Debt Financing

Dr. Derek K. Chan

HKU
Outline
1. Bonds Overview and Definition
1.1 The Nature of Bonds
1.2 Bond Classification
1.3 Advantages and Disadvantages of Issuing Bonds
2. Valuing and Accounting for Bonds
2.1 Bond Discount and Premium
2.2 Measuring Bonds Payable and Interest Expense
2.3 Accounting for Bonds Illustrated
2.4 Amortization of Bond Discount and Premium
2.5 Financial Statement Effects of Issuing a Bond
Debt Financing 2
Outline
3. Accounting for Convertible Bonds
3.1 Date of Issuance Valuation
3.2 Conversion of Bonds into Ordinary Shares
4. Extinguishment of Debts
5. Troubled Debts
5.1 Debt Impairments
5.2 Settlement of Debt
5.3 Modification of Terms
Chapter 14 of the textbook also discusses accounting issues
regarding long-term notes. In the lecture notes, we will focus
mostly on the accounting for long-term bonds.
Debt Financing 3
1. Bonds Overview and Definition
1.1 The Nature of Bonds
A bond is a contract (called a bond indenture) requiring
of payment of principal and periodic interest at a
specific rate.
Bond contract includes the exact terms of the agreement
(i.e. relevant amounts and dates.)
Bond contract usually includes debt covenants which
are terms of the contract that limit things like dividends,
other borrowings and require the maintenance of certain
financial ratios like minimum current ratio or maximum
debt-to-equity ratio.
Although corporations conventionally set the coupon or
stated rate of interest and print it in the bond indentures
several weeks prior to the date on which they are to be
issued, the actual interest rate is determined at time of
sale. Debt Financing 4
Interest rates for securities within the same category of risk
are determined by the forces of supply and demand - the
amount of funds being sought by borrowers and the
amount being available by lenders.
Ordinarily, the more financially sound the borrower, the
lower the rate of interest.
The actual interest rate is called the yield rate or effective
yield.
The effective yield is established not by changing the
coupon rate but rather by adjusting the price at which the
bond is sold.
To the issuer, bond is recorded at the present value of the
future cash outflows (discounted using the yield rate when
the liability was incurred).
Total interest expense is the amount paid to the creditors in
excess of the amount received = total interest payment +
principal repayment initial amount received.
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Face (Par) Value: the principal of each bond issued, usually
$1,000 in the US and $50,000 in HK.
Coupon: the interest payment.
A firm cannot stop its debt payments.
Usually pay interest semi-annually.
Bonds are generally freely negotiable - they can be bought
and sold in the open market subsequent to original issue.
The price at which the bond is sold in the open market would
not be that for which the bond was initially issued. Rather, it
would be at a price based on interest rates prevalent at time of
sale.
Prices quoted as a percentage of face value, e.g., in US, 97
1/4 = $972.50.

Debt Financing 6
1.2 Bond Classification
On the basis of collateral (assets)
Mortgage bonds - secured by real estate
Collateral trust bonds - secured by some asset (like bonds or
stocks of other companies owned by the bond issuer)
Debentures - unsecured by collateral
On the basis of bearers or holders
Registered bonds payments made to registered owners
Coupon bonds (or bearer bonds) payments made to coupon
presenters
On the basis of timing of principal payments
Term bonds - principal paid at the end of term
Serial bonds - principal paid in installments on a series of
specified maturity dates
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On the basis of interest payment
Fixed interest rate bonds - fixed periodic interest
payments paid to the bondholders
Zero coupon bonds - no periodic payment paid to the
bondholders; selling at a deep discount
Bonds with variable interest rates - periodic interest
payments are varied with the prevailing market interest
rates
On the basis of early retirement
Convertible bonds - convertible into stock at the
holders option
Callable bonds - can be retired at the issuers option; no
interest will be paid after the call

Debt Financing 8
1.3 Advantages and Disadvantages of Issuing
Bonds (rather than Capital Stock) - From the
Current Shareholders Point of View

Advantages:
1. Ownership and control of the company are not diluted.
2. Cash payments to the bondholders are limited to the
specified interest payments and the principal of the debt.
3. Tax-shield: The net interest cost of borrowed funds is often
less because interest expense reduces taxable income. In
contrast, dividends paid to shareholders are not tax
deductible. (Recall that interest is a deductible expense in
arriving at taxable income; dividends are not.)
Debt Financing 9
Disadvantages:
1. The required interest payments must be made each
interest period. In contrast, dividends usually are paid to
shareholders only if earnings are satisfactory. Each year,
some companies go bankrupt because of their inability
to make their required interest payments to creditors.
2. The large principal amount must be paid at maturity
date.

