Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.14-1PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACnthia J. !oone, Ph.D., CPABonds and Long-Term NotesChapter 1414-2The Nature of Long-Term DebtLiabilities signify creditors interest in a companys assets.Liabilities signify creditors interest in a companys assets.A note payable and note receivable are two sides of the same coin.A note payable and note receivable are two sides of the same coin.Periodic interest is the efective interest rate times the amont of the debt otstanding dring the period. !ebt is reported at its present valePeriodic interest is the efective interest rate times the amont of the debt otstanding dring the period. !ebt is reported at its present valeA bond payable divides a large liability into many smaller liabilities.A bond payable divides a large liability into many smaller liabilities."orporations issing bonds are obligated to repay a stated amont at a speci#ed matrity date and period interest between the isse date."orporations issing bonds are obligated to repay a stated amont at a speci#ed matrity date and period interest between the isse date.14-$Bonds %ond &elling Price %ond &elling Price%ond "erti#cate %ond "erti#cate'nterest Payments 'nterest Payments(ace )ale Payment(ace )ale Payment at *nd of %ond +erm at *nd of %ond +ermAt %ond 'ssance !ateAt %ond 'ssance !ate"ompany"ompany 'ssing'ssing %onds %onds"ompany"ompany 'ssing'ssing %onds %onds&bse,ent Periods&bse,ent Periods'nvestor'nvestor %ying%ying %onds %onds'nvestor'nvestor %ying%ying %onds %onds"ompany"ompany 'ssing'ssing %onds %onds"ompany"ompany 'ssing'ssing %onds %onds'nvestor'nvestor %ying%ying %onds %onds'nvestor'nvestor %ying%ying %onds %onds14-4The Bond Indenture+he speci#c promises made to bondholders are described in a docment called a bond indenture.+he speci#c promises made to bondholders are described in a docment called a bond indenture.-ortgage %ond secred by lien on speci#c real estate owned by the isser.-ortgage %ond secred by lien on speci#c real estate owned by the isser."allable %ond allows company to by bac. otstanding bonds prior to matrity."allable %ond allows company to by bac. otstanding bonds prior to matrity."opon %ond pays interest when investor sbmits attached copon."opon %ond pays interest when investor sbmits attached copon.!ebentre %ondsecred by the /fll faith and credit0 of company.!ebentre %ondsecred by the /fll faith and credit0 of company.14-1Recording Bonds at Issuance"n Januar #, $%#&, Masterwear Industries issued '(%%,%%% o) #$* bonds.Interest o) '+$,%%% is ,aable semiannuall on June &% and De-ember ..he bonds mature in three ears /an unrealisti-all short maturit to shorten the illustration0..he entire bond issue was sold in a ,ri1ate ,la-ement to 2nited Inter3rou,, In-., at )a-e amount.At Issuance (January 1)Masterwear (Issuer)Cash (%%,%%%Bonds ,aable(%%,%%%United (Investor)In1estment in bonds 4)a-e amount5(%%,%%%Cash(%%,%%%14-2Determining the Selling Price14-3Determining the Selling Price4n 5anary 16 271$6 -asterwear 'ndstries issed $700,000 of 12% bonds6 dated 5anary 1. 'nterest is payable semiannally on 5ne $7 and !ecember $1. +he bonds matre in three years.+he mar.et yield for bonds of similar ris. and matrity is 14%.