Understanding Debt Instruments

Bonds and Notes Payable

Characteristics
Bond indentures represent a promise to pay both the following:
a. A sum of money on a designated maturity date
b. Periodic interest at a specified rate on the maturity amount (face
value)
Bonds may be sold through an investment banker or by private
placement
Investment bankers may do one of two things:
a. Firm Underwriting: Underwrite the entire issue by
guaranteeing a certain sum to the corporation, thus taking the risk of
selling the bonds for whatever the price the agent can get
b. Best Efforts Underwriting: Sell the bonds for a commission
that will be deducted from the proceeds of the sale
Private placement is when an issuing company may choose to place a
bond issue privately by selling directly to a large institution - without the aid
of an underwriter

Types

Registered Bonds Bonds that are issued in the owner's name

To sell, the current certificate must be surrendere
and a new one is then created
Bearer (Coupon) Freely transferrable - no name attached
Bonds Physical pieces of paper
Secured Debt Backed by a pledge of some sort of collateral
Term Bonds/Notes Debt issues that mature on a single date
Serial Bonds/Notes Issues that mature in instalments
Frequently used by schools, municipalities, and
provincial and federal governments
Perpetual Unusually long terms - over 100 years or no
Bonds/Notes maturity date
Income Bonds Pay no interest unless the issuing company is
profitable
Revenue Bonds Interest is paid from a specified revenue source
Deep Discount Also known as zero-interest debentures, bonds, o
Bonds/Notes notes
Have very little to no interest each year, and are
therefore sold at a large discount that basically provides the buyer with a
total interest payoff (at market rates) at maturity
Commodity- Also called asset-linked debt
Backed Bonds Redeemable in amounts of a commodity, such as
 barrels of oil, tonnes of coal, or ounces of rare metal
Callable Give the issuer the right to call and retire the deb
Bonds/Notes before maturity (sometimes referred to as demand loans)
Convertible Debt Allows the holder or the issuer to convert the deb
into other securities such as common stock

Defeasance
If a company would like to extinguish or pay off their debt before the
due date, but economic factors (early repayment penalties) stop it from
doing so, they can use defeasance
a. Setting the money aside in a trust or other arrangement and
allow the trust to repay the original debt (interest and principal) as it
becomes due
If the creditor of the original debt agrees to look to the trust for
repayment and give up its claim on the company, it is known as legal
defeasance

Measurement

Discounts and Premiums

Straight-Line Method (Acceptable under ASPE)
Effective Interest (Required under IFRS)
a. When the stated rate is greater (lower) than the market rate,
there is a premium (discount)

Special Situations

Non-Market Rates of Interest Marketable Securities

If a marketable security is issued for cash only and is marketable, its
fair value = cash received by issuer
The implicit / imputed interest rate is the rate that makes the cash that
is received now equal to the present value of the amounts that will be
received in the future
a. This rate should also equal the market rate of interest
b. The difference between the face amount and the PV is the
discount, which is amortized over the life of the bond/note
Example:
a. We issue a $10,000, three year, zero-interest-bearing note that
is marketable
b. The rate that equates the face value (10,000) and the PV of cash
flows (7,721.80) is 9%
We would debit cash and credit NP for 7,722
The discount (2,278) would be amortized over the three
year period

Non-Market Rates of Interest Non-Marketable Instruments

The cash paid may not be equal to the FV of what was bought there
may be additional value being transferred
 Must measure fair value of loan by discounting the cash flows using a
market rate of interest (treated like a zero-coupon bond)
Any difference is booked to net income unless it meets the definition of
an asset or liability
Example:
a. The government provides a $100,000, five year, zero-interest-
bearing note; market rate = 10%
b. Funds are to help a business fund a building
c. The company would record a discount of (37,908), which is the
difference between its face value and FV
$ 100,000
d. FV of the note is =62,902
( 1.1 )5
e. Journal Entry:
Cash
Notes Payable
Buildings

Notes Issued for Property, Goods, and Services

If the issued debt is a marketable security, the value of the transaction
would equal to fair value of the marketable security
If the issued debt is not a marketable security:
a. May try to value the debt by discounting cash flows at market
rate of interest, or
b. May use the fair value of the property, goods, services
Any discount or premium is amortized over the life of the note

Fair Value Option

Generally, LT debt is measured at amortized cost, but there is the
option to value at fair value
ASPE allows the fair value option for all financial instruments
IFRS explicitly requires that the opinion be used only where fair value
results in more relevant information
a. Note: Changes in fair value due to changes in credit risk that
arise under the fair value option flows through URGL (URGL-OCI for
IFRS)

Recognition and Derecognition

From a financial reporting perspective, the extinguishment of debt is
recorded when either of the following occurs:
a. The debtor discharges the liability by paying the creditor
b. The debtor is legally released from primary responsibility for the
liability by law or by the creditor (ex. Due to cancellation or expiry)

