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45 Cards in this Set

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Nature of long-term debt

Not all debt instruments are unchallenging, plain vanilla loan agreements, but are constantly being flavored in increasingly exotic ways by the financial community to satisfy the diverse and evolving tastes of both debtors and creditors.

Periodic interest is the effective interest rate times the amount of the debt outstanding during the interest period.

Bonds

1. Most common form of corporate debt




2. Bond issue breaks down a large debt into manageable parts-- usually $1,000 to $5,000 units; this avoids the necessity of finding a single lender who is both willing and able to loan a large amount of money at a reasonable interest rate.




3. Theoretically, instead of issuing a 400 million dollar note to borrow cash, a corporation may find it more economical to issue 400 thousand bonds to many lenders, possibly 400,000 lenders.





Bond Indenture

1. Document that describes specific promise to bondholders.




2. Due to impracticality of entering into direct agreement with each bondholder, the bond indenture is held by a trustee, usually a commercial bank or financial institution appointed by the issuing firm to represent the rights of the bondholders.




3. Trustee may bring legal action against company on behalf of bondholders





Debenture bond

1. Secured only by full faith and credit; no specific assets are pledged as security.




2. Investors in debentures have the standing as the firm's other general creditors.





Subordinated debenture

Not entitled to receive any liquidation payments until the claims of other specific debt issues are satisfied.

Mortgage bond

Bond backed by a lien on specified real estate owned by the issuer.




Commands lower interest rate than debentures, since considered less risky.

Coupon bonds

Bonds today are registered and interest checks are mailed directly to owner.




These bonds in the past were not registered to the name of the owner, and the bondholder had to clip an attached coupon and redeemed it in accordance with the indenture in order to collect interest.

Callable bonds(redeemable)

Allows issuing company to buy back, or call, outstanding bonds from bondholders before their scheduled maturity date.




Protection for relatively high-cost debt when interest rates fall before maturity.




Call price must be pre-specified and often exceeds the bond's face amount




No call provisions usually prohibit calls during the first few years of a bond's life.

Sink Fund Debenture

Bonds that are required to be redeemed on a pre-specified, year-by-year basis over its term to maturity.

Serial bonds

Retired in installments during all or part of the life of the issue.




Each bond has its own specified maturity date.





Convertible bonds

are retired as a consequence of bondholders choosing to convert them into shares of stock.

Effective interest method

Recording interest each period as the effective market rate of interest multiplied by the outstanding balance of the debt.




Effective interest on debt is the market rate of interest multiplied by the outstanding balance of the debt.




Difference between effective interest and interest paid increases the existing liability for discounts and decreases the liability for premiums.




Interest paid is stated rate times face amount.




Determining interest in this manner allows us to report the liability at the present value of future cash payments each period.





Zero-Coupon Bonds(Know the concept, but not necessarily mathematical components)

Accrued interest each period at effective rate regardless of how much cash interest actually is paid or received.




Advantage is that interest expense can be deducted for tax purposes without any related cash outflows until the bond matures.




but reverse is true for investors who annually receive no periodic cash interest, but must report annual interest revenue for tax purposes. So, those who invest in zero-coupon bonds usually have tax-deferred or tax-exempt status.*





Bonds sold at a premium

In practice, corporate bonds are rarely sold at a premium because the delay between the date the terms of the bond are established and when the bonds are issued make it difficult to set the stated rate equal to the ever-changing market rate.

Straight line method-practical expediency

Not an alternative to the effective interest method in a conceptual sense, but an application of the materiality concept by which the appropriate application of GAAP can be bypassed for reasons of practical expediency when doing so has no material effects on the results.





Debit Issue Costs

1. Rather than selling bonds directly to the public, corporations may sell bonds to an underwriter, usually investment bank, that may sell them to other security dealers or the public.




2. Underwriters underwrite the risk associated with a new issue.




3. Underwriting fee is spread between price the underwriter pays and the resale price.




4. With either publicly or privately sold debt, the issuing company will incur costs in connection with issuing bonds or notes, such as legal and accounting fees and printing costs, in addition to registration and underwriting fees.




5. Under old GAAP(old GAAP presented in this edition of the book), debt issue costs are recorded separately and amortized over the term of the related debt, which requires a debit to an asset account(debt issue costs) in which the asset is amortized over the life of the bond.








Private placement

When bond issuing company sells debt security directly to a single investor(pension fund or an insurance company).




Less costly because lengthy process of registering with SEC and underwriting fees are avoided.

IFRS Debt Issue Costs(consistent with current and new GAAP)

1. Recorded amount of debt is reduced by debt issue costs(transaction costs under IFRS).




2. Reduces the net cash the issuing receives from the sale of the debt.




3. Since a lower amount is borrowed, the effective interest rate is increased.




4. Actual increases in effective interest rate is reflected in the interest expense only if the issue cost is allowed to reduce the book value of the debt.

