1. Bonds and Long-Term Notes
Chapter 14
Chapter 14: Bonds and Long-Term Notes
This chapter continues the presentation of liabilities. Specifically, the discussion focuses on the accounting treatment of long-term liabilities. Long-term notes and bonds are discussed, as well as the extinguishment of debt and debt convertible into stock.

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.
Periodic interest is the effective interest rate times the amount of the debt outstanding during the period. Debt is reported at its present value
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. 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

4. The Bond Indenture
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.

5. Recording Bonds at Issuance
On January 1, 2013, Masterwear Industries issued $700,000 of 12% bonds. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years [an unrealistically short maturity to shorten the illustration]. The entire bond issue was sold in a private placement to United Intergroup, Inc., at face amount.
At Issuance (January 1)
Masterwear (Issuer)
Cash ,000
Bonds payable ,000
On January 1, 2013, Masterwear Industries issued $700,000 of 12% bonds. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years [an unrealistically short maturity to shorten the illustration]. The entire bond issue was sold in a private placement to United Intergroup, Inc., at face amount.
On the date of issuance Masterwear, the issuer, will debit cash and credit bonds payable for $700,000.
United, the investor, will debit investment in bonds and credit cash for $700,000.
United (Investor)
Investment in bonds (face amount) 700,000
Cash ,000

6. 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.

7. Determining the Selling Price
On January 1, 2013, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup.
Present value of an ordinary annuity of $1: n=6, i=7%
A bond issue will be priced by the marketplace to yield the market rate of interest for securities of similar risk and maturity. To illustrate, on January 1, 2013, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup.
To calculate the bond issue price, we multiply the semiannual interest annuity of $42,000 times , the present value of an ordinary annuity for $1 for 6 periods at 7% interest. Next we calculate the present value of the face amount of the bonds by multiplying the principal amount of $700,000 times , the present value factor of $1 for 6 periods at 7% interest. We add the two present value amounts to get the present value of the bonds of $666,633.
present value of $1: n=6, i=7%
Because interest is paid semiannually, the present value calculations use: (a) the semiannual stated rate (6%), (b) the semiannual market rate (7%), and (c) 6 (3 x 2) semi-annual periods.

8. Bonds Issued at a Discount
Masterwear (Issuer)
Cash ,633
Discount on bonds payable 33,367
Bonds payable ,000
United (Investor)
Investment in bonds ,000
Discount on bond investment ,367
Cash ,633
Alternative Net Method
Masterwear (Issuer)
Cash ,633
Bonds payable ,633
United (Investor)
Investment in bonds ,633
Cash ,633
On the date is issuance, Masterwear, the issuer, will debit cash for the present value amount of $666,633, debit discount on bonds payable for $33,367, and credit bonds payable for the face amount of $700,000.
On that same date, United, the investor, will debit investment in bonds for the face amount of $700,000, credit discount on bond investment for $33,367, and credit cash for $666,633, the present value amount we calculated.
As an alternative, the bonds payable and investment in bonds may be recorded at the net amount, that is the face amount less any discount and plus any premium. The net method actually is the preferred method for companies that prepare financial statements according to International Financial Reporting Standards.

9. Determining Interest – Effective Interest Method
Interest accrues on an outstanding debt at a constant percentage of the debt each period. Interest each period is recorded as the effective market rate of interest multiplied by the outstanding balance of the debt (during the interest period).
Interest is recorded as expense to the issuer and revenue to the investor. For the first six-month interest period the amount is calculated as follows:
$666,633 × (14% ÷ 2) = $46,664
Outstanding Balance Effective Rate Effective Interest
Interest accrues on an outstanding debt at a constant percentage of the debt each period. Interest each period is recorded as the effective market rate of interest multiplied by the outstanding balance of the debt (during the interest period).
Interest is recorded as expense to the issuer and revenue to the investor. For the first six-month interest period, the amount is $46,664, determined by multiplying the outstanding balance of $666,633 times the effective interest rate of 7%.
However, the bond indenture calls for semiannual interest payments of only $42,000 – the stated rate (6%) times the face value of $700,000. The difference ($4,664) increases the bond carrying value and is reflected as a reduction in the discount (a contra-liability account).
The bond indenture calls for semiannual interest payments of only $42,000 – the stated rate (6%) times the face value of $700,000. The difference ($4,664) increases the liability and is reflected as a reduction in the discount (a contra-liability account).

