Concepts, Rules, and Examples


Notes and Bonds

Long-term debt generally takes one of two forms: notes or bonds. Notes represent debt issued to a single investor without intending for the debt to be broken up among many investors. Their maturity, usually lasting one to seven years, tends to be shorter than that of a bond. Bonds also result from a single agreement. However, a bond is intended to be broken up into various subunits, typically $1,000 each, which can be issued to a variety of investors.

Notes and bonds share common characteristics: a written agreement stating the amount of the principal, the interest rate, when the interest and principal are to be paid, and the restrictive covenants, if any, that must be met. The interest rate is affected by many factors including the cost of money, the business risk factors, and the inflationary expectations associated with the business.

Nominal vs. effective rates.

The stated rate on a note or bond often differs from the market rate at the time of issuance. When this occurs, the present value of the interest and principal payments will differ from the maturity, or face value. If the market rate exceeds the stated rate, the cash proceeds will be less than the face value of the debt because the present value of the total interest and principal payments discounted back to the present yields an amount that is less than the face value. Because an investor is rarely willing to pay more than the present value, the bonds must be issued at a discount. The discount is the difference between the issuance price (present value) and the face, or stated, value of the bonds. This discount is then amortized over the life of the bonds to increase the recognized interest expense so that the total amount of the expense represents the actual bond yield.

When the stated rate exceeds the market rate, the bond will sell for more than its face value (at a premium) to bring the effective rate to the market rate and will decrease the total interest expense. When the market and stated rates are equivalent at the time of issuance, no discount or premium exists and the instrument will sell at its face value. Changes in the market rate subsequent to issuance are irrelevant in determining the discount or premium or their amortization.

Notes are a common form of exchange in business transactions for cash, property, goods, and services. Most notes carry a stated rate of interest, but it is not uncommon for noninterest-bearing notes or notes bearing an unrealistic rate of interest to be exchanged. Notes such as these, which are long-term in nature, do not reflect the economic substance of the transaction since the face value of the note does not represent the present value of the consideration involved. Not recording the note at its present value will misstate the cost of the asset or services to the buyer, as well as the selling price and profit to the seller. In subsequent periods, both the interest expense and revenue will be misstated.

While international accounting standards do not prescribe how to measure transactions such as those described above, several different models are discussed. In describing one of the common methods of reporting the elements of financial statements in the IASC's Framework for the Preparation and Presentation of Financial Statements, it is stated that "liabilities are carried at the present discounted value of future net cash outflows...." In the authors' opinion, unless the obligations issued in nonmonetary transactions (e.g., acquisition of plant assets in exchange for long-term debt) are recorded at their discounted present values, using the borrowing entity's applicable marginal borrowing rate, the economic substance of the transaction will be misstated, possibly materially so.

Accordingly, it is suggested that all commitments to pay (and receive) money at a determinable future date be subjected to present value techniques and, if necessary, interest imputation, with the exceptions of the following:

  1. Normal accounts payable due within one year

  2. Amounts to be applied to purchase price of goods or services or that provide security to an agreement (e.g., advances, progress payments, security deposits, and retainages)

  3. Transactions between parent and subsidiary

  4. Obligations payable at some indeterminable future date (warranties)

  5. Lending and depositor savings activities of financial institutions whose primary business is lending money

  6. Transactions where interest rates are affected by prescriptions of a governmental agency (e.g., revenue bonds, tax exempt obligations, etc.)

Notes issued solely for cash.

When a note is issued solely for cash, its present value is assumed to be equal to the cash proceeds. The interest rate is that rate which equates the cash proceeds to the amounts to be paid in the future (i.e., no interest rate is to be imputed). For example, a $1,000 note due in three years that sells for $889 has an implicit rate of 4% ($1,000 x .889, where .889 is the present value factor of a lump sum at 4% for three years). This rate is to be used when amortizing the discount.

Notes issued for cash and a right or privilege.

Often when a note bearing an unrealistic rate of interest is issued in exchange for cash, an additional right or privilege is granted, such as the issuer agreeing to sell merchandise to the purchaser at a reduced rate. The difference between the present value of the receivable and the cash loaned should logically be regarded as an addition to the cost of the products purchased for the purchaser/lender and as unearned revenue to the issuer. This treatment stems from the desire to match revenue and expense in the proper periods and to differentiate between those factors that affect income from operations and income or expense from nonoperating sources. In the situation above, the discount (difference between the cash loaned and the present value of the note) will be amortized to interest revenue or expense, while the unearned revenue or contractual right is amortized to sales and inventory, respectively. The discount affects income from nonoperational sources, while the unearned revenue or contractual right affects the gross profit computation. This differentiation is necessary because the amortization rates used differ for the two amounts.

Example of accounting for a note issued for both cash and a contractual right

start example
  1. Miller borrows $10,000 via a noninterest-bearing 3-year note from Krueger.

  2. Miller agrees to sell $50,000 of merchandise to Krueger at less than the ordinary retail price for the duration of the note.

