Bonds and Long-Term Notes 14 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 Long-term obligations extend beyond one year or the normal operating cycle, whichever is longer. Long-term obligations are evidenced by debt agreements called indentures. As we proceed through this material, we will perform several present value calculations in relation to bonds and long-term notes payable. 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 Part I On the date the bonds are issued, the company receives the selling price of the bond, and the investor receives the bond certificate. Part II In subsequent periods, the company pays the investors interest for the use of their money. At the maturity date of the bond the company must return the face amount of the bonds to the investors. 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 A debenture bond is merely an unsecured bond. A sinking fund bond requires the company to set aside funds to retire the bonds at maturity. Callable bonds may be redeemed by the company prior to maturity. Mortgage bonds are secured bonds. The bonds are secured either by specific pieces of property or the general assets of the company. Rather than maturing at one specific date, serial bonds mature in installments. A subordinated debenture bond is an unsecured bond, that is subordinate to any secured debt of the company. A convertible bond may generally be converted into common stock of the company. Subordinated Debenture Callable Coupon Bonds Convertible Bonds

BOND PAYABLE Bonds Face Value $1,000 Interest 10% 6/30 & 12/31 Maturity Date 12/31/15 Bond Date 1/1/06 This screen outlines the key features of a bond. First, we have a face amount, in most cases the face amount is $1,000. On the day the bonds are dated, in this case January 1, 2006, interest begins to accrue. The maturity date of the bond, in this case December 31, 2015, is when a company must return the face amount of the bonds to the investors. The bonds carry a stated rate, in this case, 10%. Almost all bonds pay interest semiannually. It would be unusual to own a bond that paid monthly interest, quarterly interest, or annual interest. 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 1/1/06, 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 January 1, 2006, Matrix issued 1,000 bonds that have a face value of $1,000 each and a stated rate of 10%. Interest is paid on June 30 and December 31. The bonds mature on December 31, 2010, so they are five-year bonds. Let’s look at the journal entry to record the issuance of the bond on January 1, 2006. Record the issuance of the bonds on 1/1/06.

Recording Bonds at Issuance Matrix, Inc. - Issuer Apex, Inc. - Investor Part I Matrix, the issuer of the bonds, will debit cash for $1 million and credit bonds payable for $1 million, on January 1, 2006. Part II Apex, the investor, will debit investment in bonds for $1 million and credit cash for the same amount.

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. Recall that we said that interest begins to accrue on the date the bonds are dated. If the bonds are sold after the day the bonds are dated, we have a problem of adjusting the interest for the investor. To resolve this problem, we ask the investor to pay the face amount of the bond plus the accrued interest to the bond issuer on the date of acquisition. On the date of interest payment. The entire six-month interest will be paid to the investor. In our example, the bonds were purchased on January 12, 2006. The investor would pay the face amount of the bonds plus accrued interest for 11 days. On June 30, 2006, the investor will receive a full six months interest. 1/1/06 Bonds Dated 1/12/06 Bonds Sold 6/30/06 First Interest Payment Date

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 Here is the same bond we looked at earlier. The only difference is that the bond was sold on January 12, 2006, rather than January 1, 2006, so we have the problem of accrued interest. Let’s see how we solve this problem.

Bonds Issued Between Interest Dates Accrued Interest $1,000,000 × 10% = $100,000 ÷ 360 days = $277.78 interest per day 11 days × $277.78 = $3,055.56 Matrix - Issuer Part I The first task we have is to calculate the accrued interest. Interest at 10% on $1 million for one year equals $100,000. Let’s assume that we will use a 360 day year for our calculation. The accrued interest per day would be $100,000 divided by 360 days or $277.78 per day. We need to accrue interest for 11 days. The total accrued interest will be $3,056 rounded. Part II Matrix the issuer will receive cash of $1,003,056. The company will credit bonds payable for $1 million, and credit interest payable for $3,056. Part III Apex, the investor, will debit investment in bonds for $1 million, debit interest receivable for $3,056, and credit cash for $1,003,056. Now, let’s look at the journal entry required on June 30, 2006, the first interest payment date. Apex - Investor

Bonds Issued Between Interest Dates At the first interest date $1,000,000 × 10% × ½ = $50,000 cash Matrix - Issuer Part I The cash interest payment due on June 30, 2006, is $50,000. We determine this amount by taking the face amount of $1 million times the stated rate of 10% for one-half of the year. Part II Matrix, the issuer, will debit interest expense for $46,944, debit interest payable for $3056, and credit cash for $50,000. It is important to remember that we must eliminate the interest payable that was recorded on the date of acquisition of the bonds. Part III Apex, the investor, will debit cash for $50,000, credit interest receivable four $3056, and credit interest revenue for $46,944. Apex - Investor

Determining the Selling Price To this point, we have assumed that bonds were sold at their face amount. This occurs only when the stated interest rate is equal to the market rate of interest. If the stated interest rate is above the market interest rate, the bonds will sell at a premium, meaning the cash received will be greater than the face amount of the bonds. If the stated interest rate is below the market interest rate, the bonds will sell at a discount,meaning the cash received will be less than the face amount of the bonds.

