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Debt Financing (Part Two)

Intermediate Accounting,17E. Debt Financing (Part Two). ACC 202 A/B. OBJECTIVE 5. Understand the effective interest method in calculation of the amortized cost for bonds. Effective-Interest Method.

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Debt Financing (Part Two)

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  1. Intermediate Accounting,17E Debt Financing (Part Two) ACC 202 A/B

  2. OBJECTIVE 5 Understand the effective interest method in calculation of the amortized cost for bonds

  3. Effective-Interest Method Interest accrues on an outstanding debt at a constant percentage of the debt each period. Interest each period is recorded as the effective market rate of interest multiplied by the outstanding balance of the debt(during the interest period).

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

  5. Effective-Interest Method Issuer’s Books July 1 Interest Expense 4,377 Discount on Bonds Payable 377 Cash 4,000 Investor’s Books July 1 Cash 4,000 Bond Investment 377 Interest Revenue 4,377

  6. 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 Assume the $100,000, 8%, 10-year bonds is sold for $107,106, based on an effective interest rate of 7%.

  7. Effective-Interest Method Interest is recorded as expense to the issuer and revenue to the investor. For the first six-month interest period the amount is calculated as follows: $107,106 × (7% ÷ 2) = $3,749 Outstanding Balance Effective Rate Effective Interest

  8. Effective-Interest Method First Interest payment Issuer’s Books July 1 Interest Expense 3,749 Premium on Bonds Payable 251 Cash 4,000 Investor’s Books July 1 Cash 4,000 Bond Investment 251 Interest Revenue 3,749

  9. Effective-Interest Method The bond indenture calls for semiannual interest payments of only $4,000 – the stated rate(4%) times the face value of $100,000. The difference (e.g. $251 for interest payment 1) decreases the liability for the Issuer and the investment balance for the Investor.

  10. When Financial Statements Are Prepared Between Interest Dates On 1/1/09, Masterwear Industries issues $700,000 face value bonds to United Intergroup. The market interest rate is 14%. The bonds have the following terms: Face Value of Each Bond = $1,000 Maturity Date = 12/31/11 (3 years) Stated Interest Rate = 12% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/09 Present value (price) of the bond = 666,633 (Part One Slide 12-22) Assume Masterwear and United both have September 30th year-ends and effective interest method is used.

  11. When Financial Statements Are Prepared Between Interest Dates Masterwear - Issuer 7% × $666,633 6% × $700,000 United - Investor Left click on the button to go to Slide 12-22 (Part One).

  12. When Financial Statements Are Prepared Between Interest Dates The bond indenture calls for semiannual interest payments of only $42,000 – the stated rate(6%) times the face value of $700,000. The difference ($4,664) increases the liability and is reflected as a reduction in the discount (a valuation account).

  13. Amortization Schedule - Discount 7% × $666,633 $46,664 – 42,000 $666,633 + 4,664 6% × $700,000

  14. Amortization Schedule - Discount $48,544 is rounded to cause outstanding balance to be exactly $700,000 on 12/31/11.

  15. When Financial Statements Are Prepared Between Interest Dates Year-end is on September 30, 2009, before the second interest date of December 31, so we must accrue interest for 3 months from June 30 to September 30. Masterwear - Issuer United - Investor

  16. OBJECTIVE 6 Understand the accounting treatment for extinguishment of debt

  17. Extinguishment of Debt Prior to Maturity Debt retired at maturity results in no gains or losses. BUT Debt retired before maturity may result in an gainor loss on extinguishment. Cash Proceeds – Book Value = Gain or Loss

  18. 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). A call provision gives the issuer the option of retiring bonds prior to maturity. The inclusion of call provisions in a bond agreement is a feature favoring the issuer. The company is in a position to terminate the bond agreement and eliminate future interest charges whenever its financial position make such action feasible.

  19. Extinguishment of Debt Prior to Maturity • 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.

  20. Carrying value of bonds, 2/1/11 $97,700 Redemption price 97,000 Gain on bond redemption $ 700 Issuer’s Books Feb. 1 Bonds Payable 100,000 Discount on Bonds Payable 2,300 Cash 97,000 Gain on Bond Redemption 700 Redemption by Purchase of Bonds in the Market Trident, Inc.’s $100,000, 8% bonds are not held to maturity. They are redeemed on February 1, 2011, at 97,000. The carrying value of the bonds is $97,700 as of this date. Interest payment dates are January 31 and July 31. (continues)

  21. Redemption by Purchase of Bonds in the Market Investor’s Books Feb. 1 Cash 97,000 Loss on Sale of Bonds 700 Bond Investment— Trident Inc. 97,700

  22. Redemption by Exercise of Call Provision On July 1, 2002, Ball Corporation issued for US$900,000, 1,000 (Bond quantities) of its 9%, US$1,000 callable bonds. The bonds are dated July 1, 2002, and mature on July 1, 2012. Interest is payable semiannually on January 1 and July 1. Bell uses the straight-line method of amortizing bond discount. The bonds can be called by the issuer at 102% at any time after June 30, 2007. On July 1, 2009, Ball called in all of the bonds and retired them.

