1
Debt
Financing
2
Learning Objectives
 Understand the various classification and
measurement issues associated with debt.
 Account for short-term debt obligations,
including those expected to be refinanced,
and describe the purpose of lines of credit.
 Apply present value concepts to the
accounting for long-term debts such as
mortgages.
3
Learning Objectives
 Understand the various types of bonds,
compute the price of a bond issue, and
account for the issuance, interest, and
redemption of bonds.
 Explain various types of off-balance-sheet
financing, and understand the reasons for this
type of financing.
 Analyze a firm’s debt position using ratios.
4
Learning Objectives
 Review the notes to financial statements, and
understand the disclosure associated with
debt financing.
EXPANDED MATERIAL
 Understand the conditions under which
troubled debt restructuring occurs, and be
able to account for troubled debt
restructuring.
Time Line of Business Issues
Involved with Long-Term Debt
Notes
Mortgage
Bond
Payable
Payable
CHOOSE
the
method of
financing
Bond
ISSUE
the debt
+/ACCOUNT
PAY
interest for the specific
aspects of the
type of debt
RETIRE
the debt
5
Liabilities
• Definition: The obligation of a particular
entity to transfer assets or provide services.
– Must be the result of past transactions or
events.
– Probable transfer of assets (or services)
must be in the future.
• Current Liabilities: Paid within one year
or the operating cycle, whichever is longer.
• Noncurrent Liabilities: Not paid within
one year or the operating cycle, whichever
is longer.
6
7
Current Ratio
The current ratio is a measure of the
liquidity of a business. It is computed
by dividing total current assets by total
current liabilities.
Liquidity Example
Tree Company has current assets of
$20,000 and current liabilities of
$15,000. Calculate the current ratio.
Current Ratio:
Current assets
Current liabilities
$20,000 = 1.333
$15,000
8
Types of Liabilities
• Liabilities that are
definite in amount.
• Estimated liabilities.
• Contingent liabilities.
9
Liabilities Definite in Amount
 Record liability at face amount.
 Classify as short- or long-term based
on when debt will be repaid.
 Short-term debt to be refinanced can
be classified as long-term if:
– management intends to refinance on a
long-term basis.
– management can demonstrate an
ability to refinance.
10
Estimated Liabilities
• Refundable deposits: Report
estimated amount to be refunded as a
liability.
• Warranties: Report estimated future
expenditures as a liability.
• Premium offers/gift certificates:
Report estimated value of redeemed
offers as a liability.
11
Contingent Liabilities
Likelihood
Definition
Future event is
likely to occur
Accounting
Treatment
Record liability if
Probable
estimable
More likely than Disclose liability
remote, but less in footnotes
Reasonably likely than
probable
possible
Future event is No disclosure
not likely to
except regarding
guarantees
occur
Remote
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Accounting for Short-Term
Debt Obligations
• Accounts Payable: The amount due for the
purchase of materials by a manufacturing
company or merchandise by a wholesaler or
retailer.
• Notes Payable: A formal written promise to
pay a certain amount of money at a specified
future date.
13
Accounting for Short-Term
Debt Obligations
A short-term obligation that is
expected to be refinanced on a
long-term basis should not be
reported as a current liability.
14
Accounting for Short-Term
Debt Obligations
An ability to refinance may be demonstrated
by:
 Actually refinancing the obligation during
the period between the balance sheet date
and the date the statements are issued.
 Reaching a firm agreement that clearly
provides for refinancing on a long-term
basis.
15
Accounting for Short-Term
Debt Obligations
 The terms of the refinancing agreement
should be noncancelable as to all parties.
 The terms of the refinancing agreement
should extend beyond the current year.
 The company should not be in violation of
the agreement at the balance sheet date or
the date of issuance.
 The lender or investor should be
financially capable of meeting the
refinancing requirements.
16
17
Present Value of $1
What is the present value of $1?
The value today of $1 to be received or
paid at some future date, given a
specified interest rate.
18
Present Value of $1
• Present value of $100 paid in five years
discounted at 10 percent:
Today
1
2
3
4 Future
Discount at 10%
PV=$62.09
$100
Annuities
• Annuity: A series of equal amounts to
be received or paid at equal time
intervals, given a specified interest
rate.
• Present Value of an Annuity: The
value today of a series of equally
spaced, equal-amount payments to be
made or received, given a specified
interest rate.
19
The Present Value of the
Annuity of $1
Present value of five equal payments of
$100 discounted at 10 percent:
$100 $100 $100 $100 $100
Today 1
2
3
4
5
PV=$379.08
20
Compounding of Interest
• Compounding Periods:
The period of
time for which interest is computed.
