Learning Objectives

1. CHAPTER 14 Bonds and Long-Term Notes Learning Objectives LO14-1 Identify the underlying characteristics of debt instruments and describe the basic approach to accounting for debt. LO14-2 Account for bonds issued at par, at a discount, or at a premium, recording interest at the effective rate or by the straight-line method. LO14-7 Discuss the primary differences between U.S. GAAP and IFRS with respect to accounting for bonds and long-term notes. NOT COVERED LO14-3 Characterize the accounting treatment of notes, including installment notes, issued for cash or for noncash consideration. LO14-4 Describe the disclosures appropriate to long-term debt in its various forms. LO14-5 Record the early extinguishment of debt and its conversion into equity securities. LO14-6 Understand the option to report liabilities at their fair values.

2. The Nature of Long-Term Debt Liabilities signify creditors’ interest in a company’s assets. A note payable and note receivable are two sides of the same coin. 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.

3. The Bond Indenture (SELF-STUDY) Debenture Bondsecured 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.

4. Types of Bonds A2 Secured and Unsecured Convertible and Callable Term and Serial Registered and Bearer 10-4

5. Advantages of Bonds A1 Bonds do not affect stockholder control. Interest on bonds is tax deductible. Bonds can increase return on equity. 10-5

6. Disadvantages of Bonds A1 Bonds require payment of both periodic interest and par value at maturity. Bonds can decrease return on equity when the company pays more in interest than it earns on the borrowed funds. 10-6

7. Interest 10% Face Value $1,000 6/30 & 12/31 BOND PAYABLE Bond Date 1/1/05 Maturity Date 12/31/09

8. Bonds • A. Divide a large liability into many smaller liabilities (usually $1,000 per bond). • Obligate a company to repay a stated amount at a specified maturity date • and periodic interest between the issue date and maturity. • C. Require periodic interest as a stated percentage of the face amount. • Pay interest semiannually (usually) on designated interest dates beginning • six monthsafter the day the bonds are “dated”. • Make specific promises to bondholders who are described in a document • called a bond indenture. • Represent a liability to the corporation that issues the bonds and an asset • to a company that buys the bonds as an investment. • Issuer: • Cash xxx Bonds payable (face amount) xxxInvestor:Investment in bonds (face amount) xxx Cash xxx

9. Bond Selling Price Bond Certificate Subsequent Periods Interest Payments Company Issuing Bonds Investor Buying Bonds Face Value Payment at End of Bond Term Bonds At Bond Issuance Date Company Issuing Bonds Investor Buying Bonds

10. Bond Interest Payments Basics of Bonds A1 Corporation Investors Bond Interest Payments Interest Payment = Bond Par Value * Stated Interest Rate Bond Issue Date 10-10

11. Bond Issuing Procedures A1 . . .an investment firm called an underwriter. The underwriter sells the bonds to. . . A company sells the bonds to. . . => A trustee monitors the bond issue. . . . investors 10-11

12. Pricing of Bonds • Supply and demand cause a bond to be priced to yield the market rate of interest for securities of similar risk and maturity. • Price can be calculated as the present value of all the cash • flows required (principal and interest). • The discount rate is the market interest rate. • Other things being equal, the lower the perceived riskiness of the corporation issuing bonds, the higher the price those bonds will command. • When bond prices are quoted in financial media, they typically • are stated in terms of a percentage of face amount. • So, a price quote of 97 means a $1,000 bond will sell for $970; • a bond priced at 102 will sell for $1,020.

13. Determining the Selling Price

14. Interest 10% Face Value $1,000 6/30 & 12/31 BOND PAYABLE Bond Date 1/1/05 Maturity Date 12/31/09 1. Face value (maturity or par value) 2. Maturity Date 3. Stated Interest Rate (Contract Rate) 4.Interest Payment Dates 5. Bond Date Other Factors: 6. Market Interest Rate

15. Bond Discount or Premium P1 10-15

16. Issuing Bonds at Par P1 King Co. issues the following bonds on January 1, 2009 Par Value = $1,000,000 Stated Interest Rate = 10%; Mkt. Rate = 10% Interest Dates = 6/30 and 12/31 Bond Date = Jan. 1, 2009 Maturity Date = Dec. 31, 2028 (20 years) 10-16

17. Interest Expense on Bonds at Par P1 The entry on June 30, 2009, to record the first semiannual interest payment is . . . $1,000,000 × 10% × ½ year = $50,000This entry is made every six months until the bonds mature. 10-17

18. Issuing Bonds at Par P1 On Dec. 31, 2028, the bonds mature, King Co. makes the following entries The debt has now been extinguished. 10-18

19. Determining the Selling Price

20. Issuing Bonds at a Discount P2 Prepare the entry for Jan. 1, 2009, to record the following bond issue by Rose Co. Par Value = $1,000,000Stated Interest Rate = 10%Market Interest Rate = 12% Issue Price = Interest Dates = 6/30 and 12/31Bond Date = Jan. 1, 2009 Maturity Date = Dec. 31, 2013 (5 years) } . 10-20