  3. The fair rate of interest on a note such as this is 10%.

As set forth in the discussion above, the difference between the present value of the note and the face value of the loan is to be regarded as part of the cost of the products purchased under the agreement. The present value factor for an amount due in 3 years at 10% is .75132. Therefore, the present value of the note is $7,513 ($10,000 x .75132). The $2,487 ($10,000 - $7,513) difference between the face value and the present value is to be recorded as a discount on the note payable and as unearned revenue on the future purchases. The following entries would be made to record the transaction:

Miller

Krueger

Cash

10,000

Note receivable

10,000

Discount on note payable

2,487

Contract right with supplier

2,487

  • Note payable

10,000

  • Cash

10,000

  • Unearned revenue

2,487

  • Discount on note receivable

2,487

The discount on note payable (and note receivable) should be amortized using the effective interest (constant yield) method, while the unearned revenue account and contract right with supplier account are amortized on a pro rata basis as the right to purchase merchandise is used up. Thus, if Krueger purchased $20,000 of merchandise from Miller in the first year, the following entries would be necessary:

Miller

Krueger

Unearned revenue

995 [a]

Inventory (or cost of sales)

995

  • Sales

995

  • Contract right with supplier

995

Interest expense

751

Discount on note receivable

751

  • Discount on note payable

751[b]

  • Interest revenue

751

[a]$2,487 x (20,000/50,000)

[b]$7,513 x 10%

The amortization of unearned revenue and contract right with supplier accounts will fluctuate with the amount of purchases made. If there is a balance remaining in the account at the end of the loan term, it is amortized to the appropriate account in that final year.

end example

Noncash transactions.

When a note is issued for consideration such as property, goods, or services, and the transaction is entered into at arm's length, the stated interest rate is presumed to be fair unless (1) no interest rate is stated, (2) the stated rate is unreasonable, or (3) the face value of the debt is materially different from the consideration involved or the current market value of the note at the date of the transaction. As discussed above, it is recommended that when the rate on the note is not considered fair, the note is to be recorded at the fair market value of the property, goods, or services received or at an amount that reasonably approximates the market value of the note, whichever is the more clearly determinable. When this amount differs from the face value of the note, the difference is to be recorded as a discount or premium and amortized to interest expense.

Example of accounting for a note exchanged for property

start example
  1. Alpha sells Beta a machine that has a fair market value of $7,510.

  2. Alpha receives a 3-year noninterest-bearing note having a face value of $10,000.

In this situation, the fair market value of the consideration is readily determinable and thus represents the amount at which the note is to be recorded. The following entry is necessary:

Machine

7,510

Discount on notes payable

2,490

  • Notes payable

10,000

The discount will be amortized to interest expense over the 3-year period using the interest rate implied in the transaction.

end example

If the fair market value of the consideration or note is not determinable, the present value of the note must be determined using an imputed interest rate. This rate will then be used to establish the present value of the note by discounting all future payments on the note at this rate. General guidelines for imputing the interest rate include the prevailing rates of similar instruments from creditors with similar credit ratings and the rate the debtor could obtain for similar financing from other sources. Other determining factors include any collateral or restrictive covenants involved, the current and expected prime rate, and other terms pertaining to the instrument. The objective is to approximate the rate of interest that would have resulted if an independent borrower and lender had negotiated a similar transaction under comparable terms and conditions. This determination is as of the issuance date, and any subsequent changes in interest rates would be irrelevant.

Bonds represent a promise to pay a sum of money at a designated maturity date plus periodic interest payments at a stated rate. Bonds are used primarily to borrow funds from the general public or institutional investors when a contract for a single amount (a note) is too large for one lender to supply. Dividing up the amount needed into $1,000 or $10,000 units makes it easier to sell the bonds.

In most situations, a bond is issued at a price other than its face value. The amount of the cash exchanged is equal to the total of the present value of the interest and principal payments. The difference between the cash proceeds and the face value is recorded as a premium if the cash proceeds are greater or a discount if they are less. The journal entry to record a bond issued at a premium follows:

Cash

(proceeds)

Premium on bonds payable

(difference)

  • Bonds payable

(face value)

The premium will be recognized over the life of the bond issue. If issued at a discount, "Discount on bonds payable" would be debited for the difference. As the premium is amortized, it will reduce interest expense on the books of the issuer (a discount will increase interest expense). The premium (discount) would be added to (deducted from) the related liability when a balance sheet is prepared.

The effective interest method is the preferred method of accounting for a discount or premium arising from a note or bond, although some other method may be used (e.g., straight-line) if the results are not materially different. Although the effective interest method is not prescribed under international accounting standards as such, the profession has made the use of the effective interest method the only acceptable one. Under the effective interest method, the discount or premium is to be amortized over the life of the debt in such a way as to result in a constant rate of interest when applied to the amount outstanding at the beginning of any given period. Therefore, interest expense is equal to the market rate of interest at the time of issuance multiplied by this beginning figure. The difference between the interest expense and the cash paid represents the amortization of the discount or premium.

Where use of the straight-line amortization method does not result in a material distortion as compared to the effective interest method, it would also be acceptable. Interest expense under the straight-line method is equal to the cash interest paid plus the amortized portion of the discount or minus the amortized portion of the premium. The amortized portion is equal to the total amount of the discount or premium divided by the life of the debt from issuance in months multiplied by the number of months the debt has been outstanding that year. Formerly, the straight-line method was used because it eliminated the complicated calculations required by the effective interest method; however, the prevalence of computers and of programs that compute the interest accrual under the more accurate effective interest method have largely eliminated this reason.

