chapter 10 – Debt Financing 1 Objectives 1. Understand the various classification and measurement issues associated with debt. 2. Account for short-term debt obligations, including those expected to be refinanced, and describe the purpose of lines of credit. 3. Apply present value concepts to the accounting for long- term debts such as mortgages. 4. Understand the various types of bonds, compute the price of a bond issue, and account for the issuance, interest, and redemption of bonds. 5. Explain various types of off-balance-sheet financing, and understand the reasons for this type of financing. 6. Analyze a firm’s debt position using ratios 2 Definition of Liabilities The FASB has defined liabilities as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transaction or events.” • Current Liabilities: Paid within one year or the operating cycle, whichever is longer. • Noncurrent Liabilities: Not paid within one year or the operating cycle, whichever is longer. 3 Types of Liabilities • Liabilities that are definite in amount. • Estimated liabilities. • Contingent liabilities. 4 Liabilities Definite in Amount Record liability at face amount. Classify as short- or long-term based on when debt will be repaid. Short-term debt to be refinanced can be classified as long-term if: – management intends to refinance on a long-term basis. – management can demonstrate an ability to refinance. 5 Estimated Liabilities Items that will require definite future resource outflow, but the actual amount of the obligation cannot be established currently. • Refundable deposits: Report estimated amount to be refunded as a liability. • Warranties: Report estimated future expenditures as a liability. • Premium offers/gift certificates: Report estimated value of redeemed offers as a liability. 6 Contingent Liabilities A contingent liability results when there is a potential liability which depends on the outcome of an uncertain event E.g. pending lawsuit If the potential liability is probable and amount can be reasonably estimated, then recognize in the financial statements If the potential liability is reasonably possible, then disclose possible liability in a note If the potential liability is remote, then do nothing Accounting for Short-Term 7 Debt Obligations • Accounts Payable: The amount due for the purchase of materials by a manufacturing company or merchandise by a wholesaler or retailer. • Notes Payable: A formal written promise to pay a certain amount of money at a specified future date. Accounting for Short-Term 8 Debt Obligations Accounting for Short-Term 9 Debt Obligations A short-term obligation that is expected to be refinanced on a long-term basis should not be reported as a current liability. FASB Statement No. 6 requires that both of the following conditions be met before a short-term obligation may be properly excluded from the current liability classification. 1. Management must intend to refinance the obligation on a long-term basis. 2. Management must demonstrate an ability to refinance the obligation. Accounting for Short-Term 10 Debt Obligations An ability to refinance may be demonstrated by: 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. Accounting for Short-Term 11 Debt Obligations o The terms of the refinancing agreement should be noncancelable as to all parties. o The terms of the refinancing agreement should extend beyond the current year. o The company should not be in violation of the agreement at the balance sheet date or the date of issuance. o The lender or investor should be financially capable of meeting the refinancing requirements. 12 Line 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. 13 Present Value of $1 • Present value of $100 paid in five years discounted at 10 percent: Today 1 2 3 4 Future Discount at 10% PV=$62.09 $100 The Present Value of the 14 Annuity of $1 Present value of five equal payments of $100 discounted at 10 percent: $100 $100 $100 $100 $100 Today 1 2 3 4 5 PV=$379.08 15 PV of Long-Term Debt On January 1, 2005, Crystal Michae purchases a house for $250,000 and makes a down payment of $50,000. The remainder is financed through a mortgage on the house. The mortgage is for ten years and carries an annual interest rate of 12 percent, with payments of $2,057 due monthly. The first payment is due on February 1, 2005. 