Intermediate accounting 17e stice skousen cengage chapter 12

Accounting for Bonds• Conceptually, bonds and long-term notes are similar types of debt instruments.. Accounting for retirement of bonds either at maturity or prior to the maturity da

Intermediate Accounting,17E

Stice | Stice | Skousen

PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine

Debt Financing

Definition of Liabilities

The FASB defined liabilities as

“probable future sacrifices of

economic benefits arising from

present obligations to a particular

entity to transfer assets or provide

services to other entities in the

future as a result of past transactions

or events.”

Classification of Liabilities

• Liabilities are usually classified as

current or noncurrent.

• If a liability arises in the course of

an entity’s normal operating cycle,

it is considered current if:

 current assets are used to satisfy the obligation within one year or one operating cycle, whichever period is longer.

• When debt that has been classified

as noncurrent will mature within

the next year, the liability should

be reported as a current liability.

• The distinction between current

and noncurrent is important

because of the impact on a

company’s current ratio.

Classification of Liabilities

Short-Term Operating Liabilities

• The term account payable

usually refers to the amount due for the purchase of materials by

a manufacturing company or the purchase of merchandise by a

wholesaler or retailer.

• No recognition of interest is

required.

Short-Term Debt

• In most cases, debt is evidenced by a

written promise to pay a sum of money

in the future

• Notes issued to trade creditors for the

purchase of goods or services are called

notes issued to banks or to officers and stockholders

Short-Term Obligations Expected to be Refinanced

• A short-term obligation that is

expected to be refinanced on a

long-term basis should not be

reported as a current liability.

• The FASB issued Statement No 6 ,

which contains the authoritative

guidelines for classifying short-term obligations expected to be

refinanced.

FASB Statement No 6

(continues)

According to Statement No 6, both of

the following conditions must be met

before a short-term obligation can be

properly excluded from the current

liability classification

the obligation on a long-term basis

ability to refinance the obligation

FASB Statement No 6

Concerning the second point, the ability

to refinance may be demonstrated by

either of the following:

during the period between the balance sheet date and the date the

statements are issued

provides for refinancing on a long-term basis

Lines of Credit

arrangement with a lender in which the

terms are agreed to prior to the need for

borrowing

Present Value of

Long-Term Debt

• A mortgage is a loan backed by an

asset that serves as collateral for

the loan.

• On January 21, 2011, Crystal

Michae purchases a house for

$250,000 and makes a down

payment of $50,000 The remainder

is financed with a 12%, 30-year

mortgage.

Present Value of

Long-Term Debt

As the $2,057 monthly mortgage

payment is made, the interest portion

must be recognized On February 1, the interest is $2,000 ($200,000 × 1/12 × 0.12) The balance, $57, is applied to

the principal On March 1, the interest is

$1,999 [$200,000 – $57 (1/12 × 0.12)] This pattern continues throughout the

mortgage.

Financing with Bonds

The issuance of bonds or notes instead of stock may be preferred by management and

stockholders for the following reasons:

• Present owners remain in control of the

corporation.

• Interest is a deductible expense in arriving at

taxable income; 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 expected dividends

Accounting for Bonds

• Conceptually, bonds and long-term

notes are similar types of debt

instruments.

• The trust indenture (the bond

contract) associated with bonds

generally provides more extensive detail than the contract terms of a note.

Accounting for Bonds

There are three main considerations

in accounting for bonds:

1 Recording the issuance or purchase

2 Recognizing the applicable interest

during the life of the bonds

3 Accounting for retirement of bonds

either at maturity or prior to the maturity date

Nature of Bonds

simply as bonds , are frequently issued in

denominations of $1,000

• The amount printed on the bond is the

• The group contract between the

corporation and the bondholders is known

as the bond indenture

• Debt securities issued by state, county,

and local governments and their agencies are collectively referred to as municipal

