CHAPTER TWO.pptx 9Accounting and Finance
- 2. LEARNING OBJECTIVES 1. Describe the nature of bonds and indicate the accounting for bond issuances. 2. Describe the accounting for the extinguishment of debt. 3. Explain the accounting for long-term notes payable. 4. Describe the accounting for the fair value option. 5. Indicate how to present and analyze long-term debt
- 3. Coverage
- 4. Definition • Long term debts are liabilities that do not require the payment of cash, the shipment of goods, or the rendering of services in one year or the operating cycle, whichever is longer, for their liquidation. These include, • Bonds • Mortgage notes, • Promissory notes, • Deposits received for utilities service, • Obligations under pension and • Deferred compensation plans, • Long term lease obligations, • Deferred income tax credits, and • Long term deferred revenue and related items.
- 5. Cont’d • It is important to note that bonds represent one of the most commonly known types of long- term debts. Bonds are also a form of interest- bearing notes payable issued by various organizations. This contract is usually held by trusty such as a bank or trust company who acts as an independent third party to protect the interest of both the issuer and the bond holders.
- 6. Cont’d • A corporation may use long term financing other than bonds such as notes payable. However, these other forms of financing involve one individual company or a financial institution. So, money obtained through this instrument is sufficient to finance the funds needed for plant expansion and major projects like new building and factories. To obtain large amount of capital, corporate management usually decides whether to issue bonds or to use equity financing.
- 7. Cont’d • A corporation that issues a long-term debt, issuing bonds provide the following advantages as compared with issuing common stocks. • Bond holders do not have voting rights so current owners (stockholders) retain full control of the company. • Bond interest is deductible for tax purpose but dividend on stock are not. • Although bond interest expenses reduce net income, earnings per share on common stock are often higher under bond financing because no additional shares of common stocks are issued. • As a result of the above advantages, the cost of debt financing remains the cheapest of all capital sources in acquisition.
- 8. Types of bonds • A. Secured and unsecured bonds • Mortgage bonds are secured by a claim on real estate. Collateral trust bonds are secured by stocks and bonds of other corporations. A debenture bond is unsecured. A “Junk bond” (high- risk bonds issued by companies with a weak financial position) is unsecured and pays a high interest rate. These bonds are often used to finance leveraged buyouts.
- 9. Types of Bonds • B. Term, serial and callable bonds • Bond issues that mature on a single date are called term bonds, and issues that mature in installments are called serial bonds. Callable bonds give the issuer the right to call and retire the bonds prior to maturity.
- 10. Types of Bonds • C. Convertible, commodity – backed and deep discount bonds • If bonds are convertible into other securities of the corporation for a specified time after issuance, they are called convertible bonds. Commodity– baked bonds (also called “asset linked bonds) are redeemable in measures of a commodity such as barrels of oil and tons of coal. Deep discount bonds are bonds that pay exceptionally low rate of interest
- 11. Types of Bonds • D. Registered and bearer (coupon) bonds • Bonds issued in the name of the owner are registered bonds and require surrender of the certificate and issuance of a new certificate to complete a sale. A bearer or coupon bond, however, is not recorded in the name of the owner and may be transferred from one owner to another by mere delivery.
- 12. Types of Bonds • E. Income and revenue bonds • Income bonds pay no interest unless the issuing company is profitable. Revenue bonds are so called because the interest on them is paid from specified revenue sources. These are most frequently issued by airports, school districts, countries, toll-road authorities, and government bodies.
- 13. Issuance of Term Bonds • In a typical term bond contract, the issuer promises the following two essentially different kinds of future payments: • Payment of a fixed amount (face amount or principal) on a specified date and • Periodic payment of interest (in an amount expressed as a percentage of the face amount of the bonds).
- 14. Issuance of Term Bonds • The principal is the face value of the initial amount at which bonds are issued while interest on bonds expressed as a percentage of the face amount is referred to as the nominal or contract rate. The interest expense actually incurred on the bond is determined by the price at which the bonds are sold in the market and the rate is called effective rate (yield rate).
- 15. Issuance of Term Bonds • Effective interest rate is set by money market. The effective rate on the bond may be different from the nominal rate set by the company. This may result from a change of economic conditions between the date the company set the nominal rate and the date it was issued. Once the company set the terms of the bond issue, the selling price and therefore the effective yield of the bonds is determined.
