Bonds & Long Term Notes

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 signify A note payable and not A bond payable divides a

creditors’ interest in a receivable are two sides large liability into many
company’s assets. of the same coin. smaller liabilities.
Periodic interest in the Corporations issuing bonds are

effective interest rate times obligated to repay a stated
the amount of the debt amount at a specified maturity
outstanding during the date and period interest
period. Debt is reported at between the issue date.
its present value
14 - 2
Bonds
At Bond Issuance Date
Company Bond Selling Price Investor
Issuing Buying
Bonds Bond Certificate Bonds
Subsequent Periods
Interest Payments
Company Investor
Issuing Buying
Bonds Face Value Payment at Bonds
End of Bond Term
14 - 3
The Bond Indenture
Debenture Bond Mortgage Bond
secured by the “full secured by lien on
faith and credit” of specific real estate
company. owned by the issuer.
The specific promises made to bondholders are

described in a document called a bond indenture.
Coupon Bond pays Callable Bond allows

interest when company to buy back
investor submits outstanding bonds
attached coupon. prior to 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 bonds sells:
At a discount
Below market rate (Cash received is less
than face amount)
At face amount
Equal to market rate (Cash received is equal
to face amount)
At a premium
Above market rate (Cash received is greater
than face 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 of the Price of the Bonds
Present Values
Interest $ 42,000 × 4.76654 = $ 200,195
Principal $700000 × 0.66634 = 466,438
Present value (price) of bonds $ 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
United (Investor)
Investment in bonds 700,000
Discount on bond investment 33,367
Cash 666,633
Alternative “net method”

Masterwear (Issuer)
Cash 666,633
United (Investor)
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
Cash 42,000
United (Investor)
Cash 42,000
Investment revenue 46,664
$700,000 × (12% ÷ 2) = $42,000 $666,633 × (14% ÷ 2) = $46,664
$46,664 - $42,000 = $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 + $4,664 = $671,297
14 - 11
Zero-Coupon Bonds
These bonds do not pay interest.

Instead, they offer a return in the
form of a “deep discount” from the
face amount.
14 - 12
Bond Issued at Premium
10%
The entire bond issue was purchased by United Intergroup.

Calculation of the Price of the Bonds
Present Values
Interest $ 42,000 × 5.07569 = $ 213,179
Principal $700,000 × 0.74622 = 522,354
Present value (price) of bonds $ 735,533
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 × 5% = $36,777 $735,533 - $5,223 = $730,310
14 - 14
Bonds Sold at a Premium
Masterwear (Issuer)
Cash 735,533
Premium on bonds payable 35,533
United (Investor)
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
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 × (12% ÷ 2) = $42,000 $666,633 × (14% ÷ 2) = $46,664
14 - 17
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 payable 28,000
United (Investor)
Interest receivable 28,000
$42,000 × 4/6 = $28,000 $671,297 × 7% × 4/6 = $31,327
$31,327 - $28,000 = $3,327

14 - 18
On December 31, the next interest payment date,
the following entries would be recorded.
Masterwear (Issuer)
Interest payable 21,000
Cash 42,000
United (Investor)
Cash 42,000
Interest receivable 21,000
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)
Cash 42,000
United (Investor)
Cash 42,000
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)

Note Receivable 700,000
Cash 700,000
14 - 24
Long-Term Notes
At Each of the Six Interest Dates
Cash 42,000

Cash 42,000
Interest revenue 42,000
At Maturity
Notes payable 700,000
Cash 700,000

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

Discount on note payable 4,664
Cash 42,000
Cash 42,000
Discount on notes receivable 4,664
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 Outstanding
Date Cash Effective Interest in Debt Balance
(7% × Outstanding
Balance)
01/01/11 666,633
06/30/11 139,857 .07 × 666,633 = 46,664 93,193 573,440
12/31/11 139,857 .07 × 573,440 = 40,141 99,716 473,724
06/30/12 139,857 .07 × 473,724 = 33,161 106,696 367,028
12/31/12 139,857 .07 × 367,028 = 25,692 114,165 252,863
06/30/13 139,857 .07 × 252,863 = 17,700 122,157 130,706
12/31/13 139,857 .07 × 130,706 = 9,151 130,706 -
839,142 172,509 666,633
14 - 29 Rounded
At the Purchase Installment
Date (JanuaryNotes
1)
Machinery 666,633
Sales revenue 666,633

Note payable 93,193
Cash 139,857
Cash 139,857
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 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
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)
Loss on early extinguishment 8,710
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 × 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
50,000 bonds × 40 shares × $1 par = $2,000,000 par value

14 - 37
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
On January 1, 2011, HTL issued $100,000,000 of 8% bonds
due in 2018 at 130 (103% of face value). Accompanying each
$1,000 bond were 20 warrants. Each warrant permitted the
holder to buy one share of $1 par common stock at $25 per
share. Shortly after issuance, the warrants were listed on the
stock exchange at $3 per 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 bonds × 20 warrants × $3

14 - 41
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
Common stock 1,000,000
1,000,000 warrants × $25
$6,000,000 ÷ 2
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 • Companies may only elect the
elected by the firm. fair value option
• Although U.S. GAAP guidance 1. When a group of financial
indicates that the intent of the assets or liabilities is
fair value option under U.S. managed and its performance
is evaluated on a fair value
GAAP is to address these
basis, or
sorts of circumstances, it does
2. If the fair value option reduces
not require that those
“accounting mismatch.”
circumstances exist.
14 - 44
End of Chapter 14

Bonds &amp; Long Term Notes

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14

Bonds and Long-Term Notes

Liabilities signify A note payable and not A bond payable divides a

Periodic interest in the Corporations issuing bonds are

The specific promises made to bondholders are

Coupon Bond pays Callable Bond allows

Present value of an ordinary annuity of $1: n=6, i=7%

present value of $1: n=6, i=7%

Alternative “net method”

Interest is recorded as expense to the issuer and revenue to the

$666,633 × (14% ÷ 2) = $46,664

The bond indenture calls for semiannual interest payments of

At the First Interest Date (June 30)

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

$46,664 - $42,000 = $4,664

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

These bonds do not pay interest.

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

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

Interest expense and interest revenue will be recognized

Masterwear and United both have

Semi-annual Stated Interest June 30, 2011 Effective Interest

$31,327 - $28,000 = $3,327

• Debt issue costs are recorded • “Transaction costs” reduce the

Unless the recorded amount of the debt is reduced by the

The liability, note payable, is reported at its present value,

First BancCorp (Lender)

First BancCorp (Lender)

First BancCorp (Lender)

Present value of an ordinary annuity of $1: n=6, i=7%

present value of $1: n=6, i=7%

The accounting treatment is the same whether the amount is

At the First Interest Date (June 30)

At the First Interest Date (June 30)

Disclosures include fair value, the nature of the

Rate of return on = Net income

Rate of return on Net income

Times interest = Net income + interest + taxes

Debt retired at maturity results

$685,000 – 676,290 $700,000 – 676,290

Bonds into Stock

At Issuance, January 1, 2011

50,000 bonds × 40 shares × $1 par = $2,000,000 par value

 Stock warrants provide the option

100,000 bonds × 20 warrants × $3

1,000,000 warrants × $25

The same market forces

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