Intermediate Accounting James D. Stice Earl K. Stice

Intermediate Accounting James D. Stice Earl K. Stice
Chapter 12 Debt Financing 18th Edition Intermediate Accounting James D. Stice Earl K. Stice PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University © 2012 Cengage Learning

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.” The FASB is currently considering a revision of this liability definition. (continued)

Classification of Liabilities
For reporting purposes 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. (continued)

Classification of Liabilities
The classification of a liability as current or noncurrent can impact significantly a company’s ability to raise additional funds. When debt 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. (continued)

Measurement of Liabilities
For measurement purposes, liabilities can be divided into three categories: Liabilities that are definite in amount Estimated liabilities Contingent liabilities The measurement of liabilities always involves some uncertainty because a liability, by definition, involves a future outflow of resources.

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. Accounts payable are not recorded when purchase orders are placed but instead when legal title to the goods passes to the buyer.

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, and is usually reflected on the debtor’s books as Notes Payable. Notes issued to trade creditors for the purchase of goods or services are called trade notes payable. (continued)

Short-Term Debt Nontrade notes payable include notes issued to banks or to officers and stockholders for loans to the company. If a note has no stated rate of interest, or if the stated rate is unreasonable, then the face value of the note would be discounted to the present value to reflect the effective rate of interest implicit in the note.

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. This applies to the currently maturing portion of a long-term debt and to all other short-term obligations except those arising in the normal course of operations that are due in customary terms. (continued)

According to FASB ASC Topic 470 (Debt), both of the following conditions must be met before a short-term obligation can be properly excluded from the current liability classification. Management must intend to refinance the obligation on a long-term basis. Management must demonstrate an ability to refinance the obligation. (continued)

Concerning the second point, the ability to refinance may be demonstrated by either of the following: 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. (continued)

According to IAS 1, for the obligation to be classified as long term the refinancing must take place by the balance sheet date, not the later date when the financial statements are finalized. Under the international standard post-balance-sheet date events are NOT considered when determining whether a refinanceable obligation is reported as current or noncurrent.

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. (continued)

Lines of Credit The line of credit itself is not a liability. However, once the line of credit is used to borrow money, the company has a formal liability that will be reported as either a current or a long-term liability. Maintaining a line of credit is not costless. Banks typically charge a small amount, a fraction of 1% per year. (continued)

Present Value of Long-Term Debt
A mortgage is a loan backed by an asset that serves as collateral for the loan. If the borrower cannot repay the loan, the lender has the legal right to claim the mortgaged asset and sell it in order to recover the loan amount. Mortgages are generally payable in equal installments; a portion of each payment represents interest on the unpaid mortgage balance. (continued)

Financing with Bonds 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.

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, often including restrictions on the payment of dividends or incurrence of additional debt. (continued)

Accounting for Bonds There are three main considerations in accounting for bonds: Recording the issuance or purchase Recognizing the applicable interest during the life of the bonds Accounting for retirement of bonds either at maturity or prior to the maturity date

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.

Issuers of Bonds Bonds and similar debt instruments are issued by private corporations, the U.S. government, state, county, and local governments, school districts, and government-sponsored organizations. Debt securities issued by state, county, and local governments and their agencies are collectively referred to as municipal debt.

Types of Bonds Bonds that mature on a single date are called term bonds. Bonds that mature in installments are referred to as serial bonds. 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. (continued)

Types of Bonds 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. Registered bonds call for the registry of the owner’s name on the corporation books. (continued)

Types of Bonds 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. High-risk, high-yield bonds issued by companies that are heavily in debt or otherwise in weak financial condition are referred to as junk bonds. (continued)

Types of Bonds Junk bonds are issued in at least three types of circumstances. They are issued by companies that once had high credit ratings but have fallen on hard times. They are issued by emerging growth companies. They are issued by companies undergoing restructuring, often in conjunction with a leverage buyout. (continued)

Types of Bonds Convertible bonds provide for their conversion into some other security at the option of the bondholder. Commodity-backed bonds may be redeemable in terms of commodities, such as oil or precious metals. Bond indentures frequently give the issuing company the right to call and retire the bonds prior to maturity. Such bonds are termed callable bonds. (continued)

Types of Bonds Mortgage-backed bonds, in many cases, are just a special form of secured bonds. The underlying collateral for these bonds is the collection of mortgages owned by the issuing entity.

