1. Bonds and Long-Term Notes
CHAPTER 14
Bonds and Long-Term Notes
Learning Objectives
LO14-1 Identify the underlying characteristics of debt instruments and describe the basic approach to accounting for debt.
LO14-2 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.
LO14-7 Discuss the primary differences between U.S. GAAP and IFRS with
respect to accounting for bonds and long-term notes.
NOT COVERED
LO14-3 Characterize the accounting treatment of notes, including installment notes, issued for cash or for noncash consideration.
LO14-4 Describe the disclosures appropriate to long-term debt in its various forms.
LO14-5 Record the early extinguishment of debt and its conversion into equity securities.
LO14-6 Understand the option to report liabilities at their fair values.

2. The Nature of Long-Term Debt
Liabilities signify creditors’ interest in a company’s assets.
A note payable and note receivable are two sides of the same coin.
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.
A company must raise funds to finance its operations and often the expansion of those operations. Presumably, at least some of the necessary funding can be provided by the company’s own operations, though some funds must be provided by external sources. Ordinarily, external financing includes some combination of equity and debt funding. We explore debt financing first.
The existence of long-term debt:
Signifies creditors’ interest in a company’s assets.
Requires the future payment of cash in specified (or estimated) amounts, at specified (or projected) dates.
Requires interest accrual on the debt, as time passes.
Recognizes that periodic interest is the effective interest rate times the amount of the debt outstanding during the interest period.
Debt is reported at the present value of its related cash flows (principal and/or interest payments), discounted at the effective rate of interest at issuance.

3. The Bond Indenture (SELF-STUDY)
Debenture Bond secured by the “full faith and credit” of company.
Mortgage Bond secured by lien on specific real estate owned by the issuer.
The specific promises made to bondholders are described in a document called a bond indenture.
The specific promises made to bondholders are described in a document called a bond indenture. Because it would be impractical for the corporation to enter into a direct agreement with each of the many bondholders, the bond indenture is held by a trustee, usually a commercial bank or other financial institution, appointed by the issuing firm to represent the rights of the bondholders. If the company fails to live up to the terms of the bond indenture, the trustee may bring legal action against the company on behalf of the bondholders.
Most corporate bonds are debenture bonds. A debenture bond is secured only by the “full faith and credit” of the issuing corporation. No specific assets are pledged as security. Investors in debentures usually have the same standing as the firm’s other general creditors. So in case of bankruptcy, debenture holders and other general creditors would be treated equally. An exception is the subordinated debenture, which is not entitled to receive any liquidation payments until the claims of other specified debt issues are satisfied.
A mortgage bond, on the other hand, is backed by a lien on specified real estate owned by the issuer. Because a mortgage bond is considered less risky than debentures, it typically will command a lower interest rate.
Today most corporate bonds are registered bonds. Interest checks are mailed directly to the owner of the bond, whose name is registered with the issuing company. Years ago, it was typical for bonds to be structured as coupon bonds (sometimes called bearer bonds). The name of the owner of a coupon bond was not registered. Instead, to collect interest on a coupon bond the holder actually clipped an attached coupon and redeemed it in accordance with instructions in the indenture. A carryover effect of this practice is that we still sometimes see the term coupon rate in reference to the stated interest rate on bonds.
Coupon Bond pays interest when investor submits attached coupon.
Callable Bond allows company to buy back outstanding bonds prior to maturity.

