A Review of the Accounting Cycle

1
Debt Financing
2
Learning Objectives

• Understand the various classification and
  measurement issues associated with debt.
• Account for short-term debt obligations,
  including those expected to be refinanced, and
  describe the purpose of lines of credit.
• Apply present value concepts to the accounting
  for long-term debts such as mortgages.

3
Learning Objectives

• Understand the various types of bonds, compute
  the price of a bond issue, and account for the
  issuance, interest, and redemption of bonds.
• Explain various types of off-balance-sheet
  financing, and understand the reasons for this
  type of financing.
• Analyze a firms debt position using ratios.

4
Learning Objectives

• Review the notes to financial statements, and
  understand the disclosure associated with debt
  financing.

EXPANDED MATERIAL

• Understand the conditions under which troubled
  debt restructuring occurs, and be able to account
  for troubled debt restructuring.

5
Time Line of Business Issues Involved with
Long-Term Debt
/-
Notes Payable
Bond
Mortgage Payable
Bond
CHOOSE the method of financing
6
Liabilities

• Definition 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.
• 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.

7
Current Ratio
The current ratio is a measure of the liquidity
of a business. It is computed by dividing total
current assets by total current liabilities.
8
Liquidity Example
Tree Company has current assets of 20,000 and
current liabilities of 15,000. Calculate the
current ratio.
Current Ratio Current assets 20,000
Current liabilities 15,000
1.333
9
Types of Liabilities

• Liabilities that are definite in amount.
• Estimated liabilities.
• Contingent liabilities.

10
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.

11
Estimated Liabilities

• 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.

12
Contingent Liabilities
Definition
Likelihood
Future event is
Record liability if
Probable
likely to occur
estimable
More likely than
Disclose liability in footnotes
remote, but less
Reasonably
likely than probable
possible
Future event is not likely to occur
No disclosure except regarding guarantees
Remote
13
Accounting for Short-TermDebt 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.

14
Accounting for Short-TermDebt Obligations
A short-term obligation that is expected to be
refinanced on a long-term basis should not be
reported as a current liability.
15
Accounting for Short-TermDebt 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.

16
Accounting for Short-TermDebt Obligations

• The terms of the refinancing agreement should be
  noncancelable 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.

17
Present Value of 1
What is the present value of 1?
The value today of 1 to be received or paid at
some future date, given a specified interest rate.
18
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
PV62.09
100
19
Annuities

• Annuity A series of equal amounts to be
  received or paid at equal time intervals, given a
  specified interest rate.
• Present Value of an Annuity The value today of
  a series of equally spaced, equal-amount payments
  to be made or received, given a specified
  interest rate.

20
The Present Value of the 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
21
Compounding of Interest

• Compounding Periods The period of time for
  which interest is computed.
• Interest is compounded annually or semiannually.
• The interest rate per compounding period is the
  yearly interest rate divided by compounding
  periods per year.
• Compound Interest Interest computed on
  principal plus previously accumulated interest.

22
Effects of Compound Interest
Comparing the value of 100 lump sum invested at
10 for 20 years with simple interest and
compound interest.
23
Mortgage Payable Example
On January 1, 2002, Crystal 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, 2002.
24
Mortgage Payable Example
Payment Interest Amount Applied to
Remaining Date Amount Expense Reduce
Principal Balance
1/1/02 200,000 2/1/02 2,057 2,000 57 199,94
3 3/1/02 2,057 1,999 58 199,885 4/1/02 2,057 1,999
58 199,827 5/1/02 2,057 1,998 59 199,768 6/1/02 2
,057 1,998 59 199,709
2/1/02 Interest Expense 2,000 Mortgage
Payable 57 Cash 2,057
25
Secured Loan
A secured loan is a loan backed by certain assets
as collateral.
26
Nature of 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.

27
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.

28
Types of Bonds (Cont.)

• 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.

29
Types of Bonds (Cont.)

• Zero-interest bonds Bonds that do not bear
  interest but instead are sold at significant
  discounts.
• Convertible bonds Bonds that can be converted
  to other securities at the option of the
  bondholder.
• 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.

