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
Liabilities signify
signify A
A note
note payable
payable and
and not
not A
A bond
bond payable
payable divides
divides aa
creditors’
creditors’ interest
interest in
in aa receivable
receivable are
are two
two sides
sides large
large liability
liability into
into many
many
company’s
company’s assets.
assets. of
of the
the same
same coin.
coin. smaller
smaller liabilities.
liabilities.

Periodic
Periodic interest
interest in
in the
the Corporations
Corporations issuing
issuing bonds
bonds are
are
effective
effective interest
interest rate
rate times
times obligated
obligated toto repay
repay aa stated
stated
the
the amount
amount of of the
the debt
debt amount
amount atat aa specified
specified maturity
maturity
outstanding
outstanding during
during the
the date
date and
and period
period interest
interest
period.
period. Debt
Debt isis reported
reported atat between
between the the issue
issue date.
date.
its
its present
present value
value

14 - 2
 Bonds
At Bond Issuance Date
Company
Company Bond Selling Price Investor
Investor
Issuing
Issuing Buying
Buying
Bonds
Bonds Bond Certificate Bonds
Bonds

Subsequent Periods
Interest Payments
Company
Company Investor
Investor
Issuing
Issuing Buying
Buying
Bonds
Bonds Face Value Payment at Bonds
Bonds
End of Bond Term

14 - 3
 The Bond Indenture
Debenture
Debenture Bond
Bond Mortgage
Mortgage Bond
Bond
secured
secured byby the
the “full
“full secured
secured byby lien
lien on
on
faith
faith and
and credit”
credit” of
of specific
specific real
real estate
estate
company.
company. owned
owned byby the
the issuer.
issuer.

The
The specific
specific promises
promises made
made to
to bondholders
bondholders are
are
described
described in
in aa document
document called
called aa bond
bond indenture
indenture..

Coupon
Coupon BondBond pays
pays Callable
Callable Bond
Bond allows
allows
interest
interest when
when company
company to to buy
buy back
back
investor
investor submits
submits outstanding
outstanding bonds
bonds
attached
attached coupon.
coupon. prior
prior to
to maturity.
maturity.

14 - 4
 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)
Masterwear (Issuer)
Cash 700,000
Bonds payable 700,000

United (Investor)
Investment in bonds (face amount) 700,000
Cash 700,000

14 - 5
 Determining the Selling Price
Stated interest rate is: The
The bonds sells:
At a discount
Below market rate (Cash
(Cash received
received is
is less
less
than
than face
face amount)
amount)

At face
face amount
amount
Equal
Equal to market rate (Cash
(Cash received
received is
is equal
equal
to
to face
face amount)
amount)

At a premium
Above market rate (Cash
(Cash received
received is
is greater
greater
than
than face
face amount)
amount)
14 - 6
 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
Calculation of
of the
the Price
Price of
of the
the Bonds
Bonds
Present
Present Values
Values
Interest
Interest $$ 42,000
42,000 ×× 4.76654
4.76654 == $$ 200,195
200,195
Principal
Principal $700000
$700000 ×× 0.66634
0.66634 == 466,438
466,438
Present
Present value
value (price)
(price) of
of bonds
bonds $$ 666,633
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 666,633
Discount on bonds payable 33,367
Bonds payable 700,000

United (Investor)
Investment in bonds 700,000
Discount on bond investment 33,367
Cash 666,633

Alternative “net method”

Masterwear (Issuer)
Cash 666,633
Bonds payable 666,633
United (Investor)
Investment in bonds 666,633
Cash 666,633
14 - 8
 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 × (14% ÷ 2) = $46,664

Outstanding Balance Effective Rate 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 42,000
Discount on bond investment 4,664
Investment revenue 46,664

$700,000
$700,000 ×× (12%
(12% ÷÷ 2)
2) == $42,000
$42,000 $666,633
$666,633 ×× (14%
(14% ÷÷ 2)
2) == $46,664
$46,664
$46,664
$46,664 -- $42,000
$42,000 == $4,664
$4,664
14 - 10
 Bond Amortization Schedule
Here is a bond amortization schedule showing the cash interest, effective
interest, discount amortization, and the carrying value of the bonds.
Effective Increase in Outstanding
Date Cash Interest Balance Balance
1/1/11 $ 666,633
6/30/11 $ 42,000 $ 46,664 $ 4,664 671,297
12/31/11 42,000 46,991 4,991 676,288
6/30/12 42,000 47,340 5,340 681,628
12/31/12 42,000 47,714 5,714 687,342
6/30/13 42,000 48,114 6,114 693,456
12/31/13 42,000 48,544 * 6,544 700,000
$ 252,000 $ 285,367 $ 33,367
*Rounded.

$666,633
$666,633 ++ $4,664
$4,664 == $671,297
$671,297

14 - 11
 Zero-Coupon Bonds

These
These bonds
bonds do not pay interest.
Instead,
Instead, they offer a return in the
form
form of a “deep
“deep discount”
discount” from
from the
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%.
10%
The entire bond issue was purchased by United Intergroup.

