Chapter 12
18th
Edition
Debt
Financing
Intermediate
Financial Accounting
Earl K. Stice James D. Stice
PowerPoint presented by Douglas Cloud
Professor Emeritus of Accounting, Pepperdine University
© 2012 Cengage Learning
12-1
Definition of Liabilities
The FASB defined liabilities as “probable
future sacrifices of economic benefits
arising from present obligations to a
particular entity to transfer assets or
provide services to other entities in the
future as a result of past transactions or
events.”
The FASB is currently considering a
revision of this liability definition.
(continued)
12-2
Classification of Liabilities
•
For reporting purposes liabilities are
usually classified as current or noncurrent.
•
If a liability arises in the course of an
entity’s normal operating cycle, it is
considered current if current assets are
used to satisfy the obligation within one
year or one operating cycle, whichever
period is longer.
(continued)
12-3
Classification of Liabilities
•
The classification of a liability as current or
noncurrent can impact significantly a
company’s ability to raise additional funds.
•
When debt classified as noncurrent will
mature within the next year, the liability
should be reported as a current liability.
•
The distinction between current and
noncurrent is important because of the
impact on a company’s current ratio.
(continued)
12-4
Measurement of Liabilities
For measurement purposes, liabilities can be
divided into three categories:
1. Liabilities that are definite in amount
2. Estimated liabilities
3. Contingent liabilities
The measurement of liabilities always
involves some uncertainty because a liability,
by definition, involves a future outflow of
resources.
12-5
Short-Term Operating Liabilities
•
The term account payable usually refers to
the amount due for the purchase of
materials by a manufacturing company or
the purchase of merchandise by a
wholesaler or retailer.
•
Accounts payable are not recorded when
purchase orders are placed but instead
when legal title to the goods passes to the
buyer.
12-6
Short-Term Debt
•
In most cases, debt is evidenced by a
promissory note, which is a formal written
promise to pay a sum of money in the
future, and is usually reflected on the
debtor’s books as Notes Payable.
•
Notes issued to trade creditors for the
purchase of goods or services are called
trade notes payable.
(continued)
12-7
Short-Term Debt
•
Nontrade notes payable include notes
issued to banks or to officers and
stockholders for loans to the company.
•
If a note has no stated rate of interest, or if
the stated rate is unreasonable, then the
face value of the note would be discounted
to the present value to reflect the effective
rate of interest implicit in the note.
12-8
Short-Term Obligations
Expected to be Refinanced
•
•
A short-term obligation that is expected to
be refinanced on a long-term basis should
not be reported as a current liability.
This applies to the currently maturing
portion of a long-term debt and to all other
short-term obligations except those arising
in the normal course of operations that are
due in customary terms.
(continued)
12-9
Short-Term Obligations
Expected to be Refinanced
According to FASB ASC Topic 470
(Debt), both of the following conditions
must be met before a short-term
obligation can be properly excluded from
the current liability classification.
1. Management must intend to refinance
the obligation on a long-term basis.
2. Management must demonstrate an
ability to refinance the obligation.
(continued)
12-10
Short-Term Obligations
Expected to be Refinanced
Concerning the second point, the ability to
refinance may be demonstrated by either of
the following:
a) Actually refinancing the obligation during
the period between the balance sheet
date and the date the statements are
issued.
b) Reaching a firm agreement that clearly
provides for refinancing on a long-term
basis.
(continued)
12-11
Short-Term Obligations
Expected to be Refinanced
• According to IAS 1, for the obligation to be
classified as long term the refinancing must
take place by the balance sheet date, not
the later date when the financial statements
are finalized.
• Under the international standard postbalance-sheet date events are NOT
considered when determining whether a
refinanceable obligation is reported as
current or noncurrent.
12-12
Lines of Credit
A line of credit is a negotiated arrangement
with a lender in which the terms are agreed to
prior to the need for borrowing.
(continued)
12-13
Lines of Credit
•
The line of credit itself is not a liability.
