Ch14 Bonds.and.Long Term Notes

Callable Bond allows company to buy back outstanding bonds prior to maturity.. Callable Bond allows company to buy back outstanding bonds prior to maturity.. Learning ObjectivesAccount

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Chapter 14

Bonds and Long-Term Notes

Learning Objectives

Identify the underlying characteristics

of debt instruments and describe the basic approach to accounting for debt.

Investor Buying Bonds

Investor Buying Bonds

The Bond Indenture

The specific promises made to bondholders

are described in a document called a bond

indenture.

The specific promises made to bondholders

are described in a document called a bond

indenture

Mortgage Bond secured by lien on specific real estate owned by the

issuer.

Mortgage Bond secured by lien on specific real estate owned by the

issuer.

Callable Bond allows company to

buy back outstanding bonds prior to maturity.

Callable Bond allows company to

buy back outstanding bonds prior to maturity.

Coupon Bond pays

interest when investor submits

attached coupon.

Coupon Bond pays

interest when investor submits

made by the company to the bondholders.

1 Face value (maturity or par value)

Learning Objectives

Account for bonds issued at par, at a discount,

or at a premium, recording interest at the effective rate or by the straight-line method.

Determining the Selling Price

Recording Bonds at Issuance

On 1/1/06, Matrix, Inc issues 1,000 bonds at face value to Apex, Inc The market interest rate is 10% The bonds

have the following terms:

Face Value = $1,000

Maturity Date = 12/31/10 (5 years)

Stated Interest Rate = 10%

Interest Dates = 6/30 & 12/31

Maturity Date = 12/31/10 (5 years)

Stated Interest Rate = 10%

Interest Dates = 6/30 & 12/31

Bond Date = 1/1/06

Record the issuance of the bonds on 1/1/06.

Recording Bonds at Issuance

Matrix, Inc - Issuer

Apex, Inc - Investor

Determining the Selling Price

On 1/1/06, Matrix, Inc issues 1,000 bonds at face value to Apex, Inc The market interest rate is 12% The bonds

have the following terms:

Face Value = $1,000

Maturity Date = 12/31/10 (5 years)

Stated Interest Rate = 10%

Interest Dates = 6/30 & 12/31

Bond Date = 1/1/06

On 1/1/06, Matrix, Inc issues 1,000 bonds at face value to Apex, Inc The market interest rate is

Apex, Inc The market interest rate is 12% 12% The bonds

have the following terms:

Face Value = $1,000

Maturity Date = 12/31/10 (5 years)

Stated Interest Rate = 10%

Interest Dates = 6/30 & 12/31

Bond Date = 1/1/06

What is the selling price of these bonds?

Determining the Selling Price

n = 5 years × 2 payments per year = × 2 payments per year = 1010

i = 12% ÷ 2 payments per year =

i = 12% ÷ 2 payments per year = 6%6%

Determining the Selling Price

Matrix, Inc - Issuer

Apex, Inc - Investor

Determining Interest

Effective Interest Method

(Effective rate multiplied by the outstanding balance of the debt)

$926,395 × 6%

$55,584 - $50,000

$55,584 - $50,000

$926,395 + $5,584

Determining Interest

Effective Interest Method

(Effective rate multiplied by the outstanding balance of the debt)

Determining Interest

Matrix, Inc - Issuer

Apex, Inc - Investor

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 Those

who invest in zero-coupon bonds usually have tax-deferred or tax-exempt

status

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

Bonds Sold at a Premium

On 1/1/06, Matrix, Inc issues 1,000 bonds at face value to Apex, Inc The market interest rate is 8% The bonds have

the following terms:

Face Value = $1,000

Maturity Date = 12/31/10 (5 years)

Stated Interest Rate = 10%

Interest Dates = 6/30 & 12/31

Bond Date = 1/1/06

On 1/1/06, Matrix, Inc issues 1,000 bonds at face value to Apex, Inc The market interest rate is

Apex, Inc The market interest rate is 8% 8% The bonds have

the following terms:

Face Value = $1,000

Maturity Date = 12/31/10 (5 years)

Stated Interest Rate = 10%

Interest Dates = 6/30 & 12/31

Bond Date = 1/1/06

What is the selling price of these bonds?

Bonds Sold at a Premium

n = 5 years × 2 payments per year = × 2 payments per year = 1010

i = 8% ÷ 2 payments per year =

i = 8% ÷ 2 payments per year = 4%4%

Bonds Sold at a Premium

Matrix, Inc - Issuer

Apex, Inc - Investor

Bonds Sold at a Premium

Straight-Line Method

The discount or

premium is allocated

to each period

over the outstanding life

of the bond.

Considered

practical and expedient.

Considered

practical and expedient.

Straight-Line Method

In our last example, straight-line premium amortization would be:

$81,105 ÷ 10 = $8,111 every six months.

In our last example, straight-line premium amortization would be:

$81,105 ÷ 10 = $8,111 every six months.

Straight-Line Method

Debt Issue Costs

Debt Issue Costs

 These costs should be recorded

separately and amortized over the term

of the related debt.

 Straight-line amortization is often used

 These costs should be recorded

separately and amortized over the term

of the related debt.

 Straight-line amortization is often used

Debt Issue Costs

Record issue cost:

Debt issue cost……… xxx

Cash……… xxx

Amortize over the years using straight line:

Debt issue expense……… xxx

Debt issue cost……… xxx

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.

Decision Makers’ Perspective

Long-term debt impacts several key

financial ratios.

Debt to

equity ratio

Total liabilities Shareholders’ equity

=

Rate of return

on assets

Net income Total assets

=

Rate of return on

shareholders’ equity

Net income Shareholders’ equity

=

Times interest earned ratio =

Net income + interest + taxes

Interest

Learning Objectives

Record the early extinguishment of debt and its conversion into equity securities.

Early Extinguishment of Debt

Debt retired at maturity results

in no gains or losses

Debt retired at maturity results

in no gains or losses

Debt retired before maturity may result in an

gain or loss on extinguishment.

Cash Proceeds – Book Value = Gain or Loss

Debt retired before maturity may result in an

gain or loss on extinguishment.

Cash Proceeds – Book Value = Gain or Loss

BUT

Early Extinguishment of Debt (p.820, Ex: 14-7)

Convertible Bonds

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.

Bonds into Stock

Convertible Bonds

The Book Value Method Record new stock at the book value of the convertible

bonds No gain or loss is recognized.

On December 31, 2006, 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

$1,500,000 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

On December 31, 2006, 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

$1,500,000 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

Convertible Bonds

10,000 × 50 shares × $1 par value

10,000 × 50 shares × $1 par value

The carrying value of the bonds is

assigned to the stock.

Bonds with Detachable Warrants

 Stock warrants give the investor an option to

purchase a stated number of shares at a

specified price within a specified period of time

 The issue price is allocated between the bonds

and the warrants using market values

Ex: Illustration 14-19, p.823

Ex: Illustration 14-19, p.823

If one-half of the warrants (1 million) are

exercised when the market value of HTL’s

common stock (1$ par) is $30 per share, how

do we record?

-Cash (1,000,000 warrants × $25) 25

Equity—stock warrants (1,000,000 warrants × $3) 3

Common stock (to balance) 1

PIC, exceed par ……… ………27

Ex: Illustration 14-19, p.824

At Issuance

At Exercise

Remember

 Read the text book

 Do all examples in text book

 Do Review Exercise

 Do homework

End of Chapter 14