- 16. Issuance of Term Bonds • First, if the effective rate is equal to the nominal rate, the purchaser of the bond pays the face value of the bond i.e. the bonds are sold at their par value. • Second, if the effective rate is more than the nominal rate, the purchaser of the bond pays less than face value of the bond, and the bonds are sold at discount. • Third, if the effective rate is less than the nominal rate, the purchaser of the bond pay more than the face value of the bonds i.e. the bonds are sold at premium.
- 17. Cont’d • The market value (present value) of a bond is, therefore, a function of three factors including, 1. The birr amount to be received at the end of the contract period (face amount) 2. The length of time until the amounts are received 3. The market rate of interest
- 18. Cont’d • The market interest rate (effective rate or yield) is the investor’s demand for lending funds to the company. • The process of finding the present value of Bond issued is called discounting. • The following is the formula to compute the present value of a bond with face value of “P” and effective market interest rate “r”
- 19. Formula Where, PV= is present value of a bond P= Principal n = number of discounting periods I = Interest per period computed using nominal rate r = effective rate (face value) of a bond
- 20. Example Assume that ABC Company issued Br 100,000 of five year, 7% term bond. The bond promises Br.100, 000 at the end of five years and Br.7, 000 (7% x Br.100, 000) annual interest, then are offered to a group of investment bankers. Required Based on the above information, determine the proceeds (present value) from issuing the bond and give the appropriate journal entries for the issuer under, a) the effective market interest rate of 7% b) the effective market interest rate of 6% c) the effective market interest rate of 8%
- 21. a) Effective rate (r) = 7%
- 22. b) Effective rate (r) = 6%
- 23. c) Effective rate (r) = 8%
- 24. Cont’d • Discount or premium should be reported in the balance sheet as direct addition or deduction from the face amount of the note. Because differences between the effective rate and the nominal rate of interest are reflected in bond prices, the amount of premium or discount affects the periodic interest expense of the issuer.
- 25. Cont’d • This is illustrated by a comparison of the five-year interest expense under each of the two assumptions given below. • 1. assuming Effective Rate =6% Nominal Interest (7000*5)-------------35,000 Less: Premium( 104,213-100,000)---(4,213) Five Years Interest Expense-----------30,787
- 26. Cont’d • 2, Assuming Effective Rate =8% Nominal Interest(7000*5)-----------35,000 Add: Discount(100,000-96007)------3,993 Five Years Interest Expense---------38,993
- 27. Term Bond Interest Expense • Because differences between the effective rate and the nominal rate of interest are reflected in bond prices, the amount of premium or discount affects the periodic interest expense of the issuer. If bonds are issued at a yield rate greater than the nominal rate, the discount represents an additional amount of interest that will be paid by the issuer at maturity.
- 28. Cont’d • Similarly, if the bonds are issued at a yield rate less than the nominal rate, the premium represents an advance paid by bond holders for the right to receive layer annual interest checks and is viewed as a reduction in the effective interest expense. The premium in effect is returned to bond holders in the form of larger periodic interest payments.
- 29. Cont’d • The present value of the bonds on the date of issuance differs from their face amount because the market rate of interest differs from the periodic interest payments provided for in the bond contract. Therefore, the process of amortizing the bond discount or premium in conjunction with the computation of periodic interest expense is a means of recording the change in the carrying amount of the bonds as they approach maturity.
- 30. Cont’d • In the bond discount case, the increase in the carrying amount of the bonds is caused by the decrease in bond discount through amortization. Similarly, in the bond premium case, the decrease in the carrying amount of the bonds is caused by the decrease in bond premium through amortization.
- 31. Amortization of Premium/Discount • Both premium and discount should be amortized periodically to make bond’s carrying amount equal with its face value on maturity date. There are two methods of premium or discount amortization. A. Straight line method B. Interest method
- 32. Straight line method of amortization • Under this method, the additional interest expense (discount) or reduction of interest expense (premium) may be allocated evenly over the term of the bonds. It results in a uniform periodic interest expense. The use of straight- line method is acceptable if it is applied to immaterial amounts of discount or premium.
