14

Bonds and Long-Term Notes

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

The Nature of Long-Term Debt

Liabilities signify creditors interest in a companys assets.

A note payable and not receivable are two sides of the same coin.

A bond payable divides a large liability into many smaller liabilities.

Periodic interest in the effective interest rate times the amount of the debt outstanding during the period. Debt is reported at its present value

Corporations issuing bonds are obligated to repay a stated amount at a specified maturity date and period interest between the issue date.

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Bonds
At Bond Issuance Date
Company Issuing Bonds
Bond Selling Price Bond Certificate

Investor Buying Bonds

Subsequent Periods
Company Issuing Bonds
Interest Payments

Face Value Payment at End of Bond Term

Investor Buying Bonds

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The Bond Indenture

Debenture Bond secured by the full faith and credit of company. Mortgage Bond secured by lien on specific real estate owned by the issuer.

The specific promises made to bondholders are described in a document called a bond indenture.
Coupon Bond pays interest when investor submits attached coupon. Callable Bond allows company to buy back outstanding bonds prior to maturity.

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Recording Bonds at Issuance

On January 1, 2011, Masterwear Industries issued $700,000 of 12% bonds. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years [an unrealistically short maturity to shorten the illustration]. The entire bond issue was sold in a private placement to United Intergroup, Inc. at face amount. At Issuance (January 1) Masterwear (Issuer) Cash Bonds payable United (Investor) Investment in bonds (face amount) Cash 700,000 700,000

700,000
700,000

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Determining the Selling Price

Stated interest rate is: Below market rate The bonds sells: At a discount
(Cash received is less than face amount)

Equal to market rate

At face amount
(Cash received is equal to face amount)

At a premium Above market rate

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(Cash received is greater than face amount)

Determining the Selling Price

On January 1, 2011, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup.
Present value of an ordinary annuity of $1: n=6, i=7%
Calculation of the Price of the Bonds Interest Principal Present value (price) of bonds $ 42,000 4.76654 = $700000 0.66634 = Present Values $ 200,195 466,438 $ 666,633

present value of $1: n=6, i=7% Because interest is paid semiannually, the present value calculations use: (a) the semiannual stated rate (6%), (b) the semiannual market rate (7%), and (c) 6 (3 x 2) semi-annual periods.
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Masterwear (Issuer) Cash Discount on bonds payable Bonds payable

Bonds Issued at a Discount

666,633 33,367 700,000 700,000 33,367 666,633

United (Investor) Investment in bonds Discount on bond investment Cash

Alternative net method

Masterwear (Issuer) Cash Bonds payable United (Investor) Investment in bonds Cash
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666,633
666,633 666,633

666,633

Determining Interest Effective Interest Method

Interest accrues on an outstanding debt at a constant percentage of the debt each period. Interest each period is recorded as the effective market rate of interest multiplied by the outstanding balance of the debt (during the interest period).
Interest is recorded as expense to the issuer and revenue to the investor. For the first six-month interest period the amount is calculated as follows:

$666,633
Outstanding Balance

(14% 2)
Effective Rate

$46,664
Effective Interest

The bond indenture calls for semiannual interest payments of only $42,000 the stated rate (6%) times the face value of $700,000. The difference ($4,664) increases the liability and is reflected as a reduction in the discount (a valuation account).
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Recording Interest Expense

The effective interest is calculated each period as the market rate times the amount of the debt outstanding during the interest period. At the First Interest Date (June 30) Masterwear (Issuer) Interest expense 46,664 Discount on bonds payable 4,664 Cash 42,000 United (Investor) Cash Discount on bond investment Investment revenue
$700,000 (12% 2) = $42,000 $46,664 - $42,000 = $4,664
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42,000 4,664 46,664

$666,633 (14% 2) = $46,664

Bond Amortization Schedule

Here is a bond amortization schedule showing the cash interest, effective interest, discount amortization, and the carrying value of the bonds.
Date 1/1/11 6/30/11 12/31/11 6/30/12 12/31/12 6/30/13 12/31/13
*Rounded.

Cash $ 42,000 42,000 42,000 42,000 42,000 42,000 $ 252,000 $

Effective Interest

Increase in Balance 4,664 4,991 5,340 5,714 6,114 6,544 33,367

46,664 $ 46,991 47,340 47,714 48,114 48,544 * $ 285,367 $

Outstanding Balance $ 666,633 671,297 676,288 681,628 687,342 693,456 700,000

$666,633 + $4,664 = $671,297

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Zero-Coupon Bonds These bonds do not pay interest. Instead, they offer a return in the form of a deep discount from the face amount.

