McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. BONDS AND LONG-TERM NOTES Chapter 14

Slide Long-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 Nature of Long-Term Debt Obligations that extend beyond one year or the operating cycle, whichever is longer Mirror image of an asset Accrue interest expense Reported at present value Loan agreement restrictions

Slide 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

Slide Bonds Sold at Face Amount On 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. Masterwear - Issuer At Issuance (January 1) United - Investor

Slide Determining the Selling Price

Slide Determining the Selling Price On 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. 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 Journal Entries at Issuance – Bonds Issued at a Discount Masterwear - Issuer United - Investor

Slide Determining Interest – Effective Interest Method Interest 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) = $46,664 Outstanding Balance Effective Rate Effective Interest

Slide Journal 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) Masterwear - Issuer United - Investor

Slide Change in Debt When Effective Interest Exceeds Cash Paid 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 Amortization Schedule – Discount Since less cash is paid each period than the effective interest, the unpaid difference increases the outstanding balance of the debt. 6% × $700,000 $666, ,664 $46,664 – 42,000 7% × $666,633

Slide Amortization Schedule – Discount $48,544 is rounded to cause outstanding balance to be exactly $700,000 on 12/31/11.

Slide 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.

Slide When Financial Statements Are Prepared Between Interest Dates On 1/1/09, Masterwear Industries issues $700,000 face value bonds to United Intergroup. The market interest rate is 14%. The bonds have the following terms: Face Value of Each Bond = $1,000 Maturity Date = 12/31/11 (3 years) Stated Interest Rate = 12% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/09 On 1/1/09, Masterwear Industries issues $700,000 face value bonds to United Intergroup. The market interest rate is 14%. The bonds have the following terms: Face Value of Each Bond = $1,000 Maturity Date = 12/31/11 (3 years) Stated Interest Rate = 12% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/09 Assume Masterwear and United both have September 30 th year-ends.

Slide Recall the entries we prepared on June 30, These entries will not change. Masterwear - Issuer United - Investor When Financial Statements Are Prepared Between Interest Dates

Slide Year-end is on September 30, 2009, before the second interest date of December 31, so we must accrue interest for 3 months from June 30 to September 30. Masterwear - Issuer United - Investor When Financial Statements Are Prepared Between Interest Dates

Slide When Financial Statements Are Prepared Between Interest Dates On December 31, the next interest payment date, the following entries would be recorded. Masterwear - Issuer United - Investor

Slide The Straight-Line Method – A Practical Expediency 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 Fair 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 Fair Value Option – Example 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 On December 31, the fair value of the bonds was $183,000. Fair Value Option – Example Rather than increasing the bonds payable account itself, we increase it indirectly with a valuation allowance (or contra) account: 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 Debt Issue Costs  Legal  Accounting  Underwriting  Commission  Engraving  Printing  Registration  Promotion

Slide Long-Term Notes Present value techniques are used for valuation and interest recognition. The procedures are similar to those we encountered with bonds.

Slide Long-Term Notes On January 1, 2009, Skill Graphics, Inc., a product labeling and 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. Skill Graphics (Borrower) At Issuance First BancCorp (Lender)

Slide Long-Term Notes (continued) At Each of the Six Interest Dates Skill Graphics (Borrower) First BancCorp (Lender) At Maturity Skill Graphics (Borrower) First BancCorp (Lender)

Slide Note Exchanged for Assets or Services 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 Note Exchanged for Assets or Services At the Purchase Date (January 1) Skill Graphics (Buyer/Issuer) Hughes–Barker (Seller/Lender At the First Interest Date (June 30) Skill Graphics (Buyer/Issuer) Hughes–Barker (Seller/Lender

Slide Installment Notes oTo compute cash payment use present value tables. oInterest expense or revenue: Effective interest rate Effective interest rate × Outstanding balance of debt Interest expense or revenue Interest expense or revenue oPrincipal reduction: Cash amount Cash amount – Interest component Principal reduction per period Principal reduction per period oTo compute cash payment use present value tables. oInterest expense or revenue: Effective interest rate Effective interest rate × Outstanding balance of debt Interest expense or revenue Interest expense or revenue oPrincipal reduction: Cash amount Cash amount – Interest component Principal reduction per period Principal reduction per period

Slide Installment Notes $666,633 ÷ = $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 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

Slide Early Extinguishment 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 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.

Slide Convertible Bonds Some bonds may be converted into common stock at the option 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

Slide 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. 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. 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. 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. A portion of the selling price of the bonds is allocated to the detachable stock warrants.