Amortization tables are often created at the time of the bond's issuance to provide figures when recording the necessary entries relating to the debt issue. They also provide a check of accuracy since the final values in the unamortized discount or premium and carrying value columns should be equal to zero and the bond's face value, respectively.

Example of applying the effective interest method

start example
  1. A three-year, 12%, $10.000 bond is issued at 1/1/03, with interest payments semiannually.

  2. The market rate is 10%.

The amortization table would appear as follows:

Date

Credit cash

Debit int. exp.

Debit prem.

Unam. prem. bal.

Carrying Value

1/1/03

$507.61

$10,507.61[a]

7/1/03

$ 600.00[b]

$ 525.38[c]

$ 74.62[d]

432.99[e]

10,432.99[f]

1/1/04

600.00

521.65

78.35

354.64

10.354.64

7/1/04

600.00

517.73

82.27

272.37

10,272.37

1/1/05

600.00

513.62

86.38

185.99

10,185.99

7/1/05

600.00

509.30

90.70

95.29

10.095.29

1/1/06

600.00

504.71[g]

95.29

--

$10,000,00

$3,600,00

$3,092,39

$507.61

[a]PV of principal and interest payments

$10,000(.74622) = $ 7,462,20

$ 600(5.07569) = 3,045,41

    • $10,507,61

[b]$10,000.00x.06

[c]$10,507.61 x.05

[d]$600.00 - $525.38

[e]$507.61 - $74.62

[f]$10,507.61 - $74.62

(or $10.000 + $432.99)

[g]Rounding error = $.05

end example

When the interest date does not coincide with the year-end, an adjusting entry must be made. The proportional share of interest payable should be recognized along with the amortization of the discount or premium. Within the amortization period, the discount or premium can be amortized using the straight-line method, as a practical matter, or can be computed more precisely as described above.

If the bonds are issued between interest dates, discount or premium amortization must be computed for the period between the sale date and the next interest date. This is accomplished by "straight-lining" the period's amount calculated using the usual method of amortization. In addition, the purchaser prepays the seller the amount of interest that has accrued since the last interest date. This interest is recorded as a payable by the seller. At the next interest date, the buyer then receives the full amount of interest regardless of how long the bond has been held. This procedure results in interest being paid equivalent to the time the bond has been outstanding.

Costs may be incurred in connection with issuing bonds. Examples include legal, accounting, and underwriting fees; commissions; and engraving, printing, and registration costs. Although these costs should be classified as a deferred charge and amortized using the effective interest method, generally the amount involved is insignificant enough that use of the simpler straight-line method would not result in a material difference. These costs do not provide any future economic benefit and therefore should not be considered an asset. Since these costs reduce the amount of cash proceeds, they in effect increase the effective interest rate and probably should be accounted for the same as an unamortized discount. Short-term debt obligations that are expected to be refinanced on a long-term basis, and that accordingly are classified as long-term debt according to IAS 1, are discussed in Chapter 12.

The diagram below illustrates the recommended accounting treatments for monetary assets (and liabilities).

Extinguishment of Debt

Substantial modification of the terms of existing debt.

When an existing borrower and lender of debt exchange instruments with substantially different terms, this represents an extinguishment of the old debt and results in derecognition of that debt and recognition of a new debt instrument. IAS 39 (paras. 61 and 62) deal with "substantial modification of the terms" of an existing debt instrument and require that it should be accounted for as an extinguishment of the old debt, provided that the discounted present value of cash flows under the terms of the new debt is at least 10% greater or lesser than the discounted present value of the remaining cash flows of the original debt instrument.

In computing the discounted present values for determining whether the 10% limit has been exceeded, there was concern over whether the effective interest rate of the debt being modified or exchanged, or the effective interest rate of the replacement debt, should be used. This issue was considered by the IAS 39 Implementation Guidance Committee (IGC), which addressed many unresolved matters arising from the promulgation of IAS 39. In IGC 62-1, this matter is discussed and resolved by concluding that either rate could be reasonably employed, but that whichever effective interest rate is used should be applied consistently to all modifications and exchanges of debt instruments.

The IGC further elaborated upon the rule in IAS 39 by stating that, if the difference in present values is at least 10%, the transaction is to be accounted for as an extinguishment of the old debt. On the other hand, if the difference is less than 10%, the difference is amortized over the remaining term of the debt instrument.

If an exchange of debt instruments or modification of terms is accounted for as an extinguishment, any costs or fees incurred are recognized as part of the gain or loss on the extinguishments. Otherwise, any costs or fees incurred in the transaction are accounted for as an adjustment to the carrying amount of the liability and are amortized over the remaining term of the modified loan.

Under IAS 39, the reasons for the debt modification or exchange are irrelevant—in contrast to US GAAP, which historically had applied different accounting to "troubled debt restructurings."

click to expand

Example of accounting for debt exchange or restructuring with gain recognition

start example

Assume that Debtor Corp. owes Friendly Bank $90,000 on a 5% interest-bearing non-amortizing note payable in five years, plus accrued and unpaid interest, due immediately, of $4,500. Friendly Bank agrees to a restructuring to assist Debtor Corp., which is suffering losses and is threatening to declare bankruptcy. The interest rate is reduced to 4%, the principal is reduced to $72,500, and the accrued interest is forgiven outright. Future interest payments are due in arrears annually, and the principal is due in a lump sum at maturity.

