© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 14 Bonds and Long-Term Notes

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 14-2 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 14-4 The Bond Indenture Debenture Bond Mortgage Bond Subordinated Debenture Coupon Bonds CallableCallable Sinking Fund Serial Bonds Convertible Bonds The indenture is the written specific promises made by the company to the bondholders. Types of Bonds

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 14-5 Bonds BOND PAYABLE Face Value $1,000 Interest 10% 6/30 & 12/31 Maturity Date 12/31/11 Bond Date 1/1/02 1. Face value (maturity or par value) 2. Maturity Date 3. Stated Interest Rate 4. Interest Payment Dates 5. Bond Date Other Factors: 6. Market Interest Rate 7. Issue Date

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 14-6 Recording Bonds at Issuance On 1/1/02, Graphics Inc. issues 1,000 bonds at face value to Webster, Inc. The market interest rate is 10%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02 On 1/1/02, Graphics Inc. issues 1,000 bonds at face value to Webster, Inc. The market interest rate is 10%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02 Record the issuance of the bonds on 1/1/02.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 14-7 Recording Bonds at Issuance Graphics, Inc. - Issuer Webster, Inc. - Investor

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 14-8 Bonds Issued Between Interest Date Interest begins to accrue on the date the bonds are dated. If the bonds are issued after the day they are dated, the investor would be asked to pay the company accrued interest. On the interest payment date, the investor will receive a check for the full period’s interest.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 14-9 Bonds Issued Between Interest Date On 2/1/02, Graphics Inc. issues 1,000 bonds at face value plus accrued interest to Webster, Inc. The market interest rate is 10%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02 On 2/1/02, Graphics Inc. issues 1,000 bonds at face value plus accrued interest to Webster, Inc. The market interest rate is 10%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Bonds Issued Between Interest Date Accrued Interest $1,000,000 × 10% × = $8, Graphic - Issuer Webster - Investor

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Bonds Issued Between Interest Date At the first interest date $1,000,000 × 10% × ½ = $50,000 Graphic - Issuer Webster - Investor

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Determining the Selling Price

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Determining the Selling Price On 1/1/02, Graphics Inc. issues 1,000 bonds at face value to Webster, Inc. The market interest rate is 12%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02 On 1/1/02, Graphics Inc. issues 1,000 bonds at face value to Webster, Inc. The market interest rate is 12%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02 What is the selling price of these bonds?

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Determining the Selling Price n = 5 years × 2 payments per year = 10 i = 12% ÷ 2 payments per year = 6% Interest annuity = $1,000,000 × 10% ÷ 2 = $50,000 Bonds issued at a discount.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Determining the Selling Price Graphics, Inc. - Issuer Webster, Inc. - Investor

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Determining Interest Effective Interest Method (Effective rate multiplied by the outstanding balance of the debt) $926,395 × 6% $55,584 - $50,000 $73,605 - $5,584

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Determining Interest Effective Interest Method (Effective rate multiplied by the outstanding balance of the debt)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Determining Interest Graphics, Inc. - Issuer Webster, Inc. - Investor

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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. 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Bonds Sold at a Premium On 1/1/02, Graphics Inc. issues 1,000 bonds at face value to Webster, Inc. The market interest rate is 8%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02 On 1/1/02, Graphics Inc. issues 1,000 bonds at face value to Webster, Inc. The market interest rate is 8%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/06 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 1/1/02 What is the selling price of these bonds?

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Bonds Sold at a Premium n = 5 years × 2 payments per year = 10 i = 8% ÷ 2 payments per year = 4% Interest annuity = $1,000,000 × 10% ÷ 2 = $50,000 Bonds issued at a premium.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Bonds Sold at a Premium Graphics, Inc. - Issuer Webster, Inc. - Investor

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Bonds Sold at a Premium

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Financial Statements Prepared Between Interest Dates Assume that in our previous example, Graphic, Inc. and Webster, Inc. both have fiscal years that end on September 30. Let’s look at the June 30 entry: Graphics, Inc. - Issuer Webster, Inc. - Investor

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Financial Statements Prepared Between Interest Dates Year-end is on September 30, 2002, before the second interest date of December 31. $42,974 × ½ = $21,487 (3 months interest) $ 7,026 × ½ = $ 3,513 (3 months amortization) Graphics, Inc. - Issuer

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Financial Statements Prepared Between Interest Dates Year-end is on September 30, 2002, before the second interest date of December 31. $42,974 × ½ = $21,487 (3 months interest) $ 7,026 × ½ = $ 3,513 (3 months amortization) Webster, Inc. - Investor

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Financial Statements Prepared Between Interest Dates The entries at December 31, Graphics, Inc. - Issuer Webster, Inc. - Investor

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Straight-Line Method The discount or premium is allocated equally to each period over the outstanding life of the bond. The discount or premium is allocated equally to each period over the outstanding life of the bond. Considered practical and expedient. expedient.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Debt Issue Costs LegalAccountingUnderwritingCommissionEngravingPrintingRegistrationPromotion

