1 / 60

The Nature of Long-Term Debt

Unit 13 – Noncurrent Liabilities. The Nature of Long-Term Debt. Bonds and Long-term Notes. Liabilities signify creditors’ interest in a company’s assets. bonds payable: Medium and large sized corp. often choose to borrow money by issuing bonds.

melchior-magda
Download Presentation

The Nature of Long-Term Debt

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Unit 13 – Noncurrent Liabilities The Nature of Long-Term Debt Bonds and Long-term Notes Liabilities signify creditors’ interest in a company’s assets. bonds payable: Medium and large sized corp. often choose to borrow money by issuing bonds. note payable and note receivable: Borrow money from lenders; two sides of the same coin.

  2. Bond Selling Price Bond Certificate Subsequent Periods Interest Payments Company Issuing Bonds Investor Buying Bonds Face Value Payment at End of Bond Term Bonds At Bond Issuance Date Company Issuing Bonds Investor Buying Bonds

  3. Classification of Bond Indenture: The specific promises made to bondholders are described in a document called a bond indenture. 1. Debenture Bondsecured by the “full faith and general credit” of company. 2. Mortgage Bond secured by lien on specific real estate owned by the issuer. 4. Callable Bond allows company to buy back outstanding bonds prior to maturity. 3. Coupon Bond pays interest when investor submits attached coupon. 5. Guaranty Bond guaranteed by a 3rd party, such as the parent of the sub that issued the bonds.

  4. Recording Bonds at Issuance On January 1, 2013, 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 3 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 700,000 United (Investor) Investment in bonds (face amount) 700,000 Cash 700,000

  5. Determining the Selling Price

  6. Determining the Selling Price On January 1, 2013, 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% (market rate). The entire bond issue was purchased by United Intergroup. Present value of an ordinary annuity of $1: n=6, i=7% present value of $1: n=6, i=7% 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.

  7. DiscountAmortization Schedule Here is a bond amortization schedule showing the cash interest, effective interest, discount amortization, and the carrying value (outstanding balance) of the bonds. B/S Bonds Payable 700,000 Less: Discount on B/P 33,367 666,633 $666,633 + $4,664 == $671,297 46,664 = 666,633 x .07

  8. Bonds Issued at a DiscountJ.E. for Initial Issuer and Investor Masterwear (Issuer) Cash 666,633 Discount on bonds payable 33,367 Bonds payable 700,000 United (Investor) Investment in bonds 700,000 Discount on bond investment 33,367 Cash 666,633 Alternative Net Method Masterwear (Issuer) Cash 666,633 Bonds payable 666,633 United (Investor) Investment in bonds 666,633 Cash 666,633

  9. Determining Interest – Effective Interest Method of Amortization Interest expense accrues on an outstanding debt at a constant % of the debt each period. Interest expense for each period is recorded as: effective interest rate (market) x the outstanding balance of the debt(BV at the end of interest period). Actual interest expense is recorded to the issuer and revenue to the investor. For the first six-month interest period the amount is calculated as follows: $666,633 × (14% ÷ 2) = $46,664 Outstanding Balance Effective Rate Effective Interest Exp The bond indenture calls for semiannualinterest payments of only $42,000 (i.e., the stated rate (6%) times the face value of $700,000). The difference ($4,664) increases the liability and is reflected as a reduction in the discount (a contra-liability account).

  10. Recording Interest Expense At the First Interest Date (June 30) Masterwear (Issuer) Interest expense 46,664 Discount on bonds payable 4,664 Cash 42,000 United (Investor) Cash 42,000 Discount on bond investment 4,664 Investment revenue 46,664 $700,000 × (12% ÷ 2) = $42,000 $666,633 × (14% ÷ 2) = $46,664 $46,664 - $42,000 = $4,664

  11. These bonds do not pay interest. Instead, they offer a return in the form of a deep discount from the face amount. Zero-Coupon Bonds

  12. Bond Issued at Premium On January 1, 2013, Masterwear Industries issued $700,000of 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 10%. The entire bond issue was purchased by United Intergroup. Present value of an ordinary annuity of $1: n=6, i=5% present value of $1: n=6, i=5% Because interest is paid semiannually, the present value calculations use: (a) the semiannual stated rate (6%), (b) the semiannual market rate (5%), and (c) 6 (3 x 2) semi-annual periods.

