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McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.
BONDS AND BONDS AND LONG-TERM NOTESLONG-TERM NOTES
Chapter 14
Slide 2
14-2
LiabilitiesLiabilities
. . . Resulting from past
transactions or events.
. . . Resulting from past
transactions or events.
. . . Arising from present obligations
to other entities . . .
. . . Arising from present obligations
to other entities . . .
Probable future
sacrifices or economic
benefits . . .
Probable future
sacrifices or economic
benefits . . .
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.
Slide 3
14-3
Long-Term DebtLong-Term Debt
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.
Slide 4
14-4
Nature of Long-Term DebtNature of Long-Term Debt
Obligations that extend Obligations that extend beyond one year or the beyond one year or the
operating cycle, operating cycle, whichever is longerwhichever is longer
Obligations that extend Obligations that extend beyond one year or the beyond one year or the
operating cycle, operating cycle, whichever is longerwhichever is longer
Mirror image of an Mirror image of an assetasset
Mirror image of an Mirror image of an assetasset
Accrue interest Accrue interest expenseexpense
Accrue interest Accrue interest expenseexpense
Reported at present Reported at present valuevalue
Reported at present Reported at present valuevalue
Loan agreement Loan agreement restrictionsrestrictions
Loan agreement Loan agreement restrictionsrestrictions
Slide 5
14-5
Bonds Bonds
Bond Selling PriceBond Selling Price
Bond CertificateBond Certificate
Interest PaymentsInterest Payments
Face Value Payment at Face Value Payment at End of Bond TermEnd of Bond Term
At Bond Issuance DateAt Bond Issuance Date
Company Company Issuing Issuing BondsBonds
Company Company Issuing Issuing BondsBonds
Subsequent PeriodsSubsequent Periods
Investor Investor Buying Buying BondsBonds
Investor Investor Buying Buying BondsBonds
Company Company Issuing Issuing BondsBonds
Company Company Issuing Issuing BondsBonds
Investor Investor Buying Buying BondsBonds
Investor Investor Buying Buying BondsBonds
Slide 6
14-6
Bonds Sold at Face AmountBonds Sold at Face AmountOn 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.
Date Description Debit CreditJan. 1 Cash 700,000
Bonds payable 700,000
Date Description Debit CreditJan. 1 Cash 700,000
Bonds payable 700,000
Masterwear - IssuerMasterwear - Issuer
At Issuance (January 1)
Date Description Debit CreditJan. 1 Investment in bonds 700,000
Cash 700,000
Date Description Debit CreditJan. 1 Investment in bonds 700,000
Cash 700,000
United - InvestorUnited - Investor
Slide 7
14-7
Determining the Selling PriceDetermining the Selling Price
Stated interest rate is: The bonds sells:
Below market rateAt a discount
(Cash received is less than face amount)
Equal to market rateAt face amount
(Cash received is equal to face amount)
Above market rateAt a premium
(Cash received is greater than face amount)
Stated interest rate is: The bonds sells:
Below market rateAt a discount
(Cash received is less than face amount)
Equal to market rateAt face amount
(Cash received is equal to face amount)
Above market rateAt a premium
(Cash received is greater than face amount)
Slide 8
14-8
Determining the Selling PriceDetermining the Selling PriceOn 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 three years. The market yield for bonds of similar risk and maturity is 14%.
The entire bond issue was purchased by United Intergroup.
Present ValuesInterest $ 42,000 × 4.76654 = 200,195$ Principal $700000 × 0.66634 = 466,438
Present value (price) of bonds 666,633$
Calculation of the Price of the BondsPresent Values
Interest $ 42,000 × 4.76654 = 200,195$ Principal $700000 × 0.66634 = 466,438
Present value (price) of bonds 666,633$
Calculation of the Price of the Bonds
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.
