MANAGEMENT DECISIONS
AND FINANCIAL
ACCOUNTING REPORTS
Baginski & Hassell
Chapter 3
Financing Decisions - Debt
• Topics
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Characteristics of debt securities
Cash interest versus effective interest
Effective interest overview
Computation of effective interest
Accounting for long-term bonds payable
– Application of effective interest method to
bonds payable
– Example illustrating effective interest method
– Notes payable
– Hybrid securities
– Convertible debt
– Debt-like characteristics of preferred stock
Characteristics of Debt Securities
• Security
– Claims against specific asset (secured)
– General claims against all assets (unsecured)
• Maturity
– Have a definite maturity date
– May be callable earlier at the borrower’s
discretion
• Convertibility
– Normally, debt is not convertible into other
securities.
– Debt securities, particularly bonds, may be
convertible into common stock at
holder’s discretion.
– Bonds may be issued with detachable
warrants, which allow the holder to purchase
common stock at predetermined prices.
• Interest payment characteristics
– In general, debt has a fixed maturity value
(principal) and a stated interest rate.
– Maturity value (principal) also is referenced as
face value or par value.
“Cash” Interest
• “Cash” Interest Paid by Debtor
– Multiply maturity value times the stated
interest rate (as printed on the instrument)
Example: On January 1, 2004, the Liu Co.
issued $10,000,000 of 10 year, 8% bonds due
January 1, 2014, with interest to be paid
annually on January 1. (Liu will disburse
“cash” interest of $800,000 each year, on
January 1, starting on January 1, 2005.)
“Effective” Interest Overview
• “Effective” Interest
– The market rate of interest for debt (on the date
of transaction), being a function of economywide conditions and borrower-specific risk
factors.
• Components
– Underlying real rate of return
– Inflation premium
– Risk premium
Effective Interest: Computation
Mathematics of Finance (in general) is based
on five variables:
n = Number of interest payment periods
P = Principal (present value) - the amount
being borrowed
MV = Maturity (future) value of the debt
R = “Rent” (generic term) payments on
“rented” capital, i.e., the interest
payment per period (n) and ...
i = Interest (or market) rate per period (also
known as the effective rate per period)
Note: Investors compare investment opportunities by
comparing respective rates of return available, by
calculating effective rates per year. For example, a
stated rate of “8%, compounded semiannually”
equates to an effective rate per year of 8.16%.
Of course, payments (R), representative of
the “cash” interest payments over n
periods, may be arranged as either:
• Ordinary annuity payments (payments at
the end of each period), or
• Annuity due payments (payments at the
beginning of each period).
Typically, if three of the variable factors
are “given” (known), financial calculators
aid in easily deriving the other two; an
example relating to bonds (where four
“givens” are needed), follows.
The focus of such problems is very often
the effective interest rate being earned per
period or per year.
The Present Value of a bond investment, i.e., an
investor’s bid price (also known as the
market, sales, or issue price of a bond) is
equal to
The present value of future cash interest
annuity PLUS the present value of the
future maturity value, both “discounted” by
using the current market rate of interest for
similar debts.
EXAMPLE: On January 1, 2004, the Liu Co.
issued $10,000,000 of 10 year, 8% bonds due
January 1, 2015, with interest paid annually on
January 1. Given that the market price (sales
price) of the bonds is $9,358,234 (rounded to
nearest dollar), solve for the effective interest rate
per year, i.
PV = $9,358,234; MV = $10,000,000
n = 10; R = $800,000 ($10,000,000 × 8%)
i = ? = 9%
Accounting for Long-term
Bonds Payable
• At Issuance
– Bonds payable are recorded by the debtor at
the issue (sale) price, by reflecting any ...
• Premium situation: bonds issued at greater
amount than maturity value (risk “low”)
• Discount situation: bonds issued at lesser
amount than maturity value (risk “high”)
– Book value (or carrying value) = The face value
plus/minus any premium/discount
– If bonds are issued between interest payment
dates, the buyer also pays the issuer accrued
interest from the last interest payment date to
date of issuance. (*)
– At the next interest payment date, the issuer
pays the entire amount due for a full interest
payment period.
(*) This principle applies to any acquisition of bonds from
any seller, just as it applied to the original issuer involved.
This traditional procedure is “fair to all.” Why?
• After Issuance
– After issuance, bond accounting uses the
effective interest method, which emphasizes
the interest expense per period.
• Premium/discount amortization per period
is the difference between interest expense
calculation and cash interest paid (or
payable).
Application of Effective
Interest Method
• Calculated on a per period basis
with ...
• n = number of interest payments
to be made (i.e., periods during
the life of the debt security)
• Computation:
Beginning of the period carrying (book) value
× Historical effective interest rate at time of
issuance
× appropriate time frame
= Interest expense
– Interest paid (or payable)
= Premium/discount amortization for the period
EXAMPLE: Apply effective interest method
after calculating the effective interest rate per
period.