  13. PremiumAmortization Schedule Here is a bond amortization schedule showing the cash interest, effective interest, premium amortization, and the carrying value of the bonds. 42,000 = 700,000 x 6% $735,533 × 5% = $36,777 $735,533 - $5,223 = $730,310

  14. Journal Entries for Bonds Sold at a Premium Masterwear (Issuer) Cash 735,533 Premium on bonds payable 35,533 Bonds payable 700,000 United (Investor) Investment in bonds 700,000 Premium on bond investment 35,533 Cash 735,533 Interest expense and interest revenue will be recognized in a manner consistent with bonds issued at a discount. B/S Bonds Payable 700,000 Plus: Premium on B/P 35,533 735,533

  15. Premium and Discount Amortization Compared

  16. When Financial Statements Are Prepared Between Interest Dates On January 1, 2013, 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 at a cost of $666,633. Assuming Issuer and Buyer both have October 31st year-ends. June 30, 2013 Effective Interest (expense) Semi-annual Stated Interest (payment) $700,000 × (12% ÷ 2) = $42,000 $666,633 × (14% ÷ 2) = $46,664

  17. Year-end is on October 31, 2013, before the second interest date of December 31, so we must accrue interest for 4 months from June 30 to October 31. When Financial Statements Are Prepared Between Interest Dates - Discount First year-end (10/31/13) accrual of interest expense and interest income: Masterwear (Issuer) Interest expense 31,327 Discount on bonds payable 3,327 Interest payable 28,000 United (Investor) Interest receivable 28,000 Discount on bond investment 3,327 Investment revenue 31,327 2. $671,297 × 7% × 4/6 = $31,327 1. $42,000 × 4/6 = $28,000 3. $31,327 - $28,000 = $3,327 6/30/13 outstanding balance (earlier slide)

  18. When Financial Statements Are Prepared Between Interest Dates - Discount 12/31/13, the next interest payment date,the following entries would be recorded. Masterwear (Issuer) Interest expense 15,664 Interest payable 28,000 Discount on bonds payable 1,664 Cash 42,000 United (Investor) Cash (6 months) 42,000 Discount on bond investment (2 months) 1,664 Interest receivable (4 months) 28,000 Investment revenue (2 months) 15,664 671,297 × 7% × 2/6 = $15,664 671,297 x 7% = 46,991 46,991 – 42,000 = 4,991 4,991 – 3,327 = 1,664 671,297 was 6/30/13 outstanding balance

  19. The Straight-Line Method – A Practical Expediency Using the straight-line method of amortizing discounts and premiums, 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 47,561 Discount on bonds payable 5,561 Cash 42,000 United (Investor) Cash 42,000 Discount on bond investment 5,561 Investment revenue 47,561

  20. Legal Accounting Underwriting Commission Engraving Printing Registration Promotion Debt Issue Costs Recoding: Record separately to an asset account (Dr. Debt Issue Costs; & amortize to Debt Issue Expense). Amortized over the term of the related debt.

  21. U. S. GAAP vs. IFRS Debt issue costs (called transaction costs under IFRS) are accounted for differently by U.S. GAAP and IFRS. “Debt issue costs” are recorded separately as an asset. Amortized over the term to maturity. • “Transaction costs”reduce the recorded amount of the debt. • The cost of these services reduces the net cash the issuing company receivesand the amount recorded for the debt. Unless the recorded amount of the debt is reduced by the transaction costs, the higher effective interest rate is not reflected in a higher recorded interest expense.