However, once the line of credit is used to
borrow money, the company has a formal
liability that will be reported as either a
current or a long-term liability.
•
Maintaining a line of credit is not costless.
Banks typically charge a small amount, a
fraction of 1% per year.
(continued)
12-14
Present Value of
Long-Term Debt
•
•
•
A mortgage is a loan backed by an asset
that serves as collateral for the loan.
If the borrower cannot repay the loan, the
lender has the legal right to claim the
mortgaged asset and sell it in order to
recover the loan amount.
Mortgages are generally payable in equal
installments; a portion of each payment
represents interest on the unpaid mortgage
balance.
(continued)
12-15
Financing with Bonds
1. Present owners remain in control of the
corporation.
2. Interest is a deductible expense in arriving at
taxable income; dividends are not.
3. Current market rates of interest may be
favorable relative to stock market prices.
4. The charge against earnings for interest may
be less than the amount of expected
dividends.
12-16
Accounting for Bonds
• Conceptually, bonds and long-term notes
are similar types of debt instruments.
• The trust indenture (the bond contract)
associated with bonds generally provides
more extensive detail than the contract
terms of a note, often including
restrictions on the payment of dividends
or incurrence of additional debt.
(continued)
12-17
Accounting for Bonds
There are three main considerations in
accounting for bonds:
1. Recording the issuance or purchase
2. Recognizing the applicable interest during
the life of the bonds
3. Accounting for retirement of bonds either at
maturity or prior to the maturity date
12-18
Nature of Bonds
• Bond certificates, commonly referred to
simply as bonds, are frequently issued in
denominations of $1,000.
• The amount printed on the bond is the face
value, par value, or maturity value of the
bond.
• The group contract between the corporation
and the bondholders is known as the bond
indenture.
12-19
Issuers of Bonds
•
Bonds and similar debt instruments are
issued by private corporations, the U.S.
government, state, county, and local
governments, school districts, and
government-sponsored organizations.
•
Debt securities issued by state, county, and
local governments and their agencies are
collectively referred to as municipal debt.
12-20
Types of Bonds
•
Bonds that mature on a single date are
called term bonds.
•
Bonds that mature in installments are
referred to as serial bonds.
•
Secured bonds offer protection to investors
by providing some form of security, such as
a mortgage on real estate or the pledge of
other collateral.
(continued)
12-21
Types of Bonds
•
A collateral trust bond is usually secured by
stocks and bonds of other corporations
owned by the issuing company.
•
Unsecured bonds (frequently termed
debenture bonds) are not protected by the
pledge of any specific assets.
•
Registered bonds call for the registry of the
owner’s name on the corporation books.
(continued)
12-22
Types of Bonds
• Bearer bonds, or coupon bonds, are not
recorded in the name of the owner; title to
these bonds passes with delivery.
• Zero-interest bonds or deep-discount
bonds do not bear interest. Instead, these
securities sell at a significant discount.
• High-risk, high-yield bonds issued by
companies that are heavily in debt or
otherwise in weak financial condition are
referred to as junk bonds.
(continued)
12-23
Types of Bonds
Junk bonds are issued in at least three types of
circumstances.
1. They are issued by companies that once had
high credit ratings but have fallen on hard
times.
2. They are issued by emerging growth
companies.
3. They are issued by companies undergoing
restructuring, often in conjunction with a
leverage buyout.
(continued)
12-24
Types of Bonds
•
Convertible bonds provide for their
conversion into some other security at the
option of the bondholder.
•
Commodity-backed bonds may be
redeemable in terms of commodities, such
as oil or precious metals.
Bond indentures frequently give the issuing
company the right to call and retire the bonds
prior to maturity. Such bonds are termed
callable bonds.
•
(continued)
12-25
Types of Bonds
•
Mortgage-backed bonds, in many cases,
are just a special form of secured bonds.
The underlying collateral for these bonds
is the collection of mortgages owned by
the issuing entity.