+he entire bond isse was prchased by 8nited 'ntergrop.Be-ause interest is ,aid semiannually, the ,resent 1alue -al-ulations use: 4a5 the semiannual stated rate 46*5, 4b5 the semiannual market rate 4(*5, and 4-5 6 4& 7 $5 semi-annual ,eriods.Present 1alue o) an ordinar annuit o) '#: n86, i8(*,resent 1alue o) '#: n86, i8(*14-9Bonds Issued at a DiscountMasterwear (Issuer)Cash 666,6&&Dis-ount on bonds ,aable &&,&6(Bonds ,aable(%%,%%%United (Investor)In1estment in bonds(%%,%%%Dis-ount on bond in1estment&&,&6(Cash666,6&&Alternative :et -ethodMasterwear (Issuer)"ash 22262$$%onds payable22262$$United (Investor)'nvestment in bonds22262$$"ash22262$$14-;Determining Interest Efective Interest MethodInterest a--rues on an outstandin3 debt at a constant percentage o) the debt ea-h ,eriod.Interest ea-h ,eriod is re-orded as the effective market rate of interest multiplied by the outstanding balance of the debt 4durin3 the interest ,eriod5..he bond indenture -alls )or semiannual interest ,aments o) onl '+$,%%% 9 the stated rate 46*5 times the face value o) '(%%,%%%..he di))eren-e 4'+,66+5 in-reases the liabilit and is re)le-ted as a redu-tion in the dis-ount 4a -ontra:liabilit a--ount5. Interest is re-orded as expense to the issuer and revenue to the in1estor. ;or the )irst si7:month interest ,eriod the amount is -al-ulated as )ollows: '666,6&& < 4#+* = $5 8 '+6,66+Outstanding Balance Effective RateEffective Interest14-17Recording Interest Expense.he e))e-ti1e interest is -al-ulated ea-h ,eriod as the market rate times the amount o) the debt outstandin3 durin3 the interest ,eriod.At the First Interest Date (June 30)Masterwear (Issuer)Interest e7,ense +6,66+Dis-ount on bonds ,aable +,66+Cash +$,%%%United (Investor)Cash +$,%%%Dis-ount on bond in1estment +,66+In1estment re1enue +6,66+'(%%,%%% < 4#$* = $5 8 '+$,%%% '(%%,%%% < 4#$* = $5 8 '+$,%%% '+6,66+ : '+$,%%% 8 '+,66+ '+6,66+ : '+$,%%% 8 '+,66+ '666,6&& < 4#+* = $5 8 '+6,66+'666,6&& < 4#+* = $5 8 '+6,66+14-11Bond Amortization Schedule>ere is a bond amorti?ation s-hedule showin3 the -ash interest, e))e-ti1e interest, dis-ount amorti?ation, and the -arrin3 1alue o) the bonds.'666,6&& @ '+,66+ 8 '6(#,$A('666,6&& @ '+,66+ 8 '6(#,$A(14-12Zero-Coupon Bonds +hese bonds do not pay interest. +hese bonds do not pay interest. 'nstead6 they ofer a retrn in 'nstead6 they ofer a retrn in the form of a deep discont the form of a deep discont from the face amont. from the face amont. +hese bonds do not pay interest. +hese bonds do not pay interest. 'nstead6 they ofer a retrn in 'nstead6 they ofer a retrn in the form of a deep discont the form of a deep discont from the face amont. from the face amont. 14-1$Bond Issued at Premium"n Januar #, $%#&, Masterwear Industries issued $700,000 o) 1! bonds, dated Januar #.Interest is ,aable semiannuall on June &% and De-ember ..he bonds mature in three years..he market ield )or bonds o) similar risk and maturit is 10! 10!..he entire bond issue was ,ur-hased b 2nited Inter3rou,.Be-ause interest is ,aid semiannually, the ,resent 1alue -al-ulations use: 4a5 the semiannual stated rate 46*5, 4b5 the semiannual market rate 4B*5, and 4-5 6 4& 7 $5 semi-annual ,eriods.Present 1alue o) an ordinar annuit o) '#: n86, i8B*,resent 1alue o) '#: n86, i8B*14-14Premium Amortization Schedule>ere is a bond amorti?ation s-hedule showin3 the -ash interest, e))e-ti1e interest, ,remium amorti?ation, and the -arrin3 1alue o) the bonds.'