4. Convertible and Callable
Types of Bonds A2
Secured and Unsecured
Convertible and Callable
Term and Serial
Registered and Bearer
There are several common types of bonds.
Secured bonds have specific assets of the issuer pledged as collateral. Unsecured bonds are backed by the issuer’s general credit standing.
Term bonds are scheduled for maturity on one specified date. Serial bonds mature at more than one date.
Registered bonds are issued in the names and addresses of their holders. Bearer bonds are payable to whoever holds the bond.
Convertible bonds can be exchanged for a fixed number of common shares of the issuing corporation. Callable bonds have an option exercisable by the issuer to retire them at a stated dollar amount prior to maturity.
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5. Bonds do not affect stockholder control.
Advantages of Bonds A1
Bonds do not affect stockholder control.
Interest on bonds is tax deductible.
There are several advantages for issuing bonds instead of stock. Companies issue bonds because it is a way to raise needed capital without sacrificing ownership in the company. The interest on bonds is tax deductible, thereby reducing the actual taxes paid by the company. Issuing bonds can increase the return on equity if the company earns a higher return on the borrowed funds than it pays in interest.
Bonds can increase return on equity.
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6. Disadvantages of Bonds
Bonds require payment of both periodic interest and par value at maturity.
On the other side of the issue, there are some disadvantages to issuing bonds. Bonds require regular payment of interest and repayment of the principal borrowed. These required cash payments may be difficult if a company faces tight cash flows. Bonds can also decrease the return on equity if the company pays more in interest than it earns on the borrowed funds.
Bonds can decrease return on equity when the company pays more in interest than it earns on the borrowed funds.
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7. BOND PAYABLE Face Value $1,000 Interest 10% 6/30 & 12/31
Maturity Date 12/31/09
Bond Date 1/1/05

8. Bonds
A. Divide a large liability into many smaller liabilities (usually $1,000 per bond).
Obligate a company to repay a stated amount at a specified maturity date
and periodic interest between the issue date and maturity.
C. Require periodic interest as a stated percentage of the face amount.
Pay interest semiannually (usually) on designated interest dates beginning
six months after the day the bonds are “dated”.
Make specific promises to bondholders who are described in a document
called a bond indenture.
Represent a liability to the corporation that issues the bonds and an asset
to a company that buys the bonds as an investment.
Issuer:
Cash xxx Bonds payable (face amount) xxx Investor: Investment in bonds (face amount) xxx Cash xxx

9. 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
Bonds obligate the issuing corporation to repay a stated amount (variously referred to as the principal, par value, face amount, or maturity value) at a specified maturity date. Maturities for bonds typically range from 10 to 40 years. In return for the use of the money borrowed, the company also agrees to pay interest to bondholders between the issue date and maturity. The periodic interest is a stated percentage of face amount (variously referred to as the stated rate, coupon rate, or nominal rate). Ordinarily, interest is paid semiannually on designated interest dates beginning six months after the day the bonds are “dated.”
On the date the bonds are issued, the company receives the selling price of the bond, and the investor receives the bond certificate.
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

10. Bond Interest Payments
Basics of Bonds A1
Bond Interest Payments
Corporation
Investors
Bond Interest Payments
Bonds are debt. They are similar to other debts a company issues. However, one difference is that state and federal laws govern bond issues. The legal document identifying the rights and obligations of both the bondholders and the issuer is called the bond indenture. The bond indenture is the legal contract between the issuer and the bondholders.
On the issue date, the bondholders give the company the market value, or selling price of the bond. The company gives the bondholders a bond certificate.
At regularly scheduled dates during the life of the bond, the company pays the bondholders interest. Interest is calculated as Bond Par Value times the Stated Interest Rate on the bond times the length of time the bond has been outstanding during the year.
Just like all interest rates, the stated interest rate is expressed on an annual basis. As a result, in this slide, we can assume that interest payments are made annually since the interest payment computation does not have a time component in it.
At the maturity date, the company pays the bondholders the bond’s par value. Now, let’s see how to account for a bond issue.
Interest Payment =
Bond Par Value * Stated Interest Rate
Bond Issue Date
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11. Bond Issuing ProceduresA1
. . .an investment firm called an underwriter. The underwriter sells the bonds to. . .
A company sells the
bonds to =>
Bonds are securities that can be readily bought and sold. A large number of bonds are traded on the New York Exchange and the American Exchange. Since bonds are bought and sold in the market, they have a market value, or price. For convenience, bond market values are expressed as a percent of their par value.
When an underwriter sells bonds to a large number of investors, a trustee monitors the bond issue and protects the bondholders’ interests.
A trustee monitors the bond issue.
. . . investors
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12. Pricing of Bonds
Supply and demand cause a bond to be priced to yield the market rate of interest for securities of similar risk and maturity.
Price can be calculated as the present value of all the cash
flows required (principal and interest).
The discount rate is the market interest rate.
Other things being equal, the lower the perceived riskiness of the corporation issuing bonds, the higher the price those bonds will command.
When bond prices are quoted in financial media, they typically
are stated in terms of a percentage of face amount.
So, a price quote of 97 means a $1,000 bond will sell for $970;
a bond priced at 102 will sell for $1,020.