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 Here are the same bonds, we worked with earlier. The only difference is that the stated interest rate is 10% of the market interest rate is 12%. Will these bonds sell at a premium or discount? If you are having trouble answering this question, go back to the previous screen. Because the stated rate is less than the market rate of interest, these bonds will be sold at a discount. That means that the company will receive less cash than the face amount of the bonds. Because less cash is received than the face amount of the bonds, the interest expense will be impacted. 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. Part I We must begin by calculating the present value of the bonds. These are five-year bonds that have semiannual interest payments, so there are 10 periods in our calculation. Because the interest is paid semiannually, we’ll use 6% as the discount rate. The interest annuity is $50,000, and we have previously calculated this amount. Part II We began by calculating the present value of the principal amount. The principal amount is multiplied by the present value factor of one dollar for 10 periods at 6%. The present value of the principal amount is $558,390 rounded. Next, we calculate the present value of the interest annuity. The amount of the annuity, $50,000, is multiplied by the present value factor of an ordinary annuity of one dollar at 6% for 10 periods. The present value of the interest annuity is 368,005 rounded. When we add the two present value amounts together, we see that the present value of the bond is $926,395. The face amount of the bonds is $1 million and cash received from the sale of the bonds will be $926,395. Matrix will receive cash in an amount less than the face amount of the bond.

Determining the Selling Price Matrix, Inc. - Issuer Apex, Inc. - Investor Part I On January 1, 2006, Matrix will debit cash for $926,395, debit discount on bonds payable for $73,605, and credit bonds payable for $1 million. The amount of the discount is the difference between the face amount of the bonds and the cash received. Part II Apex will debit investment in bonds for $1 million, credit discount on bond investment for $73,605, and credit cash for $926,395.

Determining Interest Effective Interest Method (Effective rate multiplied by the outstanding balance of the debt) $926,395 × 6% $926,395 + $5,584 $55,584 - $50,000 Let’s look at the calculation of the effective interest on this bond. We know that the cash interest is $50,000. The effective interest is determined by taking the carrying amount of the bond $926,395 and multiplying it by the market rate of interest, 6%. Remember we’re dealing with semiannual interest so that 12% annual rate is divided by two to arrive at our 6% rate. We subtract the cash interest from the effective interest to determine the $5,584 increase in the carrying value of the bonds. Finally, we add the increase in the carrying value of the bonds to the previous carrying value to arrive at our new carrying value of $931,979. We continue this process as long as the bonds are outstanding.

Determining Interest Effective Interest Method (Effective rate multiplied by the outstanding balance of the debt) Here is the completed effective interest method schedule. Take a few minutes with your calculator and be sure you can determine the amounts shown in the effective interest column. Remember, the amounts in the schedule are rounded to the nearest whole dollar.

Determining Interest Matrix, Inc. - Issuer Apex, Inc. - Investor Part I On June 30, Matrix, will debit interest expense for $55,584, credit discount on bonds payable for $5,584, and credit cash for $50,000. You can see that because Matrix received less cash than the face amount of the bonds, the interest expense is greater than a cash interest. Part II Apex, the investor, will debit cash for $50,000, debit discount on bond investment for $5,584, and credit interest revenue for $55,584. You can see that because Apex was able to buy the bonds at less than face amount, the interest revenue is greater than the cash interest.

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. Zero-coupon bonds do not pay interest, instead, they are sold at a very deep discount from face amount. As the bonds get closer to maturity, carrying value approaches face amount.

What is the selling price of these bonds? 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 Here is the bond that we have worked with before, but in this case the stated rate of interest, 10%, is greater than the market rate of interest of 8%. Will these bonds sell for a premium or a discount? You may wish to refer back to the table we prepared earlier to see the answer to this question. These bonds will be sold at a premium. 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. Part I Our first task is to calculate the present value of the bonds, as that amount represents the proceeds that we will receive. These are five year bonds that pay interest semiannually, so the number of periods is equal to 10. The market interest rate is one-half of 8%, or 4%. We know that the interest annuity is $50,000 every six months. Part II As you can see the present value of the principal is $675,560, and the present value of the interest annuity is $405,545. The present value of the bonds is $1,081,105 rounded. We can determine the premium of $81,105.