Present value of an ordinary annuity of $1: n=6, i=7%
present value of $1: n=6, i=7%
Slide 9
14-9
Journal Entries at Issuance – Bonds Journal Entries at Issuance – Bonds Issued at a DiscountIssued at a Discount
Date Description Debit CreditJan. 1 Cash 666,633
Discount on bonds payable 33,367 Bonds payable 700,000
Date Description Debit CreditJan. 1 Cash 666,633
Discount on bonds payable 33,367 Bonds payable 700,000
Masterwear - IssuerMasterwear - Issuer
Date Description Debit CreditJan. 1 Investment in bonds 700,000
Discount on bond investment 33,367 Cash 666,633
Date Description Debit CreditJan. 1 Investment in bonds 700,000
Discount on bond investment 33,367 Cash 666,633
United - InvestorUnited - Investor
Slide 10
14-10
Determining Interest – Effective Interest Determining Interest – Effective Interest MethodMethodInterest 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).
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).
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) = $46,664Outstanding Balance Effective Rate Effective Interest
Slide 11
14-11
Journal Entries – The Interest MethodJournal 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)
Date Description Debit CreditJun. 30 Interest expense 46,664
Discount on bonds payable 4,664 Cash 42,000
Date Description Debit CreditJun. 30 Interest expense 46,664
Discount on bonds payable 4,664 Cash 42,000
Masterwear - IssuerMasterwear - Issuer
Date Description Debit CreditJun. 30 Cash 42,000
Discount on bond investment 4,664 Interest revenue 46,664
Date Description Debit CreditJun. 30 Cash 42,000
Discount on bond investment 4,664 Interest revenue 46,664
United - InvestorUnited - Investor
Slide 12
14-12
Change in Debt When Effective Interest Change in Debt When Effective Interest Exceeds Cash PaidExceeds Cash Paid
Outstanding Bonds Payable DiscountDate Interest Balance (Face Value) on Bonds
Jan. 1 666,633 = 700,000 – 33.367Accrued at 7%.07 × 666,633 = 46,664
Paid at 6%.06 × 700,000 = (42,000)
Unpaid
46,664 – 42,000 = (4,664)
Jun. 30 671,297 = 700,000 – 28,703
Jun. 30
Jun. 30
Jun. 30
Account BalancesOutstanding Bonds Payable Discount
Date Interest Balance (Face Value) on BondsJan. 1 666,633 = 700,000 – 33.367
Accrued at 7%.07 × 666,633 = 46,664
Paid at 6%.06 × 700,000 = (42,000)
Unpaid
46,664 – 42,000 = (4,664)
Jun. 30 671,297 = 700,000 – 28,703
Jun. 30
Jun. 30
Jun. 30
Account Balances
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.
Slide 13
14-13
Amortization Schedule – DiscountAmortization Schedule – Discount
Since less cash is paid each period than the effective interest, theunpaid difference increases the outstanding balance of the debt.
