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Strategic Accounting

Strategic Accounting. ACCOUNTING FOR FINANCIAL ASSETS AND LIABILITIES. LONG-TERM DEBT.  Signifies creditors’ interest in a company’s assets.  Requires the future payment of cash in specified (or estimated) amounts, at specified (or projected) dates.

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Strategic Accounting

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  1. Strategic Accounting ACCOUNTING FOR FINANCIAL ASSETS AND LIABILITIES

  2. LONG-TERM DEBT  Signifies creditors’ interest in a company’s assets.  Requires the future payment of cash in specified (or estimated) amounts, at specified (or projected) dates.  As time passes, interest accrues on debt.  Periodic interest is the effective interest rate times the amount of the debt outstanding during the interest period.  Debt is reported at the present value of its related cash flows (principal and/or interest payments), discounted at the effective rate of interest at issuance.

  3. Bonds Sold at Face Amount On January 1, 2009, Masterwear Industries issued $700,000 of 12% bonds. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years [an unrealistically short maturity to shorten the illustration]. The entire bond issue was sold in a private placement to United Intergroup, Inc. at face amount. At Issuance (January 1) Masterwear (Issuer) Cash 700,000 Bonds payable (face amount) 700,000 United (Investor)Investment in bonds (face amount) 700,000 Cash 700,000

  4. Determining the Selling Price A bond issue will be priced by the marketplace to yield the market rate of interest for securities of similar risk and maturity. Illustration – On January 1, 2009, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in threeyears. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup. Present value (price) of the bonds: Interest $ 42,000 x 4.76654 * = $200,195 Principal $700,000 x 0.66634 ** = 466,438 Present value (price) of the bonds $666,633 * present value of an ordinary annuity of $1: n=6, i=7% ** present value of $1: n=6, i=7% Note: Because interest is paid semiannually, the present value calculations use: (a) the semiannual stated rate (6%), (b) the semiannual market rate (7%), and (c) 6 (3 x 2) semi-annual periods.

  5. JOURNAL ENTRIES AT ISSUANCE –BONDS SOLD AT DISCOUNT Masterwear (Issuer) Cash (price calculated above) 666,633Bonds payable 666,633 United (Investor) Investment in bonds 666,633 Cash (price calculated above) 666,633

  6. Determining Interest – Effective Interest Method Interest accrues on an outstanding debt at a constant percentage of the debt each period. Interest each period is recorded as the effective market rate of interest multiplied by the outstanding balance of the debt (during the interest period). Interest recorded (as expense to the issuer and revenue to the investor) for the first six-month interest period is $46,664: $666,633 x [14% ÷ 2] = $46,664 Outstanding Balance Effective Rate Effective Interest However, the bond indenture calls for semiannual interest payments of only $42,000 – the stated rate (6%) times the face value ($700,000). The difference – $4,664 – increases the liability and is reflected as a reduction in the discount (a valuation account).

  7. JOURNAL ENTRIES – THE INTEREST METHOD  The effective interest is calculated each period as the market rate times the amount of the debt outstanding during the interest period. At the First Interest Date (June 30) Masterwear (Issuer) Interest expense (market rate x outstanding bal.) 46,664Bonds payable (difference) 4,664 Cash (stated rate x face amount) 42,000 United (Investor) Cash (stated rate x face amount) 42,000 Bond investment (difference) 4,664Interest revenue (market rate x outstanding bal.) 46,664

  8. CHANGE IN DEBT WHEN EFFECTIVE INTEREST EXCEEDS CASH PAID Interest paid is the amount specified in the bond indenture – the stated rate times the face value. Outstanding Balance January 1 $666,633 Interest accrued at 7% 46,664 Portion of interest paid (42,000) June 30 $671,297 The “unpaid” portion of the effective interest increases the existing liability. Interest accrues on the outstanding debt at the effective rate.

  9. Amortization Schedule – Discount • Since less cash is paid each period than the effective interest, the unpaid difference increases the outstanding balance of the debt. Cash Effective Increase in Outstanding Interest Interest Balance Balance6% x Face Value 7% x Outstanding Debt 1/01/09 666,633 6/30/09 42,000 .07 (666,633)= 46,664 4,664 671,297 12/31/09 42,000 6/30/10 42,000 12/30/10 42,000 6/30/11 42,000 12/30/11 42,000 7% x $666,633 $46,664 – 42,000 6% x $700,000 $666,633 + 4,664