(&B,B&& : 'B,$$& 8 '(&%,%'(&B,B&& : 'B,$$& 8 '(&%,%'(&B,B&& < B* 8 '&6,((('(&B,B&& < B* 8 '&6,(((14-11Bonds Sold at a PremiumMasterwear (Issuer)Cash (&B,B&&Premium on bonds ,aable&B,B&&Bonds ,aable(%%,%%%United (Investor)In1estment in bonds(%%,%%%Premium on bond in1estment &B,B&&Cash(&B,B&&Interest e7,ense and interest re1enue will be re-o3ni?ed in a manner -onsistent with bonds issued at a dis-ount.14-12Premium and Discount Amortization Compared14-13When Financial Statements Are Prepared Between Interest DatesMasterwear and 2nited both ha1e Masterwear and 2nited both ha1e "-tober "-tober st st ear:ends.ear:ends."n Januar #, $%#&, Masterwear Industries issued $700,000 o) 1! bonds, dated Januar #.Interest is ,aable semiannuall on June &% and De-ember ..he bonds mature in three years..he market ield )or bonds o) similar risk and maturit is 1"!..he entire bond issue was ,ur-hased b 2nited Inter3rou, at a -ost o) '666,6&&.'(%%,%%% < 4#$* = $5 8 '+$,%%% '(%%,%%% < 4#$* = $5 8 '+$,%%% '666,6&& < 4#+* = $5 8 '+6,66+'666,6&& < 4#+* = $5 8 '+6,66+Semi:annual Stated Interest June &%, $%#& C))e-ti1e Interest14-19When Financial Statements Are Prepared Between Interest Datesu3hes9Barker Cor,oration b issuin3 a #$*, '(%%,%%%, &:ear note that reGuires interest to be ,aid semiannuall..he ma-hine -ould ha1e been ,ur-hased at a cash ,ri-e o) '666,6&&..he -ash ,ri-e im,lies an annual market rate o) interest o) #+*..hat is, (* is the semiannual dis-ount rate that ields a ,resent 1alue o) '666,6&& )or the noteJs -ash )lows 4interest ,lus ,rin-i,al5 -om,uted as )ollows: .he a--ountin3 treatment is the same whether the amount is determined direct'y )rom the market 1alue o) the ma-hine or indirect'y as the ,resent 1alue o) the note.14-23Note Exchanged for Assets or ServicesAt the /urchase Date (January 1)At the First Interest Date (June 30)%0i'' .ra+hics (1uyer4Issuer)Ma-hiner666,6&&Dis-ount on note ,aable&&,&6(Iotes ,aable (%%,%%%5u*hes61ar0er (%e''er43ender)Iotes re-ei1able (%%,%%%Dis-ount on notes ,aable &&,&6(Sales re1enue 666,6&&%0i'' .ra+hics (1uyer4Issuer)Interest e7,ense+6,66+Dis-ount on note ,aable+,66+Cash+$,%%%5u*hes61ar0er (%e''er43ender5Cash +$,%%%Dis-ount on notes ,aable +,66+In1estment re1enue +6,66+14-29Installment Noteso+o compte cash payment se present +o compte cash payment se present vale tables.vale tables.o*ach payment incldes both an interest *ach payment incldes both an interest amont and a principal amont.amont and a principal amont.o'nterest eApense or reveneB'nterest eApense or reveneBEe!tive interest rate" #utstandin$ ba%an!e o& debt Interest e'(ense or revenueoPrincipal redctionBPrincipal redctionB )ash a*ount+ Interest !o*(onent ,rin!i(a% redu!tion (er (eriod14-2;Installment Notes $777,7338",7779":$13;,.L re-entl issued non-on1ertible, $% ear, E* debentures at AE."n Januar #, $%#&, >.L Manu)a-turers issued '#%%,%%%,%%% o) E* -on1ertible debentures due $%&& at #%& 4#%&* o) )a-e 1alue5. .he bonds are -on1ertible at the o,tion o) the holder into '# ,ar -ommon sto-k at a -on1ersion ratio o) +% shares ,er '#,%%% bond. >.L re-entl issued non-on1ertible, $% ear, E* debentures at AE.At Issuance, January 1, 013$100,000,000 B 103!$100,000,000 B 103!5=3 (Issuer)Cash#%&,%%%,%%%Con1ertible bonds ,aable #%%,%%%,%%%Premium on bonds ,aable &,%%%,%%%14-$3Convertible BondsAssume the bondholder e7er-ises one:hal) o) their o,tion to -on1ert the bonds into shares o) sto-k when there is an unamorti?ed ,remium o) '$,%%%,%%% asso-iated with these bonds..he bonds are remo1ed )rom the a--ountin3 re-ords and the new shares issued are re-orded at the same amount 4in other words, at the book 1alue o) the bonds5.Assume the bondholder e7er-ises one:hal) o) their o,tion to -on1ert the bonds into shares o) sto-k when there is an unamorti?ed ,remium o) '$,%%%,%%% asso-iated with these bonds..he bonds are remo1ed )rom