Repayment before Maturity Date

When debt is paid out prior to maturity, the amount paid is called the
reacquisition price
a. Includes any call premium and expenses
 b. If the net carrying amount is greater than the reacquisition price,
the excess amount is a gain from extinguishment
c. If the reacquisition price is greater than the net carrying amount,
the excess is a loss from extinguishment
Net carrying amount is the amount payable at maturity
adjusted for any unamortized premium or discount and cost of
issuance

Exchange of Debt Instruments

The replacement of an existing issuance with a new one is sometimes
called refunding
If the new debt is substantially the same as the old debt, the economic
substance is a continuation of the old debt, even though, legally, the old
debt may have been settled

Troubled Debt Restructurings

Occurs when a creditor grants a [favourable] concession to the debtor
(for economic / legal reasons related to the debtor's financial difficulties)
A troubled debt restructuring can be either one of these two basic
types of transactions:
a. Settlement of the debt at less than its carrying amount
b. Continuation of the debt, but with a modification of its terms
Substantial Modification
Non-Substantial Modification

Settlement of a Debt
Old debt and all related discounts, premiums, and insurance costs, will be
removed from the debtor's books (derecognized)
A gain is usually recognized since the creditor generally settles at less than
the carrying value
In order to settle the debt, the debtor may do one of the following:
a. Transfer non-cash assets (real estate, receivables, or other
assets)
If non-cash assets are used to settle the debt, the debtor
will recognize a G/L on disposal of the asset (FV - BV)
b. Issue shares
c. Issue new debt to another creditor and use cash to repay the
existing debt

2 In some cases, a debtor will have serious short-term cash flow problems that
lead it to request one or a combination of the following modifications:
a. Reduction of the stated interest rate
b. Extension of the maturity date of the debt's face amount
c. Reduction of the debt's face amount
d. Reduction or deferral of any accrued interest
e. Change in currency

Substantial Modification
 3 If there are substantial modifications, the transaction is treated like a
settlement. It would be considered substantial if:
a. The discounted PV under the new terms (discounted with the
original interest rate) is at least 10% different from the discounted PV of
the remaining cash flows under the old debt
b. There is a change in creditor and the original debt is legally
discharged

Non-Substantial Modification of Terms

4 No gain or loss is recognized
5 New effective interest rate must be computed to determine future interest
expense

Defeasance Revisited
6 Sufficient funds set aside (ex. In a trust) to pay off principal and interest of
debt
7 Legal Defeasance: The debt is extinguished and the creditor looks to the
trust for repayment (the debtor may derecognize the debt)
8 In-Substance Defeasance: When the creditor is not aware of the trust
arrangement
a. The debt may not be derecognized since the company still owes
the money

Off-Balance Sheet Financing

9 Off-balance sheet financing represents borrowing arrangements that are not
recorded on the SFP
10 Examples of off-balance sheet financing:
a. Non-consolidated entities: Under GAAP, a parent company does
not have to consolidate an entity that is less than 50% owned where
there is no control
The liabilities of the company would not be reflected on
the balance sheet of the parent company, although the parent may
be ultimately liable for the debt
b. Special purpose entities or variable interest entities: A special
purpose entity (SPE) or variable interest entity (VIE) is an entity that a
company creates to perform a special project or function (OVER THE
SCOPE OF THIS BOOK)
Access Financing (securitization of assets)
Take on risk from the company
Isolate certain assets from other company assets
c. Operating Leases: Leasing rather than owning
If the lease is considered an operating lease, the company
would need to record rent expense each period with note
disclosure
11 In general, increased note disclosure is the accounting profession's response
to off-balance sheet financing

Presentation, Disclosure, and Analysis

Presentation
Current versus Long-Term Debt
12 Debt to be refinanced is treated as current unless the refinancing has
occurred before the release of the FS or a refinancing agreement is in place

Debt versus Equity

13 Dependent on nature of the instrument

Disclosures
14 Note disclosures generally indicate the following:
a. The nature of the liabilities
b. Maturity dates
c. Interest rates
d. Call provisions
e. Conversion privileges
f. Restrictions imposed on creditors
g. Assets designated or pledged as security
15 Any assets pledged as security should be shown as such in the assets
section of the SoFP
16 Fair value of LT-debt should also be disclosed

Analysis
17 Lenders put covenants in lending agreements to encourage reporting basis
a. Covenants are often written in a way that can be interpreted (or
misinterpreted) in different ways; therefore, they provide little to no
protection

18 Debt to Total Assets Ratio = Total Debt / Total Assets

a. The higher the percentage, the greater the risk of meeting
obligations
19 Times Interest Earned Ratio = Income before Income Taxes and Interest
Expense / Interest Expense
a. The higher the ratio, the better the company's ability to ensure
that its interest payments are made