Chapter 14 Long Term Debt Financing

I Basic Accounting for Bonds

 Basics for Bonds
o What are bonds?
o Why issue bonds?
o Types of Bonds
 Determining Bonds’ Issuing Prices
o Bonds Issued at Face Value
o Bonds Issued at a Discount
o Bonds Issued at a Premium
 Accounting for Bonds Issued at Face Value
 Accounting for Bonds Issued at a Discount
 Accounting for Bonds Issued at a Premium

II. Special Issues

a. Non-December Fiscal Year End
b. Bond Issued between Interest Dates
c. Extinguishment of L-T Liabilities
d. Fair Value Option
e. Off-Balance-Sheet Financing
i. Brief Introduction of Special Purpose Entity
ii. Further reading: Off-Balance Sheet Financing

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I Accounting for Bonds

(1.1) Basics for Bonds

a. What are bonds?—
1. a form of interest bearing notes payable
2. Bond contract known as a bond indenture
3. Paper certificate, typically a 1,000 face value.

b. Why issue bonds?—to obtain large amount of long term capital

Q: Bond or Loan?

c. Type of Bonds
 The extent to which bondholders are protected
o Debenture (Unsecured, no underlying assets pledged)
o Secure Bonds (with pledge of company assets)

 How the bond interest is paid

o Registered Bonds (Pay interest only to registered bondholders)
o Coupon Bonds (Pay interest to anyone hold the bonds with coupon)

 How the bond mature

o Term bonds (bonds that mature in one single sum on a specified future date)
o Serial bonds (bonds that mature in a series of installments)
o Callable bonds (bonds that issuer can redeem at any time at a specified price)
o Convertible bonds (bonds can be converted to other securities, such as stocks
after a specified date at the option of bondholders)
 Others
o Deep-discounted/zero-interested bonds (bonds that are sold at a discount and
provides the buyer’s total interest payoff at maturity).
o Income bond (bonds that pay no interest unless the issuing company is profitable)
o Revenue bond (bonds that pay interests from specified revenue sources. They are
most frequently issued by air ports, school districts, toll-road authorities etc.)

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(1.2) Determining a Bond’s Issuance Price

Effective rate (yield rate, market rate) of interest—rate investors expect to earn on their
investment

Stated rate (coupon rate, nominal) of interest—the rate printed on the bond

 Effective rate=stated rate bonds issued at?

 Effective rate>stated rate bonds issued at?
 Effective rate<stated rate bonds issued at?

What factors influence the market price of bonds (effective rate)?

 The riskiness of the bonds
o General economic condition
o Individual company’s financial status
 The interest rate at which the bonds are issued
 The characteristics of bond (callable? Convertible? Mortgage backed? ...)

4 steps to compute bond values (Term bond):

 (1) Determine the market interest rate (effective rate)*
 (2) Compute the PV of the maturity amount**
 (3) Compute the PV of the annuity of annual interest payment **
 Add (2) and (3)
Note: *Investors rely on Moody’s or Standard and Poor Bond rating to determine the expected
rate of return
**Discounted by the effective rate (market rate)
**The stated rate of interest is sued only to compute the amount of the periodic interest
payments.

(1.3). Accounting for bonds issued at face value

Illustration: Santos Company issues R$100,000 in bonds dated January 1, 2019, due in five
years with 9 percent interest payable annually on January 1. At the time of issue, the market rate
for such bonds is 9 percent.

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 PV of the Bond:

 Journal entry on date of issue, Jan. 1, 2019.

 Journal entry on fiscal year end Dec.31, 2019.

 Journal entry to record first payment on Jan.1, 2020

 Journal entry to record last payment on Jan.1, 2024

Big Questions:
Conceptually, what are “bond premium” and “bond discount”? How do we treat them?

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(1.4). Accounting for bonds issued at a discount
Illustration: Evermaster Corporation issued €100,000 of 8% term bonds on January 1, 2019, due on
January 1, 2024, with interest payable each July 1 and January 1. Investors require an effective-interest
rate of 10%. Calculate the bond proceeds.

What is the bond value?

 Journal entry on 1.1.2019

 Journal entry for the first payment of interest on 7.1.2019

 Adjusting entry on 12.31.2019

 Cash entry on 1.1.2020

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(1.5). Accounting for bonds issued at a premium
Illustration: Evermaster Corporation issued €100,000 of 8% term bonds on January 1, 2019, due on
January 1, 2020, with interest payable each July 1 and January 1. Investors require an effective-interest
rate of 6%. Calculate the bond proceeds.