Debt Financing 10
Sound financing of a business requires a realistic balance
between the amounts of debt and owners equity.

HOW does the choice of the equity or bond financing

affect the financial statements for the next couple of years,
such as:

1. The effect of interest expenses and dividends on after-

tax net income
2. The effect of interest and dividends on cash flows
3. The effect on debt-to-equity ratio

Debt Financing 11
2. Valuing and Accounting for Bonds
2.1 Bond Discount and Premium
If purchasers pay the face amount for a bond, the bond is
said to be issued at par.

If purchasers pay less than the face amount for a bond,

then the difference between the face amount and what the
purchasers actually pay is referred to as a bond discount.

If the purchasers pay more than the face amount, then the
additional payment is referred to as a bond premium.

Debt Financing 12
These situations will prevail because
1. the periodic cash interest payment is fixed (depending on
the coupon rate),
2. the market rate of interest (the yield rate or effective yield)
is set by the market.

Therefore, the price paid for the bond must be adjusted to

earn the market rate of interest for the investors.

Debt Financing 13
The selling price of a bond is determined by the relationship
between the bonds contract interest rate and the market
interest rate when the bond is issued.
Bond sells at:
Premium (i.e. selling price >
>
face value)
Coupon Rate = Market Rate face value
Discount (i.e. selling price <
<
face value)
Consider when a bond is sold at discount, investor will not buy your bond
if they can earn a higher rate elsewhere. You will need to drop the price of
your bond so that the investors are really getting the market rate of return.
In other words, you need to drop the price to the present value of the bond
using the market interest rate.
Debt Financing 14
2.2 Measuring Bonds Payable and Interest
Expense
The cash flows related to a bond for the bond issuers are as
follows:

1. Cash received at issuance date = market price of the bond.

2. Cash paid at each interest date = par value of the bond
stated (coupon) rate of interest.
3. Cash paid at maturity date = par value.

The accounting approach used to account for bonds payable

is based primarily on the historical cost and matching
principles.

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At issuance date:
In conformity with the historical cost principle, bonds
payable are recorded at their issue price, which is equal to
the present value of all future payments using the market
rate of interest.

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 A price that a buyer is willing to pay for a bond is the sum of
the present values of
1. Face amount of the bonds at the maturity date, F.
2. Periodic interest payments, R.

Cash Flow
$R $R $R $F+R

0 1 2 3 n
Time

PV = $F pi,n + $R Pi,n
PV of $1 = pi,n = 1 / (1 + i)n PV of annuity of $1 = Pi,n = [1 - 1 / (1 + i)n] / i
(Table 2, P-2) (Table 4, P-4)
Debt Financing 17
At the end of each interest period:

Each interest period bond interest expense is measured,

recorded, and reported in conformity with the matching
principle.

At the end of each period, the amount of interest unpaid

must be accrued and reported as expense so that it will
be matched with the revenue in the period in which it
was accrued.

Debt Financing 18
2.3 Accounting for Bonds Illustrated
Issue at Discount:

Suppose that a $1,000 bond has a coupon rate of 10%,

payable semi-annually, and 10 years to redemption - that
is, the holder of the bond will be entitled to two interest
payments of $50 each year plus principal payment of
$1,000 when the bond is mature.
At the time of sale, the prevailing market interest rate for
that type of bond is 12%. What would be the price that
purchasers are willing to pay for such a bond?

Debt Financing 19
F= Face value of $1,000
n= 20 (number of time periods in 10 years that interest
payments are paid)
i= Market rate of interest is 6% (since annual interest rate
is 12%, semiannual interest rate is 6%)
R= payments of 10% of $1,000 are $50 per half-year
p= 0.3118 $1,000 = $312, is the present value of face
value of the bond to be paid in 10 years or 20 half-year
periods
P= 11.4699 $50 = $573, is the present value of the
interest payments which will be paid each half-year for
the 10 years
Debt Financing 20
The issue price of the bond would be the sum of the two
present value amounts (PV = $312 + $573 = $885) and
this is the amount that bonds would sell for on the open
market.