the a--ountin3 re-ords and the new shares issued are re-orded at the same amount 4in other words, at the book 1alue o) the bonds5.5=3 (Issuer)Con1ertible bonds ,aable B%,%%%,%%%Premium on bonds ,aable #,%%%,%%%Common sto-k$,%%%,%%%Paid:in -a,ital 9 e7-ess o) ,ar +A,%%%,%%%At Date o$ #&ercise o$ Cne6ha'$ o$ the 1onds 90,000 )onds B "0 shares B $1 +ar : $,000,000 +ar va'ue90,000 )onds B "0 shares B $1 +ar : $,000,000 +ar va'ue14-$9Induced ConversionCom,anies sometimes tr to indu-e -on1ersion. .he moti1ation mi3ht be to redu-e debt and be-ome a better risk to ,otential lenders or a-hie1e a lower debt:to:eGuit ratio. Com,anies sometimes tr to indu-e -on1ersion. .he moti1ation mi3ht be to redu-e debt and be-ome a better risk to ,otential lenders or a-hie1e a lower debt:to:eGuit ratio. When the s,e-i)ied -all ,ri-e is less than the -on1ersion 1alue o) the bonds 4the market 1alue o) the shares5, -allin3 the -on1ertible bonds ,ro1ides bondholders with in-enti1e to -on1ert. When the s,e-i)ied -all ,ri-e is less than the -on1ersion 1alue o) the bonds 4the market 1alue o) the shares5, -allin3 the -on1ertible bonds ,ro1ides bondholders with in-enti1e to -on1ert. 14-$;U.S. GAAP vs. IFRSConvertible Bonds8nder '(=&6 nli.e 8.&. DAAP6 convertible debt is divided into its %iabi%ity and e-uity elements. ?E in millions@"ash ?17$FE177million@ 17$H"onvertible bonds payable ?vale of the debt only@ ;9IH*,ityJconversion option ?diference@1 I+he discont is combined with the face amont of the bonds.+his is the /net method0 J the preferred method nder '(=&. "ompond instrments sch as this one are separated into their liability and e,ity components in accordance with IAS No. 32. 'f the bonds have a se(arate &air va%ue o& $./ *i%%ion6 we record that amont as the %iabi%ity and the re*ainin$ $0 *i%%ion as e-uity. 14-47Bonds With Detachable Warrants&toc. warrants provide the option to prchase a speci#ed nmber of shares of common stoc. at a speci#ed option price per share within a stated period.A portion of the selling price of the bonds is allocated to the detachable stoc. warrants.&toc. warrants provide the option to prchase a speci#ed nmber of shares of common stoc. at a speci#ed option price per share within a stated period.A portion of the selling price of the bonds is allocated to the detachable stoc. warrants.14-41Bonds With Detachable Warrants"n Januar #, $%#&, >.L issued '#%%,%%%,%%% o) E* bonds"n Januar #, $%#&, >.L issued '#%%,%%%,%%% o) E* bonds due in $%$% at #%& 4#%&* o) )a-e 1alue5. A--om,anin3 ea-hdue in $%$% at #%& 4#%&* o) )a-e 1alue5. A--om,anin3 ea-h '#,%%% bond were $% warrants. Ca-h warrant ,ermitted the'#,%%% bond were $% warrants. Ca-h warrant ,ermitted the holder to bu one share o) '# ,ar -ommon sto-k at '$B ,erholder to bu one share o) '# ,ar -ommon sto-k at '$B ,er share. Shortl a)ter issuan-e, the warrants were listed on theshare. Shortl a)ter issuan-e, the warrants were listed on the sto-k e7-han3e at '& ,er warrant.sto-k e7-han3e at '& ,er warrant. "n Januar #, $%#&, >.L issued '#%%,%%%,%%% o) E* bonds"n Januar #, $%#&, >.L issued '#%%,%%%,%%% o) E* bonds due in $%$% at #%& 4#%&* o) )a-e 1alue5. A--om,anin3 ea-hdue in $%$% at #%& 4#%&* o) )a-e 1alue5. A--om,anin3 ea-h '#,%%% bond were $% warrants. Ca-h warrant ,ermitted the'#,%%% bond were $% warrants. Ca-h warrant ,ermitted the holder to bu one share o) '# ,ar -ommon sto-k at '$B ,erholder to bu one share o) '# ,ar -ommon sto-k at '$B ,er share. Shortl a)ter issuan-e, the warrants were listed on theshare. Shortl a)ter issuan-e, the warrants were listed on the sto-k e7-han3e at '& ,er warrant.sto-k e7-han3e at '& ,er warrant. 