McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

DEBT FINANCING DEBT FINANCING (Part 2)(Part 2)

LECTURE 4

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

Lecture Outline

Part 1Brief discussions on debt financingPresent value of money conceptAccounting for debt (bonds)

1.Recording the issuance of bonds.

Part 22.Recognizing the applicable interest during the life of the

bonds.3.Accounting for the retirement of bonds either at maturity or

prior to the maturity date.

Disclosure

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Determining Interest – Effective Interest Determining Interest – Effective Interest MethodMethodInterest 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).

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).

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 × (14% ÷ 2) = $46,664Outstanding Balance Effective Rate Effective Interest

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Journal Entries – The Interest MethodJournal 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)

Date Description Debit CreditJun. 30 Interest expense 46,664

Discount on bonds payable 4,664 Cash 42,000

Date Description Debit CreditJun. 30 Interest expense 46,664

Discount on bonds payable 4,664 Cash 42,000

Masterwear - IssuerMasterwear - Issuer

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Change in Debt When Effective Interest Change in Debt When Effective Interest Exceeds Cash PaidExceeds Cash Paid

Outstanding Bonds Payable DiscountDate Interest Balance (Face Value) on Bonds

Jan. 1 666,633 = 700,000 – 33.367Accrued at 7%.07 × 666,633 = 46,664

Paid at 6%.06 × 700,000 = (42,000)

Unpaid

46,664 – 42,000 = (4,664)

Jun. 30 671,297 = 700,000 – 28,703

Jun. 30

Jun. 30

Jun. 30

Account BalancesOutstanding Bonds Payable Discount

Date Interest Balance (Face Value) on BondsJan. 1 666,633 = 700,000 – 33.367

Accrued at 7%.07 × 666,633 = 46,664

Paid at 6%.06 × 700,000 = (42,000)

Unpaid

46,664 – 42,000 = (4,664)

Jun. 30 671,297 = 700,000 – 28,703

Jun. 30

Jun. 30

Jun. 30

Account Balances

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.

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Amortization Schedule – DiscountAmortization Schedule – Discount

Since less cash is paid each period than the effective interest, theunpaid difference increases the outstanding balance of the debt.

Cash Effective Increase in OutstandingDate Interest Interest Balance Balance

(6% × Face (7% × Outstanding (DiscountAmount) Balance) Reduction)

01/01/09 666,633 06/30/09 42,000 .07 × 666,633 = 46,664 4,664 671,297 12/31/09 42,000 06/30/10 42,000 12/31/10 42,000 06/30/11 42,000 12/31/11 42,000

252,000

Cash Effective Increase in OutstandingDate Interest Interest Balance Balance

(6% × Face (7% × Outstanding (DiscountAmount) Balance) Reduction)

01/01/09 666,633 06/30/09 42,000 .07 × 666,633 = 46,664 4,664 671,297 12/31/09 42,000 06/30/10 42,000 12/31/10 42,000 06/30/11 42,000 12/31/11 42,000

252,000 6% × $700,000 $666,633 + 4,664

$46,664 – 42,0007% × $666,633

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Amortization Schedule – DiscountAmortization Schedule – DiscountCash Effective Increase in Outstanding

Date Interest Interest Balance Balance(6% × Face (7% × Outstanding (Discount

Amount) Balance) Reduction)01/01/09 666,633 06/30/09 42,000 .07 × 666,633 = 46,664 4,664 671,297 12/31/09 42,000 .07 × 671,633 = 46,991 4,991 676,288 06/30/10 42,000 .07 × 676,288 = 47,340 5,340 681,628 12/31/10 42,000 .07 × 681,628 = 47,714 5,714 687,342 06/30/11 42,000 .07 × 687,342 = 48,114 6,114 693,456 12/31/11 42,000 .07 × 693,456 = 48,544 6,544 700,000

252,000 285,367 33,367

Cash Effective Increase in OutstandingDate Interest Interest Balance Balance

(6% × Face (7% × Outstanding (DiscountAmount) Balance) Reduction)

01/01/09 666,633 06/30/09 42,000 .07 × 666,633 = 46,664 4,664 671,297 12/31/09 42,000 .07 × 671,633 = 46,991 4,991 676,288 06/30/10 42,000 .07 × 676,288 = 47,340 5,340 681,628 12/31/10 42,000 .07 × 681,628 = 47,714 5,714 687,342 06/30/11 42,000 .07 × 687,342 = 48,114 6,114 693,456 12/31/11 42,000 .07 × 693,456 = 48,544 6,544 700,000

