Chapter 14--Learning Objectives

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




Chapter
 14-1
                     Learning Objectives

         Bond Pricing
         Accounting for Bonds (effective interest
          rate method)
             At Par; Premium; Discount
         Extinguishment of debt
         Impairments (Appendix 14A)
         Troubled Debt Restructuring (Appendix 14A)
             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
•  Methods to retire bonds:
1. Retirement @ maturity
2. 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                          Restructuring

                                       Creditor grants a
  Probable loss:                        concession to
 Creditor unable                        debtor due to
to collect principal                   debtor’s financial
   and interest.                          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
                                 Interest    Discount
                  Cash Paid      Expense     Amortized
        Date        (10%)         (12%)     (Difference)   CV of Note
     Date of issue: 12/31/2006                                 927,908
 1    12/31/2007      100,000     111,349      11,348.96       939,257
 2    12/31/2008      100,000     112,711      12,710.84       951,968
 3    12/31/2009      100,000     114,236      14,236.14       966,204
 4    12/31/2010      100,000     115,944      15,944.47       982,148
 5    12/31/2011      100,000     117,858      17,857.81     1,000,006
      Troubled Debt: Key Terms

                     Restructuring

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


        Settlement             Modification of Terms

Debtor transfers equity     1. Reduction of principal
      interest or           2. Reduction of interest rate
  assets to creditor        3. Extension of maturity date
                            4. Reduction of accrued interest
   Progression of Troubled Debt


Loan             Loan              Restructuring   Foreclosure
Origination    Impairment                          /Bankruptcy




                                               If all else fails –
    Creditor             Debtor may            to ensure some
  recognizes              recognize            level of collection
     loss               gain/Creditor
                      refines estimate
                            of loss
    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                      Creditor
• Gain = excess of          • Loss = excess of
  carrying amount of          loan receivable over
  payable over fair           fair value of assets
  value of assets             received from
  transferred to creditor     debtor
• The gain is not           • The loss is ordinary
  extraordinary               and is charged to
• Recognize loss or           Allowance for
  gain on disposition of      Doubtful Accounts
  non-cash assets
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 pre-
       restruct. 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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