16 PV of Long-Term Debt Payment Interest Amount Applied to Remaining Date Amount Expense Reduce Principal Balance 1/1/05 $200,000 2/1/05 $2,057 $2,000 $57 199,943 3/1/05 2,057 1,999 58 199,885 4/1/05 2,057 1,999 58 199,827 5/1/05 2,057 1,998 59 199,768 6/1/05 2,057 1,998 59 199,709 17 PV of Long-Term Debt Payment Interest Amount Applied to Remaining Date Amount Expense Reduce Principal Balance 1/1/05 $200,000 2/1/05 $2,057 $2,000 $57 199,943 3/1/05 2,057 1,999 58 199,885 4/1/05 2,057 1,999 58 199,827 5/1/05 2,057 1,998 59 199,768 6/1/05 2,057 1,998 59 199,709 2/1/05 Interest Expense 2,000 Mortgage Payable 57 Cash 2,057 18 Secured Loan A secured loan is a loan backed by certain assets as collateral. Secured Loan 19 Financing With Bonds A bond is a contract between a borrower and a lender in which the borrower promises to pay a specified amount of interest for each period the bond is outstanding and repay the principal at the maturity date.Fargo, Inc. $10,000 Paid to the bearer of this bond $10,000 at 8 percent annually on January 1 and July 1. 20 Financing With Bonds Reasons that management and stockholders may prefer to issue bonds or notes instead of stock: 1) Present owners remain in control of the corporation. 2) Interest is deductible for tax purposes; dividends are not. 3) Current market rates of interest may be favorable relative to stock market prices. 4) The charge against earnings for interest may be less than the amount of dividends that might be expected by shareholders. 21 Nature of Bonds Face value: The amount that will be paid on a bond at the maturity date. Bond discount: The difference between the face value and the sales price when bonds are sold below their face value. Bond premium: The difference between the face value and the sales price when bonds are sold above their face value. 22 Types of Bonds • Term bonds: Bonds that mature in one lump sum on a specified future date. • Serial bonds: Bonds that mature in a series of installments at future dates. • Collateral trust bonds: Bonds usually secured by stocks and bonds of other corporations owned by the issuing company. • Unsecured (debenture) bonds: Bonds for which no specific collateral has been pledged. Continued 23 Types of Bonds • Registered bonds: Bonds for which the issuing company keeps a record of the names and addresses of all bondholders and pays interest only to those individuals whose names are on file. • Bearer (coupon) bonds: Unregistered bonds for which the issuer has no record of current bondholders, but instead pays interest to anyone who can show evidence of ownership. Continued 24 Types of Bonds. • Zero-interest bonds: Bonds that do not bear interest but instead are sold at significant discounts. • Junk bond: High-risk, high-yield bonds issued by companies in a weak financial condition. • Commodity-backed bonds: Bonds that may be redeemed in terms of commodities. • Callable bonds: Bonds for which the issuer reserves the right to pay the obligation prior to the maturity date. 25 Market Price of Bonds Yield 8% Premium Bond Stated Interest 10% Face Value Rate 10% 12% Discount 26 Market Price of Bonds Ten-year, 8% bonds of $100,000 are to be sold on the bond issue date. On that date, the effective interest rate for bonds of similar quality and maturity is 10%, compounded semiannually. What is the issue price? 