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Bond Issued at Premium

On January 1, 2011, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 10%. The entire bond issue was purchased by United Intergroup.
Present value of an ordinary annuity of $1: n=6, i=6%
Calculation of the Price of the Bonds Interest Principal Present value (price) of bonds $ 42,000 5.07569 = $700,000 0.74622 = Present Values $ 213,179 522,354 $ 735,533

present value of $1: n=6, i=5% Because interest is paid semiannually, the present value calculations use: (a) the semiannual stated rate (6%), (b) the semiannual market rate (5%), and (c) 6 (3 x 2) semi-annual periods.
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Premium Amortization Schedule

Here is a bond amortization schedule showing the cash interest, effective interest, premium amortization, and the carrying value of the bonds.
Date 1/1/11 6/30/11 12/31/11 6/30/12 12/31/12 6/30/13 12/31/13
*Rounded.

Cash $ 42,000 42,000 42,000 42,000 42,000 42,000 $ 252,000 $

Effective Interest

Decrease in Balance 5,223 5,485 5,759 6,047 6,349 6,671 35,533

36,777 $ 36,515 36,241 35,953 35,651 35,329 * $ 216,467 $

Outstanding Balance $ 735,533 730,310 724,825 719,066 713,020 706,671 700,000

$735,533 5% = $36,777
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$735,533 - $5,223 = $730,310

Bonds Sold at a Premium

Masterwear (Issuer) Cash Premium on bonds payable Bonds payable United (Investor) Investment in bonds Premium on bond investment Cash

735,533
35,533 700,000 700,000 35,533 735,533

Interest expense and interest revenue will be recognized in a manner consistent with bonds issued at a discount.

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Premium and Discount Amortization Compared

$735,533

Premium Amortization Discount Amortization $700,000

$666,633

1/1/11

12/31/13

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When Financial Statements Are Prepared Between Interest Dates

On January 1, 2011, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup at a cost of $666,633.

Masterwear and United both have October 31st year-ends.

Semi-annual Stated Interest June 30, 2011 Effective Interest

$700,000 (12% 2) = $42,000

$666,633 (14% 2) = $46,664

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When Financial Statements Are Prepared Between Interest Dates

Year-end is on October 31, 2011, before the second interest date of December 31, so we must accrue interest for 4 months from June 30 to October 31. Year-end accrual of interest expense and interest income.
Masterwear (Issuer) Interest expense Discount on bonds payable Interest payable United (Investor) Interest receivable Discount on bond investment Investment revenue
$42,000 4/6 = $28,000
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31,327 3,327 28,000

28,000 3,327
31,327
$671,297 7% 4/6 = $31,327

$31,327 - $28,000 = $3,327

When Financial Statements Are Prepared Between Interest Dates

On December 31, the next interest payment date, the following entries would be recorded.
Masterwear (Issuer) Interest expense Interest payable Discount on bonds payable Cash United (Investor) Cash Discount on bond investment Interest receivable Investment revenue 23,496 21,000 2,496 42,000

42,000 2,496 21,000 23,496

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The Straight-Line Method A Practical Expediency

Using the straight-line method of amortizing discounts and premiums, the discount in the earlier illustration would be allocated equally to the 6 semiannual periods (3 years): $33,367 6 periods = $5,561 per period
At Each of the Six Interest Dates

Masterwear (Issuer) Interest expense Discount on bonds payable Cash United (Investor) Cash Discount on bond investment Investment revenue
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47,561 5,561 42,000

42,000 5,561 47,561

Debt Issue Costs

Legal Accounting Underwriting Commission Engraving Printing Registration Promotion
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U. S. GAAP vs. IFRS

Debt issue costs (called transaction costs under IFRS) are accounted for differently by U.S. GAAP and IFRS.

Debt issue costs are recorded separately as an asset. Amortized over the term to maturity.

Transaction costs reduce the recorded amount of the debt. The cost of these services reduces the net cash the issuing company receives and the amount recorded for the debt.

Unless the recorded amount of the debt is reduced by the transaction costs, the higher effective interest rate is not reflected in a higher recorded interest expense.
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Long-Term Notes
Promissory Note (Note Payable)

Company (Borrower)

Bank

Property, goods, or services. The liability, note payable, is reported at its present value, similar to the accounting for bonds payable.