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 bond premium. If the stated rate is less than the market, the bonds will sell at a bond discount. The actual return rate on a bond is known as the market, yield, or effective interest rate. (continued)

Market Price of Bonds Yield 8% Premium Bond Stated Interest Rate 10%
Face Value 12% Discount (continued)

Issuance of Bonds Bonds may be sold directly to investors by the issuer or they may be sold in the open market through security exchanges or through investment bankers. Bonds issued or acquired in exchange for noncash assets or services are recorded at the fair value of the bonds unless the value of the exchanged assets or services is more clearly determinable. (continued)

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. (continued)

Bonds Issued at Par on Interest Date
Issuer’s Books Jan. 1 Cash 100,000 Bonds Payable 100,000 July 1 Interest Expense 4,000 Cash 4,000 Dec. 31 Interest Expense 4,000 Interest Payable 4,000 (continued)

Bonds Issued at Par on Interest Date
Investor’s Books Jan. 1 Bond Investment 100,000 Cash 100,000 July 1 Cash 4,000 Interest Revenue 4,000 Dec. 31 Interest Receivable 4,000 Interest Revenue 4,000

Bonds Issued at Discount on Interest Date
Issuer’s Books Jan. 1 Cash 87,538 Discount on Bonds Payable 12,462 Bonds Payable 100,000 Investor’s Books Jan. 1 Bond Investment 87,538 Cash 87,538

Bonds Issued at Premium on Interest Date
The bonds were issued on January 1 but the effective rate of interest was 7%, requiring recognition of a premium of $7,106. Only reading the table for 3 ½ percent, you should arrive at the bonds having a present value of $107,106. (continued)

Bonds Issued at Premium on Interest Date
Issuer’s Books Jan. 1 Cash 107,106 Premium on Bonds Payable 7,106 Bonds Payable 100,000 Investor’s Books Jan. 1 Bond Investment 107,106 Cash 107,106 (continued)

Bonds Issued at Par between Interest Date
Issuer’s Books Mar. 1 Cash 101,333 Bonds Payable 100,000 Interest Payable 1,333 ($100,000 × 0.08 × 2/12) July 1 Interest Expense 2,667 Interest Payable 1,333 Cash 4,000 ($100,000 × 0.08 × 4/12) (continued)

Bonds Issued at Par between Interest Date
Investor’s Books Mar. 1 Bond Investment 100,000 Interest Receivable 1,333 Cash 101,333 July 1 Cash 4,000 Interest Receivable 1,333 Interest Revenue 2,667

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.

Accounting for Bond Interest
When bonds are issued at a premium or discount, the market acts to adjust the stated interest rate to a market or effective interest rate. Because the initial premium or discount, the periodic interest payments made over the bond’s life by the issuer do not represent the total interest expense involved, an amortization adjustment is made.

Straight-Line Method The straight-line method provides for the recognition of an equal amount of premium or discount amortization each period. A 10-year, 10% bond issue with a maturity value of $200,00 was sold on the issuance date at 103, the $6,000 premium would be amortized evenly over 120 months until maturity. (continued)

Straight-Line Method To illustrate the accounting for bond interest using straight-line amortization, consider the earlier example of the $100,000, 8%, 10-year bonds issued on January 1. When sold at a $12,462 discount, the appropriate entries to record interest on July 1 and December 31 are shown next. (continued)

Straight-Line Method Issuer’s Books July 1 Interest Expense 4,623
Discount on Bonds Payable 623 Cash 4,000 $12,462/120 × 6 mo. = $623 (rounded) Dec. 31 Interest Expense 4,623 Discount on Bonds Payable 623 Interest Payable 4,000 (continued)

Straight-Line Method Investor’s Books July 1 Cash 4,000
Bond Investment 623 Interest Revenue 4,623 Dec. 31 Interest Receivable 4,000 Bond Investment 623 Interest Revenue 4,623 (continued)

Straight-Line Method Assume the bonds were sold for $107,106.
Issuer’s Books Reflects effective interest of 7% July 1 Interest Expense 3,645 Premium on Bonds Payable 355 Cash 4,000 $7,106/120 × 6 mo. = $355 (rounded) Dec. 31 Interest Expense 3,645 Premium on Bonds Payable 355 Interest Payable 4,000 (continued)