What is the bond value?

 Journal entry on 1.1.2019

 Journal entry for the first payment of interest on 7.1.2019

 Adjusting entry on 12.31.2020

 Cash entry on 1.1.2020

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(2) Special Issues:

(2.1) Fiscal year end is not December

What happens if Evermaster prepares financial statements at the end of February 2019? In this case, the
company prorates the premium by the appropriate number of months to arrive at the proper interest
expense.

(2.2) Bonds Issued between Interest Dates

Bond investors will pay the seller the interest accrued from the last interest payment date to the date of
issue. On the next semiannual interest payment date, bond investors will receive the full six months’
interest payment.

Bond Issued at Par:

Illustration: Assume Evermaster issued its five-year bonds, dated January 1, 2019, on May 1, 2019, at
par (€100,000). Evermaster records the issuance of the bonds between interest dates as follows.

On July 1, 2019, two months after the date of purchase, Evermaster pays the investors six months’
interest, by making the following entry.

Bonds Issued at Premium

Illustration: Assume that the Evermaster 8% bonds were issued on May 1, 2019, to yield 6%. Thus, the
bonds are issued at a premium price of €108,039. Evermaster records the issuance of the bonds between
interest dates as follows.

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(2.3) Extinguishment of Non-Current Liabilities
1. Extinguishment with cash before maturity,
2. Extinguishment by transferring assets or securities, and
3. Extinguishment with modification of terms.

Extinguishment with cash before maturity,

 Net carrying amount > Reacquisition price = Gain

 Reacquisition price > Net carrying amount = Loss
 At time of reacquisition, unamortized premium or discount must be amortized up to
the reacquisition date.

Illustration: Evermaster bonds issued at a discount on January 1, 2019. These bonds are due in five years.
The bonds have a par value of €100,000, a coupon rate of 8% paid semiannually, and were sold to yield
10%.

Two years after the issue date on January 1, 2021, Evermaster calls the entire issue at 101 and cancels it.

Extinguishment by Exchanging Assets or Securities

 Creditor should account for the non-cash assets or equity interest received at their fair
value.
 Debtor recognizes a gain equal to the excess of the carrying amount of the payable over
the fair value of the assets or equity transferred (gain).

Illustration: Hamburg Bank loaned €20,000,000 to Bonn Mortgage Company. Bonn, in turn, invested
these monies in residential apartment buildings. However, because of low occupancy rates, it cannot meet
its loan obligations. Hamburg Bank agrees to accept from Bonn Mortgage real estate with a fair value of
€16,000,000 in full settlement of the €20,000,000 loan obligation. The real estate has a carrying value of
€21,000,000 on the books of Bonn Mortgage. Bonn (debtor) records this transaction as follows.

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Now assume that Hamburg Bank agrees to accept from Bonn Mortgage 320,000 ordinary shares (€10 par)
that have a fair value of €16,000,000, in full settlement of the €20,000,000 loan obligation. Bonn
Mortgage (debtor) records this transaction as follows

Extinguishment with Modification of Terms

IFRS requires the modification to be accounted for as an extinguishment of the old note and issuance of
the new note, measured at fair value.

Illustration: On December 31, 2019, Morgan National Bank enters into a debt modification agreement
with Resorts Development Company. The bank restructures a ¥10,500,000 loan receivable issued at par
(interest paid to date) by:
► Reducing the principal obligation from ¥10,500,000 to ¥9,000,000;
► Extending the maturity date from December 31, 2019, to December 31, 2023; and
► Reducing the interest rate from the historical effective rate of 12 percent to 8 percent.
Given Resorts Development’s financial distress, its market-based borrowing rate is 15
percent.

The gain on the modification is ¥3,298,664, which is the difference between the prior carrying value
(¥10,500,000) and the fair value of the restructured note, as computed in Illustration 14-23 (¥7,201,336).
Given this information, Resorts Development makes the following entry to record the modification.

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(2.4) Fair Value Option

Companies have the option to record fair value in their accounts for most financial assets and
liabilities, including bonds and notes payable.

