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Conducted by: Mr. Koy Chumnith Bonds and Long-Term Notes 14 McGraw-Hill/Irwin 2011, Royal University of Law and Economics.

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Presentation on theme: "Conducted by: Mr. Koy Chumnith Bonds and Long-Term Notes 14 McGraw-Hill/Irwin 2011, Royal University of Law and Economics."— Presentation transcript:

1 Conducted by: Mr. Koy Chumnith Bonds and Long-Term Notes 14 McGraw-Hill/Irwin 2011, Royal University of Law and Economics

2 The Nature of Long-Term Debt Liabilities signify creditors interest in a companys assets. A note payable and not receivable are two sides of the same coin. Periodic interest in the effective interest rate times the amount of the debt outstanding during the period. Debt is reported at its present value A bond payable divides a large liability into many smaller liabilities. Corporations issuing bonds are obligated to repay a stated amount at a specified maturity date and period interest between the issue date.

3 Bonds Bond Selling Price Bond Certificate Interest Payments Face Value Payment at End of Bond Term At Bond Issuance Date Company Issuing Bonds Subsequent Periods Investor Buying Bonds Company Issuing Bonds Investor Buying Bonds

4 The Bond Indenture The specific promises made to bondholders are described in a document called a bond indenture. Mortgage Bond secured by lien on specific real estate owned by the issuer. Callable Bond allows company to buy back outstanding bonds prior to maturity. Coupon Bond pays interest when investor submits attached coupon. Debenture Bond secured by the full faith and credit of company.

5 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) Cash700,000 Bonds payable 700,000 United (Investor) Investment in bonds (face amount) 700,000 Cash 700,000

6 Determining the Selling Price

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

8 Bonds Issued at a Discount Masterwear (Issuer) Cash666,633 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) Cash666,633 Bonds payable 666,633 United (Investor) Investment in bonds 666,633 Cash 666,633

9 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). 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). 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

10 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 expense46,664 Discount on bonds payable 4,664 Cash 42,000 United (Investor) Cash42,000 Discount on bond investment 4,664 Investment revenue 46,664 $700,000 × (12% ÷ 2) = $42,000 $666,633 × (14% ÷ 2) = $46,664 $46,664 - $42,000 = $4,664

11 Bond Amortization Schedule Here is a bond amortization schedule showing the cash interest, effective interest, discount amortization, and the carrying value of the bonds. $666,633 + $4,664 = $671,297

12 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. These bonds do not pay interest. Instead, they offer a return in the form of a deep discount from the face amount.

13 Bond Issued at Premium 10% 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%. The entire bond issue was purchased by United Intergroup. 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. Present value of an ordinary annuity of $1: n=6, i=6% present value of $1: n=6, i=5%

14 Premium Amortization Schedule Here is a bond amortization schedule showing the cash interest, effective interest, premium amortization, and the carrying value of the bonds. $735,533 - $5,223 = $730,310 $735,533 × 5% = $36,777

15 Bonds Sold at a Premium Masterwear (Issuer) Cash735,533 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.

16 Premium and Discount Amortization Compared 1/1/1112/31/13 $700,000 $735,533 $666,633 Premium Amortization Discount Amortization

17 When Financial Statements Are Prepared Between Interest Dates Masterwear and United both have October 31 st year-ends. 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. $700,000 × (12% ÷ 2) = $42,000 $666,633 × (14% ÷ 2) = $46,664 Semi-annual Stated InterestJune 30, 2011 Effective Interest

18 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 expense31,327 Discount on bonds payable 3,327 Interest payable 28,000 United (Investor) Interest receivable28,000 Discount on bond investment 3,327 Investment revenue 31,327 $42,000 × 4/6 = $28,000 $671,297 × 7% × 4/6 = $31,327 $31,327 - $28,000 = $3,327

19 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 expense23,496 Interest payable21,000 Discount on bonds payable 2,496 Cash 42,000 United (Investor) Cash42,000 Discount on bond investment 2,496 Interest receivable21,000 Investment revenue 23,496

20 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 expense47,561 Discount on bonds payable 5,561 Cash 42,000 United (Investor) Cash42,000 Discount on bond investment 5,561 Investment revenue 47,561

21 Debt Issue Costs Legal Legal Accounting Accounting Underwriting Underwriting Commission Commission Engraving Engraving Printing Printing Registration Registration Promotion Promotion

22 U. S. GAAP vs. IFRS 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. Debt issue costs (called transaction costs under IFRS) are accounted for differently by U.S. GAAP and IFRS. Debt issue costs are recorded separately as an asset. Amortized over the term to maturity. Transaction costs reduce the recorded amount of the debt. The cost of these services reduces the net cash the issuing company receives and the amount recorded for the debt.

