INTERMEDIATE FINANCIAL ACCOUNTING II

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Welcome to ACCT 352!

INTERMEDIATE FINANCIAL ACCOUNTING II

INTERMEDIATE FINANCIAL ACCOUNTING II


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FINANCINGPART I: OVERVIEWPART I: OVERVIEW

DEBT(Chapter 14)

EQUITY(CHAPTER 18)

Recording/ Retirement Conversion Warrants Reporting/Fair Value

REPORTINGBASIC/DILUTIVE EARNINGS PER SHARES

(CHAPTER 19)


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KEY POINTS:FINANCIAL REPORTING

Bigger picture Outside the box External impact Global impactExpand your knowledge:Read/listen/watch News

KNOWLEDGEKNOWLEDGE


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CURRENT ECONOMIC CONDITIONS

DISCUSSION:Current US economic conditions?Is US the most important economy in the world? E.g. crisis?

Why is it important?Impact on Corporations Globally

CURRENT US MARKETCURRENT US MARKET


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What is :CAPITAL MARKET?‘Who are the key players?‘‘Which market is bigger?

FINANCIAL REPORTING & ECONOMICS

FINANCIAL REPORTING & ECONOMICS


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New York Stock Exchange (NYSE) is the largest centralized bond market, representing mostly corporate bonds.

Why is it important for us to know the US/Global perspective of BOND/STOCK MARKET?

Source: Securities Industry & Financial Markets Association (SIFMA)

BOND MARKET!BOND MARKET!


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OPTIONS: ISSUE: PRO/CON

1.BOND MARKET

1.STOCK MARKET

LONG TERM FINANCINGCORPORATION’S PERSPECTIVE

LONG TERM FINANCINGCORPORATION’S PERSPECTIVE


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MAJOR DIFFERENCES:MAJOR DIFFERENCES:Debt Financing & Equity FinancingDebt Financing & Equity Financing

MAJOR DIFFERENCES:MAJOR DIFFERENCES:Debt Financing & Equity FinancingDebt Financing & Equity Financing


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Bond Certificates-

Bond borrowing agreement:Indenture or covenants

NATURE OF BONDSNATURE OF BONDSNATURE OF BONDSNATURE OF BONDS

Professor Vedd


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Bonds Bonds

Bond Selling PriceBond Selling Price

Bond CertificateBond Certificate

Interest PaymentsInterest Payments

Face Value Payment Face Value Payment at End of Bond Termat End of Bond Term

At Bond Issuance DateAt Bond Issuance Date

Company Company Issuing BondsIssuing Bonds


Subsequent PeriodsSubsequent Periods

Investor Investor Buying BondsBuying Bonds







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The Bond IndentureThe Bond Indenture

The specific promises made to bondholders are The specific promises made to bondholders are described in a document called a described in a document called a bond indenturebond indenture..

The specific promises made to bondholders are The specific promises made to bondholders are described in a document called a described in a document called a bond indenturebond indenture..

MortgageMortgage Bond secured Bond secured by lien on specific real by lien on specific real

estate owned by the estate owned by the issuer.issuer.

MortgageMortgage Bond secured Bond secured by lien on specific real by lien on specific real

estate owned by the estate owned by the issuer.issuer.

CallableCallable Bond allows Bond allows company to buy back company to buy back

outstanding bonds prior outstanding bonds prior to maturity.to maturity.

CallableCallable Bond allows Bond allows company to buy back company to buy back

outstanding bonds prior outstanding bonds prior to maturity.to maturity.

CouponCoupon Bond pays Bond pays interest when investor interest when investor

submits attached submits attached coupon.coupon.

CouponCoupon Bond pays Bond pays interest when investor interest when investor

submits attached submits attached coupon.coupon.

DebentureDebenture Bond Bondsecured by the secured by the ““full full faith and creditfaith and credit”” of of company.unsecuredcompany.unsecured

DebentureDebenture Bond Bondsecured by the secured by the ““full full faith and creditfaith and credit”” of of company.unsecuredcompany.unsecured


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Callable/Redeemable bonds:

Convertible bonds:

PROVISIONS: BONDSPROVISIONS: BONDSPROVISIONS: BONDSPROVISIONS: BONDS

Professor Vedd


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BONDS:Recording/Reporting/Issue of bondsInterest payment/accruals (during the termPresentation/disclosuresReporting Changes in Fair Value

RETIREMENT: Prior to Maturity

CONVERSION: Convert Bonds to StockSTOCK WARRANTS

ACCOUNTING FOR BONDSACCOUNTING FOR BONDS


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LONG TERM DEBTUS GAAP:

APB Opinion 21 (Issue costs) & APB Opinion 14 (convertible debt)SFAS No 159/157: The Fair Value Option FASB ASC Topic 470 / IAS 1

IFRS: IAS 32 & 39

US GAAP & IFRSUS GAAP & IFRSUS GAAP & IFRSUS GAAP & IFRS


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FACE VALUE:Nominal/principalPar value or maturity value.

