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1
chapterchapter 10 – Debt Financing
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.
5. Explain various types of off-balance-sheet financing, and understand the reasons for this type of financing.
6. Analyze a firm’s debt position using ratios
Objectives
2
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.”
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.”
• 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.
3
Types of Liabilities
• Liabilities that are Liabilities that are definite in amount.definite in amount.
• Estimated liabilities.Estimated liabilities.
• Contingent liabilities.Contingent liabilities.
• Liabilities that are Liabilities that are definite in amount.definite in amount.
• Estimated liabilities.Estimated liabilities.
• Contingent liabilities.Contingent liabilities.
4
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.
5
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.
Items that will require definite future resource outflow, but the actual amount of the
obligation cannot be established currently.
6
Contingent Liabilities
A contingent liability results when there is a potential liability which depends on the outcome of
an uncertain event E.g. pending lawsuit
A contingent liability results when there is a potential liability which depends on the outcome of
an uncertain event E.g. pending lawsuit
If the potential liability is reasonably possible, then disclose
possible liability in a note
If the potential liability is probable and amount can be reasonably estimated, then
recognize in the financial statements
If the potential liability is remote, then do nothing
7Accounting 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.
8Accounting for Short-TermDebt Obligations
9Accounting 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.
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.
10
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.
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.
Accounting for Short-TermDebt Obligations
An ability to refinance may be demonstrated by:
11
o The terms of the refinancing agreement should be noncancelable as to all parties.
o The terms of the refinancing agreement should extend beyond the current year.
o The company should not be in violation of the agreement at the balance sheet date or the date of issuance.
o The lender or investor should be financially capable of meeting the refinancing requirements.
Accounting for Short-TermDebt Obligations
12
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.
13
• Present value of $100 paid in five years discounted at 10 percent:
Today 1 2 3 4 Future
PV=$62.09 $100
Discount at 10%Discount at 10%
Present Value of $1
14The Present Value of the Annuity of $1
Present value of five equal payments of $100 discounted at 10 percent:
Today 1 2 3 4 5$100$100$100$100$100
PV=$379.08
15
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.
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.
16
Payment Interest Amount Applied to RemainingDate Amount Expense Reduce Principal Balance
1/1/05 $200,0002/1/05 $2,057 $2,000 $57 199,9433/1/05 2,057 1,999 58 199,8854/1/05 2,057 1,999 58 199,8275/1/05 2,057 1,998 59 199,7686/1/05 2,057 1,998 59 199,709
PV of Long-Term Debt
$200,000 x .12 x 1/12
17
Payment Interest Amount Applied to RemainingDate Amount Expense Reduce Principal Balance
1/1/05 $200,0002/1/05 $2,057 $2,000 $57 199,9433/1/05 2,057 1,999 58 199,8854/1/05 2,057 1,999 58 199,8275/1/05 2,057 1,998 59 199,7686/1/05 2,057 1,998 59 199,709
2/1/05 Interest Expense 2,000Mortgage Payable 57
Cash 2,057
PV of Long-Term Debt
18
Secured Loan
Secured Loan
A secured loan is a loan backed by certain assets as
collateral.
A secured loan is a loan backed by certain assets as
collateral.
19
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.
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. Fargo, Inc.
Paid to the bearer of this bond $10,000 at 8 percent annually on
January 1 and July 1.
$10,000
20
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.
21
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.
Nature of Bonds
22
• 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
ContinuedContinuedContinuedContinued
23
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.
ContinuedContinuedContinuedContinued
24
• 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.
Types of Bonds.
25
Market Price of Bonds
BondBondStatedStatedInterestInterest
RateRate10%10%
8%8% PremiumPremium
1010% FaceFace ValueValue
12%12% DiscountDiscount
Yield
26
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.
What is the issue price?
What is the issue price?
27
Market Price of BondsPart 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 $100,0004,000
Effective interest rate, 10% per year
(5% per semiannual period)$49,849
Total present value (market price) of bond $87,538
28Bond Issued atPar on Interest Date
Issuer’s BooksIssuer’s BooksIssuer’s BooksIssuer’s Books
Jan. 1 Cash 100,000Bonds Payable 100,000
July 1 Interest Expense 4,000Cash 4,000
Dec. 31 Interest Expense 4,000Cash 4,000
29Bond Issued atPar on Interest Date
Investor’s BooksInvestor’s BooksInvestor’s BooksInvestor’s Books
Jan. 1 Bond Investment 100,000Cash 100,000
July 1 Cash 4,000Interest Revenue 4,000
Dec. 31 Cash 4,000Interest Revenue 4,000
30Bond 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).
