A Review of the Accounting Cycle

1
chapter 10
Debt Financing
An electronic presentation by Douglas Cloud
Pepperdine University
2
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.

Continued
3
Learning Objectives

• 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 firms debt position using ratios.

Continued
4
Learning Objectives

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

EXPANDED MATERIAL
8. 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
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.
7
Definition of Liabilities
Analysis of 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.

8
Classification of Liabilities

• 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.

9
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.
10
Liquidity Example
Sporting Equipment Company has current assets of
200,000 and current liabilities of 150,000.
11
Measurement of Liabilities
Current Ratio
Coca-Cola 0.85 Delta Air Lines 0.56 Dow
Chemical 1.27 IBM 1.21 McDonalds 0.81 Microsoft 3
.56 Wal-Mart 1.04
12
Types of Liabilities

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

13
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.

14
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.

15
Contingent Liabilities
A contingent liability results only when there is
a high degree of uncertainty as to the outcome of
the event associated with the potential liability.

• pending lawsuit
• discounting a note
• Purchase commitments

16
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.

17
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.
18
Accounting for Short-TermDebt Obligations
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.
19
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.

20
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.

21
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.
22
Unused Line of Credit

Outstanding Unused
Short-Term and Company Line of Credit
Long-Term Debt
IBM 16.1 27.2 Philip Morris 15.6 23.6 Ford
(auto- motive only) 7.5 23.4 Ford (Financial
services only) 8.3 143.9 Sears 5.6 22.5
23
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
24
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
25
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.
26
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 57 199,94
3 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
27
Secured Loan
A secured loan is a loan backed by certain assets
as collateral.
28
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.

29
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.
30
Nature of Bonds
The power of a corporation to create bond
indebtedness is found in the corporation laws of
a state and may be specifically granted by
charter.
31
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.

32
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
33
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
34
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.

35
Market Price of Bonds
Yield
Bond Stated Interest Rate 10
36
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.
37
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
38
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
39
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
40
Bond Issued ata 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).
Effective rate, 10
100,000 8
41
Bond Issued ata Discount on Interest Date
Issuers Books
Jan. 1 Cash 87,538 Discount on Bonds
Payable 12,462 Bonds Payable 100,000
Investors Books
Jan. 1 Bond Investment 87,538 Cash 87,538
42
Bond Issued ata 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).
Effective rate,7
100,000 8
43
Bond Issued ata Premium on Interest Date
Issuers Books
Jan. 1 Cash 107,106 Prem. on Bonds
Payable 7,106 Bonds Payable 100,000
Investors Books
Jan. 1 Bond Investment 107,106 Cash 107,106
44
Bonds Issued at Par Between 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.
Effective rate,8
100,000 8
45
Bonds Issued at Par Between Interest Dates
Issuers Books
Mar. 1 Bond Investment 101,333 Bonds
Payable 100,000 Interest Payable 1,333
100,000 x 0.08 x 2/12
July 1 Interest Expense 2,667 Interest
Payable 1,333 Cash 4,000
100,000 x 0.08 x 4/12
46
Bonds Issued at Par Between Interest Dates
Investors 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
47
Straight-Line Amortization Discount
On Slide 40, 100,000 of 8 bonds were issued at
87,538 (a discount of 12,462). Appropriate
amortization entries must be made on both the
issuers books and the investors books.
Issuers Books
July 1 Interest Expense 4,623 Disc. on Bonds
Payable 623 Cash 4,000
12,462/120 x 6 months
Dec. 31 Interest Expense 4,623 Disc. On Bonds
Payable 623 Interest Payable 4,000
48
Straight-Line Amortization Discount
Investors 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
49
Straight-Line Amortization Premium
In Slide 42, 100,000 of 8 bonds were issued at
107,106. Appropriate amortization entries must
be made on both the issuers books and the
investors books.
Issuers Books
July 1 Interest Expense 3,645 Premium on Bonds
Payable 355 Cash 4,000
7,106/120 x 6 months
Dec. 31 Interest Expense 3,645 Premium On Bonds
Payable 355 Interest Payable 4,000
50
Straight-Line Amortization Premium
Investors Books
July 1 Cash 4,000 Bond Investment 355 Interes
t Revenue 3,645
Dec. 31 Interest Receivable 4,000 Bond
Investment 355 Interest Revenue 3,645
51
Effective-Interest MethodDiscount
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
52
Effective-Interest MethodDiscount
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
53
Effective-Interest MethodPremium
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
54
Effective-Interest MethodPremium
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
55
Effective-Interest MethodPremium
(A B)
(D C)
(100,000 D)
(100,000 x 04)
(E x 0.035)
Prem.
Unamort.
Bond

Payment
Int. Exp.
Amort.
Prem.
Book
7,106
107,106
56
Effective-Interest MethodPremium
(A B)
(D C)
(100,000 D)
(100,000 x 04)
(E x 0.035)
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
57
Effective-Interest MethodPremium
(A B)
(D C)
(100,000 D)
(100,000 x 04)
(E x 0.035)
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
58
Effective-Interest MethodPremium
(A B)
(D C)
(100,000 D)
(100,000 x 04)
(E x 0.035)
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
59
Extinguishment of Debt 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.

60
Extinguishment of Debt Prior 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.
61
Extinguishment of Debt 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
62
Extinguishment of Debt Prior to Maturity
Investors Books
Feb. 1 Cash 97,000 Loss on Sale of
Bonds 700 Bond Investment Triad
Inc. 97,700
63
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
64
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.
65
Convertible Bonds
Par value Selling price of bond without
conversion feature
66
Accounting for 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.
67
Accounting for 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
68
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.

69
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.

70
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)
71
Asset SwapDebtor
FMV Asset lt debt?
72
Equity SwapDebtor
FMV Equity lt debt?
73
Asset or Equity SwapCreditor
FMV Asset gt loan?
74
Modification of TermsDebtor
Total future payments lt debt book value?
75
chapter 10
The End
76
(No Transcript)