CHAPTER 12 Debt Financing

A.Definition of liabilities 1. Must be the result of past transactions or events. : Thus, contractual obligations from an exchange of promises if performance by both parties is still in the future are not recognized as liabilities. 2. Probable transfer of assets (or services) must be in the future B. Classification of Liabilities Current Liabilities 1. 2. Payable within 1 year Reported at maturity value

Non Current Liabilities Measurement of Liabilities 1. Liabilities that are definite in amount: 2. Estimated liabilities: 3. Contingent liabilities:

C.

D.

Accounting for a bond There are three main considerations in accounting for bonds:

1.

The issuance of bonds 2. Interest during the life of the bonds. 3. The retirement of bonds either at maturity or prior to the maturity date. The Issuance of bonds 1. 2. 3. 4. Bonds sell at price plus accrued interest. Bonds are typically stated in terms of a percentage of face value. (e.g., a bond at 97 or a bond at 103) Bond discounts are recorded as contra accounts to Bonds Payable (Issuer) and Investment in Bonds (Investor). Bond premiums represent adjunct accounts which increase Bonds Payable (Issuer) and Investment in Bonds (Investor).

Bond Sold at Face Amount

On January 1, 2009, Masterwear Industries issued $700,000 of 12% bonds. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years [an unrealistically short maturity to shorten the illustration]. The bond was sold at face amount. At Issuance (January 1) Masterwear (Issuer)

Dr. Cash Cr. Bonds payable (face amount)

* Bond payable is always recorded at

Determining the Selling Price Bonds Sold at a Discount

On January 1, 2009, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%.
Present value (price) of the bonds: Present Values Interest $42,000 x 4.76654 * = $200,195 Principal $700,000 x 0.66634 ** = 466,438 Present value (price) of the bonds $666,633 * present value of an ordinary annuity of $1: n=6, i=7% (Table IV) ** present value of $1: n=6, i=7% (Table II)

Because interest is paid semiannually, the PV calculations use: (a) semiannual market rate (7%), and (b) 6 (3 x 2) semiannual periods.

Masterwear (Issuer)
(Dr) Cash (price calculated above) (Dr) Discount on bonds payable (difference) (Cr) Bonds payable (face amount)

Determining the Selling Price Bonds Sold at a Premium

On January 1, 2009, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 10%.
Present value (price) of the bonds: Present Values Interest $42,000 x 5.07569 * = $213,179 Principal $700,000 x 0.74622 ** = 522,354 Present value (price) of the bonds $735,533 * present value of an ordinary annuity of $1: n=6, i=5% (Table IV) ** present value of $1: n=6, i=5% (Table II)

Because interest is paid semiannually, the PV calculations use: (a) semiannual market rate (5%), and (b) 6 (3 x 2) semiannual periods.

Masterwear (Issuer)
(Dr) Cash (price calculated above) (Cr) Premium on bonds payable (difference) (Cr) Bonds payable (face amount)

Debt Issue Costs o Include legal and accounting fees, printing fees, and registration and underwriting fees. Debt issue costs are amortized to expense over the term to maturity.

Interest (When Bonds are Issued at a Premium or Discount) 1. The periodic interest payments made by the issuer are not the total interest expense. An adjustment to interest expense (amortization) associated with the cash payment is necessary to reflect the effective interest being incurred on the bonds.
2.

Effective Interest Method The amount of interest to be recognized each period is computed at a uniform interest rate (the market / effective rate) The amount paid is determined by stated rate (coupon rate) Difference between the amount paid and the compound interest expense is reflected as amortization of discount or premium

DETERMINING INTEREST The Effective Interest Method

Continuing Example of Masterwear Industries: $700,000 of 12% bonds; Market yield of 14%

