Long-Term Debt u By the end of today’s class you should understand… –Bond terminology –the effective interest rate method of accounting for long term bonds –basic long-term debt accounting

Long-Term Debt u The Balance Sheet Line Items: –Secured Bonds (with collateral) –Debentures ( unsecured) –Capital Lease Obligations u At what value are these obligations carried in the B/S u How do we measure interest expense? –Cash Paid? –Effective Interest?

Definition u Bond? –An obligation to make a series of payments to the bondholder. The payments are described in terms of principal and interest u Debenture? –An unsecured bond. That is, there is no collateral backing any default u Zero coupon bond? –A bond that does not make periodic interest payments eg. U.S. Savings bond u Convertible bond? –A bond that can be converted into another security, typically common shares. Convertible bonds can be thought of as Bonds with Embedded Call Options

Definitions (cont) u Subordinated Bond? –A bond that, in the event of the issuing company’s default cannot be paid until more “senior” claims have been paid u Fixed rate bond? –A bond with an interest rate will not vary with changing economic conditions u Floating rate bond? –A bond with an interest rate that can vary. It might vary as a function of the prime rate, LIBOR, or even the results of a division’s operations

Bond Terminology u Par Value, Face Value or Principal –The amount that will be paid at the end of the term of the bond u Coupon Rate, Stated Rate, or Nominal rate –The interest rate used to determine the coupon payment u Coupon Payment –The amount of the periodic interest payments –Determined by multiplying the coupon rate times the face value of the bond u Effective Rate, Yield, or Implicit Rate –The discount or interest rate that equates the present value of the remaining payments with the market value of the security

Bonds as a Stream of Payments u Periodic Payments of Interest and Principal u Discount the Cash Flows to Determine Proceeds of Debt Issuance u Account for Payments using the Effective Interest Rate Method –rate used is the original market rate NOT the current market ( or the coupon) rate

Bond Valuation - Basics u On issuance, proceeds to issuer equal PV of future cash flows for interest and principal u Market value will fluctuate over the life of the bond u Accountants ignore the fluctuation

Bond Accounting - Example 1 u Issue a bond on Jan 1. It has a 2 year term, $1,000 face value, a 10% coupon rate, with interest payable semiannually. u Assume the bond is issued to yield 12% i.e.., bondholders require a 12% return compounded semiannually (6% every six months) u The company will receive $965 when it issues the bond –PV of $1,000, n = 4, r = 6% => 792 –PV of pmt = $50, n=4, r=6% => –Journal Entry on issuance »Dr Cash $ 965 »Dr. Discount 35 Cr.Bond Payable $1,000

Example 1 (contd) u Interest Expense for the first 6 months –BV of Bond * Effective Rate »$965*6% = $57.9 u Interest Payment for the first 6 months –Face Value * Coupon Rate »$1000 * 5% = $50 u Journal Entry –Dr. Interest Expense 57.9 –Cr.Discount 7.9 –Cr.Cash 50.0 u Repeat for each interest payment

Bond Accounting - Example 1 - Contd u Interest Expense for second 6 months –BV of Bond * Effective Rate »[$ } * 6% = $58.37 u Journal Entry –Dr. Interest Expense$58.37 –Cr.Discount 8.37 –Cr. Cash 50.0 u Interest Expense for third 6 months –BV of Bond *Effective Rate –[$ ] * 6% = $58.88 u Journal Entry –Dr. Interest Expense$58.88 –Cr.Discount 8.88 –Cr. Cash 50.0

Example 1 (contd) u Interest Expense for final 6 months –BV of Bond * Effective Rate »[ $ ]* 6% = u Journal Entry –Dr. Interest Expense $59.41 –Cr.Discount 9.41 –Cr. Cash 50 u Repay the bond –Dr. Bond payable1000 –Cr.Cash 1000 u Bond discount account = (difference is due to rounding)

Bond Retirement u Buyback from the market u Exercise call provision u Convertible bonds u In-substance defeasance

Accounting for Bonds - Main Points u Use effective interest rate method u Amortize discount or premium over the life of the bond u Effective interest rate method ensures that interest rate does not fluctuate over the life of the debt ( as it would if the premium or discount were amortized using straight line) u The effective rate used is the effective rate at the time the debt was issued u The market rate will likely change over the term of the bond –If a bond is paid off early, there will be a gain or loss ( considered an extraordinary item) unless the market rate at the time is the same as the effective rate at the date of issuance (highly unlikely)

Bonds - Useful Information u Interest Expense = Book Value of Bond * Interest Rate u Interest paid = Annuity= Face Value of Bond * Coupon Rate u Discount = Face Value - Book Value => FV > BV u Premium = Book Value - Face Value => BV > FV u Book Value = Present Value of future cash flows => PV at time 0 is the price or cash proceeds of the bond. u Total interest expense = Annuity*Number of payments + Face Value - Cash Proceeds

Take Home Point u You should understand… –Basic bond terminology –Basic long-term debt accounting –accountants use the effective interest rate method to account for long-term debt –effective rate and current market rate may differ –Understand the long-term debt section in the F/S