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Chapter 14

Chapter 14. Bonds and Long-Term Notes. Topics of Long-Term Liabilities. Issuance of bonds (at a premium or discount) Fair value option of bonds Issuance of bonds between interest payment dates Extinguishment of debt Bonds issued with detachable stock warrants

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Chapter 14

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  1. Chapter 14 Bonds and Long-Term Notes

  2. Topics of Long-Term Liabilities • Issuance of bonds (at a premium or discount) • Fair value option of bonds • Issuance of bonds between interest payment dates • Extinguishment of debt • Bonds issued with detachable stock warrants • Convertible Bonds (including Induced Conversion) • Long-term Notes Payable • Troubled Debt Restructuring Long-Term Liabilities

  3. Long-Term Liabilities • Present value concept: Present value of $1 is the value today of $1 to be received at some future date, given a specific interest rate. • Example: 1. What is the present value of $100 to be received a year from now given an annual market interest rate of 10%? P.V.  (1+10%) = $100 P.V. = $100/1.1 = $100  0.9091 = $90.91 Long-Term Liabilities

  4. Long-Term Liabilities 2. What is the present value of $100 to be received two years from now given an annual interest rate of 10%? P.V  (1+10%)  (1+10%) = $100 P.V  (1+10%)2 = $100 P.V.  1.21 = $100 P.V. = $100 / 1.21 = $100  0.8264 = $82.64 Long-Term Liabilities

  5. $100 $100 $100 $100 $100 1 year Annuity: • Receiving (or paying)a constant amount of money at the end of each period (equal time internal) for a given number of periods • Receiving $100 every year for the following 5 years. (period = 1 year) (starting a year from now) Long-Term Liabilities

  6. Present Value (P.V.) of an Annuity: 1. Using the example above given a10% Interest rate: P.V. of the first $100 = $100  0.9091 = $90.91 P.V. of the second $100 = $100  0.8264 = $82.64 P.V. of the third $100 = $100  0.7513 = $75.13 P.V. of the fourth $100 = $100  0.6830 = $68.30 P.V. of the fifth $100 = $100 0.6209 = $62.09 Total 3.7907 $379.07 Long-Term Liabilities

  7. Present Value (P.V.) of an Annuity (contd.): • The P.V. of $100 annuity receiving every year for the following 5 years, starting a year from now => • $100 * 3.7907 = $379.07 • The P.V. of this annuity can be obtained from an annuity table under 10%, 5 periods. Long-Term Liabilities

  8. P.V. = $300 x 4.2124 = 1,263.7 Annuity Table, 5 periods at 6% (30/6=5) (12%/2=6%) Present Value (P.V.) of an Annuity (contd.): 2. What is the P.V. of $300 annuity receiving every 6 months for the following 30 months, starting 6 months from now ? The annual interest rate is 12%. Long-Term Liabilities

  9. Corporate Bonds: • Bonds are securities issued by a corporation to borrow money from the public (many lenders). • This is a source to raise funds. • The corporation will receive cash when bonds are issued. Long-Term Liabilities

  10. Corporate Bonds: • The face value of the bonds must be repaid to the bondholders on the maturity date of the bonds. • Also, the bond issuers will pay interests to the bondholders periodically (i.e., semi-annually). Long-Term Liabilities

  11. Bonds Payable • Long-Term Liability: if bonds mature in more than one year. • Short-Term Liability: if bonds mature in less than one year Long-Term Liabilities

  12. Bond Indenture • Bond Indenture is an agreement between the bond issuer and investors stating the following: • Interest rate of bonds; • Interest Payment dates; • The maturity date of bonds; • The type of bonds: callable, convertible,.. • The indenture is held by a trustee appointed by the issuing firm to represent the rights of the bondholders. Long-Term Liabilities