Cash Effective Increase in OutstandingDate Interest Interest Balance Balance
(6% × Face (7% × Outstanding (DiscountAmount) Balance) Reduction)
01/01/09 666,633 06/30/09 42,000 .07 × 666,633 = 46,664 4,664 671,297 12/31/09 42,000 06/30/10 42,000 12/31/10 42,000 06/30/11 42,000 12/31/11 42,000
252,000
Cash Effective Increase in OutstandingDate Interest Interest Balance Balance
(6% × Face (7% × Outstanding (DiscountAmount) Balance) Reduction)
01/01/09 666,633 06/30/09 42,000 .07 × 666,633 = 46,664 4,664 671,297 12/31/09 42,000 06/30/10 42,000 12/31/10 42,000 06/30/11 42,000 12/31/11 42,000
252,000 6% × $700,000 $666,633 + 4,664
$46,664 – 42,0007% × $666,633
Slide 14
14-14
Amortization Schedule – DiscountAmortization Schedule – DiscountCash Effective Increase in Outstanding
Date Interest Interest Balance Balance(6% × Face (7% × Outstanding (Discount
Amount) Balance) Reduction)01/01/09 666,633 06/30/09 42,000 .07 × 666,633 = 46,664 4,664 671,297 12/31/09 42,000 .07 × 671,633 = 46,991 4,991 676,288 06/30/10 42,000 .07 × 676,288 = 47,340 5,340 681,628 12/31/10 42,000 .07 × 681,628 = 47,714 5,714 687,342 06/30/11 42,000 .07 × 687,342 = 48,114 6,114 693,456 12/31/11 42,000 .07 × 693,456 = 48,544 6,544 700,000
252,000 285,367 33,367
Cash Effective Increase in OutstandingDate Interest Interest Balance Balance
(6% × Face (7% × Outstanding (DiscountAmount) Balance) Reduction)
01/01/09 666,633 06/30/09 42,000 .07 × 666,633 = 46,664 4,664 671,297 12/31/09 42,000 .07 × 671,633 = 46,991 4,991 676,288 06/30/10 42,000 .07 × 676,288 = 47,340 5,340 681,628 12/31/10 42,000 .07 × 681,628 = 47,714 5,714 687,342 06/30/11 42,000 .07 × 687,342 = 48,114 6,114 693,456 12/31/11 42,000 .07 × 693,456 = 48,544 6,544 700,000
252,000 285,367 33,367
$48,544 is rounded to cause outstanding balance to be exactly $700,000 on 12/31/11.
Slide 15
14-15
Zero-Coupon BondsZero-Coupon Bonds
These bonds do not pay interest. These bonds do not pay interest. Instead, they offer a return in the Instead, they offer a return in the
form of a “deep discount” from the form of a “deep discount” from the face amount. face amount.
These bonds do not pay interest. These bonds do not pay interest. Instead, they offer a return in the Instead, they offer a return in the
form of a “deep discount” from the form of a “deep discount” from the face amount. face amount.
Slide 16
14-16
When Financial Statements Are Prepared When Financial Statements Are Prepared Between Interest DatesBetween Interest Dates
On 1/1/09, Masterwear Industries issues $700,000 face On 1/1/09, Masterwear Industries issues $700,000 face value bonds to United Intergroup. The market interest value bonds to United Intergroup. The market interest
rate is rate is 14%14%. . The bonds have the following terms:The bonds have the following terms:
Face Value of Each Bond = $1,000Face Value of Each Bond = $1,000
Maturity Date = 12/31/11 (3 years) Maturity Date = 12/31/11 (3 years)
Stated Interest Rate = Stated Interest Rate = 12%12%
Interest Dates = 6/30 & 12/31Interest Dates = 6/30 & 12/31
Bond Date = 1/1/09Bond Date = 1/1/09
On 1/1/09, Masterwear Industries issues $700,000 face On 1/1/09, Masterwear Industries issues $700,000 face value bonds to United Intergroup. The market interest value bonds to United Intergroup. The market interest
rate is rate is 14%14%. . The bonds have the following terms:The bonds have the following terms:
Face Value of Each Bond = $1,000Face Value of Each Bond = $1,000
Maturity Date = 12/31/11 (3 years) Maturity Date = 12/31/11 (3 years)
Stated Interest Rate = Stated Interest Rate = 12%12%
Interest Dates = 6/30 & 12/31Interest Dates = 6/30 & 12/31
Bond Date = 1/1/09Bond Date = 1/1/09
Assume Masterwear and United both have Assume Masterwear and United both have September 30September 30thth year-ends. year-ends.
Slide 17
14-17
Recall the entries we prepared on June 30, 2009.Recall the entries we prepared on June 30, 2009.These entries will not change.These entries will not change.