Bonds Sold at a Premium Matrix, Inc. - Issuer Apex, Inc. - Investor Part I On the date of issuance, Matrix will debit cash for $1,081,105, credit premium on bonds payable for $81,105, and credit bonds payable for $1 million. Part II The investor will debit investment in bonds for $1 million, debit premium on bonds payable for $81,105, and credit cash for $1,081,105.

Bonds Sold at a Premium Here is our completed effective interest method table. The effective interest of $43,244 at June 30, 2006, is determined by multiplying the carrying value of $1,081,105 times 4%. Once again, all amounts on this table are rounded to the nearest dollar.

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 Part I Let’s assume that both the issuer and investor have year ends of September 30. Let’s begin the accounting process by looking at the journal entries at June 30, 2006. Part II On June 30, Matrix will debit interest expense for $43,244, debit premium on bonds payable for $6,756, and credit cash for $50,000. Part III Apex, will debit cash for $50,000, credit premium on bonds payable for $6,756, and credit interest revenue for $43,244. Because the investor paid more for the bonds than face amount, the interest revenue is less than the cash interest received. Apex, Inc. - Investor

Financial Statements Prepared Between Interest Dates 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 Part I The year ended September 30, 2006, is three months from the interest payment date of June 30, 2006. We will recognize the interest for the three-month period of $21,487. In addition, we will amortize the premium for the three-month period in the amount of $3,513. Part II The issuer will debit interest expense for $21,487, debit premium on bonds payable for $3514 and credit interest payable for $25,000. Remember the interest is not been paid, its merely been accrued. Part III The investor will debit interest receivable for $25,000, credit premium on bond investment for $3,513, and credit interest revenue for $21,487. Apex, Inc. - Investor

Financial Statements Prepared Between Interest Dates The entries at December 31, 2006. Matrix, Inc. - Issuer Apex, Inc. - Investor The next interest payment date is December 31, 2006. The issuer will debit interest expense for $21,478, debit interest payable for $25,000, debit premium on bonds payable for $3,513 and credit cash for $50,000. You can see that the entry for the investor is very similar.

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. Instead of effective interest amortization, companies are allowed to use straight-line amortization. The straight-line method is considered to be practical and expedient. Any discount or premium is allocated equally to each period over the life of the bond. The straight-line method is only acceptable when it does not produced results that are materially different than the effective interest method.

In our last example, straight-line premium amortization would be: Straight-Line Method In our last example, straight-line premium amortization would be: $81,105 ÷ 10 = $8,111 every six months. In the last example we worked we had a premium of $81,105. Using straight-line amortization, we would charge each six-month period with $8,111 to eliminate the premium.

Straight-Line Method Here is the completed table assuming straight-line amortization. The interest expense of $41,889 is the difference between the cash interest of $50,000 cash interest and the amortization of the premium of $8,111.

Debt Issue Costs Legal Accounting Underwriting Commission Engraving Printing Registration Promotion Companies that issue bonds incur substantial debt issue costs. Here is a list of some of the costs that the company is likely to incur.

Debt Issue Costs These costs should be recorded separately and amortized over the term of the related debt. Straight-line amortization is often used. For most companies, debt issue costs are recorded in a separate account and amortized over the life of the bond using the straight-line method.

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. Long-term notes use the same present value techniques and interest recognition as bonds.

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. Here is a three-year, 6% stated rate note exchanged for equipment. Interest is paid annually on December 31, of each of the next three years. The note carries an unrealistic interest rate of 6%. A more appropriate interest rate would be 9%. First let’s calculate the present value of the note because it will become the cost of the equipment purchased. 92

Notes Exchanged for Assets or Services We discount the principal amount of the note, using the present value of one dollar for three periods at 9% interest, and get $77,218 rounded. The interest annuity of $6,000, is discounted using the present value of an ordinary annuity of one dollar for three periods at 9%. The present value of the interest annuity is $15,188. The present value of our note is $92,406 rounded.

Notes Exchanged for Assets or Services Amortization Schedule Here is a completed interest amortization schedule prepared using the effective interest method. See if you can calculate the $8,317 interest at December 31, 2006. We get the amount of effective interest by multiplying the carrying value of $92,406 times the market rate of interest of 9%. Let’s prepare the entries on January 1.

