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
company’s assets.
A note payable and not
receivable are two sides
of the same coin.
Periodic interest in the
effective interest rate times
the amount of the debt
outstanding during the
period. Debt is reported at
its present value
14 - 2
A bond payable divides a
large liability into many
smaller liabilities.
Corporations issuing bonds are
obligated to repay a stated
amount at a specified maturity
date and period interest
between the issue date.
Bonds
At Bond Issuance Date
Company
Issuing
Bonds
Bond Selling Price
Bond Certificate
Investor
Buying
Bonds
Subsequent Periods
Company
Issuing
Bonds
14 - 3
Interest Payments
Face Value Payment at
End of Bond Term
Investor
Buying
Bonds
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.
14 - 4
Callable Bond allows
company to buy back
outstanding bonds
prior to maturity.
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)
14 - 5
Masterwear (Issuer)
Cash
Bonds payable
700,000
United (Investor)
Investment in bonds (face amount)
Cash
700,000
700,000
700,000
Determining the Selling Price
Stated interest rate is:
Below market rate
Equal to market rate
The bonds sells:
At a discount
(Cash received is less
than face amount)
At face amount
(Cash received is equal
to face amount)
At a premium
Above market rate
14 - 6
(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
$ 42,000 × 4.76654 =
$700000 × 0.66634 =
Present value (price) of bonds
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.
14 - 7
Bonds Issued at a Discount
Masterwear (Issuer)
Cash
Discount on bonds payable
Bonds payable
United (Investor)
Investment in bonds
Discount on bond investment
Cash
666,633
33,367
700,000
700,000
33,367
666,633
Alternative “net method”
14 - 8
Masterwear (Issuer)
Cash
Bonds payable
666,633
United (Investor)
Investment in bonds
Cash
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).
14 - 9
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
14 - 10
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
Effective
Interest
Cash
$
42,000
42,000
42,000
42,000
42,000
42,000
$ 252,000
$
Increase in
Balance
46,664
$
46,991
47,340
47,714
48,114
48,544 *
$ 285,367
$
4,664
4,991
5,340
5,714
6,114
6,544
33,367
Outstanding
Balance
$ 666,633
671,297
676,288
681,628
687,342
693,456
700,000
*Rounded.
$666,633 + $4,664 = $671,297
14 - 11
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.
14 - 12
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
$ 42,000 × 5.07569 =
$700,000 × 0.74622 =
Present value (price) of bonds
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.
14 - 13
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
Effective
Interest
Cash
$
42,000
42,000
42,000
42,000
42,000
42,000
$ 252,000
$
Decrease in
Balance
36,777
$
36,515
36,241
35,953
35,651
35,329 *
$ 216,467
$
5,223
5,485
5,759
6,047
6,349
6,671
35,533
Outstanding
Balance
$ 735,533
730,310
724,825
719,066
713,020
706,671
700,000
*Rounded.
$735,533 × 5% = $36,777
14 - 14
$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.
14 - 15
Premium and Discount Amortization
Compared
$735,533
Premium Amortization
Discount Amortization
$700,000
$666,633
1/1/11
14 - 16
12/31/13
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
$700,000 × (12% ÷ 2) = $42,000
14 - 17
June 30, 2011 Effective Interest
$666,633 × (14% ÷ 2) = $46,664
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
14 - 18
$31,327 - $28,000 = $3,327
31,327
3,327
28,000
28,000
3,327
31,327
$671,297 × 7% × 4/6 = $31,327
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
14 - 19
23,496
21,000
2,496
42,000
42,000
2,496
21,000
23,496
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
14 - 20
47,561
5,561
42,000
42,000
5,561
47,561
Debt Issue Costs
 Legal
 Accounting
 Underwriting
 Commission
 Engraving
 Printing
 Registration
 Promotion
14 - 21
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.
14 - 22
Long-Term Notes
Company
(Borrower)
Promissory
Note
(Note
Payable)
Bank
Property, goods,
or services.
The liability, note payable, is reported at its present value,
similar to the accounting for bonds payable.
14 - 23
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
14 - 24
Skill Graphics (Borrower)
Cash
Note payable
700,000
First BancCorp (Lender)
Investment in bonds
Cash
700,000
700,000
700,000
Long-Term Notes
At Each of the Six Interest Dates
Skill Graphics (Borrower)
Interest expense
Cash
42,000
First BancCorp (Lender)
Cash
Interest revenue
42,000
42,000
42,000
At Maturity
14 - 25
Skill Graphics (Borrower)
Notes payable
Cash
700,000
First BancCorp (Lender)
Cash
Notes receivable
700,000
700,000
700,000
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 note’s cash
flows (interest plus principal) computed as follows:
Present value of an ordinary annuity of $1: n=6, i=7%
Interest
Principal
$ 42,000 × 4.76654 =
$700000 × 0.66634 =
Present value (price) of note
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.
14 - 26
At the Purchase Date (January 1)
Note Exchanged for Assets or Services
Skill Graphics (Buyer/Issuer)
Machinery
Discount on note payable
Notes payable
Hughes-Baker (Seller/Lender)
Notes receivable
Discount on notes payable
Sales revenue
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
14 - 27
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
14 - 28
Installment Notes
Notes often are paid in installments,
rather than a single amount at maturity.
$666,633
amount of loan
Date
01/01/11
06/30/11
12/31/11
06/30/12
12/31/12
06/30/13
12/31/13
14 - 29
Cash
÷
4.76654
(from Table 4)
n=6, i=7.0%
Effective Interest
(7% × Outstanding
Balance)
=
$139,857
installment
payment
Decrease
in Debt
139,857
139,857
139,857
139,857
139,857
139,857
.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
93,193
99,716
106,696
114,165
122,157
130,706
839,142
172,509
666,633
Rounded
Outstanding
Balance
666,633
573,440
473,724
367,028
252,863
130,706
-
At the Purchase Installment
Date (JanuaryNotes
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
14 - 30
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
company’s 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.
14 - 31
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
14 - 32
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
14 - 33
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
14 - 34
700,000
8,710
23,710
685,000
$700,000 – 676,290
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
14 - 35
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%
14 - 36
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
14 - 37
50,000,000
1,000,000
2,000,000
49,000,000
50,000 bonds × 40 shares × $1 par = $2,000,000 par value
Induced Conversion
Companies sometimes try to
induce conversion. The
motivation might be to reduce
debt and become a better risk
to potential lenders or achieve
a lower debt-to-equity ratio.
When the specified call price is less than the
conversion value of the bonds (the market value
of the shares), calling the convertible bonds
provides bondholders with incentive to convert.
14 - 38
U.S. GAAP vs. IFRS
Convertible Bonds
Under IFRS, unlike U.S. GAAP, convertible debt is divided into its liability
and equity elements.
($ in millions)
Cash (103%  $100 million)
Convertible bonds payable (value of the debt only)
Equity–conversion 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.
14 - 39
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.
 A portion
of the selling price of the
bonds is allocated to the
detachable stock warrants.
14 - 40
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
14 - 41
Bonds With Detachable Warrants
Assume one-half of the warrants (1,000,000) are
exercised when the market value of HTL’s
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
14 - 42
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.
14 - 43
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.
14 - 44
• 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