Straight-Line Method Investor’s Books July 1 Cash 4,000
Bond Investment 355 Interest Revenue 3,645 Dec. 31 Interest Receivable 4,000 Bond Investment 355 Interest Revenue 3,645

Effective-Interest Method
The effective-interest method of amortization uses a uniform interest rate based on a changing loan balance and provides for an increasing premium or discount amortization each period. In order to use this method, the effective-interest rate for the bonds must be known. (continued)

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 period 5% Stated rate per semiannual period 4% 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 $ (continued)

Assume the $100,000, 8%, 10-year bonds is sold for $107,106, based on an effective interest rate of 7%. The premium amortization for the first 6-month period would be computed as follows: Bond balance (carrying value) at beginning of first period $107,106 Effective 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) ,000 Interest amount based on carrying value and effective rate ($107,106 × .035) ,749 Premium amortization $ (continued)

The second 6-month period would be computed as follows: Bond balance (carrying value) at beginning of second period ($107,106 – $251) $106,855 Effective 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) ,000 Interest amount based on carrying value and effective rate ($106,855 x .035) ,740 Premium amortization $ (continued)

Cash Flow Effects of Amortizing Bond Premiums and Discounts
The amortization of a bond discount or premium does not involve the receipt or payment of cash. Like other noncash items, it must be considered in preparing a statement of cash flows. Using the indirect method, the discount amortization is added back to net income. (continued)

Using the indirect method, the premium amortization is subtracted from net income. Using the direct method, the expense reported on the income statement is decreased by the amount of discount amortization or increased by the amount of the premium amortization. (continued)

A company issues $100,000, 8%, 10-year bonds when the effective rate of interest is 10%. The bonds are issued at a price of $87,538. The amount of discount amortized during the first year is $733 ($377 + $396). The amount of interest expense disclosed on the income statement is $8,773 ($4,377 + $4,396), and the amount of cash paid is $8,000. (continued)

Retirement of Bonds at Maturity
If the bonds are held to maturity, the discount or premium has been eliminated over the life of the bond. The entry for retiring the bond is straightforward. Assume a $100,000 bond matures on July 1. July 1 Bonds Payable 100,000 Cash 100,000 Issuer’s Books (continued)

Retirement of Bonds at Maturity
Investor’s Books July 1 Cash 100,000 Bond Investment 100,000 There is no gain or loss on retirement because the carrying value is equal to the maturity value. Any bonds not presented for payment at their maturity date should be moved to Matured Bonds Payable.

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.

Redemption by Purchase of Bonds in the Market
Triad, Inc.’s $100,000, 8% bonds are not held to maturity. They are redeemed on February 1, 2013, at 97. The carrying value of the bonds is $97,700 as of this date. Interest payment dates are January 31 and July 31. Carrying value of bonds, 2/1/13 $97,700 Redemption price 97,000 Gain on bond redemption $ Issuer’s Books Feb. 1 Bonds Payable 100,000 Discount on Bonds Pay. 2,300 Cash 97,000 Gain on Bond Redemption 700 (continued)

Redemption by Purchase of Bonds in the Market
Investor’s Books Feb. 1 Cash 97,000 Loss on Sale of Bonds Bond Investment— Triad Inc. 97,700 Before the issuance of FASB Statement No. 125 in 1996, early extinguishment of debt could also be accomplished through in-substance defeasance.

Redemption by Exercise of Call Provision
A call provision gives the issuer the option of retiring bonds prior to maturity. Frequently, the call must be made on an interest payment date. When bonds are called, the difference between the amount paid and the bond carrying value is reported as a gain or a loss on both the issuer’s and investor’s books.

Convertible Bonds Convertible debt securities usually have the following features: 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 A call option retained by the issuer Convertible debt gives both the issuer and the holder advantages. (continued)

Issued with Conversion Feature Nondetachable
Convertible Bonds Issued with Conversion Feature Nondetachable 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. Cash 525,000 Bonds Payable 500,000 Premium on Bonds Payable 25,000 (continued)

Convertible Bonds Issued with Conversion Feature Nondetachable Cash 525,000 Discount on Bonds Payable 20,000 Bonds Payable 500,000 Paid-In Capital Arising from Bond Conversion Feature 45,000 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 (continued)

Convertible Bonds Issued with Conversion Feature Nondetachable Cash 525,000 Discount on Bonds Payable 20,000 Bonds Payable 500,000 Paid-In Capital Arising from Bond Conversion Feature 45,000 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

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.