- 33. Cont’d • Discount Amortization Using Straight Line Method • 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 =Total 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 Number of Periods • 𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 =Present Value −Face Value of the Bond • 𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡=96,007−100,000 =3,993 • 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡=3,993 = 798.6 5
- 34. Cont’d • Periodic discount has to be added on carrying value beginning to determine carrying value ending. • 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 𝐸𝑛𝑑𝑖𝑛𝑔 =Carrying Value Beginning + Periodic Discount • 𝐼𝑛𝑒𝑡𝑒𝑟𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒=Periodic Interest Payment + Periodic Discount
- 35. Discount Amortization Table Using Straight Line Method Time Carrying Vale Beg. (A)= (A+C) Interest Paid (7%) of FV(B) Periodic Discount (C) Interest Expense (B+C) Carrying Value Ending (A+C Year 1 96,007 7,000 798.60 7,798.60 96,805.6 0 Year 2 96,805.60 7,000 798.60 7,798.60 97,604.2 Year 3 97,604.2 7,000 798.60 7,798.60 98,402.8 Year 4 98,402.8 7,000 798.60 7,798.60 99,201.4 Year 5 99,201.4 7,000 798.60 7,798.60 100,000
- 36. Cont’d…. Journal Entries • At end of each period Interest Expense……….7,798.6 Cash………………………7,000 Bond Payable……….……….798.6 • On maturity date Bond Payable…………..100,000 Cash………………100,000
- 37. Premium Amortization Using Straight Line Method • Periodic Premium under this method is determine as follows • 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡=Total 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 Number of Periods • 𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡=Present Value − Face Value • 𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑒𝑚𝑖𝑢𝑚=104,213−100,000 =4,213 • 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑃𝑟𝑒𝑚𝑖𝑢𝑚=4,2135 = 842.6 5
- 38. Cont’d • Periodic premium has to be deducted from carrying value beginning to determine carrying value ending. • Book =BV Beg − Periodic Premium 𝑉𝑎𝑙𝑢𝑒 𝐸𝑛𝑑𝑖𝑛𝑔 • 𝐼nt, . = Periodic Interest Payment−Periodic 𝐸𝑥 Premium
- 39. Premium Amortization Table Using Straight Line Method Time Carrying Value Beg (A) Interest paid @ 7% of FV (B) Periodic Premium (C) Interest Expense (D) Book Value Ending (E)=A-C Year 1 104,213 7,000 842.60 6,157.40 103,370.40 Year 2 103,370.40 7,000 842.60 6,157.40 102,527.80 Year 3 102,527.80 7,000 842.60 6,157.40 101,685.20 Year 4 101685.20 7,000 842.60 6,157.40 100,842.60 Year 5 100,842.60 7,000 842.60 6,157.40 100,000
- 40. Journal Entries • At end of each period Interest Expense…………….6,117.4 Bond Payable……….………….842.6 Cash…………………………7,000 • On maturity date Bond Payable……………..100,000 Cash……………………100,000
- 41. Interest Method of Amortization for Term Bonds • In this method, the bond interest expense in each accounting period is equal to the effective interest expense, i.e., the effective rate of interest applied to the carrying amount of the bonds at the beginning of the period. It is theoretically sound and an acceptable method.