MATURITY DATE

INTEREST RATE:Rate Printed on Bond: Stated/face/coupon/nominal rate

Determines cash interest payments

• Market Interest Rate (effective rate) (Yield)Rate in effect when bonds are issued

FEATURES OF BONDSFEATURES OF BONDSFEATURES OF BONDSFEATURES OF BONDS


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TWO WAYS:

1. NYSE/WSJ etc•Quoted: percentage of face amount

Bonds are quoted as a % of face valuee.g. 98

DETERMINE PRICE OF DETERMINE PRICE OF BONDSBONDS


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TWO WAYS:

2. PRESENT VALUE (PV)PV of the future cash flows:=

A. PV: interest: annuity PAYMENT (Stated Interest Rate) plusB. PV of the Face/Par Value

•Discounted at the market (yield) rate of interest in effect at issue date.

DETERMINE PRICE OF DETERMINE PRICE OF BONDSBONDS


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Bond Interest RatesBond Interest RatesBond Interest RatesBond Interest Rates

Bond Stated Rate = 9%

Market Rate = 9%

Bonds Sell AtPar (Face)

Market Rate = 8%

Bonds Sell ata Premium

Market Rate = 10%

Bonds Sell at a Discount


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Year 1Year 1 Year 2Year 2 Year 3Year 3 Year 4Year 4 Year 5Year 5

$$9,0009,000 $$9,0009,000 $$9,0009,000 $$9,0009,000 $$9,0009,000

Discount at market ratemarket rate, 11%$9,000 * 3.69590

Discount at market ratemarket rate, 11%$9,000 * 3.69590$ 33,263$ 33,263

$100,000$100,000Discount at market ratemarket rate, 11%$100,000 * 0.59345

Discount at market ratemarket rate, 11%$100,000 * 0.59345$ 59,345$ 59,345

plusplus

=$92,608 is the issue price=$92,608 is the issue price

Bond Valuation ILLUSTRATIONBond Valuation ILLUSTRATION


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In Class Illustration: Example AIn Class Illustration: Example A

On January 1, 2012, JJ Corporation issues $500,000 long-terms bonds with stated interest rate of 10%, due on January 1, 2017. Interest is paid semiannually on January 1 and July 1 each year. At the time of issuance, market interest rate is 12%. December 31 year-end

Step 1: Calculate the price of the bondStep 2: Record the issue of bonds Jan 1, 2012Step 3: Prepare schedule of interest expenseStep 4: Record entries for interest expense/payments for 2012Step 5: Presentation: statement December 31, 2012


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PV of interest payments PV: ordinary annuity (6%, 10 periods)

= ($500,000 x 5%) x 7.3601 $184,002

Present Value (PV of principal)

= $500,000 (6%, 10 periods)

= $500,000 x 0.5584 $279,200

BOND PRICE = $463,202

Cont. Example A: Cont. Example A: Calculating the Price of the BondCalculating the Price of the Bond

Cont. Example A: Cont. Example A: Calculating the Price of the BondCalculating the Price of the Bond


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Face Value: $500,000Sold: $463,202Issued $36,798 discount.

Date: January 1, 2012Dr. Cash 463,202Dr. Discount on Bonds Payable 36,798 Cr. Bonds payable 500,000

Record the issue of bondsRecord the issue of bonds


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Effective interest methodEffective interest methodAmortize premium/discountAmortize premium/discount


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Discount on bonds Payable 36,798 – (2,792+2,960) = 31,046

Reporting: Statement PresentationReporting: Statement Presentation

JJ CorporationJJ CorporationPartial Balance SheetPartial Balance SheetDecember 31, 2012December 31, 2012

Current LiabilitiesCurrent Liabilities::Interest PayableInterest Payable $25,000$25,000

LT LiabilitiesLT LiabilitiesBonds PayableBonds Payable $500,000$500,000Less: Discount on Bonds Payable Less: Discount on Bonds Payable (31,046) (31,046) $468,954$468,954


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Determining the Price:Determining the Price:

On January 1, 2011, 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.


