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Intermediate Accounting James D. Stice Earl K. Stice

Chapter 12. Debt Financing. 18 th Edition. Intermediate Accounting James D. Stice Earl K. Stice. PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University. © 2012 Cengage Learning. Definition of Liabilities.

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Intermediate Accounting James D. Stice Earl K. Stice

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  1. Chapter 12 Debt Financing 18th Edition Intermediate Accounting James D. Stice Earl K. Stice PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University © 2012 Cengage Learning

  2. Definition of Liabilities The FASB defined liabilitiesas “probable future sacrifices of economic benefits arising from present obligations to a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” The FASB is currently considering a revision of this liability definition. (continued)

  3. Classification of Liabilities • For reporting purposes liabilities are usually classified as current or noncurrent. • If a liability arises in the course of an entity’s normal operating cycle, it is considered current if current assets are used to satisfy the obligation within one year or one operating cycle, whichever period is longer. (continued)

  4. Classification of Liabilities • The classification of a liability as current or noncurrent can impact significantly a company’s ability to raise additional funds. • When debt classified as noncurrent will mature within the next year, the liability should be reported as a current liability. • The distinction between current and noncurrent is important because of the impact on a company’s current ratio. (continued)

  5. Measurement of Liabilities For measurement purposes, liabilities can be divided into three categories: • Liabilities that are definite in amount • Estimated liabilities • Contingent liabilities The measurement of liabilities always involves some uncertainty because a liability, by definition, involves a future outflow of resources.

  6. Short-Term Operating Liabilities • The term account payable usually refers to the amount due for the purchase of materials by a manufacturing company or the purchase of merchandise by a wholesaler or retailer. • Accounts payable are not recorded when purchase orders are placed but instead when legal title to the goods passes to the buyer.

  7. Short-Term Debt • In most cases, debt is evidenced by a promissory note, which is a formal written promise to pay a sum of money in the future, and is usually reflected on the debtor’s books as Notes Payable. • Notes issued to trade creditors for the purchase of goods or services are called tradenotes payable. (continued)

  8. Short-Term Debt • Nontrade notes payable include notes issued to banks or to officers and stockholders for loans to the company. • If a note has no stated rate of interest, or if the stated rate is unreasonable, then the face value of the note would be discounted to the present value to reflect the effective rate of interest implicit in the note.

  9. Short-Term Obligations Expected to be Refinanced • A short-term obligation that is expected to be refinanced on a long-term basis should not be reported as a current liability. • This applies to the currently maturing portion of a long-term debt and to all other short-term obligations except those arising in the normal course of operations that are due in customary terms. (continued)

  10. Short-Term Obligations Expected to be Refinanced According to FASB ASC Topic 470(Debt), bothof the following conditions must be met before a short-term obligation can be properly excluded from the current liability classification. • Management must intend to refinance the obligation on a long-term basis. • Management must demonstrate anability to refinance the obligation. (continued)

  11. Short-Term Obligations Expected to be Refinanced Concerning the second point, the ability to refinance may be demonstrated by either of the following: • 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. (continued)

  12. Short-Term Obligations Expected to be Refinanced • According to IAS 1, for the obligation to be classified as long term the refinancing must take place by the balance sheet date, not the later date when the financial statements are finalized. • Under the international standard post-balance-sheet date events are NOT considered when determining whether a refinanceable obligation is reported as current or noncurrent.

  13. Lines of Credit A line of credit is a negotiated arrangement with a lender in which the terms are agreed to prior to the need for borrowing. (continued)

  14. Lines of Credit • The line of credit itself is not a liability. However, once the line of credit is used to borrow money, the company has a formal liability that will be reported as either a current or a long-term liability. • Maintaining a line of credit is not costless. Banks typically charge a small amount, a fraction of 1% per year. (continued)

  15. Present Value of Long-Term Debt • A mortgage is a loan backed by an asset that serves as collateral for the loan. • If the borrower cannot repay the loan, the lender has the legal right to claim the mortgaged asset and sell it in order to recover the loan amount. • Mortgages are generally payable in equal installments; a portion of each payment represents interest on the unpaid mortgage balance. (continued)

  16. Financing with Bonds • Present owners remain in control of the corporation. • Interest is a deductible expense in arriving at taxable income; 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 expected dividends.

  17. Accounting for Bonds • Conceptually, bonds and long-term notes are similar types of debt instruments. • The trust indenture (the bond contract) associated with bonds generally provides more extensive detail than the contract terms of a note, often including restrictions on the payment of dividends or incurrence of additional debt. (continued)

  18. Accounting for Bonds There are three main considerations in accounting for bonds: • Recording the issuance or purchase • Recognizing the applicable interest during the life of the bonds • Accounting for retirement of bonds either at maturity or prior to the maturity date

  19. Nature of Bonds • Bond certificates, commonly referred to simply as bonds, are frequently issued in denominations of $1,000. • The amount printed on the bond is the face value, par value, or maturity valueof the bond. • The group contract between the corporation and the bondholders is known as the bondindenture.

