Bonds and Long-Term Notes

1. Bonds and Long-Term Notes 14

2. 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

3. 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

4. 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

5. 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

6. 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.

7. Matrix, Inc. - Issuer Apex, Inc. - Investor Recording Bonds at Issuance

8. 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.

9. 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

10. 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

11. Matrix - Issuer Apex - Investor Bonds Issued Between Interest Dates At the first interest date$1,000,000 × 10% × ½ = $50,000 cash

12. Determining the Selling Price

13. 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?

14. 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

15. Matrix, Inc. - Issuer Apex, Inc. - Investor Determining the Selling Price

16. 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

17. Effective Interest Method(Effective rate multiplied by the outstanding balance of the debt) Determining Interest

18. Matrix, Inc. - Issuer Apex, Inc. - Investor Determining Interest

19. 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

20. 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?

21. 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

22. Matrix, Inc. - Issuer Apex, Inc. - Investor Bonds Sold at a Premium

23. Bonds Sold at a Premium

24. 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:

25. 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

26. Apex, Inc. - Investor Financial Statements Prepared Between Interest Dates The entries at December 31, 2006. Matrix, Inc. - Issuer

27. The discount or premium is allocated equally to each period over the outstanding life of the bond. Straight-Line Method Consideredpracticaland expedient.

28. Straight-Line Method In our last example, straight-line premium amortization would be: $81,105 ÷ 10 = $8,111 every six months.

29. Straight-Line Method

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

31. These costs should be recorded separately and amortized over the term of the related debt. Straight-line amortization is often used. Debt Issue Costs

32. Present value techniques are used for valuation and interest recognition. The procedures are similar to those we encountered with bonds. Long-Term Notes

33. 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

34. Notes Exchanged for Assets or Services

35. Notes Exchanged for Assets or Services Amortization Schedule Let’s prepare the entries on January 1.

36. Apex, Inc. - Seller Notes Exchanged for Assets or Services Matrix, Inc. - Purchaser

37. Entries for the first interest period. Apex, Inc. - Seller Notes Exchanged for Assets or Services Matrix, Inc. - Purchaser

38. 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

39. 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)

40. Installment Notes Here is our loan amortization table.

41. Apex Motors - Seller Installment Notes The entries on date of purchase are: Matrix, Inc. - Purchaser

42. Apex Motors - Seller Installment Notes Date of first payment. Matrix, Inc. - Purchaser

43. 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.

44. 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

45. Some bonds may be converted into common stock at the options of the holder. When bonds are converted the issuer updates interest expense and 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

46. Convertible Bonds • The Book Value Method • Record new stock at the book value of the convertible bonds. No gain or loss is recognized. On December 31, 2006, all of the bondholders of Matrix, Inc. convert their bonds into common stock. There are 10,000 bonds outstanding with a face value of $1,000 each. Each bond is convertible into 50 shares of the company’s $1 par value common stock. There is $1,500,000 on unamortized discount associated with the bonds that are converted. Interest and discount amortization have been brought up to December 31. Let’s look at the entry to record the conversion.

47. Convertible Bonds 10,000 × 50 shares × $1 par value The carrying value of the bonds is assigned to the stock.

48. Induced Conversion Companies sometimes try to induce conversion of their bonds into stock. One way to induce conversion is through a “call” provision. 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. Bondholders will choose the shares rather than the lower call price.

49. 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