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Bonds and Long-Term Notes. 14. Learning Objectives. Identify the underlying characteristics of debt instruments and describe the basic approach to accounting for debt. LO1. Nature of Long-Term Debt. Loan agreement restrictions. Mirror image of an asset.
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Learning Objectives Identify the underlying characteristicsof debt instruments and describe thebasic approach to accounting for debt. LO1
Nature of Long-Term Debt Loan agreement restrictions Mirror image of an asset Obligations that extend beyond one year or the operating cycle, whichever is longer Reported at present value Accrue interest expense
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
The Bond Indenture The indenture is the written specific promises made by the company to the bondholders. Types of Bonds Debenture Bond Mortgage Bond Serial Bonds Sinking Fund Subordinated Debenture Callable Coupon Bonds Convertible Bonds
Interest 10% Face Value $1,000 6/30 & 12/31 BOND PAYABLE Bond Date 1/1/06 Maturity Date 12/31/15 Bonds 1. Face value (maturity or par value) 2. Maturity Date 3. Stated Interest Rate 4.Interest Payment Dates 5. Bond Date Other Factors: 6. Market Interest Rate 7. Issue Date
Learning Objectives 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. LO2
On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to Apex, Inc. The market interest rate is 10%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/10 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/06 Recording Bonds at Issuance Record the issuance of the bonds on 1/1/06.
Matrix, Inc. - Issuer Apex, Inc. - Investor Recording Bonds at Issuance
6/30/06 1/12/06 1/1/06 BondsDated BondsSold First InterestPayment Date Bonds Issued Between Interest Dates Interest begins to accrue on the date the bonds are dated. If the bonds are issued after the day they are dated, the investor would be asked to pay the company accrued interest. On the interest payment date, the investor will receive a check for the full period’s interest.
Bonds Issued Between Interest Dates On 1/12/06, Matrix, Inc. issues 1,000 bonds at face value plus accrued interest to Apex, Inc. The market interest rate is 10%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/10 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/06
Matrix - Issuer Apex - Investor Bonds Issued Between Interest Dates Accrued Interest$1,000,000 × 10% = $100,000 ÷ 360 days = $277.78 interest per day 11 days × $277.78 = $3,055.56
Matrix - Issuer Apex - Investor Bonds Issued Between Interest Dates At the first interest date$1,000,000 × 10% × ½ = $50,000 cash
Determining the Selling Price On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to Apex, Inc. The market interest rate is 12%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/10 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/06 What is the selling price of these bonds?
Bonds issued at a discount. Determining the Selling Price n = 5 years × 2 payments per year = 10i = 12% ÷ 2 payments per year = 6%Interest annuity = $1,000,000 × 10% ÷ 2 = $50,000
Matrix, Inc. - Issuer Apex, Inc. - Investor Determining the Selling Price
Effective Interest Method(Effective rate multiplied by the outstanding balance of the debt) $926,395 × 6% $55,584 - $50,000 $926,395 + $5,584 Determining Interest
Effective Interest Method(Effective rate multiplied by the outstanding balance of the debt) Determining Interest
Matrix, Inc. - Issuer Apex, Inc. - Investor Determining Interest
These bonds do not pay interest. Instead, they offer a return in the form of a “deep discount” from the face amount. Those who invest in zero-coupon bonds usually have tax-deferred or tax-exempt status. Zero-Coupon Bonds
Bonds Sold at a Premium On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to Apex, Inc. The market interest rate is 8%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/10 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/06 What is the selling price of these bonds?
Bonds issued at a premium. Bonds Sold at a Premium n = 5 years × 2 payments per year = 10i = 8% ÷ 2 payments per year = 4%Interest annuity = $1,000,000 × 10% ÷ 2 = $50,000
Matrix, Inc. - Issuer Apex, Inc. - Investor Bonds Sold at a Premium
Matrix, Inc. - Issuer Apex, Inc. - Investor Financial Statements Prepared Between Interest Dates Assume that in our previous example, Matrix, Inc. and Apex, Inc. both have fiscal years that end on September 30. Let’s look at the June 30 entry:
Year-end is on September 30, 2006, before the second interest date of December 31. Matrix, Inc. - Issuer Financial Statements Prepared Between Interest Dates $42,974 × ½ = $21,487 (3 months interest)$ 7,026 × ½ = $ 3,513 (3 months amortization) Apex, Inc. - Investor
Apex, Inc. - Investor Financial Statements Prepared Between Interest Dates The entries at December 31, 2006. Matrix, Inc. - Issuer
The discount or premium is allocated equally to each period over the outstanding life of the bond. Straight-Line Method Consideredpracticaland expedient.
Straight-Line Method In our last example, straight-line premium amortization would be: $81,105 ÷ 10 = $8,111 every six months.
Legal Accounting Underwriting Commission Engraving Printing Registration Promotion Debt Issue Costs
These costs should be recorded separately and amortized over the term of the related debt. Straight-line amortization is often used. Debt Issue Costs
Learning Objectives Characterize the accounting treatment of notes including installment notes, issued for cash or for noncash consideration. LO3
Present value techniques are used for valuation and interest recognition. The procedures are similar to those we encountered with bonds. Long-Term Notes
On 1/1/06, Matrix, Inc. issued a $100,000, 3-year, 6% note in exchange for equipment owned by Apex, Inc. Interest is paid every 12/31. The equipment does not have a ready market value. The appropriate rate of interest for notes of this type is 9%. Let’s determine the present value of the note. Notes Exchanged for Assets or Services
Notes Exchanged for Assets or Services Amortization Schedule Let’s prepare the entries on January 1.
Apex, Inc. - Seller Notes Exchanged for Assets or Services Matrix, Inc. - Purchaser
Entries for the first interest period. Apex, Inc. - Seller Notes Exchanged for Assets or Services Matrix, Inc. - Purchaser
To compute cash payment use present value tables. 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
PV of annuity of $1, n = 4, i = 9% Installment Notes On January 1, 2006, Matrix, Inc. purchased a truck by issuing a 4-year note payable to Apex Motors. The truck cost $50,000 and is financed at a 9% interest rate. Payments are made at the end of each of the next four years. Let’s calculate the annual payment. $50,000 ÷ 3.23972 = $15,433 (rounded)
Installment Notes Here is our loan amortization table.
Apex Motors - Seller Installment Notes The entries on date of purchase are: Matrix, Inc. - Purchaser
Apex Motors - Seller Installment Notes Date of first payment. Matrix, Inc. - Purchaser
Learning Objectives Describe the disclosures appropriateto long-term debt in its various forms. LO4
Financial Statement Disclosures Long-Term Debt For all long-term borrowing, disclosures should include the aggregate amounts maturing and sinking fund requirement, if any, for each of the next five years.
Rate of return on shareholders’ equity Net incomeShareholders’ equity = Decision Makers’ Perspective Long-term debt impacts several key financial ratios. Times interest earned ratio Net income + interest + taxesInterest = Debt toequity ratio Total liabilitiesShareholders’ equity = Rate of return on assets Net incomeTotal assets =
Learning Objectives Record the early extinguishment of debtand its conversion into equity securities. LO5
Early Extinguishment of Debt Debt retired at maturity results in no gains or losses. BUT Debt retired before maturity may result in an gainor loss on extinguishment. Cash Proceeds – Book Value = Gain or Loss