13. Determining the Selling Price
Up 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 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. 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.

14. BOND PAYABLE Face Value $1,000 Interest 10% 6/30 & 12/31
Maturity Date 12/31/09
Bond Date 1/1/05
1. Face value (maturity or par value)
2. Maturity Date
3. Stated Interest Rate (Contract Rate)
4. Interest Payment Dates
5. Bond Date
Other Factors:
6. Market Interest Rate

15. Bond Discount or Premium
In almost all cases, the stated (contract) rate and the market rate of interest will not agree. When these two interest rates are different, it might make sense to you for us to just change our stated rate to equal the market rate and then everything would be fine. Well, we can’t do that. Remember that the bond certificate lists all of the specifics about the bond including the interest rate. Because we have to print the bond certificates in advance, we are stuck having to pay the interest printed on the bond certificate.
The only thing that is not printed on the bond certificate is the selling price. So, the issuing company and the bond investors come to an agreement on the selling price that incorporates the difference in the stated interest rate and the market interest rate.
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16. Issuing Bonds at Par P1
King Co. issues the following bonds on January 1, 2009
Par Value = $1,000,000
Stated Interest Rate = 10%; Mkt. Rate = 10%
Interest Dates = 6/30 and 12/31
Bond Date = Jan. 1, 2009
Maturity Date = Dec. 31, 2028 (20 years)
King Company issues bonds at par value. This means that the stated interest rate on the bond and the market interest rate on the bond are equal. King’s bonds have a par value of one million dollars, a stated interest rate of ten percent with interest payable on June 30th and December 31st. The bonds are dated January 1, 2009 and mature twenty years later on December 31, 2028.
On the issue date, King would debit Cash and credit Bonds Payable for one million dollars. The Bonds Payable account is always credited for the par value, or maturity value, of the bonds.
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17. Interest Expense on Bonds at Par
The entry on June 30, 2009, to record the first semiannual interest payment is . . .
On the first interest payment date, King would debit Bond Interest Expense and credit Cash for fifty thousand dollars. The interest was calculated as Par value times stated rate times months outstanding.
King will actually make this entry every six months until the maturity date.
$1,000,000 × 10% × ½ year = $50,000 This entry is made every six months until the bonds mature.
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18. The debt has now been extinguished.
Issuing Bonds at Par P1
On Dec. 31, 2028, the bonds mature, King Co. makes the following entries
On the maturity date, King will repay the par value of the bonds by debiting Bonds Payable and crediting Cash for one million dollars. At this time, the debt is extinguished.
The debt has now been extinguished.
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19. Determining the Selling Price

20. Issuing Bonds at a DiscountP2
Prepare the entry for Jan. 1, 2009, to record the following bond issue by Rose Co. Par Value = $1,000,000 Stated Interest Rate = 10% Market Interest Rate = 12%
Issue Price = Interest Dates = 6/30 and 12/31 Bond Date = Jan. 1, 2009
Maturity Date = Dec. 31, 2013 (5 years) } .
In this example, Rose Company is issuing bonds with a par value of one million dollars, a stated interest rate of ten percent with interest payable semiannually on June thirtieth and December thirty-first. However, the market interest rate on the issue date for financial instruments with similar risk is twelve percent.
Now, if our bond is paying ten percent and the market is paying twelve percent, how many investors will want to buy our bonds? None! So, we have to make our bonds more attractive by reducing the selling price to make up the difference in the interest rates.
In this example, Rose Company sells its bonds for % of its par value. This discount in the selling price raises the effective interest rate that the investors will earn to twelve percent.
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21. Calculating Bond issue Price (Discount Bond)
Face value = $1,000,000
Interest Payment= $50,000 = 1,000,000 * 10%/2
n= 10 = 5 years * 2
i= 6% = 12% /2
PVOA (n=10, i= 6%) =
PV$ (n=10, i= 6%) =
PV of Coupon payments = $50,000 * = $368,005
PV of Principal payment = $1,000,000 * = $558,390
Total Issue Price = $926,395