10. Recording Interest Expense
The effective interest is calculated each period as the market rate times the amount of the debt outstanding during the interest period.
At the First Interest Date (June 30)
Masterwear (Issuer)
Interest expense 46,664
Discount on bonds payable 4,664
Cash ,000
United (Investor)
Cash ,000
Discount on bond investment 4,664
Investment revenue ,664
At the first interest payment date, June 30, Masterwear, the issuer, will debit interest expense for $46,664, credit discount on bonds payable for $4,664, and credit cash for $42,000. On the same date, United, the investor, will debit cash for $42,000, debit discount on bond investment for $4,664, and credit interest revenue for $46,664.
$700,000 × (12% ÷ 2) = $42,000
$46,664 - $42,000 = $4,664
$666,633 × (14% ÷ 2) = $46,664

11. Bond Amortization Schedule
Here is a bond amortization schedule showing the cash interest, effective interest, discount amortization, and the carrying value of the bonds.
The bond amortization schedule shows all the amounts that will enter into the journal entries in connection with this bond. Remember that effective interest is determined each period by multiplying the outstanding balance times the effective periodic interest rate. For example, for June 30, 2014, the effective interest is calculated by multiplying $676,288, the balance at the beginning of June 30, 2014, times the effective interest rate of 7 percent to get $47,340, rounded.
$666,633 + $4,664 = $671,297

12. 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.
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.

13. Bond Issued at Premium
On January 1, 2013, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 10%. The entire bond issue was purchased by United Intergroup.
Present value of an ordinary annuity of $1: n=6, i=5%
A bond issue will be priced by the marketplace to yield the market rate of interest for securities of similar risk and maturity. To illustrate, On January 1, 2013, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 10%. The entire bond issue was purchased by United Intergroup at a cost of $735,533, or a premium of $35,533 ($735,533 ̶ $700,000).
To calculate the bond issue price, we multiply the semiannual interest annuity of $42,000 times , the present value of an ordinary annuity for $1 for 6 periods at 5% interest. Next we calculate the present value of the face amount of the bonds by multiplying the principal amount of $700,000 times , the present value factor of $1 for 6 periods at 5% interest. We add the two present value amounts to get the present value of the bonds of $735,533.
present value of $1: n=6, i=5%
Because interest is paid semiannually, the present value calculations use: (a) the semiannual stated rate (6%), (b) the semiannual market rate (5%), and (c) 6 (3 x 2) semi-annual periods.

14. Premium Amortization Schedule
Here is a bond amortization schedule showing the cash interest, effective interest, premium amortization, and the carrying value of the bonds.
$735,533 × 5% = $36,777
$735,533 - $5,223 = $730,310
The bond amortization schedule shows all the amounts that will enter into the journal entries in connection with this bond. Remember that effective interest is determined each period by multiplying the outstanding balance times the effective periodic interest rate. For example, for June 30, 2014, the effective interest is calculated by multiplying $724,825, the balance at the beginning of June 30, 2014, times the effective interest rate of 5 percent to get $36,241, rounded.
Notice that the carrying value of the debt declines each period. As the premium is reduced by amortization, the carrying value of the bonds declines toward face value. This is because the effective interest each period is less than the cash interest paid. Remember, this is precisely the opposite of when debt is sold at a discount, when the effective interest each period is more than the cash paid. As the discount is reduced by amortization, the carrying value of the bonds increases toward face value.