Date Description Debit CreditJun. 30 Interest expense 46,664
Discount on bonds payable 4,664 Cash 42,000
Date Description Debit CreditJun. 30 Interest expense 46,664
Discount on bonds payable 4,664 Cash 42,000
Masterwear - IssuerMasterwear - Issuer
Date Description Debit CreditJun. 30 Cash 42,000
Discount on bond investment 4,664 Interest revenue 46,664
Date Description Debit CreditJun. 30 Cash 42,000
Discount on bond investment 4,664 Interest revenue 46,664
United - InvestorUnited - Investor
When Financial Statements Are Prepared When Financial Statements Are Prepared Between Interest DatesBetween Interest Dates
Slide 18
14-18
Year-end is on September 30, 2009, before the second Year-end is on September 30, 2009, before the second interest date of December 31, so we must accrue interest interest date of December 31, so we must accrue interest
for 3 months from June 30 to September 30.for 3 months from June 30 to September 30.
Date Description Debit CreditSep. 30 Interest expense ($46,991 × 1/2) 23,496
Discount on bonds payable 2,496 Interest payable ($42,000 × 1/2) 21,000
Date Description Debit CreditSep. 30 Interest expense ($46,991 × 1/2) 23,496
Discount on bonds payable 2,496 Interest payable ($42,000 × 1/2) 21,000
Masterwear - IssuerMasterwear - Issuer
Date Description Debit CreditSep. 30 Interest receivable 21,000
Discount on bond investment 2,496 Interest revenue 23,496
Date Description Debit CreditSep. 30 Interest receivable 21,000
Discount on bond investment 2,496 Interest revenue 23,496
United - InvestorUnited - Investor
When Financial Statements Are Prepared When Financial Statements Are Prepared Between Interest DatesBetween Interest Dates
Slide 19
14-19
When Financial Statements Are Prepared When Financial Statements Are Prepared Between Interest DatesBetween Interest Dates
On December 31, the next interest payment date,On December 31, the next interest payment date,the following entries would be recorded.the following entries would be recorded.
Date Description Debit CreditDec. 31 Interest expense ($46,991 × 1/2) 23,496
Interest payable ($42,000 × 1/2) 21,000 Discount on bonds payable 2,496 Cash ($700,000 × 6%) 42,000
Date Description Debit CreditDec. 31 Interest expense ($46,991 × 1/2) 23,496
Interest payable ($42,000 × 1/2) 21,000 Discount on bonds payable 2,496 Cash ($700,000 × 6%) 42,000
Masterwear - IssuerMasterwear - Issuer
Date Description Debit CreditDec.31 Cash 42,000
Discount on bond investment 2,496 Interest receivable 21,000 Interest revenue 23,496
Date Description Debit CreditDec.31 Cash 42,000
Discount on bond investment 2,496 Interest receivable 21,000 Interest revenue 23,496
United - InvestorUnited - Investor
Slide 20
14-20
The Straight-Line Method – A Practical The Straight-Line Method – A Practical ExpediencyExpediency
Date Description Debit CreditJun.30 Interest expense (to balance) 47,561
Discount on bonds payable (total discount ÷ 6 periods) 5,561 Cash (stated rate × face amount) 42,000
Date Description Debit CreditJun.30 Interest expense (to balance) 47,561
Discount on bonds payable (total discount ÷ 6 periods) 5,561 Cash (stated rate × face amount) 42,000
Date Description Debit CreditJun. 30 Cash 42,000
Discount on bond investment 5,561 Interest revenue 47,561
Date Description Debit CreditJun. 30 Cash 42,000
Discount on bond investment 5,561 Interest revenue 47,561
Masterwear(Issuer)
United(Investor)
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
Slide 21
14-21
Fair Value OptionFair Value Option
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.
Slide 22
14-22
Fair Value Option – ExampleFair Value Option – Example
Date Description Debit CreditDec. 31 Interest expense ($180,000 × 5%) 9,000
Discount on bonds payable 1,000 Cash ($200,000 × 4%) 8,000
Date Description Debit CreditDec. 31 Interest expense ($180,000 × 5%) 9,000
Discount on bonds payable 1,000 Cash ($200,000 × 4%) 8,000
Bonds payable 200,000$ Less: Unamortized discount (19,000) Book value 181,000$
Bonds payable 200,000$ Less: Unamortized discount (19,000) Book value 181,000$
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.