Facts: On January 1, 2004, the Faulconer Co.
issued (for $4,550,000) the following bond:
$4,000,000 of 7-year, 8% bonds, due January
1, 2011; interest is paid semiannually (on
July 1 and January 1) each year. Faulconer
incurred $75,000 in transactions costs.
Note: Any bond issue costs are recorded separately
and amortized over the life of the bond.
• Solution: The effective interest rate = 2.8%
per semiannual period; a “5.6%,
compounded semiannually” stated rate.
• Documentation:
n = 14; (7=year bonds × 2 semiannual periods)
R = interest payment per period = $160,000;
($4,000,000 × 8% × one-half year)
PV (present value) = purchase price = $4,550,000
MV in the future = face value = $4,000,000
i per n = ? = 2.8%
THEN ...
Faulconer Co.: Computation of Interest
Expense, First Semiannual Period
Beginning carrying value (1/1/04)
$4,550,000
Effective interest rate per n
Interest expense (1/1/04 – 6/30/04)
Interest payable (1/1/04 – 6/30/04)
Premium amortization =
Thus, ending carrying value on
6/30/04 = $4,550,000 - $32,600 =
2.8%
127,400
160,000
$ 32,600
$4,517,400
Faulconer Co.
Financial Statement Information
For six months ended June 30, 2004
Statement of Cash Flows
Operating activities
(No Effect as of June 30(*)]
Income Statement
Interest expense - bonds
(*) Interest will be paid on July 1.
$127,400
Balance Sheet
Current Liabilities
Interest payable
$ 160,000
Long-term Liabilities
Bonds payable
Premium
$4,000,000
517,400
$4,517,400
Partial Bond Amortization Schedule
Faulconer Co. Effective Interest Amortization
Table – Bond Premium
Date
4% Cash
Interest
1/1/04
7/1/04 160,000
1/1/05 160,000
7/1/05 160,000
2.8% Eff.
Interest
Expense*
127,400
126,487
125,549
Premium
Amort.
Book Value
of Debt
32,600
33,513
34,451
$4,550,000
4,517,400
4,483,887
4,449,436
*Beginning Book Value × 2.8% effective interest rate
Accounting for Notes Payable
• Normally issued for cash, but may be
issued for non-cash consideration (e.g.,
goods and services).
• Apply the effective interest method if
issued for a premium/discount (rare).
• Notes payable, as compared to bonds, are
more likely to be issued at face value, but
may be issued at a premium or discount
– If stated and market interest rates are equal, the
note is issued at face value, and no premium or
discount occurs.
– This happens because the borrower and lender
have typically agreed to base the note’s terms to
reflect the market rate of interest on the date of
the transaction.
Hybrid Securities
• Hybrid securities are securities that
have both debt-like and equity-like
characteristics.
• Examples
– Convertible debt incorporates an option
to acquire common stock.
• Total FMV is attributed to the debt
feature.
– Debt incorporating detachable warrants
(Warrants may be tendered to acquire
common stock.)
• The FMV of the debt security is
allocated between debt features and the
equity features, preferably based on
the relative separate FMVs of the debt
and warrants (if practical).
Convertible Debt
EXAMPLE: On January 1, 2004, the Lopez Co.
issued at face value of $5,000,000 of 8-year, 10%
convertible debentures, due January 1, 2012.
Interest is paid annually on December 31. Each
$1,000 bond is convertible into 30 shares of Lopez’s
$10 par common stock at the option of the holder.
On January 1, 2006 (after payment of the
December 31, 2005, interest payment), all bonds
were converted to common stock.
The balance sheet presentation just before and just
after the conversion is as follows:
Lopez Co. Balance Sheet
Before conversion
Long-term liabilities
Bonds payable
$5,000,000
After conversion
Stockholders’ Equity
Common Stock (1)
$1,500,000
Additional paid-in capital (2)
$3,500,000
Documentation
(1) 5,000 bonds × 30 shares = 150,000 shares;
150,000 shares × $10 par = $1,500,000
(2) $5,000,000 book value of debt – $1,500,000 par
value of stock
FAQs?
What would be the impact on the journal
entry if the FMV of the common stock in
the above example at the time of
conversion was $25 per share? $35 per
share?
How would premiums/discounts affect it?
Give it a shot!
Debt-like Characteristics of
Preferred Stock
• Preferred stock and convertible preferred
stock are equity securities with some debtlike features:
– Like debt holders, preferred shareholders have
priority in liquidation over common
stockholders. (Note: Debt holders have
priority in liquidation over all shareholders).
– Stated dividend preference per period is
somewhat similar to a stated interest rate.
– If preferred stock is cumulative and current
period dividends are not declared, then
dividends in arrears is somewhat similar to
interest payable.
– Note: Neither debt holders nor preferred
stockholders vote.
End of Chapter 3