Kế toán, kiểm toán - Chapter 14: Bonds and long - Term notes

BONDS AND LONG-TERM NOTESChapter 14© 2013 The McGraw-Hill Companies, Inc.Liabilities. . . Resulting from past transactions or events.. . . Arising from present obligations to other entities . . .Probable future transfer of economic benefits . . . Some liabilities are not contractual obligations and may not be payable in cash. Notice that the definition of a liability involves the present, the future, and the past. It is a present responsibility, to transfer assets or services in the future, caused by a transaction or other event that already has happened.© 2013 The McGraw-Hill Companies, Inc.Long-Term DebtCreditors’ interests in a company’s assets.Obligation for future payments at specified (or estimated) amounts, at specified (or projected) dates.Interest accrues on debt over time. Periodic interest is the effective interest rate times the amount of the debt outstanding during the interest period. Debt is reported at the present value of principal and/or interest payments, discounted at the effective rate of interest at issuance.© 2013 The McGraw-Hill Companies, Inc.Nature of Long-Term DebtObligations that extend beyond one year or the operating cycle, whichever is longerMirror image of an assetAccrue interest expenseReported at present valueLoan agreement restrictions© 2013 The McGraw-Hill Companies, Inc.Company Issuing BondsBonds Bond Selling PriceBond CertificateInterest PaymentsPrincipal Value Payment at End of Bond TermAt Bond Issuance DateSubsequent PeriodsInvestor Buying BondsCompany Issuing BondsInvestor Buying Bonds© 2013 The McGraw-Hill Companies, Inc.Bonds Sold at ParOn January 1, 2012, Masterwear Industries issued $700,000 of 12% bonds. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years [an unrealistically short maturity to shorten the illustration]. The entire bond issue was sold in a private placement to United Intergroup, at principal amount (i.e. at par).Masterwear - IssuerAt Issuance (January 1)United - Investor© 2013 The McGraw-Hill Companies, Inc.Determining the Selling Price© 2013 The McGraw-Hill Companies, Inc.Determining the Selling PriceOn January 1, 2012, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup.Because interest is paid semiannually, the present value calculations use: (a) the semiannual stated rate (6%), (b) the semiannual market rate (7%), and (c) 6 (3 x 2) semi-annual periods.Present value of an ordinary annuity of $1: n=6, i=7%present value of $1: n=6, i=7%© 2013 The McGraw-Hill Companies, Inc.Journal Entries at Issuance – Bonds Issued at a DiscountMasterwear - IssuerUnited - Investor© 2013 The McGraw-Hill Companies, Inc.Determining Interest – Effective Interest MethodInterest accrues on an outstanding debt at a constant percentage of the debt each period. Interest each period is recorded as the effective interest rate multiplied by the outstanding balance of the debt (during the interest period).The bond indenture calls for semiannual interest payments of only $42,000 – the stated rate (6%) times the principal value of $700,000. The difference ($4,664) increases the liability and is reflected as a reduction in the discount (a valuation account). Interest is recorded as expense to the issuer and revenue to the investor. For the first six-month interest period the amount is calculated as follows: 666,633 × (14% ÷ 2) = $46,664Outstanding Balance Effective Rate Effective Interest© 2013 The McGraw-Hill Companies, Inc.Journal Entries – The Interest MethodThe effective interest is calculated each period as the effective interest rate times the amount of the debt outstanding during the interest period.At the First Interest Date (June 30)Masterwear - IssuerUnited - Investor© 2013 The McGraw-Hill Companies, Inc.Change in Debt When Effective Interest Exceeds Cash PaidThe “unpaid” portion of the effective interest ($4,644) increases the outstanding balance to $671,297 and reduces the discount to $28,703 on June 30. © 2013 The McGraw-Hill Companies, Inc.Amortization Schedule – DiscountSince less cash is paid each period than the effective interest, theunpaid difference increases the outstanding balance of the debt.6% × $700,000$666,633 + 4,664$46,664 – 42,0007% × $666,633© 2013 The McGraw-Hill Companies, Inc.Amortization Schedule – Discount$48,544 is rounded to cause outstanding balance to be exactly $700,000 on 12/31/14.© 2013 The McGraw-Hill Companies, Inc.Zero-Coupon BondsThese bonds do not pay interest. Instead, they offer a return in the form of a “deep discount” from the principal amount. In some countries, these bonds are attractive to investors as tax is not paid on the zero cash coupons!