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Chapter 14

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Administrative Studies
ADMS 3595
Shaweta Roopra

ADMS 3595 Chapter 14 (Week 2) UNDERSTANDING DEBT INSTRUMENTS  Long term debt consists of obligations that are not payable within a year or the operating cycle, and will require sacrifices of economic benefits in the future  Include bonds payable, long term notes payable, mortgages payable, pension liabilities, and lease liabilities  Liability contracts may include restrictive covenants that are meant to limit activities and protect both lenders and borrowers Bonds and Notes Payable  The main purpose of a bond is to borrow for the long term when the amount of capital that is needed is too large for one lender to supply  Bond is created by a contract known as the bond indenture, and represents a promise to pay a sum of money at a designated maturity date, and periodic interest at a specified rate on the maturity amount o The bond interest payments are made semi-annually Registered and Bearer (coupon) bonds  Registered bonds are Issued in the owner's name, and in order to sell a registered bond, the current certificate is surrendered and a new one issued  The bearer bond is not recorded in the owner's name and may be transferred from one owner to the other Secured and Unsecured debt  Secured is backed by a pledge of collateral  Unsecured debt are not backed by collateral  Junk bonds are unsecured and are very risky, therefore they pay a high interest rate Term, Serial, and Perpetual Bonds/Notes  Term bonds mature on a single date  Bonds that mature in instalments are called serial bonds/notes  Perpetual bonds/notes have unusually long terms Income, revenue and deep discount bonds  Income bonds pay no interest unless the issuing company is profitable  Revenue bonds pay interest from a specified revenue source  Deep discount bonds have very little or no interest, and are therefore sold at a large discount Commodity-backed bonds  Redeemable in amounts of commodity, such as barrels of oil, tonnes of coal, or ounces of rare metal Callable, convertible bonds and notes and debt with various settlement and other options  Callable bonds/notes give the issuer the right to call and retire the debt before maturity  Convertible debt allows the holder/issuer to convert the debt into other securities such as shares Credit Ratings  Issued by independent credit rating agencies  Reflects a current assessment of the company's ability to pay the amount that will be due on that specific borrowing Defeasance  When a company sets aside an amount of money in a trust, in order for the investment and any return to be enough to pay the principal and interest directly to the creditor once the note is due Types of Companies that have significant debt financing  Financing is generally obtained through 3 sources: o Borrowing o Issuing equity (shares) o Using internally generated funds  Borrowed funds must be repaid, and increase liquidity and solvency risk o Can increase funds (known as leverage), by investing the borrowed money at a higher return that then interest to be paid  Issuing shares does not effect liquidity/solvency as share capital need not be repaid and dividends are not mandatory o May result in dilution of ownership MEASUREMENT  When issued, bonds and notes are valued at the PV of their future interest and principal cash flows Bonds and Notes issued at par  No interest has accrued and there is no premium/discount  Assume that a company plans to issue a 10-year term bonds with a par value of $800,000, dated January 1, 2014 and bearing interest at an annual rate of 10% payable semi-annually on January 1 and July 1. If it decides to issue them on January 1 at par, the entry on its books would be: Cash 800,000 Bonds Payable 800,000  The entry to record the first semi-annual interest payment of $40,000 ($800,000 * 0.1 * 6/12) on July 1, 2014 would be: Interest Expense 40,000 Cash 40,000  The entry to record accrued interest expense at December 31, 2014 would be: Interest Expense 40,000 Interest Payable 40,000 Discounts and Premiums  If the bonds sell for less than their face value, they are being sold at a discount, and this is where the coupon rate is lower than the market rate  If the bonds sell for more than their face value, they are being sold at a premium, which is where the coupon rate is higher than the market rate Straight-Line Method  May be used under GAAP and IFRS  If the $800,000 of bonds were issued on January 1, 2014 at 97, the issuance would be recorded as follows: Cash 776,000 Bonds Payable 776,000 $800,000 * 0.97  The discount is amortized and charged to interest expense over the period of time that the bonds are outstanding Using the discount above of $24,000, the amount amortized to