• Bonds that mature on a single date are

called term bonds

• When bonds mature in installments, they

are referred to as serial bonds

Nature of Bonds

• Secured bonds offer protection to

investors by providing some form of

security, such as a mortgage on real

estate or the pledge of other collateral

secured by stocks and bonds of other

corporations owned by the issuing

company

the pledge of any specific assets

Nature of Bonds

• Registered bonds call for the registry of the owner’s name on the corporation

books

recorded in the name of the owner; title to these bonds passes with delivery

these securities sell at a significant

discount

Nature of Bonds

• High-risk, high-yield bonds issued by

companies that are heavily in debt or

otherwise in a weak financial condition are often called junk bonds

• Convertible bonds provide for their

conversion into some other security at the option of the bondholder

commodities

Nature of Bonds

• Bond indentures frequently give the

issuing company the right to call and

retire the bonds prior to maturity Such

bonds are termed callable bonds

Nature of Bonds

Market Price of Bonds

• The amount of interest paid on bonds is a

specified percentage of the face value

This percentage is termed the stated

rate, or contract rate

• If the stated rate exceeds the market rate,

the bonds will sell at a discount If the

market rate exceeds the stated rate, the bonds will sell at a premium

• The actual return rate on a bond is known

as the market, yield, or effective

12% Discount Yield

Market Price of Bonds

Market Price of Bonds

Ten-year, 8% bonds of $100,000 are

to be sold on the bond issue date

The effective interest rate for bonds

of similar quality and maturity is 10%, compounded semiannually The

computation of the market price of

the bonds may be divided into two

parts (as shown in Slide 12-26 ).

Part 1 Present value of principal (maturity value):

Maturity value of bonds after 10 years,

or 20 semiannual periods $100,000

Effective interest rate: 10% per year,

or 5% per semiannual period $37,689

Part 2 Present value of twenty interest

payments:

Semiannual payment, 4% of $100,000 $4,000

Effective interest rate: 10% per year,

or 5% per semiannual period 49,849 Total present value (market price) of bond $87,538

Market Price of Bonds

Issuance of Bonds

Each of the bond situations in the

following slides will be illustrated

using the following data: $100,000, 8%, 10-year bonds are issued;

semiannual interest of $4,000

($100,000 × 0.08 × 6/12) is

payable on January 1 and July 1.

Bonds Issued at Par on

Bonds Issued at Par on

Interest Revenue 4,000

Bonds Issued at Discount on

Bonds Issued at Premium on

Bonds Issued at Par between Interest Date

Jan 1 Cash 101,333

Bonds Payable 100,000 Interest Payable 1,333

Bonds Issued at Par between Interest Date

Jan 1 Bond Investment 100,000

Bond Issuance Costs

• The issuance of bonds normally

involves bond issuance costs to the issuer for legal services, printing and engraving, taxes, and

Accounting for Bond Interest

• When bonds are issued at a

premium or discount, an adjustment is made to periodic interest expense to reflect the effective interest rate incurred on the bonds

• This periodic adjustment is

referred to as bond premium or discount amortization

Straight-Line Method

• The straight-line method

provides for the recognition of an

equal amount of premium or

discount amortization each period.

• $100,000, 8%, 10-year bonds were

issued on January 1 at a $12,462

discount Interest is payable on July

1 and December 31.

Straight-Line Method

July 1 Interest Expense 4,623

Discount on Bonds Payable 623

Issuer’s Books

Dec 31 Interest Expense 4,623

Discount on Bonds Payable 623 Interest Payable 4,000

(continues)

$12,462/120 × 6 mo = $623 (rounded)

Straight-Line Method

July 1 Cash 4,000

Bond Investment 623 Interest Revenue 4,623

Investor’s Books

Dec 31 Interest Receivable 4,000

Bond Investment 623 Interest Revenue 4,623

Straight-Line Method

July 1 Interest Expense 3,645

Premium on Bonds Payable 355

Issuer’s Books

Dec 31 Interest Expense 3,645

Premium on Bonds Payable 355 Interest Payable 4,000

(continues)

$7,106/120 × 6 mo = $355 (rounded)

Assume the bonds were sold for $107,106

Reflects effective interest of 7%

Straight-Line Method

July 1 Cash 4,000

Bond Investment 355 Interest Revenue 3,645

Investor’s Books

Dec 31 Interest Receivable 4,000

Bond Investment 355 Interest Revenue 3,645

Effective-Interest Method

• The effective-interest method

of amortization provides for a

uniform interest rate based on a

changing loan balance.

• Provides for an increasing premium

or discount amortization each

period.

Effective-Interest Method

Consider once again the $100,000, 8%, year bonds sold for $87,539, based on an effective interest rate of 10%

10-Bond balance (carrying value) at beginning of year $87,538 Effective rate per semiannual period 5% Stated rate per semiannual period 4% Interest amount based on carrying value and effective

rate ($87,538 × 0.05) $ 4,377 Interest payment based on face value and stated

rate ($100,00 × 0.040) 4,000 Discount amortization $ 377

Effective-Interest Method

Assume the $100,000, 8%, 10-year bonds

is sold for $107,106, based on an effective interest rate of 7%

Bond balance (carrying value) at beginning of first period $107,106 Effective rate per semiannual period 3.5% Stated rate per semiannual period 4% Interest payment based on face value and stated

rate ($100,00 × 0.040) 4,000 Interest amount based on carrying value and effective

rate ($107,106 × 035) 3,749 Premium amortization $ 251

Extinguishment of Debt

Prior to Maturity

1 Bonds may be redeemed by the issuer by

purchasing the bonds on the open

market or by exercising the call provision (if available)

2 Bonds may be converted, that is,

exchanged for other securities

3 Bonds may be refinanced by using the

proceeds from the sale of a new bond

issue to retire outstanding bonds

Redemption by Purchase of

Bonds in the Market

Issuer’s Books

Feb 1 Bonds Payable 100,000

Discount on Bonds Pay 2,300

Gain on Bond Redemption 700

Triad, Inc.’s $100,000, 8% bonds are not held

to maturity They are redeemed on February

1, 2011, at 97 The carrying value of the

bonds is $97,700 as of this date Interest

payment dates are January 31 and July 31.