– Interest is compounded annually or
semiannually.
– The interest rate per compounding period is the
yearly interest rate divided by compounding
periods per year.
• Compound Interest: Interest computed on
principal plus previously accumulated interest.
21
22
Effects of Compound Interest
$700
$600
Investment Value
Comparing
the value
of $100 lump sum
invested at 10%
for 20 years with
simple interest
and compound
interest.
$500
$400
$300
$200
$100
0
2
4
6
8 10 12 14 16 18 20
Year
Simple
Compound
Mortgage Payable Example
On January 1, 2002, Crystal purchases a
house for $250,000 and makes a down
payment of $50,000. The remainder is
financed through a mortgage on the
house. The mortgage is for ten years
and carries an annual interest rate of 12
percent, with payments of $2,057 due
monthly. The first payment is due on
February 1, 2002.
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Mortgage Payable Example
24
Payment Interest Amount Applied to Remaining
Date Amount Expense Reduce Principal
Balance
1/1/02
2/1/02
3/1/02
4/1/02
5/1/02
6/1/02
$2,057
2,057
2,057
2,057
2,057
$2,000
1,999
1,999
1,998
1,998
2/1/02 Interest Expense
$200,000 Payable
x .12 x 1/12
Mortgage
Cash
$200,000
199,943
199,885
199,827
199,768
199,709
$57
58
58
59
59
2,000
57
2,057
Secured Loan
A secured loan is a loan
backed by certain assets
as collateral.
Secured
Loan
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26
Nature of Bonds
A bond is a contract between a borrower
and a lender in which the borrower
promises to pay a specified amount of
interest for each period the bond is
outstanding and repay the principal at
the maturity date.
Fargo, Inc.
$10,000
Paid to the bearer
of this bond
$10,000 at 8
percent annually
on January 1 and
July 1.
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Types of Bonds
• Registered bonds: Bonds for which the
issuing company keeps a record of the
names and addresses of all bondholders and
pays interest only to those individuals
whose names are on file.
• Bearer (coupon) bonds: Unregistered
bonds for which the issuer has no record of
current bondholders, but instead pays
interest to anyone who can show evidence
of ownership.
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Types of Bonds (Cont.)
• Term bonds: Bonds that mature in one lump
sum on a specified future date.
• Serial bonds: Bonds that mature in a series of
installments at future dates.
• Collateral trust bonds: Bonds usually secured
by stocks and bonds of other corporations
owned by the issuing company.
• Unsecured (debenture) bonds: Bonds for
which no specific collateral has been pledged.
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Types of Bonds (Cont.)
• Zero-interest bonds: Bonds that do not bear
interest but instead are sold at significant
discounts.
• Convertible bonds: Bonds that can be
converted to other securities at the option of the
bondholder.
• Commodity-backed bonds: Bonds that may be
redeemed in terms of commodities.
• Callable bonds: Bonds for which the issuer
reserves the right to pay the obligation prior to
the maturity date.
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Types of Bonds (Cont.)
What are junk bonds?
31
Types of Bonds (Cont.)
High-risk, high-yield bonds
issued by companies that are
heavily in debt or weak
financially.
32
Financing With Bonds
Reasons management may
prefer issuing bonds or notes
instead of stock:
33
Financing With Bonds
 Present owners remain in control of the
corporation.
 Interest is a deductible expense in arriving
at taxable income, while dividends are not.
 Current market rates of interest may be
favorable relative to stock market prices.
 The charge against earnings for interest
may be less than the amount of dividends
that might be expected by shareholders.
34
Characteristics of Bonds
 Face value: The amount that will be
paid on a bond at the maturity date.
 Bond discount: The difference between
the face value and the sales price when
bonds are sold below their face value.
 Bond premium: The difference
between the face value and the sales
price when bonds are sold above their
face value.
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Characteristics of Bonds
Yield
Bond
Stated
Interest
Rate
10%
8%
Premium
10%
Face Value
12%
Discount
Example: Bond Issued at
Par on Interest Date
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Issuer’s Books
Jan. 1
July 1
Cash
Bonds Payable
Interest Expense
Cash
Dec. 31 Interest Expense
Cash
100,000
100,000
4,000
4,000
4,000
4,000
Example: Bond Issued at
Par on Interest Date
37
Investor’s Books
Jan. 1
July 1
Bond Investment
Cash
100,000
100,000
Cash
Interest Revenue
4,000
Dec. 31 Cash
Interest Revenue
4,000
4,000
4,000
Example: Bond Issued at
a Discount
On January 1, $100,000, 8%, 10-year bonds
were issued for $87,519 (which provided an
effective interest rate of 10% to the investor).
