Debt Financing
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LECTURE 4
DEBT FINANCING (Part 2)
McGraw-Hill /Irwin
© 2009 The McGraw-Hill Companies, Inc.
Lecture Outline Part 1 Brief discussions on debt financing Present value of money concept Accounting for debt (bonds) 1.Recording the issuance of bonds.
Part 2 1.Recognizing the applicable interest during the life of the bonds. 2.Accounting for the retirement of bonds either at maturity or prior to the maturity date.
Disclosure
McGraw-Hill /Irwin
© 2009 The McGraw-Hill Companies, Inc.
Slide 3
Determining Interest – 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). 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:
666,633
Outstanding Balance
×
(14% ÷ 2)
Effective Rate
=
$46,664
Effective Interest
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). 14-3
Slide 4
Journal Entries – The Interest Method The effective interest is calculated each period as the market rate times the amount of the debt outstanding during the interest period. At the First Interest Date (June 30)
Masterwear - Issuer Date Description Jun. 30 Interest expense Discount on bonds payable Cash
Debit 46,664
Credit 4,664 42,000
14-4
Slide 5
Change in Debt When Effective Interest Exceeds Cash Paid Date Jan. 1 Jun. 30 Jun. 30 Jun. 30 Jun. 30
Interest Accrued at 7% .07 × 666,633 Paid at 6% .06 × 700,000 Unpaid
Account Balances Outstanding Bonds Payable Discount Balance (Face Value) on Bonds 666,633 = 700,000 – 33.367 =
46,664
=
(42,000)
46,664 – 42,000 671,297
=
700,000
=
(4,664)
–
28,703
The “unpaid” portion of the effective interest ($4,644) increases the outstanding balance to $671,297 and reduces the discount to $28,703 on June 30. 14-5
Slide 6
Amortization Schedule – Discount Since less cash is paid each period than the effective interest, the unpaid difference increases the outstanding balance of the debt.
Date
01/01/09 06/30/09 12/31/09 06/30/10 12/31/10 06/30/11 12/31/11
Cash Interest (6% × Face Amount) 42,000 42,000 42,000 42,000 42,000 42,000 252,000
Effective Interest (7% × Outstanding Balance) .07 × 666,633 = 46,664
7% × $666,633
6% × $700,000
Increase in Balance (Discount Reduction)
Outstanding Balance
4,664
666,633 671,297
$46,664 – 42,000 $666,633 + 4,664
14-6
Slide 7
Amortization Schedule – Discount Date
01/01/09 06/30/09 12/31/09 06/30/10 12/31/10 06/30/11 12/31/11
Cash Interest (6% × Face Amount) 42,000 42,000 42,000 42,000 42,000 42,000 252,000
Effective Interest (7% × Outstanding Balance) .07 × .07 × .07 × .07 × .07 × .07 ×
666,633 = 671,633 = 676,288 = 681,628 = 687,342 = 693,456 =
Increase in Balance (Discount Reduction)
46,664 46,991 47,340 47,714 48,114 48,544
4,664 4,991 5,340 5,714 6,114 6,544
285,367
33,367
Outstanding Balance
666,633 671,297 676,288 681,628 687,342 693,456 700,000
$48,544 is rounded to cause outstanding balance to be exactly $700,000 on 12/31/11. 14-7
Slide 8
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
Assume Masterwear has September 30th yearends. 14-8
Slide 9
When Financial Statements Are Prepared Between Interest Dates Recall the entries we prepared on June 30, 2009. These entries will not change.
Masterwear - Issuer Date Description Jun. 30 Interest expense Discount on bonds payable Cash
Debit 46,664
Credit 4,664 42,000
14-9
Slide 10
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 Date Description Sep. 30 Interest expense ($46,991 × 1/2) Discount on bonds payable Interest payable ($42,000 × 1/2)
Debit 23,496
Credit 2,496 21,000
14-10
Slide 11
When Financial Statements Are Prepared Between Interest Dates On December 31, the next interest payment date, the following entries would be recorded.
Masterwear - Issuer Date Description Dec. 31 Interest expense ($46,991 × 1/2) Interest payable ($42,000 × 1/2) Discount on bonds payable Cash ($700,000 × 6% )
Debit 23,496 21,000
Credit
2,496 42,000
14-11
Slide 12
The Straight-Line Method – A Practical Expediency Using the straight-line method, the discount in the earlier illustration would be allocated equally to the 6 semiannual periods (3 years): $33,367 ÷ 6 periods = $5,561 per period At Each of the Six Interest Dates Masterwear (Issuer)
Date Description Jun.30 Interest expense (to balance) Discount on bonds payable (total discount ÷ 6 periods) Cash (stated rate × face amount)
Debit 47,561
Credit
5,561 42,000
14-12
Slide 13
Debt Issue Costs Legal Accounting Underwriting Commission Engraving Printing Registration Promotion
14-13
Slide 14
Long-Term Notes
Present value techniques are used for valuation and interest recognition. The procedures are similar to those we encountered with bonds.