22. Issuing Bonds at a DiscountP2
$1,000,000 ´ %
Rose will receive cash of nine hundred twenty six thousand, four hundred five dollars from the bond investors. The difference between the par value of the bonds and the cash price received is the discount that we offered the bond investors.
Remember that the whole reason we offered the discount is because of the difference between the stated rate and the market rate of interest. As a result, the discount represents an additional interest factor that will be amortized to interest expense over the life of the bond. Amortizing the discount will increase the total interest expense recorded for the bond to equal twelve percent, the market rate of interest.
Amortizing the discount increases interest expense over the outstanding life of the bond.
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23. Issuing Bonds at a DiscountP2
On Jan. 1, 2009, Rose Co. would record the bond issue as follows.
On the issue date, Rose will debit Cash for the amount of the cash proceeds, credit Bonds Payable for the par value of the bonds issued, and debit Discount on Bonds Payable for the difference between the two.
Discount on Bonds Payable is a contra-liability account and has a normal debit balance.
Contra-Liability
Account
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24. Issuing Bonds at a DiscountP2
Maturity Value
On the balance sheet, the amount of the unamortized discount is subtracted from the par value of the bonds to arrive at the current carrying value of the bonds.
Using the straight-line method to amortize the discount, Rose will divide the amount of the discount by the number of interest payment periods during the bond’s life. Since this is a 5 year bond and it pays interest semiannually, there are 10 interest payment periods. This calculation determines that the discount amortization will be seven thousand, three hundred sixty dollars at every interest payment date.
Carrying Value
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25. P2
An amortization table illustrates the interest payment, interest expense, discount amortization, unamortized discount balance, and the carrying value of the bond for each interest payment period over the life of the bond.
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26. Issuing Bonds at a DiscountP2
Every six months, Rose will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. It is calculated as par value times the stated interest rate times one half of a year. The credit to the Discount on Bonds Payable account is determined using the straight-line method we discussed on the previous slide. The debit to Bond interest expense is the total of the two credit amounts in this entry.
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27. Issuing Bonds at a Premium
Prepare the entry for Jan. 1, 2009, to record the following bond issue by Rose Co. Par Value = $1,000,000 Issue Price = ???????? Stated Interest Rate = 10% Market Interest Rate = 8% Interest Dates = 6/30 and 12/31 Bond Date = Jan. 1, 2009
Maturity Date = Dec. 31, 2013 (5 years) }
Bond will sell at a premium.
In this example, Rose Company is issuing bonds with a par value of one million dollars, a stated interest rate of ten percent with interest payable semiannually on June 30th and December 31st. However, the market interest rate on the issue date for financial instruments with similar risk is eight percent.
Now, if our bond is paying ten percent, and the market is paying eight percent, how many investors will want to buy our bonds? All of them! So, we can increase the price of our bonds and they will still be attractive to the bond investors.
In this example, Rose company sells its bonds for % of its par value. This premium in the selling price reduces the effective interest rate that the investors will earn to eight percent.
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28. Calculating Bond issue Price (Premium Bond)
Face value = $1,000,000
Interest Payment= $50,000
n= 10
i= 4%
PVoA (n=10, i= 4%) =
PV$ (n=10, i= 4%) =
PV of Coupon payments = $50,000 * = $405,545
PV of Principal payment = $1,000,000 * = $675,560
Total Price = $1,081,105