Notes Exchanged for Assets or Services Matrix, Inc. - Purchaser Apex, Inc. - Seller Part I Matrix, the purchaser of the equipment, will debit equipment for $92,406, debit discount on notes payable for $7,594, and credit notes payable for $100,000. Part II Apex, the seller, will debit notes receivable for $100,000, credit discount on its receivable for $7, 594, and credit sales revenue for $92,406. If we had not used present value we would have misstated the cost of the equipment on the books of the purchaser, and the sales revenue on the books of the seller.

Notes Exchanged for Assets or Services Entries for the first interest period. Matrix, Inc. - Purchaser Apex, Inc. - Seller Part I At December 31, 2006, the purchaser will debit interest expense for $8,317, credit discount notes payable for $2,317, and credit cash for $6,000. Part II The seller will debit cash for $6,000, debit discount note receivable for $2,317, and credit interest revenue for $8,317.

Installment Notes To compute cash payment use present value tables. Interest expense or revenue: Effective interest rate × Outstanding balance of debt Interest expense or revenue Principal reduction: Cash amount – Interest component Principal reduction per period When we have an installment note, a part of each payment is applied to principal and a part is applied to interest. You can see on the screen the way we calculate the interest portion of the payment, as well as the principal reduction.

Installment Notes $50,000 ÷ 3.23972 = $15,433 (rounded) 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 ÷ 3.23972 = $15,433 (rounded) PV of annuity of $1, n = 4, i = 9% Part I In this example we have an installment note for the purchase of a $50,000 truck that is financed at 9% for four years. Our first task is to calculate a periodic annual payment. Part II To calculate the payment, we divide the principal amount of the note by the present value of an annuity of one dollar for four periods at 9%. The periodic payment is $15,433 rounded.

Here is our loan amortization table. Installment Notes Here is our loan amortization table. Here is the effective interest amortization schedule for the payments on this note. The effective interest at December 31, 2006, of $4,500, is determined by multiplying the $50,000 principal amount times the 9% interest rate.

The entries on date of purchase are: Installment Notes The entries on date of purchase are: Matrix, Inc. - Purchaser Apex Motors - Seller Part I On the date of acquisition the purchaser will debit delivery truck for $50,000 and credit notes payable for $50,000. Part II The seller of the truck will debit notes receivable for $50,000, and credit sales revenue for $50,000.

Installment Notes Date of first payment. Matrix, Inc. - Purchaser Apex Motors - Seller Part I On December 31st, the purchaser makes the first annual payment. The journal entry is to debit interest expense for $4,500, debit notes payable for $10,933, and credit cash for $15,433. Part II The seller receives the cash of $15,433, recognizes interest revenue of $4,500, and reduces the note receivable by $10,933.

Financial Statement Disclosures Long-Term Debt For all long-term debt, disclosures should include the aggregate amount maturing in each of the next five years, as well as any sinking fund payments required. 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.

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 When debt is retired at maturity, no gain or loss is recognized. If debt is retired early, that is before maturity, the company could recognize a gain or loss. A gain or loss is determined by comparing the cash proceeds to the book value of the debt.

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. Some bonds have a provision permitting the holder to convert the bond into common shares. When the bonds are converted they must be removed from the books along with any unamortized discount or premium at the date of conversion. Along with the reduction in the bonds we have an increase in the number of common shares outstanding. Bonds into Stock

Let’s look at the entry to record the conversion. Convertible Bonds The Book Value Method 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. Let’s look at the accounting for these convertible bonds using the book value method. Under the book value method stock issued is recorded at the book value of the bonds retire. No gain or loss is recognized. Read through this example, and on the next slide we will look at a journal entry.

The carrying value of the bonds is assigned to the stock. Convertible Bonds 10,000 × 50 shares × $1 par value The proper journal entry is to debit bonds payable for $10 million, credit discount bonds payable for $1,500,000, credit common stock for $500,000, and credit paid-in capital in excess of par for $8 million. There are 500,000 new common shares issued upon conversion and the par value per share is one dollar. The carrying value of the bonds is assigned to the stock.

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. Companies can induce conversion of debt through the use of call provisions. When the call price is less than the market price of the bonds, the bondholders will be induced to convert their bonds into common stock or suffer a loss.

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. Some bonds are issued with detachable stock purchase warrants. A detachable warrant gives the holder the right to purchase a share of common stock by relinquishing the warrant. When bonds are issued with detachable warrants, a portion of the proceeds received from the sale of the bonds is assigned to the detachable stock warrants. 81