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:
Slide 23
14-23
On December 31, the fair value of the bonds was $183,000.
Bonds payable 200,000$ Less: Unamortized discount (19,000) Book value 181,000 Fair value of bonds 183,000 Fair value adjustment needed 2,000
Bonds payable 200,000$ Less: Unamortized discount (19,000) Book value 181,000 Fair value of bonds 183,000 Fair value adjustment needed 2,000
Fair Value Option – ExampleFair Value Option – Example
Rather than increasing the bonds payable account itself, we increase it indirectly with a valuation allowance (or contra) account:
Date Description Debit CreditDec. 31 Unrealized holding loss 2,000
Fair value adjustment 2,000
Date Description Debit CreditDec. 31 Unrealized holding loss 2,000
Fair value adjustment 2,000
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.
Slide 24
14-24
Debt Issue CostsDebt Issue Costs
LegalLegal AccountingAccounting UnderwritingUnderwriting CommissionCommission EngravingEngraving PrintingPrinting RegistrationRegistration Promotion Promotion
Slide 25
14-25
Long-Term NotesLong-Term Notes
Present value techniques are used for Present value techniques are used for valuation and interest recognition.valuation and interest recognition.
The procedures are similar to those we The procedures are similar to those we encountered with bonds. encountered with bonds.
Slide 26
14-26
Long-Term NotesLong-Term Notes
On January 1, 2009, Skill Graphics, Inc., a product labelingand 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.
Date Description Debit CreditJan. 1 Cash 700,000
Notes payable 700,000
Date Description Debit CreditJan. 1 Cash 700,000
Notes payable 700,000
Skill Graphics (Borrower)
At Issuance
Date Description Debit CreditJan. 1 Notes receivable 700,000
Cash 700,000
Date Description Debit CreditJan. 1 Notes receivable 700,000
Cash 700,000
First BancCorp (Lender)
Slide 27
14-27
Long-Term Notes (continued)Long-Term Notes (continued)At Each of the Six Interest Dates
Date Description Debit CreditInterest expense 42,000 Cash 42,000
Date Description Debit CreditInterest expense 42,000 Cash 42,000
Skill Graphics (Borrower)
Date Description Debit CreditCash 42,000 Interest revenue 42,000
Date Description Debit CreditCash 42,000 Interest revenue 42,000
First BancCorp (Lender)
At Maturity
Date Description Debit CreditNotes payable 700,000 Cash 700,000
Date Description Debit CreditNotes payable 700,000 Cash 700,000
Skill Graphics (Borrower)
Date Description Debit CreditCash 700,000 Notes receivable 700,000
Date Description Debit CreditCash 700,000 Notes receivable 700,000
First BancCorp (Lender)
Slide 28
14-28
Note Exchanged for Assets or ServicesNote Exchanged for Assets or Services
Present ValuesInterest $ 42,000 × 4.76654 = 200,195$ Principal $700000 × 0.66634 = 466,438
Present value (price) of note 666,633$
Present ValuesInterest $ 42,000 × 4.76654 = 200,195$ Principal $700000 × 0.66634 = 466,438
Present value (price) of note 666,633$
present value of $1: n=6, i=7%
Present value of an ordinary annuity of $1: n=6, i=7%
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:
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).
