14 1 Bonds and LongTerm Notes Chapter 14

14 -1 Bonds and Long-Term Notes Chapter 14 Power. Point Authors: Susan Coomer Galbreath, Ph. D. , CPA Charles W. Caldwell, D. B. A. , CMA Jon A. Booker, Ph. D. , CPA, CIA Cynthia J. Rooney, Ph. D. , CPA Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

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

14 -3 Bonds At Bond Issuance Date Company Issuing Bonds Bond Selling Price Bond Certificate Investor Buying Bonds Subsequent Periods Company Issuing Bonds Interest Payments Face Value Payment at End of Bond Term Investor Buying Bonds

14 -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. Coupon Bond pays interest when investor submits attached coupon. Callable Bond allows company to buy back outstanding bonds prior to maturity.

14 -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 Bonds payable 700, 000 United (Investor) Investment in bonds (face amount) Cash 700, 000

14 -6 Determining the Selling Price

14 -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% 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.

14 -8 Bonds Issued at a Discount Masterwear (Issuer) Cash Discount on bonds payable Bonds payable 666, 633 33, 367 700, 000 United (Investor) Investment in bonds Discount on bond investment Cash 700, 000 33, 367 666, 633 Alternative Net Method Masterwear (Issuer) Cash Bonds payable 666, 633 United (Investor) Investment in bonds Cash 666, 633

14 -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) Outstanding Balance Effective Rate = $46, 664 Effective Interest 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).

14 -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 42, 000 United (Investor) Cash Discount on bond investment Investment revenue $700, 000 × (12% ÷ 2) = $42, 000 $46, 664 - $42, 000 = $4, 664 42, 000 4, 664 46, 664 $666, 633 × (14% ÷ 2) = $46, 664

14 -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. $666, 633 + $4, 664 = $671, 297

14 -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.

14 -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% 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 -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

14 -15 Bonds Sold at a Premium Masterwear (Issuer) Cash Premium on bonds payable Bonds payable 735, 533 700, 000 United (Investor) Investment in bonds Premium on bond investment Cash 700, 000 35, 533 735, 533 Interest expense and interest revenue will be recognized in a manner consistent with bonds issued at a discount.

Premium and Discount Amortization Compared 14 -16

When Financial Statements Are Prepared Between Interest Dates 14 -17 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 31 st year-ends. Semi-annual Stated Interest $700, 000 × (12% ÷ 2) = $42, 000 June 30, 2013 Effective Interest $666, 633 × (14% ÷ 2) = $46, 664

When Financial Statements Are Prepared Between Interest Dates 14 -18 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 Discount on bonds payable Interest payable United (Investor) Interest receivable Discount on bond investment Investment revenue $42, 000 × 4/6 = $28, 000 $31, 327 - $28, 000 = $3, 327 31, 327 3, 327 28, 000 3, 327 31, 327 $671, 297 × 7% × 4/6 = $31, 327

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 Interest payable Discount on bonds payable Cash United (Investor) Cash Discount on bond investment Interest receivable Investment revenue 15, 664 28, 000 1, 664 42, 000 1, 664 28, 000 15, 664 14 -19

14 -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 period At Each of the Six Interest Dates Masterwear (Issuer) Interest expense Discount on bonds payable Cash United (Investor) Cash Discount on bond investment Investment revenue 47, 561 5, 561 42, 000 5, 561 47, 561

14 -21 Debt Issue Costs v Legal v Accounting v Underwriting v Commission v Engraving v Printing v Registration v Promotion

14 -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. 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.

14 -23 Long-Term Notes Company (Borrower) Promissory Note (Note Payable) Bank Property, goods, or services. The liability, note payable, is reported at its present value, similar to the accounting for bonds payable.

14 -24 Long-Term Notes On January 1, 2013, Skill Graphics, Inc. , a product labeling and graphics firm, borrowed $700, 000 cash from First Banc. Corp 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 Note payable 700, 000 First Banc. Corp (Lender) Note receivable Cash 700, 000

14 -25 Long-Term Notes At Each of the Six Interest Dates Skill Graphics (Borrower) Interest expense Cash 42, 000 First Banc. Corp (Lender) Cash Interest revenue 42, 000 At Maturity Skill Graphics (Borrower) Notes payable Cash 700, 000 First Banc. Corp (Lender) Cash Notes receivable 700, 000

14 -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% 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.

