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Ch14(LTDebt)

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Ch14(LTDebt) ...

    Chapter 10 “Technical Notes”

    Debt Financing

I. Some conceptual issues to review from the text

     Definition of a liability past, present & future elements.

     “Off-balance sheet” liabilities – some examples.

     Current versus noncurrent liabilities --

     When can “maturing” debt be classified as noncurrent?

     Measuring the book value of debt present value versus market value.

    II. Bonds as a Common Form of Debt Financing -- Determining the

    Issue Price of Bonds

    A. Cash Flows

     1. Promise to pay an amount "a" (face value or principal) in "n"

    periods.

     For non-interest bearing (zero coupon) bonds, this

     is the only cash flow.

     2. For interest bearing bonds, also have promise to pay coupon

    payments of "R" each period for "n" periods.

     Coupon = R = Coupon Rate * a = cr * a

     (Coupon = Stated = Contract Interest Rate)

     3. On time line (n=5):

     $a

     $PV $R $R $R $R $R BOND

     |__________|__________|__________|__________|__________|

     0 1 2 3 4 5

     PV = a (PV1,i,n) + R (PVA,i,n) BOND**

     where n, a, and R are fixed by the bond contract.

     (PV1,i,n) indicates the present value factor for a lump sum amount

    of $1 measured using discount rate “i” and number of periods “n”.

     (PVA,i,n) indicates the present value factor for an ordinary annuity,

    also using a discount rate “i” and number of periods “n”.

     B. What is the appropriate discount rate i?

     1. It is the market (or effective) rate of interest, "mr", NOT cr.

Chapter 10 Debt Financing Page 1

     2. Then, PV = a (PV1,mr,n) + R (PVA,mr,n)BOND **

     3. If coupons are semiannual, use one-half of mr and cr

     and twice the number of years for n (# of payments).

     C. Issues on Interest Dates

     See the Sample Problem at the end of these notes. This

    problem is from an earlier quarter’s test!

     Complete part a.

II. Recognizing Interest Expense over Life of Bond

     A. General Journal Entry:

     Interest Expense $y

     Discount (or Premium) on B/P (x) x

     Interest Payable (or Cash) $a*cr*fraction

    The difference between the straight-line and effective interest methods

    is which amount in the JE (y or x) is a "plug".

TOTAL interest expense over life of bond = same for both methods.

    For bonds issued at a premium,

     TOTAL Expense = Total Coupons - Total Premium

    For bonds issued at a discount,

     TOTAL Expense = Total Coupons + Total Discount

     B. Amortization of Discount or Premium

     1. "Interest Payable" (or Cash) is fixed in bond contract.

     2. "Straight-line method" of amortization

     a. Acceptable only if int. expense not materially different from

    effective interest method.

     b. Amortization of Premium or Discount Each Period

     = (Total Premium or Discount at Issue) / n

     Interest Expense = PLUG.

     3. "Effective interest method" (or "interest method")

     Interest Expense

     = Book Value at Coupon Pd. Start * mr

     = the Change in the Present Value

     during the Coupon Period

Chapter 10 Debt Financing Page 2

     Amortization of prem. or discount is a PLUG in JE.

    B. Effective Interest Method

    Complete part b of the Sample Problem.

     D. When accounting period end does not coincide

     with interest dates:

     1. Determine the interest expense for the six-month period ending

    after the acctg period end.

     2. Allocate the interest expense based on the fraction of the six-

    month period included in the accounting period.

    3. Complete part c of the Sample Problem.

III. Issuing bonds between interest dates

     A. Special features of the transaction

     1. Lenders/bondholders prepay coupon for time from previous

    interest date to issue date; full period's coupon then paid on next

    interest date. PRACTICAL.

     2. Total Cash Proceeds are:

     ...in concept, PV of Future Cash Flows as of issue date.

    ...calculated as Issue Price if issued on previous interest date PLUS

    Effective Interest from previous interest date to issue date.

    ...recorded as Actual Issue Price + Prepaid Coupon

     B. Example Use the same facts for the June 1, 1998 issue (in the

    Sample Problem). Still assuming the bonds are issued to

    yield 12%, determine the total amount received by the issuer

    if the bonds are issued on July 1, 1998 & prepare JE’s to

    record the issue & the payment of the first coupon on

    November 30, 1998.

     NOTE: to record the first coupon payment, NOW ASSUME

    that any premium or discount is amortized using the straight-

    line method.

Chapter 10 Debt Financing Page 3

IV. Extinguishment of Debt

     A. Tips for Recording Extinguishment

     1. Determine the interest expense for time passed since the last accrual

    (or payment).

     2. Determine the amount of any premium/discount remaining.

     3. BEST to record in two JE's (one to record int. exp. and one to

    retire bond), instead of one JE (netting the two together).

     4. When redeem using a call option or on the open market, or if use

    a “market value” method of recording a bond conversion,

    "Extraordinary Gain/Loss on Retirement of Bonds"

     = Net Carrying Value - Reacquisition Costs

     = {Bond Payable + Premium (or - Discount.)}

     - { Purchase Amount}

     --- Not extraordinary if redemption not subject to management

    control (SFAS 64).

Chapter 10 Debt Financing Page 4

    B. Example

     Prepare part d of the Sample Problem (where we assume we’re

    using the effective interest method, just as in the earlier parts of the

    Sample Problem).

    C. When bonds are converted to common stock, the

    bond conversions can be recorded using either their book value (the

    book value method) OR the market value of the shares issued or (if

    more easily determinable) the market value of the debt converted

    (the market value method).

     Prepare parts e and f of the Sample Problem (where we still

    assume we’re using the effective interest method).

Chapter 10 Debt Financing Page 5

Sample Bond Problem

On June 1, 1998, Garone Company sold 10% bonds with a face value of $300,000 to yield 12%.

    The bonds pay interest semiannually, on November 30 and May 31. The bonds will mature on June

    1, 2013. Garone uses the effective interest method to measure interest and amortize any discount or

    premium.

a. Prepare any journal entry (or entries) required to record the issuance of the bonds. Show any

    calculations you make to support the entry (or entries).

    Chapter 10 Debt Financing Page 6

     b. Prepare any journal entry (or entries) required to record the bonds' first coupon payment

    on November 30, 1998.

c. Assume that Garone closes its books on December 31, 1998 and does not prepare any

    reversing entries on January 1, 1999. Prepare the adjusting journal entry for December

    31, 1998, and the journal entry to record the second coupon payment on May 31, 1999.

Chapter 10 Debt Financing Page 7

d. On December 1, 2008, when the bonds are trading at an effective yield of 8%, Garone buys one-

    fourth of the bonds on the open market. Prepare a journal entry (or entries) to record this open

    market purchase. Show any calculations you make to support the entry (or entries).

    e. Consider the facts presented in part d. Now assume that the holders of the bonds (one-fourth of

    the original issue) choose to convert the bonds into 1,000 shares of Garone common stock,

    instead of redeeming them for cash. Prepare any journal entry (or entries) to record the

    conversion, assuming the stock has a par value of $0.50 per share and Garone chooses to use the

    book value method to record debt conversions.

f. Consider the facts presented in part e. Now assume that conversion is recorded using the market

     value method, where the market value of a share of Garone’s common stock is $82.00.

    Chapter 10 Debt Financing Page 8

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