Journal entry to record this issue

Cash (asset) $885

Discount on bonds payable 115

(contra account)
Bonds payable (liability) $1,000

To record issuance of the bond at a discount

Debt Financing 21
Balance Sheet Presentations

Unless bonds are due to mature within one year, they are
listed in the long-term liability section of the balance sheet.
A discount (premium) is subtracted (added) from (to) the
bond payable account.
Thus, if the financial statements were prepared immediately
after the issuance, the liability would be reported as follows:

Bonds payable $1,000

Less: Discount on bonds 115

Net liability $885
Debt Financing 22
Remarks:
The net liability to be reported would be only $885, not the
$1,000 face value of the bond. The company will, of course,
have to pay $1,000 at time of maturity. But if it only borrowed
$885, then the extra $115 must represent interest, in addition
to the semi-annual coupon payments, to be paid to the lender.
The additional $115 has the effect of increasing the rate of
interest paid by the company from 10% to 12%.
Interest is not ordinarily reported as a liability and recorded as
an expense until the borrower has had use of the funds. Thus,
the liability for the additional interest of $115 should be added
to the liability account over the remaining life of the bond
issue - as the firm has used of the funds borrowed.

Debt Financing 23
Issue at Premium:

If the prevailing interest rate was lower than 10%, say 8%,
then rational buyers would be willing to pay more than
$1,000 for the bond. If they were to purchase the bonds of
similar companies, the buyers would receive only $40 per
half-year in interest. They would be willing to pay
something above $1,000 to receive a return of $50 per
half-year.

Debt Financing 24
F= Face value of $1,000
n= 20
i= Market rate of interest is 4%
R= Payments of 10% of 1,000 are $50 per half-year
p= 0.4564 $1,000 = $456, is the present value of face 10
years
P= 13.5903 $50 = $680, is the present value of the
interest payments which will be paid per half-year for
the 10 years

Debt Financing 25
The issue price of the bond would be the sum of the
two present value amounts (PV = $456 + $680 =
$1,136) and this is the amount that bonds would sell
for on the open market.

Journal entry to record the issue:

Cash $ 1,136
Premium on bonds payable $136
Bond Payable $1,000
To record issuance of the bond at a premium

Debt Financing 26
Thus, if the financial statements were prepared immediately
after the issuance, the liability would be reported as
follows:

Bonds payable $1,000

Plus: Premium on bonds payable 136
Net liability $1,136
The net liability to be reported would be $1,136, not the
$1,000 face value of the bond.
The $136 represents a reduction, over the life of the bond
issue, of the firms borrowing costs and should be
accounted for as such.
Debt Financing 27
2.4 Amortization of Bond Discount and Premium
To comply with the matching principle, a discount or
premium should be allocated systematically to each
accounting period benefiting from the use of the cash
proceeds.
A discount or premium on bonds payable is amortized to
interest expense over the life of the bonds by using the
effective interest rate method (which is required by IFRS).
At each subsequent balance sheet date:
Net Liability = Face Amount of the Bonds
Unamortized Discount
(or + Unamortized Premium)
Debt Financing 28
 Under the effective interest rate method:
For each subsequent accounting period:

Amount of Amortization =
||(Beginning) Net Liability Effective Interest Rate*
Amount of Interest Paid||

* The effective interest rate is the market interest rate at the

bond issuance date.

In the previous example of bonds payable issued at a

discount, the company borrowed $885 at an effective
interest rate of 12% (6% per interest period). Each interest
date, however, it must pay the bondholder only $50.
Debt Financing 29
On the first interest date, its effective interest expense of $885, or
$53 ($885 6%), an amount that is $3 greater than the actual
payment of $50 to be made to the bondholder.
The $3 represents the first interest periods share of the $115 in
additional interest to be paid upon maturity of the loan. It is the
amount of the discount that must be amortized and charged as
additional interest expense in the first interest period.
The following entry would reflect this interpretation of the bond
discount:
Interest expense $53
Cash $50
Discount on bonds payable 3
To record payment of interest and amortization of discount
Debt Financing 30
As a result of this entry, the unamortized portion of the bond
discount has been reduced from $115 to $112. The bond
would be reported in the liability section of the balance sheet
as follows:
Bonds payable $1,000
Less: Discount on bonds payable 112
Net liability $888