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Long-Term Notes
On January 1, 2011, Skill Graphics, Inc., a product labeling and graphics firm, borrowed $700,000 cash from First BancCorp and issued a 3-year, $700,000 promissory note. Interest of $42,000 was payable semiannually on June 30 and December 31.

January 1, At Issuance
Skill Graphics (Borrower) Cash Note payable First BancCorp (Lender) Investment in bonds Cash

700,000
700,000 700,000

700,000

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Long-Term Notes
At Each of the Six Interest Dates
Skill Graphics (Borrower) Interest expense Cash First BancCorp (Lender) Cash Interest revenue 42,000 42,000 42,000 42,000

At Maturity
Skill Graphics (Borrower) Notes payable Cash 700,000 700,000 700,000 700,000

First BancCorp (Lender) Cash Notes receivable

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Note Exchanged for Assets or Services

Skill Graphics purchased a package labeling machine from Hughes Barker Corporation by issuing a 12%, $700,000, 3-year note that requires interest to be paid semiannually. The machine could have been purchased at a cash price of $666,633. The cash price implies an annual market rate of interest of 14%. That is, 7% is the semiannual discount rate that yields a present value of $666,633 for the notes cash flows (interest plus principal) computed as follows:
Present value of an ordinary annuity of $1: n=6, i=7%
Interest Principal Present value (price) of note $ 42,000 4.76654 = $700000 0.66634 = Present Values $ 200,195 466,438 $ 666,633

present value of $1: n=6, i=7%

The accounting treatment is the same whether the amount is determined directly from the market value of the machine or indirectly as the present value of the note.
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At the Purchase Date (January 1)

Skill Graphics (Buyer/Issuer) Machinery Discount on note payable Notes payable Hughes-Baker (Seller/Lender) Notes receivable Discount on notes payable Sales revenue

Note Exchanged for Assets or Services

666,633 33,367 700,000 700,000 33,367 666,633

At the First Interest Date (June 30)

Skill Graphics (Buyer/Issuer) Interest expense Discount on note payable Cash Hughes-Baker (Seller/Lender) Cash Discount on notes payable Investment revenue
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46,664 4,664 42,000 42,000 4,664 46,664

Installment Notes
o To compute cash payment use present value tables. o Each payment includes both an interest amount and a principal amount. o Interest expense or revenue:
Effective interest rate Outstanding balance of debt Interest expense or revenue

o Principal reduction:
Cash amount Interest component Principal reduction per period
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Installment Notes
Notes often are paid in installments, rather than a single amount at maturity.
$666,633 amount of loan 4.76654 (from Table 4) n=6, i=7.0% = $139,857 installment payment
Outstanding Balance

Date

Cash

Effective Interest (7% Outstanding Balance) .07 666,633 = 46,664 .07 573,440 = 40,141 .07 473,724 = 33,161 .07 367,028 = 25,692 .07 252,863 = 17,700 .07 130,706 = 9,151 172,509
Rounded

Decrease in Debt

01/01/11 06/30/11 12/31/11 06/30/12 12/31/12 06/30/13 12/31/13

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139,857 139,857 139,857 139,857 139,857 139,857 839,142

93,193 99,716 106,696 114,165 122,157 130,706 666,633

666,633 573,440 473,724 367,028 252,863 130,706 -

At the Purchase Installment Notes Date (January 1)

Skill Graphics (Buyer/Issuer) Machinery Notes payable Hughes-Baker (Seller/Lender) Notes receivable Sales revenue 666,633 666,633 666,633 666,633

At the First Interest Date (June 30)

Skill Graphics (Buyer/Issuer) Interest expense Note payable Cash Hughes-Baker (Seller/Lender) Cash Notes receivable Interest revenue
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46,664 93,193 139,857 139,857 93,193 46,664

Financial Statement Disclosures Matrix, Inc.

Partial Balance Sheet December 31, 2011 Long-term liabilities Bonds payable, face amount Less: unamortized discount unamortized issue costs Bonds payable, net $ 50,000,000 (244,875) (127,500) 49,627,625

Disclosures include fair value, the nature of the companys liabilities, interest rates, maturity dates, call provisions, conversion options, restrictions imposed by creditors, any assets pledges as collateral and the aggregate amounts payable for each of the next five years.
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Decision Makers Perspective

Debt to Total liabilities = equity ratio Shareholders equity Rate of return on = assets Net income Total assets

Rate of return on Net income = shareholders equity Shareholders equity

Times interest = Net income + interest + taxes earned ratio Interest

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Early Extinguishment of Debt

Debt retired at maturity results in no gains or losses.