14-14
Slide 15
Long-Term Notes On January 1, 2009, Skill Graphics, Inc., a product labeling and graphics firm, borrowed 700,000 cash from First BancCorp and issued a 3-year, $700,000 promissory note. Interest of $42,000 was payable semiannually on June 30 and December 31.
At Issuance Skill Graphics (Borrower) Date Description Jan. 1 Cash Notes payable
Debit 700,000
Credit 700,000
14-15
Slide 16
Long-Term Notes (continued) At Each of the Six Interest Dates Skill Graphics (Borrower) Date
Description Interest expense Cash
At Maturity Date
Debit 42,000
Credit 42,000
Skill Graphics (Borrower) Description Notes payable Cash
Debit 700,000
Credit 700,000
14-16
Slide 17
Early Extinguishment of Debt Debt retired at maturity results in no gains or losses.
BUT Debt retired before maturity may result in an gain or loss on extinguishment. Cash Proceeds – Book Value = Gain or Loss
14-17
Slide 18
Early Extinguishment Illustration – On January 1, 2010, Masterwear Industries called its $700,000, 12% bonds when their carrying amount was $676,290. The indenture specified a call price of $685,000. The bonds were issued previously at a price to yield 14%. Date Description Jan. 1 Bonds payable Loss on early extinguishment Discount on bonds payable Cash $685,000 – 676,290
Debit 700,000 8,710
Credit
23,710 685,000
($700,000 – 676,290
14-18
Slide 19
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
14-19
Slide 20
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. 14-20
Slide 21
Bonds With Detachable Warrants Stock warrants provide the option
to purchase a specified number of shares of common stock at a specified option price per share within a stated period. A portion of the selling price of the
bonds is allocated to the detachable stock warrants. 14-21
Slide 22
Bonds With Detachable Warrants Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the holder to purchase one share of stock for $18 per share. Immediately after issue the bonds were selling for 98 without the warrants and the warrants have a market value of $16.
Proportional Method Fair value of bonds without warrants Fair value of the warrants Aggregrate fair value
$ 9,800,000 160,000 $ 9,960,000
98.39% 1.61% 100.00%
Allocate to bonds $10,000,000 x 98.39% $ 9,839,000 Allocate to warrants $10,000,000 x 1.61% 161,000 Total face value $ 10,000,000 14-22
Slide 23
Tutorial questions P14-6 P14-15 E14-17 E14-20
14-23
DEBT FINANCING (Part 2)
McGraw-Hill /Irwin
© 2009 The McGraw-Hill Companies, Inc.
Lecture Outline Part 1 Brief discussions on debt financing Present value of money concept Accounting for debt (bonds) 1.Recording the issuance of bonds.
Part 2 1.Recognizing the applicable interest during the life of the bonds. 2.Accounting for the retirement of bonds either at maturity or prior to the maturity date.
Disclosure
McGraw-Hill /Irwin
© 2009 The McGraw-Hill Companies, Inc.
Slide 3
Determining Interest – 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). 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:
666,633
Outstanding Balance
×
(14% ÷ 2)
Effective Rate
=
$46,664
Effective Interest
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). 14-3
Slide 4
Journal Entries – The Interest Method The effective interest is calculated each period as the market rate times the amount of the debt outstanding during the interest period. At the First Interest Date (June 30)
Masterwear - Issuer Date Description Jun. 30 Interest expense Discount on bonds payable Cash
Debit 46,664
Credit 4,664 42,000
14-4
Slide 5
Change in Debt When Effective Interest Exceeds Cash Paid Date Jan. 1 Jun. 30 Jun. 30 Jun. 30 Jun. 30
Interest Accrued at 7% .07 × 666,633 Paid at 6% .06 × 700,000 Unpaid
Account Balances Outstanding Bonds Payable Discount Balance (Face Value) on Bonds 666,633 = 700,000 – 33.367 =
46,664
=
(42,000)
46,664 – 42,000 671,297
=
700,000
=
(4,664)
–
28,703
The “unpaid” portion of the effective interest ($4,644) increases the outstanding balance to $671,297 and reduces the discount to $28,703 on June 30. 14-5
Slide 6
Amortization Schedule – Discount Since less cash is paid each period than the effective interest, the unpaid difference increases the outstanding balance of the debt.
