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Chapter 14

Chapter 14. Bonds and Long-Term Notes. 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. Bond Selling Price.

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Chapter 14

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  1. Chapter 14 Bonds andLong-Term Notes

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

  3. 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

  4. The Bond Indenture The indenture is the written specific promises made by the company to the bondholders. Types of Bonds Debenture Bond Mortgage Bond Serial Bonds Sinking Fund Subordinated Debenture Callable Coupon Bonds Convertible Bonds

  5. Interest 10% Face Value $1,000 6/30 & 12/31 BOND PAYABLE Bond Date 1/1/02 Maturity Date 12/31/11 Bonds 1. Face value (maturity or par value) 2. Maturity Date 3. Stated Interest Rate 4.Interest Payment Dates 5. Bond Date Other Factors: 6. Market Interest Rate 7. Issue Date

  6. On 1/1/02, Graphics Inc. issues 1,000 bonds at face value to Webster, Inc. The market interest rate is 10%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02 Recording Bonds at Issuance Record the issuance of the bonds on 1/1/02.

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

  8. Bonds Issued Between Interest Date Interest begins to accrue on the date the bonds are dated. If the bonds are issued after the day they are dated, the investor would be asked to pay the company accrued interest. On the interest payment date, the investor will receive a check for the full period’s interest.

  9. Bonds Issued Between Interest Date On 2/1/02, Graphics Inc. issues 1,000 bonds at face value plus accrued interest to Webster, Inc. The market interest rate is 10%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02

  10. Accrued Interest$1,000,000 × 10% × = $8,333 Graphic - Issuer 112 Webster - Investor Bonds Issued Between Interest Date

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

  12. Determining the Selling Price

  13. Determining the Selling Price On 1/1/02, Graphics Inc. issues 1,000 bonds at face value to Webster, Inc. The market interest rate is 12%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02 What is the selling price of these bonds?

  14. Bonds issued at a discount. Determining the Selling Price n = 5 years × 2 payments per year = 10i = 12% ÷ 2 payments per year = 6%Interest annuity = $1,000,000 × 10% ÷ 2 = $50,000

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

  16. Effective Interest Method(Effective rate multiplied by the outstanding balance of the debt) $926,395 × 6% $55,584 - $50,000 $73,605 - $5,584 Determining Interest

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

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

  19. These bonds do not pay interest. Instead, they offer a return in the form of a “deep discount” from the face amount. Those who invest in zero-coupon bonds usually have tax-deferred or tax-exempt status. Zero-Coupon Bonds

  20. Bonds Sold at a Premium On 1/1/02, Graphics Inc. issues 1,000 bonds at face value to Webster, Inc. The market interest rate is 8%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02 What is the selling price of these bonds?

  21. Bonds issued at a premium. Bonds Sold at a Premium n = 5 years × 2 payments per year = 10i = 8% ÷ 2 payments per year = 4%Interest annuity = $1,000,000 × 10% ÷ 2 = $50,000

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

  23. Bonds Sold at a Premium

  24. Webster, Inc. - Investor Financial Statements Prepared Between Interest Dates Assume that in our previous example, Graphic, Inc. and Webster, Inc. both have fiscal years that end on September 30. Let’s look at the June 30 entry: Graphics, Inc. - Issuer

  25. Year-end is on September 30, 2002, before the second interest date of December 31. Financial Statements Prepared Between Interest Dates $42,974 × ½ = $21,487 (3 months interest)$ 7,026 × ½ = $ 3,513 (3 months amortization) Graphics, Inc. - Issuer

  26. Year-end is on September 30, 2002, before the second interest date of December 31. Financial Statements Prepared Between Interest Dates $42,974 × ½ = $21,487 (3 months interest)$ 7,026 × ½ = $ 3,513 (3 months amortization) Webster, Inc. - Investor

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

  28. The discount or premium is allocated equally to each period over the outstanding life of the bond. Straight-Line Method Consideredpracticaland expedient.

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

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

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

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

  33. On 1/1/03, Matters, Inc. issued a $100,000, 3-year, 6% note in exchange for equipment owned by West, Inc. Interest is paid every 12/31. The equipment does not have a ready market value. The appropriate rate of interest for notes of this type is 9%. Let’s determine the present value of the note. Notes Exchanged for Assets or Services

  34. Notes Exchanged for Assets or Services

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

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

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

  38. To compute cash payment use present value tables. Interest expense or revenue: Book value at beginning of period × Interest rate on the note payable Interest expense or revenue Principal reduction: Cash amount – Interest component Principal reduction per period Installment Notes

  39. PV of annuity of $1, n = 4, i = 9% Installment Notes Jetson Delivery purchased a truck by issuing a 4-year note payable to Wink Motors. The truck cost $20,000 and is financed at a 9% interest rate. Payments are made at the end of each of the next for years. Let’s calculate the annual payment. $20,000 ÷ 3.23972 = $6,173 (rounded)

  40. Installment Notes Here is our loan amortization table.

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

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

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

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

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

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

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

  48. Convertible Bonds On December 31, 2003, all of the bondholders of Matrix, Inc. convert their bonds into common stock. There are 10,000 bonds outstanding with a face value of $1,000 each. Each bond is convertible into 50 shares of the company’s $1 par value common stock. There is $1,645,000 on unamortized discount associated with the bonds that are converted. Interest and discount amortization have been brought up to December 31. Let’s look at the entry to record the conversion.

  49. Convertible Bonds 10,000 × 50 shares × $1 par value The carrying value of the bonds is assigned to the stock.

  50. 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

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