AMORTIZATION SCHEDULE DISCOUNT

Cash Interest 6% x Face 1/01/09 6/30/09 6/30/10 42,000 .07(666,633) = 46,664 42,000 .07(676,288) = 47,340 4,664 4,991 5,340 5,714 6,114 6,544 33,367 12/31/09 42,000 .07(671,297) = 46,991 12/31/10 42,000 .07(681,628) = 47,714 6/30/11 42,000 .07(687,342) = 48,114 12/31/11 42,000 .07(693,456) = 48,544* 252,000 285,367 *Rounded Effective Interest 7% x O/S Debt Increase Outstanding in Balance Balance Disct Reduction 666,633 671,297 676,288 681,628 687,342 693,456 700,000

At the First Interest Date (June 30)

Masterwear (Issuer) (Dr) Interest expense (market rate x carrying value.) (Cr) Discount on bonds payable (difference) (Cr) Cash (stated rate x face amount)
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Straight-Line Method the recognition of an equal amount of premium or discount amortization for each period The amount paid is determined by stated rate (coupon rate) Interest expense is the balanced amount of the amount paid and the recognition of premium or discount 3. Both methods result in the same amount of total interest expense over the life of the bond. 4. Interest expense is increased amortization and decreased amortization. by by discount premium

5. If an accounting period ends between interest dates, interest should be accrued.

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Determining Interest The Straight-Line Method

Continuing Example of Masterwear Industries: $700,000 of 12% bonds; Market yield of 14%
Under the straight-line method, the discount would be allocated equally to the 6 semiannual periods (3 years): Discount: $700,000 - $666,633 = $33,367

At Each of the Six Interest Dates

Masterwear (Issuer) (Dr) Interest expense (to balance) (Cr)Discount on bonds payable (discount 6 periods) (Cr)Cash (stated rate x face amount)

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Extinguishment of Debt Prior to Maturity When debt is retired prior to maturity, a gain or loss must be recognized for the difference between the carrying value of the debt and the amount to satisfy the obligation

Extinguishment of Debt Prior to Maturity

Triad, Inc.s $100,000, 8% bonds are not held to maturity. They are redeemed on February 1, 2010, 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
(Dr) Bonds Payable (Face value) 100,000 (Cr) Discount on Bonds Payable (Cr) Cash (The amount Triad paid) (Cr) Gain in Bond Redemption (The balance)

2,300 97,000 700

Note: Discount = The difference between the face and carrying value
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Convertible Bonds Bonds that provide for their conversion into some other security at the option of the bondholder Generally they are permitted to be exchanged for common stock There are two ways to account for the issuance of convertible bonds Debt and equity not separated (U.S. GAAP) Debt and equity separated Convertible Bonds (Detachable)

The Issuer of the bonds and the stock warrants is required to allocate the joint issuance price between debt and equity instrument.

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Convertible Bonds Issuance 500 ten-year bonds, face value $1,000, are sold at 105, or a total issue price of $525,000 (500$1,000 1.05). The bonds contain a conversion privilege that provides for exchange of a $1,000 bond for 20 shares of stock, par value $1. The interest rate on the bonds is 8%. It is estimated that without the conversion privilege, the bonds would sell at 96.

- Debt and equity not separated

Cash 525,000 Bonds Payable Premium on Bonds Payable Debt and equity separated Cash Discount on Bonds Payable Bonds Payable Paid-In Capital Arising from Bond Conversion Feature 525,000 20,000

500,000 25,000

500,000 equity>>> 45,000

Note: Discount on bonds payable = $500,000 * (100%96%) w/o 96% * 500,000=$480,000<<<<debt

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U.S. GAAP vs. IASB

U.S. GAAP: Despite of theoretical support for the separation of debt and equity, common practice follows FASB ASC Section 470-20-25, which designates all of the proceeds as belonging to the bond alone: non separation between debt and equity

IASB: IAS 32 No distinction between Nondetachable vs. Detachable Proceeds should be allocated to debt and equity: Separation between debt and equity Accounting for Conversion Should we recognize gain and loss as the part of the conversion process or not? If convertible security is viewed as equity, then the conversion is not significant transaction: no gain or loss is recognized If convertible security is viewed as debt, then the conversion would seem to be a significant transaction: gain or loss recognized

