Bonds and Long-Term Notes

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Bonds and Long-Term Notes

• CHAPTER 14

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Nature of Long-Term Debt
Mirror image of an asset
Loan agreement restrictions
Obligations that extend beyond one year or the
operating cycle, whichever is longer
Accrue interest expense
Reported at present value
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Bonds Cash Flow
At Bond Issuance Date
Bond Selling Price
Company Issuing Bonds
Investor Buying Bonds
Bond Certificate
Subsequent Periods
Interest Payments
Investor Buying Bonds
Company Issuing Bonds
Face Value Payment at End of Bond Term
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The Bond Indenture
Mortgage Bond
Debenture Bond
Serial Bonds
Sinking Fund
Subordinated Debenture
Callable
Coupon Bonds
Convertible Bonds
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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
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Bonds Issued at Face Value on Bond Date

• On 12/31/X0, Graphics Inc. issues 10 bonds at
  face value. The market interest rate is 10.
  The bonds have the following terms
• Face Value 1,000
• Maturity Date 12/31/X5 (5 years)
• Stated Interest Rate 10
• Interest Dates 6/30 12/31
• Bond Date 12/31/X0

Prepare the journal entry to record the issuance
of the bonds on 12/31/X0.
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Bonds Issued at Face Value on Bond Date

• Journal entry to record the issuance of the bonds
  on 12/31/X0.

Long-term Liability
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Bonds Issued at Face Value on Bond Date

• Prepare Graphics journal entry every 6/30 and
  12/31 to pay interest.

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Bonds Issued at Face Value on Bond Date

• Prepare Graphics journal entry every 6/30 and
  12/31 to pay interest.

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Bonds Issued at Face Value Between Interest Dates

• On 4/1/X1, Graphics Inc. issues 10 bonds at face
  value. The market interest rate is 10. The
  bonds have the following terms
• Face Value 1,000
• Maturity Date 12/31/X5 (5 years)
• Stated Interest Rate 10
• Interest Dates 6/30 12/31
• Bond Date 12/31/X0

Prepare the journal entry to record the issuance
of the bonds on 4/1/X1.
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Bonds Issued at Face Value Between Interest Dates

• Journal entry to record the issuance of the bonds
  on 4/1/X1.

The investor has to pay the accrued interest for
January, February, and March. 10,000 10 3/12
250
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Bonds Issued at Face Value Between Interest Dates

• Prepare Graphics journal entry for the first
  interest payment on 6/30/X1.

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Bonds Issued at Face Value Between Interest Dates

• Prepare Graphics journal entry for the first
  interest payment on 6/30/X1.

The interest expense is only for the three months
that the bonds were outstanding (April, May and
June).
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Determining the Selling Price
Bonds Sell at Par Value Market rate Stated rate
Bonds Sell at a Discount Market rate gt Stated rate
Bonds Sell at a Premium Market rate lt Stated rate
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Bonds Issued Below Face Value on Bond Date
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Bonds Issued Below Face Value on Bond Date

• If the bond is paying 10 interest and the market
  is paying 12 interest, Graphics Inc. would
• Issue the bond below face value--at a discount
• BUT
• Pay interest on the full face value
• AND
• Repay the full face value at maturity.

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Bonds Issued Below Face Value on Bond Date

• This arrangement will increase the effective
  interest rate of Graphics Inc. bonds to the
  market rate.

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Bonds Issued Below Face Value on Bond Date

• On 12/31/X0, Graphics Inc. sells 1,000 bonds.
  The market interest rate is 12. The bonds have
  the following terms
• Face Value 1,000
• Maturity Date 12/31/X5 (5 years)
• Stated Interest Rate 10
• Interest Dates 6/30 12/31
• Bond Date 12/31/X0

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Bonds Issued Below Face Value on Bond Date
Calculate how Graphics, Inc. determined the
selling price of the bonds.
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Bonds Issued Below Face Value on Bond Date
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Bonds Issued Below Face Value on Bond Date

• The difference between the face value ofthe
  bonds and the cash received is the discount.
• 1,000,000 - 926,395 73,605
• Amortization of the discount increases Interest
  Expense.