The effective liability of the company has increased from $885

to $888 because the company now owes not only the original
amount borrowed ($885) but also a portion of the interest which
the bondholder has earned during the first interest period. The
additional interest now owed is equal to the effective interest for
the period ($53) less the amount actually paid ($50).
Debt Financing 31
2.5 Financial Statement Effects of Issuing a Bond

Statement of Cash Flow

Cash Flow from Financing Cash Flow from Operations

Issuance of Increased by cash received No effect
debt (Present value of the bond at
the market interest rate)
Periodic No effect Decreased by interest paid
interest (coupon rate face value)
payments
Payment at Decreased by face (par) No effect
maturity value

Debt Financing 32
 Income Statement
Issued at Par Issued at a Premium Issued at a Discount
Market rate = face rate Market rate < face rate Market rate > face rate
Interest expense Interest expense Interest expense
= coupon rate face = cash paid amortization = cash paid +
value of premium (reduction in amortization of discount
interest) (addition to interest)
= cash paid
Interest expense is Interest expense decreases Interest expense increases
constant over time over time

Debt Financing 33
 Balance Sheet
Issued at Par Issued at a Premium Issued at a Discount
Carried at face value Carried at face value plus Carried at face value less
premium discount
The liability is The liability decreases as The liability increases as
constant the premium is amortized to the discount is amortized to
decrease interest expense increase interest expense

Debt Financing 34
 The Carrying Value of a Bond Issued at a Discount
The discount:
It gets smaller as time passes

Maturity
value:
$1 million
The carrying value
Issue
of bonds payable:
price:
It gradually increases
$970,000
toward the maturity date

Issuance Maturity
date date
Debt Financing 35
Example:
Three different two-year, $1,000 face-value bonds are
issued at an annual market rate of interest of 10 percent.
The bonds have different annual coupon rates (10%, 12%
and 0%) resulting in differing issuing prices.

Bond A Bond B* Bond C

Coupon rate 10% 12% 0%
Issue price (PV of Cash Flow at 10%) ? $1,035 ?

* $1,000 0.8264 + $120 1.7355 = $1,035

Debt Financing 36
Example Contd
Year 1
Bond A Bond B Bond C
Cash flow from financing +$1,000 +1,035 +$ 826
Cash flow from operations -100 -120 ?
Interest expense 100 103 ?
Debt at end of year 1,000 1,018 ?
Year 2
Bond A Bond B Bond C
Cash flow from financing -$1,000 -$1,000 -$1,000
Cash flow from operations -100 -120 ?
Interest expense 100 102 ?
Debt at end of year 0 0 0
Debt Financing 37
Explanation of the example
During the year when the bonds are issued:
Different interest expenses represent different amount of
cash received from the three bonds
Zero-coupon bond C has no deduction from cash flow from
operation even though it has interest expense
Bond issued at a discount will have more cash flow from
operations (CFO overstated) and less cash flow from
financing (CFF is understated) since interest paid < interest
expense
Bond issued at a premium will have more cash flow from
financing (CFF is overstated) and less cash flow from
operations (CFO is understated) since interest paid > interest
expense

Debt Financing 38
3. Accounting for Convertible Bonds
A convertible bond gives the investor the option of
converting the security into a specified number of shares of
ordinary share/common stock within a specified time
period.

Two accounting events related to convertible bond are (1)

valuation at the date of issue and (2) accounting for
conversion.

Debt Financing 39
3.1 Date of Issuance Valuation
Convertible bond usually can be issued at a high price than
bond issued without a conversion feature. (WHY?)

HKAS 32 Financial Instruments: Disclosure and

Presentation requires the following method for the
accounting for convertible bond at the time of issuance:

With-and-without method:
Convertible bond is considered to consist of a liability
component and an equity component. The total proceeds
received on the sale of convertible bond are allocated
between debt and stockholders equity. The split is made at
the issuance and is not revised for subsequent changes in
market interest rates, share prices or other events that change
the likelihood that conversion option will be exercised.
Debt Financing 40
For example, suppose without conversion feature, the bonds
would have a higher yield (say, 9% instead of 8% in the
absence of the conversion feature). Price would go down.

The difference would be credited to Paid-in Capital from

Bond Conversion Feature (HKAS 32 and IAS 32).

It is as if the bond investor has paid for the option to become

a shareholder in addition to paying for the right to receive
cash flows.