15. Bonds Sold at a Premium
Masterwear (Issuer)
Cash ,533
Premium on bonds payable ,533
Bonds payable ,000
United (Investor)
Investment in bonds ,000
Premium on bond investment 35,533
Cash ,533
On the date of acquisition, Masterwear, the bond issuer, will debit cash for $735,533, credit premium on bonds payable for $35,533, and credit bonds payable for $700,000. At the same time, United (the investor in the bonds) will debit investment in bonds for $700,000, debit premium on bond investment for $35,533, and credit cash for $735,533.
Interest expense and interest revenue will be recognized in a manner consistent with bonds issued at a discount.

16. 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.

17. When Financial Statements Are Prepared Between Interest Dates
On January 1, 2013, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup at a cost of $666,633.
Masterwear and United both have October 31st year-ends.
We have accounted for these bonds on previous slides, so we are familiar with the values calculated. For example, on the date of issue the cash paid by United (investor) to Masterwear (issuer) will be $666,633. The total discount is $33,367. Let’s see the proper accounting when both companies have an October 31 year-end, and interest is paid on June 30 and December 31.
Semi-annual Stated Interest
June 30, 2013 Effective Interest
$700,000 × (12% ÷ 2) = $42,000
$666,633 × (14% ÷ 2) = $46,664

18. When Financial Statements Are Prepared Between Interest Dates
Year-end is on October 31, 2013, before the second interest date of December 31, so we must accrue interest for 4 months from June 30 to October 31.
Year-end accrual of interest expense and interest income.
Masterwear (Issuer)
Interest expense 31,327
Discount on bonds payable 3,327
Interest payable ,000
The year ended October 31, 2013, is four months from the interest payment date of June 30, The year-end entry is an accrual; no cash will change hands. Instead the issuer will record interest payable and the investor will record interest receivable.
We will recognize the interest for the four-month period of $31,327 (refer to the amortization schedule to calculate this amount). We will need to multiply the values in the amortization table by 4/6 to account for the portion of the future payment we are accruing at the end of October.
The issuer will debit interest expense for $31,327 credit discount on bonds payable for $3,327 and credit interest payable for $28,000. The investor will debit interest receivable for $28,000, debit discount on bond investment for $3,327, and credit interest revenue for $31,327.
United (Investor)
Interest receivable 28,000
Discount on bond investment 3,327
Investment revenue ,327
$42,000 × 4/6 = $28,000
$31,327 - $28,000 = $3,327
$671,297 × 7% × 4/6 = $31,327

19. When Financial Statements Are Prepared Between Interest Dates
On December 31, the next interest payment date, the following entries would be recorded.
Masterwear (Issuer)
Interest expense 15,664
Interest payable 28,000
Discount on bonds payable 1,664
Cash ,000
On December 31, the next interest payment date, Masterwear, the issuer, will recognize an additional two months’ interest expense, an additional two months’ discount amortization, record the payment of cash, and remove the liability interest payable created by the accrual entry on October 31. Likewise, United, the investor, will recognize an additional two months’ interest revenue, an additional two months’ discount amortization, record the receipt of cash, and remove the asset interest receivable created by the accrual entry on October 31.
United (Investor)
Cash ,000
Discount on bond investment 1,664
Interest receivable 28,000
Investment revenue ,664

20. The Straight-Line Method – A Practical Expediency
Using the straight-line method of amortizing discounts and premiums, the discount in the earlier illustration would be allocated equally to the 6 semiannual periods (3 years):
$33,367 ÷ 6 periods = $5,561 per period
At Each of the Six Interest Dates
Masterwear (Issuer)
Interest expense 47,561
Discount on bonds payable 5,561
Cash ,000
In some circumstances the profession permits an exception to the conceptually appropriate method of determining interest for bond issues. A company is allowed to determine interest indirectly by allocating a discount or a premium equally to each period over the term to maturity—if doing so produces results that are not materially different from the usual (and preferable) effective interest method.
Using the straight-line method, the discount in the earlier illustration would be allocated equally to the 6 semiannual periods (3 years) by dividing the total discount of $33,367 by 6 periods for a semiannual amortization of $5,561 per period.
On June 30, 2013, the first interest payment date, Masterwear, the issuer, will debt interest expense of $47,561, credit discount on bonds payable for $5,561 (the amount we just calculated), and credit cash for $42,000. United, the investor, will debit cash for $42,000, debit discount on bonds investment for $5,561, and credit interest revenue of $47,561. Both companies will make the same journal entry each interest period.
United (Investor)
Cash ,000
Discount on bond investment 5,561
Investment revenue ,561