© 2013 The McGraw-Hill Companies, Inc.When Financial Statements Are Prepared Between Interest DatesOn 1/1/12, Masterwear Industries issues $700,000 face value bonds to United Intergroup. The market interest rate is 14%. The bonds have the following terms:Face Value of Each Bond = $1,000Maturity Date = 12/31/14 (3 years) Stated Interest Rate = 12%Interest Dates = 6/30 & 12/31Bond Date = 1/1/12Assume Masterwear and United both have October 31st year-ends.© 2013 The McGraw-Hill Companies, Inc.Recall the entries we prepared on June 30, 2012.These entries will not change.Masterwear - IssuerUnited - InvestorWhen Financial Statements Are Prepared Between Interest Dates© 2013 The McGraw-Hill Companies, Inc.Year-end is on October 31, 2012, before the second interest date of December 31, so we must accrue interest for 4 months from June 30 to September 30.Masterwear - IssuerUnited - InvestorWhen Financial Statements Are Prepared Between Interest Dates© 2013 The McGraw-Hill Companies, Inc.When Financial Statements Are Prepared Between Interest DatesOn December 31, the next interest payment date,the following entries would be recorded.Masterwear - IssuerUnited - Investor© 2013 The McGraw-Hill Companies, Inc.When Financial Statements Are Prepared Between Interest DatesDetermining interest by allocating the discount (or premium) on a straight-line basis is NOT permitted under IFRS, although it is allowed under U.S. GAAP© 2013 The McGraw-Hill Companies, Inc.Fair Value OptionFinancial liabilities that are held-for-trading must be measured at fair value at the end of each reporting period.A company is not required to, but has the option to measure, non-trading financial assets and liabilities, including bonds and notes, at fair value if any of the following conditions exist.An accounting mismatch exists between financial assets and financial liabilities. Management of financial assets and liabilities requires the use of fair value information. The financial liability contains an embedded derivative and the issuer is permitted to measure, the hybrid instrument comprising the host and embedded derivative, at fair value.© 2013 The McGraw-Hill Companies, Inc.Fair Value OptionIFRS is more restrictive than U.S. GAAP which permits the issuer to apply the fair value option unconditionally.The option need not be applied to all financial instruments but may be applied selectively.If a company chooses the option to report at fair value, then it reports changes in fair value in its income statement. Fair value may be determined by discounting the bond’s remaining interest and principal payments by the current market interest rate for a bond with similar credit risk characteristics© 2013 The McGraw-Hill Companies, Inc.Fair Value Option – ExampleThe June 30 entry reduced the unamortized discount to $28,703 and increased the book value of the liability by to $671,297.From our earlier example on Masterware, assume that on June 30, 2012, the market interest rate dropped to 11% (5.5% semiannually). Masterwear would report the increase in fair value from $666,633 to $714,943, or $48,310 (refer to slide 8 for method):At June 30, 2012, record interest and coupon as per normal:© 2013 The McGraw-Hill Companies, Inc.On June 30, the fair value of the bonds was $714,943. Fair Value Option – ExampleRather than increasing the bonds payable account itself, we increase it indirectly with a valuation allowance (or contra) account:The $43,646 credit to fair value adjustment will increase the bond credit balance to $714,943. Masterwear must also recognize the loss in the income statement.© 2013 The McGraw-Hill Companies, Inc.Debt Transaction Costs Legal Accounting Underwriting Commission Registration Promotion Debt Transaction CostsTransaction costs include fees and commissions paid to advisers, intermediaries, regulatory agencies and exchanges, and specific taxes paid to governmentsDebt premiums or discounts, financing costs or internal administrative or holding costs are not transaction costs.© 2013 The McGraw-Hill Companies, Inc.Debt Transaction CostsDebt transaction costs are recognized as yield adjustments to the effective interest rate. The costs are kept on the statement of financial position in a contra/linked account to the debt accountAs the costs reduce the net proceeds from the debt issue, they increase the effective borrowing rateNot all transaction costs qualify for yield adjustments. For example service fees incurred periodically to maintain, but not originate, the loan are expensed off in the periods incurredTransaction costs that are an integral part of the effective interest rate are amortized, together with premiums or discounts, over the expected life of the debt or the period in which the benefits relating to the cost are realized, whichever is shorter© 2013 The McGraw-Hill Companies, Inc.Long-Term NotesPresent value techniques are used for valuation and interest