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6 Critical Financial Accounting Problems Exhibit 1.1 Teta Company: Schedule of Bond Discount Amortization, Effective Interest Method, Semi-Annual Interest Payments, 12% Bonds Sold to Yield 14% (a) $200,000 (face value) ⫻ 0.12 (stated rate) ⫻ 1⁄2 year (b) Previous book value ⫻ 0.14 (effective rate) ⫻ 1⁄2 year (c) (b) ⫺ (a) (d) Previous book value ⫹ (c) Carrying Value Bond Interest Paid ⫽ Face Value minus any unamortized discount plus any unamortized premium ⫽ Face Amount of Bonds ⫻ Stated Interest Rate The computation of the bond interest expense and discount amortization schedule is shown in Exhibit 1.1. It is used on June 30, 1996, to make the following entry: Bond Interest Expense Discount on Bonds Payable Cash $13,016.69 $1,016.69 $12,000.00 The following entry is made on December 31, 1996: Bond Interest Expense $13,087.86 Long-Term Liabilities Discount on Bonds Payable Cash 7 $1,087.86 $12,000.00 Effective Interest Method and Bonds Issued at a Premium To illustrate, assume that on January 1, 1996, the Smith Company issued $200,000 of five-year bonds paying semi-annual interest with a stated rate of 12% and an effective interest rate of 10%. The premium may be computed as follows: 1. Present Value of principal: $200,000 ⫻ 0.613913 ⫽ 2. Present Value of interest: $12,000 ⫻ 7.721735 ⫽ $122,782.60 $92,660.82 3. Selling Price $215,443.42 4. Face Value $200,000.00 5. Premium $15,443.42 The journal entry to record the issuance of the bonds follows: Cash Premium on Bonds Payable Bonds Payable $215,443.42 $15,442.42 $200,000.00 The computation of the bond interest expense and premium amortization schedule is shown in Exhibit 1.2. It is used on June 30, 1996, to make the following entry: Bond Interest Expense Premium on Bonds Payable Cash $10,772.17 $1,227.83 $12,000.00 Accruing Bond Interest When interest payment dates and the date of the financial statements issuance are not the same, there is a need for accounting for accrual of interest and a partial premium or discount amortization to be made at the end of the fiscal year. For example, let’s assume that the previous example of the Smith Company includes a need to report the financial statements by the end of March 1996. In that case the matching concept 8 Critical Financial Accounting Problems Exhibit 1.2 Smith Company: Schedule of Bond Premium Amortization, Effective Interest Method, Semi-Annual Interest Payments, 12% Bonds Sold to Yield 10% (a) $200,000 (face value) ⫻ 0.12 (stated rate) ⫻ 1⁄2 year (b) Previous book value ⫻ 0.14 (effective rate) ⫻ 1⁄2 year (c) (a) ⫺ (b) (d) Previous book value ⫺ (c) dictates a proration over three months of interest and premium amortized as follow: 1. Premium amortized (1,227.83 ⫻ 3/6) $613.915 2. Interest Expense (10,772.17 ⫻ 3/6) $5,386.085 3. Interest Payable (12,000 ⫻ 3/6) $6,000.000 The journal entry at the end of March 1996 to record the accrual is as follows: Interest Expense Premium on Bonds Payable Interest Payable $5,386.085 $613.915 $6,000.000 Long-Term Liabilities 9 Costs of Issuing Bonds Various expenditures may be required for the issuance of bonds, including legal and accounting fees, printing costs and registration fees. The present GAAP requirement is to defer the costs of issuing bonds and amortize over the life of the bond issue by the straight-line method. To illustrate, assume that on January 1, 1996, Tucker Company issued five-year bonds with a face value of $10,000,000 and a price of $10,500,000. Expenditures connected with the issue amounted to $250,000. The journal entry to record the issue is as follows: Cash (10,500,000 ⫺ 250,000) Unamortized Bond Issue Costs Premium on Bonds Payable Bonds Payable $10,250,000 $250,000 $500,000 $10,000,000 The journal entry on December 31, 1996, to record the amortization is as follows: Bond Interest Expense Unamortized Bond Issue Costs (250,000/5) $50,000 $50,000 The unamortized bond issue costs are to be disclosed as deferred charge on other assets. Bonds Issued with Detachable Warrants Bonds issued with detachable warrants allow the bondholder to acquire a specific number of common shares at a given price and a given time. The bonds are known as bonds with stock warrants or stock rights. The proceeds of the bonds are allocated to both the bonds and the warrants as follows: 1. Amount Allocated to Bonds ⫽ Market Value of Bonds without Warrants Market Value of Bonds without Warrants ⫹ Market Value of Warrants Issuance ⫻ Price 10 Critical Financial Accounting Problems 2. Amount Allocated ⫽ to Warrant Market Value of Warrant Market Value of Bonds Without Warrants ⫹ Market Value of