21. 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.

22. 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.

23. 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.

24. Long-Term Notes January 1, At Issuance
On January 1, 2013, Skill Graphics, Inc., a product labeling and graphics firm, borrowed $700,000 cash from First BancCorp and issued a 3-year, $700,000 promissory note. Interest of $42,000 was payable semiannually on June 30 and December 31.
January 1, At Issuance
Skill Graphics (Borrower)
Cash ,000
Note payable ,000
To illustrate the accounting for long-term notes assume that on January 1, 2013, Skill Graphics, Inc., a product labeling and graphics firm, borrowed $700,000 cash from First BancCorp and issued a 3-year, $700,000 promissory note. Interest of $42,000 was payable semiannually on June 30 and December 31. Skill Graphics, the borrower, will debit cash and credit notes payable for $700,000. First BancCorp, the lender, will debit notes receivable and credit cash for $700,000.
First BancCorp (Lender)
Note receivable ,000
Cash ,000

25. Long-Term Notes At Each of the Six Interest Dates At Maturity
Skill Graphics (Borrower)
Interest expense ,000
Cash ,000
First BancCorp (Lender)
Cash ,000
Interest revenue ,000
At Maturity
Every six months interest is paid by Skill Graphics to First BancCorp and the journal entries shown on your screen will be made. Skill Graphics will debit interest expense and credit cash and First BancCorp will debit cash and credit interest revenue for $42,000. At maturity, Skill Graphics will pay the note in full and debit notes payable and credit cash for $700,000. First BancCorp will debit cash and credit notes receivable for $700,000.
Skill Graphics (Borrower)
Notes payable ,000
Cash ,000
First BancCorp (Lender)
Cash ,000
Notes receivable ,000

26. Note Exchanged for Assets or Services
Skill Graphics purchased a package labeling machine from Hughes–Barker Corporation by issuing a 12%, $700,000, 3-year note that requires interest to be paid semiannually. The machine could have been purchased at a cash price of $666,633. The cash price implies an annual market rate of interest of 14%. That is, 7% is the semiannual discount rate that yields a present value of $666,633 for the note’s cash flows (interest plus principal) computed as follows:
Present value of an ordinary annuity of $1: n=6, i=7%
Now let’s assume Skill Graphics purchased a package labeling machine from Hughes–Barker Corporation by issuing a 12%, $700,000, 3-year note that requires interest to be paid semiannually. Also assume that the machine could have been purchased at a cash price of $666,633. The cash purchase price of the equipment gives us an implied annual market interest rate of 14% as shown in the present value computation. The accounting treatment is the same whether the amount is determined directly from the market value of the machine (and thus the note, also) or indirectly as the present value of the note (and thus the value of the asset, also).
present value of $1: n=6, i=7%
The accounting treatment is the same whether the amount is determined directly from the market value of the machine or indirectly as the present value of the note.