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Bonds Issued Below Face Value on Bond Date

• Prepare the journal entry to record the issue of
  the bonds on 12/31/X0.

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Bonds Issued Below Face Value on Bond Date

• Prepare the journal entry to record the issue of
  the bonds on 12/31/X0.

Contra-Liability Account
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Bonds Issued Below Face Value on Bond Date
Book valueof bonds
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Effective Interest Method

• Interest Expense for each period is calculated as
  follows
• Book Value of Bond at Beginning of Period
• Market Interest Rate at Date of Bond Issuance
• Interest Expense
• The amortization for the discount or premium is
  calculated as follows
• Cash Payment for Interest
• - Interest Expense
• Amortization Amount

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Effective Interest Method Amortization Table
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Effective Interest Method Amortization Table

Rounded.
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Bonds Issued Below Face Value on Bond Date

• Prepare the journal entry for 6/30/X1, to record
  the interest payment.

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Bonds Issued Below Face Value on Bond Date

• Prepare the journal entry for 6/30/X1, to record
  the interest payment.

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Preparing Financial Statements Between Interest
Dates

• Any accrued interest and amortization since the
  last interest date must be recorded by an
  adjusting entry.

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Straight-Line Method

• The discount or premium is allocated equally to
  each period over the outstanding life of the bond.

Consideredpracticaland expedient.
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Bonds Issued Above Face Value on Bond Date
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Bonds Issued Above Face Value on Bond Date

• This arrangement will decrease the effective
  interest rate of Graphics Inc. bonds to the
  market rate.

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Bonds Issued Above Face Value on Bond Date

• On 12/31/X0, Graphics Inc. sells 1,000 bonds.
  The market interest rate is 8. The bonds have
  the following terms
• Face Value 1,000
• Maturity Date 12/31/X5 (5 years)
• Stated Interest Rate 10
• Interest Dates 6/30 12/31
• Bond Date 12/31/X0

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Bonds Issued Above Face Value on Bond Date
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Bonds Issued Above Face Value on Bond Date
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Bonds Issued Above Face Value on Bond Date

• The difference between the face value of the
  bonds and the cash received is the premium.
• 1,081,105 - 1,000,000 81,105
• Amortization of the premium will decrease
  Interest Expense.

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Bonds Issued Above Face Value on Bond Date

• Prepare the journal entry to record the issue of
  the bonds on 12/31/X0.

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Bonds Issued Above Face Value on Bond Date

• Prepare the journal entry to record the issue of
  the bonds on 12/31/X0.

Adjunct-Liability Account
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Bonds Issued Above Face Value on Bond Date
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Effective Interest Method

• Interest Expense for each period is calculated as
  follows
• Book Value of Bond at Beginning of Period
• Market Interest Rate at Date of Bond Issuance
• Interest Expense
• The amortization for the discount or premium is
  calculated as follows
• Cash Payment for Interest
• - Interest Expense
• Amortization Amount

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Effective Interest Method Amortization Table
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Effective Interest Method Amortization Table

Rounded
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Bonds Issued Above Face Value on Bond Date

• Prepare the journal entry to record the first
  interest payment on 6/30/X1.

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Bonds Issued Above Face Value on Bond Date

• Prepare the journal entry to record the first
  interest payment on 6/30/X1.

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Debt Issue Costs

• Legal
• Accounting
• Underwriting
• Commission
• Engraving
• Printing
• Registration
• Promotion

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Convertible Bonds

• Can be exchanged for capital stock of the bond
  issuer.
• Accounting for interest expense and amortization
  of discount or premium is not affected by
  convertibility.