  20. Issuers of Bonds • Bonds and similar debt instruments are issued by private corporations, the U.S. government, state, county, and local governments, school districts, and government-sponsored organizations. • Debt securities issued by state, county, and local governments and their agencies are collectively referred to as municipal debt.

  21. Types of Bonds • Bonds that mature on a single date are called term bonds. • Bonds that mature in installments are referred to as serial bonds. • Secured bondsoffer protection to investors by providing some form of security, such as a mortgage on real estate or the pledge of other collateral. (continued)

  22. Types of Bonds • Acollateral trust bond is usually secured by stocks and bonds of other corporations owned by the issuing company. • Unsecured bonds (frequently termed debenture bonds) are not protected by the pledge of any specific assets. • Registered bondscall for the registry of the owner’s name on the corporation books. (continued)

  23. Types of Bonds • Bearer bonds, or coupon bonds, are not recorded in the name of the owner; title to these bonds passes with delivery. • Zero-interest bonds or deep-discount bondsdo not bear interest. Instead, these securities sell at a significant discount. • High-risk, high-yield bonds issued by companies that are heavily in debt or otherwise in weakfinancial condition are referred to as junk bonds. (continued)

  24. Types of Bonds Junk bonds are issued in at least three types of circumstances. • They are issued by companies that once had high credit ratings but have fallen on hard times. • They are issued by emerging growth companies. • They are issued by companies undergoing restructuring, often in conjunction with a leverage buyout. (continued)

  25. Types of Bonds • Convertible bonds provide for their conversion into some other security at the option of the bondholder. • Commodity-backed bondsmay be redeemable in terms of commodities, such as oil or precious metals. • Bond indentures frequently give the issuing company the right to call and retire the bonds prior to maturity. Such bonds are termed callable bonds. (continued)

  26. Types of Bonds • Mortgage-backed bonds, in many cases, are just a special form of secured bonds. The underlying collateral for these bonds is the collection of mortgages owned by the issuing entity.

  27. Market Price of Bonds • The amount of interest paid on bonds is a specified percentage of the face value. This percentage is termed the stated rate, or contract rate. • If the stated rate exceeds the market rate, the bonds will sell at a bond premium. If the stated rate is less than the market, the bonds will sell at a bond discount. • The actual return rate on a bond is known as the market, yield, or effective interest rate. (continued)

  28. Market Price of Bonds 8% Premium 10% FaceValue 12% Discount Yield Bond Stated Interest Rate 10% (continued)

  29. Issuance of Bonds • Bonds may be sold directly to investors by the issuer or they may be sold in the open market through security exchanges or through investment bankers. • Bonds issued or acquired in exchange for noncash assets or services are recorded at the fair value of the bonds unless the value of the exchanged assets or services is more clearly determinable. (continued)

  30. Issuance of Bonds Each of the bond situations in the following slides will be illustrated using the following data: $100,000, 8%, 10-year bonds are issued; semiannual interest of $4,000 ($100,000 × 0.08 × 6/12) is payable on January 1 and July 1. (continued)

  31. Bonds Issued at Par on Interest Date Issuer’s Books Jan. 1 Cash 100,000 Bonds Payable 100,000 July 1 Interest Expense 4,000 Cash 4,000 Dec. 31 Interest Expense 4,000 Interest Payable 4,000 (continued)

  32. Bonds Issued at Par on Interest Date Investor’s Books Jan. 1 Bond Investment 100,000 Cash 100,000 July 1 Cash 4,000 Interest Revenue 4,000 Dec. 31 Interest Receivable 4,000 Interest Revenue 4,000

  33. Bonds Issued at Discount on Interest Date Issuer’s Books Jan. 1 Cash 87,538 Discount on Bonds Payable 12,462 Bonds Payable 100,000 Investor’s Books Jan. 1 Bond Investment 87,538 Cash 87,538

  34. Bonds Issued at Premium on Interest Date • The bonds were issued on January 1 but the effective rate of interest was 7%, requiring recognition of a premium of $7,106. • Only reading the table for 3 ½ percent, you should arrive at the bonds having a present value of $107,106. (continued)

  35. Bonds Issued at Premium on Interest Date Issuer’s Books Jan. 1 Cash 107,106 Premium on Bonds Payable 7,106 Bonds Payable 100,000 Investor’s Books Jan. 1 Bond Investment 107,106 Cash 107,106 (continued)

