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Bond issues

1 Factors to consider

1 Face value of the debt

2 Actual money obtained

3 Length of time that money is borrowed

4 Market interest rate - Interest rate is yield to maturity

5 Coupon rate on the bond issue – coupons are intermediate payments

2 Result is a present value calculation

1 Par (face value) (coupon rate = interest rate)

2 Discounts (coupon rate < interest rate)

3 Premium (coupon rate > interest rate)

3 Bond payment structures

1 Single payment of borrowing plus accrued interest at maturity

1 Zero coupon bond

2 Interest accrued as expense each year

3 Large balloon payment at maturity

4 Reported book value follows PV formula

2 Regular interest payments and payment of borrowing at maturity

1 Typical corporate bond

2 Coupon payments until maturity

3 Principal repayment at maturity

4 Reported book value follows PV formula

3 Floating rate debt and payment of borrowing at maturity

1 Coupon payments until maturity

2 Coupon rate is reset to new market rate every period

3 Principal repayment at maturity

4 Book value of bond stays at par value

4 Installment repayments of borrowing at specific times

1 Interest payments each period

2 Principal repayments at regular times

Bonds issued at par (coupon rate = interest rate or c = r)

1 Issue

Cash Par

Bond payable Par

2 Interest expense (could be an adjusting entry)

Interest expense rPar (r = c)

Interest payable cPar

3 Interest payment

Interest payable cPar

Cash cPar

4 Year before maturity

Bond payable Par

Curr portion of B/P Par

5 Payment

Curr portion of B/P Par

Cash Par

Bonds issued at discount (coupon rate < interest rate or c < r))

1 Issue

Cash Par-Disc

Bond discount Disc

Bond payable Par

2 Interest expense (could be an adjusting entry)

Interest expense r(Par-Disc)

Bond discount r(Par-Disc)-cPar

Interest payable cPar

3 Amount of the discount changes every period

4 Interest payment

Interest payable cPar

Cash cPar

Bonds issued at premium (coupon rate > interest rate or c > r))

1 Issue

Cash Par+Prem

Bond premium Prem

Bond payable Par

2 Interest expense (could be an adjusting entry)

Interest expense r(Par+Prem)

Bond premium r(Par+Prem)-cPar

Interest payable cPar

3 Amount of the premium changes every period

4 Interest payment

Interest payable cPar

Cash cPar

Floating rate debt

1 Issue

Cash Par

Bond payable Par

2 Interest expense

Interest expense rPar

Interest payable rPar

3 Interest expense (at new rate r’)

Interest expense r’Par

Interest payable r’Par

Early Retirement (Extinguishment)

1 Could lead to a gain or loss

2 May be called if rates fall

3 May be bought at market price if rates rise

4 Considered an extraordinary item

Call at 105

Bond Payable 100

Loss 5+x

Cash 105

Disc x

Troubled debt restructuring- Impact on notes or debt payable

1 Borrower cannot make normal payments

2 Response

1 Interest and principal payments can be stretched out

2 Interest and principal payments can be reduced

3 Can be a settlement for cash, assets or equity

3 Settlement (borrower)

1 Entry

Note payable

Interest payable

Loss (ordinary)or Gain (extraordinary)

Asset

4 Modification of terms

1 Restructure the loan

2 Calculate undiscounted sum of future expected cash flows

3 Include already accrued interest payable

1 Calculate new present value using old interest rate

2 Put new payable on books

3 Compare undiscounted cash flows to original obligation

4 If undiscounted cash flows exceed original obligation

1 Entry

Note payable

Interest payable

Restructured note payable

5 If undiscounted cash flows less than original obligation

1 Entry

Note payable

Interest payable

Restructured note payable

Gain on restructuring (extraordinary)

Conversion of debt to equity

1 Considered an extraordinary item

Bond payable Book value

Common stock Market value

Gain on Extinguishment [Market value – book value]

Leases

1 Lessee (User of the asset in exchange for series of payments)

2 Lessor (Provider of the asset)

1 Through owning the asset used by lessee

2 Through financing asset owned by lessee

3 Financing is very specific (not like debt)

3 Leases types - lessee

1 Operating leases

2 Capital leases

3 Lessees and lessor both affected by type of lease used

It is a capital lease if:

1 Lease life is 75% or more of asset useful life (original lease only) or

2 PV of lease payments is 90% or more of market value or

3 Bargain purchase option or

4 Transfer of ownership

1 If any holds it is a purchase of the asset

2 If none hold it is a use of asset owned by someone else

Operating lease – Lessee

1 Treated like short-term usage of service (use of employee, electric)

2 Rent expense

1 Payments as required as interest

2 An operating expense unlike interest

3 Expense

Rent expense X

Lease liability X

4 Payment

Lease liability X

Cash X

Capital lease – Lessee

1 Treated like an acquisition of the asset

2 Treated like a debt issue with payments in accord with lease contract

1 Payments usually a mix of interest payments and reduction of lease obligation

2 Like installment borrowing

3 Capitalize asset as ownership with borrowing

Leased Asset X

Capital Lease Liability X

4 Improve the leased asset for use

Leasehold Improvements Z

Cash Z

5 Include current portion in CL

Leased Asset X

Long-Term Capital Lease Liability V

Current Portion X-V

6 Period expenses

1 Asset related amortization (depreciation) each period

Amortization Exp X/n

Accumulated Amort X/n

2 On any leasehold improvements

Amortization Exp Z/n

Accumulated Amort Z/n

3 Liability related interest each period

Interest Exp Y (use effective interst rate method)

Interest Payable Y

4 Payment

Interest Payable Y

Current Portion X-V

Cash Y+X-V

5 Aging (next portion becomes current)

Long-Term Capital Lease Liability W

Current Portion W

Comparison of operating & capital leases for the lessee

1 Over full period

1 Cost allocation issue

1 Total expense same

2 Total cash flow same

2 Income from operations higher for capital lease

3 CFO higher for capital lease

4 Interest expense higher for capital lease

5 Amortization (and depreciation) higher for capital lease

2 At beginning - expenses

1 Capital lease expenses more early, less later

2 Income from operations ? (depends on amortization)

3 Income from operations higher for capital lease (St-L)

4 Income lower for capital lease

5 Shareholders’ equity lower for capital lease

3 At beginning - balance sheet

1 Capital lease asset declines quicker than lease liability

2 Asset falls by straight line

3 Liability falls more slowly

4 More interest in early years as loan is largest

5 Asset – liability is negative

6 More debt

4 At beginning - cash flows

1 Payments are equal

2 More interest in early years as loan is largest

3 As loan is partially paid off

1 Less interest in payment

2 Increased payoffs of debt

4 Interest is an operating cash outflow

5 Debt repayment is a financing cash outflow

6 Capital lease allocates some cash outflow to financing

1 Shows higher operating cash

2 Shows lower financing cash

5 Reporting

1 Operating flows in notes (5 years + as of NOW)

2 Capital flows and PV of obligation in notes (5 years +)

3 Both full repayment and lease repayment due in current period

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