Under IAS 39, whether Debtor Corp. recognizes a gain on the restructuring depends on whether the 10% threshold is exceeded. Assume that 5% is the relevant discount rate to be used to compare the present values of the old and the new debt obligations. The present value of the old debt is simply the principal amount, $90,000, plus the interest due at present, $4,500, for a total of $94,500.

The present value of the replacement debt is the discounted present value of the reduced principal and the reduced future interest payments; the forgiven interest in arrears does not enter the calculation. The reduced principal, $72,500, discounted using a 5% discount factor (= .78353), has a present value of $56,806. The stream of future interest payments ($72,500 x .04 = $2,900 annually in arrears), discounted at 5% (= 4.3293 annuity factor), has a present value of $12,555. The total present value, therefore, is ($56,806 + $12,555 =) $69,361, which is about 27% below the present value of the old debt obligation. Accordingly, since the 10% threshold is exceeded, the difference of ($94,500 - $69,361 =) $25,139 is recognized as a gain at the date of the restructuring.

The entry to record this event would be

Debt obligation (old) payable

90,000

Interest payable

4,500

Discount on debt obligation (new)

3,139

  • Debt obligation (new) payable

72,500

  • Gain on debt restructuring

25,139

Note that the new debt obligation is recorded at a net of $69,361, not at the face value of $72,500. The difference, $3,139, is a discount to be amortized to interest expense over the next five years, in order to reflect the actual market rate of 5%, rather than the nominal 4% being charged. Amortization should be accomplished on the effective yield method, although if the discrepancy is not material the straight-line method may be employed.

end example

Example of accounting for debt exchange or restructuring with gain deferral

start example

Assume now that Hopeless Corp. owes Callous Bank $90,000 on a 5% interest-bearing nonamortizing note payable in five years, plus accrued and unpaid interest, due immediately, of $4,500. Callous Bank agrees to a restructuring to assist Hopeless Corp., which is also suffering losses and is threatening to declare bankruptcy. However, Callous is only willing to reduce the principal amount from $90,000 to $85,000, and reduce interest to 4.5% from 5%. It is not willing to forego the currently owed $4,500 interest payment, and furthermore requires that the loan maturity be shortened to three years, from five, in order to limit its risk. Hopeless agrees to the new terms.

In order to comply with IAS 39, the present value of the new debt must be compared to the present value of the old, existing obligation. As in the preceding example, the present value of the old debt is simply the principal amount, $90,000, plus the interest due at present, $4,500, for a total of $94,500.

The present value of the replacement debt is the discounted present value of the reduced principal and the reduced future interest payments, plus the interest using a 5% discount factor (= .86384 for the new three-year term), has a present value of $73,426. The stream of future interest payments ($85,000 x .045 = $3,825 annually in arrears), discounted at 5% (= 2.7231 annuity factor), has a present value of $10,416. The total present value, therefore, is ($73,426 + $10,416 + $4,500 =) $88,342, which is about 7% below the present value of the old debt obligation. Accordingly, since the 10% threshold is not exceeded, the difference of ($94,500 - $88,342 =) $6,158 is not recognized as a gain at the date of the restructuring, but rather is deferred and amortized over the new three-year term of the restructured loan.

The entry to record this event would be

Debt obligation (old) payable

90,000

Discount on debt obligation (new)

1,158

  • Debt obligation (new) payable

85,000

  • Deferred gain on debt restructuring

6,158

Note that the new debt obligation is recorded at a net of $83,842, not at the face value of $85,000. The difference of $1,158 represents a discount to be amortized to interest expense over the subsequent three years; this will result in an interest expense at the actual market rate of 5%, rather than at the nominal 4.5% rate. Amortization should be computed on the effective yield method, although if the discrepancy is not material the straight-line method may be employed. The deferred gain, $6,158, will be amortized over the three-year revised term. While the discount amortization will be added to interest expense. IAS 39 is silent as to how the amortization of the deferred gain should be handled. However, by reference to how a gain in excess of the 10% threshold (and thus been subject to immediate recognition) would have been reported, it is thought likely that this amortization should be included in "other income," and should not be offset against interest expense.

end example

Presentation of the gain or loss from debt restructurings is not explicitly dealt with under IAS. While US GAAP for many years required that such gain or loss be shown as an "extraordinary item" in the income statement, it very recently has eliminated that treatment. (Such gain or loss may still appear as an extraordinary item, but only if the more general criteria for such display are met, which would typically not be the case.)

This concern will shortly become moot under IAS, since the Improvements Project's proposed amendment to IAS 8 would totally eliminate the extraordinary items classification. Accordingly, the gain or loss on debt extinguishments should probably be displayed as an item of "other" income or expense in the income statement prepared in conformity with IAS.

Defeasance of debt.