$100,000
8%
Effective
rate, 10%
38
Example: Bond Issued at
a Discount
39
The Provo Company agreed to issue 5-year,
Issuer’s Books
$500,000 bonds and pay 10% interest,
compounded
semiannually. Assume
Jan.
1 Cash
87,539 the
Discount
Bonds
Payable 12,461
effective
rate on
is 12
percent.
Bonds Payable
July 1
100,000
Interest Expense
4,377
Discount on Bonds Payable
377
Cash ($87,539 +
4,000
Dec. 31 Interest Expense
4,396 x
$377) x 0.10
$87,539
Discountxon
Bonds Payable
6/12
0.10 x 6/12 396
Cash
4,000
Example: Bond Issued at
a Discount
40
The Provo Company agreed to issue 5-year,
Investor’s Books
$500,000 bonds and pay 10% interest,
compounded
semiannually. Assume
Jan.
1 Bond Investment
87,539 the
87,539
effectiveCash
rate is 12 percent.
July 1
Cash
Bond Investment
Interest Revenue
Dec. 31 Cash
Bond Investment
Interest Revenue
4,000
377
4,377
4,000
396
4,396
Example: Bond Issued at
a Premium
On January 1, $100,000, 8%, 10-year bonds
were issued for $107,107 (which provided an
effective interest rate of 7% to the investor).
$100,000
8%
7%
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Example: Bond Issued at
a Premium
Issuer’s Books
Jan. 1
Cash
107,107
Premium on Bonds Pay.
7,107
Bonds Payable
100,000
July 1
Interest Expense
3,749
Premium on Bonds Payable
251
Cash
4,000
$107,107
x .07 x
6/12
42
Example: Bond Issued at
a Premium
43
Investor’s Books
Jan. 1
July 1
Bond Investment
Cash
Cash
Bond Investment
Interest Revenue
107,107
107,107
4,000
251
3749
Straight-Line Amortization
On January 1, 2002, Tree Company agreed to issue
10-year, $200,000 bonds and pay 10% interest,
compounded semiannually. The company
received $196,000 for the bonds. Make the entry
to record the issuance of the bonds.
Jan. 1 Cash
196,000
Discount on Bonds Payable
4,000
Bonds Payable
200,000
Issued $200,000 bond at a discount.
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Straight-Line Amortization
Using straight-line amortization,
what entry is made for the interest
payment on June 30, 2002?
Jun. 30 Interest Expense
10,200
Discount on Bonds Payable
200
Cash
10,000
Paid Interest ($200,000 x .10 x 1/2).
45
Straight-Line Amortization
On January 1, 2002, Tree Company agreed
to issue 10-year, $200,000 bonds and pay
10% interest, compounded semiannually.
The company received $210,000 for the
bonds. Using straight-line amortization,
what entry is needed on July 31, 2002?
Jun. 30 Interest Expense
Premium on Bonds Payable
Cash
9,500
500
Paid Interest ($200,000 x .10 x 1/2).
10,000
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Example: Effective-Interest
Method
The Pioneer Company issues a
$1,000, 8%, 10-year bond. The
market rate was 6% at the time
of issuance. Create an
effective-interest table.
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Example: Effective-Interest
Method
A
($1,000 x 04)
#
48
B
C
D
E
(E x 0.03)
(A-B)
(D-C)
(1,000+D)
Payment Int. Exp.
Prem.
Amort.
Unamort.
Prem.
Bond
Book
$148.80
$1,148.80
Example: Effective-Interest
Method
A
($1,000 x 04)
#
1
B
C
D
E
(E x 0.03)
(A-B)
(D-C)
(1,000+D)
Payment Int. Exp.
$40.00
49
$34.46
Prem.
Amort.
$5.54
Unamort.
Prem.
Bond
Book
$148.80
$1,148.80
143.26
1,143.26
Example: Effective-Interest
Method
A
($1,000 x 04)
#
50
B
C
D
E
(E x 0.03)
(A-B)
(D-C)
(1,000+D)
Payment Int. Exp.
Prem.
Amort.
Unamort.
Prem.
Bond
Book
$148.80
$1,148.80
1
$40.00
$34.46
$5.54
143.26
1,143.26
2
40.00
34.30
5.70
137.56
1,137.56
Example: Effective-Interest
Method
A
($1,000 x 04)
#
51
B
C
D
E
(E x 0.03)
(A-B)
(D-C)
(1,000+D)
Payment Int. Exp.
Prem.
Amort.
Unamort.
Prem.