Date
01/01/09 06/30/09 12/31/09 06/30/10 12/31/10 06/30/11 12/31/11
Cash Interest (6% × Face Amount) 42,000 42,000 42,000 42,000 42,000 42,000 252,000
Effective Interest (7% × Outstanding Balance) .07 × 666,633 = 46,664
7% × $666,633
6% × $700,000
Increase in Balance (Discount Reduction)
Outstanding Balance
4,664
666,633 671,297
$46,664 – 42,000 $666,633 + 4,664
14-6
Slide 7
Amortization Schedule – Discount Date
01/01/09 06/30/09 12/31/09 06/30/10 12/31/10 06/30/11 12/31/11
Cash Interest (6% × Face Amount) 42,000 42,000 42,000 42,000 42,000 42,000 252,000
Effective Interest (7% × Outstanding Balance) .07 × .07 × .07 × .07 × .07 × .07 ×
666,633 = 671,633 = 676,288 = 681,628 = 687,342 = 693,456 =
Increase in Balance (Discount Reduction)
46,664 46,991 47,340 47,714 48,114 48,544
4,664 4,991 5,340 5,714 6,114 6,544
285,367
33,367
Outstanding Balance
666,633 671,297 676,288 681,628 687,342 693,456 700,000
$48,544 is rounded to cause outstanding balance to be exactly $700,000 on 12/31/11. 14-7
Slide 8
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
Assume Masterwear has September 30th yearends. 14-8
Slide 9
When Financial Statements Are Prepared Between Interest Dates Recall the entries we prepared on June 30, 2009. These entries will not change.
Masterwear - Issuer Date Description Jun. 30 Interest expense Discount on bonds payable Cash
Debit 46,664
Credit 4,664 42,000
14-9
Slide 10
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 Date Description Sep. 30 Interest expense ($46,991 × 1/2) Discount on bonds payable Interest payable ($42,000 × 1/2)
Debit 23,496
Credit 2,496 21,000
14-10
Slide 11
When Financial Statements Are Prepared Between Interest Dates On December 31, the next interest payment date, the following entries would be recorded.
Masterwear - Issuer Date Description Dec. 31 Interest expense ($46,991 × 1/2) Interest payable ($42,000 × 1/2) Discount on bonds payable Cash ($700,000 × 6% )
Debit 23,496 21,000
Credit
2,496 42,000
14-11
Slide 12
The Straight-Line Method – A Practical Expediency Using the straight-line method, the discount in the earlier illustration would be allocated equally to the 6 semiannual periods (3 years): $33,367 ÷ 6 periods = $5,561 per period At Each of the Six Interest Dates Masterwear (Issuer)
Date Description Jun.30 Interest expense (to balance) Discount on bonds payable (total discount ÷ 6 periods) Cash (stated rate × face amount)
Debit 47,561
Credit
5,561 42,000
14-12
Slide 13
Debt Issue Costs Legal Accounting Underwriting Commission Engraving Printing Registration Promotion
14-13
Slide 14
Long-Term Notes
Present value techniques are used for valuation and interest recognition. The procedures are similar to those we encountered with bonds.
14-14
Slide 15
Long-Term Notes On January 1, 2009, Skill Graphics, Inc., a product labeling and graphics firm, borrowed 700,000 cash from First BancCorp and issued a 3-year, $700,000 promissory note. Interest of $42,000 was payable semiannually on June 30 and December 31.
At Issuance Skill Graphics (Borrower) Date Description Jan. 1 Cash Notes payable
Debit 700,000
Credit 700,000
14-15
Slide 16
Long-Term Notes (continued) At Each of the Six Interest Dates Skill Graphics (Borrower) Date
Description Interest expense Cash
At Maturity Date
Debit 42,000
Credit 42,000
Skill Graphics (Borrower) Description Notes payable Cash
Debit 700,000
Credit 700,000
14-16
Slide 17
Early Extinguishment of Debt Debt retired at maturity results in no gains or losses.
BUT Debt retired before maturity may result in an gain or loss on extinguishment. Cash Proceeds – Book Value = Gain or Loss
14-17
Slide 18
Early Extinguishment Illustration – On January 1, 2010, Masterwear Industries called its $700,000, 12% bonds when their carrying amount was $676,290. The indenture specified a call price of $685,000. The bonds were issued previously at a price to yield 14%. Date Description Jan. 1 Bonds payable Loss on early extinguishment Discount on bonds payable Cash $685,000 – 676,290
Debit 700,000 8,710
Credit
23,710 685,000
($700,000 – 676,290
14-18
Slide 19
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
14-19
Slide 20
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. 14-20
Slide 21
Bonds With Detachable Warrants Stock warrants provide the option
to purchase a specified number of shares of common stock at a specified option price per share within a stated period. A portion of the selling price of the
bonds is allocated to the detachable stock warrants. 14-21
Slide 22
Bonds With Detachable Warrants Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the holder to purchase one share of stock for $18 per share. Immediately after issue the bonds were selling for 98 without the warrants and the warrants have a market value of $16.
Proportional Method Fair value of bonds without warrants Fair value of the warrants Aggregrate fair value
$ 9,800,000 160,000 $ 9,960,000
98.39% 1.61% 100.00%
Allocate to bonds $10,000,000 x 98.39% $ 9,839,000 Allocate to warrants $10,000,000 x 1.61% 161,000 Total face value $ 10,000,000 14-22
Slide 23
Tutorial questions P14-6 P14-15 E14-17 E14-20
14-23
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