  36. Bonds Issued at Par between Interest Date ($100,000 × 0.08 × 2/12) ($100,000 × 0.08 × 4/12) Issuer’s Books Mar. 1 Cash 101,333 Bonds Payable 100,000 Interest Payable 1,333 July 1 Interest Expense 2,667 Interest Payable 1,333 Cash 4,000 (continued)

  37. Bonds Issued at Par between Interest Date Investor’s Books Mar. 1 Bond Investment 100,000 Interest Receivable 1,333 Cash 101,333 July 1 Cash 4,000 Interest Receivable 1,333 Interest Revenue 2,667

  38. Bond Issuance Costs • The issuance of bonds normally involves bond issuance costs to the issuer for legal services, printing and engraving, taxes, and underwriting. • In Statement of Financial AccountingConcepts No.3, the FASB stated that “deferred charges” such as bond issuance costs fail to meet the definition of assets.

  39. Accounting for Bond Interest • When bonds are issued at a premium or discount, the market acts to adjust the stated interest rate to a market or effective interest rate. • Because the initial premium or discount, the periodic interest payments made over the bond’s life by the issuer do not represent the total interest expense involved, an amortizationadjustment is made.

  40. Straight-Line Method • The straight-line method provides for the recognition of an equal amount of premium or discount amortization each period. • A 10-year, 10% bond issue with a maturity value of $200,00 was sold on the issuance date at 103, the $6,000 premium would be amortized evenly over 120 months until maturity. (continued)

  41. Straight-Line Method • To illustrate the accounting for bond interest using straight-line amortization, consider the earlier example of the $100,000, 8%, 10-year bonds issued on January 1. • When sold at a $12,462 discount, the appropriate entries to record interest on July 1 and December 31 are shown next. (continued)

  42. Straight-Line Method $12,462/120 × 6 mo. = $623 (rounded) Issuer’s Books July 1 Interest Expense 4,623 Discount on Bonds Payable 623 Cash 4,000 Dec. 31 Interest Expense 4,623 Discount on Bonds Payable 623 Interest Payable 4,000 (continued)

  43. Straight-Line Method Investor’s Books July 1 Cash 4,000 Bond Investment 623 Interest Revenue 4,623 Dec. 31 Interest Receivable 4,000 Bond Investment 623 Interest Revenue 4,623 (continued)

  44. Straight-Line Method Reflects effective interest of 7% $7,106/120 × 6 mo. = $355 (rounded) Assume the bonds were sold for $107,106. Issuer’s Books July 1 Interest Expense 3,645 Premium on Bonds Payable 355 Cash 4,000 Dec. 31 Interest Expense 3,645 Premium on Bonds Payable 355 Interest Payable 4,000 (continued)

  45. Straight-Line Method Investor’s Books July 1 Cash 4,000 Bond Investment 355 Interest Revenue 3,645 Dec. 31 Interest Receivable 4,000 Bond Investment 355 Interest Revenue 3,645

  46. Effective-Interest Method • The effective-interest method of amortization uses a uniform interest rate based on a changing loan balance and provides for an increasing premium or discount amortization each period. • In order to use this method, the effective-interest rate for the bonds must be known. (continued)

  47. Bond balance (carrying value) at beginning of year $87,538 Effective rate per semiannual period 5% Stated rate per semiannual period 4% Interest amount based on carrying value and effective rate ($87,538 × 0.05) $ 4,377 Interest payment based on face value and stated rate ($100,00 × 0.040) 4,000 Discount amortization $ 377 Effective-Interest Method Consider once again the $100,000, 8%, 10-year bonds sold for $87,539, based on an effective interest rate of 10%. (continued)

  48. Bond balance (carrying value) at beginning of first period $107,106 Effective rate per semiannual period 3.5% Stated rate per semiannual period 4% Interest payment based on face value and stated rate ($100,00 × 0.040) 4,000 Interest amount based on carrying value and effective rate ($107,106 × .035) 3,749 Premium amortization $ 251 Effective-Interest Method Assume the $100,000, 8%, 10-year bonds is sold for $107,106, based on an effective interest rate of 7%. The premium amortization for the first 6-month period would be computed as follows: (continued)

  49. Bond balance (carrying value) at beginning of second period ($107,106 – $251) $106,855 Effective rate per semiannual period 3.5% Stated rate per semiannual period 4% Interest payment based on face value and stated rate ($100,00 × 0.040) 4,000 Interest amount based on carrying value and effective rate ($106,855 x .035) 3,740 Premium amortization $ 260 Effective-Interest Method The second 6-month period would be computed as follows: (continued)

  50. Cash Flow Effects of Amortizing Bond Premiums and Discounts • The amortization of a bond discount or premium does not involve the receipt or payment of cash. • Like other noncash items, it must be considered in preparing a statement of cash flows. • Using the indirect method, the discount amortization is added back to net income. (continued)

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