CPA FAR CHAPTER 12
Reporting
The face amount of bond spay able is reported net of unamortized discount or premium in the balance sheet.
Detachable Warrants
When debt is issued with detachable warrants, the proceeds must be allocated b/w the underlying debt and warrants pro rata based on their relative fair values at the time of issuance. To allocate the proceeds pro rata to the debt: Cash proceeds received x (FV of debt/FV of debt + warrants) To record the issuance of the debt: Debit: Cash (calculated in previous equation) Debit: Discount on bonds payable Credit: Bonds payable To allocate the proceeds pro rata to the warrants: Cash proceeds received x (FV of warrants/ FV of debt + warrants) To record the issuance of the warrants: Debit: Cash (calculated in previous equation) Credit: Paid-in capital -- warrants
Modification of terms when future cash flows exceed the carrying amount
3 changes in there terms of the loan are common 1. a reduction in the principal 2. an extension of the maturity date 3. a lowering of the interest rate The debtor will recognize a gain if the total of the cash flows associated with the modified terms in less than the carrying amount of the troubled debt. The recording of this event does not consider the time value of money. When a TDR involves a modification of terms and the undiscounted total future cash flows (UCF) that the debtor has committed to pay are greater than the carrying amount of the debt, the debtor recognizes no gain. The creditor must recognize the impairment of a loan when it is probable that the debtor will not be able to pay all the amounts (principal and interest) due in accordance with the original terms of the loan. The total impairment recognized is based on the recorded investment in the loan, not the carrying amount. I this situation, the current impairment loss is the difference betws a) the discounted expected cash flows (DCF) reflecting an effective rate based on the original contractual rate and b) the carrying amount of the receivable. Because the creditor uses the time value of money in this calculation, its impairment loss does not equal the debtor's gain (the debtor can have no gain). An alternative measure of impairment is the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. If foreclosure is probable, impairment is based on the fair value of the collateral.
Bond sinking fund
A bond indenture may require a bond sinking fund (long-term investment) for payments. Payments into the fund plus the revenue earned on its investments provide the assets to settle bond liabilities.
Classification of Bonds
A bond is a formal contract to pay an amount of money (face amount) at the maturity date plus interest at the stated rate at specific intervals. All terms of the agreement are stated in an indenture
IFRS Difference
A compound financial instrument (e.g. bonds convertible into stock) has liability and equity components. The issuer allocates to the liability component its fair value. The equity component is allocated the residual amount of the initial carrying amount of the instrument.
Derecognition
A debtor derecognizes a liability only if it has been extinguished. Extinguishment results only if the debtor: 1. Pays the creditor and is relieved of its relieved of its obligation with respect to the liability or 2. Is legally released from being the primary obligor, either judicially or by the creditor.
Costs associated wit exit or disposal activities
A liability for exit or disposal costs is ordinarily recognized and measured at fair value when the liability is incurred. The liability is incurred when a present obligation to others exist: a) a present obligation exists when the entity has little discretion to avoid a future transfer of assets in settlement b) the commitment to an exist or disposal plan does not, by itself, create the required present obligation. An exit activity includes an activity involving any entity recently acquired through a business combination. Among the activities included in definition are restructurings, which are programs planned and controlled by management that materially alter either the scope of the business or how it is conducted. Exit on disposal costs include such typical items as facilities consolidation and employee relocation costs. Also include: 1. Certain one-time termination benefits and 2. Contract termination costs other than those for a capital lease Changes in the liability are recorded using the CARF rate on which the initial measurement was based.
Securities with characteristics of liabilities and equity - classification
A liability results from a current oblation to transfer assets or provide services. Equity is the residual interest in the assets of an entity after subtraction of liabilities. Common stock or preferred stock that is not redeemable is treated as equity. Each confers a residual interest in entity assets, and no obligation exists to pay dividends or redeem the stock. Bonds are treated as liabilities They represent an obligation to make interest and principal payments with no residual interest in entity assets.
Accounting subsequent to initial recognition
After initial recognition, the ARC should be depreciated over the asset's useful life. The liability recognized must be adjusted periodically for 1) the passage of time (accretion expense) and 2) revisions in the original estimate. At the end of the asset's useful life, the actual costs incurred to settle the liability may differ from the carrying amount of the liability on that date. The difference between the amount paid and the carrying amount of the liability for an ARO is recognized as a gain or loss on settlement of the ARO.
Initial recognition and measurement
An entity must recognize the fair value of a liability for an ARO. Upon initial recognition of such a liability, an entity must capitalized an asset retirement cost (ARC) by increasing the carrying amount of the related asset by the same amount as the liability recognized. JE: Debit: Asset Credit: Liability for asset retirement obligation If an item of PPE with an existing ARO is acquired, the entity credits a liability for that obligation and debits the carrying amount of the item for the same amount (the ARC) at the acquisition date. The effect is the same as if that obligation were incurred on that date. The fair value of the liability is initially measured by using an expected present value technique. The liability recognized equals the present value of the future cash flows expected to be paid to settle the obligation discounted at the credit-adjusted risk-free rate.