5=3 (Issuer)Cash#%&,%%%,%%%Dis-ount on bonds ,aable &,%%%,%%%Bonds ,aable #%%,%%%,%%%CGuit 9 sto-k warrants6,%%%,%%%100,000 )onds B 0 warrants B $3 100,000 )onds B 0 warrants B $3 14-42Bonds With Detachable WarrantsAssume one:hal) o) the warrants 4#,%%%,%%%5 are e7er-ised when the market 1alue o) >.LJs -ommon sto-k is '&% ,er share. .he e7er-ise ,ri-e is '$B ,er -ommon share.Assume one:hal) o) the warrants 4#,%%%,%%%5 are e7er-ised when the market 1alue o) >.LJs -ommon sto-k is '&% ,er share. .he e7er-ise ,ri-e is '$B ,er -ommon share.5=3 (Issuer)Cash$B,%%%,%%%CGuit 9 sto-k warrants &,%%%,%%%Common sto-k #,%%%,%%%Paid:in -a,ital 9 -ommon sto-k $(,%%%,%%%1,000,000 warrants B $9 1,000,000 warrants B $9 $7,000,000 8$7,000,000 814-4$Option to Report Liabilities at Fair ValueCom,anies ha1e the o,tion to 1alue some or all o) their )inan-ial assets and liabilities at )air 1alue. Com,anies ha1e the o,tion to 1alue some or all o) their )inan-ial assets and liabilities at )air 1alue. .he same market )or-es that in)luen-e the )air 1alue o) an in1estment in debt se-urities 4interest rates, e-onomi- -onditions, risk, et-.5 in)luen-e the )air 1alue o) liabilities..he same market )or-es that in)luen-e the )air 1alue o) an in1estment in debt se-urities 4interest rates, e-onomi- -onditions, risk, et-.5 in)luen-e the )air 1alue o) liabilities.14-44U. S. GAAP vs. IFRS+he fair vale option may be elected by the #rm.Althogh 8.&. DAAP gidance indicates that the intent of the fair vale option nder 8.&. DAAP is to address these sorts of circmstances6 it does not re-uire that those circmstances eAist.Internationa' accountin* standards are (ore restrictive than U,%, standards $or deter(inin* when $ir(s are a''owed to e'ect the $air va'ue o+tion,"ompanies may only elect the fair vale option when1. Chen a grop of #nancial assets or liabilities is managed and its performance is evalated on a fair vale basis6 or2. 'f the fair vale option redces /acconting mismatch.014-41Where Were Headed8nder a proposed change in the way we accont for #nancial assets and liabilities6 #nancial assets wold be measred at ?a@ fair vale with changes reported in net income ?()-:'@6 ?b@ at fair vale throgh 4ther "omprehensive 'ncome ?()-4"'@6 or ?c@ at amorti>ed cost6 the classi#cation depending on the assets characteristics and the companys bsiness strategy for holding the assets.-ost liabilities wold be acconted for at amorti>ed cost as described in this chapter.+he fair vale option6 thogh6 wold no longer be permitted eAcept in ni,e circmstances. +he proposed change is a reslt of a Koint proKect on #nancial instrments by the 'nternational Acconting &tandards %oard ?'A&%@ and the (A&% as part of a broader goal of achieving a single set of high ,ality global acconting standards.At the time this teAt is being written6 a #nal standard is eApected to be issed in 2712.8nder a proposed change in the way we accont for #nancial assets and liabilities6 #nancial assets wold be measred at ?a@ fair vale with changes reported in net income ?()-:'@6 ?b@ at fair vale throgh 4ther "omprehensive 'ncome ?()-4"'@6 or ?c@ at amorti>ed cost6 the classi#cation depending on the assets characteristics and the companys bsiness strategy for holding the assets.-ost liabilities wold be acconted for at amorti>ed cost as described in this chapter.