,000 Discount on Bonds Payable150 Accounting for Conversion

59 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

60 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.