Chapter 14--Learning Objectives by vivi07

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									Announcement
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FOR HW: Do E14-5 instead of P14-1

Chapter 14-1

Learning Objectives
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Bond Pricing Accounting for Bonds (effective interest rate method)
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At Par; Premium; Discount

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Extinguishment of debt

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Impairments (Appendix 14A)
Troubled Debt Restructuring (Appendix 14A)
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Settlement Modification of Terms

Chapter 14-2

CH 14 – Long-Term Liabilities
Capital Structure - mix of debt & equity financing in an enterprise Why Issue Debt? • Cost of Debt < Cost of Capital (MM & M) • Benefits of Debt – issuing debt  ’ed taxes – issuing equity dilutes ownership, dividends not tax deductible • Costs of Debt - ’ed risk - interest and principal must be paid

Bond basics
• • • • • • • • • Bond indenture - detailed bond agreement Term (mature on a single date) or serial (mature in installments) Interest - fixed, variable, or zero-coupon Callable (issuer has the right to call and retire bonds prior to maturity) Convertible (bonds are convertible into other securities of the corp.) Mortgage bonds (secured by a claim on real estate) Debenture bonds (unsecured) Stated rate (aka coupon rate) Effective rate (aka yield or market)

Bond Pricing
A. Price@selling date = PV of FCF discounted @ Mkt Rate, i.e., PV(Int. Pmts) + PV(Princ) - Risk class - Term B. Discounts and Premiums - if Mkt Rt > Coupon Rt  sold @ Discount - if Mkt Rt < Coupon Rt  sold @ Premium - Why ? -  an inverse relation b/twn interest rates and bond prices

Bond Pricing: P14-5 (2)
Brad Dougherty Co.
Sells $600,000 12% Bonds on 6/1/2007; Yield: 10% Pay Interest: 12/1 & 6/1

Due Date of Bonds: 6/1/2011
**On 10/1/2008 buy back $120,000 worth of bonds for $126,000 (includes accrued interest)

What is the price of the Bond?

Chapter 14-6

Acctg for Bonds - EI Method
A. Acctg @ Issue Date • If mkt rate = coupon rate, sold @ par • If mkt rate > coupon rate, sold @ discount [PV(FCF) < par] 1. Disc. on BP is  in Interest Exp over life of bond 2.  Interest Exp. always > cash interest paid 3. Interest Exp. ’s over bond life • If mkt rate < coupon rt, sold @ premium [PV(FCF) > par] 1. Prem. on BP is  in Interest Exp over life of bond 2.  Interest Exp. always < cash interest paid 3. Interest Exp. ’s over bond life

Acctg for Bonds - EI Method
B. Acctg @ Payment Dates & AJE’s • Amortization of Disc or Prem • Interest Exp = @issue mkt rate * beg of pd. Carrying value •  Int Exp ’s each pd as f(liability bal) • Cash paid - Int. Exp. = amort. of premium (discount) • Accruals needed when interest pmt & acctg periods do not coincide • Set up EI table • PRACTICE: E14-3, E14-4, E14-5, E14-9, E14-10 (HW) Bond Issue Costs – GAAP says record as asset, amortize (typically S/L)

Bond Pricing: P14-5 (2)
Brad Dougherty Co.
Sells $600,000 12% Bonds on 6/1/2007; Yield: 10% Pay Interest: 12/1 & 6/1

Due Date of Bonds: 6/1/2011
**On 10/1/2008 buy back $120,000 worth of bonds for $126,000 (includes accrued interest)

Construct the Effective Interest Rate Table..... What are the Journal Entries through 6/1/2007?
Chapter 14-9

Extinguishment of debt
• 1. 2. • Methods to retire bonds: Retirement @ maturity Open market acquisition of bond may occur on interest pmt date - if not make necessary accruals •  b/twn Carrying Value of bonds & Acquis Cost is Gain or Loss 3. Call the bonds 4. Swaps 5. PRACTICE: E14-13, E14-14 (HW)

Extinguishment of Debt
Extinguishment before Maturity Date
Reacquisition price > Net carrying amount = Loss Net carrying amount > Reacquisition price = Gain

At time of reacquisition, unamortized premium or discount, and any costs of issue applicable to the bonds, must be amortized up to the reacquisition date.

Chapter 14-11

Bond Pricing: P14-5 (2)
Brad Dougherty Co.
Sells $600,000 12% Bonds on 6/1/2007; Yield: 10% Pay Interest: 12/1 & 6/1

Due Date of Bonds: 6/1/2011
**On 10/1/2008 buy back $120,000 worth of bonds for $126,000 (includes accrued interest)

What are the Journal Entries through 10/1/2008?

Chapter 14-12

Accounting Issues
• In troubled debt cases, two important issues emerge:
• When should a loss be recognized?
• When it is likely a loss will occur, and • When the loss can be measured

• What is the amount of loss to be recognized?

Troubled Debt: Key Terms
Troubled debt
Impairment Probable loss: Creditor unable to collect principal and interest. Restructuring

Creditor grants a concession to debtor due to debtor’s financial difficulties.

