Bonds and Long-Term Notes Chapter 14 Bonds and Long-Term Notes

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

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

Subordinated Debenture 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

Bonds BOND PAYABLE Face Value $1,000 Interest 10% 6/30 & 12/31 Maturity Date 12/31/11 Bond Date 1/1/02 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

Recording Bonds at Issuance On 1/1/02, Graphics Inc. issues 1,000 bonds at face value to Webster, Inc. The market interest rate is 10%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02 Record the issuance of the bonds on 1/1/02.

Recording Bonds at Issuance Graphics, Inc. - Issuer Webster, Inc. - Investor

Bonds Issued Between Interest Date 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.

Bonds Issued Between Interest Date On 2/1/02, Graphics Inc. issues 1,000 bonds at face value plus accrued interest to Webster, Inc. The market interest rate is 10%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02

Bonds Issued Between Interest Date Accrued Interest $1,000,000 × 10% × = $8,333 1 12 Graphic - Issuer Webster - Investor

Bonds Issued Between Interest Date At the first interest date $1,000,000 × 10% × ½ = $50,000 Graphic - Issuer Webster - Investor

Determining the Selling Price

Determining the Selling Price On 1/1/02, Graphics Inc. issues 1,000 bonds at face value to Webster, Inc. The market interest rate is 12%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02 What is the selling price of these bonds?

Determining the Selling Price n = 5 years × 2 payments per year = 10 i = 12% ÷ 2 payments per year = 6% Interest annuity = $1,000,000 × 10% ÷ 2 = $50,000 Bonds issued at a discount.

Determining the Selling Price Graphics, Inc. - Issuer Webster, Inc. - Investor

Determining Interest Effective Interest Method (Effective rate multiplied by the outstanding balance of the debt) $926,395 × 6% $55,584 - $50,000 $73,605 - $5,584

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

Determining Interest Graphics, Inc. - Issuer Webster, Inc. - Investor

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. Those who invest in zero-coupon bonds usually have tax-deferred or tax-exempt status.

What is the selling price of these bonds? Bonds Sold at a Premium On 1/1/02, Graphics Inc. issues 1,000 bonds at face value to Webster, Inc. The market interest rate is 8%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02 What is the selling price of these bonds?

Bonds Sold at a Premium n = 5 years × 2 payments per year = 10 i = 8% ÷ 2 payments per year = 4% Interest annuity = $1,000,000 × 10% ÷ 2 = $50,000 Bonds issued at a premium.

Bonds Sold at a Premium Graphics, Inc. - Issuer Webster, Inc. - Investor

Bonds Sold at a Premium

Financial Statements Prepared Between Interest Dates Assume that in our previous example, Graphic, Inc. and Webster, Inc. both have fiscal years that end on September 30. Let’s look at the June 30 entry: Graphics, Inc. - Issuer Webster, Inc. - Investor

Financial Statements Prepared Between Interest Dates Year-end is on September 30, 2002, before the second interest date of December 31. $42,974 × ½ = $21,487 (3 months interest) $ 7,026 × ½ = $ 3,513 (3 months amortization) Graphics, Inc. - Issuer

Financial Statements Prepared Between Interest Dates Year-end is on September 30, 2002, before the second interest date of December 31. $42,974 × ½ = $21,487 (3 months interest) $ 7,026 × ½ = $ 3,513 (3 months amortization) Webster, Inc. - Investor

Financial Statements Prepared Between Interest Dates The entries at December 31, 2002. Graphics, Inc. - Issuer Webster, Inc. - Investor

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

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

Debt Issue Costs Legal Accounting Underwriting Commission Engraving Printing Registration Promotion

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

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

Notes Exchanged for Assets or Services On 1/1/03, Matters, Inc. issued a $100,000, 3-year, 6% note in exchange for equipment owned by West, 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. 92

Notes Exchanged for Assets or Services

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

Notes Exchanged for Assets or Services Matters, Inc. - Purchaser West, Inc. - Seller

Notes Exchanged for Assets or Services Entries for the first interest period. Matters, Inc. - Purchaser West, Inc. - Seller

Installment Notes To compute cash payment use present value tables. Interest expense or revenue: Book value at beginning of period × Interest rate on the note payable Interest expense or revenue Principal reduction: Cash amount – Interest component Principal reduction per period

Installment Notes $20,000 ÷ 3.23972 = $6,173 (rounded) Jetson Delivery purchased a truck by issuing a 4-year note payable to Wink Motors. The truck cost $20,000 and is financed at a 9% interest rate. Payments are made at the end of each of the next for years. Let’s calculate the annual payment. $20,000 ÷ 3.23972 = $6,173 (rounded) PV of annuity of $1, n = 4, i = 9%

Here is our loan amortization table. Installment Notes Here is our loan amortization table.

Installment Notes The entries on date of purchase are: Jetson Delivery - Purchaser Wink Motors - Seller

Jetson Delivery - Purchaser Installment Notes Date of first payment. Jetson Delivery - Purchaser Wink Motors - Seller

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.

Key Ratios Long-term debt impacts several key financial ratios. Rate of return on shareholders’ equity Net income Shareholders’ equity = Times interest earned ratio = Net income + interest + taxes Interest Debt to equity ratio Total liabilities Shareholders’ equity = Rate of return on assets Net income Total assets =

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

Convertible Bonds 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 The Book Value Method Record new stock at the book value of the convertible bonds. No gain or loss is recognized.

Let’s look at the entry to record the conversion. Convertible Bonds On December 31, 2003, 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 $1,645,000 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.

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

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. 81

Bonds With Detachable Warrants Matrix issues 10,000, $1,000 face value, 8% debt with detachable warrants that permit the holder to purchase one share of stock for $18 per share. Immediately after the issue the bonds were selling for 98 without the warrants and the warrants have a market value of $16. 81

Bonds With Detachable Warrants Matrix issues 10,000, $1,000 face value, 8% debt with detachable warrants that permit the holder to purchase one share of stock for $18 per share. Immediately after the issue the bonds were selling for 98 without the warrants and the warrants have a market value of $16. 81

Bonds With Detachable Warrants Assume that all 10,000 warrants are exercised and Matrix received $180,000 (10,000 × $18 per share) and issues 10,000 shares of its $1 par value common stock. 81

Troubled Debt Restructuring Troubled debt may be restructured in one of two ways: Settled at time of restructuring. Continued with modified terms.

Troubled Debt Restructuring Settled at time of restructuring. Debtor reports ordinary gain or loss on adjustment to fair value of the asset transferred. Book value of the debt – Fair value of asset transferred Gain on restructuring Debtor reports as extraordinary gain.

Troubled Debt Restructuring Continued with modified terms. Reduce or delay interest payments. Reduce or delay maturity payment. Accounting treatment depends on a comparison of total cash payments after restructuring with the book value of the original debt.

Troubled Debt Restructuring Continued with modified terms. Cash payments less than book value of debt. Cash payments more than book value of debt. Debtor reports difference as extraordinary gain. All cash payments are reductions in principal. (No interest) No gain reported. Compute new effective interest rate. Record annual interest at new rate.

End of Chapter 14