Carrying value of bonds, 2/1/11 $97,700 Redemption price 97,000 Gain on bond redemption $ 700

Convertible Bonds

• Convertible debt securities usually

have the following features:

1 An interest rate lower than the issuer

could establish for nonconvertible debt

2 An initial conversion price higher than

the market value of the common stock

at time of issuance

3 A call option retained by the issuer

• Convertible debt gives both the

issuer and the holder advantages.

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

Convertible Bonds

Issued with Conversion Feature Nondetachable

and Debt and Equity Not Separated

Bonds Payable 500,000 Premium on Bonds Payable 25,000

Convertible Bonds

Discount on Bonds Payable 20,000

Bonds Payable 500,000 Paid-In Capital Arising from Bond

Conversion Feature 45,000

Issued with Conversion Feature Nondetachable

and Debt and Equity Separated

Par value of bonds (500 × $1,000) $500,000

Selling price of bonds without

conversion feature ($500,000 x 0.96) 480,000

Discount on bonds w/o conversion $ 20,000

Convertible Bonds

Discount on Bonds Payable 20,000

Bonds Payable 500,000 Paid-In Capital Arising from Bond

Conversion Feature 45,000

Issued with Conversion Feature Nondetachable

and Debt and Equity Separated

Total cash received on sale of bonds $525,000

Selling price of bonds without

conversion feature ($500,000 × 0.96) 480,000

Amount applicable to conversion $ 45,000

Accounting for Conversion

Debt According to IAS 32

• IAS 32 does not differentiate

between convertible debt with

nondetachable and detachable

conversion features.

• IAS 32 states that for all convertible

debt issues, the issuance proceeds should be allocated between debt

and equity.

Accounting for Conversion

HiTec Co offers bondholders 40

shares of HiTec Co common stock,

$1 par, in exchange for each $1,000, 8% bond held An investor

exchanges bonds of $10,000 for 400 shares of common stock having a

market value at the time of the

exchange of $26 per share.

Accounting for Conversion

Investment in HiTec Co Common

Bond Investment—HiTec Co 9,850 Gain on Conversion of HiTec Co Bonds 550

Investor’s Books—Gain Recognized

Market value of stock issued (400 shares at $26) $10,400 Face value of bonds payable $10,000

Less unamortized discount 150 9,850 Loss to company on conversion of bonds $ 550

Accounting for Conversion

Investor’s Books

Investment in HiTec Co Common

Stock (carrying value on books) 9,850

Bond Investment—HiTec Co 9,850

Bonds Payable 10,000

Loss on Conversion of Bonds 550

Common Stock, $1 par 400 Paid-In Capital in Excess of Par 10,000 Discount on Bonds Payable 150

Issuer’s Books

Bond Refinancing

• Cash for the retirement of a bond issue

is frequently raised through the “sale of

a new issue” and is referred to as bond

• When refinancing before the maturity

date of the old issue, the APB selected the immediate recognition of a gain or loss for all early extinguishment of debt

Fair Value Option

• SFAS No 159 allows a company to

report, at each balance sheet date, any

or all of its financial assets and liabilities

at their fair market value on the balance sheet date

• The FASB reasoned that the objective is

to improve financial reporting by

providing entities with the opportunity to mitigate volatility in reported earnings

Off-Balance-Sheet Financing

• Off-balance-sheet financing procedures

to avoid disclosing all debt on the balance

sheet in order to make the company’s

financial position look stronger.

• Common techniques used:

 Leases

 Unconsolidated subsidiaries

 Variable interest entities (VIEs)

 Joint ventures

 Research and development arrangements

 Project financing arrangements

Leases are considered to be either rentals

(operating leases) or asset purchases with borrowed money (capital leases) The four

classification criteria are as follows:

life of the asset

more of the asset value

Unconsolidated Subsidiaries

• The FASB issued Statement No 94

in 1987, effectively eliminating one opportunity that companies have

used for off-balance-sheet

financing.

• Companies are able to avoid

recognizing debt associated with

subsidiaries that are less than 50% owned by the company.