12-26
Market Price of Bonds
•
The amount of interest paid on bonds is a
specified percentage of the face value. This
percentage is termed the stated rate, or
contract rate.
•
If the stated rate exceeds the market rate, the
bonds will sell at a bond premium. If the stated
rate is less than the market, the bonds will sell
at a bond discount.
•
The actual return rate on a bond is known as
the market, yield, or effective interest rate.
(continued)
12-27
Market Price of Bonds
Yield
Bond
Stated
Interest
Rate
10%
8%
Premium
10%
Face Value
12%
Discount
(continued)
12-28
Issuance of Bonds
•
Bonds may be sold directly to investors by
the issuer or they may be sold in the open
market through security exchanges or
through investment bankers.
•
Bonds issued or acquired in exchange for
noncash assets or services are recorded at
the fair value of the bonds unless the value
of the exchanged assets or services is
more clearly determinable.
(continued)
12-29
Issuance of Bonds
Each of the bond situations in the following
slides will be illustrated using the following
data: $100,000, 8%, 10-year bonds are
issued; semiannual interest of $4,000
($100,000 × 0.08 × 6/12) is payable on
January 1 and July 1.
(continued)
12-30
Bonds Issued at Par
on Interest Date
Issuer’s Books
Jan. 1 Cash
Bonds Payable
100,000
July 1 Interest Expense
Cash
4,000
Dec. 31 Interest Expense
Interest Payable
4,000
100,000
4,000
4,000
(continued)
12-31
Bonds Issued at Par
on Interest Date
Investor’s Books
Jan. 1
July 1
Bond Investment
Cash
100,000
100,000
Cash
Interest Revenue
4,000
Dec. 31 Interest Receivable
Interest Revenue
4,000
4,000
4,000
12-32
Bonds Issued at Discount
on Interest Date
Issuer’s Books
Jan. 1 Cash
Discount on Bonds Payable
Bonds Payable
87,538
12,462
100,000
Investor’s Books
Jan. 1 Bond Investment
Cash
87,538
87,538
12-33
Bonds Issued at Premium
on Interest Date
•
The bonds were issued on January 1 but
the effective rate of interest was 7%,
requiring recognition of a premium of
$7,106.
•
Only reading the table for 3 ½ percent,
you should arrive at the bonds having a
present value of $107,106.
(continued)
12-34
Bonds Issued at Premium
on Interest Date
Issuer’s Books
Jan. 1 Cash
107,106
Premium on Bonds Payable
7,106
Bonds Payable
100,000
Investor’s Books
Jan. 1 Bond Investment
Cash
107,106
107,106
(continued)
12-35
Bonds Issued at Par
between Interest Date
Issuer’s Books
Mar. 1 Cash
Bonds Payable
Interest Payable
101,333
($100,000 × 0.08 × 2/12)
July 1 Interest Expense
Interest Payable
Cash
($100,000 × 0.08 × 4/12)
100,000
1,333
2,667
1,333
4,000
(continued)
12-36
Bonds Issued at Par
between Interest Date
Investor’s Books
Mar. 1 Bond Investment
Interest Receivable
Cash
July 1 Cash
Interest Receivable
Interest Revenue
100,000
1,333
101,333
4,000
1,333
2,667
12-37
Bond Issuance Costs
•
The issuance of bonds normally involves
bond issuance costs to the issuer for
legal services, printing and engraving,
taxes, and underwriting.
•
In Statement of Financial Accounting
Concepts No.3, the FASB stated that
“deferred charges” such as bond issuance
costs fail to meet the definition of assets.
12-38
Accounting for Bond Interest
•
When bonds are issued at a premium or
discount, the market acts to adjust the
stated interest rate to a market or
effective interest rate.
•
Because the initial premium or discount,
the periodic interest payments made over
the bond’s life by the issuer do not
represent the total interest expense
involved, an amortization adjustment is
made.
12-39
Straight-Line Method
•
•
The straight-line method provides for the
recognition of an equal amount of premium
or discount amortization each period.