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

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Early Extinguishment of Debt

Illustration On January 1, 2011, Masterwear Industries called its $700,000, 12% bonds when their carrying amount was $676,290. The indenture specified a call price of $685,000. The bonds were issued previously at a price to yield 14%.
Masterwear (Issuer) Bonds payable Loss on early extinguishment Discount on bonds payable Cash
$685,000 676,290

700,000 8,710 23,710 685,000

$700,000 676,290

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Convertible Bonds
Some bonds may be converted into common stock at the option of the holder. When bonds are converted the issuer (1) updates interest expense and (2) amortization of discount or premium to the date of conversion. The bonds are reduced and shares of common stock are increased.
Bonds into Stock

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Convertible Bonds
On January 1, 2011, HTL Manufacturers issued $100,000,000 of 8% convertible debentures due 2031 at 103 (103% of face value). The bonds are convertible at the option of the holder into $1 par common stock at a conversion ratio of 40 shares per $1,000 bond. HTL recently issued nonconvertible, 20 year, 8% debentures at 98. At Issuance, January 1, 2011
HTL (Issuer) Cash Convertible bonds payable Premium on bonds payable 103,000,000 100,000,000 3,000,000

$10,000,000 103%
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Convertible Bonds
Assume the bondholder exercise one-half of their option to convert the bonds into shares of stock when there is an unamortized premium of $2,000,000 associated with these bonds. The bonds are removed from the accounting records and the new shares issued are recorded at the same amount (in other words, at the book value of the bonds). At Date of Exercise of One-half of the Bonds
HTL (Issuer) Convertible bonds payable Premium on bonds payable Common stock Paid-in capital excess of par
50,000,000 1,000,000 2,000,000 49,000,000

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50,000 bonds 40 shares $1 par = $2,000,000 par value

Induced Conversion
Companies sometimes try to induce conversion. The motivation might be to reduce debt and become a better risk to potential lenders or achieve a lower debt-to-equity ratio. When the specified call price is less than the conversion value of the bonds (the market value of the shares), calling the convertible bonds provides bondholders with incentive to convert.
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U.S. GAAP vs. IFRS

Convertible Bonds
Under IFRS, unlike U.S. GAAP, convertible debt is divided into its liability and equity elements.
($ in millions)

Cash (103% $100 million) Convertible bonds payable (value of the debt only) Equityconversion option (difference)

103 98* 5

*The discount is combined with the face amount of the bonds. This is the net method the preferred method under IFRS.

Compound instruments such as this one are separated into their liability and equity components in accordance with IAS No. 32. If the bonds have a separate fair value of $98 M, we record that amount as the liability and the remaining $5 M as equity.
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Bonds With Detachable Warrants

Stock

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

A portion

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Bonds With Detachable Warrants

On January 1, 2011, HTL issued $100,000,000 of 8% bonds due in 2018 at 130 (103% of face value). Accompanying each $1,000 bond were 20 warrants. Each warrant permitted the holder to buy one share of $1 par common stock at $25 per share. Shortly after issuance, the warrants were listed on the stock exchange at $3 per warrant.
HTL (Issuer) Cash 103,000,000 Discount on bonds payable 3,000,000 Bonds payable Paid-in capital stock warrants

100,000,000 6,000,000

100,000 bonds 20 warrants $3

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Bonds With Detachable Warrants

Assume one-half of the warrants (1,000,000) are exercised when the market value of HTLs common stock is $30 per share. The exercise price is $25 per common share.
HTL (Issuer) Cash 25,000,000 Paid-in capital stock warrants 3,000,000 Common stock 1,000,000 Paid-in capital stock warrants 27,000,000

1,000,000 warrants $25 $6,000,000 2

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Option to Report Liabilities at Fair Value

Companies have the option to value some or all of their financial assets and liabilities at fair value.
The same market forces that influence the fair value of an investment in debt securities (interest rates, economic conditions, risk, etc.) influence the fair value of liabilities.
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U. S. GAAP vs. IFRS

International accounting standards are more restrictive than U.S. standards for determining when firms are allowed to elect the fair value option.

The fair value option may be elected by the firm. Although U.S. GAAP guidance indicates that the intent of the fair value option under U.S. GAAP is to address these sorts of circumstances, it does not require that those circumstances exist.
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Companies may only elect the fair value option

1. When a group of financial assets or liabilities is managed and its performance is evaluated on a fair value basis, or 2. If the fair value option reduces accounting mismatch.

End of Chapter 14