27. Note Exchanged for Assets or Services
At the Purchase Date (January 1)
Skill Graphics (Buyer/Issuer)
Machinery ,633
Discount on note payable ,367
Notes payable ,000
Hughes-Barker (Seller/Lender)
Notes receivable 700,000
Discount on notes payable 33,367
Sales revenue ,633
At the First Interest Date (June 30)
At the date of purchase, Skill Graphics will debit machinery for the cash purchase price of $666,633, debit discount on notes payable for $33,367, and credit notes payable for $700,000. Hughes-Barker will debit notes receivable for $700,000, credit discount on notes receivable for $33,367, and credit sales revenue for $666,633.
On the first interest payment date, Skill Graphics will debit interest expense for $46,664, credit discount on notes payable for $4,664, and credit cash for $42,000. On the same date, Hughes-Barker will debit cash for $42,000, debit discount on notes receivable for $4,664, and credit interest revenue for $46,664.
Skill Graphics (Buyer/Issuer)
Interest expense ,664
Discount on note payable ,664
Cash ,000
Hughes-Barker (Seller/Lender)
Cash ,000
Discount on notes payable 4,664
Investment revenue ,664

28. 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.

29. Installment Notes
Notes often are paid in installments, rather than a single amount at maturity.
$666,633 ÷ = $139,857
amount of loan (from Table 4) installment n=6, i=7.0% payment
Notes often are paid in installments rather than a single amount at maturity. Assume that is the case with our previous example. The installment amount is determined by dividing the amount of the loan $666,633 by the present value of an ordinary annuity for 6 periods at 7% interest ( ) to determine the periodic installment of $139,857.
We subtract the effective interest from the amount of each installment to determine the decrease in the outstanding balance. For example, for the first installment payment we subtract the effective interest of $46,664 from the payment of $139,857, to get the reduction in the outstanding balance of $93,193. Now, we reduce the outstanding balance from $666,633 to $573,440. The next period interest amount is determined using the new outstanding balance of $573,440.
Rounded

30. At the Purchase Date (January 1) At the First Interest Date (June 30)
Installment Notes
At the Purchase Date (January 1)
Skill Graphics (Buyer/Issuer)
Machinery ,633
Notes payable ,633
Hughes-Barker (Seller/Lender)
Notes receivable 666,633
Sales revenue ,633
At the First Interest Date (June 30)
Skill Graphics (Buyer/Issuer)
Interest expense ,664
Note payable ,193
Cash ,857
At the date of purchase, Skill Graphics will debit machinery for the cash purchase price of $666,633 and credit notes payable for the same amount. Hughes-Barker will debit notes receivable for $666,633 and credit sales revenue for the same amount.
On the first interest payment date, Skill Graphics will debit interest expense for $46,664, debit notes payable for $93,193, and credit cash for $139,857. On the same date, Hughes-Barker will debit cash for $139,857, credit notes receivable for $93,193, and credit interest revenue for $46,664.
Hughes-Barker (Seller/Lender)
Cash ,857
Notes receivable ,193
Interest revenue ,664

31. Financial Statement Disclosures
Disclosures include fair value, the nature of the company’s liabilities, interest rates, maturity dates, call provisions, conversion options, restrictions imposed by creditors, any assets pledged as collateral, and the aggregate amounts payable for each of the next five years.
The fair value of financial instruments must be disclosed either in the body of the financial statements or in disclosure notes. In addition, the disclosure note for debt includes the nature of the company’s liabilities, interest rates, maturity dates, call provisions, conversion options, restrictions imposed by creditors, and any assets pledged as collateral. For all long-term borrowings, disclosures also should include the aggregate amounts payable for each of the next five years.

32. 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

33. 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.