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Convertible Bonds

• When the bonds are converted, the issuer updates
  interest expense and amortization of discount or
  premium to the date of conversion.

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Convertible Bonds

• At Conversion Date
• Record new stock at the book value of the
  convertible bonds.
• Recognize neither gain nor loss.

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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.
• Credit Paid-in Capital Stock Warrants (an
  equity account).

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Long-Term Notes

• Present value techniques are used for valuation
  and interest recognition.
• The procedures are similar to those we
  encountered with bonds.

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Long-Term NotesExample

• On 1/1/X4, Dairy Farms Inc. issued a 100,000,
  3-year, 6 note in exchange for equipment.
  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.
• First, lets determine the present value of the
  note and review the amortization table.

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Long-Term NotesExample
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Long-Term NotesExample
Prepare the journal entry to record issuance of
the note on January 1, 19X4.
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Long-Term NotesExample

• Journal entry to record issuance of the note on
  January 1, 19X4.

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Long-Term NotesExample

• Prepare the journal entry for
• December 31, 19X4.

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Long-Term NotesExample

• Prepare the journal entry for
• December 31, 19X4.

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Installment NotesEven Payments

• Cash Amount
• Amount calculated using present valueof the
  annuity 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

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Debt Retirement
Debt retired at maturity results in no gains or
losses.
BUT
Debt retired before maturity may result in an
extraordinary gain or loss on extinguishment. Cash
Proceeds Book Value Gain or Loss
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Troubled Debt Restructuring
Troubled debt may berestructured in one of two
ways

• Settled at timeof restructuring.

• Continued withmodified terms.

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Troubled Debt Restructuring

• Settled at time of restructuring.

Debtor reports ordinary gain or loss
onadjustment to fair value of theasset
transferred.
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Troubled Debt Restructuring

• Continued with modified terms.

Reduce or delayinterest payments.
Reduce or delaymaturity payment.
Accounting treatment depends on a comparison of
total cash payments after restructuring with the
book value of the original debt.
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Troubled Debt Restructuring

• Continued with modified terms.

Cash payments less thanbook value of debt.
Cash payments more thanbook value of debt.

• Debtor reports differenceas extraordinary gain.
• All cash payments arereductions in
  principal.(No interest)

• No gain reported.
• Compute neweffective interest rate.
• Record annualinterest at new rate.

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Derivatives
Financial instruments that derive theirvalues
or contractually required cashflows from some
other security or index.
Tools used to manage (hedge) exposure risk.
Interest rate riskPrice riskForeign exchange
risk
Taking a risk position that is oppositeto an
actual risk to which thecompany is already
exposed.
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Derivatives
Thats right!If used properly,derivatives
canreduce risk.
I get it!Derivatives arelike insuranceagainst
risk.
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Derivatives

• Futures contract
• Agreement between a buyer and seller that
  requires the seller to deliver a commodity at a
  designated future date at a predetermined price.

When the commodity is a financial instrument, the
contract is referred toas a financial futures
contract.
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Accounting for Derivatives
All derivatives are reported on the balance sheet
at fair market value.
Accounting for the gain or loss infair value of
a derivative dependson how the derivative is
used.
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Accounting for Derivatives
Gains or losses in fair value of derivativesheld
for speculative purposes (not for hedging)are
recognized immediately in earnings.

• Reporting gains or losses in fair value
  ofderivatives used to hedge against riskdepends
  on the derivative classification
• fair value hedge,
• cash flow hedge, or
• foreign currency hedge.

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Accounting for Derivatives

• Fair Value Hedge
• Recognized immediately in earnings along with
  the gain or loss from the item being hedged.
• Cash Flow Hedge
• Deferred as a component of other comprehensive
  income until it can be recognized in earnings
  along with the earnings effect of the item being
  hedged.
• Foreign Exchange Hedge
• Reported in other comprehensive income as apart
  of the cumulative translation adjustment.

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Sometimes, We Get More Than We Asked For!