Slide 29
14-29
Note Exchanged for Assets or ServicesNote Exchanged for Assets or ServicesAt the Purchase Date (January 1)
Skill Graphics(Buyer/Issuer)
Date Description Debit CreditJan. 1 Machinery 666,633
Discount on notes payable 33,367 Notes payable 700,000
Date Description Debit CreditJan. 1 Machinery 666,633
Discount on notes payable 33,367 Notes payable 700,000
Date Description Debit CreditJan. 1 Notes receivable 700,000
Discount on notes receivable 33,367 Sales revenue 666,633
Date Description Debit CreditJan. 1 Notes receivable 700,000
Discount on notes receivable 33,367 Sales revenue 666,633
Hughes–Barker(Seller/Lender
At the First Interest Date (June 30)
Skill Graphics(Buyer/Issuer)
Date Description Debit CreditJun. 30 Interest expense 46,664
Discount on notes payable 33,367 4,644 Cash 42,000
Date Description Debit CreditJun. 30 Interest expense 46,664
Discount on notes payable 33,367 4,644 Cash 42,000
Date Description Debit CreditJun. 30 Cash 42,000
Discount on notes receivable 4,644 Interest revenue 46,664
Date Description Debit CreditJun. 30 Cash 42,000
Discount on notes receivable 4,644 Interest revenue 46,664
Hughes–Barker(Seller/Lender
Slide 30
14-30
Installment NotesInstallment Notes
o To compute cash payment use To compute cash payment use present value tables.present value tables.
o Interest expense or revenue:Interest expense or revenue: Effective interest rateEffective interest rate× Outstanding balance of debt× Outstanding balance of debt Interest expense or revenueInterest expense or revenue
o Principal reduction:Principal reduction: Cash amountCash amount– – Interest componentInterest component Principal reduction per periodPrincipal reduction per period
o To compute cash payment use To compute cash payment use present value tables.present value tables.
o Interest expense or revenue:Interest expense or revenue: Effective interest rateEffective interest rate× Outstanding balance of debt× Outstanding balance of debt Interest expense or revenueInterest expense or revenue
o Principal reduction:Principal reduction: Cash amountCash amount– – Interest componentInterest component Principal reduction per periodPrincipal reduction per period
Slide 31
14-31
Installment NotesInstallment Notes
Cash Effective Decrease OutstandingDate Payment Interest in Debt Balance
(7% × OutstandingBalance)
01/01/09 666,633 06/30/09 139,857 .07 × 666,633 = 46,664 93,193 573,440 12/31/09 139,857 .07 × 573,440 = 40,141 99,716 473,724 06/30/10 139,857 .07 × 473,724 = 33,161 106,696 367,028 12/31/10 139,857 .07 × 367,028 = 25,692 114,165 252,863 06/30/11 139,857 .07 × 252,863 = 17,700 122,157 130,706 12/31/11 139,857 .07 × 130,706 = 9,151 130,706 -
839,142 172,509 666,633
Cash Effective Decrease OutstandingDate Payment Interest in Debt Balance
(7% × OutstandingBalance)
01/01/09 666,633 06/30/09 139,857 .07 × 666,633 = 46,664 93,193 573,440 12/31/09 139,857 .07 × 573,440 = 40,141 99,716 473,724 06/30/10 139,857 .07 × 473,724 = 33,161 106,696 367,028 12/31/10 139,857 .07 × 367,028 = 25,692 114,165 252,863 06/30/11 139,857 .07 × 252,863 = 17,700 122,157 130,706 12/31/11 139,857 .07 × 130,706 = 9,151 130,706 -
839,142 172,509 666,633
$666,633 ÷ 4.76654 = $139,857 amount (from Table 4) installment of loan n=6, i=7.0% payment
Notes often are paid in installments, rather than a single amount at maturity.
Rounded
Slide 32
14-32
Early Extinguishment of DebtEarly Extinguishment of Debt
Debt retired at maturity results Debt retired at maturity results in no gains or losses. in no gains or losses.
Debt retired at maturity results Debt retired at maturity results in no gains or losses. in no gains or losses.
Debt retired before maturity may result in an Debt retired before maturity may result in an gaingain or lossor loss on extinguishment. on extinguishment.
Cash Proceeds – Book Value = Gain or LossCash Proceeds – Book Value = Gain or Loss
Debt retired before maturity may result in an Debt retired before maturity may result in an gaingain or lossor loss on extinguishment. on extinguishment.
