1. 1 Debt Financing

2. 2 Learning Objectives  Understand the various classification and measurement issues associated with debt.  Account for short-term debt obligations, including those expected to be refinanced, and describe the purpose of lines of credit.  Apply present value concepts to the accounting for long-term debts such as mortgages.

3. 3 Learning Objectives  Understand the various types of bonds, compute the price of a bond issue, and account for the issuance, interest, and redemption of bonds.  Explain various types of off-balance-sheet financing, and understand the reasons for this type of financing.  Analyze a firm’s debt position using ratios.

4. 4 Learning Objectives  Review the notes to financial statements, and understand the disclosure associated with debt financing. EXPANDED MATERIAL  Understand the conditions under which troubled debt restructuring occurs, and be able to account for troubled debt restructuring.

5. 5 ISSUE the debt Time Line of Business Issues Involved with Long-Term Debt Notes Payable Mortgage Payable Bond CHOOSE the method of financing Bond PAY interest +/- RETIRE the debt ACCOUNT for the specific aspects of the type of debt

6. 6 Liabilities Definition: The obligation of a particular entity to transfer assets or provide services. –Must be the result of past transactions or events. –Probable transfer of assets (or services) must be in the future. 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.

7. 7 Current Ratio The current ratio is a measure of the liquidity of a business. It is computed by dividing total current assets by total current liabilities.

8. 8 Liquidity Example Tree Company has current assets of $20,000 and current liabilities of $15,000. Calculate the current ratio. Current Ratio: Current assets $20,000 Current liabilities $15,000 = 1.333

9. 9 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.

10. 10 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.

11. 11 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.

12. 12 Contingent Liabilities Likelihood Definition Accounting Treatment Probable Future event is likely to occur Record liability if estimable Reasonably possible More likely than remote, but less likely than probable Disclose liability in footnotes Remote Future event is not likely to occur No disclosure except regarding guarantees

13. 13 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.

14. 14 Accounting for Short-Term Debt Obligations A short-term obligation that is expected to be refinanced on a long-term basis should not be reported as a current liability.

15. 15 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:

16. 16 The terms of the refinancing agreement should be noncancelable as to all parties. The terms of the refinancing agreement should extend beyond the current year. The company should not be in violation of the agreement at the balance sheet date or the date of issuance. The lender or investor should be financially capable of meeting the refinancing requirements. The terms of the refinancing agreement should be noncancelable as to all parties. The terms of the refinancing agreement should extend beyond the current year. The company should not be in violation of the agreement at the balance sheet date or the date of issuance. The lender or investor should be financially capable of meeting the refinancing requirements. Accounting for Short-Term Debt Obligations

17. 17 Present Value of $1 The value today of $1 to be received or paid at some future date, given a specified interest rate. What is the present value of $1?

18. 18 Present value of $100 paid in five years discounted at 10 percent: Today1234Future PV=$62.09$100 Discount at 10% Present Value of $1

19. 19 Annuities Annuity: A series of equal amounts to be received or paid at equal time intervals, given a specified interest rate. Present Value of an Annuity: The value today of a series of equally spaced, equal-amount payments to be made or received, given a specified interest rate.

20. 20 The Present Value of the Annuity of $1 Present value of five equal payments of $100 discounted at 10 percent: Today12345 $100 PV=$379. 08

21. 21 Compounding of Interest Compounding Periods: The period of time for which interest is computed. –Interest is compounded annually or semiannually. –The interest rate per compounding period is the yearly interest rate divided by compounding periods per year. Compound Interest: Interest computed on principal plus previously accumulated interest.

22. 22 Effects of Compound Interest Comparing the value of $100 lump sum invested at 10% for 20 years with simple interest and compound interest.

23. 23 Mortgage Payable Example On January 1, 2002, Crystal 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, 2002.

24. 24 Mortgage Payable Example Payment Interest Amount Applied to Remaining Date Amount Expense Reduce Principal Balance 1/1/02$200,000 2/1/02$2,057$2,000$57199,943 3/1/022,0571,99958199,885 4/1/022,0571,99958199,827 5/1/022,0571,99859199,768 6/1/022,0571,99859199,709 $200,000 x.12 x 1/12 2/1/02 Interest Expense2,000 Mortgage Payable57 Cash2,057

25. 25 Secured Loan A secured loan is a loan backed by certain assets as collateral.

26. 26 Nature of 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

27. 27 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.