Present value of an ordinary annuity of $1: n=6, i=6%

Calculation
Calculation of
of the
the Price
Price of
of the
the Bonds
Bonds
Present
Present Values
Values
Interest
Interest $$ 42,000
42,000 ×× 5.07569
5.07569 == $$ 213,179
213,179
Principal
Principal $700,000
$700,000 ×× 0.74622
0.74622 == 522,354
522,354
Present
Present value
value (price)
(price) of
of bonds
bonds $$ 735,533
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.
Effective Decrease in Outstanding
Date Cash Interest Balance Balance
1/1/11 $ 735,533
6/30/11 $ 42,000 $ 36,777 $ 5,223 730,310
12/31/11 42,000 36,515 5,485 724,825
6/30/12 42,000 36,241 5,759 719,066
12/31/12 42,000 35,953 6,047 713,020
6/30/13 42,000 35,651 6,349 706,671
12/31/13 42,000 35,329 * 6,671 700,000
$ 252,000 $ 216,467 $ 35,533
*Rounded.

$735,533
$735,533 ×× 5%
5% == $36,777
$36,777 $735,533
$735,533 -- $5,223
$5,223 == $730,310
$730,310

14 - 14
 Bonds Sold at a Premium

Masterwear (Issuer)
Cash 735,533
Premium on bonds payable 35,533
Bonds payable 700,000
United (Investor)
Investment in bonds 700,000
Premium on bond investment 35,533
Cash 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
$700,000
Discount Amortization

$666,633

1/1/11 12/31/13

14 - 16
 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 June 30, 2011 Effective Interest

$700,000
$700,000 ×× (12%
(12% ÷÷ 2)
2) == $42,000
$42,000 $666,633
$666,633 ×× (14%
(14% ÷÷ 2)
2) == $46,664
$46,664

14 - 17
 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 31,327
Discount on bonds payable 3,327
Interest payable 28,000
United (Investor)
Interest receivable 28,000
Discount on bond investment 3,327
Investment revenue 31,327
$42,000
$42,000 ×× 4/6
4/6 == $28,000
$28,000 $671,297
$671,297 ×× 7%
7% ×× 4/6
4/6 == $31,327
$31,327
$31,327
$31,327 -- $28,000
$28,000 == $3,327
$3,327
14 - 18
 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 23,496
Interest payable 21,000
Discount on bonds payable 2,496
Cash 42,000

United (Investor)
Cash 42,000
Discount on bond investment 2,496
Interest receivable 21,000
Investment revenue 23,496

14 - 19
 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 47,561
Discount on bonds payable 5,561
Cash 42,000

United (Investor)
Cash 42,000
Discount on bond investment 5,561
Investment revenue 47,561

14 - 20
 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 • “Transaction costs” reduce the

separately as an asset. recorded amount of the debt.
• The cost of these services
• Amortized over the term to reduces the net cash the issuing
maturity. 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

Promissory
Company Note Bank
(Borrower) (Note
Payable)
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
Skill Graphics (Borrower)
Cash 700,000
Note payable 700,000

First BancCorp (Lender)

Investment in bonds 700,000
Cash 700,000

14 - 24
 Long-Term Notes
At Each of the Six Interest Dates
Skill Graphics (Borrower)
Interest expense 42,000
Cash 42,000

First BancCorp (Lender)

Cash 42,000
Interest revenue 42,000

At Maturity
Skill Graphics (Borrower)
Notes payable 700,000
Cash 700,000

First BancCorp (Lender)

Cash 700,000
Notes receivable 700,000
14 - 25
 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%

Present
Present Values
Values
Interest
Interest $$ 42,000
42,000 ×× 4.76654
4.76654 == $$ 200,195
200,195
Principal
Principal $700000
$700000 ×× 0.66634
0.66634 == 466,438
466,438
Present
Present value
value (price)
(price) of
of note
note $$ 666,633
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
 Note Exchanged for Assets or Services
At the Purchase Date (January 1)
Skill Graphics (Buyer/Issuer)
Machinery 666,633
Discount on note payable 33,367
Notes payable 700,000
Hughes-Baker (Seller/Lender)
Notes receivable 700,000
Discount on notes payable 33,367
Sales revenue 666,633

At the First Interest Date (June 30)