Note issue for cash(Excluded)

Discount and premiums less likely for notes than bonds.

Note exchanged for assets or services(Excluded)

Usually the stated rate in the note is equal to the market rate because the rate is usually negotiated at the time of the loan, but this is occasionally not the case.




If so, the value of the asset or service exchanged for the note establish the market rate.




However, it should be noted that the value of the asset or debt that is more reliable should be used to establish the market rate.





Implicit rate of interest(Possibly Excluded)

1. rate implicit in the agreement.




2. Implicit rate may not be apparent if the value of the asset or service is not readily determinable and the stated interest rate is unrealistic for the particular transaction. Imputing an interest rate involves deciding the appropriate rate under these circumstances.




3. Imputing a rate could be done by considering external information.




4. Basic accounting concept is substance over form; economic essence of a transaction should prevail over its outward appearance.





Installment notes

1. Outstanding balance does not eventually become face amount, but has a zero balance at maturity.

2. No lump payment and higher periodic cash payments.

3. After covering interest, excess amount amortizes the debt to zero at maturity.



Financial Statement Disclosure

1. Long-term debt(liability for the debtor; asset for creditor) is typically reported as a single amount net of discounts or premiums.




2. Any portion of the debt to be paid or received during the year is reported as a current amount.




3. Fair value of financial instruments must be disclosed in the body of the financial statements or in disclosure notes




4. If fair value not available from market exchange, the fair value may require evidence from other means, such as approximation through present value calculations using a discount rate commensurate with the risks involved.




5. Disclosure note for debts includes nature of company's liabilities, interest rates, maturity dates, call provisions, conversion options, restrictions imposed by creditors, and assets pledged as collateral.





Early Extinguishment of Debt

1. When debt of any type, regardless of method, is retired before maturity.




2. Gain or loss may result from retiring debt before scheduled maturity.




3. Even if bonds are not callable, issuing company can retire bonds early by purchasing them open market.




4. Any difference between outstanding debt(book value) and the amount paid to retire the debt represents either a gain or a loss.





Convertible Bonds

1. Bonds converted into shares of stock at the option of the bondholder.




2. Sometimes serves as indirect way to issue stock when there is shareholder resistance to direct issuance of additional equity.




3. Hybrid security




4. Increases investors upside potential while limiting the downside risk.




5. Conversion feature has monetary value that depends on the conversion terms and market conditions.




6. Entire issue price is recorded as debt, as if they are nonconvertible bonds.




7. Value of conversion feature is not separately recorded typically.







Reasons for issuing convertible bonds rather than straight debt

1. To sell the bonds at a higher price, which means a lower effective interest cost.




2. To use as a medium of exchange in merges and acquisitions




3. To enable smaller firms or debt-heavy firms to obtain access to the bond market.




4. Attractive to investors





Additional Consideration:Exception to inseparability of conversion option to bond issue price(Excluded)

1. Separable when conversion option is deemed to be a beneficial conversion feature, which is when the conversion option has a positive intrinsic value at the time the bonds are issued.




2. Positive intrinsic value is when the fair value of the stock into which the bonds are convertible exceeds the face amount of the bonds.

IFRS: Convertible Bonds

The components of compound financial instruments such as convertible bonds are valued and reported separately under IFRS.




Equity and debt components separable for convertible bonds under IFRS.

When the conversion option is exercised

Book value method(most common): Bonds are removed from accounting records and new shares issued at the same amount.




Market value method: Records new shares at market value of shares themselves or of the bonds, whichever is more easily determinable, meaning there could be a gain or loss on the conversion.

Induced conversion

1. Investors may be reluctant to convert bonds, even if stock prices rise, because market price of convertible bonds rise with market price of stock.




2. Companies may try to lower debt or lower debt-to-equity ratio to become a better risk to potential lenders.




3. May try to induce conversion through call provision.




4. If call price is less than conversion value of the bonds, bondholders have incentive for conversion.




5. Corporations may try to encourage voluntary conversion through added inducements in the form of cash, stock warrants, or a more attractive conversion ratio.




6. Fair value of additional considerations provided in added inducements are considered an expense.

Bonds with detachable warrants

1. Less common way to sweeten bond deal




2. Gives investor an option to purchase a stated number shares of common stock at a specified option price, often within a given period of time.




3. Lower interest rate often enables a company to issue when borrowing would not be feasible otherwise.




4. Unlike conversion features for bonds, warrants can be separated from bonds.




5. Can be exercised independently or traded in the market separately from the bond, having their own market price.




6. Bonds and warrants are essentially two different securities.




7. Issue price allocated between them on the basis of their fair values.




8. If the independent market value of one of the securities is readily determinable, that value establishes the allocation.




9. Market value of shares not used at date of exercise, but new shares are recorded at the total of previously measured values of both the warrants and shares.