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 Effective rate, 10%rate, 10%
$100,000
8%
Later Slide
31
Issuer’s BooksIssuer’s BooksIssuer’s BooksIssuer’s Books
Jan. 1 Cash 87,538Discount on Bonds Payable 12,462
Bonds Payable 100,000
Bond Issued ata Discount on Interest Date
Investor’s BooksInvestor’s BooksInvestor’s BooksInvestor’s Books
Jan. 1 Bond Investment 87,538Cash
87,538
32Bond 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).
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 Effective rate,7%rate,7%
$100,000
8%
33
Issuer’s BooksIssuer’s BooksIssuer’s BooksIssuer’s Books
Jan. 1 Cash 107,106Prem. on Bonds Payable 7,106Bonds Payable 100,000
Bond Issued ata Premium on Interest Date
Investor’s BooksInvestor’s BooksInvestor’s BooksInvestor’s Books
Jan. 1 Bond Investment 107,106Cash
107,106
34Bonds 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.
On March 1, $100,000, 8%, 10-year bonds were issued to yield 8 %. Interest for two
months has accrued on the bonds.
Effective Effective rate,8%rate,8%
$100,000
8%
35
Issuer’s BooksIssuer’s BooksIssuer’s BooksIssuer’s Books
Bonds Issued at Par Between Interest Dates
Mar. 1 Cash 101,333Bonds Payable 100,000Interest Payable 1,333
July 1 Interest Expense 2,667Interest Payable 1,333
Cash 4,000$100,000 x 0.08 x 4/12$100,000 x 0.08 x 4/12
$100,000 x 0.08 x 2/12$100,000 x 0.08 x 2/12
36
Investor’s BooksInvestor’s BooksInvestor’s BooksInvestor’s Books
Bonds Issued at Par Between Interest Dates
Mar. 1 Bond Investment 100,000Interest Receivable 1,333
Cash 101,333
July 1 Cash 4,000Interest Receivable 1,333Interest Revenue 2,667
37
On an earlier slide, $100,000 of 8% bonds were issued at $87,538 (a discount of $12,462).
Appropriate amortization entries must be made on both the issuer’s books and the investor’s books.
On an earlier slide, $100,000 of 8% bonds were issued at $87,538 (a discount of $12,462).
Appropriate amortization entries must be made on both the issuer’s books and the investor’s books.
Straight-Line Amortization—Discount
Issuer’s BooksIssuer’s BooksIssuer’s BooksIssuer’s Books
July 1 Interest Expense 4,623Disc. on Bonds Payable 623Cash 4,000
Dec. 31 Interest Expense 4,623Disc. On Bonds Payable 623Interest Payable 4,000
$12,462/120 x 6 months$12,462/120 x 6 months$12,462/120 x 6 months$12,462/120 x 6 months
38
Investor’s BooksInvestor’s BooksInvestor’s BooksInvestor’s Books
July 1 Cash 4,000Bond Investment 623
Interest Revenue 4,623
Dec. 31 Interest Receivable 4,000Bond Investment 623
Interest Revenue 4,623
Straight-Line Amortization—Discount
39Straight-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 issuer’s books and the investor’s books.
In Slide 42, $100,000 of 8% bonds were issued at $107,106. Appropriate
amortization entries must be made on both the issuer’s books and the investor’s books.
Issuer’s BooksIssuer’s BooksIssuer’s BooksIssuer’s Books
July 1 Interest Expense 3,645Premium on Bonds Payable 355
Cash 4,000
Dec. 31 Interest Expense 3,645Premium On Bonds Payable 355
Interest Payable 4,000
$7,106/120 x 6 months$7,106/120 x 6 months$7,106/120 x 6 months$7,106/120 x 6 months
40Straight-Line Amortization—Premium
Investor’s BooksInvestor’s BooksInvestor’s BooksInvestor’s Books
July 1 Cash 4,000Bond Investment 355Interest Revenue 3,645
Dec. 31 Interest Receivable 4,000Bond Investment 355Interest Revenue 3,645
41Effective-Interest Method—Discount
Consider again the $100,000, 8%, 10-year bonds sold for
$87,538. The effective rate for the bonds is 10%.
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) $4,377Interest payment ($100,000 x 0.04) 4,000Discount amortization $ 377
42Effective-Interest Method—Discount
Effective rate for semiannual period 5 %Stated rate per semiannual period 4 %Interest amount ($87,915 x 0.05) $4,396Interest payment ($100,000 x 0.04) 4,000Discount amortization $ 396
Second PeriodSecond PeriodSecond PeriodSecond Period
$87,538 + $377$87,538 + $377$87,538 + $377$87,538 + $377
43Effective-Interest Method—Premium
Now consider the $100,000, 8%, 10-year bonds sold for
$107,106. The effective rate for the bonds is 7%.
