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Debt Financing
Chapter 12
Intermediate Accounting
16E
Prepared by: Sarita Sheth | Santa Monica College
COPYRIGHT © 2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Learning 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.
Definition of Liabilities
• The obligation of a particular entity to
transfer assets or provide services.
– Must be the result of past
transactions or events.
– Probable transfer of assets (or
services) must be in the future.
Classification of Liabilities
• Current LiabilitiesPaid within one
year or the
operating cycle,
whichever is longer.
• Noncurrent
Liabilities- Not paid
within one year or
the operating cycle,
whichever is longer.
Measurement of Liabilities
For measurement purposes, liabilities
can be divided into three categories:
1. Liabilities that are definite in
amount.
2. Estimated liabilities.
3. Contingent liabilities.
Accounting for Short-Term Debt
• Short-Term obligations are due within
one year or an operating cycle.
• Account Payable -the amount due for
the purchase of materials.
• Notes Payable – a formal written
promise to pay a sum of money in the
future, also known as a promissory
note.
Short-Term Obligations
Expected to be Refinanced
• A short-term obligation that is
expected to be refinanced on a long1. basis
Management
intend
to
term
shouldmust
not be
reported
as a
refinance the obligation on a longcurrent
liability
term basis.
• FASB Statement No. 6 requires that
must
both of 2.
theManagement
following conditions
be
demonstrate
an ability
to
met before
a short-term
obligation
refinance
obligation.
may be
properlythe
excluded
from the
current liability classification:
Short-Term Obligations
Expected to be Refinanced
• 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.
Short-Term Obligations
Expected to be Refinanced
• The terms of the refinancing agreement
should be non-cancelable as to all parties.
• The terms of the refinancing agreement
should extend beyond the current year.
• The company should not be in violation of
the agreement at the balance sheet date or
the date of issuance.
• The lender or investor should be financially
capable of meeting the refinancing
requirements.
Lines of Credit
• Line of credit- is a negotiated arrangement
with a lender in which the terms are agreed
to prior to the need for borrowing.
• A company with an established line of
credit can access funds quickly without the
“red tape”.
• Once the line of credit is used to borrow
money, the company has a formal liability
(current or noncurrent).
Present Value of Long-Term
Debt
• A liability should be reported at the
amount that would satisfy the
obligation
the entry
balance
sheet
Exampleon
journal
to record
a date.
payment:
• For amortgage
long-term
obligation, this
Interest
Expense value
2,000 of the
amount is
the present
future payments
to be made.
Mortgage Payable
57
• The division ofCash
these payments
2,057into
interest and principal components is
a process called loan amortization.
Types of Loans
• Mortgage- 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.
• Secured loan- similar to a mortgage, a loan
backed by assets as collateral and can be
claimed by the lender if the borrower
defaults.
– There is a reduction in risk for the lender with a
secured loan, thus a reduced interest cost for
the borrower.
Financing with Bonds
•
Reasons management may choose to issue
bonds instead of stock:
1. Present owners remain in control of the
corporation.
2. Interest is a deductible expense in arriving at
taxable income; 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.
Financing with Bonds
•
Disadvantages and limitations of
issuing debt securities:
1. It is only possible to use debt financing
if the company is in satisfactory
financial condition.
2. Interest obligations must be paid
regardless of the company’s earnings
and financial position.
3. If a company has losses and is unable
to raise cash to pay interest payments,
secured debt holders may take legal
action.
Accounting for Bonds
•
There are three main considerations
in accounting for bonds:
1. Recording the issuance or purchase.
2. Recognizing the applicable interest
during the life of the bonds.
3. Accounting for the retirement of bonds
either at maturity or prior to the
maturity date.
Nature of Bonds
• Bond Certificates- commonly referred
to as bonds are issued in
denominations of $1,000.
• Face Value- the amount that will be
paid on a bond at maturity date. Also
known as par value or maturity value.
• Bond indenture- a group contract
between the corporation and the
bondholders.
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.
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.
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.
Market Price of Bonds
• 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.
Extinguishment of Debt Prior to
Maturity
1. Bonds may be redeemed by the issuer by
purchasing the bonds on the open market
or by exercising the call provision (if
available).
2. Bonds may be converted, that is,
exchanged for other securities.
3. Bonds may be refinanced by using the
proceeds from the sale of a new bond
issue to retire outstanding bonds.
Extinguishment of Debt Prior to
Maturity
Triad, Inc.’s $100,000, 8% bonds are not
held to maturity. They are redeemed on
February 1, 2007, at 97. The carrying value
of the bonds is $97,700 as of this date.
Interest payment dates are January 31 and
July 31.
Carry
value of
bonds, 1/1/02
Issuer’s
Books
Investor’s
Books
Redemption price
Feb.
100,000
Gain on bond redemption
Feb.11 Bonds
Cash Payable
97,000
Discount on Bonds Pay.
Loss on Sale of Bonds
Cash
Bond InvestmentExtraordinary
Triad Inc. Gain on
Bond Redemption
700
$97,700
97,000
$
700
2,300
97,000
97,700
700
Convertible Bonds
•
Convertible debt securities usually
have the following features:
1. An interest rate lower than the issuer
could establish for nonconvertible debt.
2. An initial conversion price higher than
the market value of the common stock
at time of issuance.
3. A call option retained by the issuer
•
Convertible debt gives both the
issuer and the holder advantages.
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.
Convertible Bonds
Debt and Equity Not Separated
Cash
525,000
Par value –
Bonds Payable
Selling price500,000
of
Premium on Bonds Payablebond without
25,000
conversion
feature
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
Off-Balance-Sheet Financing
• Off-Balance-Sheet-Financing- procedures to
avoid disclosing all debt on the balance
sheet in order to make the company’s
financial position look stronger.
• Common techniques used:
–
–
–
–
–
–
Leases
Unconsolidated subsidiaries
Variable interest entities (VIEs)
Joint ventures
Research and development arrangements
Project financing arrangements
Analyzing a Firm’s Debt
Position
• Debt-to-Equity Ratio- measures the relationship
between the debt and equity of an entity.
Formula: total debt ÷ total stockholders’ equity
• Debt Ratio- indicates a company’s overall ability to
repay its debts.
Formula: total liabilities ÷ total assets.
• Times Interest Earned- shows a company’s ability
to meet interest payments.
Formula: income before interest expense and income
taxes ÷ interest expense for the period.
Disclosing Debt in the Financial
Statements
• Companies may want to disclose additional
information about long-term debt in the
notes like:
–
–
–
–
–
–
–
–
–
Nature of the liabilities
Maturity dates
Interest rates
Methods of liquidation
Conversion privileges
Sinking fund requirements
Borrowing restrictions
Assets pledged,
Dividend limitations
Troubled Debt Restructuring
Troubled debt restructuring exists only
if the “creditor for economic or legal
reasons related to the debtor’s
financial difficulties grants a
concession to the debtor that it would
not otherwise consider.” (SFAS 15.2)