29. Issuing Bonds at a Premium
$1,000,000 ´ %
Rose will receive cash of one million, eighty-one thousand, one hundred forty-five dollars from the bond investors. The difference between the par value of the bonds and the cash price received is the premium we charged the bond investors.
Remember that the whole reason we could offer the premium is because of the difference between the stated rate and the market rate of interest. As a result, the premium represents a reduction in the interest expense recorded over the life of the bond. Amortizing the premium will decrease the total interest expense recorded for the bond to equal eight percent, the market rate of interest.
Amortizing the premium decreases interest expense over the life of the bond.
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30. Issuing Bonds at a Premium
On Jan. 1, 2009, Rose Co. would record the bond issue as follows.
On the issue date, Rose will debit Cash for the amount of the cash proceeds, credit Bonds Payable for the par value of the bonds issued, and credit Premium on Bonds Payable for the difference between the two.
Premium on Bonds Payable is an adjunct-liability or accretion account and has a normal credit balance.
Adjunct-Liability
(or accretion)
Account
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31. Issuing Bonds at a Premium
On the balance sheet, the premium account is added to the par value of the bonds to arrive at the current carrying value of the bonds.
Using the straight-line method to amortize the premium, Rose will divide the premium by the number of interest payment periods during the bond’s life. Since this is a five-year bond and it pays interest semiannually, there are ten interest payment periods. This calculation determines that the premium amortization will be eight thousand, one hundred fifteen dollars at every interest payment date.
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32. P3
An amortization table illustrates the interest payment, interest expense, premium amortization, unamortized premium balance, and the carrying value of the bond for each interest payment period over the life of the bond.
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33. Issuing Bonds at a Premium
This entry is made every six months to record the cash interest payment and the amortization of the premium.
Every six months, Rose will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. It is calculated as par value times the stated interest rate times one half of a year. The debit to the Premium on Bonds Payable account is determined using the straight-line method we discussed on the previous slide. The debit to Bond interest expense is amount of the cash credit less the bond premium amortization.
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34. Premium and Discount Amortization Compared
Bonds sold at a premium are sold at an amount above face amount, and bonds sold at a discount are sold at an amount less than face amount. The amortization process writes up (or down) to maturity over the life of the bond. At maturity, the liability for bonds payable is equal to the amount of cash necessary to extinguish the debt.

35. Accruing Bond Interest Expense
End of accounting period
Interest Payment Dates
Jan. 1
Apr. 1
Oct. 1
Dec. 31
3 months’ accrued interest
When bond interest payment dates do not fall at year-end, an adjusting entry is required to record the bond interest expense and the bond interest payable that has accrued since the last interest payment date.
At year-end, an adjusting entry is necessary to recognize bond interest expense accrued since the most recent interest payment.
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36. U. S. GAAP vs. IFRS
International accounting standards are more restrictive than U.S. standards for determining when firms are allowed to elect the fair value option.
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.
Companies may only elect the fair value option when
When a group of financial assets or liabilities is managed and its performance is evaluated on a fair value basis, or
If the fair value option reduces “accounting mismatch.”
International accounting standards are more restrictive than U.S. standards for determining when firms are allowed to elect the fair value option.
From the viewpoint of the IFRS,
Companies may only elect the fair value option when
A group of financial assets or liabilities is managed and its performance is evaluated on a fair value basis, or
If the fair value option reduces “accounting mismatch.”
As far as the FASB is concerned,
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 the sorts of circumstances required under IFRS, U.S. GAAP does not require that those circumstances exist.

37. U. S. GAAP vs. IFRS
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.
There are some difference in the treatment of debt issuance costs between U.S. GAAP and the rules of the IFRS. Some differences are:
From the viewpoint of the FASB,
Debt issuance costs are recorded separately as an asset and amortized over the term to maturity.
The IFRS
Debt issuance costs reduce the recorded amount of the debt.
A lower [net] amount is borrowed at the same cost, increasing the effective interest rate. However, unless the recorded amount of the debt is reduced by the transaction costs, the higher rate is not reflected in a higher recorded interest expense. The actual increase in the effective interest rate is reflected in the interest expense if the issue cost is allowed to reduce the carrying amount of the debt.
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.