34. Early Extinguishment of Debt
Illustration – On January 1, 2013, Masterwear Industries called its $700,000, 12% bonds when their carrying amount was $676,290. The indenture specified a call price of $685,000. The bonds were issued previously at a price to yield 14%.
Masterwear (Issuer)
Bonds payable ,000
Loss on early extinguishment ,710
Discount on bonds payable ,710
Cash ,000
$685,000 – 676,290
$700,000 – 676,290
Let’s look at the proper accounting for an early extinguishment of debt. Assume that on January 1, 2013, Masterwear Industries called its $700,000, 12% bonds when their carrying amount was $676,290. The indenture specified a call price of $685,000. The bonds were issued previously at a price to yield 14%. At the date of early extinguishment, we will eliminate the bonds payable by crediting that account for $700,000, and we will eliminate the unamortized discount on bonds payable with a credit of $23,710. You may wish to refer back to the amortization schedule developed earlier in this discussion. Next, we will credit cash for the call price of $685,000. Finally, we will recognize the loss on early extinguishment of $8,710, the difference between the call price of the bonds and the bond carrying value on the date of retirement.
For several years the FASB required companies to report gains and losses from early extinguishment of debt as extraordinary items, but no longer. Now, these gains and losses are subject to the same criteria as other gains and losses for such treatment; namely, that they be both (a) unusual and (b) infrequent.

35. 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

36. Convertible Bonds
On January 1, 2013, HTL Manufacturers issued $100,000,000 of 8% convertible debentures due 2033 at 103 (103% of face value). The bonds are convertible at the option of the holder into $1 par common stock at a conversion ratio of 40 shares per $1,000 bond. HTL recently issued nonconvertible, 20 year, 8% debentures at 98.
At Issuance, January 1, 2013
HTL (Issuer)
Cash ,000,000
Convertible bonds payable ,000,000
Premium on bonds payable ,000,000
On January 1, 2013, HTL Manufacturers issued $100,000,000 of 8% convertible debentures due 2031 at 103 (103% of face value). The bonds are convertible at the option of the holder into $1 par common stock at a conversion ratio of 40 shares per $1,000 bond. HTL recently issued nonconvertible, 20 year, 8% debentures at 98.
$100,000,000 × 103%

37. At Date of Exercise of One-half of the Bonds
Convertible Bonds
Assume the bondholder exercises one-half of their option to convert the bonds into shares of stock when there is an unamortized premium of $2,000,000 associated with these bonds. The bonds are removed from the accounting records and the new shares issued are recorded at the same amount (in other words, at the book value of the bonds).
At Date of Exercise of One-half of the Bonds
HTL (Issuer)
Convertible bonds payable 50,000,000
Premium on bonds payable 1,000,000
Common stock ,000,000
Paid-in capital – excess of par ,000,000
Assume the bondholder exercises one-half of their option to convert the bonds into shares of stock when there is an unamortized premium of $2,000,000 associated with these bonds. The bonds are removed from the accounting records and the new shares issued are recorded at the same amount (in other words, at the book value of the bonds).
On the date of exercise HTL will debit convertible bonds payable for $50,000,000, debit premium on bonds payable for $1.000,000, credit common stock for $2.000,000, and credit paid-in capital in excess of par for $49,000,000.
50,000 bonds × 40 shares × $1 par = $2,000,000 par value

38. 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.

39. U.S. GAAP vs. IFRS Convertible Bonds
Under IFRS, unlike U.S. GAAP, convertible debt is divided into its liability and equity elements.
  ($ in millions)
Cash (103%  $100 million)
 Convertible bonds payable (value of the debt only) 98*
 Equity–conversion option (difference)
  *The discount is combined with the face amount of the bonds. This is the “net method” – the preferred method under IFRS.
 Compound instruments such as this one are separated into their liability and equity components in accordance with IAS No. 32.
 If the bonds have a separate fair value of $98 million, we record that amount as the liability and the remaining $5 million as equity.
Under IFRS, unlike U.S. GAAP, convertible debt is divided into its liability and equity elements. For example, a journal entry to recognize the conversion of bonds would be to debit cash for $103 million, credit convertible bonds payable for the value of the debt, $98 million, and credit equity from conversion option for the difference of $5 million. The discount on the convertible bonds of $2 million is combined with the face amount of the debt of $100 million, to arrive at the net amount of the credit to convertible bonds payable of $98 million.
Compound instruments such as this one are separated into their liability and equity components in accordance with IAS No. 32.

40. 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.