A 10-year, 10% bond issue with a maturity
value of $200,00 was sold on the issuance
date at 103, the $6,000 premium would be
amortized evenly over 120 months until
maturity.
(continued)
12-40
Straight-Line Method
•
To illustrate the accounting for bond
interest using straight-line amortization,
consider the earlier example of the
$100,000, 8%, 10-year bonds issued on
January 1.
•
When sold at a $12,462 discount, the
appropriate entries to record interest on
July 1 and December 31 are shown next.
(continued)
12-41
Straight-Line Method
Issuer’s Books
July 1 Interest Expense
4,623
Discount on Bonds Payable
Cash
623
4,000
$12,462/120 × 6 mo. = $623 (rounded)
Dec. 31 Interest Expense
4,623
Discount on Bonds Payable
Interest Payable
623
4,000
(continued)
12-42
Straight-Line Method
Investor’s Books
July 1 Cash
Bond Investment
Interest Revenue
4,000
623
Dec. 31 Interest Receivable
Bond Investment
Interest Revenue
4,000
623
4,623
4,623
(continued)
12-43
Straight-Line Method
Assume the bonds were sold for $107,106.
Issuer’s Books
July 1
Interest Expense
Premium on Bonds Payable
Cash
$7,106/120 × 6 mo. = $355 (rounded)
Dec. 31 Interest Expense
Premium on Bonds Payable
Interest Payable
3,645
355
Reflects
effective
interest of
7%
4,000
3,645
355
4,000
(continued)
12-44
Straight-Line Method
Investor’s Books
July
1 Cash
Bond Investment
Interest Revenue
4,000
Dec. 31 Interest Receivable
Bond Investment
Interest Revenue
4,000
355
3,645
355
3,645
12-45
Effective-Interest Method
•
The effective-interest method of
amortization uses a uniform interest rate
based on a changing loan balance and
provides for an increasing premium or
discount amortization each period.
•
In order to use this method, the effectiveinterest rate for the bonds must be known.
(continued)
12-46
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%.
Bond balance (carrying value) at beginning of year
Effective rate per semiannual period
Stated rate per semiannual period
Interest amount based on carrying value and effective
rate ($87,538 × 0.05)
Interest payment based on face value and stated
rate ($100,00 × 0.040)
Discount amortization
(continued)
$87,538
5%
4%
$ 4,377
4,000
$ 377
12-47
Effective-Interest Method
Assume the $100,000, 8%, 10-year bonds is
sold for $107,106, based on an effective interest
rate of 7%. The premium amortization for the first
6-month period would be computed as follows:
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
(continued)
12-48
Effective-Interest Method
The second 6-month period would be computed
as follows:
Bond balance (carrying value) at beginning of second
period ($107,106 – $251)
Effective rate per semiannual period
Stated rate per semiannual period
Interest payment based on face value and stated
rate ($100,00 × 0.040)
Interest amount based on carrying value and effective
rate ($106,855 x .035)
Premium amortization
$106,855
3.5%
4%
4,000
3,740
$
260
(continued)
12-49
Cash Flow Effects of Amortizing
Bond Premiums and Discounts
•
The amortization of a bond discount or
premium does not involve the receipt or
payment of cash.
•
Like other noncash items, it must be
considered in preparing a statement of
cash flows.
•
Using the indirect method, the discount
amortization is added back to net income.
(continued)
12-50
Cash Flow Effects of Amortizing
Bond Premiums and Discounts
•
Using the indirect method, the premium
amortization is subtracted from net income.
•
Using the direct method, the expense
reported on the income statement is
decreased by the amount of discount
amortization or increased by the amount of
the premium amortization.
(continued)
12-51
Cash Flow Effects of Amortizing
Bond Premiums and Discounts
•
A company issues $100,000, 8%, 10-year
bonds when the effective rate of interest is
10%. The bonds are issued at a price of
$87,538.