  10. Amortization Schedule – Discount • Since less cash is paid each period than the effective interest, the unpaid difference increases the outstanding balance of the debt. Cash Effective Increase in Outstanding Interest Interest Balance Balance6% x Face Value 7% x Outstanding Debt 1/01/09 666,633 6/30/09 42,000 .07 (666,633)= 46,664 4,664 671,297 12/31/09 42,000 .07 (671,297)= 46,991 4,991 676,288 6/30/10 42,000 .07 (676,288)= 47,340 5,340 681,628 12/30/10 42,000 .07 (681,628)= 47,714 5,714 687,342 6/30/11 42,000 .07 (687,342)= 48,114 6,114 693,456 12/30/11 42,000.07 (693,456)=48,544*6,544 700,000 252,000 285,367 33,367 * rounded

  11. The Straight-Line Method – A Practical Expediency By the straight-line method, the discount in the earlier illustration would be allocated equally to the 6 semiannual periods (3 years): $33,367 ÷ 6 periods = $5,561 per period At Each of the Six Interest Dates Masterwear (Issuer) Interest expense (to balance) 47,561 Bonds payable (discount ÷ 6 periods) 5,561 Cash (stated rate x face amount) 42,000 United (Investor) Cash (stated rate x face amount) 42,000 Bond investment (discount ÷ 6 periods) 5,561Interest revenue (to balance) 47,561

  12. Convertible Bonds Convertible bonds can be converted into (that is, exchanged for) shares of stock at the option of the bondholder. The conversion feature is attractive to investors. This hybrid security has features of both debt (the bonds) and equity (the conversion feature). In essence, the issuer is selling two securities – (1) bonds and (2) an option to convert to stock - for one package price. The bonds represent a liability; the option is shareholders’ equity. Compound instruments such as this one are separated into their liability and equity components in accordance with IAS 32.

  13. Convertible Bonds Illustration On January 1, 2009, HTL Manufacturers issued $100 million of 8% convertible bonds due 2029 at 103 (103% of face value). The bonds are convertible at the option of the holder into no par common stock at a conversion ratio of 40 shares per $1,000 bond (4 million shares). HTL recently issued nonconvertible, 20-year, 8% bonds at 98. Journal Entry at Issuance—Convertible Bonds ($ in millions) Cash (103%  $100 million) 103  Convertible bonds payable (98% x $100 million) 98 Equity – conversion option (difference) 5

  14. Convertible Bonds IFRS / U.S. GAAP DIFFERENCE Under IFRS, convertible debt is divided into its liability and equity elements. Under U.S. GAAP, the currently accepted practice is to record the entire issue price as debt in precisely the same way as for nonconvertible bonds.

  15. Convertible Bonds HTL will record interest on the bonds at 8%, the interest rate that would be the market rate on the bonds if they were issued without the conversion feature.

  16. Convertible Bonds Flip Side.A company that invests in the convertible bonds also separates its investment in the conversion option from its investment in the host instrument. Let’s say Aurora Industries purchased 10% of the HTL convertible bonds. ($ in millions) Investment in HTL bonds (10% x $98 million) 9.8 Investment in conversion option (10% x $5 million) 0.5  Cash (10% x $103 million) 10.3 Because the conversion option derives its value from the value of the stock into which the bonds may be converted, we refer to it as a “derivative.” IAS 39 requires that all derivative securities be reported at FV.

  17. When the Conversion Option is Exercised If the convertible bonds issued by HTL Manufacturers are converted at a time when the remaining unamortized discount is $1 million: Journal Entry at Conversion ($ in millions) Equity – conversion option (account balance) 5 Convertible bonds payable (account balance) 99  Common stock (to balance) 104

  18. Distinguishing Between Debt and EquitySecurities • IFRS / U.S. GAAP DIFFERENCE • Preferred stock (preference shares) often is reported under IFRS (IAS 32) as debt, with the dividends reported in the income statement as interest expense. • When payments are not at the discretion of the issuer. • Dividend payments usually are at the discretion of the issuer, even if cumulative. • Other cash payments often are at the discretion of the holder, e.g., if redemption is on a specific date (manditorily redeemable) or at the option of the holder. • Under U.S. GAAP, preferred stock is reported as debt only if it is “manditorily redeemable.”

  19. Early Extinguishment Illustration – On January 1, 2010, Masterwear Industries called its $700,000, 12% bonds when their carrying amount was $676,290. The indenture specified a call price of $685,000. The bonds were issued previously at a price to yield 14%. Bonds payable (face amount) 676,290 Loss on early extinguishment (to balance) 8,710 Cash (call price) 685,000 IFRS / U.S. GAAP DIFFERENCE Under U.S GAAP, the gain or loss is classified in the Income Statement as an extraordinary item if the situation meets the criteria of being both unusual and infrequent. Reporting items as extraordinary is not permitted under IFRS.