Recognizing gain or loss would seem to be reasonable, but no recognition of gain or loss is widespread practice.
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Accounting for Conversion HiTec Co. offers bondholders 40 shares of HiTec Co. common stock, $1 par, in exchange for each $1,000, 8% bond held. An investor exchanges bonds of $10,000 (carrying value as up to date for both investor and issuer, $9,850) for 400 shares of common stock having a market price at the time of the exchange of $26 per share. The exchange is completed at the interest payment date. 9850 =face value-discount 9850=$10,000=$150 Recognition of gain or loss Nov. 1 Bonds Payable 10,000 Loss on Conversion of Bonds 550 Common Stock, $1 par Paid-In Capital in Excess of Par Value Discount on Bonds Payable

400 10,000 150

Note: Market value of stock issued 400 shares * $26 = $10,400 (-) Bonds payable = 10,000 (-) Discount on bonds payable = 150 Loss on conversion of bonds = 550
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No recognition of gain or loss Nov. 1 Bonds Payable 10,000 Common Stock, $1 par Paid-In Capital in Excess of Par Value Discount on Bonds Payable 400 9,450 150

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E.

Fair Value Option

1.

SFAS No. 159 allows a company 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. Why? The FASB reasoned that the objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings.

2.

Example: Lily Kay Company has one asset, a Lusvardi Company Bond that it purchased (on the day it was issued) as investment and one liability, one of its own bonds that Lily Kay issued to finance the purchase of Lusvardi Company Bond investment. Both bonds have the same terms: $1,000 face value, 20 year life, 10% coupon rate, and single interest payments made at the end of each year, 10% of market interest rate when they were issued. Balance Sheet on the day it purchased Lusvardi Company Bond Assets Lusvardi Company Bond Amount Liability $1,000 Bond Payable Equity
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Amount $1,000 0

Case 1: Market interest increases to 12%

a. Investment

at fair value & liability at cost Amount Liability Amount $851 Bond Payable $1,000 Equity ($149)* Unrealized loss $149 = $851- $1,000 =

Assets Lusvardi Company Bond ($149)

b. Both investment and liability at fair value Assets Lusvardi Company Bond Amount Liability $851 Bond Payable Equity No impact on net income Amount $851 0

Case 2: Market interest decreases to 8% a. Investment at fair value & liability at cost Assets Lusvardi Company Bond = $196 b. Both investment and liability at fair value Assets Lusvardi Company Bond Amount Liability $1,196 Bond Payable Equity No impact on net income
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Amount Liability Amount $1,196 Bond Payable $1,000 Equity $196* Unrealized gain $196 = $1,196- $1,000

Amount $1,196 0

3.

To pervent companies from using fair value option to enhance reported earnings selectively, SFAS 159 requires a company to designate whether it is using the fair value option with respect to a financial asset or financial liability when the initial transaction to create the item occurs

F.

Off-Balance-Sheet-Financing: procedures to avoid disclosing all debt on the balance sheet in order to make the companys financial position look stronger. 1. Operating vs. Capital leases In excess of 90% of all leases are accounted for operating leases in which no obligation to make future lease payments is reflected in the balance sheet 2. Unconsolidated subsidiaries FASB statement No. 94 requires all majorityowned ( greater than 50%) subsidiaries to be consolidated Companies still can avoid reporting debt associated with subsidiaries that are less than 50% owned
3.

Variable Interest Entities (VIEs), formerly called Special-Purpose Entities (SPEs): no debt would be recorded in sponsors balance sheet.

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Example: Sponsor Company requires the use of a building costing $100,000. 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). - Sponsor companys book Assets - VIEs Book Assets Building Amount Liability $100,000 Bank Loan Paid-in-capital Amount $90,000 10,000 $0 Liability $0

4. Joint venture: 50:50 joint venture will be accounted under equity method. No debt of joint ventures will be recorded in a parent companys balance sheet Reasons for Off-Balance-Sheet Financing Allow a company to borrow more than it otherwise could due to debt-limit restriction Lower borrowing cost, e.g., lower cost of capital (interest rate)

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