BONDS AND LONG-TERM NOTES

1. Chapter 14 BONDS AND LONG-TERM NOTES

2. Liabilities Probable future sacrifices or economic benefits . . . . . . Arising from present obligations to other entities . . . . . . Resulting from past transactions or events. • Some liabilities are not contractual obligations and may not be payable in cash. • Notice that the definition of a liability involves the present, the future, and the past. It is a present responsibility, to sacrifice assets in the future, caused by a transaction or other event that already has happened.

3. Signifies creditors’ interest in a company’s assets. Requires the future payment of cash in specified (or estimated) amounts, at specified (or projected) dates. As time passes, interest accrues on debt. 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. Long-Term Debt

4. Nature of Long-Term Debt Loan agreement restrictions Mirror image of an asset Obligations that extend beyond one year or the operating cycle, whichever is longer Reported at present value Accrue interest expense

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

6. Bonds Sold at Face Amount On January 1, 2009, 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 United - Investor

7. Determining the Selling Price

8. Determining the Selling Price On January 1, 2009, 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 threeyears. 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.

9. Journal Entries at Issuance – Bonds Issued at a Discount Masterwear - Issuer United - Investor

10. 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 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 valuation account).

11. Journal Entries – The Interest Method 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 United - Investor

12. Change in Debt When Effective Interest Exceeds Cash Paid The “unpaid” portion of the effective interest ($4,644) increases the outstanding balance to $671,297 and reduces the discount to $28,703 on June 30.

13. Amortization Schedule – Discount Since less cash is paid each period than the effective interest, theunpaid difference increases the outstanding balance of the debt. 7% × $666,633 $46,664 – 42,000 $666,633 + 4,664 6% × $700,000

14. Amortization Schedule – Discount $48,544 is rounded to cause outstanding balance to be exactly $700,000 on 12/31/11.

15. 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

16. When Financial Statements Are Prepared Between Interest Dates On 1/1/09, Masterwear Industries issues $700,000 face value bonds to United Intergroup. The market interest rate is 14%. The bonds have the following terms: Face Value of Each Bond = $1,000 Maturity Date = 12/31/11 (3 years) Stated Interest Rate = 12% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/09 Assume Masterwear and United both have September 30th year-ends.

17. When Financial Statements Are Prepared Between Interest Dates Recall the entries we prepared on June 30, 2009.These entries will not change. Masterwear - Issuer United - Investor

18. Year-end is on September 30, 2009, before the second interest date of December 31, so we must accrue interest for 3 months from June 30 to September 30. When Financial Statements Are Prepared Between Interest Dates Masterwear - Issuer United - Investor

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 United - Investor

20. The Straight-Line Method – A Practical Expediency Using the straight-line method, 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) United(Investor)

21. A company is not required to, but has the option to, value some or all of its financial assets and liabilities, including bonds and notes, at fair value. If a company chooses the option to report at fair value, then it reports changes in fair value in its income statement. It’s not necessary that the company elect the option to report all of its financial instruments at fair value or even all instruments of a particular type at fair value. They can "mix and match" on an instrument-by-instrument basis. A company must make the election when the item originates and is not allowed to switch methods once a method is chosen. Fair Value Option

22. Fair Value Option – Example On July 1, HSA, Inc. issued $200,000 face value, 8% bonds, priced at $180,000 to yield an effective rate of 10% . HSA chose the fair value option for the bonds. Six months later, on December 31, HSA recorded the following interest entry: The December 31 entry reduced the unamortized discount to $19,000 and increased the book value of the liability by $1,000 to $181,000.

23. Fair Value Option – Example On December 31, the fair value of the bonds was $183,000. Rather than increasing the bonds payable account itself, we increase it indirectly with a valuation allowance (or contra) account: The $2,000 credit to fair value adjustment will increase the bon credit balance to $183,000. HSA will also must recognize the unrealized holding loss in the income statement.