Ability to refinance current obligations
An obligation may be reclassified from current liabilities to concurrent when an entity 1) intends to refinance it on a concurrent basis 2) demonstrates an ability to consummate the refinancing Ability to consummate the refinancing may be demonstrated by a post-balance-sheet-date issuance of a concurrent obligation or equity securities prior to the issuance of the balance sheet. Ability to consummate may also be demonstrated by a financing agreement prior to the issuance of the balance sheet that meets the following criteria: a. The agreement does not expire w/in the longer of 1 year or the operating cycle b. It is non cancelable by the lender c. No violation of the agreement exists at the balance sheet date d. The lender is financially capable of honoring the agreement.
One-time termination benefits
Are paid under a one-time benefit arrangement based on a plan of termination for a specified termination event or future period. The arrangement exists when the plan has been communicated to employees and certain other requirements are met. Timing of recognition and the fair value measurement of the liability depend on whether employees must provide services until terminated. If so, a second issue is whether employees will be retained beyond a minimum rent ion period which cannot exceed 60 days. No required service to termination or no retention beyond min. retention period: recognize on communication date; measure at fair value on the communication date Required service to termination and retention beyond min. retention period: recognize proportionately over the future service period; measure on communication date at fair value on termination date.
Bonds Payable - subsequent measurement
Bond discount/premium must be amortized using the effective interest method unless the results of another method are not materially different. Annual interest expense = carrying amount x effective interest rate. Cash paid for periodic interest also remains constant over the life of the bonds Cash interest paid = face amount x stated rate The difference b/w interest expense and cash interest paid is the discount or premium amortization. At the maturity date, the discount or premium is fully amortized, and the carrying amount of the bonds equal the face amount.
Classification of bonds by redemption provisions
Callable bonds - may be repurchased by the issuer before maturity Redeemable bonds - may be presented for payment by the creditor prior to the maturity date. Usually are redeemable only after a specified period. Convertible bonds - may be converted into equity securities of the issuer at the option of the holder (buyer) under specified conditions.
Carrying Amount
Carrying amount of convertible debt is affected by all related accounts. 1. Unamortized premium or discount, unamortized issue costs, and conversion costs all affect the carrying amount. 2. Consequently, these items are adjustments of additional paid-in capital when the book value method is used for conversion.
Asset retirement obligations
Certain long-lived tangible assets such as mines or nuclear power plants incur significant costs after the end of their productive lives. An asset retirement obligation (ARO) reflects a legal obligation arising from acquisition, construction, development, or normal operation of an asset. A legal obligation is one arising from an existing or enacted law, astute, ordinance, or contract.
Reporting
Costs covered by exit or disposal activities are included in income from continuing operations (before income taxes for a business entity). If these costs involve a discontinued operation, they are included in the results of discontinued operations.
Convertible debt
Debt that may be exchanged for common stock of the issuer. May be more attractive to issuers than nonconvertible debt because it is usually issued at a lower interest rate. Under GAAP, the debt and equity elements are treated as inseparable. The entire proceeds, typically cash, should be accounted for and reported asa liability until conversion. The issue price (fair value) is affected by the conversion feature. (debit: cash, credit: premium on bonds payable, credit: bonds payable).
Noncurrent notes payable
Essentially accounted for the same as the bonds. However: a. a note is payable to a single creditor while bonds are payable to many creditors b. Notes are usually of shorter duration than bonds c. A loan agreement may require the debtor to pay principal and interest at specified intervals. Any material premium or discount is amortized using the effective-interest method. a. Discount or premium, loan origination fees, etc. are amortized in accordance with the effective-interest method. b. Discount or premium is not an asset or liability separable from the related not. It is reported in the balance sheet as a direct subtraction from or addition to the face amount of the note. Noncurrent notes that are payable in installments are classified as current to the extent of any payments due in the coming year. Payments not due in the current year are classified as noncurrent.
Interest on bonds paid more often than annually
Ex. semiannual payments. Accounting is based on the number of periods in which interest is paid. Interest rates on bonds are provided on an annual basis.
Gains or Losses on extinguishment of debt
Gains or losses are recognized in earnings in the period of extinguishment. They are presumed to be ordinary. The gain or loss is measured by the difference b/w the reacquisition price (including any call premium and misc. costs of reacquisition) and the carrying amount of the debt (including any unamortized debt issue cost).
Issuance of bonds at a premium
If bonds' stated rate is > the current market rate, cash proceeds are > the face amount and bonds are sold at a premium. Premium on bonds = cash proceeds - bonds' face amount. Sometimes issue price is an exact percentage and said to be sold at ex. "101" or "102". This means they are issued at a price equal to 101% or 102% of the face amount.