For some period of time the practice of in-substance defeasance enjoyed popularity, to a possibly large extent due to the accounting treatment that was permitted under earlier US GAAP. In-substance defeasance occurs when certain assets are set aside in an irrevocable trust arrangement, to be used solely for the servicing and ultimate retirement of specific debt obligations. If the cash flows from the segregated assets are carefully matched to the debt service and retirements obligations, the sponsoring entity will have no further concerns, even if its legal obligations have not been satisfied, assuming that the assets so segregated (e.g., government bonds) have no or only remote credit risk.

Under a now-superseded US standard, the sponsor was permitted to remove both the segregated assets and the debt from its balance sheet. While this would not have any impact on the entity's net equity or its future net earnings, it did reduce both assets and liabilities by a like amount, thereby improving its debt-to-equity ratio and, accordingly, its apparent financial strength or lack of riskiness. This was often referred to as "window dressing" the balance sheet and was severely criticized by many commentators on financial reporting matters.

This practice was subsequently prohibited by SFAS 125 and remains so by replacement standard SFAS 140.

The matter of in-substance defeasance has more recently been addressed by IAS. According to IAS 39, payments to a third party (including a trust) do not relieve the debtor of its primary obligation to the creditor of record, in the absence of legal release. Accordingly, in-substance defeasance cannot be accounted for as elimination of debt and of the segregated assets.

Computing the gain or loss on debt extinguishments.

The difference between the net carrying value and the acquisition price is to be recorded as a gain or loss. If the acquisition price is greater than the carrying value, a loss exists. A gain is generated if the acquisition price is less than the carrying value. These gains or losses are to be recognized in the period in which the retirement took place. These should be reported as "other" income or expense, which is the same category in which interest expense is normally reported. It would not be appropriate, however, to include any gain or loss in the interest pool from which capitalized interest is computed under IAS 23 (discussed in Chapter 8).

The unamortized premium or discount and issue costs should be amortized to the acquisition date and recorded prior to determination of the gain or loss. If the extinguishment of debt does not occur on the interest date, the interest payable accruing between the last interest date and the acquisition date must also be recorded.

Example of accounting for the extinguishment of debt

start example
  1. A 10%, ten-year, $200,000 bond is dated and issued on 1/1/03 at $98, with the interest payable semiannually.

  2. Associated bond issue costs of $14,000 are incurred.

  3. Four years later, on 1/1/07, the entire bond issue is repurchased at $102 per $100 face value and is retired.

  4. The straight-line method of amortization is used since the result is not materially different from that when the effective interest method is used.

The gain or loss on the repurchase is computed as follows:

Reacquisition price [(102/100) x $200,000]

$204,000

Net carrying amount:

  • Face value

$200,000

  • Unamortized discount [2% x 200,000 x (6/10)]

(2,400)

  • Unamortized issue costs [14,000 x (6/10)]

(8,400)

189,200

Loss on bond repurchase

$ 14,800

end example

Convertible Debt

Bonds are frequently issued with the right to convert them into common stock of the company at the holder's option when certain terms and conditions are met (i.e., a target market price is reached). Convertible debt is used for two reasons. First, when a specific amount of funds is needed, convertible debt often allows fewer shares to be issued (assuming conversion) than if the funds were raised by directly issuing the shares. Thus, less dilution occurs. Second, the conversion feature allows debt to be issued at a lower interest rate and with fewer restrictive covenants than if the debt were issued without it.

This dual nature of debt and equity, however, creates a question as to whether the equity element should receive separate recognition. Support for separate treatment is based on the assumption that this equity element has economic value. Since the convertible feature tends to lower the rate of interest, it can easily be argued that a portion of the proceeds should be allocated to this equity feature. On the other hand, a case can be made that the debt and equity elements are inseparable, and thus that the instrument is either all debt or all equity. International accounting standards had not previously addressed this matter directly, although the focus of Framework for Preparation and Presentation of Financial Statements on "true and fair presentation" could be said to support the notion that the proceeds of a convertible debt offering be allocated between debt and equity accounts. The promulgation of IAS 32 resulted in the defining of convertible bonds (among other instruments) as being compound financial instruments, the component parts of which must be classified according to their separate characteristics.

Features of convertible debt.

Features of convertible debt typically include (1) a conversion price 15 to 20% greater than the market value of the stock when the debt is issued; (2) conversion features (price and number of shares) that protect against dilution from stock dividends, splits, and so on; and (3) a callable feature at the issuer's option that is usually exercised once the conversion price is reached (thus forcing conversion or redemption).

Convertible debt also has its disadvantages. If the stock price increases significantly after the debt is issued, the issuer would have been better off simply by issuing the stock. Additionally, if the price of the stock does not reach the conversion price, the debt will never be converted (a condition known as overhanging debt).

Accounting for compound instruments.

IAS 32 establishes the notion that component parts of compound instruments, such as convertible bonds, must be accounted for separately, consistent with their separate characteristics, but does not prescribe specific methodologies to accomplish this. However, several measurement strategies are noted in the standard, and these are illustrated in the following paragraphs.

Residual allocation method.

One method of allocating proceeds from the issuance of convertible debt would be allocate to the less easily measured component (probably the conversion feature) the residual after first assigning the market value to the more directly measured component (the debt, absent the conversion feature). To illustrate this approach, consider the following fact situation.

Example of the residual allocation method

start example

Istanbul Corp. sells convertible bonds having aggregate par (face) value of $25 million to the public at a price of $98 on January 2, 2003. The bonds are due December 31, 2010, but can be called at $102 anytime after January 2, 2006. The bonds carry a coupon of 6% and are convertible into Istanbul Corp. common stock at an exchange ratio of twenty-five shares per bond (each bond having a face value of $1,000). Taking the discount on the offering price into account, the bonds were priced to yield about 6.3% to maturity.

The company's investment bankers have advised it that without the conversion feature, Istanbul's bonds would have had to carry an interest yield of 8% to have been sold in the current market environment. Thus, the market price of a pure bond with a 6% coupon at January 2, 2003, would have been about $883.48 (the present value of a stream of semiannual interest payments of $30 per bond, plus a terminal value of $1,000, discounted at a 4% semiannual rate).

This suggests that of the $980 being paid for each bond, $883.48 is being paid for the pure debt obligation, and another $96.52 is being offered for the conversion feature. Given this analysis, the entry to record the original issuance of the $25 million in debt securities on January 2, 2003, would be as follows:

Cash

24,500,000

Discount on bonds payable

2,913,000

  • Bonds payable

25,000,000

  • Paid-in capital—conversion feature

2,413,000

The discount should be amortized to interest expense, ideally by the effective yield method (constant return on increasing base) over the eight years to the maturity date. For purposes of this example, however, straight-line amortization ($2,913,000 16 periods = $182,000 per semiannual period) will be used. Thus, the entry to record the June 30, 2003 interest payment would be as follows:

Interest expense

932,000

  • Discount on bonds payable

182,000

  • Cash

750,000

The paid-in capital account arising from the foregoing transaction would form a permanent part of the capital of Istanbul Corp. If the bonds are later converted, this would be transferred to the common stock accounts, effectively forming part of the price paid for the shares ultimately issued. If the bondholders decline to convert and the bonds are eventually paid off at maturity, the paid-in capital from the conversion feature will form a type of "donated capital" to the enterprise: the bondholders effectively have forfeited this capital that they had contributed to the company.

If the bonds are not converted, the discount on the bonds payable will continue to be amortized until maturity. However, if they are converted, the remaining unamortized balance in this account, along with the face value of the bonds, will constitute the "price" being paid for the stock to be issued.

To illustrate this, assume the following:

On July 1, 2006, all the bonds are tendered for conversion to common stock of Istanbul Corp. The remaining book value of the bonds will be converted into common stock, which does not carry any par or stated value. The first step is to compute the book value of the debt.

Bonds payable

$25,000,000

Discount on bonds payable

  • Original discount

$2,913,000

  • Less amortization to date (4.4 yrs.)

(1,638,000)

1,275,000

Net book value of obligation

$23,725,000

The entry to record the conversion, given the foregoing information, is as follows:

Bonds payable

25,000,000

Paid-in capital—conversion feature

2,413,000

  • Discount on bonds payable

1,275,000

  • Common stock, no par value

26,138,000

end example

Note that in the foregoing entry, the effective price recorded for the shares being issued is the book value of the remaining debt, adjusted by the price previously recorded to reflect the sale of the conversion feature. In the present instance, given the book value at the conversion date (a function of when the conversion privilege was exercised), and given the conversion ratio of twenty-five shares per bond, an effective price of $41.82 per share is being paid for the stock to be issued. This is determined without any reference to the market value at the date of the conversion. Presumably, the market price is higher, as it is unlikely that the bondholders would surrender an asset earning 6%, with a fixed maturity date, for another asset having a lower value and having an uncertain future worth (although if the dividend yield were somewhat higher than the equivalent bond interest, an unlikely event, this might happen).

Another approach to the conversion would be to reflect the stock issuance at the then-current market value, reporting a gain or loss for the difference between the market value per share and the amount computed on the book value basis, as shown above. However, this can he criticized because it is not normally acceptable to report income statement events (the gain or loss) arising from capital transactions. For this reason, the book value approach is recommended.

Relative market value approach.

The alternative to the residual value allocation method described above for assigning the proceeds from the sale of convertible debt would be to measure directly the market value of each component of the compound financial instrument. This may be more easily accomplished in some circumstances than in others. For example, if options on Istanbul stock are currently being traded on the open market at the time the convertible debt is offered for sale, it would be possible to assess the value of the conversion feature, although some judgment might be involved to adjust for the different features and limitations of exchange traded options and the conversion feature. Consider the following example.

Example of the relative market value approach

start example

As in the example above, Istanbul Corp. sells convertible bonds having aggregate par (face) value of $25 million to the public at a price of $98 on January 2, 2003. The bonds are due December 31, 2010, but can be called at $102 anytime after January 2, 2006. The bonds carry a coupon of 6% and are convertible into Istanbul Corp. common stock at an exchange ratio of 25 shares per bond (each bond having a face value of $1,000). Taking the discount on the offering price into account, the bonds were priced to yield about 6.3% to maturity.

The company's investment bankers again have advised it that without the conversion feature, Istanbul's bonds would have had to carry an interest yield of 8% to have been sold in the current market environment. Thus, the market price of a "pure" bond with a 6% coupon at January 2, 2003, would have been about $883.48. Now, however, assume also that options on Istanbul stock are being traded on the open market. The common stock is presently selling for $32 per share; options to buy the stock at $42 are trading at $3.50 each.