21. Calculating Bond issue Price (Discount Bond) Face value = $1,000,000 Interest Payment= $50,000 = 1,000,000 * 10%/2 n= 10 = 5 years * 2 i= 6% = 12% /2 PVOA (n=10, i= 6%) = 7.36009 PV$ (n=10, i= 6%) = 0.55839 PV of Coupon payments = $50,000 * 7.36009= $368,005 PV of Principal payment = $1,000,000 * 0.55839 = $558,390 Total Issue Price = $926,395

22. Issuing Bonds at a Discount P2 $1,000,000´ 92.6395% Amortizing the discount increases interest expense over the outstanding life of the bond. 10-22

23. Issuing Bonds at a Discount P2 On Jan. 1, 2009, Rose Co. would record the bond issue as follows. Contra-Liability Account 10-23

24. Issuing Bonds at a Discount P2 Maturity Value Carrying Value 10-24

25. P2 10-25

26. Issuing Bonds at a Discount P2 10-26

27. Issuing Bonds at a Premium P3 Prepare the entry for Jan. 1, 2009, to record the following bond issue by Rose Co. Par Value = $1,000,000Issue Price = ????????Stated Interest Rate = 10%Market Interest Rate = 8%Interest Dates = 6/30 and 12/31Bond Date = Jan. 1, 2009 Maturity Date = Dec. 31, 2013 (5 years) } Bond will sell at a premium. 10-27

28. Calculating Bond issue Price (Premium Bond) Face value = $1,000,000 Interest Payment= $50,000 n= 10 i= 4% PVoA (n=10, i= 4%) = 8.11090 PV$ (n=10, i= 4%) = 0.67556 PV of Coupon payments = $50,000 * 8.11090= $405,545 PV of Principal payment = $1,000,000 * 0.67556 = $675,560 Total Price = $1,081,105

29. Issuing Bonds at a Premium P3 $1,000,000´ 108.1105% Amortizing the premium decreasesinterest expense over the life of the bond. 10-29

30. Issuing Bonds at a Premium P3 On Jan. 1, 2009, Rose Co. would record the bond issue as follows. Adjunct-Liability (or accretion) Account 10-30

31. Issuing Bonds at a Premium P3 10-31

32. P3 10-32

33. Issuing Bonds at a Premium P3 This entry is made every six months to record the cash interest payment and the amortization of the premium. 10-33

34. Premium and Discount Amortization Compared

35. Accruing Bond Interest Expense C3 End of accounting period Interest Payment Dates Jan. 1 Apr. 1 Oct. 1 Dec. 31 3 months’ accrued interest At year-end, an adjusting entry is necessary to recognize bond interest expense accrued since the most recent interest payment. 10-35

36. 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. • Companies may only elect the fair value option when • When a group of financial assets or liabilities is managed and its performance is evaluated on a fair value basis, or • If the fair value option reduces “accounting mismatch.”

37. 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.

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

39. Legal Accounting Underwriting Commission Engraving Printing Registration Promotion Debt Issue Costs

40. Long-Term Notes PromissoryNote (Note Payable) Bank Company (Borrower) Property, goods, or services. The liability, note payable, is reported at its present value, similar to the accounting for bonds payable.

41. To compute cash payment use present value tables. Each payment includes both an interest amount and a principal amount. Interest expense or revenue: Effective interest rate × Outstanding balance of debt Interest expense or revenue Principal reduction: Cash amount – Interest component Principal reduction per period Installment Notes

42. Rate of return on shareholders’ equity Net incomeShareholders’ equity = Decision Makers’ Perspective Times interest earned ratio Net income + interest + taxesInterest = Debt toequity ratio Total liabilitiesShareholders’ equity = Net incomeTotal assets Rate of return on assets =

43. 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

44. 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. Convertible Bonds Bonds into Stock

45. 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.

46. 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. Bonds With Detachable Warrants

47. 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.

48. Where We’re Headed Under a proposed change in the way we account for financial assets and liabilities, financial assets would be measured at (a) fair value with changes reported in net income (FV-NI), (b) at fair value through Other Comprehensive Income (FV-OCI), or (c) at amortized cost, the classification depending on the assets’ characteristics and the company’s business strategy for holding the assets. Most liabilities would be accounted for at amortized cost as described in this chapter. The fair value option, though, would no longer be permitted except in unique circumstances. The proposed change is a result of a joint project on financial instruments by the International Accounting Standards Board (IASB) and the FASB as part of a broader goal of achieving a single set of high quality global accounting standards. At the time this text is being written, a final standard is expected to be issued in 2012.

49. Appendix 14BTroubled Debt Restructuring When changing the original terms of a debt agreement is motivated by financial difficulties experienced by the debtor (borrower), the new arrangement is referred to as a troubled debt restructuring. A troubled debt restructuring may be achieved in either of two ways: • The debt may be settled at the time of the restructuring. • The debt may be continued, but with modified terms.

50. End of Chapter 14