Intermediate accounting 19th by stice stice chapter 12

Nature of Bonds• Bond certificates, commonly referred to simply as bonds , are frequently issued in... • If the stated rate exceeds the market rate, the bonds will sell at a bond premi

Intermediate

Accounting

James D Stice Earl K Stice

Debt Financing

Chapter 12

19 th

Edition

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.”

The FASB is currently considering a revision of this liability definition.

(continued)

Classification of Liabilities

• For reporting purposes 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

(continued)

• The classification of a liability as current or noncurrent can impact significantly a

company’s ability to raise additional funds

• When debt 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

(continued)

Classification of Liabilities

The measurement of liabilities always

involves some uncertainty because a liability,

by definition, involves a future outflow of

resources

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

• Accounts payable are not recorded when

purchase orders are placed but instead

when legal title to the goods passes to the buyer

Short-Term Debt

• In most cases, debt is evidenced by a

promissory note, which is a formal written promise to pay a sum of money in the

future, and is usually reflected on the

debtor’s books as Notes Payable

• Notes issued to trade creditors for the

purchase of goods or services are called

trade notes payable

(continued)

Short-Term Debt

• Nontrade notes payable include notes

issued to banks or to officers and

stockholders for loans to the company

• If a note has no stated rate of interest, or if the stated rate is unreasonable, then the

face value of the note would be discounted

to the present value to reflect the effective rate of interest implicit in the note

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

• This applies to the currently maturing

portion of a long-term debt and to all other short-term obligations except those arising

in the normal course of operations that are due in customary terms

(continued)

According to FASB ASC Topic 470

(Debt) , both of the following conditions

must be met before a short-term

obligation can 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

Short-Term Obligations Expected to be Refinanced

(continued)

Concerning the second point, the ability to

refinance may be demonstrated by either of the following:

Short-Term Obligations Expected to be Refinanced

a) Actually refinancing the obligation during

the period between the balance sheet

date and the date the statements are

issued.

b) Reaching a firm agreement that clearly

provides for refinancing on a long-term

basis.

Short-Term Obligations Expected to be Refinanced

• According to IAS 1, for the obligation to be classified as long term the refinancing must take place by the balance sheet date, not the later date when the financial statements are finalized.

• Under the international standard

post-balance-sheet date events are NOT

considered when determining whether a

refinanceable obligation is reported as

current or noncurrent.

Lines 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

(continued)

Lines of Credit

• The line of credit itself is not a liability

However, once the line of credit is used to borrow money, the company has a formal liability that will be reported as either a

current or a long-term liability

• Maintaining a line of credit is not costless Banks typically charge a small amount, a fraction of 1% per year

(continued)

Present Value of Long-Term Debt

• A mortgage is a loan backed by an asset that serves as collateral for the loan.

• If the borrower cannot repay the loan, the

lender has the legal right to claim the

mortgaged asset and sell it in order to recover the loan amount.

• Mortgages are generally payable in equal

installments; a portion of each payment

represents interest on the unpaid mortgage

balance.

Financing with Bonds

1 Present owners remain in control of the

corporation.

2 Interest is a deductible expense in arriving at

taxable income; 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 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, often including

restrictions on the payment of dividends

or incurrence of additional debt.

(continued)

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

Accounting for Bonds

Nature of Bonds

• Bond certificates, commonly referred to

simply as bonds , are frequently issued in

• Bonds and similar debt instruments are

issued by private corporations, the U.S

government, state, county, and local

governments, school districts, and

Types of Bonds

• Bonds that mature on a single date are

called term bonds

• Bonds that mature in installments are

referred to as serial 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

(continued)

• A collateral trust bond is usually secured

by stocks and bonds of other corporations

owned by the issuing company

• Unsecured bonds (frequently termed

debenture bonds) are not protected by the pledge of any specific assets

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

Types of Bonds

(continued)

• Bearer bonds, or coupon bonds, are not

recorded in the name of the owner; title to

these bonds passes with delivery.

• Zero-interest bonds or deep-discount

bonds do not bear interest Instead, these

securities sell at a significant discount.

• High-risk, high-yield bonds issued by

companies that are heavily in debt or

otherwise in weak financial condition are

referred to as junk bonds.

Types of Bonds

Types of Bonds

Junk bonds are issued in at least three types of circumstances.

high credit ratings but have fallen on hard

times.

companies.

restructuring, often in conjunction with a

leverage buyout.

• Convertible bonds provide for their

conversion into some other security at the

option of the bondholder

redeemable in terms of commodities, such

as oil or precious metals

Types 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

• Mortgage-backed bonds , in many cases,

are just a special form of secured bonds The underlying collateral for these bonds

is the collection of mortgages owned by

the issuing entity

Types 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 bond premium If the stated rate is less than the market, the bonds will sell

at a bond discount.

• The actual return rate on a bond is known as the

market, yield, or effective interest rate.