Cash Proceeds – Book Value = Gain or LossCash Proceeds – Book Value = Gain or Loss
BUTBUT
Slide 33
14-33
Early ExtinguishmentEarly Extinguishment
Date Description Debit CreditJan. 1 Bonds payable 700,000
Loss on early extinguishment 8,710 Discount on bonds payable 23,710 Cash 685,000
Date Description Debit CreditJan. 1 Bonds payable 700,000
Loss on early extinguishment 8,710 Discount on bonds payable 23,710 Cash 685,000
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%.
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.
$685,000 – 676,290 ($700,000 – 676,290
Slide 34
14-34
Financial Statement DisclosuresFinancial Statement Disclosures
Long-Term DebtLong-Term Debt
Long-term liabilities Bonds payable, face amount 50,000,000$ Less: unamortized discount (244,875) unamortized issue costs (127,500) Bonds payable, net 49,627,625$
Matrix, Inc.Partial Balance Sheet
December 31, 2009
For all long-term borrowing, disclosures should For all long-term borrowing, disclosures should include the aggregate amounts maturing and include the aggregate amounts maturing and
sinking fund requirement, if any, for each of the sinking fund requirement, if any, for each of the next five years.next five years.
Slide 35
14-35
Times interest Times interest earned ratioearned ratio ==
Net income + interest + taxesNet income + interest + taxesInterestInterest
Decision Makers’ PerspectiveDecision Makers’ Perspective
Long-term debt impacts several key Long-term debt impacts several key financial ratios.financial ratios.
Debt toDebt toequity ratioequity ratio
Total liabilitiesTotal liabilitiesShareholders’ equityShareholders’ equity==
Rate of return on Rate of return on shareholders’ equityshareholders’ equity
Net incomeNet incomeShareholders’ equityShareholders’ equity==
Rate of return Rate of return on assetson assets
Net incomeNet incomeTotal assetsTotal assets
==
Slide 36
14-36
Convertible BondsConvertible Bonds
Some bonds may be converted into common Some bonds may be converted into common stock at the option of the holder. When bonds stock at the option of the holder. When bonds
are converted the issuer updates interest are converted the issuer updates interest expense and amortization of discount or expense and amortization of discount or premium to the date of conversion. The premium to the date of conversion. The
bonds are reduced and shares of common bonds are reduced and shares of common stock are increased.stock are increased.
Bonds into Stock
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Induced ConversionInduced 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.
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.
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Bonds With Detachable WarrantsBonds With Detachable Warrants
Stock warrants provide the option Stock warrants provide the option to purchase a specified number of to purchase a specified number of shares of common stock at a shares of common stock at a specified option price per share specified option price per share within a stated period.within a stated period.
A portion of the selling price of the A portion of the selling price of the bonds is allocated to the bonds is allocated to the detachable stock warrants.detachable stock warrants.
Stock warrants provide the option Stock warrants provide the option to purchase a specified number of to purchase a specified number of shares of common stock at a shares of common stock at a specified option price per share specified option price per share within a stated period.within a stated period.
A portion of the selling price of the A portion of the selling price of the bonds is allocated to the bonds is allocated to the detachable stock warrants.detachable stock warrants.
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Bonds With Detachable WarrantsBonds With Detachable Warrants
Matrix issues at par 10,000, $1,000 face value, 8% Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the debt with detachable warrants that permit the
holder to purchase one share of stock for $18 per holder to purchase one share of stock for $18 per share. Immediately after issue the bonds were share. Immediately after issue the bonds were
selling for 98 without the warrants and the warrants selling for 98 without the warrants and the warrants have a market value of $16. have a market value of $16.