Warrants Issuance ⫻ Price To illustrate, let’s assume that the Dimitra Company sold $400,000 of 12% bonds at 101 or $404,000. Each $1,000 bond is issued with 10 detachable warrants that entitle the holder to acquire one share of $10 par common stock for $30 per share. Following the issuance the bonds without the rights attached (ex. rights) were quoted at 99 and the warrants at $3 each. The proceeds of the bonds are allocated as follows: 1. Amount Allocated to Bonds ⫽ $990 ⫻ 400 ⫻ $404,000 ⫽ $392,117.68 (990 ⫻ 400) ⫹ (3 ⫻ 400 ⫻ 10) 2. Amount $3 ⫻ 400 ⫻ 10 Allocated ⫽ ⫻ $404,000 ⫽ $11,882.396 (990 ⫻ 400) ⫹ (3 ⫻ 400 ⫻ 10) to Warrant As a result the following entry may be made: Cash Discount on Bonds Payable (400000 ⫺ 392117.68) Bonds Payable Common Stock Warrants $404,000.00 $7,882.32 $400,000.00 11,882.32 The value of each warrant is $2.96 (11882.32/4000). Assuming 100 warrants were exercised, the following entry will be made: Cash ($30 ⫻ 100) Common Stock Warranty (2.97 ⫻ 100) Common Stock (10 ⫻ 100) Additional Paid-in Capital on Common Stock $3,000.00 $297.00 $1,000.00 $2,297.00 If all the remaining warrants expire, the following entry is made: Long-Term Liabilities Common Stock Warrants Additional Paid-in Capital on Common Stock 11 $11,585.32 $11,585.32 Accounting for Convertible Bonds and Preferred Stock Convertible bonds are bonds that can be converted into common stocks, allowing the bondholder (a creditor) to become a stockholder by exchanging the bonds for a specified number of shares. Issuance of convertible bonds may be motivated by making an increase in equity later or an increase in bonds now, more attractive through the conversion feature. Other factors that may motivate a firm to issue convertible bonds is related to its desire to: 1. Avoid the downward price pressure on its stock that placing a large new issue of common stock on the market would cause 2. Avoid the direct sale of common stock when it believes its stock currently is undervalued in the market 3. Penetrate that segment of the capital market that is unwilling or unable to participate in a direct common stock issue 4. Minimize the costs associated with selling securities.1 The first accounting problem facing convertible debts is the accounting at the time of issuance. Following APB Opinion No. 14,2 accounting for convertible debt at the time of issuance treats it solely as a debt, with the discount or premium amortized to its maturity date. The second accounting problem arises at the time of conversion. Two methods may be used for recording the conversion. 1. Book Value Method. Under this method the stockholders’ equity (common stock and additional paid-in capital) is credited at the book value of convertible bonds on the date of conversion, resulting in no gain or loss being recognized. 2. Market Value Method. Under this method the stockholders’ equity (common stock and additional paid-in capital) is credited at the market value of the shares issued on the date of conversion, resulting in the recognition of a gain or loss to be included as ordinary rather than extraordinary income. To illustrate both methods, let’s assume that the Bulls Corporation has issued $20,000 worth of convertible bonds that have now a book value 12 Critical Financial Accounting Problems of $21,000. Each $1,000 bond is convertible into 20 shares of common stock (par value $40). At the time of conversion, interest had been paid on the debt, and the market value of the common stock is $60 per share. The entries under both methods would be: A. Under the Book Value Method: Bonds Payable Premium on Bonds Payable Common Stock (40 ⫻ 20 ⫻ 20) Additional Paid-in Capital from Bond Conversion (21,000 ⫺ 16,000) $20,000 $1,000 $16,000 $5,000 B. Under the Market Value Method: Bonds Payable Premium on Bonds Payable Loss on Conversion (48,000 ⫺ 21,000) Common Stock (40 ⫻ 20 ⫻ 20) Additional Paid-in Capital from Bond Conversion (40 ⫻ 20 ⫻ 40) $20,000 $1,000 $27,000 $16,000 $32,000 Let’s assume that in the previous example the firm has agreed to pay an extra $5,000 to the bondholders to induce conversion; the following entry under the book value method will be made: Debt Conversion Expense Bonds Payable Premium on Bonds Payable Common Stock Additional Paid-in Capital Cash $5,000 $20,000 $1,000 $16,000 $5,000 $5,000 The cash used to induce conversion is treated as an ordinary expense of the current period. Upon retirement of a convertible debt, the difference between the cash acquisition price of the debt and its carrying amount is treated as an Long-Term Liabilities 13 extraordinary gain or loss on extinguishment of debt.3 The book value is