Since 625,000 shares will be issued if all the bonds are converted, this suggests a gross value of $2,187,500 due to the conversion feature, or an equivalent of $87.50 per bond. However, the actual conversion feature is at a lower price than is attached to the market-traded options ($40 vs. $42), and these have a longer life (8 years vs. a typical 2 years on market-traded options), so the investment bankers advise Istanbul management that the value per stock right would he $6, or an indicated value of $150 per bond (since each is convertible into 25 shares), for a total value of $3,750,000. Since the total indicated value of the conversion privilege ($3,750,000) plus the pure bonds ($883.48 x 25,000 bonds = $22,087,000) is greater (at $25,837,000) than the actual selling price of the bonds ($24,500,000), the amounts to be allocated to the debt and to the equity conversion feature should be pro rated, as follows:

22,087,000/25,837,000

x

24,500,000

=

$20,944,050

($837.76 per bond)

3,750,000/25,837,000

x

24,500,000

=

$ 3,555,950

($142.24 per bond)

This suggests that of the $980 being paid for each bond, $837.76 is being paid for the pure debt obligation, and another $142.24 is being offered for the conversion feature. Given this analysis, the entry to record the original issuance of the $25 million in debt securities on January 2, 2003, would be as follows:

Cash

24.500.000

Discount on bonds payable

4,055,950

  • Bonds payable

25,000,000

  • Paid-in capital—conversion feature

3,555,950

end example

As with the earlier example, the indicated discount would be amortized over the term to maturity of the debt, eight years in this case, by the effective yield method, or by the straight-line method if this would not make a material difference in reported financial position and results of operations.

It might be noted that under present US GAAP, when convertible debt is issued no value is apportioned to the conversion feature when recording the issue. However, it is likely that US standards will eventually follow the path set by IAS 32 in this regard, since the issue of accounting for compound financial instruments has been debated for over five years and the existence of the newly promulgated international standard will doubtless put added pressure on US standard setters.

Induced Conversion of Debt

A special situation may occur in that the conversion privileges of convertible debt are modified after issuance of the debt. These modifications may take the form of reduced conversion prices or additional consideration paid to the convertible debt holder. The debtor offers these modifications or "sweeteners" to induce prompt conversion of the outstanding debt. This is in addition to the normal strategy of calling the convertible debt to induce the holders to convert, assuming the underlying economic values make this attractive (debtors often do this when only a small fraction of the originally issued convertible debt remains outstanding).

Logically, there are two ways to account for these sweeteners. The first would be to treat this as a reduction in the proceeds of the stock offering, thereby reducing paid-in capital from the transaction. The second possible accounting treatment would be to record these payments as an expense in the period of conversion. The former position is based on the notion that costs associated with the raising of equity capital are netted against the proceeds so generated; if a sweetener is deemed needed to raise the equity capital in a given situation, this should be accounted for as any other costs, such as underwriting fees, would be. The latter position springs from a recognition that if it had been part of the original arrangement, a change in the exchange ratio or other adjustment would have affected the allocation of the original proceeds between debt and equity, and the discount or premium originally recognized would have been different in amount, and hence periodic amortization would have differed as well.

There are no specific international standards on this matter, and the arguments for both treatments are impressive. Accordingly, both are illustrated here. The example that follows illustrates the calculation and recording of the debt conversion expense if the cost of the sweetener is deemed to be a period cost.

Example of debt conversion expense

start example
  1. January 1, 2003, Imag Company issued ten 8% convertible bonds at $1,000 par value without a discount or premium, maturing December 31, 2013.

  2. The bonds are initially convertible into no-par common stock of Imag at a conversion price of $25.

  3. On July 1, 2007, the convertible bonds have a market value of $600 each.

  4. To induce the convertible bondholders to convert their bonds quickly, Imag reduces the conversion price to $20 for bondholders who convert before July 21, 2007 (within 20 days).

  5. The market price of Imag Company's common stock on the date of conversion is $15 per share.

The fair value of the incremental consideration paid by Imag upon conversion is calculated as follows for each bond converted before July 21, 2007:

Value of securities issued to debt holders:

Face amount

$1,000

per bond

New conversion price

$20

per share

Number of common shares issued upon conversion

50

shares

x

Price per common share

x $15

per share

Value of securities issued

$ 750

(a)

Value of securities issuable pursuant to the original conversion privileges:

Face amount

$1,000

per bond

Original conversion price

$25

per share

Number of common shares issuable pursuant to original conversion privilege

40

shares

x

Price per share

x $15

per share

Value of securities issuable pursuant to original conversion privileges

$ 600

(b)

Value of securities issued

$ 750

(a)

Value of securities issuable pursuant to the original conversion privileges

600

(b)

Fair value of incremental consideration

$ 150

The entry to record the debt conversion for each bond is

Convertible debt

1,000

Debt conversion expense

150

  • Common stock—no par

1,150

If instead of the foregoing accounting treatment, it was decided to treat the sweetener as a cost of raising capital, in this fact situation the only change would be to credit common stock for $1,000 per bond rather than the market-determined $1,150. Depending on whether the stock carried a par or a stated value, it might have been necessary to make a slightly different entry, but the concept would be the same.

end example

Debt Issued with Stock Warrants

Warrants are certificates enabling the holder to purchase a stated number of shares of stock at a certain price within a certain period. They are often issued with bonds to enhance the marketability of the bonds and to lower the bond's interest rate.