  22. Long-Term Notes Payable • Accounting is Similar to Bonds • A note is valued at the present value of its future interest and principal cash flows. • Company amortizes any discount or premium over the life of the note.

  23. Long-Term Notes PromissoryNote (Note Payable) Bank Company (Borrower) Property, goods, or services.

  24. Long-Term Notes – Issued at Face Value On January 1, 2013, Skill Graphics, Inc., a product labelingand graphics firm, borrowed $700,000 cash from First BancCorpand issued a 3-year, $700,000 promissory note. Interest of$42,000 was payable semiannually on June 30 and December 31. January 1, At Issuance Skill Graphics (Borrower) Cash 700,000 Note payable 700,000 First BancCorp (Lender) Note receivable 700,000 Cash 700,000

  25. Long-Term Notes At Each of the Six Interest Dates Skill Graphics (Borrower) Interest expense 42,000 Cash 42,000 First BancCorp (Lender) Cash 42,000 Interest revenue 42,000 At Maturity Skill Graphics (Borrower) Notes payable 700,000 Cash 700,000 First BancCorp (Lender) Cash 700,000 Notes receivable 700,000

  26. Note Issued for Assets or Services Skill Graphics purchased a package labeling machine from Hughes–Barker Corporation by issuing a 12%,$700,000, 3-year note that requires interest to be paid semiannually. The machine could have been purchased at acash price of $666,633. The cash price implies an annual market rate of interest of 14%. That is, 7% is the semiannual discount rate (market rate) that yields a present value of $666,633 for the note’s cash flows (interest plus principal) computed as follows: Present value of an ordinary annuity of $1: n=6, i=7% present value of $1: n=6, i=7% The accounting treatment: the amount is determined directly from the market value of the machine orindirectly as the present value of the note.

  27. Note Exchanged for Assets or Services At the Purchase Date (January 1) Skill Graphics (Buyer/Issuer) Machinery 666,633 Discount on note payable 33,367 Notes payable 700,000 Hughes-Barker (Seller/Lender) Notes receivable 700,000 Discount on notes Receivable 33,367 Sales revenue 666,633 At the First Interest Date (June 30) Skill Graphics (Buyer/Issuer) Interest expense 46,664 Discount on note payable 4,664 Cash 42,000 Hughes-Barker (Seller/Lender) Cash 42,000 Discount on notes Receivable 4,664 Investment revenue 46,664

  28. To compute cash payment use present value tables. Each payment includes both an interest amount and a principal amount. Interest expense or revenue: Effective interest rate × Outstanding balance of debt Interest expense or revenue Principal reduction: Cash amount – Interest component Principal reduction per period Installment Notes

  29. Installment Notes Notes often are paid in installments (equal amounts each period; e.g., cars and houses), rather than a single amount at maturity. $666,633 ÷ 4.76654 = $139,857 amount of loan (from Table 4) installmentn=6, i=7.0% payment 0 Rounded

  30. Installment Notes At the Purchase Date (January 1) Skill Graphics (Buyer/Issuer) Machinery 666,633 Notes payable 666,633 Hughes-Barker (Seller/Lender) Notes receivable 666,633 Sales revenue 666,633 At the First Interest Date (June 30) Skill Graphics (Buyer/Issuer) Interest expense 46,664 Note payable (principal) 93,193 Cash 139,857 Hughes-Barker (Seller/Lender) Cash 139,857 Notes receivable 93,193 Interest revenue 46,664

  31. Financial Statement Disclosures Carrying value; it will be 50MM at Bonds Maturity. Disclosures include fair value, the nature of the company’s liabilities, interest rates, maturity dates, call provisions, conversion options, restrictions imposed by creditors, any assets pledged as collateral, and the aggregate amounts payable for each of the next five years.