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Determining the Price:Determining the Price:On January 1, 2011, 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.

Present ValuesInterest $ 42,000 × 4.76654 = 200,195$ Principal $700000 × 0.66634 = 466,438

Present value (price) of bonds 666,633$

Calculation of the Price of the BondsPresent Values

Interest $ 42,000 × 4.76654 = 200,195$ Principal $700000 × 0.66634 = 466,438

Present value (price) of bonds 666,633$

Calculation of the Price of the Bonds

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%


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Bond Amortization ScheduleBond Amortization Schedule

Effective Increase in OutstandingDate Cash Interest Balance Balance

1/1/11 666,633$ 6/30/11 42,000$ 46,664$ 4,664$ 671,297

12/31/11 42,000 46,991 4,991 676,288 6/30/12 42,000 47,340 5,340 681,628

12/31/12 42,000 47,714 5,714 687,342 6/30/13 42,000 48,114 6,114 693,456

12/31/13 42,000 48,544 * 6,544 700,000 252,000$ 285,367$ 33,367$

*Rounded.

Here is a bond amortization schedule showing the cash interest, effective interest, discount amortization, and the carrying value of the bonds.

$666,633 + $4,664 = $671,297$666,633 + $4,664 = $671,297


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LESSON 1: CHAPTER 14 PART IILESSON 1: CHAPTER 14 PART II

BONDS ISSUE COSTBONDS ISSUED INBETWEEN DATESRETIREMENT OF BONDSCONVERSION OF BONDS


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What is Bond issue Costs?

– According to FASB: (APB21)

•Debt issue costs are recorded separately as an asset.

•Amortized over the term to maturity using straight line method.

Bond Issue CostsBond Issue Costs


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U. S. GAAP vs. IFRSU. S. GAAP vs. IFRS

Debt issue costs (called transaction costs under IFRS) are accounted for differently by U.S. GAAP and IFRS.

• Debt issue costs are recorded separately as an asset.

• Amortized over the term to maturity.

• “Transaction costs” reduce the recorded amount of the debt.

• The cost of these services reduces the net cash the issuing company receives and the amount recorded for the debt.


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Bonds issued between interest days

Interest accrues from the date of the bonds

Buyer is required to pay accrued interest

Accrued interest is reported as interest payable (current liability)

Year-end Between interest dates

Bonds issued between interest days

Interest accrues from the date of the bonds

Buyer is required to pay accrued interest

Accrued interest is reported as interest payable (current liability)

Year-end Between interest dates

BONDS ISSUEDBONDS ISSUEDBETWEEN INTEREST DATESBETWEEN INTEREST DATES

BONDS ISSUEDBONDS ISSUEDBETWEEN INTEREST DATESBETWEEN INTEREST DATES


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Issued between interest date:Issued between interest date:April 30April 30thth issued $100,000 6% bonds on May 31 issued $100,000 6% bonds on May 31

April 30Bond Date

May 31Issue Date

Oct 31Interest PaymentDate

Investor pays face value + Accrued interest$100,000 + $500($100,000 x 6% x 1/12)

Corp. pays full 6 months’of interest of $3,000


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Bonds retired at Maturity or Early

Bonds may be “Called” (Reacquisition)

or “Redeemed” retired prior to maturity May be for all outstanding bonds, or a portion

*Refinancing or refunding: issuing new bonds and applying the proceeds to the retirement of outstanding bonds/debts before maturity

Retirement of Bonds: Extinguishment of DebtRetirement of Bonds: Extinguishment of Debt(Bonds Refinancing)*(Bonds Refinancing)*


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Early Extinguishment of DebtEarly Extinguishment of Debt(FASB 145)(FASB 145)

- Update the relevant accounts:- Update the relevant accounts: (premium/discount and any issue costs) (premium/discount and any issue costs)

- Carrying Value (book value)- Carrying Value (book value)

Debt retired before maturity may result in an Debt retired before maturity may result in an gain or loss on extinguishment.gain or loss on extinguishment.

Cash Proceeds – Book Value = Gain or LossCash Proceeds – Book Value = Gain or Loss

Debt retired before maturity may result in an Debt retired before maturity may result in an gain or loss on extinguishment.gain or loss on extinguishment.

Cash Proceeds – Book Value = Gain or LossCash Proceeds – Book Value = Gain or LossThe FASB requires that the gain or loss be classified in the Income

Statement as(OTHER gains/losses) unusual/infrequent

Debt retired at maturity results in NO gain/losses


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Sell the bonds at higher price (lower interest rate)

In-Direct way of selling stock Medium of exchange in business

combination ….