ADDITIONAL READINGS: HKAS 32. (It can be found

in http://www.hkicpa.org.hk. Click Standards &
Regulation, then Standards, then Financial Reporting, and
then choose Hong Kong Accounting Standards (HKAS).)
Debt Financing 41
Remarks:
The effective interest rate of the convertible bond is the
market interest rate of a pure bond of similar credit risk
characteristics.
When convertible bond is issued at a premium or discount, a
question arises regarding the time period over which the
premium or discount should be amortized. Since there is no
way to predict with certainty when conversion will occur, the
premium or discount should be amortized as if the bonds will
remain outstanding until maturity.

Debt Financing 42
Example:
On-Wing Corp. issued $120,000 of 10%, payable annually,
10-year convertible bonds for $136,105 (an 8% effective
yield). Each $1,000 bond was convertible to 8 shares of
ordinary share on any interest date beginning 2 years from
date of issue.

Following the WITH-AND-WITHOUT METHOD and lets

assume that without the option, investors would demand a
HIGHER yield of 9%.

Debt Financing 43
Bonds payable without conversion feature:
PV on issuance date = 120,000 p 9%,10
+12,000 P 9%,10
= 127,701

Journal entries (Date of Issuance):

Cash $136,105
Bonds payable $120,000
Premium on bonds payable 7,701
Paid-in capital from bond
conversion feature (plug-in) 8,404

Debt Financing 44
3.2 Conversion of Bonds into Ordinary Shares
When convertible bond is converted into ordinary shares,
it is necessary to remove the bonds and to record the
ordinary shares issued.
Accounting for bond conversion under HKAS 32 and IAS
32 - the book value method:
No gain or loss is recognized when the bonds are
converted, because the conversion occurs under terms
of pre-existing contract that already has been
recognized in the financial statements.
The book value of equity shares issued will be the same
as the sum of the book carrying values of bonds and
paid-in capital from bond conversion feature at the date
of conversion.

Debt Financing 45
Example (Continued):
Now, lets consider at the end of 6th year, the date when
Mr. Black, the investor who owned 40% of all debt
outstanding of On-Wing Corp., converted.

The book carrying value of bonds payable at the end of 6th

year
= PV at the end of 6th year
= 120,000 p 9%,4 + 12,000 P 9%,4
= 123,888.

Debt Financing 46
At conversion date, using the BOOK VALUE METHOD,
no gain or loss recorded by the issuer.

Issuer ---------------------->
40% 120 8 = 384 ordinary shares

Debt with a BV of $49,555 ($123,888 40%)

+ conversion option with a BV of $3,362 ($8,404 40%)
< ------------------- Investor

Debt Financing 47
Journal entries (Date of Conversion):
Bonds payable ($120,000 40%) $48,000
Premium on bonds payable
(49,555 48,000) 1,555
Paid-in capital from bond conversion
feature* 3,362
Ordinary shares capital 52,917
(to balance)

* If no more conversion takes place till the expiration date of

the conversion option, the remaining balance in the paid-in
capital from bond conversion feature account will be
transferred to the ordinary share capital account.
Debt Financing 48
4. Extinguishment of Debts
Retirement of debts at the maturity date - Simple!

Early Extinguishment of Debts - retirement of debts before

they mature
Reasons:
Refinancing debts taking advantage of the
lowering interest rate
To change the financial leverage so as to avoid debt
covenant violation
Idle cash

Debt Financing 49
Methods for Early Extinguishment of Debts
1. Purchasing on the open market
2. Exercising the callable option
3. Refinancing: substituting new debt for original issue by
using the proceeds of new debt to retire old debt
4. Defeasance: legally released from being the primary
obligor of the debt, e.g., parent company assumes the role
of being the primary obligor of its subsidiary
5. In-substance defeasance: placing sufficient risk-free
assets in an irrevocable trust solely for the purpose of
servicing the debt; does not involve the actual retirement
of debt

Debt Financing 50
Gain or Loss on Early Extinguishment of Debts
Even though we always use the market interest rate of
the issuance date to calculate the interest expenses
throughout the life of the bonds, the market interest rate
generally changes every day.
When the market interest rate moves up (down), the
market value of the bonds decreases (increases).
For various reasons, the issuing firm may want to
purchase back the bonds it sold to the investing public.
This will result in a gain or loss.

Debt Financing 51
Gain or Loss = Book Value of the Bonds
Cash Paid (market value)

Any gain or loss on the transaction is reported on the income

statement.