Bond Refinancing Cash for the retirement of a bond is frequently raised through the sale of a new issue and referred to as bond refinancing. Bond refinancing may take place when an issue matures, or bonds may be refinanced prior to their maturity when the interest rate has dropped and the interest savings on a new issue will more than offset the cost of retiring the old issue. (continued)

Bond Refinancing A corporation has outstanding $1,000,000 of 12% bonds callable at 102 with a remaining 10-year term, and similar 10-year bonds can be marketed currently at an interest rate of only 10%. When refinancing takes place before the maturity date of the old issue, the call premium and unamortized discount and issue costs of the original bonds are considered in computing the gain or loss.

Fair Value Option Because accounting has long been founded on a backbone of historical cost, the FASB and IASB are transitioning cautiously, item by item, to fair value. Under SFAS No. 159, a company has the option 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. (continued)

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

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: Lease transfers ownership Lease includes a bargain purchase option Lease covers 75% or more of the economic life of the asset Present value of lease payments is 90% or more of the asset value

Unconsolidated Subsidiaries
In 1987, the FASB issued pre-Codification Statement No. 94 requiring all majority-owned subsidiaries to be consolidated. This effectively eliminated one opportunity that companies had been using for off-balance-sheet financing. Companies are able to avoid recognizing debt associated with subsidiaries that are less than 50% owned by the company.

Variable Interest Entities (VIEs) Example
Sponsor Company requires the use of a building costing $100,000. Rather than buy the building, Sponsor facilitates the establishment of 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 to Sponsor (carefully crafted to qualify as an operating lease). (continued)

Variable Interest Entities (VIEs) Example
Sponsor’s Books Assets $0 Liabilities 0 VIE Company’s Books Assets: Building $100,000 Liabilities: Bank loan 90,000 Equity: Paid-in capital 10,000

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.

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? R&D arrangements may take a variety of forms, including a limited partnership.

Research and Development Arrangements
At times, companies become involved in long-term commitments that are related to project financing arrangements. The arrangement should be disclosed in a note to the financial statements.

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 = (continued)

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 = The number of times interest is earned reflects the company’s ability to meet interest payments and the degree of safety afforded the creditors.

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, and can take many different forms. (continued)

Accounting for Troubled Debt Restructuring
The major issue addressed by FASB ASC Subtopic is whether a troubled debt restructuring agreement should be viewed as a significant economic transaction. If it is considered to be a significant economic transaction, entries should be made on the issuer’s books to reflect any gain or loss. If not considered significant, no entries are required.

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: a gain or loss on disposal of the asset and a gain arising from the concession granted in the restructuring of the debt. (continued)

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 The gain or loss on disposal of an asset is usually reported as an ordinary income item . (continued)

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 The classification of this loss depends on the criteria being used to recognize irregular or extraordinary items. (continued)

Realty, Inc. holds $40,000 face value of Stanton’s bonds. Because of the troubled financial condition of Stanton Industries, Realty Inc. has previously recognized as a loss a $5,000 decline in the value of the debt, plus interest receivable of $4,000. The entries for Stanton and Realty are on Slides and (continued)

Stanton Industries (Issuer) Interest Payable 50,000 Bonds Payable 500,000 Discount on Bonds Payable 5,000 Long-Term Investment—Worth Common Stock 350,000 Gain on Disposal of Worth Common Stock 50,000 Gain on Restructuring of Debt 145,000 Carrying value of Worth common $350,000 Market value of Worth common $400,000 Carrying value of debt liquidated $545,000 $50,000 gain on disposal $145,000 gain from restructuring (continued)

Realty Inc. (Investor) Long-Term Investments—Worth Common Stock 32,000 Loss on Restructuring of Debt 7,000 Bond Investments—Stanton Industries 35,000 Interest Receivable 4,000 Percentage of debt held by Realty Inc.: $40,000/$500,000 = 8% Market value of long-term investment received in settlement of debt: 0.08 × $400,000 = $32,000

Modification of Debt Terms
There are many ways debt terms may be modified to aid a troubled debtor. Modification may involve either the interest or the maturity value or both. Interest concessions may involve a reduction of the interest rate, forgiveness of unpaid interest, or a moratorium on interest payments for a period of time. (continued)

Chapter 12 ₵ The End $

Intermediate Accounting James D. Stice Earl K. Stice

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