•
The amount of discount amortized during the
first year is $733 ($377 + $396). The amount
of interest expense disclosed on the income
statement is $8,773 ($4,377 + $4,396), and
the amount of cash paid is $8,000.
(continued)
12-52
Retirement of Bonds at Maturity
If the bonds are held to maturity, the
discount or premium has been eliminated
over the life of the bond. The entry for
retiring the bond is straightforward. Assume
a $100,000 bond matures on July 1.
Issuer’s Books
July 1
Bonds Payable
Cash
100,000
100,000
(continued)
12-53
Retirement of Bonds at Maturity
Investor’s Books
July 1
Cash
Bond Investment
100,000
100,000
•
There is no gain or loss on retirement
because the carrying value is equal to the
maturity value.
•
Any bonds not presented for payment at their
maturity date should be moved to Matured
Bonds Payable.
12-54
Extinguishment of Debt
Prior to Maturity
1. Bonds may be redeemed by the issuer by
purchasing the bonds on the open market or
by exercising the call provision (if available).
2. Bonds may be converted, that is,
exchanged for other securities.
3. Bonds may be refinanced by using the
proceeds from the sale of a new bond issue
to retire outstanding bonds.
12-55
Redemption by Purchase
of Bonds in the Market
Triad, Inc.’s $100,000, 8% bonds are not held to
maturity. They are redeemed on February 1, 2013,
Carrying
valuevalue
of bonds,
2/1/13
$97,700
at 97. The
carrying
of the
bonds is $97,700
as
Redemption
price
97,000
of this date.
Interest
payment dates are January
31
Gain
$ 700
and July
31.on bond redemption
Issuer’s Books
Feb. 1 Bonds Payable
100,000
Discount on Bonds Pay.
Cash
Gain on Bond Redemption
(continued)
2,300
97,000
700
12-56
Redemption by Purchase
of Bonds in the Market
Investor’s Books
Feb. 1 Cash
Loss on Sale of Bonds
Bond Investment—
Triad Inc.
97,000
700
97,700
Before the issuance of FASB Statement No.
125 in 1996, early extinguishment of debt
could also be accomplished through insubstance defeasance.
12-57
Redemption by Exercise
of Call Provision
•
A call provision gives the issuer the option
of retiring bonds prior to maturity.
•
Frequently, the call must be made on an
interest payment date.
•
When bonds are called, the difference
between the amount paid and the bond
carrying value is reported as a gain or a
loss on both the issuer’s and investor’s
books.
12-58
Convertible Bonds
• Convertible debt securities usually have
the following features:
1. An interest rate lower than the issuer
could establish for nonconvertible debt
2. An initial conversion price higher than
the market value of the common stock at
time of issuance
3. A call option retained by the issuer
• Convertible debt gives both the issuer and
the holder advantages.
(continued)
12-59
Convertible Bonds
Issued with Conversion
Feature Nondetachable
Assume that 500 ten-year bonds, face value
$1,000, are sold at 105 ($525,000). The bonds
contain a conversion privilege that provides for
exchange of a $1,000 bond for 20 shares of
stock, par value $1.
Cash
Bonds Payable
Premium on Bonds Payable
(continued)
525,000
500,000
25,000
12-60
Convertible Bonds
Issued with Conversion
Feature Nondetachable
Cash
525,000
Discount on Bonds Payable
20,000
Bonds Payable
500,000
Paid-In Capital Arising from Bond
Conversion Feature
45,000
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
(continued)
12-61
Convertible Bonds
Issued with Conversion
Feature Nondetachable
Cash
525,000
Discount on Bonds Payable
20,000
Bonds Payable
500,000
Paid-In Capital Arising from Bond
Conversion Feature
45,000
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
12-62
Accounting for Conversion Debt
According to IAS 32
•
IAS 32 does not differentiate between
convertible debt with nondetachable and
detachable conversion features.
•
IAS 32 states that for all convertible debt
issues, the issuance proceeds should be
allocated between debt and equity.
