LECTURE 4

DEBT FINANCING (Part 2)

McGraw-Hill /Irwin

2009 The McGraw-Hill Companies, Inc.

Lecture Outline
Part 1 Brief discussions on debt financing Present value of money concept Accounting for debt (bonds)
1. Recording the issuance of bonds.

Part 2
2. Recognizing the applicable interest during the life of the bonds. 3. Accounting for the retirement of bonds either at maturity or prior to the maturity date.

Disclosure

McGraw-Hill /Irwin

2009 The McGraw-Hill Companies, Inc.

Slide 3

Determining Interest Effective Interest Method

Interest accrues on an outstanding debt at a constant percentage of the debt each period. Interest each period is recorded as the effective market rate of interest multiplied by the outstanding balance of the debt (during the interest period).
Interest is recorded as expense to the issuer and revenue to the investor. For the first six-month interest period the amount is calculated as follows:

666,633
Outstanding Balance

(14% 2)
Effective Rate

$46,664
Effective Interest

The bond indenture calls for semiannual interest payments of only $42,000 the stated rate (6%) times the face value of $700,000. The difference ($4,664) increases the liability and is reflected as a reduction in the discount (a valuation account).
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Slide 4

Journal Entries The Interest Method

The effective interest is calculated each period as the market rate times the amount of the debt outstanding during the interest period. At the First Interest Date (June 30)

Masterwear - Issuer
Date Description Jun. 30 Interest expense Discount on bonds payable Cash Debit 46,664 Credit 4,664 42,000

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Slide 5

Change in Debt When Effective Interest Exceeds Cash Paid

Date Jan. 1 Jun. 30 Jun. 30 Jun. 30 Jun. 30 Interest Accrued at 7% .07 666,633 Paid at 6% .06 700,000 Unpaid 46,664 42,000 671,297 = 700,000 Account Balances Outstanding Bonds Payable Discount Balance (Face Value) on Bonds 666,633 = 700,000 33.367 = = 46,664 (42,000) = (4,664) 28,703

The unpaid portion of the effective interest ($4,644) increases the outstanding balance to $671,297 and reduces the discount to $28,703 on June 30.
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Slide 6

Amortization Schedule Discount

Since less cash is paid each period than the effective interest, the unpaid difference increases the outstanding balance of the debt.
Cash Interest (6% Face Amount) 42,000 42,000 42,000 42,000 42,000 42,000 252,000 Effective Interest (7% Outstanding Balance) .07 666,633 = 46,664 Increase in Balance (Discount Reduction) 4,664 Outstanding Balance

Date

01/01/09 06/30/09 12/31/09 06/30/10 12/31/10 06/30/11 12/31/11

666,633 671,297

7% $666,633

$46,664 42,000

6% $700,000

$666,633 + 4,664

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Slide 7

Amortization Schedule Discount

Date Cash Interest (6% Face Amount) 42,000 42,000 42,000 42,000 42,000 42,000 252,000 Effective Interest (7% Outstanding Balance) .07 .07 .07 .07 .07 .07 666,633 = 671,633 = 676,288 = 681,628 = 687,342 = 693,456 = 46,664 46,991 47,340 47,714 48,114 48,544 Increase in Balance (Discount Reduction) 4,664 4,991 5,340 5,714 6,114 6,544 33,367 Outstanding Balance

01/01/09 06/30/09 12/31/09 06/30/10 12/31/10 06/30/11 12/31/11

666,633 671,297 676,288 681,628 687,342 693,456 700,000

285,367

$48,544 is rounded to cause outstanding balance to be exactly $700,000 on 12/31/11.

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Slide 8

When Financial Statements Are Prepared Between Interest Dates

On 1/1/09, Masterwear Industries issues $700,000 face value bonds to United Intergroup. The market interest rate is 14%. The bonds have the following terms:

Face Value of Each Bond = $1,000 Maturity Date = 12/31/11 (3 years) Stated Interest Rate = 12% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/09

Assume Masterwear has September 30th yearends.

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Slide 9

When Financial Statements Are Prepared Between Interest Dates

Recall the entries we prepared on June 30, 2009. These entries will not change.

Masterwear - Issuer
Date Description Jun. 30 Interest expense Discount on bonds payable Cash Debit 46,664 Credit 4,664 42,000

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Slide 10

When Financial Statements Are Prepared Between Interest Dates

Year-end is on September 30, 2009, before the second interest date of December 31, so we must accrue interest for 3 months from June 30 to September 30.