41. Bonds With Detachable Warrants
On January 1, 2013, HTL issued $100,000,000 of 8% bonds due in 2020 at 103 (103% of face value). Accompanying each $1,000 bond were 20 warrants. Each warrant permitted the holder to buy one share of $1 par common stock at $25 per share. Shortly after issuance, the warrants were listed on the stock exchange at $3 per warrant.
HTL (Issuer)
Cash ,000,000
Discount on bonds payable 3,000,000
Bonds payable ,000,000
Equity – stock warrants ,000,000
On January 1, 2013, HTL issued $100,000,000 of 8% bonds due in 2020 at 103 (103% of face value). Accompanying each $1,000 bond were 20 warrants. Each warrant permitted the holder to buy one share of $1 par common stock at $25 per share. Shortly after issuance, the warrants were listed on the stock exchange at $3 per warrant.
At the date of issuance of the bonds, HTL will debit cash for $103,000,000 ($100,000,000 times 103 percent), debit discount on bonds payable for $3,000,000, credit bonds payable for $100,000,000 (face amount), and credit equity—stock warrants for $6,000,000. The equity—stock warrants will be reported as part of shareholders’ equity.
100,000 bonds × 20 warrants × $3

42. Bonds With Detachable Warrants
Assume one-half of the warrants (1,000,000) are exercised when the market value of HTL’s common stock is $30 per share. The exercise price is $25 per common share.
HTL (Issuer)
Cash ,000,000
Equity – stock warrants ,000,000
Common stock ,000,000
Paid-in capital – common stock ,000,000
1,000,000 warrants × $25
$6,000,000 ÷ 2
Assume one-half of the warrants (1,000,000) are exercised when the market value of HTL’s common stock is $30 per share. The exercise price is $25 per common share.
At the date of exercise, HTL will debit cash for $25,000,000, debit paid-in capital from stock warrants for $3,000,000, credit common stock for $1,000,000 (1,000,000 shares times $1 par per share), and credit paid-in capital from common stock for $27,000,000.

43. 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.

44. 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.

45. 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.

46. Appendix 14A: Bonds Issued Between Interest Dates
Suppose a weak market caused a delay in selling the bonds until two months after the bond date of January 1(four months before semiannual interest was to be paid). In that case, the buyer would be asked to pay the seller accrued interest for two months in addition to the price of the bonds.
Masterwear was unable to sell $700,000 face amount of bonds, dated January 1, and paying interest semiannually at an annual rate of 12%. The bonds were eventually sold on March 1. Let’s calculate the accrued interest.
Suppose a weak market caused a delay in selling the bonds until two months after the bond date of January 1 (four months before semiannual interest was to be paid). In that case, the buyer would be asked to pay the seller accrued interest for two months in addition to the price of the bonds.
Masterwear was unable to sell $700,000 face amount of bonds, dated January 1, and paying interest semiannually at an annual rate of 12%. The bonds were eventually sold on March 1. Let’s calculate the accrued interest.
We would multiply the face amount ($700,000) times the annual rate of interest (12%), and adjust this amount by the length of time the bonds were not outstanding (2 months), to arrive at the total accrued interest of $14,000.

47. Appendix 14A: Bonds Issued Between Interest Dates
The journal entry at the date of issuance (March 1) on the books of the issuer and investor are shown below:
The journal entry on the books of Masterwear (the issuer) is to debit cash for the face amount of the bonds ($700,000) plus the accrued interest paid ($14,000) for a total of $714,000. We credit bonds payable for the face amount of $700,000, and credit interest payable for $14,000. On the next slide we will see how the credit to interest payable is handled.
On the investor’s books we will debit investment in bonds for $700,000, debit interest receivable for $14,000, and credit cash of the total amount paid of $714,000.

