1 Debt Financing. 2 Learning Objectives Understand the various classification and measurement...

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Debt Debt FinancingFinancing

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.

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.

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.

ISSUE the debt

Time Line of Business Issues Involved with Long-Term Debt

PayableMortgage

PayableBond

CHOOSE the

method of financing

PAYinterest

+/-RETIREthe debt

ACCOUNTfor the specific aspects of the type of debt

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.

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.

The current ratio is a measure of the liquidity of a business. It is

computed by dividing total current assets by total current liabilities.

Liquidity Example

Tree Company has current assets of $20,000 and current liabilities of

$15,000. Calculate the current ratio.

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

Types of Liabilities

• Liabilities that are Liabilities that are definite in amount.definite in amount.

• Estimated liabilities.Estimated liabilities.

• Contingent liabilities.Contingent liabilities.

• Liabilities that are Liabilities that are definite in amount.definite in amount.

• Estimated liabilities.Estimated liabilities.

• Contingent liabilities.Contingent liabilities.

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.

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.

Contingent Liabilities

Likelihood Definition AccountingTreatment

Probable Future event is likely to occur

Record liability ifestimable

Reasonably possible

More likely than remote, but less likely than probable

Disclose liabilityin footnotes

Remote

Future event is not likely tooccur

No disclosureexcept regardingguarantees

13Accounting for Short-TermDebt 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.

14Accounting for Short-TermDebt Obligations

A short-term obligation that is expected to be refinanced on a long-term basis should not be reported as a current liability.

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-TermDebt Obligations

An ability to refinance may be demonstrated by:

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-TermDebt Obligations

Present Value of $1

The value today of $1 to be received or paid at some future date, given a

specified interest rate.

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?What is the present value of $1?

• Present value of $100 paid in five years discounted at 10 percent:

Today 1 2 3 4 Future

PV=$62.09 $100

Discount at 10%Discount at 10%

Present Value of $1

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.

20The Present Value of the Annuity of $1

Present value of five equal payments of $100 discounted at 10 percent:

Today 1 2 3 4 5$100$100$100$100$100

PV=$379.08

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.

Effects of Compound Interest

0 2 4 6 8 10 12 14 16 18 20 Year

Simple Compound

Comparingthe valueof $100 lump suminvested at 10%for 20 years withsimple interestand compoundinterest.

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.

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.

Mortgage Payable Example

Payment Interest Amount Applied to RemainingDate Amount Expense Reduce Principal Balance

1/1/02 $200,0002/1/02 $2,057 $2,000 $57 199,9433/1/02 2,057 1,999 58 199,8854/1/02 2,057 1,999 58 199,8275/1/02 2,057 1,998 59 199,7686/1/02 2,057 1,998 59 199,709

$200,000 x .12 x 1/122/1/02 Interest Expense 2,000

Mortgage Payable 57Cash 2,057

Secured Loan

A secured loan is a loan backed by certain

assets as collateral.

A secured loan is a loan backed by certain

assets as collateral.

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.

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

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.

• 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.)

• 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.

What are junk bonds?

High-risk, high-yield bonds issued by companies that are

heavily in debt or weak financially.

Reasons management may Reasons management may prefer issuing bonds or notes prefer issuing bonds or notes

instead of stock:instead of stock:

Reasons management may Reasons management may prefer issuing bonds or notes prefer issuing bonds or notes

instead of stock:instead of stock:

Financing With Bonds

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

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

BondBondStatedStatedInterestInterest

RateRate10%10%

8%8% PremiumPremium

1010% FaceFace ValueValue

12%12% DiscountDiscount

36Example: Bond Issued atPar on Interest Date

Issuer’s BooksIssuer’s BooksIssuer’s BooksIssuer’s Books

Jan. 1 Cash 100,000Bonds Payable 100,000

July 1 Interest Expense 4,000Cash 4,000

Dec. 31 Interest Expense 4,000Cash 4,000

37Example: Bond Issued atPar on Interest Date

Investor’s BooksInvestor’s BooksInvestor’s BooksInvestor’s Books

Jan. 1 Bond Investment 100,000Cash 100,000

July 1 Cash 4,000Interest Revenue 4,000

Dec. 31 Cash 4,000Interest Revenue 4,000

38Example: Bond Issued ata 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).

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 Effective rate, 10%rate, 10%

$100,000

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. 1 Cash 87,539Discount on Bonds Payable 12,461

Bonds Payable 100,000

July 1 Interest Expense 4,377Discount on Bonds Payable 377Cash 4,000

Dec. 31 Interest Expense 4,396Discount on Bonds Payable 396Cash 4,000

$87,539 x $87,539 x 0.10 x 6/12 0.10 x 6/12 $87,539 x $87,539 x

0.10 x 6/12 0.10 x 6/12

($87,539 + ($87,539 + $377) x 0.10 $377) x 0.10

x 6/12x 6/12

($87,539 + ($87,539 + $377) x 0.10 $377) x 0.10

x 6/12x 6/12

The Provo Company agreed to issue 5-year, $500,000 bonds and pay 10% interest, compounded semiannually. Assume the effective rate is 12 percent.