Issuance of bonds at a discount
If the bonds' stated rate is less than the current market rate, the cash proceeds are less than the face amount, and the bonds are sold at a discount. Discount on bonds = Bonds' face amount - cash proceeds Sometimes issue price is an exact percentage of the face amount and said to be sold at ex. "97" or "98". This means they are issued at a price equal to 97% or 98% of the face amount.
Classification of bonds by repayment provision
Income bonds - pay interest contingent on the debtor's profitability. Revenue bonds - issued by governments and are payable from specific revenue sources. Participating bonds - share in excess earnings of the debtor
Debt issue costs
Issue costs are incurred to bring debt to market. Include: 1. Printing and engraving costs 2. Legal fees 3. Accountants' fees 4. Registration fees and 6. Promotion costs
Early Extinguishment of debt
Issuers sometimes retire debt before maturity to eliminate high-interest debt when rates are declining or to improve debt ratios. All early extinguishments are fundamentally alike and should be accounted for similarly. The carrying amount is the amount due at maturity adjusted for unamortized premium or discount and unamortized issue costs. The reacquisition price is the amount paid on extinguishment, including any call premium and misc. costs of reacquisition. An extinguishment may be done by exchanging new securities for the old (a refunding). The reacquisition price equals the total present value of the new securities.
Classification of bonds by nature of security
Mortgage bond - backed by specific assets usually real estate Debentures - backed on by the borrower's general credit Collateral trust bonds - backed by specific securities Guaranty bonds - guaranteed by a third party, the parent of the subsidiary that issued the bond.
Troubled debt restructuring (TDR)
Occurs when "the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider". TDR can consist of either a settlement of the debt in full or a continuation of the debt with a modification in terms.TDRs almost always involve a loss to the creditor and a gain to the debtor.
Classification of bonds by ownership
Registered bonds - issued in the name of the owner who receives interest payments directly. When the owner sells the bonds, the certificate must be surrendered and new certificate must be issued. Bearer bonds (coupon bonds) - bearer instruments. Whoever presents the interest coupons is entitled to payment.
Different Patterns of repayments
Some notes require one principal payment at the end of the note's term plus periodic interest payments during the note's rem (like a term bond). Other notes require equal periodic principal payments plus interest. Each periodic payment includes an equal amount of return of principal and an amount of interest accrued on the beginning carrying amount. A third type of notes requires equal periodic cash payments. Each payment includes a principal component and an interest component.
Classification of bonds by priority
Subordinated debentures and second mortgage bonds - junior securities with claims inferior to those of senior bonds.
Time value of money
TVM affect accounting for concurrent receivables and payables (bonds and notes), leases, and certain employee benefits. A quantity of money to be received or paid in the future is worth less than the same amount now. The difference is measured in terms of interest calculated using the appropriate discount rate. Interest is the payment received by an owner of money from the current consumer to forgo current consumption.
Classification of bonds by maturity plan
Term bond - has a single maturity date at the end of its term Serial bond - matures in stated amounts at regular intervals
FV of a Single Amount
The amount available at a specified time in the future based on a single investment (deposit) today. The FV is the amount to be computed if one knows the present value and the appropriate discount rate. = current payment times the future value of 1
Bonds payable - calculation of proceeds
The amount entities receive from investors on date of bond sale equals the sum of the present value of cash flows associated with the bonds discounted at the interest rate prevailing in the market at the time (called the market rate or effective rate). The cash flows with bonds are 1) Face amount (PV of a single amount) and 2) interest payments (present value of an annuity). Using the effective rate as the discount rat ensures that the bonds' yield to maturity is equal to the rate of return prevailing in the market at the time of sale. Results in cash proceeds equal to, less than, or greater than the face amount of bonds, depending on the relationship of the bonds' stated rate of interest to the market. If bonds' stated rate = market rate at time of sale, the PV will equal their face amount. This means they are sold "at par". This is rare.
Balance Sheet Classification
The amount excluded from current liabilities must not exceed the proceeds from the new obligation or equity securities issued. Sometimes a current liability is repaid after year end and refinanced by concurrent debt before the balance sheet is issued. Because retirement requires the use of current assets, the liability must be classified as current in the balance sheet. Noncurrent obligation that are callable by the creditor because of the debtor's violation of the debt agreement at the balance sheet date are classified as current liabilities. Notes to the financial statements should include a general description of the financing agreement and the terms of any new obligation incurred or securities issued.