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Debt Issue Costs These costs should be recorded separately and amortized over the term of the related debt. These costs should be recorded separately and amortized over the term of the related debt. Straight-line amortization is often used. Straight-line amortization is often used. These costs should be recorded separately and amortized over the term of the related debt. These costs should be recorded separately and amortized over the term of the related debt. Straight-line amortization is often used. Straight-line amortization is often used.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Long-Term Notes Present value techniques are used for valuation and interest recognition. The procedures are similar to those we encountered with bonds.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Notes Exchanged for Assets or Services On 1/1/03, Matters, Inc. issued a $100,000, 3-year, 6% note in exchange for equipment owned by West, Inc. Interest is paid every 12/31. The equipment does not have a ready market value. The appropriate rate of interest for notes of this type is 9%. Let’s determine the present value of the note. On 1/1/03, Matters, Inc. issued a $100,000, 3-year, 6% note in exchange for equipment owned by West, Inc. Interest is paid every 12/31. The equipment does not have a ready market value. The appropriate rate of interest for notes of this type is 9%. Let’s determine the present value of the note.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Notes Exchanged for Assets or Services

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Notes Exchanged for Assets or Services Let’s prepare the entries on January 1. Amortization Schedule

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Notes Exchanged for Assets or Services Matters, Inc. - Purchaser West, Inc. - Seller

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Notes Exchanged for Assets or Services Entries for the first interest period. Matters, Inc. - Purchaser West, Inc. - Seller

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Installment Notes To compute cash payment use present value tables. To compute cash payment use present value tables. Interest expense or revenue: Interest expense or revenue: Book value at beginning of period Book value at beginning of period × Interest rate on the note payable Interest expense or revenue Interest expense or revenue Principal reduction: Principal reduction: Cash amount Cash amount – Interest component Principal reduction per period Principal reduction per period To compute cash payment use present value tables. To compute cash payment use present value tables. Interest expense or revenue: Interest expense or revenue: Book value at beginning of period Book value at beginning of period × Interest rate on the note payable Interest expense or revenue Interest expense or revenue Principal reduction: Principal reduction: Cash amount Cash amount – Interest component Principal reduction per period Principal reduction per period

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Installment Notes Jetson Delivery purchased a truck by issuing a 4- year note payable to Wink Motors. The truck cost $20,000 and is financed at a 9% interest rate. Payments are made at the end of each of the next for years. Let’s calculate the annual payment. $20,000 ÷ = $6,173 (rounded) PV of annuity of $1, n = 4, i = 9%

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Installment Notes Here is our loan amortization table.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Installment Notes The entries on date of purchase are: Jetson Delivery - Purchaser Wink Motors - Seller

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Installment Notes Date of first payment. Jetson Delivery - Purchaser Wink Motors - Seller

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Key Ratios 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Early Extinguishment of Debt Debt retired at maturity results in no gains or losses. Debt retired before maturity may result in an extraordinary gain or loss on extinguishment. Cash Proceeds – Book Value = Gain or Loss Debt retired before maturity may result in an extraordinary gain or loss on extinguishment. Cash Proceeds – Book Value = Gain or Loss BUT

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Convertible Bonds The Book Value Method  Record new stock at the book value of the convertible bonds.  No gain or loss is recognized. The Book Value Method  Record new stock at the book value of the convertible bonds.  No gain or loss is recognized.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Convertible Bonds On December 31, 2003, 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 $1,645,000 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, 2003, 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 $1,645,000 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Convertible Bonds 10,000 × 50 shares × $1 par value The carrying value of the bonds is assigned to the stock.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Bonds With Detachable Warrants Matrix issues 10,000, $1,000 face value, 8% debt with detachable warrants that permit the holder to purchase one share of stock for $18 per share. Immediately after the issue the bonds were selling for 98 without the warrants and the warrants have a market value of $16.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Bonds With Detachable Warrants Matrix issues 10,000, $1,000 face value, 8% debt with detachable warrants that permit the holder to purchase one share of stock for $18 per share. Immediately after the issue the bonds were selling for 98 without the warrants and the warrants have a market value of $16.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Bonds With Detachable Warrants Assume that all 10,000 warrants are exercised and Matrix received $180,000 (10,000 × $18 per share) and issues 10,000 shares of its $1 par value common stock.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Troubled Debt Restructuring Troubled debt may be restructured in one of two ways:  Settled at time of restructuring.  Continued with modified terms.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Troubled Debt Restructuring  Settled at time of restructuring. Book value of the debt Book value of the debt – Fair value of asset transferred Gain on restructuring Gain on restructuring Book value of the debt Book value of the debt – Fair value of asset transferred Gain on restructuring Gain on restructuring Debtor reports as extraordinary gain. Debtor reports ordinary gain or loss on adjustment to fair value of the asset transferred.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Troubled Debt Restructuring  Continued with modified terms. Reduce or delay interest payments. Reduce or delay maturity payment. Accounting treatment depends on a comparison of total cash payments after restructuring with the book value of the original debt.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Troubled Debt Restructuring  Continued with modified terms. Cash payments less than book value of debt. Cash payments more than book value of debt.  Debtor reports difference as extraordinary gain.  All cash payments are reductions in principal. (No interest)  Debtor reports difference as extraordinary gain.  All cash payments are reductions in principal. (No interest)  No gain reported.  Compute new effective interest rate.  Record annual interest at new rate.  No gain reported.  Compute new effective interest rate.  Record annual interest at new rate.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide End of Chapter 14