July 1 Cash 4,000Bond Investment 377

Interest Revenue 4,377

Dec. 31 Cash 4,000Bond Investment 396

Interest Revenue 4,396

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%7%$100,000

Example: Bond Issued ata Premium

42Example: Bond Issued ata Premium

Jan. 1 Cash 107,107Premium on Bonds Pay. 7,107Bonds Payable 100,000

July 1 Interest Expense 3,749Premium on Bonds Payable 251

Cash 4,000

$107,107 $107,107 x .07 x x .07 x 6/126/12

Example: Bond Issued ata Premium

July 1 Cash 4,000Bond Investment 251Interest Revenue 3749

Jan. 1 Cash 196,000Discount on Bonds Payable 4,000 Bonds Payable 200,000

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.

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

Using straight-line amortization, what entry is made for the interest

payment on June 30, 2002?

Using straight-line amortization, what entry is made for the interest

payment on June 30, 2002?

Jun. 30 Interest Expense 10,200Discount on Bonds Payable 200

Cash 10,000

Paid Interest ($200,000 x .10 x 1/2).

Jun. 30 Interest Expense 9,500Premium on Bonds Payable 500 Cash 10,000

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?

47Example: 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.

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.

A B C D E

(A-B) (D-C) (1,000+D)($1,000 x 04) (E x 0.03)

Prem. Unamort. Bond # Payment Int. Exp. Amort. Prem. Book

$148.80 $1,148.80

(A-B) (D-C) (1,000+D)

# Payment Int. 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

(A-B) (D-C) (1,000+D)

$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

(A-B) (D-C) (1,000+D)

$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

Apr. 30 Cash 155,000 Bonds Payable 150,000 Interest Payable 50,000 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?

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?

53Example: Bonds Issued Between Interest Dates

What is the required entry on June 30 to record payment of interest?

June 30 Interest Expense 2,500Interest Payable 5,000

Cash 7,500 Paid interest ($150,000 x 10% x 1/2).

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.

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.

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.

Feb. 1 Bonds Payable 100,000Discount on Bonds Pay. 2,300Cash 97,000Extraordinary Gain on Bond Redemption 700

Carry value of bonds, 1/1/02 $97,700Redemption price 97,000Gain on bond redemption $ 700

Feb. 1 Cash 97,000Loss on Sale of Bonds 700

Investment in Triad, Inc. Bonds 97,700

Bond Conversion

HiTec Company offers bondholders 40 shares of HiTec Company common

stock, $1 par, in exchange for each $1,000, 8% bond held.

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.

On November 1, an investor exchanges bonds of $10,000 (carry value, $9,850) for 400

shares of common stock.

Bond Conversion

Nov. 1 Investment in HiTec Co. Common Stock 10,400

Investment in HiTec Co. Bonds 9,850Gain on Conversion of HiTec Co. Bonds 550

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.

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.

Bond Conversion

Nov. 1 Bonds Payable 10,000Loss on Conversion of Bonds 550

Common Stock, $1 par 400Paid-In Capital in Excess

of Par Value 10,000Discount on Bonds Payable 150

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.

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.

Troubled Debt Restructuring

Troubled debt restructuring exists only if Troubled debt restructuring exists only if the “creditor for economic or legal the “creditor for economic or legal

reasons related to the debtor’s financial reasons related to the debtor’s financial difficulties grants a concession to the difficulties grants a concession to the

debtor that it would not otherwise debtor that it would not otherwise consider.” (SFAS 15.2)consider.” (SFAS 15.2)

Troubled debt restructuring exists only if Troubled debt restructuring exists only if the “creditor for economic or legal the “creditor for economic or legal

reasons related to the debtor’s financial reasons related to the debtor’s financial difficulties grants a concession to the difficulties grants a concession to the

debtor that it would not otherwise debtor that it would not otherwise consider.” (SFAS 15.2)consider.” (SFAS 15.2)

No Not a troubled debt restructure.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?

Remove debt andasset from books.

Restructuring Gain= Debt - FMV Asset

Remove debt andasset from books and record new equity.

Equity Swap--Debtor

FMV Equity< debt?

No Not a troubled debt restructure.Not a troubled

debt restructure.

Restructuring Gain=Debt - FMV Equity

Asset or Equity Swap--Creditor

FMV Asset> loan?

Yes Not a troubled debt restructure.Not a troubled

debt restructure.

Remove loan from books and record asset at

Restructure Loss =Loan - FMV Asset

Recognize gain onrestructuring. Write-down debt to sum of

future cash flows.Record all future

payments as principal payments.

Recognize gain onrestructuring. Write-down debt to sum of

future cash flows.Record all future

payments as principal payments.

NoTotal futurepayments < debt

book value?

Modification of Terms--Debtor

Reclassify thedebt and amortize

using effectiveinterest method.Interest rate is

the implicit rate.

Reclassify thedebt and amortize

using effectiveinterest method.Interest rate is

the implicit rate.

The EndThe End

1 Debt Financing. 2 Learning Objectives Understand the various classification and measurement...

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