Impairments (Append)
Recognized by Creditor only Impairment Loss = Difference between:

(1) CV of Debt and (2)PV(new CFs) using old rate

Example: E14-28 Impairments
Martinez Co. borrowed $1 million 10% 5-YR, yield: 12%
12/31/08: Bank determined Martinez Co. can only pay back $600,000 of principle but will still receive interest payments (a) Determine amt of cash received from the loan on 12/31/2006 (b) Prepare note amortization schedule for Bank up to 12/31/2008 (c) Determine the loss that the Bank should recognize 12/31/2008
Cash Paid (10%) Interest Expense (12%) 111,349 112,711 114,236 115,944 117,858 Discount Amortized (Difference) 11,348.96 12,710.84 14,236.14 15,944.47 17,857.81

Date 1 2 3 4 5

CV of Note 927,908 939,257 951,968 966,204 982,148 1,000,006

Date of issue: 12/31/2006 12/31/2007 100,000 12/31/2008 100,000 12/31/2009 100,000 12/31/2010 100,000 12/31/2011 100,000

Troubled Debt: Key Terms
Restructuring Creditor grants a concession to debtor due to debtor’s financial difficulties.

Settlement Debtor transfers equity interest or assets to creditor

Modification of Terms
1. Reduction of principal 2. Reduction of interest rate 3. Extension of maturity date 4. Reduction of accrued interest

Progression of Troubled Debt

Loan Origination

Loan Impairment

Restructuring

Foreclosure /Bankruptcy

Creditor recognizes loss

Debtor may recognize gain/Creditor refines estimate of loss

If all else fails – to ensure some level of collection

Troubled Debt Restructurings
•
•

When a creditor grants a favorable concession to a debtor Two basic types of transactions
1. Settlement of debt at less than carrying value 2. Continuation of debt with modification of terms

Gain or Loss: Debtor and Creditor Settlement
Debtor • Gain = excess of carrying amount of payable over fair value of assets transferred to creditor • The gain is not extraordinary • Recognize loss or gain on disposition of non-cash assets Creditor • Loss = excess of loan receivable over fair value of assets received from debtor • The loss is ordinary and is charged to Allowance for Doubtful Accounts

Troubled Debt Restructuring: SETTLEMENT

Troubled Debt Restructuring: SETTLEMENT
Settlement of Debt w/ Asset (if FMVAsset < CVDEBT )

Creditor: (never record Gain!)
LOSS on Restructuring (or Charge to Allow. for Uncoll. Accts) = Excess of CVDEBT over FMVASSET

Debtor:
(1) GAIN/LOSS on Disposition of Asset = FMVASSET - CVASSET (2) GAIN on Restructuring = CVDEBT - FMVASSET

Troubled Debt Restructuring: SETTLEMENT (p.701)
American City Bank loaned 20M to Union Mortgage Co. Union Mortgage, in turn, invested these monies in residential apartment buildings. However, b/c of low occupancy rates, it cannot meet its loan obligations. American City Bank agrees to accept from Union real estate with a fair market value of $16M in full element of the $20M loan obligation. The real estate has a carrying value of $21M on the books of Union Mortgage.

What is the journal entry for American City? What is the journal entry for Union Mortgage?

Troubled Debt Restructuring: SETTLEMENT
Settlement of Debt w/ Equity
Transfer of Equity - Debtor gives creditor stake in debtor Co. w/ FMVEQUITY < CVDEBT

Creditor: (never record Gain!)
LOSS on Restructuring (or Chanrge to Allow. for Uncoll. Accts) = Excess of CVDEBT over FMVEQUITY

Debtor:
(1) GAIN on Restructuring = CVDEBT - FMVEQUITY (2) Record Stock @ MV [Credit Common stock for par value & remainder to APIC)

Troubled Debt Restructuring: SETTLEMENT (p.701)
American City Bank loaned 20M to Union Mortgage Co. Union Mortgage, in turn, invested these monies in residential apartment buildings. However, b/c of low occupancy rates, it cannot meet its loan obligations. American City Bank agrees to accept from Union 320,000 shares of common stock ($10 par) taht has a fair market value of $16M in full element of the $20M loan obligation.

What is the journal entry for American City? What is the journal entry for Union Mortgage?

Modification of Terms Debt Restruct.
KEY: (1) Restructured FCFs > Pre-restr CVDEBT --> NO GAIN (2) Restructured FCFs < Pre-restr CVDEBT --> Extra. GAIN

BOTH CASES FOR CEDITOR: LOSS (or adj. to the allowance account)

Case (1) Restructured FCFs > Pre-restr CVDEBT
Debtor Accounting: a. No gain recognized on restruct. dt. b. In future: • Future pmts in excess of Principal interest-related pmts • New effective interest rt calc'd (=IRR equating PV future cash pmts to prerestruct. CV of debt) • After restruct, "amortize away" debt based on new rate Creditor Accounting (per SFAS 114): a. Loss recognized for ∆ b/twn CV of Asset and PV(new CF) • Disc Rt is historical effective rate • Loss, or BD Exp, Allow for UA

Case (2) Restructured FCFs < Pre-restr CVDEBT
Debtor Accounting: a. On Debt of restruct: • reduce CV of debt to total pmts under new Debt (no PV) • Extra. Gain recgnz’d • New effective rate not calculated b. After restruct - all pmts by debtor ↓Principal. No interest recgnz’d Creditor Accounting: a. Loss on restruct = ∆ b/twn CV and PV(new CFs) using hist rt; ↑ Allow for Doubt. b. After restruct: · use EI Method w/ Hist Rt to calc. Interest Inc, reduce Allow for DA


								
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