LECTURE 4

DEBT FINANCING
(Part 2)

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

 Lecture Outline
Part 1
 Brief discussions on debt financing
 Present value of money concept
 Accounting for debt (bonds)
1.Recording the issuance of bonds.
Part 2
1.Recognizing the applicable interest during the life of the
bonds.
2.Accounting for the retirement of bonds either at maturity or
prior to the maturity date.
 Disclosure

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

 Slide 3

Determining Interest – Effective Interest

Method
Interest accrues on an outstanding debt at a constant percentage
of the debt each period. Interest each period is recorded as the
effective market rate of interest multiplied by the outstanding
balance of the debt (during the interest period).

Interest is recorded as expense to the issuer and revenue to the

investor. For the first six-month interest period the amount is
calculated as follows:

666,633 × (14% ÷ 2) = $46,664

Outstanding Balance Effective Rate Effective Interest

The bond indenture calls for semiannual interest payments of

only $42,000 – the stated rate (6%) times the face value of
$700,000. The difference ($4,664) increases the liability and is
reflected as a reduction in the discount (a valuation account).
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 Slide 4

Journal Entries – The Interest Method

The effective interest is calculated each period as the market rate
times the amount of the debt outstanding during the interest period.

At the First Interest Date (June 30)

Masterwear - Issuer
Date Description Debit Credit
Jun. 30 Interest expense 46,664
Discount on bonds payable 4,664
Cash 42,000

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 Slide 5

Change in Debt When Effective Interest

Exceeds Cash Paid
Account Balances
Outstanding Bonds Payable Discount
Date Interest Balance (Face Value) on Bonds
Jan. 1 666,633 = 700,000 – 33.367
Accrued at 7%
Jun. 30
.07 × 666,633 = 46,664
Paid at 6%
Jun. 30
.06 × 700,000 = (42,000)
Unpaid
Jun. 30
46,664 – 42,000 = (4,664)
Jun. 30 671,297 = 700,000 – 28,703

The “unpaid” portion of the effective interest ($4,644)

increases the outstanding balance to $671,297 and
reduces the discount to $28,703 on June 30.

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 Slide 6

Amortization Schedule – Discount

Since less cash is paid each period than the effective interest, the
unpaid difference increases the outstanding balance of the debt.

Cash Effective Increase in Outstanding

Date Interest Interest Balance Balance
(6% × Face (7% × Outstanding (Discount
Amount) Balance) Reduction)
01/01/09 666,633
06/30/09 42,000 .07 × 666,633 = 46,664 4,664 671,297
12/31/09 42,000
06/30/10 42,000 7% × $666,633 $46,664 – 42,000
12/31/10 42,000
06/30/11 42,000
12/31/11 42,000
6% × $700,000 $666,633 + 4,664
252,000

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 Slide 7

Amortization Schedule – Discount

Cash Effective Increase in Outstanding
Date Interest Interest Balance Balance
(6% × Face (7% × Outstanding (Discount
Amount) Balance) Reduction)
01/01/09 666,633
06/30/09 42,000 .07 × 666,633 = 46,664 4,664 671,297
12/31/09 42,000 .07 × 671,633 = 46,991 4,991 676,288
06/30/10 42,000 .07 × 676,288 = 47,340 5,340 681,628
12/31/10 42,000 .07 × 681,628 = 47,714 5,714 687,342
06/30/11 42,000 .07 × 687,342 = 48,114 6,114 693,456
12/31/11 42,000 .07 × 693,456 = 48,544 6,544 700,000
252,000 285,367 33,367

$48,544 is rounded to cause outstanding

balance to be exactly $700,000 on 12/31/11.
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 Slide 8

When Financial Statements Are Prepared

Between Interest Dates
On 1/1/09, Masterwear Industries issues $700,000 face
value bonds to United Intergroup. The market interest
rate is 14%. The bonds have the following terms:
Face Value of Each Bond = $1,000
Maturity Date = 12/31/11 (3 years)
Stated Interest Rate = 12%
Interest Dates = 6/30 & 12/31
Bond Date = 1/1/09

Assume Masterwear has September 30th year-

ends.
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 Slide 9

When Financial Statements Are Prepared

Between Interest Dates
Recall the entries we prepared on June 30, 2009.
These entries will not change.

Masterwear - Issuer
Date Description Debit Credit
Jun. 30 Interest expense 46,664
Discount on bonds payable 4,664
Cash 42,000

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 Slide 10

When Financial Statements Are Prepared

Between Interest Dates
Year-end is on September 30, 2009, before the second
interest date of December 31, so we must accrue interest
for 3 months from June 30 to September 30.