  23. Redemption by Exercise of Call Provision What is the amount of loss which Ball should report on this early extinguishment of debt for the year ended December 31, 2008? • The bonds payable ($1,000 x 1,000 = $1,000,000) were issued at a discount of $100,000 [($1,000 x 1,000) - $900,000] on 7/1/01. • The bonds are called at 102%, 7 years later on 7/1/09. Since the bonds were due in 10 years, 7/10 of the discount (7/10 x $100,000 or $70,000) would have been amortized by 7/1/08.

  24. Redemption by Exercise of Call Provision • Therefore, the balance in the bond discount account is $30,000 ($100,000 - $70,000), and the carrying amount of the debt is $970,000 ($1,000,000 - $30,000). • The loss on the retirement is the difference between the $1,020,000 x 1.02) and the $970,000 carrying amount, or $50,000.

  25. 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 refinancing. • When refinancing before the maturity date of the old issue, the Opinions of the Accounting Principles Board (“APB”) selected the immediate recognition of a gain or loss for all early extinguishment of debt.

  26. OBJECTIVE 7 Understand the accounting treatment for convertible bonds

  27. Convertible Bonds Some bonds may be converted into common stock at the option of the holder. When bonds are converted the issuer updates interest expense and amortization of discount or premium to the date of conversion. The bonds are reduced and shares of common stock are increased. Bonds into Stock

  28. 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 theissuer • Convertible debt gives both the issuer and the holder advantages.

  29. Convertible Bonds – Advantages to an issuer • An issuer is able to obtain financing at a lower interest rate because of the value of the conversion feature to the holder. • Because of the call provision, an issuer is in a position to exert influence on the holders to exchange the debt for equity securities if stock values increase. • The issuer has had the use of relatively low interest rate financing if stock values do not increase.

  30. Convertible Bonds – Advantages to an issuer • The holder has a debt instrument that, barring default, ensures the return of investment plus a fixed return and, at the same times, offers an option to transfer his or her interest to equity capital should such transfer become attractive.

  31. Convertible Bonds – Induced Conversion Companies sometimes try to induce conversion of their bonds into stock. One way to induce conversion is through a “call” provision. When the specified call price is less than the conversion value of the bonds (the market value of the shares), calling the convertible bonds provides bondholders with incentive to convert. Bondholders will choose the shares rather than the lower call price.

  32. Accounting for convertible debt issuance when the conversion feature is nondetachable • Differences of opinion exist as to whether convertible debt securities should be treated by an issuer solely as debt or whether part of the proceeds received from the issuance of debt should be recognized as equity capital. • One view holds that the debt and the conversion privilege are inseparately connected, and, therefore, the debt and equity portions of a security should not be separately valued. A holder cannot sell part of the instrument and retain the other.

  33. Accounting for convertible debt issuance when the conversion feature is nondetachable • An alternative view holds that there are two distinct elements in these securities and that each should be recognized in the accounts: • The portion of the issuance price attributable to the conversion privilege should be recorded as a credit to Paid-In Capital; • The balance of the issuance price should be assigned to the debt.

  34. Accounting for convertible debt issuance when the conversion feature is nondetachable Assume that 500 ten-year bonds, face value $1,000, are sold at 105, or a total issue price of $525,000 (500 x $1,000 x 1.05). The bonds contain a conversion privilege that provides for exchange of a $1,000 bond for 20 shares of stock, par value $1. The interest rate on the bonds is 8%. It is estimated that without the conversion privilege, the bonds would sell at 96%. Assume that a separate value of the conversion feature cannot be determined. The journal entries to record the issuance on the issuer’s books under the two approaches are as follows:

  35. Convertible Bonds Convertible Bonds Issued with Conversion Feature Nondetachable and Debt and Equity Not Separated Cash 525,000 Bonds Payable 500,000 Premium on Bonds Payable 25,000

  36. 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 Issued with Conversion Feature Nondetachable and Debt and Equity Separated Cash 525,000 Discount on Bonds Payable 20,000 Bonds Payable 500,000 Paid-In Capital Arising from Bond Conversion Feature 45,000

  37. 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 Convertible Bonds Issued with Conversion Feature Nondetachable and Debt and Equity Separated Cash 525,000 Discount on Bonds Payable 20,000 Bonds Payable 500,000 Paid-In Capital Arising from Bond Conversion Feature 45,000

  38. Accounting for Conversion When conversion takes place, a special valuation question must be answered: Should the market value of the securities be used to compute a gain or loss on the transaction? Two approaches are possible to account for bond conversions: valuing the transaction at cost (book value of the bonds), or valuing at market (of the stocks or bonds, whichever is more reliable).