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

25. Present value techniques are used for valuation and interest recognition. The procedures are similar to those we encountered with bonds. Long-Term Notes

26. Long-Term Notes On January 1, 2009, Skill Graphics, Inc., a product labelingand graphics firm, borrowed 700,000 cash from First BancCorpand issued a 3-year, $700,000 promissory note. Interest of$42,000 was payable semiannually on June 30 and December 31. At Issuance • Skill Graphics(Borrower) • First BancCorp (Lender)

27. Long-Term Notes (continued) At Each of the Six Interest Dates • Skill Graphics(Borrower) • First BancCorp (Lender) At Maturity • Skill Graphics(Borrower) • First BancCorp (Lender)

28. 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 (and thus the note, also) or indirectly as the present value of the note (and thus the value of the asset, also).

29. Note Exchanged for Assets or Services At the Purchase Date (January 1) • Skill Graphics(Buyer/Issuer) • Hughes–Barker(Seller/Lender At the First Interest Date (June 30) • Skill Graphics(Buyer/Issuer) • Hughes–Barker(Seller/Lender

30. To compute cash payment use present value tables. Interest expense or revenue: Effective interest rate × Outstanding balance of debt Interest expense or revenue Principal reduction: Cash amount – Interest component Principal reduction per period Installment Notes

31. Installment Notes Notes often are paid in installments, rather than a single amount at maturity. $666,633 ÷ 4.76654 = $139,857amount (from Table 4) installment of loan n=6, i=7.0% payment Rounded

32. Early Extinguishment of Debt Debt retired at maturity results in no gains or losses. BUT Debt retired before maturity may result in an gainor loss on extinguishment. Cash Proceeds – Book Value = Gain or Loss

33. Early Extinguishment Illustration – On January 1, 2010, 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%. $685,000 – 676,290 ($700,000 – 676,290 The FASB requires that the gain or loss be classified in the Income Statement as an extraordinary item only if the situation meets the usual criteria of being both unusual and infrequent.

34. Financial Statement Disclosures Long-Term Debt For all long-term borrowing, disclosures should include the aggregate amounts maturing and sinking fund requirement, if any, for each of the next five years.

35. Rate of return on shareholders’ equity Net incomeShareholders’ equity = Decision Makers’ Perspective Long-term debt impacts several key financial ratios. Times interest earned ratio Net income + interest + taxesInterest = Debt toequity ratio Total liabilitiesShareholders’ equity = Rate of return on assets Net incomeTotal assets =

36. Some bonds may be converted into common stock at the option of the holder. When bonds are converted the issuer updates interest expense and amortization of discount or premium to the date of conversion. The bonds are reduced and shares of common stock are increased. Convertible Bonds Bonds into Stock

37. Induced Conversion Companies sometimes try to induce conversion of their bonds into stock. One way to induce conversion is through a “call” provision. When the specified call price is less than the conversion value of the bonds (the market value of the shares), calling the convertible bonds provides bondholders with incentive to convert. Bondholders will choose the shares rather than the lower call price.

38. 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. Bonds With Detachable Warrants

39. Bonds With Detachable Warrants Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the holder to purchase one share of stock for $18 per share. Immediately after issue the bonds were selling for 98 without the warrants and the warrants have a market value of $16.

40. Troubled Debt Restructuring - Appendix Troubled debt may berestructured in one of two ways: • Settledat timeof restructuring. • Continued withmodifiedterms.

41. Troubled Debt Restructuring - Appendix • Settledat time of restructuring. Book value of the debt – Fair value of asset transferred Gain on restructuring Debtor reports ordinary gain or loss onadjustment to fair value of the asset transferred.

42. Troubled Debt Restructuring - Appendix • Continuedwith modified terms. Reduce or delayinterestpayments. Reduce or delaymaturity payment. Accounting treatment depends on a comparison of total cash payments after restructuring with the book value of the original debt.

43. Troubled Debt Restructuring • Continuedwithmodifiedterms. Cash payments less thanbook value of debt. Cash payments more thanbook value of debt. • Debtor reports differenceas a gain. • All cash payments arereductions in principal.(No interest) • No gain reported. • Compute neweffective interest rate. • Record annualinterest at new rate.

44. End of Chapter 14