Conversion of debt
The conversion of debt into common stock ordinarily is accounted for using the book-value method. Bonds payable are removed from the books at their carrying amount including unamortized premium or discount and common stock and additional paid-capital are credited . No gain/loss is recognized. Additional paid-in capital equals the carrying amount of bonds minus par value of stock. Debit: Bonds payable Debit: Unamortized premium or Credit: Unamortized discount Credit: Common stock Credit: Additional paid-in capital
Settlement in full with transfer of an equity interest
The creditor again recognizes a current loss equal to the difference b/w the fair value of the assets received and the carrying amount of the receivable. The debtor recognizes a gain only on the restructuring (excess of the carrying amount of the debt over the fair value of the equity given). The creditor's total loss equals the debtor's gain on restructuring.
Settlement in full with a transfer of assets
The creditor recognizes a loss equal to the difference between the fair value of the assets received and the carrying amount of the receivable. If the allowance method is used for recording bad debts, the loss is net of the previously recognized bad debt expense related to the debt. If the creditor receives long-lived assets to be sold in full satisfaction. The debtor recognizes a gain on restructuring when the carrying amount of the debt exceeds the fair value of the asset given. The debtor also recognizes a gain/loss on disposition of the asset equal to the difference b/w the fair value of the assets given and their carrying amount. The creditor's total loss (bad debt expense previously recognized + current loss) equals the debtor's gain on restructuring.
PV of a Single Amount
The value today of some future amount. = the future payment times the present value of 1
Induced Conversion
To reduce interest costs or total debt, an issuer of convertible debt may induce conversion. This is accomplished by offering cash, additional securities, changes in conversion privileges, or other consideration as an incentive. Additional consideration given is reported as an ordinary expense. The amount of expense recognized equals the fair value of all securities and other consideration transferred in excess of fair value of the securities would have been issued under the original conversion privilege. Debit: Bonds payable Debit: Debt conversion expense Credit: Common stock Credit: Additional paid-in capital Credit: Cash Treatment of gains or losses from early extinguishment of convertible debt is the same as for the retirement of ordinary debt.
Contract termination costs
Two types of costs other than those for a capital lease: 1. Costs to terminate prior to completion of the contract's term and 2. Contract costs that will continue to be incurred w/o economic benefit (continuing costs). If the contract is an operating lease, the fair value of the liability at the date use ends must be determined based on the remaining lease rentals. This amount is reduced by estimated sublease rentals that could be reasonably obtained even if the entity does not intend to sublease the propriety. The remaining lease rentals must not be reduced below zero.
Accounting treatment
Under GAAP, issue costs should be reported in the balance sheet as deferred charges and amortized over the life of the debt, not combined with premium or discount. Issue costs should be amortized using the interest method but SL method may be applied if the results are not materially different. JE at date of bond issue Debit: cash Debit/Credit: discount/ premium Debit: Unamortized debt issue costs Credit: Debt payable JE at date of amortization Debit: Debt issue expense Credit: Unamortized debt issue costs
Annuities
Usually a series of equal payments at equal intervals of time. Ordinary annuity (annuity in arrears) is a series of payments occurring at the end of of each period. Annuity due (annuity in advance) the payments are made (received) at the beginning of each period. PV of an ordinary annuity - the 1st payment is discounted. Uses the typical present value table. PV of an annuity due - the 1st payment is not discounted. Uses the factor for an ordinary annuity for one less period (n-1) and add 1.000 to it to include the initial payment which is not discounted. FV of ordinary annuity - interest is not earned for the 1st period. Uses the typical future value table. FV of annuity due - interest is earned on the 1st payment. Uses the same table but for one more period (n+1) minus 1.000.
Classification of bonds by valuation
Variable rate bonds - pay interest that is dependent on market conditions Zero-coupon or deep-discount bonds - non interest- bearing bonds. Sold at less than their face amount and an interest rate is imputed. Commodity-backed bonds - payable at prices related to a commodity such as gold.
Detachable vs. Nondetachable Warrants
Warrants allow a debt holder to obtain common shares. Unlike convertible debt, warrants require the debt holder to pay an additional amount to receive the shares. When warrants are nondetachable, their conversion feature is considered inseparable from the underlying debt and the entire proceeds are attributed to debt.
Modification of terms when future cash flows are less than the carrying amount
When a TDR involves a modification of terms and the UCF are less than the carrying amount of the debt, the debtor recognizes a gain. The creditor's impairment does not equal the debtor's gain. Costs of debt restructuring are expensed as incurred except by debtors issuing equity securities (restructuring expenses reduce paid-in capital from these securities).
Bonds sold b/w interest dates
When issued b/w interest payments, the buyer pays the issuer the amount of interest that has accrued since the last payment.
Nondetachable Warrants
When the fair value of the warrants but not the debt is known, paid-in capital from warrants should be credited for the fair value of the warrants. The remainder is credited to debt.
When warrants are exercised
debit: Cash Debit: Paid-in capital -- warrants Credit: Common stock Credit: Paid-in capital