  20. FAIR VALUE OPTION IAS 39 gives a company the option to, value some or all of its financial assets and liabilities, including bonds and notes, at fair value.  If a company chooses the option to report at fair value, then it reports changes in fair value in its income statement.  It’s not necessary that the company elect the option to report all of its financial instruments at fair value or even all instruments of a particular type at fair value. They can "mix and match" on an instrument-by-instrument basis.  A company must make the election when the item originates and is not allowed to switch methods once a method is chosen.

  21. Fair Value Option Conditions To avoid misuse, the fair value option is limited to only those financial instruments falling into one of the following categories. • Their performance is evaluated on a fair value basisin accordance with a documented risk management or investment strategy, or • The fair value option choice eliminates or significantly reduces an “accounting mismatch” that would otherwise arise from measuring assets or liabilities or recognizing the gains and losses on them on different bases.

  22. IFRS / U.S. GAAP DIFFERENCE • Fair Value Option. International accounting standards are more restrictive than U.S. standards for determining when firms are allowed to elect the fair value option. Under IFRS No. 39, companies can elect the fair value option only in specific circumstances. • Although SFAS No. 159 indicates that the intent of the fair value option under U.S. GAAP is to address these sorts of circumstances, it does not require that those circumstances exist.

  23. FAIR VALUE OPTION Illustration HSA, Inc. chooses the fair value option for its bonds. $200,000 of 8% bonds, priced to yield 10%, are issued for $180,000 on July 1. Their fair value was $183,000 on December 31, at which time HSA recorded the following entry: Interest expense ($180,000 x 10% x 6/12) 9,000 Bonds payable 1,000 Cash ($200,000 x 8% x 6/12) 8,000  Amortizing the discount in this entry increased the book value of the liability by $1,000 to $181,000.  Comparing that amount with the fair value of the bonds on that date provides the amount needed to adjust the bonds to their fair value. Dec. 31 fair value $183,000 Dec. 31 book value (amortized initial amount) 181,000 Fair value adjustment needed $ 2,000  Rather than increasing the bonds payable account itself, though, we instead increase it indirectly with a valuation allowance (or contra) account: Unrealized holding loss 2,000 Fair value adjustment ($183,000 – 181,000) 2,000  HSA must recognize the unrealized holding loss in the income statement. Unpaid interest Face amt. x stated rate Balance x effective rate Book Value$181,000FV adjustment 2,000 Fair value $183,000 Bonds Payable  less: Discount Book Value

  24. IASB: Modify the FVO Illustration HSA, Inc. chooses the fair value option for its bonds. $200,000 of 8% bonds, priced to yield 10%, are issued for $180,000 on July 1. Their fair value was $183,000 on December 31, at which time HSA recorded the following entry: Interest expense ($180,000 x 10% x 6/12) 9,000 Bonds payable 1,000 Cash ($200,000 x 8% x 6/12) 8,000  Amortizing the discount in this entry increased the book value of the liability by $1,000 to $181,000.  Comparing that amount with the fair value of the bonds on that date provides the amount needed to adjust the bonds to their fair value. Dec. 31 fair value $183,000 Dec. 31 book value (amortized initial amount) 181,000 Fair value adjustment needed $ 2,000  Assume that $1,500 of the increase was due to a decline in relevant interest rates, the remainder due to an improvement in credit rating. Unrealized holding loss (I/S) 2,000 Fair value adjustment ($183,000 – 181,000) 2,000 Unrealized holding loss (OCI) 500 Unrealized holding loss (I/S) ($2,000 – 1,500) 500 Unpaid interest Face amt. x stated rate Balance x effective rate Book Value$181,000FV adjustment 2,000 Fair value $183,000 Bonds Payable  less: Discount Book Value

  25. IASB: Modify the FVO Statement of Comprehensive Income Revenues $xxx Expenses (xxx) Total change in fair value of financial liabilities $xx Less: change in fair value of financial liabilities due to credit risk (xx) xx Net income $xxx Other comprehensive income: Change in fair value of financial liabilities due to credit risk xx Total comprehensive income $xx

  26. FASB: Financial Instruments at Fair Value • Most financial instruments (e.g., borrowings and investments in stock) would be reported each period at fair value with all changes in fair value reported in net income (FVTNI). • Exception: When a company’s business strategy is to hold a financial instrument for the collection or payment of the contractual cash flows, report in the balance sheet at fair value with changes reported in other comprehensive income (OCI).

  27. TRANSACTION COSTS Costs such as legal costs, printing costs, and underwriting fees are recorded as a reduction in the proceeds of the bond issue, unless classified as at FVTPL (then expensed immediately). IFRS / U.S. GAAP DIFFERENCE   Under U.S. GAAP, transaction costs are debited to a "bond issue costs" account and amortized on a straight-line basis.

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