Matrix issues at par 10,000, $1,000 face value, 8% Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the debt with detachable warrants that permit the
holder to purchase one share of stock for $18 per holder to purchase one share of stock for $18 per share. Immediately after issue the bonds were share. Immediately after issue the bonds were
selling for 98 without the warrants and the warrants selling for 98 without the warrants and the warrants have a market value of $16. have a market value of $16.
Fair value of bonds without warrants 9,800,000$ 98.39%Fair value of the warrants 160,000 1.61%Aggregrate fair value 9,960,000$ 100.00%
Allocate to bonds $10,000,000 x 98.39% $ 9,839,000 Allocate to warrants $10,000,000 x 1.61% 161,000 Total face value $ 10,000,000
Proportional Method
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Troubled Debt Restructuring - AppendixTroubled Debt Restructuring - Appendix
Troubled debt may beTroubled debt may berestructured in one of two ways:restructured in one of two ways:
Troubled debt may beTroubled debt may berestructured in one of two ways:restructured in one of two ways:
SettledSettled at timeat timeof restructuring.of restructuring.
SettledSettled at timeat timeof restructuring.of restructuring.
Continued Continued withwithmodifiedmodified terms.terms.
Continued Continued withwithmodifiedmodified terms.terms.
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Troubled Debt Restructuring - AppendixTroubled Debt Restructuring - Appendix
SettledSettled at time of restructuring.at time of restructuring.SettledSettled at time of restructuring.at time of restructuring.
Book value of the debtBook value of the debt
– – Fair value of asset transferredFair value of asset transferred
GainGain on restructuring on restructuring
Book value of the debtBook value of the debt
– – Fair value of asset transferredFair value of asset transferred
GainGain on restructuring on restructuring
Debtor reports Debtor reports ordinary gain or lossordinary gain or loss on onadjustment to fair value of the asset transferred.adjustment to fair value of the asset transferred.
Debtor reports Debtor reports ordinary gain or lossordinary gain or loss on onadjustment to fair value of the asset transferred.adjustment to fair value of the asset transferred.
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Troubled Debt Restructuring - AppendixTroubled Debt Restructuring - Appendix
ContinuedContinued with with modified modified terms.terms.ContinuedContinued with with modified modified terms.terms.
ReduceReduce or delay or delayinterestinterest payments. payments.ReduceReduce or delay or delay
interestinterest payments. payments.ReduceReduce or delay or delay
maturitymaturity payment. payment.ReduceReduce or delay or delay
maturitymaturity payment. payment.
Accounting treatment depends on a comparison Accounting treatment depends on a comparison of total cash payments after restructuring with of total cash payments after restructuring with
the book value of the original debt.the book value of the original debt.
Accounting treatment depends on a comparison Accounting treatment depends on a comparison of total cash payments after restructuring with of total cash payments after restructuring with
the book value of the original debt.the book value of the original debt.
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Troubled Debt RestructuringTroubled Debt Restructuring
ContinuedContinued withwith modifiedmodified terms.terms.ContinuedContinued withwith modifiedmodified terms.terms.
Cash payments Cash payments lessless than thanbook value of debt.book value of debt.
Cash payments Cash payments lessless than thanbook value of debt.book value of debt.
Cash payments Cash payments moremore than thanbook value of debt.book value of debt.
Cash payments Cash payments moremore than thanbook value of debt.book value of debt.
Debtor reports differenceDebtor reports differenceas a gain.as a gain.
All cash payments areAll cash payments arereductions in principal.reductions in principal.
(No interest)(No interest)
Debtor reports differenceDebtor reports differenceas a gain.as a gain.
All cash payments areAll cash payments arereductions in principal.reductions in principal.
(No interest)(No interest)
No gain reported.No gain reported.
Compute newCompute neweffective interest rate.effective interest rate.
Record annualRecord annualinterest at new rate.interest at new rate.
No gain reported.No gain reported.
Compute newCompute neweffective interest rate.effective interest rate.
Record annualRecord annualinterest at new rate.interest at new rate.
McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.
End of Chapter 14End of Chapter 14