Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved 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 Bonds and Long-Term Notes Chapter 14

14-2 The Nature of Long-Term Debt Liabilities signify creditors’ interest in a company’s assets. A note payable and note receivable are two sides of the same coin. Periodic interest is the effective interest rate times the amount of the debt outstanding during the period. Debt is reported at its present value A bond payable divides a large liability into many smaller liabilities. Corporations issuing bonds are obligated to repay a stated amount at a specified maturity date and period interest between the issue date.

14-3 Bonds Bond Selling Price Bond Certificate Interest Payments Face Value Payment at End of Bond Term At Bond Issuance Date Company Issuing Bonds Subsequent Periods Investor Buying Bonds Company Issuing Bonds Investor Buying Bonds

14-4 The 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. Callable Bond allows company to buy back outstanding bonds prior to maturity. Coupon Bond pays interest when investor submits attached coupon. Debenture Bond secured by the “full faith and credit” of company.

14-5 Determining the Selling Price

14-6 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. These bonds do not pay interest. Instead, they offer a return in the form of a deep discount from the face 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 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. 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.

14-10 Long-Term Notes Bank Promissory Note (Note Payable) Promissory Note (Note Payable) Company (Borrower) Company (Borrower) 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 Times interest earned ratio = Net income + interest + taxes Interest Decision Makers’ Perspective Debt to equity ratio Total liabilities Shareholders’ equity = Rate of return on shareholders’ equity Net income Shareholders’ equity= Rate of return on assets Net income Total assets =

14-13 Early Extinguishment of Debt 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

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