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MGMT 351 Ch. 12 Book Notes

by: Emily McIlhattan

MGMT 351 Ch. 12 Book Notes MGMT 351

Marketplace > Purdue University > Accounting > MGMT 351 > MGMT 351 Ch 12 Book Notes
Emily McIlhattan
GPA 3.72
Intermediate Accounting II
Byong Ro

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This is a summary and key words with concepts for Ch. 12. This Chapter coincides with the first few weeks of class- liabilities and bonds.
Intermediate Accounting II
Byong Ro
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This 9 page Reader was uploaded by Emily McIlhattan on Thursday January 22, 2015. The Reader belongs to MGMT 351 at Purdue University taught by Byong Ro in Winter2015. Since its upload, it has received 312 views. For similar materials see Intermediate Accounting II in Accounting at Purdue University.

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Date Created: 01/22/15
MGMT 351 Chapter 12 Debt Financing I Classi cation and Measurement Issues Associated with Debt a De nition of Liabilities i As quotprobable future sacri ces of economic bene ts arising from present obligations of particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events 1 Not recognized until incurred 2 Liability when occurrence of the future event seems probable ii Nontrading only stated rate of interest b Classi cation arises in the course of an entity s normal operating cycle it is considered current if current assets will be used to satisfy the obligation within one year or one operating cycle whichever period is longer i Current ratio dividing total current assets by total current liabilities measure of an entity s ability to meet current obligations frequently lt 1 c The fair value measurement used for liabilities is typically the present value of the future cash out ows to settle the obligation this amount of cash required to pay someone else to accept responsibility for obligation today i Current Liabilities generally due between 3060 days normally not discounted trade AP are not reported at there PV even though they carry no interest provision 1 Liabilities that are de nite in amount 2 Estimated Liabilities 3 Contingent Liabilities pending lawsuit a Always involves uncertainty bc it s the measurement of future out ow of resources b 1 and 2 are reported on the balance sheet ll Accounting for Shortterm Deb Obligations a ShortTerm Operating Liabilities i AP refers to the amount due for the purchase of materials by a manufacturing company or merchandise by a wholesaler or retailer b Short Term Debt i Notes Payable notes issued to trade creditors for the purchase of goods or services are trade NP nontrade notes issued to banks or of cers for loans to the company and those issued to others for the purchase of noncurrent operating assets 1 Reported at its PV normally the Face Value bears a reasonable stated interest rate c ShortTerm Intending to be re nanced i Must be realistic not just a possibility ii Management must intend to re nance iii Management must demonstrate an ability to re nance 1 Actually re nancing 2 Reaching a rm agreement that clearly provides for re nancing on a longterm basis d Lines of Credit i Negotiated arrangement with a lender in which the terms are agreed to prior to the need for borrowing an established line of credit allows the company access to funds immediately without having to go through the credit approval process 1 Not itself a liability once it is used to borrow money then it will become one lll Present Value of Longterm Debt a Sum of the future cash payments to be made on a longterm debt is not a good measure of actual economic obligation i Mortgage loan backed by an asset that serves as collateral for the loan if the borrower can t repay the loan the lender has the legal right to claim the mortgaged asset and sell it payable in equal installments 1 Reported in the balance sheet at its PV which approximates the cash amount that would fully satisfy the obligation today ii Secured Loan similar to a mortgage in that it is a loan backed by certain assets more common among rms experiencing nancial dif culties reduces the risk to the lender and therefore reduces the interest cost for the borrower IV Financing with Bonds a Why i Present owners remain in control of the corporation ii Interest is deductible expense in arriving at taxable income dividends are not iii Current market rates of interest may be favorable relative to stock market prices iv The charge against earnings for interest may be less than the amount of dividends that might be expected by shareholders b Only possible when the company is in a satisfactory nancial condition and can offer adequate security to creditors c Accounting for Bonds i Trust indenture bond contract associated with bonds provides more extensive detail iL Congder 1 Recording the issuance or purchase 2 Recognizing the applicable interest during the life of the bonds 3 Accounting for the retirement of bonds either at maturity or prior to the maturity date d Nature of Bonds 1 2 Bond Certi cates orjust bonds are typically issued at parface value 1000 Bond indenture group contract between the corporation and the bondholders details the rights and obligations of the contracting parties indicates the property pledged as well as the protection offered on the loan and names the bank or trust company that is to represent the