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 A
A note
note payable
payable and
and A
A bond
bond payable
payable
creditors
creditors interest
interest in
in note
note receivable
receivable are
are divides
divides aa large
large
aa companys
companys assets.
assets. two
two sides
sides of
of the
the liability
liability into
into many
many
same
same coin.
coin. smaller
smaller liabilities.
liabilities.

Periodic
Periodic interest
interest is
is the
the Corporations
Corporations issuing
issuing bonds
bonds
effective
effective interest
interest rate
rate are
are obligated
obligated toto repay
repay aa
times
times the
the amount
amount of of the
the stated
stated amount
amount at at aa
debt
debt outstanding
outstanding during
during specified
specified maturity
maturity date
date and
and
the
the period.
period. Debt
Debt isis period
period interest
interest between
between
reported
reported atat its
its present
present the
the issue
issue date.
date.
value
value
 14-3

Bonds
At Bond Issuance Date
Company
Company Bond Selling Price Investor
Investor
Issuing
Issuing Buying
Buying
Bonds
Bonds Bond Certificate Bonds
Bonds

Subsequent Periods
Company Interest Payments Investor
Company Investor
Issuing
Issuing Buying
Buying
Bonds
Bonds Face Value Payment Bonds
Bonds
at End of Bond Term
 14-4

The Bond Indenture

Debenture Bond Mortgage Bond
secured by the secured by lien on
full faith and specific real estate
credit of company. 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

Determining the Selling Price

 14-6

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.
 14-7

Premium and Discount Amortization

Compared
 14-8

Debt Issue Costs

Legal
Accounting
Underwriting
Commission
Engraving
Printing
Registration
Promotion
 14-9

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 Transaction costs reduce the

recorded separately as an
asset.
Amortized over the term to
maturity.
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.
 14-10

Long-Term Notes

Promissor
y
Company Bank
Note
(Borrower) (Note
Payable)
Property,
goods, or
services.

The liability, note payable, is reported at its present value,

similar to the accounting for bonds payable.
 14-11

Installment Notes
o 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:
Effective interest rate
Outstanding balance of debt
Interest expense or revenue
o Principal reduction:
Cash amount
Interest component
Principal reduction per period
 14-12

Decision Makers Perspective

Debt to Total liabilities

=
equity ratio Shareholders equity

Rate of return on = Net income

assets Total assets

Rate of return on Net income

=
shareholders equity Shareholders equity

Times interest = Net income + interest + taxes

earned ratio Interest
 14-13

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
 14-14

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

 14-15

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.
 14-16

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.
 14-17

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.
 14-18

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 Companies may only elect

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.
the fair value option when
1. When a group of financial
assets or liabilities is
managed and its
performance is evaluated
on a fair value basis, or
2. If the fair value option
reduces accounting
mismatch.
 14-19

Where Were Headed

Under
Under a a proposed
proposed change
change inin the
the way
way wewe 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 onon 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 bebe permitted
permitted except
except in
in unique
unique circumstances.
circumstances.

The
The proposed
proposed change
change isis 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 asas part
part of
of a
a broader
broader goal
goal of
of achieving
achieving aa
single
single set
set of
of high
high quality
quality global
global accounting
accounting standards.
standards. AtAt the
the
time
time this
this text
text is
is being
being written,
written, a
a final
final standard
standard isis expected
expected to
to be
be
issued
issued in
in 2012.
2012.
 14-20

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.
 14-21

End of Chapter 14