12-63
Bond Refinancing
•
Cash for the retirement of a bond is
frequently raised through the sale of a new
issue and referred to as bond refinancing.
•
Bond refinancing may take place when an
issue matures, or bonds may be refinanced
prior to their maturity when the interest rate
has dropped and the interest savings on a
new issue will more than offset the cost of
retiring the old issue.
(continued)
12-64
Bond Refinancing
• A corporation has outstanding $1,000,000 of
12% bonds callable at 102 with a remaining
10-year term, and similar 10-year bonds can
be marketed currently at an interest rate of
only 10%.
• When refinancing takes place before the
maturity date of the old issue, the call
premium and unamortized discount and
issue costs of the original bonds are
considered in computing the gain or loss.
12-65
Fair Value Option
•
Because accounting has long been founded
on a backbone of historical cost, the FASB
and IASB are transitioning cautiously, item
by item, to fair value.
•
Under 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 market value on the balance
sheet date.
(continued)
12-66
Off-Balance-Sheet Financing
•
•
Off-balance-sheet financing procedures to
avoid disclosing all debt on the balance sheet in
order to make the company’s financial position
look stronger.
Common techniques used:
1.
2.
3.
4.
5.
6.
Leases
Unconsolidated subsidiaries
Variable interest entities (VIEs)
Joint ventures
Research and development arrangements
Project financing arrangements
12-67
Leases
Leases are considered to be either rentals (operating
leases) or asset purchases with borrowed money
(capital leases). The four classification criteria are as
follows:
1. Lease transfers ownership
2. Lease includes a bargain purchase option
3. Lease covers 75% or more of the economic life of
the asset
4. Present value of lease payments is 90% or more
of the asset value
12-68
Unconsolidated Subsidiaries
•
In 1987, the FASB issued pre-Codification
Statement No. 94 requiring all majorityowned subsidiaries to be consolidated.
This effectively eliminated one opportunity
that companies had been using for offbalance-sheet financing.
•
Companies are able to avoid recognizing
debt associated with subsidiaries that are
less than 50% owned by the company.
12-69
Variable Interest Entities (VIEs)
Example
•
Sponsor Company requires the use of a
building costing $100,000. Rather than buy the
building, Sponsor facilitates the establishment
of VIE Company.
•
VIE Company is started with a $10,000
investment from a private investor along with a
$90,000 bank loan. VIE then leases the
building to Sponsor (carefully crafted to qualify
as an operating lease).
(continued)
12-70
Variable Interest Entities (VIEs)
Example
Sponsor’s Books
Assets
Liabilities
$0
0
VIE Company’s
Books
Assets:
Building
Liabilities:
Bank loan
Equity:
Paid-in capital
$100,000
90,000
10,000
12-71
Joint Ventures
•
When companies join forces with other
companies to share the costs and benefits
associated with specifically defined projects,
it is called a joint venture.
•
Because the benefits of joint ventures are
uncertain, companies could incur substantial
liabilities with few, if any, assets resulting
from their efforts.
12-72
Research and Development
Arrangements
• These arrangements involve situations in
which an enterprise obtains the results of
research and development activities funded
partially or entirely by others.
• Accounting issue: Is this arrangement, in
essence, a means of borrowing to fund
research and development or is it simply a
contract to do research for others?
• R&D arrangements may take a variety of
forms, including a limited partnership.
12-73
Research and Development
Arrangements
•
At times, companies become involved in
long-term commitments that are related to
project financing arrangements.
•
The arrangement should be disclosed in a
note to the financial statements.
12-74
Analyzing a Firm’s
Debt Position
The term leverage refers to the
relationship between a firm’s debt and
assets or its debt and stockholders’ equity.
A common measure of a firm’s leverage is
the debt-to-equity ratio.