bondholders ii Issuers of Bonds 1 Municipal Debt debt securities issued by state county and local governments and their agencies interest received by investors from such securities is exempt from the federal income tax generally carry lower interest rates iii Types of Bonds 1 2 3 4 Term mature at single date Serial mature in installments Secured protection to investors by providing security claim to an asset Collateral trust bond secured by stocks and bonds of other corporations owned by the issuing company generally transferred to a trustee who holds them Unsecured no protected by pledge of asset debentures 6 Registered the registry of the owner s name on the corporations books 7 BearerCoupon not recorded in the name of the owner title to these bonds passes with delivery each bond is accompanied by coupons for individual interest payments covering the life of the issue 8 DeepdiscountZerointerest do not bear interest total interest is paid off at maturity 9 Junk Bonds highrisk highyield bonds issued by companies that are heavily in debt Ba2BB lower in rank 10 Convertible bonds provide for their conversion into some other type of security at the option of the bondholder 11 Commoditybacked bonds redeemable in terms of commodities such as oil or precious metals 12 Callable bonds give the issuing company the righto call and retire the bonds prior to their maturity e Market Price of Bonds i Varies with the safety of the investment and the current market interest rate for similar securities 1 Stated ratecontract speci ed percentage of face value of a bond that is paid on interest 2 Bond premium stated rate is greater than market rate 3 Bond discount stated rate is less than market rate a These are the amounts needed to adjust the stated rate of interest to the actual market rate of interest or yield for that particular bond 4 Market rateyield actual rate of return f Issuance of Bonds 1 When bonds are issued sold the issuer must record the receipt of cash and recognize the longterm liability normally records the bond obligation at its Face Value a If issued at other amount you adjust premium discount ii Bonds issued at Par on lnterest Date 1 There is not premium or discount to be recognized nor any accrued interest at the date of issuance iii Bonds issued at discountpremium on interest date 1 You include the difference Bn FV and disc Or prem iv Bonds issued at par between interest dates 1 An adjustment is made for the interest accrued between the last interest payment date and the date of the transaction v Bond Issuance Costs 1 FASB stated quotdeferred chargesquot such as bond issuance costs fail to meet the de nition of assets they say that all issuance costs for both debt and equity nancing should be expensed as incurred g Accounting for Bond Interest i Amortization periodic adjustment that results in a gradual adjustment of the bond s carrying value toward the bond s face value 1 The bonds carrying value is adjusted to equal its maturity value 2 Periodic interest expense is adjusted to re ect the fact that the effective interest rate on the bonds is either higher discount or lower premium than the actual amount of the cash paid each period V Cash Flow Effects of Amortizing Bond Premiums and Discounts a Does not involve the receipt or payment of cash and like other noncash items it must be considered in preparing a statement of cash ows i When bond discount is amortized interest expense reported on the income statement is higher than interest paid and net income on a cash basis is understated 1 Appropriate Adj add the amount of the discount back to Nl reverse is true in the case of a bond premium the amount of the bond premium amortization is subtracted from NI to arrive at cash ow from operations Vl Retirement of Bonds at Maturity a When bond discount or premium and issuance costs have been properly amortized over the life of the bonds bond retirement at maturity simply calls for elimination of the liability or the investment by a cash transaction i No recognition of any gain or loss on retirement because the carrying value is equal to the maturity value which is also equal to the market value of the bonds at the point in time Vll Extinguishment of Debt Prior to Maturity a A gain or loss must be recognized for the difference between the carrying value of the debt security and the amount paid to satisfy the obligation i Bonds may be redeemed by the issuer by purchasing the bonds on the open market or by exercising the call provision that is frequently included in bond indentures ii Bonds may be converted that is exchanged for other securities iii Bonds may be re nanced refunded by using the proceeds from the sale of a new bond issue to retire outstanding bonds b Redemption by Purchase of Bonds in the Market i When bonds are purchased amortization of bond premium or discount and issue costs should be brought up to date purchase by the issuer calls for the cancellation of the bonds face value together with any related premium discount or issue costs as of the purchase date c Redemption by Exercise of Call Provision i A call provision gives the issuer the option of retiring bonds prior to maturity frequently the call must be made on an interest payment date and no further interest accrues on the bonds not presented at the time 1 The inclusion of a call provision in a bond agreement is a feature favoring the issuer 2 The company