recognition.The procedures are similar to those we encountered with bonds. © 2013 The McGraw-Hill Companies, Inc.Long-Term NotesOn January 1, 2012, Skill Graphics, a product labeling and graphics firm, borrowed 700,000 cash from First BancCorp and issued a 3-year, $700,000 promissory note. Interest of $42,000 was payable semiannually on June 30 and December 31.Skill Graphics (Borrower)At IssuanceFirst BancCorp (Lender)© 2013 The McGraw-Hill Companies, Inc.Long-Term Notes (continued)At Each of the Six Interest DatesSkill Graphics (Borrower)First BancCorp (Lender)At MaturitySkill Graphics (Borrower)First BancCorp (Lender)© 2013 The McGraw-Hill Companies, Inc.Note Exchanged for Assets or Servicespresent value of $1: n=6, i=7%Present value of an ordinary annuity of $1: n=6, i=7%Skill Graphics purchased a package labeling machine from Hughes–Barker company by issuing a 12%, $700,000, 3-year note that requires interest to be paid semiannually. The machine could have been purchased at a cash price of $666,633. The cash price Implies an annual market rate of interest of 14%. That is, 7% is the semiannual discount rate that yields a present value of $666,633 for the note’s cash flows (interest plus principal) computed as follows: The accounting treatment is the same whether the amount is determined directly from the market value of the machine (and thus the note, also) or indirectly as the present value of the note (and thus the value of the asset, also).Note Exchanged for Assets or ServicesAt the Purchase Date (January 1)Skill Graphics(Buyer/Issuer)Hughes–Barker(Seller/Lender)At the First Interest Date (June 30)Skill Graphics(Buyer/Issuer)Hughes–Barker(Seller/Lender)Installment NotesTo compute cash payment use present value tables.Interest expense or revenue: Effective interest rate× Outstanding balance of debt Interest expense or revenuePrincipal reduction: Cash amount– Interest component Principal reduction per period© 2013 The McGraw-Hill Companies, Inc.Installment Notes $666,633 ÷ 4.76654 = $139,857 amount (from Table 4) installment of loan n=6, i=7.0% payment Notes often are paid in installments, rather than a single amount at maturity. RoundedEarly Extinguishment of DebtDebt retired at maturity results in no gains or losses. Debt retired before maturity may result in an gain or loss on extinguishment.Cash Proceeds – Book Value = Gain or LossBUT© 2013 The McGraw-Hill Companies, Inc.Early ExtinguishmentIllustration – On January 1, 2013, Masterwear Industries called its $700,000, 12% bonds when their carrying amount was $676,290. The indenture specified a call price of $685,000. The bonds were issued previously at a price to yield 14%.$685,000 – 676,290($700,000 – 676,290© 2013 The McGraw-Hill Companies, Inc.Financial Statement DisclosuresLong-Term DebtFor all long-term borrowing, disclosures should include the aggregate amounts maturing and sinking fund requirement, if any, for each of the next five years.© 2013 The McGraw-Hill Companies, Inc.Times interest earned ratio=Net income + interest + taxesInterestDecision Makers’ PerspectiveLong-term debt impacts several key financial ratios.Debt toequity ratioTotal liabilitiesShareholders’ equity=Rate of return on shareholders’ equityNet incomeShareholders’ equity=Rate of return on assetsNet incomeTotal assets=© 2013 The McGraw-Hill Companies, Inc.Convertible BondsSome bonds may be converted into ordinary shares at the option of the holder. They are accounted for as both debt and equityBonds into StockSubstance over FormConvertible bonds are no different from a pure bond with a detachable warrant or stand-alone call option.BifurcationDebt and equity components are accounted for separately even though each is not separable.Bond ComponentThe effective interest rate of the convertible bond is the market interest rate of a pure bond of similar credit risk characteristics© 2013 The McGraw-Hill Companies, Inc.Accounting for Convertible BondsAt IssuanceThe entire issue price of the convertible bonds is split between debt and equity, which are recorded separately Illustration – On January 1, 2012, HTL Manufacturers issued $100 million of 8% convertible debentures due 2032 at 103 (103% of face value). The bonds are convertible at the option of the holder at a conversion ratio of 40 shares per $1,000 bond. HTL recently issued nonconvertible, 20-year, 8% debentures at 98.