interest expense each year for 10  years is $2,400 ($24,000/10) and, if amortization is recorded annually, it is recorded as follows: Interest Expense 2,400 Bonds Payable 2,400  At the end of the first year 2014, as a result of the amortization entry above, the unamortized balance of the discount is $21,600 ($24,000-$2,400)  If the bonds were dated and sold on October 1, 2014, and if the corporation's fiscal year ended on December 31, the discount amortized during 2014 would be 3/12 of $24,000 or $600  If the $800,000 of par value, 10 year bonds are dated and sold January 1, 2014, at 103, the following entry is made to record the issuance: Cash 824,000 Bonds Payable 824,000 $800,000 * 1.03  At the end of each year that the bonds are outstanding, the entry to amortize the premium on a straight line basis is: Bonds Payable 2,400 Interest Expense 2,400  When bonds are issued between interest payment dates, bond buyers will pay the seller the interest that has accrued from the last interest payment date to the date of issue  Assume that $800,000 of par value-10 year bonds, dated January 1, 2014, and bearing interest at an annual rate of 10% paid semi-annually on January 1, and July 1, are issued on March 1, 2014, at par plus accrued interest. The entry on the books of the issuing corporation is: Cash 813,333 Bonds Payable 800,000 Interest Payable/Expense 13,3333*  *$800,000 * 10% * 2/12  If the 10% bonds were issued at 102, the entry on March 1 on the issuing corporation's books would be: Cash [($800,000*1.02)+($800,000*10%*2/12)] 829,333 Bonds Payable 816,000 Interest Expense 13,333 Effective Interest Method  Must be used under IFRS, and is allowed under ASPE  The steps are as follows: 1. Interest expense is calculated first by multiplying the carrying value of the bonds/notes at the beginning of the period by the effective interest rate 2. The discount or premium amortized is determined by comparing the interest expense that should have been paid (using the market rate) with the interest that was actually paid (using the coupon/stated rate) Bonds issues at a discount  Assume that Master Corp issued $100,000 of 8% term bonds on January 1, 2014 that are due on January 1, 2019, with interest payable each July 1 and January 1. Because investors require and effective interest rate of 10%, they paid $92,278 for the $100,000 of bonds, creating a $7,722 discount. The discount is calculated as follows: FV=-$100,000 N=10 6 month periods PMT=$100,000*8%/2=$4,000 every 6 month period I/Y=10% market rate/2=5% market rate every 6 month period CPT PV=$92,278 The 5 year amortization schedule is shown   The entry to record the issuance of Master Corp's bonds at a discount on January 1, 2014 is: Cash 92,278 Bonds Payable 92,278  The journal entry to record the first interest payment on July 1, 2014 and amortization of the discount is: Interest Expense 4,614 Bonds Payable 614 Cash 4,000  The journal entry to record the interest expense accrued at December 31, 2014 and amortization of the discount is: Interest Expense 4,645 Bonds Payable 645 Interest Payable 4,000 Bonds issued at premium  If instead the market rate is 6% and the coupon rate is 10%, investors would have paid $108,530 or a premium of $8,530, calculated as follows: FV=$100,000 PMT= $100,000*8%*6/12=-$4,000 N=5 years * 2 = 10 6 month periods I/Y=6% annual market rate / 2=3% semi-annual market rate CPT PV= $108,530 The 5-year amortization schedule is shown  The entry to record the issuance of the Master Corp. bonds at a premium on January 1, 2014 is: Cash 108,530 Bonds Payable 108,530  The journal entry to record the first interest payment on July 1, 2014 and amortization of the premium is: Interest Expense 3,256 Bonds Payable 744 Cash 4,000 Accruing Interest  If Master Corp. wishes to report financial statements at the end of February 2014, the premium is prorated by the appropriate number of months to arrive at the proper interest expense Interest Accrual ($4,000 * 2/6) $1,333.33 Premium Amortized ($744 * 2/6) ($248.00) Interest Expense (Jan. to Feb.)($3,256 * 2/6) $1,085.33  The journal entry to record this accrual is: Bonds Payable 248 Interest Expense 1,085 Interest Payable 1,333  If the company prepares financial statements six months later, the same procedure is followed to amortize the premium Premium amortized (Mar.-June) ($744*4/6) $496 Premium amortized (Jun-Aug.) ($766*2/6) 255.33 Premium amortized (Mar.-Aug.) $751.33 Special Situations Non-Market Rates of Interest-Marketable Securities  If a zero-interest-bearing marketable security is issued for cash only, its fair value is the cash received by the issuer  The implicit/imputed interest rate is the rate that makes the cash that is received now (PV)=to the PV of the amounts that will be received
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