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) $4,000Interest amount ($107,106 x 0.35) 3,749Premium amortization $ 251
44Effective-Interest Method—Premium
Effective rate for semiannual period 3.5 %Stated rate per semiannual period 4.0 %Interest payment ($100,000 x 0.04) $4,000Interest amount ($106,855 x 0.035) 3,740Discount amortization $ 260
Second PeriodSecond PeriodSecond PeriodSecond Period
$107,106 $107,106 –– $251 $251$107,106 $107,106 –– $251 $251
45
A B C D E
(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
Effective-Interest Method—Premium
46
A B C D E
(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
Effective-Interest Method—Premium
1 $4,000 $3,749 $251 6,855 106,855
$107,106 x 0.035$107,106 x 0.035
47
A B C D E
(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
Effective-Interest Method—Premium
$106,855 x 0.035$106,855 x 0.035
1 $4,000 $3,749 $251 6,855 106,8552 $4,000 $3,740 $260 6,595 106,595
48
A B C D E
(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
Effective-Interest Method—Premium
1 $4,000 $3,749 $251 6,855 106,8552 $4,000 $3,740 $260 6,595 106,5953 $4,000 $3,731 $269 6,326 106,3264 $4,000 $3,721 $279 6,047 106,0475 $4,000 $3,712 $288 5,759 105,759
49Extinguishment 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.
50
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.
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.
Extinguishment of Debt Prior to Maturity
51
Issuer’s BooksIssuer’s BooksIssuer’s BooksIssuer’s Books
Feb. 1 Bonds Payable 100,000Discount on Bonds Pay. 2,300Cash 97,000Extraordinary Gain on Bond Redemption 700
Carry value of bonds, 1/1/02 $97,700Redemption price 97,000Gain on bond redemption $ 700
Extinguishment of Debt Prior to Maturity
52
Investor’s BooksInvestor’s BooksInvestor’s BooksInvestor’s Books
Feb. 1 Cash 97,000Loss on Sale of Bonds 700
Bond Investment— Triad Inc. 97,700
Extinguishment of Debt Prior to Maturity
53
Convertible Bonds
An interest rate lower than the issuer could establish for
nonconvertible debt
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
An initial conversion price higher than the market value of the common stock at time
of issuance
Convertible debt securities usually have the following features:
A call option retained by the issuer
A call option retained by the issuer
54
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. It
is estimated that without the conversion privilege, the bonds
would sell at 96.
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. It
is estimated that without the conversion privilege, the bonds
would sell at 96.
55
Convertible Bonds
Debt and Equity Not SeparatedDebt and Equity Not SeparatedDebt and Equity Not SeparatedDebt and Equity Not Separated
Cash 525,000Bonds Payable 500,000Premium on Bonds Payable 25,000
Debt and Equity SeparatedDebt and Equity SeparatedDebt and Equity SeparatedDebt and Equity Separated
Cash 525,000Discount on Bonds Payable 20,000
Bonds Payable 500,000Paid-In Capital Arising from Bond Conversion Feature 45,00050
0,00
0-
(500
,000
x
.96)50
0,00
0-
(500
,000
x
.96)
56
Accounting for Conversion
Assume that HiTec Co. offers bondholders 40 shares of HiTec Co. Common stock, $1 par, in exchange for each $1000, 8%
bond held. An investor exchanges bonds of $10,000 (carrying value
as brought up to date for both investor and issuer, $9,850) for
400 shares of common stock having a market price at the time of the exchange of $26 per share.
Assume that HiTec Co. offers bondholders 40 shares of HiTec Co. Common stock, $1 par, in exchange for each $1000, 8%
bond held. An investor exchanges bonds of $10,000 (carrying value
as brought up to date for both investor and issuer, $9,850) for
400 shares of common stock having a market price at the time of the exchange of $26 per share.
57
Accounting for Conversion
Investor’s BooksInvestor’s BooksInvestor’s BooksInvestor’s Books
Nov. 1 Investment in HiTec Co. Common Stock 10,400
Investment in HiTec Co. Bonds 9,850Gain 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.
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.
58
Issuer’s BooksIssuer’s BooksIssuer’s BooksIssuer’s Books
Nov. 1 Bonds Payable 10,000Loss on Conversion of Bonds 550
Common Stock, $1 par 400Paid-In Capital in Excess
of Par Value 10,000Discount on Bonds Payable 150
Accounting for Conversion
59
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.– Leases– Unconsolidated entities– Special-purpose entities (SPEs)– Joint Ventures– Research and development arrangements– Project financing arrangements
60
Analyzing a Firm’s 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 company’s overall ability to repay its debts. Formula: total liabilities ÷ total assets.
• Times Interest Earned: An indicator of a company’s ability to meet interest payments. Formula: income before interest expense and income taxes ÷ interest expense for the period.
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