Debt Financing 52
 Example (Early Extinguishment of Debts by Open
Market Purchase and In-substance Defeasance):

On January 1, 2014, Chung Shan Company issued 2,000 of

its 5-year, $1,000 face value, 11% bonds at an effective
annual interest rate (yield) of 9%. Interest is payable each
December 31.
Chung Shan uses the effective-interest method of
amortization.
On December 31, 2015, the 2,000 bonds were extinguished
early through acquisition in the open market by Chung
Shan for $1,980,000.

Debt Financing 53
 COMPUTATIONS for 11% bonds: (Interest payable once
per year)

F= $2,000,000
p 9%,5 = 0.6499 (PV Lump Sum; 5 years; 9%
interest)
p= $2,000,000 .6499 = $1,299,800
R= $220,000 ($2,000,000 11%)
P 9%,5 = 3.8897 (PV Annuity; 5 years; 9% interest)
P= $220,000 3.8897 = 855,734
$2,155,534

Debt Financing 54
 Journal Entries (Date of Issuance):

2014
Jan 1 Cash $2,155,534
Bonds Payable $2,000,000
Premium on Bonds Payable 155,534

Debt Financing 55
Computations for premium amortizations
1Present value of bonds January 1, 2014 $2,155,534
Interest payment at 11% $220,000
Interest expense at 9% (193,998)
Premium amortization for period 26,002
Present value of bonds January 1, 2015 $2,129,532
Interest payment at 11% 220,000
Interest expense at 9% (191,658)
Premium amortization for period 28,342
Present value of bonds December 31, 2015 $2,101,190

Debt Financing 56
Computations for gain (loss) on bond retirement
2Unamortized premium as of Dec 31, 2015:
$155,534 $26,002 $28,342 = $101,190
(See 1 above)
3Carrying value of bonds $2,101,190
Cash paid/received on bond retirement (1,980,000)
Gain (loss) on bond retirement $121,190

Debt Financing 57
Journal Entries (Interest Payment Date):
2014
Dec.31 Interest Expense 193,9981
Premium on Bonds Payable 26,0021
Cash 220,000

Debt Financing 58
Journal Entries (Interest Payment and Early Bond Retirement):
2015
Dec.31 Interest Expense 191,6581
Premium on Bonds Payable 28,3421
Cash 220,000
Dec.31 Bonds Payable 2,000,000
Premium on Bonds Payable 101,1902
Cash 1,980,000
Gain on Bond Retirement 121,1903

Debt Financing 59
Now, suppose that Chung Shan could not purchase the
debt in the open market on December 31, 2015, but they
could purchase a risk-free instrument (government bonds)
with a face value of $2,000,000 and a 3-year term, which
pays 11% interest on December 31.
If they put this instrument in an irrevocable trust (operated
independently by a bank), the interests and principal of this
instrument can pay off Chung Shans debt.
This is called in-substance defeasance and the journal
entries are:

Debt Financing 60
Purchase of the risk-free instrument at a market value
of $1,950,000:

Investment $1,950,000
Cash $1,950,000

In-substance defeasance:
Bonds payable $2,000,000
Premium on bonds payable 101,190
Investment $1,950,000
Gain on bond retirement 151,190

Debt Financing 61
5. Troubled Debts

An issuer of debts may find it difficult to make the cash

payments required under the terms of the debt instrument
because of changes in economic conditions.

Debt Financing 62
5.1 Debt Impairments
A loan is considered impaired when it is probable, based
on current information and events, that the creditor will be
unable to collect all amounts due (both principal and
interest) according to the contractual terms of the loan.

Because nothing legally has changed, we are making

speculation about the outcome of future events. From the
lenders perspective we are dealing with a loss contingency
(a gain contingency from the borrowers perspective).

Debt Financing 63
 How do we calculate the lenders loss?

Carrying Value of Debt

Less: PV of expected future Cash Flows Using Historical Rates
= Loss on Impairment

Lenders journal entry (for making a provision):

Bad Debt XXX
Allowance for Doubtful A/C XXX

Debt Financing 64
Remarks:

Expected future Cash Flows (CF) are what we believe we

are going to collect, not the payments due under the normal
loan agreement.

The lender will write the loss off as a bad debt. Interest is
calculated based on new Carrying Value (CV) using the
historical effective rate, i.e., interest revenue = New CV
historical effective rate

The borrower makes no entry for a contingent gain.