48. Appendix 14A: Bonds Issued Between Interest Dates
On June 30, the first interest payment date, the following journal entries will be made for the issuer and investor.
On June 30, the first interest payment date, the issuer will pay a full six-months interest to the investor. The journal entry on the books of Masterware is to debit interest expense for $28,000 (4-months of interest), debit interest payable for $14,000 (to reverse the interest portion of the entry made on the date of sale) and credit cash for $42,000, the 6-month’s interest cost.
The investor will debit cash for $42,000, credit interest receivable for $14,000, and credit interest revenue for $28,000 (4-months interest income).

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. Debt Settled at Time of Restructuring
First Prudent Bank is holding a $30,000,000 note from the developer of some property. The developer is in financial trouble and cannot pay the bank the amount owed. The bank agrees to accept property with a fair value of $20,000,000 in full settlement of the note. The property is carried on the books of the developer at $17,000,000. Let’s look at the entries on the books of the developer to record the settlement.
Land … ,000,000 Gain on disposal of land … ,000,000
($20,000,000 less carrying value of $17,000,000)
First Prudent Bank is holding a $30,000,000 note from the developer of some property. The developer is in financial trouble and cannot pay the bank the amount owed. The bank agrees to accept property with a fair value of $20,000,000 in full settlement of the note. The property is carried on the books of the developer at $17,000,000. Let’s look at the entries on the books of the developer to record the settlement.
The first journal entry is to record the gain on the disposal of the property. We will debit land for $3,000,000 (the fair value of the land less the $17,000,000 carrying value on the books of the developer) and credit gain on disposal of land for the same amount.
The second journal entry is to eliminate the note payable and the property. We will debit note payable for $30,000,000 (the amount owed), and credit gain on troubled debt restructuring for $10,000,000), and credit land for $20,000,000.
Note payable … ,000,000 Gain on troubled debt restructuring ,000,000
Land………………………………… ,000,000

51. Debt is Continued, but with Modified Terms
Let’s look at an example where the total cash payments are less than the carrying amount of the debt. First Prudent Bank holds a $30,000,000 note from a property developer. The note bears interest at 10%, and matures in two years. The developer is in financial difficulty and the bank agrees to modify the terms of the agreement as follows:
Forgive the interest accrued from last year of $3,000,000.
Reduce the remaining two interest payments to $2,000,000 each.
Reduce the principal amount to $25,000,000.
Let’s look at an example where the total cash payments are less than the carrying amount of the debt. First Prudent Bank holds a $30,000,000 note from a property developer. The note bears interest at 10%, and matures in two years. The developer is in financial difficulty and the bank agrees to modify the terms of the agreement as follows:
Forgive the interest accrued from last year of $3,000,000.
Reduce the remaining two interest payments to $2,000,000 each.
Reduce the principal amount to $25,000,000.
The carrying value of the note is $33,000,000 ($30,000,000 face amount plus accrued interest of $3,000,000). The total future payments are $29,000,000, the new principal amount is $25,000,000, and two interest payments of $2,000,000 are required.

52. Debt is Continued, but with Modified Terms
At the date of the new agreement, the following journal entry is required:
Accrued interest payable ,000,000 Note payable … ,000,000
Gain on debt restructuring ……… ,000,000
The debit to notes payable is for the difference between the old face amount of $30,000,000 and the total future cash payments of $29,000,000
At the date of modification of terms, the developer will debit accrued interest payable for $3,000,000, the amount of interest forgiven, debit note payable for $1,000,000, and credit gain on debt restructuring for $4,000,000. The debit to note payable is for the difference between the old face amount of $30,000,000 and the total future cash payments of $29,000,000.
At each of the next two interest payment dates the developer will debit note payable, and credit cash for $2,000,000.
At each of the next two interest payments, we will make the following entry:
Note payable … ,000,000 Cash ……………………………… 2,000,000

53. Debt is Continued, but with Modified Terms
At maturity, the developer will make the following entry:
Note payable … ,000,000 Cash ……………………………… 25,000,000
At the date of maturity, the modified note has a carrying value of $25,000,000. The developer will debit note payable for $25,000,000, and credit cash for the same amount.

54. End of Chapter 14
End of Chapter 14.