252,000 285,367 33,367

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

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When Financial Statements Are Prepared When Financial Statements Are Prepared Between Interest DatesBetween Interest Dates

On 1/1/09, Masterwear Industries issues $700,000 face On 1/1/09, Masterwear Industries issues $700,000 face value bonds to United Intergroup. The market interest value bonds to United Intergroup. The market interest

rate is rate is 14%14%. . The bonds have the following terms:The bonds have the following terms:

Face Value of Each Bond = $1,000Face Value of Each Bond = $1,000

Maturity Date = 12/31/11 (3 years) Maturity Date = 12/31/11 (3 years)

Stated Interest Rate = Stated Interest Rate = 12%12%

Interest Dates = 6/30 & 12/31Interest Dates = 6/30 & 12/31

Bond Date = 1/1/09Bond Date = 1/1/09

On 1/1/09, Masterwear Industries issues $700,000 face On 1/1/09, Masterwear Industries issues $700,000 face value bonds to United Intergroup. The market interest value bonds to United Intergroup. The market interest

rate is rate is 14%14%. . The bonds have the following terms:The bonds have the following terms:

Face Value of Each Bond = $1,000Face Value of Each Bond = $1,000

Maturity Date = 12/31/11 (3 years) Maturity Date = 12/31/11 (3 years)

Stated Interest Rate = Stated Interest Rate = 12%12%

Interest Dates = 6/30 & 12/31Interest Dates = 6/30 & 12/31

Bond Date = 1/1/09Bond Date = 1/1/09

Assume Masterwear has September 30Assume Masterwear has September 30 thth year- year-ends.ends.

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Recall the entries we prepared on June 30, 2009.Recall the entries we prepared on June 30, 2009.These entries will not change.These entries will not change.

Date Description Debit CreditJun. 30 Interest expense 46,664

Discount on bonds payable 4,664 Cash 42,000

Date Description Debit CreditJun. 30 Interest expense 46,664

Discount on bonds payable 4,664 Cash 42,000

Masterwear - IssuerMasterwear - Issuer

When Financial Statements Are Prepared When Financial Statements Are Prepared Between Interest DatesBetween Interest Dates

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Year-end is on September 30, 2009, before the second Year-end is on September 30, 2009, before the second interest date of December 31, so we must accrue interest interest date of December 31, so we must accrue interest

for 3 months from June 30 to September 30.for 3 months from June 30 to September 30.

Date Description Debit CreditSep. 30 Interest expense ($46,991 × 1/2) 23,496

Discount on bonds payable 2,496 Interest payable ($42,000 × 1/2) 21,000

Date Description Debit CreditSep. 30 Interest expense ($46,991 × 1/2) 23,496

Discount on bonds payable 2,496 Interest payable ($42,000 × 1/2) 21,000

Masterwear - IssuerMasterwear - Issuer

When Financial Statements Are Prepared When Financial Statements Are Prepared Between Interest DatesBetween Interest Dates

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When Financial Statements Are Prepared When Financial Statements Are Prepared Between Interest DatesBetween Interest Dates

On December 31, the next interest payment date,On December 31, the next interest payment date,the following entries would be recorded.the following entries would be recorded.

Date Description Debit CreditDec. 31 Interest expense ($46,991 × 1/2) 23,496

Interest payable ($42,000 × 1/2) 21,000 Discount on bonds payable 2,496 Cash ($700,000 × 6%) 42,000

Date Description Debit CreditDec. 31 Interest expense ($46,991 × 1/2) 23,496

Interest payable ($42,000 × 1/2) 21,000 Discount on bonds payable 2,496 Cash ($700,000 × 6%) 42,000

Masterwear - IssuerMasterwear - Issuer

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The Straight-Line Method – A Practical The Straight-Line Method – A Practical ExpediencyExpediency

Date Description Debit CreditJun.30 Interest expense (to balance) 47,561

Discount on bonds payable (total discount ÷ 6 periods) 5,561 Cash (stated rate × face amount) 42,000

Date Description Debit CreditJun.30 Interest expense (to balance) 47,561

Discount on bonds payable (total discount ÷ 6 periods) 5,561 Cash (stated rate × face amount) 42,000

Masterwear(Issuer)

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

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Debt Issue CostsDebt Issue Costs

LegalLegal AccountingAccounting UnderwritingUnderwriting CommissionCommission EngravingEngraving PrintingPrinting RegistrationRegistration Promotion Promotion

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Long-Term NotesLong-Term Notes

Present value techniques are used for Present value techniques are used for valuation and interest recognition.valuation and interest recognition.