*all values in millionsNote: The bond will have to be amortized as a pure bond. On 31st December 2014, the bond’s carrying value is $98,139,248© 2013 The McGraw-Hill Companies, Inc.Accounting for Convertible BondsUpon ConversionIf and when the bondholder exercises his or her option to convert the bonds into shares: The bonds and the equity options are removed from the accounting records New shares are issued, and are recorded at the amount equal to the book value of the bonds and the book value of the equity options.Illustration – Assume that the convertible bonds issued by HTL Manufacturers are converted on December 31, 2014:*all values in millions© 2013 The McGraw-Hill Companies, Inc.Accounting for Convertible BondsEarly ExtinguishmentUpon early extinguishment: Both the debt and equity components in a convertible bond have to be removed. The loss on extinguishment of a convertible debt has to be allocated to the debt and equity components using a process similar to that of allocating the initial proceeds on issue date.The loss attributable to the debt component is taken to the income statement while the loss attributable to the equity component remains in equity (although it may be re-classified from equity options to another component in equity).The loss on equity is not taken to the income statement as the loss relates to transactions with owners in their capacity as owners.© 2013 The McGraw-Hill Companies, Inc.Accounting for Convertible BondsEarly ExtinguishmentIllustration –assume that HTL Manufacturers has a right to redeem its convertible bonds from December 31, 2014 onwards at 106 and chooses to do so on this date:The market interest rate of HTL’s pure bond on 31/12/2014 was 7.95%Based on this rate, the present value of the remaining cash flows from the bond is $100,457,607. Compared to the book value of $98,139,248, this means a loss of $2,318,359 on the debt component.As the proceeds from redemption is $106,000,000, the value of the equity component is $5,542,393. Compared to the book value of $5,000,000, this means a loss of $542,393 on the equity component.*Note that this results in a deficit in equity, but will still remain in equity (unless transferred to another line item in equity)© 2013 The McGraw-Hill Companies, Inc.Induced ConversionCompanies sometimes try to induce conversion of their bonds into stock. One way to induce conversion is through a “call” provision. When the specified call price is less than the conversion value of the bonds (the market value of the shares), calling the convertible bonds provides bondholders with incentive to convert. Bondholders will choose the shares rather than the lower call price.Any additional consideration provided to induce conversion of convertible debt is recorded as an expense of the period.Bonds With Detachable WarrantsStock warrants provide the option to purchase a specified number of shares of ordinary shares at a specified option price per share within a stated period.The issue price of bonds with detachable warrants is allocated between the two different securities on the basis of their market values.© 2013 The McGraw-Hill Companies, Inc.Bonds With Detachable WarrantsMatrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the holder to purchase a share unit for $18 per share. Immediately after issue the bonds were selling for 98 without the warrants and the warrants have a market value of $16. © 2013 The McGraw-Hill Companies, Inc.Debt Restructuring – Appendix BTroubled debt may berestructured in one of two ways: Settled at timeof restructuringContinued withmodified terms© 2013 The McGraw-Hill Companies, Inc.Debt Restructuring – Appendix B Settled at time of restructuring Book value of the debt– Fair value of asset transferred Gain on restructuringDebtor reports gain or loss onadjustment to fair value of the asset transferred.© 2013 The McGraw-Hill Companies, Inc.Debt Restructuring – Appendix BTerms substantially modifiedDifference between the present value of the remaining cash flows discounted at the original effective interest and the carrying amount of the existing debt is at least 10% of the carrying amount of the existing debt.Terms not substantially modifiedDifference between the present value of the remaining cash flows discounted at the original effective interest and the carrying amount of the existing debt is less than10% of the carrying amount of the existing debt. Continued with modified terms© 2013 The McGraw-Hill Companies, Inc.Debt Restructuring – Appendix BTerms substantially modifiedRemove the carrying amount of the original debt Recognize the restructured debt as if it is a new debtRecognize the difference between the carrying amount and the fair value of the new loan as gain or lossApply the new effective interest rateTerms not substantially modifiedRestructured debt will be deemed as a continuation of the original debt.Determine the new fair value of the existing loan by discounting adjusted cash flows at the original effective interest and recognize a one-time gain/loss if requiredApply the original effective interest rate Continued with modified terms© 2013 The McGraw-Hill Companies, Inc.End of Chapter 14© 2013 The McGraw-Hill Companies, Inc.