  32. Early Extinguishment of Debt Debt retired at maturity results in no gains or losses. BUT Debt retiredbeforematurity may result in an gain or loss on extinguishment. Cash Proceeds – Book Value = Gain or Loss

  33. Early Extinguishment of Debt Illustration – On January 1, 2013, 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%. Masterwear (Issuer) Bonds payable 700,000 Loss on early extinguishment 8,710 Discount on bonds payable 23,710 Cash 685,000 $685,000 – 676,290 $700,000 – 676,290 Note: When market rates Bonds value will because bonds are paying < the market rate; if co. elected to use Fair Value option, co will record an “unrealized holding gain-income (cr; and debit Bonds payable)

  34. Some bonds may be converted into common stock at the option of the holder. When bonds are converted the issuer (1) updates interest expense and (2) amortization of discount or premium to the date of conversion. The bonds are reduced and shares of common stock are increased. Convertible Bonds

  35. Convertible Bonds - Example On January 1, 2013, HTL Manufacturers issued $100,000,000 (100,000 bonds) of 8% convertible debentures due 2033 at 103 (103% of face value). The bonds are convertible at the option of the holder into $1 par common stock at a conversion ratio of 40 shares per $1,000 bond. HTL recently issued nonconvertible, 20 year, 8% debentures at 98. At Issuance, January 1, 2013 HTL (Issuer) Cash 103,000,000 Convertible bonds payable 100,000,000 Premium on bonds payable 3,000,000 $100,000,000 × 103% Note: Conversion value of $5MM (103MM – 98MM) is not recorded; i.e., record the bond issuance the same way as for nonconvertible bonds.

  36. Convertible Bonds – Example Cont’d Assume the bondholder exercises one-half of their option to convert the bonds into shares of stock when there is an unamortized premium of $2,000,000 associated with these bonds. The bonds are removed from the accounting records and the new shares issued are recorded at the same amount or the book value of the bonds. At Date of Exercise of One-half of the Bonds HTL (Issuer) Convertible bonds payable 50,000,000 Premium on bonds payable 1,000,000 (amortized) Debt conversion expense (if any) Common stock 2,000,000 Paid-in capital – excess of par 49,000,000 (balanced) Cash (for conversion expense) Note: Callable Bonds: issuing co can call in and exchange for cash with a gain or Loss recognized, while Convertible rights are exercised by holders and exchange for stocks with no gains or losses recorded. 50,000 bonds × 40 shares × $1 par = $2,000,000 par value

  37. Under IFRS, unlike U.S. GAAP, convertible debt is divided into its liability and equity elements. ($ in millions) Cash (103%  $100 million) 103  Convertible bonds payable (value of the debt only) 98*  Equity–conversion option (difference) 5   *The discount is combined with the face amount of the bonds. This is the “net method” – the preferred method under IFRS.  Compound instruments such as this one are separated into their liability and equity components in accordance with IAS No. 32.  If the bonds have a separate fair value of $98 million, we record that amount as the liability and the remaining $5 million as equity. U.S. GAAP vs. IFRSConvertible Bonds

  38. Stock warrants allows a debt holder to purchase a specified number of shares of common stock at a specified option price per share within a stated period; like convertible debt. Unlike convertible debt, warrants require the debt holder to pay some cash to receive the share. When warrants are detachable, a portion of the selling price of the bonds is allocated to the detachable stock warrants. Bonds With Detachable Warrants

  39. Bonds With Detachable Warrants - Example On January 1, 2013, HTL issued $100,000,000 of 8% bonds due in 2020 at 103 (103% of face value). Accompanying each $1,000 bond were 20 warrants. Each warrant permitted the holder to buy one share of $1 par common stock at $25 per share. Shortly after issuance, the warrantswere listed on the stock exchange at $3 per warrant. HTL (Issuer) Cash 103,000,000 Discount on bonds payable 3,000,000 Bonds payable 100,000,000 Paid-in capital – warrants 6,000,000 100,000 bonds × 20 warrants × $3