23 Long-Term Notes Bank Promissory Note (Note Payable) Promissory Note (Note Payable) Company (Borrower) Company (Borrower) Property, goods, or services. The liability, note payable, is reported at its present value, similar to the accounting for bonds payable.

24 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) Cash700,000 Note payable 700,000 First BancCorp (Lender) Investment in bonds 700,000 Cash 700,000

25 Long-Term Notes At Each of the Six Interest Dates At Maturity Skill Graphics (Borrower) Interest expense 42,000 Cash 42,000 First BancCorp (Lender) Cash 42,000 Interest revenue 42,000 Skill Graphics (Borrower) Notes payable700,000 Cash 700,000 First BancCorp (Lender) Cash700,000 Notes receivable 700,000

26 Note Exchanged for Assets or Services present value of $1: n=6, i=7% Present value of an ordinary annuity of $1: n=6, i=7% 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 notes cash flows (interest plus principal) computed as follows: 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.

27 Note Exchanged for Assets or Services At the Purchase Date (January 1) At the First Interest Date (June 30) Skill Graphics (Buyer/Issuer) Machinery 666,633 Discount on note payable 33,367 Notes payable 700,000 Hughes-Baker (Seller/Lender) Notes receivable700,000 Discount on notes payable 33,367 Sales revenue 666,633 Skill Graphics (Buyer/Issuer) Interest expense 46,664 Discount on note payable 4,664 Cash 42,000 Hughes-Baker (Seller/Lender) Cash42,000 Discount on notes payable 4,664 Investment revenue 46,664

28 Installment Notes oTo compute cash payment use present value tables. oEach payment includes both an interest amount and a principal amount. oInterest expense or revenue: Effective interest rate × Outstanding balance of debt Interest expense or revenue oPrincipal reduction: Cash amount – Interest component Principal reduction per period

29 Installment Notes $666,633 ÷ = $139,857 amount of loan (from Table 4) installment n=6, i=7.0%payment Notes often are paid in installments, rather than a single amount at maturity. Rounded

30 Installment Notes At the Purchase Date (January 1) At the First Interest Date (June 30) Skill Graphics (Buyer/Issuer) Machinery 666,633 Notes payable 666,633 Hughes-Baker (Seller/Lender) Notes receivable666,633 Sales revenue 666,633 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

31 Financial Statement Disclosures Disclosures include fair value, the nature of the companys 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.

32 Times interest earned ratio = Net income + interest + taxes Interest Decision Makers Perspective Debt to equity ratio Total liabilities Shareholders equity = Rate of return on shareholders equity Net income Shareholders equity= Rate of return on assets Net income Total assets =

33 Early Extinguishment of Debt Debt retired at maturity results in no gains or losses. Debt retired before maturity may result in an gain or loss on extinguishment. Cash Proceeds – Book Value = Gain or Loss Debt retired before maturity may result in an gain or loss on extinguishment. Cash Proceeds – Book Value = Gain or Loss BUT

34 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%. $685,000 – 676,290 $700,000 – 676,290 Masterwear (Issuer) Bonds payable700,000 Loss on early extinguishment 8,710 Discount on bonds payable 23,710 Cash 685,000

35 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

36 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 $10,000,000 × 103% HTL (Issuer) Cash 103,000,000 Convertible bonds payable 100,000,000 Premium on bonds payable 3,000,000

37 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). HTL (Issuer) Convertible bonds payable50,000,000 Premium on bonds payable 1,000,000 Common stock 2,000,000 Paid-in capital – excess of par 49,000,000 At Date of Exercise of One-half of the Bonds 50,000 bonds × 40 shares × $1 par = $ 2,000,000 par value

38 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.

39 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.

40 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. 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.

41 Bonds With Detachable Warrants 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 bonds × 20 warrants × $3

42 Bonds With Detachable Warrants Assume one-half of the warrants (1,000,000) are exercised when the market value of HTLs 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 warrants × $25 $6,000,000 ÷ 2

43 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.

44 U. S. GAAP vs. IFRS 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. International accounting standards are more restrictive than U.S. standards for determining when firms are allowed to elect the fair value option. 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.

45 End of Chapter 14


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