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 Liabilities 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.”

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 Liabilities For measurement purposes, liabilities can be divided into three categories: 1.Liabilities that are definite in amount 2.Estimated liabilities 3.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. 6 Concerning 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 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.

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 Bonds The 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 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

12-17 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 BondStatedInterestRate10% 8%Premium 10 10% FaceValue Face Value 12%Discount Yield Market Price of Bonds

12-25 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 12-26).

12-26 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$87,538 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.1Cash100,000 Bonds Payable100,000 Issuer’s Books July 1Interest Expense4,000 Cash4,000 Dec. 31Interest Expense4,000 Interest Payable4,000 (continues)

12-29 Bonds Issued at Par on Interest Date Jan. 1Bond Investment100,000 Cash100,000 Investor’s Books July 1Cash4,000 Interest Revenue4,000 Dec. 31Interest Receivable4,000 Interest Revenue4,000

12-30 Bonds Issued at Discount on Interest Date Jan. 1Cash87,538 Discount on Bonds Payable12,462 Bonds Payable100,000 Issuer’s Books Jan. 1Bond Investment87,538 Cash87,538 Investor’s Books

12-31 Bonds Issued at Premium on Interest Date Jan. 1Cash107,106 Premium on Bonds Payable7,106 Bonds Payable100,000 Issuer’s Books Jan. 1Bond Investment107,106 Cash107,106 Investor’s Books

12-32 Bonds Issued at Par between Interest Date Jan. 1Cash101,333 Bonds Payable100,000 Interest Payable1,333 Issuer’s Books July 1Interest Expense2,667 Interest Payable1,333 Cash4,000 (continues) ($100,000 × 0.08 × 2/12) ($100,000 × 0.08 × 4/12)

12-33 Bonds Issued at Par between Interest Date Jan. 1Bond Investment100,000 Interest Receivable1,333 Cash101,333 Investor’s Books July 1Cash4,000 Interest Receivable1,333 Interest Revenue2,667

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 1Interest Expense4,623 Discount on Bonds Payable623 Cash4,000 Issuer’s Books Dec. 31Interest Expense4,623 Discount on Bonds Payable623 Interest Payable4,000 (continues) $12,462/120 × 6 mo. = $623 (rounded)

12-38 Straight-Line Method July 1Cash4,000 Bond Investment623 Interest Revenue4,623 Investor’s Books Dec. 31Interest Receivable4,000 Bond Investment623 Interest Revenue4,623 (continues)

12-39 Straight-Line Method July 1Interest Expense3,645 Premium on Bonds Payable355 Cash4,000 Issuer’s Books Dec. 31Interest Expense3,645 Premium on Bonds Payable355 Interest Payable4,000 (continues) $7,106/120 × 6 mo. = $355 (rounded) Assume the bonds were sold for $107,106. Reflects effective interest of 7%

12-40 Straight-Line Method July 1Cash4,000 Bond Investment355 Interest Revenue3,645 Investor’s Books Dec. 31Interest Receivable4,000 Bond Investment355 Interest Revenue3,645

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 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 period5% Stated rate per semiannual period4% Interest amount based on carrying value and effective rate ($87,538 × 0.05)$ 4,377 Interest payment based on face value and stated rate ($100,00 × 0.040) 4,000 Discount amortization$ 377

12-43 Effective-Interest Method Assume 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$107,106 Effective rate per semiannual period3.5% Stated rate per semiannual period4% Interest payment based on face value and stated rate ($100,00 × 0.040) 4,000 Interest amount based on carrying value and effective rate ($107,106 ×.035) 3,749 Premium amortization$ 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 Issuer’s Books Feb. 1Bonds Payable100,000 Discount on Bonds Pay.2,300 Cash97,000 Gain on Bond Redemption700 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$97,700 Redemption price 97,000 Gain on bond redemption$ 700

12-46 Redemption by Purchase of Bonds in the Market Investor’s Books Feb. 1Cash 97,000 Loss on Sale of Bonds700 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 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.

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 Bonds Issued with Conversion Feature Nondetachable and Debt and Equity Not Separated Cash 525,000 Bonds Payable500,000 Premium on Bonds Payable25,000

12-49 Convertible Bonds Cash 525,000 Discount on Bonds Payable20,000 Bonds Payable500,000 Paid-In Capital Arising from Bond Conversion Feature45,000 Issued with Conversion Feature Nondetachable and Debt and Equity Separated Par value of bonds (500 × $1,000)$500,000 Selling price of bonds without conversion feature ($500,000 x 0.96) 480,000 Discount on bonds w/o conversion$ 20,000

12-50 Convertible Bonds Cash 525,000 Discount on Bonds Payable20,000 Bonds Payable500,000 Paid-In Capital Arising from Bond Conversion Feature45,000 Issued with Conversion Feature Nondetachable and Debt and Equity Separated Total cash received on sale of bonds$525,000 Selling price of bonds without conversion feature ($500,000 × 0.96) 480,000 Amount applicable to conversion$ 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 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 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 Stock10,400 Bond Investment—HiTec Co. 9,850 Gain on Conversion of HiTec Co. Bonds550 Investor’s Books—Gain Recognized Market value of stock issued (400 shares at $26)$10,400 Face value of bonds payable$10,000 Less unamortized discount 150 9,850 Loss to company on conversion of bonds$ 550

12-54 Accounting for Conversion Investor’s Books Investment in HiTec Co. Common Stock (carrying value on books)9,850 Bond Investment—HiTec Co. 9,850 Bonds Payable10,000 Loss on Conversion of Bonds550 Common Stock, $1 par400 Paid-In Capital in Excess of Par10,000 Discount on Bonds Payable150 Issuer’s Books

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 Leases Leases 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 ownership 2.Lease includes a bargain purchase option 3.Lease covers 75% or more of the economic life of the asset 4.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 Liabilities Total 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 Expense Interest 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 Transfer of Assets in Full Settlement (Asset Swap) 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 Transfer of Assets in Full Settlement (Asset Swap) 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