The IASB believes that fair value measurement for financial instruments, including financial liabilities,
provides more relevant and understandable information than amortized cost.

Illustrations: Edmonds Company has issued €500,000 of 6 percent bonds at face value on May 1, 2015.
Edmonds chooses the fair value option for these bonds. At December 31, 2015, the value of the bonds is
now €480,000 because interest rates in the market have increased to 8 percent.

(2.5) Off-balance-sheet financing is an attempt to borrow monies in such a way to prevent recording the
obligations.

Different Forms:
► Non-Consolidated Subsidiary (Chapter 17)
► Special Purpose Entity (SPE)
► Operating Leases

(2.5.1) Brief Introduction of Special Purpose Entities

 An SPE is formed by the sponsoring company and is capitalized with equity investment.
 The SPE leverages this equity investment with borrowing form the credit markets and
purchases earnings assets from or for the sponsoring company.
 The cash flow from the earnings assets is used to repay the debt.

Illustration of SPE transaction to sell Accounts Receivable

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Illustration of SPE transaction to leaseback self-constructed assets

(2.5.2) Further readings: Off Balance Sheet Financing

Article: Uncovering Hidden Debt

By Ben McClure |
Is the company whose stock you own carrying more debt than the balance sheet is showing? Most of the
information about debt can be found on the balance sheet--but many debt obligations are not disclosed
there. Here is a review of some off-balance-sheet transactions and what they mean for investors.

The term "off-balance-sheet" debt has recently come under the spotlight. The reason, of course, is Enron,
which used underhanded techniques to shift debt off its balance sheet, making the company's
fundamentals look far stronger than they were. That said, not all off–balance-sheet finance is shady. In
fact, it can be a useful tool that all sorts of companies can use for a variety of legitimate purposes--such as
tapping into extra sources of financing and reducing liability risk that could hurt earnings.

As an investor, it's your job to understand the differences between various off-balance-sheet transactions.
Has the company really reduced its risk by shifting the burden of debt to another company, or has it
simply come up with a devious way of eliminating a liability from its balance sheet?

Operating Leases
A lot of investors don't know that there are two kinds of leases: capital leases, which show up on the
balance sheet, and operating leases, which do not.

Under accounting rules, a capital lease is treated like a purchase. Let's say an airline company buying an
airplane sets up a long-term payment lease plan and pays for the airplane over time. Since the airline will
ultimately own the plane, it shows up on its books as an asset, and the lease obligations show up as
liabilities.

If the airline sets up an operating lease, the leasing group retains ownership of the plane; therefore, the
transaction does not appear on the airline's balance sheet. The lease payments appear as operating
expenses instead. Operating leases, which are popular in industries that use expensive equipment, are
disclosed in the footnotes of the company's published financial statements.

The accounting differences between capital and operating leases impact the income statement, cash flow
statement as well as the balance sheet. Payments for operating leases show up as cash outflows from

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operations. Capital lease payments, by contrast, are divided between operating activities and financing
activities. Therefore, firms that use capital leases will typically report higher cash flows from operations
than those that rely on operating leases.

Securitizations
Banks and other financial organizations often hold assets--like credit card receivables--that third parties
might be willing to buy. To distinguish the assets it sells from the ones it keeps, the company creates
a special purpose entity (SPE). The SPE purchases the credit card receivables from the company with
the proceeds from a bond offering backed by the receivables themselves. The SPE then uses the money
received from cardholders to repay the bond investors. Since much of the credit risk gets offloaded along
with the assets, these liabilities are taken off the company's balance sheet.

Capital One is just one of many credit card issuers that securitize loans. In its 2004 first quarter report, the
bank highlights results of its credit card operations on a so-called managed basis, which includes $38.4
billion worth of off-balance-sheet securitized loans. The performance of Capital One's entire portfolio,
including the securitized loans, is an important indicator of how well or poorly the overall business is
being run.

Conclusion
Companies argue that off-balance-sheet techniques benefit investors because they allow management to
tap extra sources of financing and reduce liability risk that could hurt earnings. That's true, but off-
balance-sheet finance also has the power to make companies and their management teams look better than
they are. Although most examples of off-balance sheet debt are far removed from the shadowy world of
Enron's books, there are nonetheless billions of dollars worth of real financial liabilities that are not
immediately apparent in companies' financial reports. It's important for investors to get the full story
on company liabilities.

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