28. 28 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 (Cont.)

29. 29 Zero-interest bonds: Bonds that do not bear interest but instead are sold at significant discounts. Convertible bonds: Bonds that can be converted to other securities at the option of the bondholder. 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 (Cont.)

30. 30 Types of Bonds (Cont.) What are junk bonds?

31. 31 Types of Bonds (Cont.) High-risk, high-yield bonds issued by companies that are heavily in debt or weak financially.

32. 32 Reasons management may prefer issuing bonds or notes instead of stock: Financing With Bonds

33. 33 Present owners remain in control of the corporation. Interest is a deductible expense in arriving at taxable income, while 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 dividends that might be expected by shareholders. Financing With Bonds

34. 34  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. Characteristics of Bonds

35. 35 Characteristics of BondsBondStatedInterestRate10% 8%Premium 10 10% FaceValue Face Value 12%Discount Yield

36. 36 Example: 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

37. 37 Example: 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

38. 38 Example: Bond Issued at a Discount On January 1, $100,000, 8%, 10-year bonds were issued for $87,519 (which provided an effective interest rate of 10% to the investor). Effective rate, 10% $100,000 8%

39. 39 Example: Bond Issued at a Discount The Provo Company agreed to issue 5-year, $500,000 bonds and pay 10% interest, compounded semiannually. Assume the effective rate is 12 percent. Issuer’s Books Jan. 1Cash87,539 Discount on Bonds Payable12,461 Bonds Payable100,000 July 1Interest Expense4,377 Discount on Bonds Payable377 Cash4,000 Dec. 31Interest Expense4,396 Discount on Bonds Payable396 Cash4,000 $87,539 x 0.10 x 6/12 ($87,539 + $377) x 0.10 x 6/12

40. 40 Example: Bond Issued at a Discount The Provo Company agreed to issue 5-year, $500,000 bonds and pay 10% interest, compounded semiannually. Assume the effective rate is 12 percent. Jan. 1Bond Investment87,539 Cash87,539 July 1Cash4,000 Bond Investment377 Interest Revenue4,377 Dec. 31Cash4,000 Bond Investment396 Interest Revenue4,396 Investor’s Books

41. 41 On January 1, $100,000, 8%, 10-year bonds were issued for $107,107 (which provided an effective interest rate of 7% to the investor). 7% $100,000 8% Example: Bond Issued at a Premium

42. 42 Example: Bond Issued at a Premium Issuer’s Books Jan. 1Cash107,107 Premium on Bonds Pay.7,107 Bonds Payable100,000 July 1Interest Expense3,749 Premium on Bonds Payable251 Cash4,000 $107,107 x.07 x 6/12

43. 43 Investor’s Books Example: Bond Issued at a Premium Jan. 1Bond Investment107,107 Cash107,107 July 1Cash 4,000 Bond Investment251 Interest Revenue3749

44. 44 Jan. 1 Cash196,000 Discount on Bonds Payable 4,000 Bonds Payable200,000 Issued $200,000 bond at a discount. On January 1, 2002, Tree Company agreed to issue 10-year, $200,000 bonds and pay 10% interest, compounded semiannually. The company received $196,000 for the bonds. Make the entry to record the issuance of the bonds. Straight-Line Amortization

45. 45 Using straight-line amortization, what entry is made for the interest payment on June 30, 2002? Straight-Line Amortization Jun. 30Interest Expense10,200 Discount on Bonds Payable 200 Cash10,000 Paid Interest ($200,000 x.10 x 1/2).

46. 46 Straight-Line Amortization Jun. 30Interest Expense9,500 Premium on Bonds Payable 500 Cash10,000 Paid Interest ($200,000 x.10 x 1/2). On January 1, 2002, Tree Company agreed to issue 10-year, $200,000 bonds and pay 10% interest, compounded semiannually. The company received $210,000 for the bonds. Using straight-line amortization, what entry is needed on July 31, 2002?

47. 47 Example: Effective-Interest Method The Pioneer Company issues a $1,000, 8%, 10-year bond. The market rate was 6% at the time of issuance. Create an effective-interest table.