14 -27 Note Exchanged for Assets or Services At the Purchase Date (January 1) Skill Graphics (Buyer/Issuer) Machinery 666, 633 Discount on note payable 33, 367 Notes payable 700, 000 Hughes-Barker (Seller/Lender) Notes receivable Discount on notes payable Sales revenue 700, 000 33, 367 666, 633 At the First Interest Date (June 30) Skill Graphics (Buyer/Issuer) Interest expense 46, 664 Discount on note payable 4, 664 Cash 42, 000 Hughes-Barker (Seller/Lender) Cash 42, 000 Discount on notes payable 4, 664 Investment revenue 46, 664

14 -28 Installment Notes To compute cash payment use present value tables. o Each payment includes both an interest amount and a principal amount. o Interest expense or revenue: o Effective interest rate × Outstanding balance of debt Interest expense or revenue o Principal reduction: Cash amount – Interest component Principal reduction period

14 -29 Installment Notes often are paid in installments, rather than a single amount at maturity. $666, 633 amount of loan ÷ 4. 76654 (from Table 4) n=6, i=7. 0% = $139, 857 installment payment 0 Rounded

14 -30 Installment Notes At the Purchase Date (January 1) Skill Graphics (Buyer/Issuer) Machinery 666, 633 Notes payable 666, 633 Hughes-Barker (Seller/Lender) Notes receivable Sales revenue 666, 633 At the First Interest Date (June 30) Skill Graphics (Buyer/Issuer) Interest expense 46, 664 Note payable 93, 193 Cash 139, 857 Hughes-Barker (Seller/Lender) Cash 139, 857 Notes receivable 93, 193 Interest revenue 46, 664

14 -31 Financial Statement 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.

14 -32 Decision Makers’ Perspective Debt to Total liabilities = equity ratio Shareholders’ equity Rate of return on = assets Net income Total assets Rate of return on Net income = shareholders’ equity Shareholders’ equity Times interest = Net income + interest + taxes earned ratio Interest

14 -33 Early Extinguishment of 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

14 -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 Loss on early extinguishment Discount on bonds payable Cash $685, 000 – 676, 290 700, 000 8, 710 23, 710 685, 000 $700, 000 – 676, 290

14 -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. Bonds into Stock

14 -36 Convertible Bonds On January 1, 2013, HTL Manufacturers issued $100, 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 Convertible bonds payable Premium on bonds payable 103, 000 100, 000 3, 000 $100, 000 × 103%

14 -37 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 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 Premium on bonds payable Common stock Paid-in capital – excess of par 50, 000 1, 000 2, 000 49, 000 50, 000 bonds × 40 shares × $1 par = $2, 000 par value

14 -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. 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.

14 -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) 103  Convertible bonds payable (value of the debt only) 98*  Equity–conversion option (difference) 5 *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.

14 -40 Bonds With Detachable Warrants l. 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. l. A portion of the selling price of the bonds is allocated to the detachable stock warrants.

14 -41 Bonds With Detachable Warrants On January 1, 2013, HTL issued $100, 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 Discount on bonds payable Bonds payable Equity – stock warrants 103, 000, 000 100, 000 6, 000 100, 000 bonds × 20 warrants × $3

14 -42 Bonds With Detachable Warrants Assume one-half of the warrants (1, 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 25, 000 Equity – stock warrants 3, 000 Common stock 1, 000 Paid-in capital – common stock 27, 000 1, 000 warrants × $25 $6, 000 ÷ 2

14 -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.

14 -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 1. 2. 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. ”

14 -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.

Appendix 14 A: Bonds Issued Between Interest Dates 14 -46 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.

Appendix 14 A: 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: 14 -47

Appendix 14 A: 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. 14 -48

Appendix 14 B 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: 1. The debt may be settled at the time of the restructuring. 2. The debt may be continued, but with modified terms. 14 -49

14 -50 Debt Settled at Time of Restructuring First Prudent Bank is holding a $30, 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 in full settlement of the note. The property is carried on the books of the developer at $17, 000. Let’s look at the entries on the books of the developer to record the settlement. Land …. . . . Gain on disposal of land …. . 3, 000, 000 ($20, 000 less carrying value of $17, 000) Note payable …. . . 30, 000 Gain on troubled debt restructuring. 10, 000 Land…………………. 20, 000

14 -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 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: 1. Forgive the interest accrued from last year of $3, 000. 2. Reduce the remaining two interest payments to $2, 000 each. 3. Reduce the principal amount to $25, 000.

14 -52 Debt is Continued, but with Modified Terms At the date of the new agreement, the following journal entry is required: Accrued interest payable . . . . 3, 000 Note payable …. . . 1, 000 Gain on debt restructuring ………. 4, 000 The debit to notes payable is for the difference between the old face amount of $30, 000 and the total future cash payments of $29, 000 At each of the next two interest payments, we will make the following entry: Note payable …. . . . . 2, 000 Cash ……………… 2, 000

14 -53 Debt is Continued, but with Modified Terms At maturity, the developer will make the following entry: Note payable …. . . . . 25, 000 Cash ……………… 25, 000

14 -54 End of Chapter 14