30
Types of Bonds (Cont.)
What are junk bonds?
31
Types of Bonds (Cont.)
High-risk, high-yield bonds issued by companies
that are heavily in debt or weak financially.
32
Financing With Bonds
Reasons management may prefer issuing bonds or
notes instead of stock
33
Financing With Bonds

• Present owners remain in control of the
  corporation.
• Interest is a deductible expense in arriving at
  taxable income, while dividends are not.
• Current market rates of interest may be favorable
  relative to stock market prices.
• The charge against earnings for interest may be
  less than the amount of dividends that might be
  expected by shareholders.

34
Characteristics 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.

35
Characteristics of Bonds
Yield
Bond Stated Interest Rate 10
36
Example Bond Issued atPar on Interest Date
Issuers 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
37
Example Bond Issued atPar on Interest Date
Investors 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
38
Example Bond Issued ata Discount
On January 1, 100,000, 8, 10-year bonds were
issued for 87,519 (which provided an effective
interest rate of 10 to the investor).
Effective rate, 10
100,000 8
39
Example Bond Issued ata Discount
The Provo Company agreed to issue 5-year,
500,000 bonds and pay 10 interest, compounded
semiannually. Assume the effective rate is 12
percent.
Issuers Books
Jan. 1 Cash 87,539 Discount on Bonds
Payable 12,461 Bonds Payable 100,000
July 1 Interest Expense 4,377 Discount on Bonds
Payable 377 Cash 4,000
87,539 x 0.10 x 6/12
(87,539 377) x 0.10 x 6/12
Dec. 31 Interest Expense 4,396 Discount on
Bonds Payable 396 Cash 4,000
40
Example Bond Issued ata Discount
The Provo Company agreed to issue 5-year,
500,000 bonds and pay 10 interest, compounded
semiannually. Assume the effective rate is 12
percent.
Investors Books
Jan. 1 Bond Investment 87,539 Cash 87,539
July 1 Cash 4,000 Bond Investment 377 Interest
Revenue 4,377
Dec. 31 Cash 4,000 Bond Investment 396 Interest
Revenue 4,396
41
Example Bond Issued ata Premium
On January 1, 100,000, 8, 10-year bonds were
issued for 107,107 (which provided an effective
interest rate of 7 to the investor).
7
100,000 8
42
Example Bond Issued ata Premium
Issuers Books
Jan. 1 Cash 107,107 Premium on Bonds
Pay. 7,107 Bonds Payable 100,000
July 1 Interest Expense 3,749 Premium on Bonds
Payable 251 Cash 4,000
107,107 x .07 x 6/12
43
Example Bond Issued ata Premium
Investors Books
Jan. 1 Bond Investment 107,107 Cash 107,107
July 1 Cash 4,000 Bond Investment 251 Intere
st Revenue 3749
44
Straight-Line Amortization
On January 1, 2002, Tree Company agreed to issue
10-year, 200,000 bonds and pay 10 interest,
compounded semiannually. The company received
196,000 for the bonds. Make the entry to record
the issuance of the bonds.
Jan. 1 Cash 196,000 Discount on Bonds Payable
4,000 Bonds Payable 200,000 Issued
200,000 bond at a discount.
45
Straight-Line Amortization
Using straight-line amortization, what entry is
made for the interest payment on June 30, 2002?
Jun. 30 Interest Expense 10,200 Discount on
Bonds Payable 200 Cash 10,000 Paid
Interest (200,000 x .10 x 1/2).
46
Straight-Line Amortization
On January 1, 2002, Tree Company agreed to issue
10-year, 200,000 bonds and pay 10 interest,
compounded semiannually. The company received
210,000 for the bonds. Using straight-line
amortization, what entry is needed on July 31,
2002?
Jun. 30 Interest Expense 9,500 Premium on Bonds
Payable 500 Cash 10,000 Paid Interest
(200,000 x .10 x 1/2).
47
Example Effective-Interest Method
The Pioneer Company issues a 1,000, 8, 10-year
bond. The market rate was 6 at the time of
issuance. Create an effective-interest table.
48
Example Effective-Interest Method
(A-B)
(D-C)
(1,000D)
(1,000 x 04)
(E x 0.03)
Prem.
Unamort.
Bond

