14-1

Bonds and Long-Term Notes

Chapter 14

PowerPoint 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

Copyright2013byTheMcGrawHillCompanies,Inc.Allrightsreserved.

14-2

The Nature of Long-Term Debt

Liabilities
Liabilities signify
signify
creditors
creditors interest
interest in
in
aa companys
companys assets.
assets.

A
A note
note payable
payable and
and
note
note receivable
receivable are
are
two
two sides
sides of
of the
the
same
same coin.
coin.

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

A
A bond
bond payable
payable
divides
divides aa large
large
liability
liability into
into many
many
smaller
smaller liabilities.
liabilities.

Corporations
Corporations issuing
issuing bonds
bonds
are
are obligated
obligated to
to repay
repay aa
stated
stated amount
amount at
at aa
specified
specified maturity
maturity date
date and
and
period
period interest
interest between
between
the
the issue
issue date.
date.

14-3

Bonds
At Bond Issuance Date
Company
Company
Issuing
Issuing
Bonds
Bonds

Bond Selling Price

Bond Certificate

Investor
Investor
Buying
Buying
Bonds
Bonds

Subsequent Periods
Company
Company
Issuing
Issuing
Bonds
Bonds

Interest Payments
Face Value Payment
at End of Bond Term

Investor
Investor
Buying
Buying
Bonds
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
Callable Bond
interest when
allows company to
investor submits
buy back
attached coupon.
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

700,000

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
United (Investor)
Investment in bonds
Discount on bond investment
Cash

666,633
33,367
700,000
700,000
33,367
666,633

Alternative Net Method

Masterwear (Issuer)
Cash
Bonds payable
666,633
United (Investor)
Investment in bonds
Cash

666,633

666,633
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

Outstanding Balance

(14% 2)

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
$700,000 (12%
(12% 2)
2) == $42,000
$42,000
$46,664
$46,664 -- $42,000
$42,000 == $4,664
$4,664

42,000
4,664
46,664
$666,633
$666,633 (14%
(14% 2)
2) == $46,664
$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
$666,633 ++ $4,664
$4,664 == $671,297
$671,297

14-12

Zero-Coupon Bonds

These
These bonds
bonds do
do not
not pay
pay interest.
interest.
Instead,
Instead, they
they offer
offer a
a return
return in
in
the
the form
form of
of a
a deep
deep discount
discount
from
from the
the face
face amount.
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%.
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
$735,533 5%
5% == $36,777
$36,777

$735,533
$735,533 -- $5,223
$5,223 == $730,310
$730,310

14-15

Bonds Sold at a Premium

Masterwear (Issuer)
Cash
Premium on bonds payable
Bonds payable
United (Investor)
Investment in bonds
Premium on bond investment
Cash

735,533
35,533
700,000
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 31st year-ends.
Semi-annual Stated Interest

$700,000
$700,000 (12%
(12% 2)
2) == $42,000
$42,000

June 30, 2013 Effective Interest

$666,633
$666,633 (14%
(14% 2)
2) == $46,664
$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

31,327
3,327
28,000
28,000
3,327

$42,000
$42,000 4/6
4/6 == $28,000
$28,000
$31,327
$31,327 -- $28,000
$28,000 == $3,327
$3,327

31,327
$671,297
$671,297 7%
7% 4/6
4/6 == $31,327
$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
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 per 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
42,000
5,561
47,561

14-21

Debt Issue Costs

Legal
Accounting
Underwriting
Commission
Engraving
Printing
Registration
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)

Promissor
y
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 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
Note payable

700,000

First BancCorp (Lender)

Note receivable
Cash

700,000

700,000

700,000

14-25

Long-Term Notes
At Each of the Six Interest Dates
Skill Graphics (Borrower)
Interest expense
Cash

42,000

First BancCorp (Lender)

Cash
Interest revenue

42,000

42,000

42,000

At Maturity

Skill Graphics (Borrower)

Notes payable
Cash

700,000

First BancCorp (Lender)

Cash
Notes receivable

700,000

700,000

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 notes 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
700,000
Discount on notes payable
33,367
Sales revenue
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

Principal reduction:
Cash amount
Interest component
Principal reduction per period

14-29

Installment Notes
Notes often are paid in installments,
rather than a single amount at maturity.
$666,633

amount of loan

4.76654
=
$139,857
(from Table 4)
installment
n=6, i=7.0%
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
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
Notes receivable
Interest revenue

139,857
93,193
46,664

14-31

Financial Statement Disclosures

Disclosures include fair value, the nature of the

companys 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

Debt
Debt retired
retired at
at maturity
maturity results
results
in
in no
no gains
gains or
or losses.
losses.