is protected in the vent of a fall in the market interest rate by being able to retire the old issue from proceeds of a new issue paying a lower rate of interest a bond contract normally requires payment of a premium if bonds are called 3 Difference between the amount paid and the bond carrying value is reported as a gain or loss on both the issuer s and investor s books ii Convertible Bonds 1 Raise speci c questions as to the nature of the securities that is whether they should be considered debt or equity securities the valuation of the conversion feature and the treatment of any gain or loss on conversion a An interest rate lower than the issuer could establish for nonconvertible debt b An initial conversion price higher than the market value of the common stock at time of issuance c A call option retained by the issuer 2 Accounting for Convertible Debt Issuance When the Conversion Feature ls Nondeductible a an FASB when convertible debt is sold at a price or with a value at issuance not signi cantly in excess of the face value no portion of the proceeds from the issuance should be accounted for as attributable to the conversion feature i le no separation usually made between debt and equity when the conversion feature of the debt is not detachable or separately tradable from the debt instrument itself This is true even when separate values are determinable Combination of bonds and stock warrants is economically equivalent to convertible debt secur y Accounting for Conversion Whether the issuer of the convertible nonds use the fair value of the securities to cmpare a gain or loss on the date of the conversion depends on the nature of the conversion feature as the issuance date of the convertible bonds i If quotat least reasonablequot then no recognition ii If it is reasonable the fair value of the common stock into which the bond can be converted is lower than the fair value of the convertible bond itself on the issuance date it is a signi cant event and can be recognized General rule an asset received in a nonmonetary exchange is to be recorded on the books at its fair value on the exchange date and any gain or loss arising form a difference between this fair value and the V carrying value of the exchanged asset is to be recognized f An exception when the exchange lacks quotcommercial substancequot meaning that the cash ow expected to come from the newly received asset have the same risk timing and amount as the cash ows that had been expected from the exchanged asset 3 Bond Re nancing cash for retirement of a bond is raised refunding iii Reporting some EquityRelated Items as Liabilities 1 Mandatorily redeemable preferred shares 2 Financial instruments that obligate a company to repurchase its own shares 3 Financial instruments that obligate a company to issue a certain dollar value of its own shares Fair Value Options companies have the option to report balance sheet items at their fair value Expanded Material Accounting for Troubled Debt Restructuring a lnterest payments principal payments on installment obligations periodic payments to bond retirement funds or even payments to retire debt at maturity to avoid bankruptcy proceedings investors may agree to make concessions and revise original terms of the debt i Suspension of interest payments reduction in interest rate extension of the maturity date or exchange of assets FASB def quotA situation in which the creditor for economic or legal reasons realted to the debtor s nancial difficulties grants a concession to the debtor that it would not otherwise consider that concession ether stems from an agreement between the creditor and the debtor or is imposed by law or a courtquot i If considered to be signi cant economic transaction entries should be made to report gain or loss ll Asset Swap a Debtor transfers assets real estate inventories receivables or investments to a creditor to fully settle a payable recognize i A gain or loss on disposal of the asset ii A gain arising form the concession granted in the restructuring of the debt 1 Carrying value of assets transferred mc gain or loss on disposal 2 Mv of assets transferred carrying value of deb liquidated gain on restructuring iii Investor always recognizes a loss on the restructuring due to the concession granted unless the investment has already been written off 1 Carrying value of investment liquidated mv of asset being transferred lll Equity Swap a Debtor always recognizes a gain FV of equity interest carrying value of the liquidated liability they grant the equity interest b Creditor investor must recognize a loss FV of equity interest and carrying value of the debt as an investment IV Modi cation of Debt Terms a Can involve either i Interest reduction of interest rate forgiveness of unpaid interest or moratorium on interest payment for a period of time ii Maturity Value extension reduction in amount to be repaid b FASB only Substantially restructuring total payments to be made under the new structure including all future interest payments are less than the carrying value of the debt at the time of restructuring c When Total Future cash ows are less than the amount that is owed implicit interest rate is negative in order to raise the rate to zero the carrying value must be reduced to the cash to be realized and a gain recognized for the difference


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