Additional Consideration: Relative market values

If market imperfections cause the separate market values not to sum to the issue price of the package, allocation is achieved on the basis of relative market values.

Option to Report Liabilities at Fair value

1. Companies are not required to, but have the option to value some or all of their financial assets and liabilities at fair value.




2. Same market forces that influence fair value of investments in debt securities(interest rates, credit risk, etc.) influence the fair values of liabilities.




3. The mix of factors differ depending on the debt security, but in all cases, changes in the current market rate of interest often significantly contribute to changes in fair value.




4. Changes in interest rates cause changes in the fair value of liabilities.









Additional Consideration: Fair value not readily determinable

If fair value on debt securities, such as bonds not traded on an open-market exchange are not readily observable, then the preferable method to determine fair value would be to calculate fair value as the present value of the remaining cash flows discounted at the current interest rate.

Reporting Changes in fair value

1. Changes in fair value will create gain or loss.




2. Any portion of the gain or loss that is a result of a change in the credit risk of the debt is reported as part of OCI.




3. Any portion of gain or loss that is a result of a change in general interest rate is reported as part of net income.




4. Companies can assume that any change in fair value that exceeds the amount caused by a change in the general(risk-free) interest rate is the result of credit risk changes.




5. Consider the consequences of reporting credit risk-related fair value changes in net income to understand why the prescribed treatment is to report it in OCI.









Credit Risk

The risk that the investor in the bonds will not receive the promised interest and maturity amounts at the times they are due.

Mix and Match

Companies can mix and match on an instrument-by-instrument basis and effectively choose what financial instruments to report at fair value.




However, companies must make the election when the item originates and are not allowed to switch methods once a method is chosen.

Bonds issued between interest dates

If the date when the bond is sold is different from the issuance date, then the buyer would be asked to pay the seller accrued interest on the difference in time between those two dates, such as two months.

Troubled Debt restructuring

Creditors face a dilemma if they can demand payment from a debtor through liquidation, but the liquidation may not be the best course of action for the creditors to minimize their losses.




Thus, to minimize their losses, creditors may restructure the debt agreement.




Can be restructured in two ways:




1. Debt may be settled at the time of the restructuring




2. Debt may be continued, but with modified terms.





Debt is settled

In all areas of accounting, a noncash transaction is recorded at fair value.




Debtor may need to adjust book value of an asset to fair value prior to exchanging it for debt.





Debt is continued, but with modified terms

1. Terms of debt agreement modified to make it easier for debtor to comply




2. Creditor may agree to reduce or delay the scheduled interest payments or maturity amount or both.




3. Book value of a debt is the current balance of the primary debt plus any accrued interest.




4. The way the debtor accounts for the restructuring agreement depends on whether the total cash payments are less than the book value of the debt or still exceed the book value.

When total cash payments are less than the book value of the debt

The restructured debt agreement no longer provides interest on the debt.




When the total of future cash payments are less than the book value of the debt, the difference is recorded as a gain at the date of restructure.




No interest is recorded thereafter and all subsequent cash payments result in reduction of principal.

When total cash payments exceed the book value of the debt

Restructured debt agreement still provides interest on the debt, but less than before the agreement was revised.




Accounting objective is to determine new effective rate.




Future payments less book value=total interest




Book value/Future payments=present value factor for single cash payments




There is asymmetry between debtors' and creditors' accounting for troubled debt restructurings, which is not conceptually justified.



When the original terms of a debt agreement are changed because of financial difficulties experienced by the debtor, the new arrangement is referred to is as a troubled debt restructuring. For accounting purposes, these possibilities are classified. What are the accounting classifications of troubled debt restructuring?

Troubled debt restructuring involves concessions on the part of the creditor in which a creditor feels that it can minimize losses through a restructuring debt agreement, rather than forcing liquidation.




A troubled debt restructuring takes forms:




1. The debt may be settled at the time of the restructuring.




2. The debt may be continued, but with modified terms.


a. Under the modified terms, total cash to be paid can be less than or greater than the book value of the debt.

The way a debtor accounts for the restructuring depends on the extent of the reduction in cash payments called for by the restructured arrangement. Describe, in general, the accounting procedure for the two basic cases: when, under the new arrangement, the total cash payments (a) are less than the book value of the debt or (b) still exceed the book value of the debt.

1. a. When the total future cash payments are less than the book value of the debt, the difference is recorded as a gain to the debtor at the date of restructure.




b. No interest is recorded thereafter.




c. All subsequent cash payments produce reductions of principal.




2. a. When the total future cash payments exceed the book value of the debt, no reduction of the existing debt is necessary and no entry is required at the time of the debt restructuring.




b. The accounting objective is to determine the new(lower) effective interest and to record interest expense for the remaining term of the loan at that new, lower rate.