BUT
Debt
Debt retired
retired before
before maturity
maturity may
may result
result in
in an
an
gain
gain or
or loss
loss on
on extinguishment.
extinguishment.
Cash
Cash Proceeds
Proceeds Book
Book Value
Value == Gain
Gain or
or Loss
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
$100,000,000 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

103,000,000
100,000,000
3,000,000

$100,000,000
$100,000,000 103%
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 $2,000,000 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

50,000,000
1,000,000
2,000,000
49,000,000

50,000
50,000 bonds
bonds 40
40 shares
shares $1
$1 par
par == $$2,000,000
2,000,000 par
par value
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%$100million)

103

Convertible bonds payable (value of the debt only)

Equityconversion option (difference)

98*

*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

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.

14-41

Bonds With Detachable Warrants

On
On January
January 1,
1, 2013,
2013, HTL
HTL issued
issued $100,000,000
$100,000,000 of
of 8%
8% bonds
bonds
due
due in
in 2020
2020 at
at 103
103 (103%
(103% of
of face
face value).
value). Accompanying
Accompanying each
each
$1,000
$1,000 bond
bond were
were 20
20 warrants.
warrants. Each
Each warrant
warrant permitted
permitted the
the
holder
holder to
to buy
buy one
one share
share of
of $1
$1 par
par common
common stock
stock at
at $25
$25 per
per
share.
share. Shortly
Shortly after
after issuance,
issuance, the
the warrants
warrants were
were listed
listed on
on the
the
stock
stock exchange
exchange at
at $3
$3 per
per warrant.
warrant.
HTL (Issuer)
Cash
103,000,000
Discount on bonds payable
3,000,000
Bonds payable
Equity stock warrants

100,000,000
6,000,000

100,000
100,000 bonds
bonds 20
20 warrants
warrants $3
$3

14-42

Bonds With Detachable Warrants

Assume one-half of the warrants (1,000,000) are exercised
when the market value of HTLs common stock is $30 per
share. The exercise price is $25 per common share.
HTL (Issuer)
Cash
25,000,000
Equity stock warrants
3,000,000
Common stock
1,000,000
Paid-in capital common stock
27,000,000

1,000,000
1,000,000 warrants
warrants $25
$25
$6,000,000
$6,000,000 22

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 Were Headed

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

Appendix 14A:
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. Lets calculate the accrued interest.

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:

14-47

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.

14-48

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:
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 $30,000,000 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. Lets look at the entries on
the books of the developer to record the settlement.
Land ......................................................
Gain on disposal of land .........

3,000,000
3,000,000

($20,000,000 less carrying value of $17,000,000)

Note payable ............................................

Gain on troubled debt restructuring.
Land.

30,000,000
10,000,000
20,000,000

Debt is Continued, but with Modified

Terms

14-51

Lets
Lets look
look at
at an
an example
example where
where the
the total
total cash
cash payments
payments are
are
less
less than
than the
the carrying
carrying amount
amount of
of the
the debt.
debt. First
First Prudent
Prudent Bank
Bank
holds
holds a
a $30,000,000
$30,000,000 note
note from
from a
a property
property developer.
developer. The
The note
note
bears
bears interest
interest at
at 10%,
10%, and
and matures
matures in
in two
two years.
years. The
The developer
developer
is
is in
in financial
financial difficulty
difficulty and
and the
the bank
bank agrees
agrees to
to modify
modify the
the terms
terms
of
of the
the agreement
agreement as
as follows:
follows:
1.Forgive
1.Forgive the
the interest
interest accrued
accrued from
from last
last year
year of
of $3,000,000.
$3,000,000.
2.Reduce
2.Reduce the
the remaining
remaining two
two interest
interest payments
payments to
to $2,000,000
$2,000,000
each.
each.
3.Reduce
3.Reduce the
the principal
principal amount
amount to
to $25,000,000.
$25,000,000.

Debt is Continued, but with Modified

Terms
At the date of the new agreement, the following journal
entry is required:
Accrued interest payable .............................
Note payable ...........................................
Gain on debt restructuring .

3,000,000
1,000,000
4,000,000

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 each of the next two interest payments, we will make
the following entry:
Note payable .........................................
Cash

2,000,000
2,000,000

14-52

Debt is Continued, but with Modified

Terms

At maturity, the developer will make the following entry:

Note payable .........................................
Cash

25,000,000
25,000,000

14-53

14-54

End of Chapter 14