  39. Accounting for Conversion(Book Value or Carrying Amount Method) William, Inc. had outstanding 10%, $1,500,000 face amount convertible bonds maturing on December 31, 2012, on which interest is paid December 31 and June 30. After amortization through June 30, 2008, the unamortized balance in the bond premium account was $45,000. On that date, bonds with a face amount of $750,000 were converted into 30,000 shares of $20 par common stock. William incurred expenses of $15,000 in connection with the conversion. Compute the additional paid-in capital (“APIC”) which William should credit in it’s books (Record the conversion by the book value method).

  40. Accounting for Conversion(Book Value or Carrying Amount Method) Under the book value method, the common stock is recorded at the carrying amount of the converted bonds less any conversion expenses. No gain or loss recognized. $750,000 of the $1,500,000 of bonds are converted. The premium relating to these bonds is 750/1,500 of $45,000, or $22,500. Therefore, the carrying amount of the converted bonds is $772,500 ($750,000 + $22,500). The common stock must be recorded at this amount less the conversion expenses ($15,000), or $757,500.

  41. Accounting for Conversion(Book Value or Carrying Amount Method) Issuer’s Books Since the par value of the stock issued is $600,000 (30,000 x $20), AIPC is credited for $157,500 ($757,500 - $600,000). The journal entry is Dr. Bond payable $750,000 Dr. Premium on Bond Payable $22,500 Cr. Common stock $600,000 Cr. APIC $157,500 Cr. Cash $15,000

  42. Accounting for Conversion(Market Value Method) On September 1, 2008, after interest and amortization had been recorded, OK Co. converted $1,100,000 of its 10% convertible bonds into 55,000 shares of $5.5 par common stock. The carrying amount of the bonds on the date of conversion was $1,320,000, and the market value of OK’s common stock was $27.5 per share. Under the market value method, what amount should OK record as a credit to additional paid-in capital?

  43. Accounting for Conversion(Market Value Method) Under the market value method, a conversion of bonds to common stock is recorded at the market value of either the stock or the bonds, whichever is more reliable. In this case, the market value of OK’s stock is given. The common stock account is credited for the par value of the stock (55,000 x $5.5 = $302,500) and APIC is increased by market value minus par [55,000 x ($27.5 – $5.5) = $1,210,000]. Bonds payable and any related accounts are removed from the books.

  44. Accounting for Conversion(Market Value Method) Issuer’s Books OK sustained a loss on this redemption of $192,500, as shown in the entry recording the conversion. Dr. Loss on redemption $192,500 Dr. Bond Payable $1,100,000 Dr. Premium on Bond Payable $220,000 Cr. Common stock $302,500 Cr. APIC $1,210,000 $1,320,000 - $1,100,000

  45. (55,000 x $27.5) ($1,100,000 + $220,000) Accounting for Conversion(Market Value Method) Investor’s Books Dr. Investment in OK Co Common stock $1,512,500 Cr. Bond Investment $1,320,000 Cr. Gain on conversion $192,500

  46. OBJECTIVE 8 Discuss the use of the fair value option for financial assets and liabilities.

  47. Fair Value Option In 2007, with SFAS No. 159 (“The Fair Value Option for Financial Assets and Financial Liabilities”), the FASB took a bold step toward increased use of fair value by allowing companies a fair value option for the reporting of financial assets and liabilities.  Fair value is defined as the “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.

  48. Fair Value Option Orderly transaction A sale or transfer by the reporting entity that holds an asset or owes a liability that: • Is not a forced liquidation or distress sale; • Assumes exposure of the asset or liability to the market for a period prior to the measurement date to facilitate marketing activities that are usual and customary for transactions involving such assets or liabilities.

  49. Fair Value Option • Under the provisions of SFAS No. 159, a company has the option to report, at each balance sheet date, any or all of its financial assets and liabilities at their fair values on the balance sheet date. • This is a very interesting accounting rule because a company can choose to report some financial assets and liabilities of a certain type at fair value while at the same time continuing to use another basis, such as historical cost, for other financial assets and liabilities of exactly the same type.

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