  13. Bond Covenant • Bond Covenant is a contractual provision in a bond indenture (source: financial dictionary). • Financial covenant: requiring issuers to maintain financial ratios such as debt/equity ratio and the interest coverage ratio at a certain level. • Non-financial covenant: requiring the disclosure of certain financial information. Long-Term Liabilities

  14. The Process of Bond Issuance 1. Receive the approval from the stockholders and regulatory authorities (i.e., the SEC). 2. Print bond certificates and write indenture (to set the terms of bond issue such as the stated interest rate, the interest payment date and the maturity date…) 3. Make a public announcement of its intent to sell the bonds on a particular date. Long-Term Liabilities

  15. The Process of Bond Issuance (cont.) 4. Negotiate the appropriate selling price with the underwriters based on the terms of bond issue (i.e., the stated inters rate), the general bond market conditions, the risk of the bonds and the expected state of the economy. Long-Term Liabilities

  16. The Process of Bond Issuance (cont.) 5. The underwriter will determine the effective interest rate (yield) and thus, the selling price that it believes best reflects the current market condition and the risk the bond for a particular bond issue. 6. The underwriter will either purchase the bonds from the issuing company and resell them to the public or sell these bonds for a commission. Long-Term Liabilities

  17. The Process of Bond Issuance (cont.) • Companies can sell the entire issue of bonds to an underwriter or sell it to a single investor (i.e., a pension fund) (referred to as a private placement). • Any expenditures connected with a bond issue (legal fee, printing costs, accounting fee, underwriter's charges …) should be deferred and amortized as expense over the life of the bond using a straight line method. Long-Term Liabilities

  18. The Process of Bond Issuance (Contd.) • The yield is the market rate (effective rate) for the bond issue. • The yield is often different from the stated interest rate as a result of : • 1) different opinion between the underwriter and the company, or • 2) a change in the economic conditions between the date the terms were set and the date the bonds were issued. Long-Term Liabilities

  19. The Process of Bond Issuance (Contd.) Three possible outcomes of bond issuance: 1. Stated rate = effective rate => the bonds are sold at par 2. Stated rate < effective rate => bonds are sold at discount 3. Stated rate > effective rate => bonds are sold at premium Long-Term Liabilities

  20. Units of bonds: • At $1,000 or $5,000 denominations • Price of bonds: stated at 100s • Example: $1,000 issued at 98 • The issuing price is $1,000  98 = $980 Long-Term Liabilities

  21. Types of bonds: On the basis whether the bonds are secured: • Secured Bonds • Unsecured Bonds (Debenture bonds) On the basis of how the interests are paid: • Registered Bonds • Coupon Bonds Long-Term Liabilities

  22. Types of bonds: On the basis of how the bonds mature: • Term Bonds • Serial Bonds • Convertible Bonds • Callable Bonds Long-Term Liabilities

  23. Asset-Backed Securities and Securitization of Assets • Asset-backed securities: securities (i.e., commercial paper, bonds) issued based on (or backed by) certain assets (i.e., mortgage receivables). • A conduit can be set up by a bank as an independent entity to take the title of financial assets (i.e., mortgage or credit card receivables) of companies. Long-Term Liabilities

  24. Asset-Backed Securities and Securitization of Assets (contd.) • The conduit issues securities (i.e., commercial paper) backed by those financial assets. • The cash generated from the sale of asset-backed securities goes back to the companies who put the assets into conduits. Source: ’Conduits’ in Need of a Fix by D. Reilly and C. Mollenkamp, WSJ , 8/30/2007 • As a result, those financial assets are securitized. Long-Term Liabilities

  25. Bond Ratings (Source: BestVest Investments, Ltd) Long-Term Liabilities

  26. Bond Ratings (contd.) Long-Term Liabilities

  27. Determination of Bond Price • The obligations of bond issuers: (1) to pay the principal when bond matures on the maturity date. (2) to pay interests periodically (i.e., semiannually) over the life the bond. • Present value of a bond: the present value of future net cash flows related to the bond using the effective interest rate. Long-Term Liabilities