Convertible BondsConvertible BondsConvertible BondsConvertible Bonds


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exchanging bond -> common stock

Convertible BondsConvertible BondsConvertible BondsConvertible Bonds

(1)(1) updates interest expense andupdates interest expense and

(2)(2) amortization of discount or premium to amortization of discount or premium to the date of conversion. the date of conversion.

(3)(3) The bonds are reduced and shares of The bonds are reduced and shares of common stock are increasedcommon stock are increased..


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The conversion may be recorded under eitherBook value method (more common) or Market value method

Convertible bonds: Convertible bonds: Option of converting the bonds into common stock. Option of converting the bonds into common stock.

Convertible bonds: Convertible bonds: Option of converting the bonds into common stock. Option of converting the bonds into common stock.

Professor Vedd


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NO gain or loss is recognizedSTEPS:1. Update the accrued interest up to the conversion date,2. Amortize the bond discount or premium up to the

conversion date,3. Amortize the bond issue costs up to the conversion date,

and4. Record any difference as additional paid-in capital.(stocks are with par value)

CONVERSION OF BONDS:CONVERSION OF BONDS:BOOK VALUE METHODBOOK VALUE METHOD


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recognized gain or loss.: using Market Value Method

At conversion: –The difference between the market value of the stock –& the book value of the bonds

=gain or loss on CONVERSION.

CONVERSION OF BONDSCONVERSION OF BONDSMARKET VALUE METHODMARKET VALUE METHOD


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Attraction for Investor

Bonds are issued with an instrument -added value i.e. warrant

Stock warrants: Stock warrants: – option to purchase:option to purchase:– a specified number of COMMON shares a specified number of COMMON shares – specified option price per share specified option price per share – within a stated period.within a stated period.

Bonds with Detachable WarrantsBonds with Detachable WarrantsBonds with Detachable WarrantsBonds with Detachable Warrants


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Bonds issued in conjunction with stock warrants.

Bonds/warrants issued as elements of a single security

Investors can trade the stock warrants separately

Issuer is required to allocate the joint issuance price between the two instruments

STOCK WARRANTSSTOCK WARRANTS


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Not Required: but option to value (some or all) liabilities at Fair Value

If option is elected:– Increase/decrease in fair value is reported as a

unrealized loss/gain in the income statement

Reporting Debt at Fair ValueReporting Debt at Fair ValueSFAS No 159SFAS No 159


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To determine FV : present value of the remaining cash flows discounted at the current interest rate.

At December 31, 18 of the original 20 payments remain.

FAIR VALUE REPORTINGFAIR VALUE REPORTING(SFAS No 157(SFAS No 157))

Professor Vedd


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To determine FV : present value of the remaining cash flows discounted at the current interest rate.

REMAINING 18 PERIODSIf the current interest rate is 9% (4.5% semi-annually),

Present ValuesInterest $ 32,000¥ x 12.15999*=$389,120Principal $800,000 x 0.45280† = 362,240

Present value of the bonds $751,360¥ (8% / 2) x $800,000* Present value of an ordinary annuity of $1: n = 18, i = 4.5%. (Table 4)† Present value of $1: n = 18, i = 4.5%.

Calculating FVCalculating FVCalculating FVCalculating FV


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To increase the book value of $706,483 to Fair Value $751,360

entry:Unrealized holding loss 44,877

Fair value adjustment ($751,360 – $706,483) 44,877

Reporting FVReporting FVReporting FVReporting FV


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DECEMBER 31LONG TERM LIABILITIES:

BONDS PAYABLE $800,000LESS DISCOUNTS ON BONDS (93,517)CARRYING VALUE AT DEC. $706,483Fair value adjustment

($751,360 – $706,483) 44,877ADJUSTED CARRYING VALUE AT FV $751,360

BALANCE SHEET PRESENTATIONBALANCE SHEET PRESENTATIONBALANCE SHEET PRESENTATIONBALANCE SHEET PRESENTATION


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Debt financing Introduction Various financing Introduction: Bonds & various types of bonds

Accounting/recording: BONDS Bonds payable issued at discount/premium… Bonds Issued between interest dates Retirement/Redemption of bonds Convertible bonds Bonds refinancing Stock Warrants Fair Value Reporting

Debt Financing: Debt Financing: Chapter 14:SummaryChapter 14:Summary

Debt Financing: Debt Financing: Chapter 14:SummaryChapter 14:Summary

Professor Vedd

INTERMEDIATE FINANCIAL ACCOUNTING II

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