Skill Graphics (Buyer/Issuer)
Interest expense 46,664
Discount on note payable 4,664
Cash 42,000
Hughes-Baker (Seller/Lender)
Cash 42,000
Discount on notes payable 4,664
Investment revenue 46,664
14 - 27
 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 ÷ 4.76654 = $139,857
amount of loan (from Table 4) installment
n=6, i=7.0% payment
Decrease
Decrease Outstanding
Outstanding
Date
Date Cash
Cash Effective
Effective Interest
Interest in
in Debt
Debt Balance
Balance
(7%
(7% ×× Outstanding
Outstanding
Balance)
Balance)
01/01/11
01/01/11 666,633
666,633
06/30/11
06/30/11 139,857
139,857 .07
.07 ×× 666,633
666,633 == 46,664
46,664 93,193
93,193 573,440
573,440
12/31/11
12/31/11 139,857
139,857 .07
.07 ×× 573,440
573,440 == 40,141
40,141 99,716
99,716 473,724
473,724
06/30/12
06/30/12 139,857
139,857 .07
.07 ×× 473,724
473,724 == 33,161
33,161 106,696
106,696 367,028
367,028
12/31/12
12/31/12 139,857
139,857 .07
.07 ×× 367,028
367,028 == 25,692
25,692 114,165
114,165 252,863
252,863
06/30/13
06/30/13 139,857
139,857 .07
.07 ×× 252,863
252,863 == 17,700
17,700 122,157
122,157 130,706
130,706
12/31/13
12/31/13 139,857
139,857 .07
.07 ×× 130,706
130,706 == 9,151
9,151 130,706
130,706 --
839,142
839,142 172,509
172,509 666,633
666,633
14 - 29 Rounded
 Installment Notes
At the Purchase Date (January 1)
Skill Graphics (Buyer/Issuer)
Machinery 666,633
Notes payable 666,633
Hughes-Baker (Seller/Lender)
Notes receivable 666,633
Sales revenue 666,633

At the First Interest Date (June 30)

Skill Graphics (Buyer/Issuer)
Interest expense 46,664
Note payable 93,193
Cash 139,857

Hughes-Baker (Seller/Lender)
Cash 139,857
Notes receivable 93,193
Interest revenue 46,664
14 - 30
 Financial Statement Disclosures
Matrix, Inc.
Partial Balance Sheet
December 31, 2011
Long-term liabilities
Bonds payable, face amount $ 50,000,000
Less: unamortized discount (244,875)
unamortized issue costs (127,500)
Bonds payable, net $ 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 = Net income

assets 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
Debt retired
retired at
at maturity
maturity results
results
in
in no
no gains
gains or
or losses.
losses.

BUT
Debt
Debt retired
retired before
before maturity
maturity may
may result
result in
in an
an
gain
gain or
or loss
loss on
on extinguishment.
extinguishment.
Cash
Cash Proceeds
Proceeds –– Book
Book Value
Value == Gain
Gain or
or Loss
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 700,000
Loss on early extinguishment 8,710
Discount on bonds payable 23,710
Cash 685,000

$685,000 – 676,290 $700,000 – 676,290

14 - 34
 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 103,000,000
Convertible bonds payable 100,000,000
Premium on bonds payable 3,000,000

$10,000,000
$10,000,000 ×× 103%
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 50,000,000
Premium on bonds payable 1,000,000
Common stock 2,000,000
Paid-in capital – excess of par 49,000,000

14 - 37
50,000
50,000 bonds
bonds ×× 40
40 shares
shares ×× $1 par == $$2,000,000
$1 par 2,000,000 par
par value
value
 Induced Conversion
Companies sometimes try to
induce conversion. The
motivation might be to reduce
debt and become a better risk
to potential lenders or achieve
a lower debt-to-equity ratio.
When the specified call price is less than the
conversion value of the bonds (the market value
of the shares), calling the convertible bonds
provides bondholders with incentive to convert.
14 - 38
 U.S. GAAP vs. IFRS
Convertible Bonds
Under IFRS, unlike U.S. GAAP, convertible debt is divided into its liability and
equity elements.
  ($ in millions)
Cash (103%  $100 million) 103
 Convertible bonds payable (value of the debt only) 98*
 Equity–conversion option (difference) 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
On January
January 1,1, 2011,
2011, HTL
HTL issued
issued $100,000,000
$100,000,000 ofof 8%
8% bonds
bonds
due
due in
in 2018
2018 at
at 130
130 (103%
(103% of
of face
face value).
value). Accompanying
Accompanying eacheach
$1,000
$1,000 bond
bond were
were 2020 warrants.
warrants. Each
Each warrant
warrant permitted
permitted the
the
holder
holder to
to buy
buy one
one share
share of
of $1
$1 par
par common
common stock
stock at
at $25
$25 per
per
share.
share. Shortly
Shortly after
after issuance,
issuance, the
the warrants
warrants were
were listed
listed on
on the
the
stock
stock exchange
exchange at at $3
$3 per
per warrant.
warrant.

HTL (Issuer)
Cash 103,000,000
Discount on bonds payable 3,000,000
Bonds payable 100,000,000
Paid-in capital – stock warrants 6,000,000

100,000
100,000 bonds
bonds ×× 20
20 warrants
warrants ×× $3
$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
1,000,000 warrants
warrants ×× $25
$25

$6,000,000
$6,000,000 ÷÷ 22
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