The procedures are similar to those we The procedures are similar to those we encountered with bonds. encountered with bonds.

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Long-Term NotesLong-Term Notes

On January 1, 2009, Skill Graphics, Inc., a product labelingand 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.

Date Description Debit CreditJan. 1 Cash 700,000

Notes payable 700,000

Date Description Debit CreditJan. 1 Cash 700,000

Notes payable 700,000

Skill Graphics (Borrower)

At Issuance

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Long-Term Notes (continued)Long-Term Notes (continued)At Each of the Six Interest Dates

Date Description Debit CreditInterest expense 42,000 Cash 42,000

Date Description Debit CreditInterest expense 42,000 Cash 42,000

Skill Graphics (Borrower)

At Maturity

Date Description Debit CreditNotes payable 700,000 Cash 700,000

Date Description Debit CreditNotes payable 700,000 Cash 700,000

Skill Graphics (Borrower)

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Early Extinguishment of DebtEarly Extinguishment of Debt

Debt retired at maturity results Debt retired at maturity results in no gains or losses. in no gains or losses.

Debt retired at maturity results Debt retired at maturity results in no gains or losses. in no gains or losses.

Debt retired before maturity may result in an Debt retired before maturity may result in an gaingain or lossor loss on extinguishment. on extinguishment.

Cash Proceeds – Book Value = Gain or LossCash Proceeds – Book Value = Gain or Loss

Debt retired before maturity may result in an Debt retired before maturity may result in an gaingain or lossor loss on extinguishment. on extinguishment.

Cash Proceeds – Book Value = Gain or LossCash Proceeds – Book Value = Gain or Loss

BUTBUT

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Early ExtinguishmentEarly Extinguishment

Date Description Debit CreditJan. 1 Bonds payable 700,000

Loss on early extinguishment 8,710 Discount on bonds payable 23,710 Cash 685,000

Date Description Debit CreditJan. 1 Bonds payable 700,000

Loss on early extinguishment 8,710 Discount on bonds payable 23,710 Cash 685,000

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%.

$685,000 – 676,290 ($700,000 – 676,290

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Convertible BondsConvertible Bonds

Some bonds may be converted into common Some bonds may be converted into common stock at the option of the holder. When bonds stock at the option of the holder. When bonds

are converted the issuer updates interest are converted the issuer updates interest expense and amortization of discount or expense and amortization of discount or premium to the date of conversion. The premium to the date of conversion. The

bonds are reduced and shares of common bonds are reduced and shares of common stock are increased.stock are increased.

Bonds into Stock

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Induced ConversionInduced 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.

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.

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Bonds With Detachable WarrantsBonds With Detachable Warrants

Stock warrants provide the option Stock warrants provide the option to purchase a specified number of to purchase a specified number of shares of common stock at a shares of common stock at a specified option price per share specified option price per share within a stated period.within a stated period.

A portion of the selling price of the A portion of the selling price of the bonds is allocated to the bonds is allocated to the detachable stock warrants.detachable stock warrants.

Stock warrants provide the option Stock warrants provide the option to purchase a specified number of to purchase a specified number of shares of common stock at a shares of common stock at a specified option price per share specified option price per share within a stated period.within a stated period.

A portion of the selling price of the A portion of the selling price of the bonds is allocated to the bonds is allocated to the detachable stock warrants.detachable stock warrants.

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Bonds With Detachable WarrantsBonds With Detachable Warrants

Matrix issues at par 10,000, $1,000 face value, 8% Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the debt with detachable warrants that permit the

holder to purchase one share of stock for $18 per holder to purchase one share of stock for $18 per share. Immediately after issue the bonds were share. Immediately after issue the bonds were

selling for 98 without the warrants and the warrants selling for 98 without the warrants and the warrants have a market value of $16. have a market value of $16.

Matrix issues at par 10,000, $1,000 face value, 8% Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the debt with detachable warrants that permit the

holder to purchase one share of stock for $18 per holder to purchase one share of stock for $18 per share. Immediately after issue the bonds were share. Immediately after issue the bonds were

selling for 98 without the warrants and the warrants selling for 98 without the warrants and the warrants have a market value of $16. have a market value of $16.

Fair value of bonds without warrants 9,800,000$ 98.39%Fair value of the warrants 160,000 1.61%Aggregrate fair value 9,960,000$ 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

Proportional Method

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Tutorial questions

P14-6P14-15E14-17E14-20