38. Zero-Coupon Bonds (NOT CEVERED)
These bonds do not pay interest. Instead, they offer a return in the form of a deep discount from the face amount.
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.
An advantage of issuing zero-coupon bonds or notes is that the corporation can deduct, for tax purposes, the annual interest expense but has no related cash outflow until the bonds mature. However, the reverse is true for investors in “zeros.” Investors receive no periodic cash interest, even though annual interest revenue is reportable for tax purposes. So those who invest in zero-coupon bonds usually have tax-deferred or tax-exempt status, such as pension funds, individual retirement accounts (IRAs), and charitable organizations. Zero-coupon bonds and notes have popularity but still constitute a relatively small proportion of corporate debt.

39. 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 are recorded as a debit to a separate asset account and amortized to expense over the life of the bond using the straight-line method.

40. Property, goods, or services.
Long-Term Notes
Promissory Note
(Note Payable)
Bank
Company
(Borrower)
Property, goods, or services.
When a company borrows cash from a bank and signs a promissory note, the firm’s liability is reported as a note payable.
A note might also be issued in exchange for a noncash asset—perhaps to purchase equipment on credit. In concept, notes are accounted for in precisely the same way as bonds.
Present value techniques are used for valuation and interest recognition.
The procedures are similar to those we encountered with bonds.
The liability, note payable, is reported at its present value, similar to the accounting for bonds payable.

41. Installment Notes To compute cash payment use present value tables.
Each payment includes both an interest amount and a principal amount.
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
You may have recently purchased a car, or maybe a house. If so, unless you paid cash, you signed a note promising to pay the purchase price over, say, four years for the car, or 30 years for the house. Car and house notes usually call for payment in monthly installments rather than by a single amount at maturity. Corporations, too, often borrow using installment notes. Typically, installment payments are equal amounts each period. Each payment includes both an amount that represents interest and an amount that represents a reduction of the outstanding balance (principal reduction). You can see on the screen the way we calculate the interest portion of the payment, as well as the principal reduction.
The periodic reduction of the balance is sufficient that at maturity the note is completely paid. This amount is easily calculated by dividing the amount of the loan by the appropriate discount factor for the present value of an annuity.

42. Decision Makers’ Perspective
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 =
Business decisions involve risk. Failure to properly consider risk in these decisions is one of the most costly, yet one of the most common mistakes investors and creditors can make. Long-term debt is one of the first places decision makers should look when trying to get a handle on risk. In general, debt increases risk. As an owner, debt would place you in a subordinate position relative to creditors because the claims of creditors must be satisfied first in case of liquidation. In addition, debt requires payment, usually on specific dates. Failure to pay debt interest and principal on a timely basis may result in default and perhaps even bankruptcy.
Debt also can be an advantage. It can be used to enhance the return to shareholders. If a company earns a return on borrowed funds in excess of the cost of borrowing the funds, shareholders are provided with a total return greater than what could have been earned with equity funds alone. This desirable situation is called favorable financial leverage.
Here are four significant ratios that help us determine the impact of long-term debt on the financial statements of the company. The debt to equity ratio indicates the extent of trading on the equity, or financial leverage. The rate of return on assets indicates profitability without regard to how resources are financed. The rate of return on shareholders’ equity indicates the effectiveness of employing resources provided by owners. The times interest earned ratio indicates the margin of safety provided to creditors.
Times interest earned ratio =
Net income + interest + taxes Interest

43. 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 of any type is retired prior to its scheduled maturity date, the transaction is referred to as early extinguishment of debt. 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.