Payment
Int. Exp.
Amort.
Prem.
Book
148.80
1,148.80
49
Example Effective-Interest Method
(A-B)
(D-C)
(1,000D)
(1,000 x 04)
(E x 0.03)
Prem.
Unamort.
Bond

Payment
Int. Exp.
Amort.
Prem.
Book
148.80
1,148.80
1
40.00
34.46
5.54
143.26
1,143.26
50
Example Effective-Interest Method
(A-B)
(D-C)
(1,000D)
(1,000 x 04)
(E x 0.03)
Prem.
Unamort.
Bond

Payment
Int. Exp.
Amort.
Prem.
Book
148.80
1,148.80
1
40.00
34.46
5.54
143.26
1,143.26
2
40.00
34.30
5.70
137.56
1,137.56
51
Example Effective-Interest Method
(A-B)
(D-C)
(1,000D)
(1,000 x 04)
(E x 0.03)
Prem.
Unamort.
Bond

Payment
Int. Exp.
Amort.
Prem.
Book
148.80
1,148.80
1
40.00
34.46
5.54
143.26
1,143.26
2
40.00
34.30
5.70
137.56
1,137.56
3
40.00
34.13
5.87
131.69
1,131.69
52
Example Bonds Issued Between Interest Dates
On January 1, 2002, Miller Company received
authorization to issue 10-year, 150,000 bonds
and pay 10 interest on June 31 and December 31
of each year. The bonds sold at face value on
April 30, 2002. What is the required entry on
April 30?
Apr. 30 Cash 155,000 Bonds
Payable 150,000 Interest
Payable 50,000 Sold 150,000, 10 bond at
face value plus four months accrued
interest.
53
Example Bonds Issued Between Interest Dates
What is the required entry on June 30 to record
payment of interest?
June 30 Interest Expense 2,500 Interest
Payable 5,000 Cash 7,500 Paid interest
(150,000 x 10 x 1/2).
54
Retiring Bonds Prior 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.

55
Retiring Bonds Prior to Maturity
Triad, Inc.s 100,000, 8 bonds are not held to
maturity. They are redeemed on February 1, 2002,
at 97. The carrying value of the bonds is
97,700 as of this date. Interest payment dates
are January 31 and July 31.
56
Retiring Bonds Prior to Maturity
Issuers Books
Feb. 1 Bonds Payable 100,000 Discount on Bonds
Pay. 2,300 Cash 97,000 Extraordinary Gain
on Bond Redemption 700
57
Retiring Bonds Prior to Maturity
Investors Books
Feb. 1 Cash 97,000 Loss on Sale of
Bonds 700 Investment in Triad, Inc.
Bonds 97,700
58
Bond Conversion
HiTec Company offers bondholders 40 shares of
HiTec Company common stock, 1 par, in exchange
for each 1,000, 8 bond held.
On November 1, an investor exchanges bonds of
10,000 (carry value, 9,850) for 400 shares of
common stock.
59
Bond Conversion
Investors 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.
60
Bond Conversion
Issuers 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
61
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.
• Leveraged Buy-Out (LBO) An acquisition of a
  company where a substantial amount of the
  purchase price, often 90 percent or more, is
  debt-financed.

62
Analyzing a Firms 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 companys overall
  ability to repay its debts. Formula total
  liabilities total assets.
• Times Interest Earned An indicator of a
  companys ability to meet interest payments.
  Formula income before interest expense and
  income taxes interest expense for the period.

63
Troubled Debt Restructuring

• Troubled debt restructuring exists only if the
  creditor for economic or legal reasons related
  to the debtors financial difficulties grants a
  concession to the debtor that it would not
  otherwise consider. (SFAS 15.2)

64
Asset Swap--Debtor
FMV Asset lt debt?
65
Equity Swap--Debtor
FMV Equity lt debt?
66
Asset or Equity Swap--Creditor
FMV Asset gt loan?
67
Modification of Terms--Debtor
Total future payments lt debt book value?
68
The End