Bond
Book
$148.80
$1,148.80
1
$40.00
$34.46
$5.54
143.26
1,143.26
2
40.00
34.30
5.70
137.56
1,137.56
3
40.00
34.13
5.87
131.69
1,131.69
Example: Bonds Issued Between 52
Interest Dates
On January 1, 2002, Miller Company received
authorization to issue 10-year, $150,000 bonds and
pay 10% interest on June 31 and December 31 of
each year. The bonds sold at face value on April 30,
2002. What is the required entry on April 30?
Apr. 30 Cash
155,000
Bonds Payable
Interest Payable
Sold $150,000, 10% bond at face
value plus four months’ accrued
interest.
150,000
50,000
Example: Bonds Issued Between 53
Interest Dates
What is the required entry on June 30 to
record payment of interest?
June 30 Interest Expense
Interest Payable
Cash
Paid interest ($150,000 x
10% x 1/2).
2,500
5,000
7,500
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Retiring Bonds 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).
 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.
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Retiring Bonds Prior to Maturity
Triad, Inc.’s $100,000, 8% bonds
are not held to maturity. They are
redeemed on February 1, 2002, at
97. The carrying value of the
bonds is $97,700 as of this date.
Interest payment dates are
January 31 and July 31.
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Retiring Bonds Prior to Maturity
Issuer’s Books
Feb. 1
Bonds Payable
100,000
Discount on Bonds Pay.
Cash
Extraordinary Gain on
Bond Redemption
Carry value of bonds, 1/1/02
Redemption price
Gain on bond redemption
2,300
97,000
700
$97,700
97,000
$ 700
57
Retiring Bonds Prior to Maturity
Investor’s Books
Feb. 1
Cash
97,000
Loss on Sale of Bonds
700
Investment in Triad, Inc.
Bonds
97,700
Bond Conversion
HiTec Company offers
bondholders 40 shares of
HiTec Company common
Onpar,
November
1, anfor
investor
stock, $1
in exchange
exchanges
of $10,000
each $1,000,
8% bonds
bond held.
(carry value, $9,850) for 400
shares of common stock.
58
59
Bond Conversion
Investor’s Books
Nov. 1 Investment in HiTec Co.
Common Stock
Investment in HiTec
Co. Bonds
Gain on Conversion of
HiTec Co. Bonds
10,400
9,850
550
The investor may choose not to recognize a
gain or loss. If so, the investor in the above
situation would debit Investment in HiTec
Co. Common Stock for $9,850.
60
Bond Conversion
Issuer’s Books
Nov. 1 Bonds Payable
10,000
Loss on Conversion of
Bonds
550
Common Stock, $1 par
Paid-In Capital in Excess
of Par Value
Discount on Bonds Payable
400
10,000
150
Off-Balance-Sheet Financing
61
• Off-Balance-Sheet-Financing: Financing
procedures used by companies to avoid
disclosing all their debt on the balance sheet in
order to make their financial position look
stronger.
• Leveraged Buy-Out (LBO): An acquisition of
a company where a substantial amount of the
purchase price, often 90 percent or more, is
debt-financed.
Analyzing a Firm’s Debt Position
62
• Debt-to-Equity Ratio: A ratio that measures the
relationship between the debt and equity of an
entity. Formula: total debt ÷ total stockholders’
equity.
• Debt Ratio: An indicator of a company’s overall
ability to repay its debts. Formula: total liabilities
÷ total assets.
• Times Interest Earned: An indicator of a
company’s ability to meet interest payments.
Formula: income before interest expense and
income taxes ÷ interest expense for the period.
Troubled Debt Restructuring
Troubled debt restructuring exists only if
the “creditor for economic or legal
reasons related to the debtor’s financial
difficulties grants a concession to the
debtor that it would not otherwise
consider.” (SFAS 15.2)
63
Asset Swap--Debtor
FMV Asset
< debt?
No
Not a troubled
debt restructure.
Yes
Remove debt and
asset from books.
Restructuring Gain
= Debt - FMV Asset
Disposal Gain/Loss
= FMV Asset - Book
Value of Asset
64
Equity Swap--Debtor
FMV Equity
< debt?
No
Yes
Remove debt and
asset from books and
record new equity.
Restructuring Gain
=Debt - FMV Equity
Not a troubled
debt restructure.
65
66
Asset or Equity Swap--Creditor
FMV Asset
> loan?
No
Remove loan
from books and
record asset at
FMV.
Restructure Loss =
Loan - FMV Asset
Yes
Not a troubled
debt restructure.
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Modification of Terms--Debtor
Total future
payments < debt
book value?
Yes
Reclassify the
debt and amortize
using effective
interest method.
Interest rate is
the implicit rate.
No
Recognize gain on
restructuring. Writedown debt to sum of
future cash flows.
Record all future
payments as principal
payments.
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The End