Total Liabilities
Debt-to-Equity
=
Ratio
Total Stockholders’ Equity
(continued)
12-75
Analyzing a Firm’s
Debt Position
Another measure of a company’s performance
relating to debt is the number of times interest
is earned.Times interest earned is calculated
using the following formula:
Times Interest
Earned
=
Income Before Taxes +
Interest Expense
Interest Expense
The number of times interest is earned reflects the
company’s ability to meet interest payments and the
degree of safety afforded the creditors.
12-76
Accounting for Troubled
Debt Restructuring
•
•
A significant accounting problem is created
when economic conditions make it difficult
for an issuer of long-term debt to make the
payments under the terms of the debt
instrument.
The revision of debt terms to avoid
bankruptcy proceedings or foreclosure on
the debt is referred to as troubled debt
restructuring, and can take many different
forms.
(continued)
12-77
Accounting for Troubled
Debt Restructuring
•
•
The major issue addressed by FASB ASC
Subtopic 470-60 is whether a troubled debt
restructuring agreement should be viewed
as a significant economic transaction.
If it is considered to be a significant
economic transaction, entries should be
made on the issuer’s books to reflect any
gain or loss. If not considered significant, no
entries are required.
12-78
Transfer of Assets in Full
Settlement (Asset Swap)
A debtor that transfers assets, such as real
estate or inventories, to a creditor to fully
settle a payable will recognize two types of
gains or losses:
1) a gain or loss on disposal of the asset and
2) a gain arising from the concession granted
in the restructuring of the debt.
(continued)
12-79
Transfer of Assets in Full
Settlement (Asset Swap)
The computation of these gains and/or
losses is made as follows:
Carrying value of assets
being transferred
Major value of asset
being transferred
Carrying value of debt
being liquidated
Difference represents
gain or loss on disposal
Difference represents
gain on restructuring
The gain or loss on disposal of an asset is usually
reported as an ordinary income item .
(continued)
12-80
Transfer of Assets in Full
Settlement (Asset Swap)
An investor always recognizes a loss on the
restructuring due to concessions granted.
Carrying value of
investment liquidated
Market value of asset
being transferred
Difference represents loss
on restructuring
The classification of this loss depends on the
criteria being used to recognize irregular or
extraordinary items.
(continued)
12-81
Transfer of Assets in Full
Settlement (Asset Swap)
Realty, Inc. holds $40,000 face value of
Stanton’s bonds. Because of the troubled
financial condition of Stanton Industries,
Realty Inc. has previously recognized as a
loss a $5,000 decline in the value of the
debt, plus interest receivable of $4,000. The
entries for Stanton and Realty are on Slides
12-131 and 12-132.
(continued)
12-82
Transfer of Assets in Full
Settlement (Asset Swap)
Stanton Industries (Issuer)
Interest Payable
50,000
Bonds Payable
500,000
Discount on Bonds Payable
5,000
Long-Term Investment—Worth Common
Stock
350,000
Gain on Disposal of Worth Common
Stock
50,000
Gain on Restructuring of Debt
145,000
Carrying value of Worth common
$350,000
Market value of Worth common
$400,000
Carrying value of debt liquidated
$545,000
(continued)
$50,000 gain on disposal
$145,000 gain from
restructuring
12-83
Transfer of Assets in Full
Settlement (Asset Swap)
Realty Inc. (Investor)
Long-Term Investments—Worth
Common Stock
32,000
Loss on Restructuring of Debt
7,000
Bond Investments—Stanton Industries
Interest Receivable
35,000
4,000
Percentage of debt held by Realty Inc.: $40,000/$500,000 = 8%
Market value of long-term investment received in settlement of
debt: 0.08 × $400,000 = $32,000
12-84
Modification of Debt Terms
•
There are many ways debt terms may be
modified to aid a troubled debtor.
•
Modification may involve either the interest
or the maturity value or both.
•
Interest concessions may involve a
reduction of the interest rate, forgiveness
of unpaid interest, or a moratorium on
interest payments for a period of time.
(continued)
12-85
Chapter 12
₵
The End
$
12-86
12-87