  40. Bonds With Detachable Warrants-Example Cont’d Assume one-half of the warrants (1,000,000) are exercised when the market value of HTL’s common stock is $30 per share. The exercise price is $25 per common share. HTL (Issuer) Cash 25,000,000 Paid-in capital - warrants 3,000,000 Common stock 1,000,000 Additional paid-in capital 27,000,000 1,000,000 warrants × $25 $6,000,000 ÷ 2

  41. Option to Report Liabilities at Fair Value Companies have the option to value some or all of their financial assets and liabilities at fair value. The same market forces that influence the fair value of an investment in debt securities (interest rates, economic conditions, risk, etc.) influence the fair value of liabilities.

  42. U. S. GAAP vs. IFRS International accounting standards are more restrictive than U.S. standards for determining when firms are allowed to elect the fair value option. The fair value option may be elected by the firm. Although U.S. GAAP guidance 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. • Companies may only elect the fair value option when • When a group of financial assets or liabilities is managed and its performance is evaluated on a fair value basis, or • If the fair value option reduces “accounting mismatch.”

  43. Bonds Issued Between Interest Dates Suppose a weak market caused a delay in selling the bonds until two months after the bond date of January 1(four months before semiannual interest was to be paid). In that case, the buyer would be asked to pay the seller accrued interestfor two months in addition to the price of the bonds. Masterwear was unable to sell $700,000 face amount of bonds, dated January 1, and paying interest semiannually at an annual rate of 12%. The bonds were eventually sold on March 1. Let’s calculate the accrued interest.

  44. Bonds Issued Between Interest Dates The journal entry at the date of issuance (March 1) on the books of the issuer and investor are shown below:

  45. Bonds Issued Between Interest Dates On June 30, the first interest payment date, the following journal entries will be made for the issuer and investor.

  46. Troubled Debt Restructuring When changing the original terms of a debt agreement is motivated by financial difficulties experienced by the debtor (borrower), the new arrangement is referred to as a troubled debt restructuring. A troubled debt restructuring may be achieved in either of two ways: The debt may be settled at the time of the restructuring. The debt may be continued, but with modified terms.

  47. Debt Settled at Time of Restructuring - Example First Prudent Bank is holding a $30,000,000 note from the developer of some property. The developer is in financial trouble and cannot pay the bank the amount owed. The bank agrees to accept land with a fair value of $20,000,000 in full settlement of the note. The property is carried on the books of the developer at $17,000,000. The entries on the books of the developer to record the settlement: Land …...................................................... 3,000,000Gain on disposal of land …......... 3,000,000 ($20,000,000 less carrying value of $17,000,000) Note payable …............................................ 30,000,000Gain on troubled debt restructuring. 10,000,000 Land…………………………………. 20,000,000

  48. Debt is Continued with Modified Terms- Example Example: the total cash payments are less than the carrying amount of the debt. First Prudent Bank holds a $30,000,000 note from a property developer. The note bears interest at 10%, and matures in two years. The developer is in financial difficulty and the bank agrees to modify the terms of the agreement as follows: Forgive the interest accrued from last year of $3,000,000. Reduce the remaining two interest payments to $2,000,000 each. Reduce the principal amount to $25,000,000.

  49. Debt is Continued with Modified Terms At the date of the new agreement, the following journal entry is required: Accrued interest payable ............................. 3,000,000Note payable …........................................... 1,000,000 (to balance) Gain on debt restructuring ………. 4,000,000 Notes payable 1,000,000 = $30,000,000 (the old face amount) - $29,000,000 (total future cash payments including new interests) At each of the next two interest payments, we will make the following entry: Note payable …......................................... 2,000,000 Cash ……………………………… 2,000,000

  50. Debt is Continued with Modified Terms - Summary At maturity, the developer will make the following entry: Note payable …......................................... 25,000,000 Cash ……………………………… 25,000,000

More Related