Detachable warrants are similar to other features, such as the conversion feature discussed earlier, which under IAS 32 make the debt a compound financial instrument and which necessitates that there be an allocation of the original proceeds among the constituent elements. Since warrants, which will often be traded in the market, are easier to value than are conversion features, the second method discussed above, pro rata allocation based on relative market values, is to be favored.

Example of accounting for a bond with a detachable warrant

start example
  1. A $1,000 bond with a detachable warrant to buy 10 shares of $10 par common stock at $50 per share is issued for $1,025.

  2. Immediately after the issuance the bonds trade at $980 and the warrants at $60.

  3. The market value of the stock is $54.

The relative market value of the bonds is 94% (980/1,040) and the warrant is 6% (60/1,040). Thus, $62 (6% x $1,025) of the issuance price is assigned to the warrants. The journal entry to record the issuance is

Cash

1,025

Discount on bonds payable

37

  • Bonds payable

1,000

  • Paid-in capital—warrants (or "Stock options outstanding")

62

The discount is the difference between the purchase price assigned to the bond, $963 (94% x $1,025), and its face value, $1,000. The debt itself is accounted for in the normal fashion.

The entry to record the subsequent future exercise of the warrant would be

Cash

500

Paid-in capital—warrants

62

  • Common stock

100

  • Paid-in capital (difference)

462 (difference)

Assuming the warrants are not exercised, the journal entry is

Paid-in capital—warrants

62

  • Paid-in capital—expired warrants

62

end example

Accounting for collateral given by debtor to creditor.

In many cases, the borrower (debtor) will provide the lender (creditor) with valuable assets, most typically highly liquid assets such as marketable securities, to further secure the lending relationship and to provide the creditor with added protection. Under the provisions of IAS 39, the borrower is required to disclose the carrying amount of financial assets pledged as collateral for liabilities, as well as any significant terms and conditions relating to pledged assets. If the debtor delivers collateral to the creditor and the creditor is permitted to sell or repledge the collateral without constraints, then the debtor should disclose the collateral separately from other assets not used as collateral.

In other instances, the collateral is in the form of a security interest or mortgage deed. In those instances disclosure is still required, but the creditor is not able to take actions such as repledging or selling the collateral, as would be possible if actual assets such as negotiable instruments had been delivered.

Proposed Changes to Accounting for Liabilities

The IASB has recently exposed proposed changes to IAS 32 and 39. Certain of the proposed amendments would impact the accounting for certain debt obligations. These are summarized in the following paragraphs.

In some instances, an entity issues a financial instrument (which could nominally be a bond or a share) that it could potentially be required to settle by delivering cash or other financial assets (or otherwise in such a way that the instrument would be classified as a financial liability) depending on the occurrence or nonoccurrence of uncertain future events, or on the outcome of uncertain circumstances that are beyond the control of both the issuer and the holder of the instrument. These events could include a change in a stock market index, the consumer price index, or a defined interest rate, (or the issuer's future revenues, net income, or debt-to-equity ratio).

According to the proposed amended IAS 32, such a financial instrument must be classified as a financial liability of the issuer because the issuer does not have an unconditional right to avoid settlement of the obligation in cash or other financial assets (or otherwise in such a way that the obligation would be classified as a financial liability).

In other circumstances, an entity may issue a financial instrument with a "put" option (i.e., one that gives the holder the right to require that the issuer acquire the instrument for cash or another financial asset), the amount of which is determined on the basis of an index or other item that may have the potential to increase and decrease. Even when the legal form of a puttable instrument gives the holder a right to the residual interest in the assets of an entity, the inclusion of an option for the holder to put that right back to the issuer for cash or another financial asset means that the puttable instrument meets the definition of a financial liability and is presented as such. Whether the embedded derivative (the put option) must be separated from the host contract and accounted for as a derivative is addressed in the proposed revised IAS 32.

In yet other circumstances, an entity may have a contractual obligation of a fixed amount or an amount that fluctuates in part or in full in response to changes in a variable other than the market price of the entity's own equity instruments, but the entity must or can settle by delivery of its own equity instruments (the number of which depends on the amount of the obligation). The revised IAS 32 makes it clear that such an obligation is a financial liability of the entity, not an equity instrument.

If the number of an entity's own shares or other own equity instruments required to settle an obligation varies with changes in their fair value so that the total fair value of the entity's own equity instruments to be delivered always equals the amount of the contractual obligation, the counterparty does not, in substance, hold a residual interest in the entity. In addition, the entity may have to deliver more or fewer of its own equity instruments than would be the case at the date of entering into the contractual arrangement. Therefore, according to the proposed revised IAS 32, such an obligation is a financial liability of the entity even though the entity must or can settle it by delivering its own equity instruments.




Wiley Ias 2003(c) Interpretation and Application of International Accounting Standards
WILEY IAS 2003: Interpretation and Application of International Accounting Standards
ISBN: 0471227366
EAN: 2147483647
Year: 2005
Pages: 147

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