27 Market Price of Bonds Part 1 Present value of principle (maturity value): Maturity value of bond after 10 years (20 semiannual periods) $100,000 Effective interest rate = 10% per year (5% per semiannual period) $37,689 Part 2: Present value of 20 interest payments: Semiannual payment, 4% of $100,000 4,000 Effective interest rate, 10% per year (5% per semiannual period) $49,849 Total present value (market price) of bond $87,538 Bond Issued at 28 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 Cash 4,000 Bond Issued at 29 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 Cash 4,000 Interest Revenue 4,000 Bond Issued at 30 a Discount on Interest Date On January 1, $100,000, 8%, 10-year bonds were issued for $87,538 (which provided an effective interest rate of 10% to the investor). $100,000 Effective 8% rate, 10% Later Slide Bond Issued at 31 a 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 Bond Issued at 32 a Premium on Interest Date On January 1, $100,000, 8%, 10-year bonds were issued for $107,106 (which provided an effective interest rate of 7% to the investor). $100,000 Effective 8% rate,7% Bond Issued at 33 a Premium on Interest Date Issuer’s Books Jan. 1 Cash 107,106 Prem. on Bonds Payable 7,106 Bonds Payable 100,000 Investor’s Books Jan. 1 Bond Investment 107,106 Cash 107,106 Bonds Issued at Par Between 34 Interest Dates On March 1, $100,000, 8%, 10-year bonds were issued to yield 8 %. Interest for two months has accrued on the bonds. $100,000 Effective 8% rate,8% Bonds Issued at Par Between 35 Interest Dates Issuer’s Books Mar. 1 Cash 101,333 Bonds Payable 100,000 Interest Payable 0.08 x 2/12 $100,000 x 1,333 July 1 Interest Expense 2,667 Interest Payable 1,333 Cash 4,000 $100,000 x 0.08 x 4/12 Bonds Issued at Par Between 36 Interest Dates 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 Straight-Line Amortization— 37 Discount On an earlier slide, $100,000 of 8% bonds were issued at $87,538 (a discount of $12,462). Appropriate amortization entries must be made on both the issuer’s books and the investor’s books. Issuer’s Books July 1 Interest Expense 4,623 Disc.$12,462/120 x 6 months on Bonds Payable 623 Cash 4,000 Dec. 31 Interest Expense 4,623 Disc. On Bonds Payable 623 Interest Payable 4,000 Straight-Line Amortization— 38 Discount 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 Straight-Line Amortization— 39 Premium In Slide 42, $100,000 of 8% bonds were issued at $107,106. Appropriate amortization entries must be made on both the issuer’s books and the investor’s books. Issuer’s Books July 1 Interest Expense 3,645 Premium x months $7,106/120 on6Bonds Payable 355 Cash 4,000 Dec. 31 Interest Expense 3,645 Premium On Bonds Payable 355 Interest Payable 4,000 Straight-Line Amortization— 40 Premium 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 Effective-Interest Method— 41 Discount Consider again the $100,000, 8%, 10-year bonds sold for $87,538. The effective rate for the bonds is 10%. Effective rate for semiannual period 5% Stated rate per semiannual period 4% Interest amount ($87,538 x 0.05) $4,377 Interest payment ($100,000 x 0.04) 4,000 Discount amortization $ 377 Effective-Interest Method— 42 Discount Second Period Effective rate for semiannual period 5% Stated rate per semiannual period 4% Interest amount ($87,915 x 0.05) $4,396 Interest payment ($100,000 x 0.04) 4,000 Discount amortization $ 396 $87,538 + $377 Effective-Interest Method— 43 Premium Now consider the $100,000, 8%, 10-year bonds sold for $107,106. The effective rate for the bonds is 7%. Effective rate for semiannual period 3.5 % Stated rate per semiannual period 4.0 % Interest payment ($100,000 x 0.04) $4,000 Interest amount ($107,106 x 0.35) 3,749 Premium amortization $ 251 Effective-Interest Method— 44 Premium Second Period Effective rate for semiannual period 3.5 % Stated rate per semiannual period 4.0 % Interest payment ($100,000 x 0.04) $4,000 Interest amount ($106,855 x 0.035) 3,740 Discount amortization $ 260 $107,106 – $251 Effective-Interest Method— 45 Premium A B C D E ($100,000 x (E x 0.035) (A – B) (D – C) ($100,000 04) + D) Prem. Unamort. Bond # Payment Int. Exp. Amort. Prem. Book $7,106 $107,106 Effective-Interest Method— 46 Premium A B C D E ($100,000 x (E x 0.035) (A – B) (D – C) ($100,000 04) + D) Prem. Unamort. Bond # Payment Int. Exp. Amort. Prem. Book $7,106 $107,106 1 $4,000 $3,749 $251 6,855 106,855 $107,106 x 0.035 Effective-Interest Method— 47 Premium A B C D E ($100,000 x (E x 0.035) (A – B) (D – C) ($100,000 04) + D) Prem. Unamort. Bond # Payment Int. Exp. Amort. Prem. Book $7,106 $107,106 1 $4,000 $3,749 $251 6,855 106,855 2 $4,000 $3,740 $260 6,595 106,595 $106,855 x 0.035 Effective-Interest Method— 48 Premium A B C D E ($100,000 x (E x 0.035) (A – B) (D – C) ($100,000 04) + D) Prem. Unamort. Bond # Payment Int. Exp. Amort. Prem. Book $7,106 $107,106 1 $4,000 $3,749 $251 6,855 106,855 2 $4,000 $3,740 $260 6,595 106,595 3 $4,000 $3,731 $269 6,326 106,326 4 $4,000 $3,721 $279 6,047 106,047 5 $4,000 $3,712 $288 5,759 105,759 Extinguishment of Debt Prior 49 to Maturity Bonds may be redeemed by the issuer by purchasing the bonds on the open market or by exercising the call provision (if available). Bonds may be converted, that is, exchanged for other securities. Bonds may be refinanced by using the proceeds from the sale of a new bond issue to retire outstanding bonds. Extinguishment of Debt Prior 50 to Maturity Triad, Inc.’s $100,000, 8% bonds are not held to maturity. They are redeemed on February 1, 2005, at 97. The carrying value of the bonds is $97,700 as of this date. Interest payment dates are January 31 and July 31. Extinguishment of Debt Prior 51 to Maturity Issuer’s Books Feb. 1 Bonds Payable 100,000 Discount on Bonds Pay. 2,300 Cash 97,000 Extraordinary Gain on Bond Redemption 700 Carry value of bonds, 1/1/02 $97,700 Redemption price 97,000 Gain on bond redemption $ 700 Extinguishment of Debt Prior 52 to Maturity Investor’s Books Feb. 1 Cash 97,000 Loss on Sale of Bonds 700 Bond Investment— Triad Inc. 97,700 53 Convertible Bonds Convertible debt securities usually have the following features: An interest rate lower than the issuer could establish for nonconvertible debt An initial conversion price higher than the market value of the common stock at time of issuance A call option retained by the issuer 54 Convertible Bonds Assume that 500 ten-year bonds, face value $1,000, are sold at 105 ($525,000). The bonds contain a conversion privilege that provides for exchange of a $1,000 bond for 20 shares of stock, par value $1. It is estimated that without the conversion privilege, the bonds would sell at 96. 55 Convertible Bonds Debt and Equity Not Separated Cash 525,000 Bonds Payable 500,000 Premium on Bonds Payable 25,000 Debt and Equity Separated Cash 525,000 Discount on Bonds Payable 20,000 Bonds Payable 500,000 Paid-In Capital Arising from Bond Conversion Feature 45,000 56 Accounting for Conversion Assume that HiTec Co. offers bondholders 40 shares of HiTec Co. Common stock, $1 par, in exchange for each $1000, 8% bond held. An investor exchanges bonds of $10,000 (carrying value as brought 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. 57 Accounting for Conversion Investor’s Books Nov. 1 Investment in HiTec Co. Common Stock 10,400 Investment in HiTec Co. Bonds 9,850 Gain on Conversion of HiTec Co. Bonds 550 The investor may choose not to recognize a gain or loss. If so, the investor in the above situation would debit Investment in HiTec Co. Common Stock for $9,850. 58 Accounting for Conversion Issuer’s Books Nov. 1 Bonds Payable 10,000 Loss on Conversion of Bonds 550 Common Stock, $1 par 400 Paid-In Capital in Excess of Par Value 10,000 Discount on Bonds Payable 150 59 Off-Balance-Sheet Financing • Off-Balance-Sheet-Financing: Financing procedures used by companies to avoid disclosing all their debt on the balance sheet in order to make their financial position look stronger. – Leases – Unconsolidated entities – Special-purpose entities (SPEs) – Joint Ventures – Research and development arrangements – Project financing arrangements 60 Analyzing a Firm’s Debt Position • Debt-to-Equity Ratio: A ratio that measures the relationship between the debt and equity of an entity. Formula: total debt ÷ total stockholders’ equity. • Debt Ratio: An indicator of a company’s overall ability to repay its debts. Formula: total liabilities ÷ total assets. • Times Interest Earned: An indicator of a company’s ability to meet interest payments. Formula: income before interest expense and income taxes ÷ interest expense for the period.