generally preferred because it avoids the type of manipulation of income through gain or loss as permitted under the market value method. However, for convertible preferred stock, only the book value method is permitted for conversion where: a. Convertible preferred stock and additional paid-in capital is debited. b. Common stock and additional paid-in capital (in case an excess exists) is credited. c. Retained earning is debited if the par value of the common stock exceeds the par value of preferred stock. To illustrate, let’s assume that the Green Company issued 5,000 shares of common stock (par value $10) upon conversion of 5,000 shares of preferred stock (par value $5) that has been previously used with a premium of $800. The entry is as follows: Convertible Preferred Stock (5,000 ⫻ 5) Paid-in Capital in Excess of Par (Premium on Preferred Stock) Retained Earnings (50,000 ⫺ 25,800) Common Stock (5,000 ⫻ 10) $25,000 $800 $24,200 $50,000 Some states require, however, that the additional return used to induce conversion should be debited to paid-in capital. ACCOUNTING FOR EXTINGUISHMENT AND DEFEASANCE Long-term debt may be retired either through an extinguishment of debt (Reacquisition of Debt) or a defeasance of debt (In-Substance Defeasance of Debt). Both practices are examined next. Reacquisition of Debt Bonds may be reacquired at maturity or prior to maturity. If the bonds are reacquired at maturity, the premium or discount and issue costs are 14 Critical Financial Accounting Problems fully amortized, and the face value of the bond is equal to the market value at the time resulting in no gain or loss. If the bonds are retired before maturity or replaced with a new issue (refunding) a different situation arises. First, the net carrying amount of the bonds is adjusted for amortized premium, discount and cost of issuance. Second, the difference between the net carrying amount and the reacquisition price (call price) is either a gain or loss from extinguishment. All material gains and losses from debt extinguishment (both retirements and refunding) are classified as extraordinary item in the year of cancellation. To illustrate, let’s assume that the Mavrides Corporation had issued $200,000 worth of 10-year bonds paying 12% at 97 on January 1, 1995. The bonds, paying interest on January 1 and July 1, and callable at 105 plus accrued interest, were recalled on June 30, 2000. Two entries are required. The first entry is used to record the current interest expense as well as the amortization of the expired discount, is as follows: Interest Expense Discount on Bonds Payable (6000 / 10) ⫻ 1⁄2 Interest Payable (200,000 ⫻ .12 ⫻ 1⁄2) $12,300 $300 $12,000 The second entry, used to record the reacquisition of debt, is as follows: Bonds Payable Interest Payable Extraordinary loss on Bond Redemption Discount on Bonds Payable Cash $200,000 $12,000 $12,700 $2,700 $222,000 where: a. the discount on bonds payable is computed as 1. The original discount 2. Amortized on a straight-line basis for 51⁄2 years: 5.5 ⫻ 600 $6,000 ($3,300) Long-Term Liabilities 15 3. Unamortized discount $2,700 b. Cash ⫽ $200,000 ⫻ 1.05 ⫹ 12,000 c. Extraordinary loss on bond redemption: 1. Call price (excluding interest) 2. Less: Face Value unamortized discount $210,000 $200,000 ($2,700) ($197,300) $12,700 In-Substance Defeasance In-substance defeasance of debt is an arrangement whereby the debtor places cash or purchased securities in an irrevocable trust to be used solely to pay off the interest and principal of debt. To illustrate insubstance defeasance of debt, let’s assume that on January 1, 1996, The Das Company issued $100,000 of five-year, 12% bonds that yield 10%. On December 31, 1998, when the book value of the bonds is $103,545.92, The Das Company purchased $96,545.92 in $100,000, 12% U.S. government bonds to service the bond interest and principal and extinguish its debt. The journal entry to record this extinguishment is as follows: Bonds Payable Premium on Bonds Payable Cash Extraordinary Gain on Bond Extinguishment $100,000.00 $ 3,545.92 $96,545.92 $7,000.00 LONG-TERM NOTES PAYABLE Long-term notes differ form short-term notes on the basis of different maturities. They differ from long-term bonds on the term of tradability on organized public securities markets. Like a bond, a note payable is recorded at the present value of its future interest and principal cash flows, with any discount or premium amortized over the life of the note. Similarly, interest expense is recorded over the life of the note on the basis of the effective interest method. Examples of issuance of long-term notes payable follow: