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

2. 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

3. 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

4. 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

5. 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

6. 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.

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

8. 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.

9. 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

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

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

12. Determining the Selling Price

13. 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?

14. 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.

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

16. 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

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

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

19. 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.

20. 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?

21. 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.

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

23. Bonds Sold at a Premium

24. 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

25. 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

26. 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

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

28. 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.

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

30. Debt Issue Costs Legal Accounting Underwriting Commission Engraving
Printing
Registration
Promotion

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

32. 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.

33. 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

34. Notes Exchanged for Assets or Services

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

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

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

38. 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

39. 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 ÷ = $6,173 (rounded)
PV of annuity of $1, n = 4, i = 9%

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

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

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

43. 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.

44. 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 =

45. 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

46. 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.

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

48. 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.

49. 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.

50. 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

51. 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

52. 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

53. 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

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

55. 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.

56. 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.

57. 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.

58. End of Chapter 14