  28. Determination of Bond Price (Contd.) • Bond Price = the present value of the bond. • Present value of bonds => The sum of (1) the present value of the principal plus (2) the present value of the periodic interests using the effective interest rate (not the stated interest rate) as the discount rate. Long-Term Liabilities

  29. Determination of Bond Price (Contd.) • Discount rate = effective rate = market rate =yield • This rate depends on the riskiness of the issuer, the general state of the economy, the duration of the bond, etc. • In general, a higher risk will result in a higher effective rate. Long-Term Liabilities

  30. Determination of Bond Price (Contd.) • Bonds Issued at Face Value When the stated interest rate equals the effective interest rate, the bond price will equal the face value. Long-Term Liabilities

  31. Determination of Bond Price (Contd.) • Example 1: Page company issued a 5-year term bond with a face amount $100,000 and a stated annual interest rate of 10%. Interests are paid semiannually. Assume that the annual effective interest rate demanded by investors for bonds of this level of risk is also 10%, what is the present value of the bond (the bond price)? Long-Term Liabilities

  32. Determination of Bond Price (Contd.) (1)P.V. of the principal ($100,000 mature in 5 years, discount rate 5%, 10 periods): The annual effective rate = 10% (10%/2= 5%) $100,000  0.6139 = $61,390 (2)P.V. of the interests received semiannually for 10 periods (annuity, discount rate = 5%, 10 periods) $5,000  7.7217 = 38,608.5 annuity table, 5%, 10periods Long-Term Liabilities

  33. Determination of Bond Price (Contd.) • The P.V. of the bond = the sum of (1) and (2) (1) + (2) = $61,390 + 38,608.5 = $100,000 Note: The semiannual interest paid = $100,000  5% = $5,000 the annual stated interest rate, not the effective rate!! Long-Term Liabilities

  34. Determination of Bond Price (Contd.) • Therefore, when the stated rate equals the effective rate (the discount rate), the bond price (the P.V. of bonds) equals the face value. J.E. (when bonds are issued at face value) Cash 100,000 Bonds payable 100,000 Long-Term Liabilities

  35. Bond Issued at A Discount • When the stated interest rate is less than the effective interest rate, the present value of a bond will be less than its face value. • Example 2: Use the same example as on page 28, except that the effective rate is 12%, rather than 10% to compute the present value of the bond. Long-Term Liabilities

  36. Bond Issued at A Discount (Contd.) • Since the interests are paid semiannually, the discount rate is 6% with 10 periods. (1)P.V. of the principal = $100,000 .5584 = $55,840  P.V. table, 6%, 10periods (2) P.V. of the semiannual interest: $5,000  7.3601 = 36,800.5  Annuity table, 6%, 10periods P.V. of the bond = (1) + (2) $55,840 + 36,800.5 = $92,640.5 Long-Term Liabilities

  37. Bond Issued at A Discount (Contd.) • $92,640.5 < $100,000 (Discount = $7359.5) P.V. of bond < Face vale => when the stated rate is less than the effective rate (i.e., 10% < 12%), the P.V. of the bond will be less than the face value. • J.E. (when bonds are issued at discount) Cash 92,640.5 Discount on Bonds 7,359.5 Bonds Payable 100,000 Long-Term Liabilities

  38. Bond Issued at A Discount (Contd.) • Question: What is the total interest expense of this bond (issued at Discount)? Cash payment by the issuer ($150,000) Cash received from issuing the bond (at Discount) 92,640.5 Interest Expense $57,359.50* Discount would increase the actual interest expense and needs to be amortized over the life of the bond. *Interest Expense = interest payment + Discount = $50,000 + 7,359.50 = $57,359.50 Long-Term Liabilities

  39. Bond Issued at A Premium • When the stated interest rate is higher than the effective interest rate demanded by the investors for the level of the risk of the bonds, the present value of the bonds would be greater than its face value. • Example 3: use the same example as on page 26, except that the effective interest rate is 8%. (the stated interest rate is still at 10%) Long-Term Liabilities

