Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Bonds and Long-Term Notes 14

14-2 Learning Objectives Identify the underlying characteristics of debt instruments and describe the basic approach to accounting for debt.

14-3 Nature of Long-Term Debt Obligations that extend beyond one year or the operating cycle, whichever is longer Mirror image of an asset Accrue interest expense Reported at present value Loan agreement restrictions

14-4 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

14-5 The Bond Indenture Debenture Bond Mortgage Bond Subordinated Debenture Coupon Bonds CallableCallable Sinking Fund Serial Bonds Convertible Bonds The indenture is the written specific promises made by the company to the bondholders. Types of Bonds

14-6 Bonds BOND PAYABLE Face Value $1,000 Interest 10% 6/30 & 12/31 Maturity Date 12/31/15 Bond Date 1/1/06 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

14-7 Learning Objectives Account for bonds issued at par, at a discount, or at a premium, recording interest at the effective rate or by the straight-line method.

14-8 Recording Bonds at Issuance 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 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 Record the issuance of the bonds on 1/1/06.

14-9 Recording Bonds at Issuance Matrix, Inc. - Issuer Apex, Inc. - Investor

14-10 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. 1/1/06 Bonds Dated 1/12/06 Bonds Sold 6/30/06 First Interest Payment Date

14-11 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 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

14-12 Bonds Issued Between Interest Dates Accrued Interest $1,000,000 × 10% = $100,000 ÷ 360 days = $ interest per day 11 days × $ = $3, Matrix - Issuer Apex - Investor

14-13 Bonds Issued Between Interest Dates At the first interest date $1,000,000 × 10% × ½ = $50,000 cash Matrix - Issuer Apex - Investor

14-14 Determining the Selling Price

14-15 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 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?

14-16 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.

14-17 Determining the Selling Price Matrix, Inc. - Issuer Apex, Inc. - Investor

14-18 Determining Interest Effective Interest Method (Effective rate multiplied by the outstanding balance of the debt) $926,395 × 6% $55,584 - $50,000 $926,395 + $5,584

14-19 Determining Interest Effective Interest Method (Effective rate multiplied by the outstanding balance of the debt)

14-20 Determining Interest Matrix, Inc. - Issuer Apex, Inc. - Investor

14-21 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. 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.

14-22 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 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?

14-23 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.

14-24 Bonds Sold at a Premium Matrix, Inc. - Issuer Apex, Inc. - Investor

14-25 Bonds Sold at a Premium

14-26 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: Matrix, Inc. - Issuer Apex, Inc. - Investor

14-27 Year-end is on September 30, 2006, before the second interest date of December 31. $42,974 × ½ = $21,487 (3 months interest) $ 7,026 × ½ = $ 3,513 (3 months amortization) Matrix, Inc. - Issuer Financial Statements Prepared Between Interest Dates Apex, Inc. - Investor

14-28 Financial Statements Prepared Between Interest Dates The entries at December 31, Matrix, Inc. - Issuer Apex, Inc. - Investor

14-29 Straight-Line Method The discount or premium is allocated equally to each period over the outstanding life of the bond. The discount or premium is allocated equally to each period over the outstanding life of the bond. Considered practical and expedient. expedient.

14-30 Straight-Line Method In our last example, straight-line premium amortization would be: $81,105 ÷ 10 = $8,111 every six months. In our last example, straight-line premium amortization would be: $81,105 ÷ 10 = $8,111 every six months.

14-31 Straight-Line Method

14-32 Debt Issue Costs  Legal  Accounting  Underwriting  Commission  Engraving  Printing  Registration  Promotion

14-33 Debt Issue Costs  These costs should be recorded separately and amortized over the term of the related debt.  Straight-line amortization is often used.  These costs should be recorded separately and amortized over the term of the related debt.  Straight-line amortization is often used.

14-34 Learning Objectives Characterize the accounting treatment of notes including installment notes, issued for cash or for noncash consideration.

14-35 Long-Term Notes Present value techniques are used for valuation and interest recognition. The procedures are similar to those we encountered with bonds.

14-36 Notes Exchanged for Assets or Services 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. 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.

14-37 Notes Exchanged for Assets or Services

14-38 Notes Exchanged for Assets or Services Let’s prepare the entries on January 1. Amortization Schedule

14-39 Notes Exchanged for Assets or Services Matrix, Inc. - Purchaser Apex, Inc. - Seller

14-40 Notes Exchanged for Assets or Services Entries for the first interest period. Matrix, Inc. - Purchaser Apex, Inc. - Seller

14-41 Installment Notes oTo compute cash payment use present value tables. oInterest expense or revenue: Effective interest rate Effective interest rate × Outstanding balance of debt Interest expense or revenue Interest expense or revenue oPrincipal reduction: Cash amount Cash amount – Interest component Principal reduction per period Principal reduction per period oTo compute cash payment use present value tables. oInterest expense or revenue: Effective interest rate Effective interest rate × Outstanding balance of debt Interest expense or revenue Interest expense or revenue oPrincipal reduction: Cash amount Cash amount – Interest component Principal reduction per period Principal reduction per period

14-42 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 ÷ = $15,433 (rounded) PV of annuity of $1, n = 4, i = 9%

14-43 Installment Notes Here is our loan amortization table.

14-44 Installment Notes The entries on date of purchase are: Matrix, Inc. - Purchaser Apex Motors - Seller

14-45 Installment Notes Date of first payment. Matrix, Inc. - Purchaser Apex Motors - Seller

14-46 Learning Objectives Describe the disclosures appropriate to long-term debt in its various forms.

14-47 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.

14-48 Decision Makers’ Perspective Long-term debt impacts several key financial ratios. Debt to equity ratio Total liabilities Shareholders’ equity = Rate of return on assets Net income Total assets = Rate of return on shareholders’ equity Net income Shareholders’ equity = Times interest earned ratio = Net income + interest + taxes Interest

14-49 Learning Objectives Record the early extinguishment of debt and its conversion into equity securities.

14-50 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

14-51 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. Bonds into Stock

14-52 Convertible Bonds The Book Value Method Record new stock at the book value of the convertible bonds. No gain or loss is recognized. 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. 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.

14-53 Convertible Bonds 10,000 × 50 shares × $1 par value The carrying value of the bonds is assigned to the stock.

14-54 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.

14-55 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. 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. 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. 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. A portion of the selling price of the bonds is allocated to the detachable stock warrants.

14-56 Bonds With Detachable Warrants Matrix issues at par 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.

14-57 Bonds With Detachable Warrants Matrix issues at par 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. Journal entry at date of issuance of the bonds.

14-58 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.

14-59 Appendix 14 Troubled Debt Restructuring

14-60 Troubled Debt Restructuring Troubled debt may be restructured in one of two ways:  Settled at time of restructuring.  Continued with modified terms.

14-61 Troubled Debt Restructuring  Settled at time of restructuring. Book value of the debt Book value of the debt – Fair value of asset transferred Gain on restructuring Gain on restructuring Book value of the debt Book value of the debt – Fair value of asset transferred Gain on restructuring Gain on restructuring Debtor reports ordinary gain or loss on adjustment to fair value of the asset transferred.

14-62 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.

14-63 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 a gain.  All cash payments are reductions in principal. (No interest)  Debtor reports difference as a gain.  All cash payments are reductions in principal. (No interest)  No gain reported.  Compute new effective interest rate.  Record annual interest at new rate.  No gain reported.  Compute new effective interest rate.  Record annual interest at new rate.

14-64 End of Chapter 14