Debt Financing 65
5.2 Settlement of Debt
To avoid bankruptcy proceedings, the creditor may
sometimes grant a concession to the debtor and settle the
debt for less than its carrying amount. The creditor may
end up accepting non-cash assets (i.e., an asset swap) or an
equity interest (i.e., an equity swap) instead of cash.
Both the creditor and debtor need to compare the CV of the
debt to the Fair Market Value (FMV) of the assets
transferred (or equity interests provided) to determine if a
gain (debtor) or loss (creditor) has been realized.
The creditor records the asset received at FMV, removes
the debt off the books and records bad debt for the
difference.

Debt Financing 66
Asset Swap--Debtor
FMV Asset No Not a troubled
< debt? debt restructure.
Yes

Remove debt and

asset from books.

Restructuring Gain Disposal Gain/Loss

= Debt - FMV Asset = FMV Asset - Book
Value of Asset
Debt Financing 67
Equity Swap--Debtor
FMV Equity No Not a troubled
< debt? debt restructure.
Yes
Remove debt from
books and record new
equity.

Restructuring Gain
=Debt - FMV Equity
Debt Financing 68
Asset or Equity Swap--Creditor
FMV Asset Yes Not a troubled
> loan? debt restructure.
No
Remove loan from
books and record
asset at FMV.

Restructure Loss =
Loan - FMV Asset
Debt Financing 69
Debtor may have up to 3 transactions to reflect on his books
1) Gain on debt restructuring
2) Gain or loss on disposal of the asset (if any)
3) Issuance of shares (if any)

Debt Financing 70
Example:

FACTS: Ping Lo Co. owes $1,998,000 to Man Fat, Inc

Original Debt Terms: 10 years, 11% Note

Man Fat agrees to accept property with a net book

value of $800,000 and a FMV of $1,200,000 in
full settlement of the debt

Debt Financing 71
Step 1: Calculate the Creditors Loss and the Debtors Gain on
the settlement

Value Received/Paid to settle the Note 1,200,000

Carrying Value of the Note 1,998,000
Creditors Loss/Debtors Gain (798,000)

Step 2: Record Entry on Ping Lo Co.s books:

Debit Credit
Note Payable 1,998,000
Property Investment 800,000
Gain on Asset Disposition 400,000
Gain on Debt Restructuring 798,000
Debt Financing 72
Step 3: Record Entry on Man Fats books:

Debit Credit
Allowance for doubtful account* 798,000
Property Investment 1,200,000
Note Receivable 1,998,000

* If the client has not already reserved for this potential

bad debt or if there is an insufficient balance in the
Allowance Account, the debit would go to Bad Debt
Expense.
Debt Financing 73
5.3 Modification of Terms
The creditor grants a concession to the debtor and makes the
terms of the debt more favorable (to the debtor), including
lower interest rate, extending maturity date, lowering face
amount, and deferring or forgiving interest.

According to HKAS 32 para 40, a modification of the terms

of an existing financial liability shall be accounted for as an
extinguishment of the original financial liability and the
recognition of a new financial liability.

Debtors Gain/Creditors Loss and Future Interest - Same

calculation as with an impairment.

Debt Financing 74
Example:
Stanton Industries signed a 10% notes of $1,000,000 with
Motion Co. on Jan 1, 2014, to finance the acquisition of an
asset. Maturity date is Dec 31, 2017. Interest paid on
every Jun 30 and Dec 31.
On Jan 1, 2015, Stanton is behind in its interest payments
and is threatened with bankruptcy proceedings.
The carrying value of the notes on Stantons books is
$1,050,000 after adding unpaid interest of $50,000.
Assume that, as concessions, the interest rate on the
Stanton Industries notes is reduced from 10% to 8%, the
maturity date is extended from 3 to 4 years from the
restructuring date, the maturity value is reduced by
$200,000, and the past interest due of $50,000 is forgiven.

Debt Financing 75
At Jan 1, 2015, the fair value of the new agreement equals to the
PV of future cash flows using the historical interest rate:
$800,000 p 5%,8 + $32,000 P 5%,8 = $748,262.

Since the carrying value of the notes exceeds the fair value of the
new agreement by $301,738 ($1,050,000 $748,262), the entries
to record the restructuring and this gain on Stantons books would
be as follows:

Interest Payable 50,000

Notes Payable 1,000,000
Restructured Debt 748,262
Gain on Restructuring of Debt 301,738

Debt Financing 76