Market Price of Bonds

Issuance of Bonds

• Bonds may be sold directly to investors by the issuer or they may be sold in the open market through security exchanges or

through investment bankers

• Bonds issued or acquired in exchange for noncash assets or services are recorded at the fair value of the bonds unless the value

of the exchanged assets or services is

more clearly determinable

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

Issuance of Bonds

(continued)

Bonds Issued at Par

on Interest Date

Issuer’s Books Issuer’s Books

July 1 Interest Expense 4,000

Dec 31 Interest Expense 4,000

(continued)

Jan 1 Bond Investment 100,000

Investor’s Books Investor’s Books

Bonds Issued at Discount

Jan 1 Bond Investment 87,538

Investor’s Books Investor’s Books

Bonds Issued at Premium

• Only reading the table for 3 ½ percent,

you should arrive at the bonds having a

present value of $107,106

(continued)

Jan 1 Cash 107,106

Premium on Bonds Payable 7,106

Issuer’s Books Issuer’s Books

Jan 1 Bond Investment 107,106

Investor’s Books Investor’s Books

Bonds Issued at Premium

on Interest Date

(continued)

Bonds Issued at Par between Interest Date

Issuer’s Books Issuer’s Books

July 1 Interest Expense 2,667

Mar 1 Bond Investment 100,000

Interest Receivable 1,333

Investor’s Books Investor’s Books

Bond Issuance Costs

• The issuance of bonds normally involves

bond issuance costs to the issuer for

legal services, printing and engraving,

taxes, and underwriting

• In Statement of Financial Accounting

Concepts No.3, the FASB stated that

“deferred charges” such as bond issuance costs fail to meet the definition of assets

Accounting for Bond Interest

• When bonds are issued at a premium or discount, the market acts to adjust the

stated interest rate to a market or

effective interest rate

• Because the initial premium or discount, the periodic interest payments made over the bond’s life by the issuer do not

represent the total interest expense

involved, an amortization adjustment is

made

• The straight-line method provides for the recognition of an equal amount of premium

or discount amortization each period

• A 10-year, 10% bond issue with a maturity value of $200,00 was sold on the issuance date at 103, the $6,000 premium would be amortized evenly over 120 months until

maturity

Straight-Line Method

(continued)

Straight-Line Method

• To illustrate the accounting for bond

interest using straight-line amortization,

consider the earlier example of the

$100,000, 8%, 10-year bonds issued on January 1

• When sold at a $12,462 discount, the

appropriate entries to record interest on

July 1 and December 31 are shown next

July 1 Interest Expense 4,623

Discount on Bonds Payable 623

Issuer’s Books Issuer’s Books

Dec 31 Interest Expense 4,623

Discount on Bonds Payable 623 Interest Payable 4,000

$12,462/120 × 6 mo = $623 (rounded)

Straight-Line Method

(continued)

July 1 Cash 4,000

Bond Investment 623 Interest Revenue 4,623

Investor’s Books Investor’s Books

Dec 31 Interest Receivable 4,000

Bond Investment 623 Interest Revenue 4,623

Straight-Line Method

(continued)

July 1 Interest Expense 3,645

Premium on Bonds Payable 355

Issuer’s Books Issuer’s Books

Dec 31 Interest Expense 3,645

Premium on Bonds Payable 355

$7,106/120 × 6 mo = $355 (rounded)

Assume the bonds were sold for $107,106.

Reflects effective interest of 7%

Straight-Line Method

(continued)

July 1 Cash 4,000

Interest Revenue 3,645

Investor’s Books Investor’s Books

Dec 31 Interest Receivable 4,000

Straight-Line Method

Effective-Interest Method

• The effective-interest method of

amortization uses a uniform interest rate based on a changing loan balance and

provides for an increasing premium or

discount amortization each period

• In order to use this method, the interest rate for the bonds must be known

effective-(continued)

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

interest rate of 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% The premium amortization for the first 6-month period would be computed as follows:

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

Effective-Interest Method

The second 6-month period would be computed

as follows:

Effective-Interest Method

Bond balance (carrying value) at beginning of second

period ($107,106 – $251) $106,855 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 ($106,855 x 035) 3,740 Premium amortization $ 260

Cash Flow Effects of Amortizing Bond Premiums and Discounts

• The amortization of a bond discount or

premium does not involve the receipt or

payment of cash

• Like other noncash items, it must be

considered in preparing a statement of

cash flows

• Using the indirect method, the discount

amortization is added back to net income

(continued)

Cash Flow Effects of Amortizing Bond Premiums and Discounts

• Using the indirect method, the premium

amortization is subtracted from net income

• Using the direct method, the expense

reported on the income statement is

decreased by the amount of discount

amortization or increased by the amount of the premium amortization

Cash Flow Effects of Amortizing Bond Premiums and Discounts

bonds when the effective rate of interest is

10% The bonds are issued at a price of

$87,538

first year is $733 ($377 + $396) The amount

of interest expense disclosed on the income statement is $8,773 ($4,377 + $4,396), and the amount of cash paid is $8,000.

Retirement of Bonds at Maturity

If the bonds are held to maturity, the discount

or premium has been eliminated over the life

of the bond The entry for retiring the bond is straightforward Assume a $100,000 bond

matures on July 1

July 1 Bonds Payable 100,000

Issuer’s Books Issuer’s Books

(continued)