  40. Bond Issued at A Premium (Contd.) • Compute the P.V. of the bond: Since the interests are paid semiannually, the discount rate would be 4% and the discounting periods are 10 periods. (1) P.V. of the principal: $100,000 x 0.6756 = $67,560 Long-Term Liabilities

  41. Bond Issued at A Premium (Contd.) (2) P.V. of the semiannual interest: $5,000 x 8.1109 = $40,554.5 P.V. of the bond = (1) + (2) = $67,560 + 40,554.5 = $108,114.5 $108,114.5 > $100,000 (Premium = 8,114.5) Long-Term Liabilities

  42. Bond Issued at A Premium (Contd.) • Example 3 J.E. (When Bonds are issued at Premium) Cash 108,114.5 Bonds Payable 100,000 Premium on Bonds Payable 8,114.50 Long-Term Liabilities

  43. Bond Issued at A Premium (Contd.) • Interest Expense= interest payments - Premium = $5,000 x 10 - 8,114.5 = $41,885.5 (Premium will decrease the interest expense.) Long-Term Liabilities

  44. Bond Issued at A Premium (Contd.) • A premium account: an adjunct account to the bonds payable account and is shown as an addition to the bonds payable account. • A discount account: a contra account to the bonds payable and is shown as a deduction from the bonds payable. Long-Term Liabilities

  45. Bond Issued at A Premium (Contd.) • Book value (carrying value) of the bond issued: the face value minus any unamortized discounts or plus any unamortized premiums. • If an effective interest method is used to amortize the discount (or premium), the book value equals the present value when the effective interest rate remains unchanged. Long-Term Liabilities

  46. Accounting for Bonds Payable -Bonds Are Issued at Par • The information of example 1 on page 28 is summarized below with some additional information: Issuing Company: Page Company Stated Interest: 10% (annual) Effective Interest: 10% (annual) Date of Issuance: 2/1/x2 Date of Maturity: 2/1/x7 Interest Payment Dates: 2/1 and 8/1 Face Value: $100,000 P.V. of the Bond: $100,000 Long-Term Liabilities

  47. Accounting for Bonds Payable - Bonds Are Issued at Par (Contd.) • J.E. 2/1/x2 Cash 100,000 B/P 100,000 8/1/x2 Interest Expense 5,000 Cash 5,000 12/31/x2 Adjusting entry for 5-month interest expense occurred but not paid. The interest payment dates are 2/1 and 8/1). Interest Expense 4,167 Interest payable 4,167 Long-Term Liabilities

  48. Accounting for Bonds Payable - Bonds Are Issued at Par (Contd.) • (Reversing Entry) 1/1/x3 Interest Payable 4,167 Interest Expense 4,167 2/1/x3 Interest Expense 5,000 Cash 5,000 (If no reversing entry recorded on 1/1/x3, the J.E. of 2/1/x3 would be: Interest Expense 833 Interest Payable 4,167 Cash 5,000 Long-Term Liabilities

  49. Accounting for Bonds Payable - Bonds Are Issued at Par (Contd.) 8/1/x3 Interest Expense 5,000 Cash 5,000 12/31/x3 • Adjusting entry for the 5-month unrecorded interest expense Interest Expense 4,167 Interest payable 4,167 Long-Term Liabilities

  50. Accounting for Bonds Payable - Bonds Are Issued at Par (Contd.) • 1/1/x4 Reversing Entry • 2/1/x4 (Interest payment) • 8/1/x4 (Interest payment) • 12/31/x4 (Adjusting) • 1/1/x5 (Reversing) : • 12/31/x6 (Adjusting) • 1/1/x7 (Reversing) • 2/1/x7 Interest Expense 5,000 Cash 5,000 Bonds Payable 100,000 cash 100,000 (Bond Retirements at Maturity) Long-Term Liabilities

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