- 42. Cont’d • Bond interest expense is computed first by multiplying the carrying value of the bonds at the beginning of the period by the effective interest rate. • The bond discount or premium amortization is then determined by comparing the bond interest expense with the interest to be paid. Under this method; • 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡=𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒∗𝐶𝑜𝑢𝑝𝑜𝑛 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 • 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒=𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 𝐵𝑒𝑔∗𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒
- 43. Discount Amortization Table Using Interest Method Time Carrying Value Beginning Interest Expense( 8%) Interest Paid (7%) Periodic Discount Carrying Value Ending Year 1 96,007 7,681 7,000 681 96,688 Year 2 96,688 7,735 7,000 735 97,423 Year 3 97,423 7,794 7,000 794 98,217 Year 4 98,217 7,857 7,000 857 99,074 Year 5 99,074 7,926 7,000 926 100,000
- 44. Journal Entries
- 45. Discount Amortization Table Using Interest Method Time Carrying Value Beg (A) Interest paid (7% of FV) (B) Interest Expense 6% (C) Periodic Premium D=(B-C) Ending Bal E=(A- D) Year 1 104,213 7,000 6,253 747 103,466 Year 2 103,466 7,000 6,208 792 102,674 Year 3 102,674 7,000 6,160 840 101,834 Year 4 101,834 7,000 6,110 890 100,944 Year 5 100,944 7,000 6,056 944 100,000
- 46. Journal entries Dec 31, Year 1 Dec 31, Year 2 Dec 31, Year 3 • Interest Expense ----6,253 ----6,208 ---6,160 Bond Payable–---------747------ 792 ------840 Cash -----------7,000 ---7,000 -- 7,000 Dec 31, Year 4 Dec 31, Year 5 • Interest Expense ---------6,110 --------6,056 Bond Payable ---------------890 --------944 Cash ----------------7,000 -------7,000
- 47. Quiz (5%) • Assume that KK Co. issued Br 50,000 of four years, 10% term bond. The bond promises Br.50, 000 at the end of four years to an investor. Required Based on the above information, determine the proceeds (present value) from issuing the bond and give the appropriate journal entries for the issuer under straight line and Interest Methods, using a) the effective market interest rate of 10% b) the effective market interest rate of 8% c) the effective market interest rate of 12%
- 48. Bonds Issued Between Interest Dates • Interest on bonds is usually paid semi- annually on the dates indicated on the bond certificate. Bonds are often sold after their authorization date and between interest payment dates. In such cases, the issuing company must pay interest only for the period of time that the bonds are outstanding i.e., from the sale date to the next interest payment date.
- 49. Cont’d….. • When companies issue bonds on other than the interest payment dates, buyers of the bonds will pay the seller the interest accrued from the last interest payment date to the date of issue. The purchasers of the bonds, in effect, pay the bond issuer in advance for that portion of the full six -months’ interest payment to which they are not entitled because they have not held the bonds for that period.
- 50. Example • Information for XYZ Company’s bond issue: • The bond date is March 31, 2023, and maturity date is March 31, 2028. • The issue date is June 1,2023 (between interest dates) • The bonds pay interest each September 30 and March 31. • The stated rate is 8%, and the effective interest rate is 10%. (i = 10/2% = 5%, interest payment = 100,000 x 0.04 = Br. 4000) • Face value is Br. 100,000. • Required: Calculate price of the bond and record all necessary journal entries
- 51. Solution Determine the Present value of the bond by discounting factor Then we can pass the entry as follows Cash--------------------92,278 Bond Payable-----------------92,278 (To record the price of the bond)
- 52. Extinguishments of Long-Term Debt • The agreement between the bond holders and the issuing company always includes a specified maturity date. On this date, the company agrees to repay the face value of the bonds to the bondholders. At this time, any premium or discount will be completely amortized so that the book value of the bond is equal to the face value. Occasionally, under certain circumstance, bonds may be retired prior to their scheduled maturity date. This is called extinguishment of liability.
- 53. Cont’d….. • There are three common ways of extinguishing liabilities. 1. Extinguishment with cash before maturity 2. Extinguishment by transferring assets or securities, and 3. Extinguishment with modification of terms.
- 54. Extinguishment with cash before maturity • A company can repurchase its own bond before maturity date. Gain or loss is determined as follows. • 𝐺𝑎𝑖𝑛/ = 𝐿𝑜𝑠𝑠 𝑁𝑒𝑡 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 − 𝐴𝑚𝑜𝑢𝑛𝑡 𝑅𝑒𝑎𝑐𝑡𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛 𝑃𝑟𝑖𝑐𝑒 • Example: Assume that on January 1, 2010, ABC Co issued at 97 bonds with a par value of Br 1,000,000, due in 20 years. Fourteen years after the issue date, ABC Co calls the entire issue at 101 and cancels it. At that time, the unamortized discount balance is Br 19,000. • Required: Determine gain or loss on extinguishment of the debt and record all necessary journal entries.
- 55. Solution Term loan carrying amount Br. 1,000,000 Less: unamortized debt issuance costs (19,000) Net carrying amount 981,000 Reacquisition price 1,010,000 Loss on extinguishment Br. 29,000
- 56. Bond payable----------------1,000,000 Loss on Extinguishment----29,000 Unamortized Discount------------19,000 cash-------------------------------1,010,000