Masterwear - Issuer
Date Description Sep. 30 Interest expense ($46,991 1/2) Discount on bonds payable Interest payable ($42,000 1/2) Debit 23,496 Credit 2,496 21,000

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Slide 11

When Financial Statements Are Prepared Between Interest Dates

On December 31, the next interest payment date, the following entries would be recorded.

Masterwear - Issuer
Date Description Dec. 31 Interest expense ($46,991 1/2) Interest payable ($42,000 1/2) Discount on bonds payable Cash ($700,000 6% ) Debit 23,496 21,000 Credit

2,496 42,000

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Slide 12

The Straight-Line Method A Practical Expediency

Using the straight-line method, the discount in the earlier illustration would be allocated equally to the 6 semiannual periods (3 years): $33,367 6 periods = $5,561 per period
At Each of the Six Interest Dates
Masterwear (Issuer)
Date Description Jun.30 Interest expense (to balance) Discount on bonds payable (total discount 6 periods) Cash (stated rate face amount) Debit 47,561 Credit

5,561 42,000

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Slide 13

Debt Issue Costs

Legal Accounting Underwriting Commission Engraving Printing Registration Promotion
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Slide 14

Long-Term Notes

Present value techniques are used for valuation and interest recognition.

The procedures are similar to those we encountered with bonds.

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Slide 15

Long-Term Notes
On January 1, 2009, Skill Graphics, Inc., a product labeling and graphics firm, borrowed 700,000 cash from First BancCorp and issued a 3-year, $700,000 promissory note. Interest of $42,000 was payable semiannually on June 30 and December 31.

At Issuance
Skill Graphics (Borrower)
Date Description Jan. 1 Cash Notes payable Debit 700,000 Credit 700,000

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Slide 16

Long-Term Notes (continued)

At Each of the Six Interest Dates Skill Graphics (Borrower)
Date Description Interest expense Cash Debit 42,000 Credit 42,000

At Maturity
Date

Skill Graphics (Borrower)

Description Notes payable Cash Debit 700,000 Credit 700,000

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Slide 17

Early Extinguishment of Debt

Debt retired at maturity results in no gains or losses.

BUT
Debt retired before maturity may result in an gain or loss on extinguishment. Cash Proceeds Book Value = Gain or Loss

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Slide 18

Early Extinguishment
Illustration On January 1, 2010, Masterwear Industries called its $700,000, 12% bonds when their carrying amount was $676,290. The indenture specified a call price of $685,000. The bonds were issued previously at a price to yield 14%.
Date Description Jan. 1 Bonds payable Loss on early extinguishment Discount on bonds payable Cash
$685,000 676,290

Debit 700,000 8,710

Credit

23,710 685,000

($700,000 676,290

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Slide 19

Convertible Bonds
Some bonds may be converted into common stock at the option of the holder. When bonds are converted the issuer updates interest expense and amortization of discount or premium to the date of conversion. The bonds are reduced and shares of common stock are increased.
Bonds into Stock

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Slide 20

Induced Conversion
Companies sometimes try to induce conversion of their bonds into stock. One way to induce conversion is through a call provision. When the specified call price is less than the conversion value of the bonds (the market value of the shares), calling the convertible bonds provides bondholders with incentive to convert. Bondholders will choose the shares rather than the lower call price.
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Slide 21

Bonds With Detachable Warrants

Stock warrants provide the option to purchase a specified number of shares of common stock at a specified option price per share within a stated period. A portion of the selling price of the bonds is allocated to the detachable stock warrants.
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Slide 22

Bonds With Detachable Warrants

Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the holder to purchase one share of stock for $18 per share. Immediately after issue the bonds were selling for 98 without the warrants and the warrants have a market value of $16.

Proportional Method
Fair value of bonds without warrants Fair value of the warrants Aggregrate fair value Allocate to bonds $10,000,000 x 98.39% Allocate to warrants $10,000,000 x 1.61% Total face value $ 9,800,000 160,000 $ 9,960,000 $ 9,839,000 161,000 $ 10,000,000
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98.39% 1.61% 100.00%

Slide 23

Tutorial questions
P14-6 P14-15 E14-17 E14-20

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