Masterwear - Issuer
Date Description Debit Credit
Sep. 30 Interest expense ($46,991 × 1/2) 23,496
Discount on bonds payable 2,496
Interest payable ($42,000 × 1/2) 21,000

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 Slide 11

When Financial Statements Are Prepared

Between Interest Dates
On December 31, the next interest payment date,
the following entries would be recorded.
Masterwear - Issuer
Date Description Debit Credit
Dec. 31 Interest expense ($46,991 × 1/2) 23,496
Interest payable ($42,000 × 1/2) 21,000
Discount on bonds payable 2,496
Cash ($700,000 × 6% ) 42,000

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 Slide 12

The Straight-Line Method – A Practical

Expediency
Using the straight-line method, the discount in the earlier
illustration would be allocated equally to the 6 semiannual
periods (3 years):
$33,367 ÷ 6 periods = $5,561 per period

At Each of the Six Interest Dates

Masterwear Date Description Debit Credit
(Issuer) Jun.30 Interest expense (to balance) 47,561
Discount on bonds payable
(total discount ÷ 6 periods) 5,561
Cash (stated rate × face amount) 42,000

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 Slide 13

Debt Issue Costs

 Legal
 Accounting
 Underwriting
 Commission
 Engraving
 Printing
 Registration
 Promotion

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 Slide 14

Long-Term Notes
Present value techniques are used for
valuation and interest recognition.
The procedures are similar to those we
encountered with bonds.

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 Slide 15

Long-Term Notes
On January 1, 2009, Skill Graphics, Inc., a product labeling
and graphics firm, borrowed 700,000 cash from First BancCorp
and issued a 3-year, $700,000 promissory note. Interest of
$42,000 was payable semiannually on June 30 and December 31.

At Issuance
Skill Graphics (Borrower)
Date Description Debit Credit
Jan. 1 Cash 700,000
Notes payable 700,000

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 Slide 16

Long-Term Notes (continued)

At Each of the Six Interest Dates
Skill Graphics (Borrower)
Date Description Debit Credit
Interest expense 42,000
Cash 42,000

At Maturity
Skill Graphics (Borrower)
Date Description Debit Credit
Notes payable 700,000
Cash 700,000

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 Slide 17

Early Extinguishment of Debt

Debt retired at maturity results

in no gains or losses.

BUT
Debt retired before maturity may result in an
gain or loss on extinguishment.
Cash Proceeds – Book Value = Gain or Loss

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 Slide 18

Early Extinguishment
Illustration – On January 1, 2010, Masterwear Industries called
its $700,000, 12% bonds when their carrying amount was
$676,290. The indenture specified a call price of $685,000. The
bonds were issued previously at a price to yield 14%.

Date Description Debit Credit

Jan. 1 Bonds payable 700,000
Loss on early extinguishment 8,710
Discount on bonds payable 23,710
Cash 685,000

$685,000 – 676,290 ($700,000 – 676,290

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 Slide 19

Convertible Bonds
Some bonds may be converted into common
stock at the option of the holder. When bonds
are converted the issuer updates interest
expense and amortization of discount or
premium to the date of conversion. The
bonds are reduced and shares of common
stock are increased.

Bonds into Stock

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 Slide 20

Induced Conversion
Companies sometimes try to induce
conversion of their bonds into stock. One
way to induce conversion is through a
“call” provision. When the specified call
price is less than the conversion value of
the bonds (the market value of the
shares), calling the convertible bonds
provides bondholders with incentive to
convert. Bondholders will choose the
shares rather than the lower call price.
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 Slide 21

Bonds With Detachable Warrants

Stock warrants provide the option
to purchase a specified number of
shares of common stock at a
specified option price per share
within a stated period.
A portion of the selling price of the
bonds is allocated to the
detachable stock warrants.
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 Slide 22

Bonds With Detachable Warrants

Matrix issues at par 10,000, $1,000 face value, 8%
debt with detachable warrants that permit the
holder to purchase one share of stock for $18 per
share. Immediately after issue the bonds were
selling for 98 without the warrants and the warrants
have a market value of $16.

Proportional Method
Fair value of bonds without warrants $ 9,800,000 98.39%
Fair value of the warrants 160,000 1.61%
Aggregrate fair value $ 9,960,000 100.00%

Allocate to bonds $10,000,000 x 98.39% $ 9,839,000

Allocate to warrants $10,000,000 x 1.61% 161,000
Total face value $ 10,000,000

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 Slide 23

Tutorial questions
P14-6
P14-15
E14-17
E14-20

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