48. 48 Example: Effective-Interest Method A B C D E (A-B)(D-C)(1,000+D)($1,000 x 04) (E x 0.03) Prem.Unamort.Bond #PaymentInt. Exp.Amort.Prem.Book $148.80$1,148.80

49. 49 Example: Effective-Interest Method (A-B)(D-C)(1,000+D) #PaymentInt. Exp.Amort.Prem.Book $148.80$1,148.80 1 $40.00$34.46$5.54 143.26 1,143.26 ($1,000 x 04) (E x 0.03) A B C D E Prem.Unamort.Bond

50. 50 Example: Effective-Interest Method (A-B)(D-C)(1,000+D) #PaymentInt. Exp.Amort.Prem.Book $148.80$1,148.80 1 $40.00$34.46$5.54 143.26 1,143.26 2 40.00 34.30 5.70 137.56 1,137.56 ($1,000 x 04) (E x 0.03) A B C D E Prem.Unamort.Bond

51. 51 Example: Effective-Interest Method (A-B)(D-C)(1,000+D) #PaymentInt. Exp.Amort.Prem.Book $148.80$1,148.80 1 $40.00$34.46$5.54 143.26 1,143.26 2 40.00 34.30 5.70 137.56 1,137.56 3 40.00 34.13 5.87 131.69 1,131.69 ($1,000 x 04) (E x 0.03) A B C D E Prem.Unamort.Bond

52. 52 Apr. 30 Cash155,000 Bonds Payable150,000 Interest Payable50,000 Sold $150,000, 10% bond at face value plus four months’ accrued interest. Example: Bonds Issued Between Interest Dates On January 1, 2002, Miller Company received authorization to issue 10-year, $150,000 bonds and pay 10% interest on June 31 and December 31 of each year. The bonds sold at face value on April 30, 2002. What is the required entry on April 30?

53. 53 Example: Bonds Issued Between Interest Dates What is the required entry on June 30 to record payment of interest? June 30 Interest Expense2,500 Interest Payable5,000 Cash7,500 Paid interest ($150,000 x 10% x 1/2).

54. 54 Retiring Bonds 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.

55. 55 Retiring Bonds Prior to Maturity Triad, Inc.’s $100,000, 8% bonds are not held to maturity. They are redeemed on February 1, 2002, at 97. The carrying value of the bonds is $97,700 as of this date. Interest payment dates are January 31 and July 31.

56. 56 Retiring Bonds Prior to Maturity 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$97,700 Redemption price97,000 Gain on bond redemption$ 700

57. 57 Retiring Bonds Prior to Maturity Investor’s Books Feb. 1Cash97,000 Loss on Sale of Bonds700 Investment in Triad, Inc. Bonds97,700

58. 58 Bond Conversion HiTec Company offers bondholders 40 shares of HiTec Company common stock, $1 par, in exchange for each $1,000, 8% bond held. On November 1, an investor exchanges bonds of $10,000 (carry value, $9,850) for 400 shares of common stock.

59. 59 Bond 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.

60. 60 Bond Conversion 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

61. 61 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. Leveraged Buy-Out (LBO): An acquisition of a company where a substantial amount of the purchase price, often 90 percent or more, is debt-financed.

62. 62 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.

63. 63 Troubled Debt Restructuring Troubled debt restructuring exists only if the “creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider.” (SFAS 15.2)

64. 64 No Not a troubled debt restructure. Disposal Gain/Loss = FMV Asset - Book Value of Asset Disposal Gain/Loss = FMV Asset - Book Value of Asset Asset Swap--Debtor FMV Asset < debt? Yes Remove debt and asset from books. Restructuring Gain = Debt - FMV Asset

65. 65 Yes Remove debt and asset from books and record new equity. Remove debt and asset from books and record new equity. Equity Swap--Debtor FMV Equity < debt? No Not a troubled debt restructure. Restructuring Gain =Debt - FMV Equity Restructuring Gain =Debt - FMV Equity

66. 66 Asset or Equity Swap--Creditor FMV Asset > loan? Yes Not a troubled debt restructure. Remove loan from books and record asset at FMV. No Restructure Loss = Loan - FMV Asset Restructure Loss = Loan - FMV Asset

67. 67 Recognize gain on restructuring. Write- down debt to sum of future cash flows. Record all future payments as principal payments. Recognize gain on restructuring. Write- down debt to sum of future cash flows. Record all future payments as principal payments. No Total future payments < debt book value? Modification of Terms--Debtor Reclassify the debt and amortize using effective interest method. Interest rate is the implicit rate. Reclassify the debt and amortize using effective interest method. Interest rate is the implicit rate. Yes

68. 68 The End