44. 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.
Some bonds have a provision permitting the holder to convert the bonds 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

45. 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.
Investors often are reluctant to convert bonds to stock, even when share prices have risen significantly since the convertible bonds were purchased. This is because the market price of the convertible bonds will rise along with market prices of the stock. So 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. One way is through the call provision. As we noted earlier, most corporate bonds are callable by the issuing corporation. 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.
Occasionally, corporations may try to encourage voluntary conversion by offering an added inducement in the form of cash, stock warrants, or a more attractive conversion ratio. When additional consideration is provided to induce conversion, the fair value of that consideration is considered an expense incurred to bring about the conversion.
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.

46. 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.
Another, less common, way to sweeten a bond issue is to include detachable stock purchase warrants as part of the security issue. A stock warrant gives the investor an option to purchase a stated number of shares of common stock at a specified option price, often within a given period of time. Like a conversion feature, warrants usually mean a lower interest rate and often enable a company to issue debt when borrowing would not be feasible otherwise.
However, unlike the conversion feature for convertible bonds, warrants can be separated from the bonds. This means they can be exercised independently or traded in the market separately from bonds, having their own market price. In essence, two different securities—the bonds and the warrants—are sold as a package for a single issue price. Accordingly, the issue price is allocated between the two different securities on the basis of their market values. If the independent market value of only one of the two securities is reliably determinable, that value establishes the allocation.

47. 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.
Companies are not required to, but have the option to, value some or all of their financial assets and liabilities at fair value. There are significant problems in determining fair value of some liabilities. How does a liability’s fair value change? Remember that there are two sides to every investment. For example, if a company has an investment in General Motors’ bonds, that investment is an asset to the investor, and the same bonds are a liability to General Motors. So, 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. For bank loans or other debts that aren’t traded on a market exchange, the mix of factors will differ, but in any case, changes in the current market rate of interest will be a major contributor to changes in fair value.
When the fair value option is elected, we report changes in fair value in the income statement. Electing the fair value option means reporting unrealized holding gains and losses in earnings. A credit balance in the fair value adjustment increases the carrying value. A debit balance in the fair value adjustment reduces the carrying value.

48. Where We’re Headed
Under a proposed change in the way we account for financial assets and liabilities, financial assets would be measured at (a) fair value with changes reported in net income (FV-NI), (b) at fair value through Other Comprehensive Income (FV-OCI), or (c) at amortized cost, the classification depending on the assets’ characteristics and the company’s business strategy for holding the assets.
Most liabilities would be accounted for at amortized cost as described in this chapter. The fair value option, though, would no longer be permitted except in unique circumstances.
The proposed change is a result of a joint project on financial instruments by the International Accounting Standards Board (IASB) and the FASB as part of a broader goal of achieving a single set of high quality global accounting standards. At the time this text is being written, a final standard is expected to be issued in 2012.
Under a proposed change in the way we account for financial assets and liabilities, financial assets would be measured at (a) fair value with changes reported in net income (FV-NI), (b) at fair value through Other Comprehensive Income (FV-OCI), or (c) at amortized cost, the classification depending on the assets’ characteristics and the company’s business strategy for holding the assets.
Most liabilities would be accounted for at amortized cost as described in this chapter. The fair value option, though, would no longer be permitted except in unique circumstances.
The proposed change is a result of a joint project on financial instruments by the International Accounting Standards Board (IASB) and the FASB as part of a broader goal of achieving a single set of high quality global accounting standards. At the time this text is being written, a final standard is expected to be issued in 2012.

49. Appendix 14B Troubled Debt Restructuring
When changing the original terms of a debt agreement is motivated by financial difficulties experienced by the debtor (borrower), the new arrangement is referred to as a troubled debt restructuring.
A troubled debt restructuring may be achieved in either of two ways:
The debt may be settled at the time of the restructuring.
The debt may be continued, but with modified terms.
When changing the original terms of a debt agreement is motivated by financial difficulties experienced by the debtor (borrower), the new arrangement is referred to as a troubled debt restructuring.
A troubled debt restructuring may be achieved in either of two ways:
The debt may be settled at the time of the restructuring.
The debt may be continued, but with modified terms.

50. End of Chapter 14
End of Chapter 14.