+he fair vale option6 thogh6 wold no longer be permitted eAcept in ni,e circmstances. +he proposed change is a reslt of a Koint proKect on #nancial instrments by the 'nternational Acconting &tandards %oard ?'A&%@ and the (A&% as part of a broader goal of achieving a single set of high ,ality global acconting standards.At the time this teAt is being written6 a #nal standard is eApected to be issed in 2712.14-42Appendix 14A: Bonds Issued Between Interest Dates&ppose a wea. mar.et cased a delay in selling the bonds ntil two months after the bond date of 5anary 1?for months before semiannal interest was to be paid@. 'n that case6 the byer wold be as.ed to pay the seller a!!rued interest for two months in addition to the price of the bonds. Masterwear was unable to sell '(%%,%%% )a-e amount o) bonds, dated Januar #, and ,ain3 interest semiannuall at an annual rate o) #$*. .he bonds were e1entuall sold on Mar-h #. LetJs -al-ulate the a--rued interest.14-43Appendix 14A: Bonds Issued Between Interest Dates+he Kornal entry at the date of issance ?-arch 1@ on the boo.s of the isser and investor are shown belowB14-49Appendix 14A: Bonds Issued Between Interest Dates"n June &%, the )irst interest ,ament date, the )ollowin3 Mournal entries will be made )or the issuer and in1estor.14-4;Appendix 14BTroubled Debt RestructuringChen changing the original terms of a debt agreement is motivated by #nancial diLclties eAperienced by the debtor ?borrower@6 the new arrangement is referred to as a troub%ed debt restru!turin$.A trobled debt restrctring may be achieved in either of two waysB1.+he debt may be settled at the time of the restrctring.2.+he debt may be continued, bt with modifed terms.14-17Debt Settled at Time of Restructuring(irst Prdent %an. is holding a E$767776777 note from the developer of some property. +he developer is in #nancial troble and cannot pay the ban. the amont owed. +he ban. agrees to accept property with a fair vale of E2767776777 in fll settlement of the note. +he property is carried on the boo.s of the developer at E1367776777. Lets loo. at the entries on the boo.s of the developer to record the settlement.LandN......................................................&,%%%,%%%Gain on dis,osal o) landN......... &,%%%,%%%($20000000 less carrying value of $!"000000#Iote ,aableN............................................ &%,%%%,%%%Gain on troubled debt restru-turin3. #%,%%%,%%%LandNNNNNNNNNNNNN. $%,%%%,%%%14-11Debt is Continued, but with Modifed TermsLets loo. at an eAample where the total cash payments are less than the carrying amont of the debt. (irst Prdent %an. holds a E$767776777 note from a property developer. +he note bears interest at 17F6 and matres in two years. +he developer is in #nancial diLclty and the ban. agrees to modify the terms of the agreement as followsB1.(orgive the interest accred from last year of E$67776777.2.=edce the remaining two interest payments to E267776777 each.$.=edce the principal amont to E2167776777.Lets loo. at an eAample where the total cash payments are less than the carrying amont of the debt. (irst Prdent %an. holds a E$767776777 note from a property developer. +he note bears interest at 17F6 and matres in two years. +he developer is in #nancial diLclty and the ban. agrees to modify the terms of the agreement as followsB1.(orgive the interest accred from last year of E$67776777.2.=edce the remaining two interest payments to E267776777 each.$.=edce the principal amont to E2167776777.14-12Debt is Continued, but with Modifed TermsA--rued interest ,aable.............................&,%%%,%%%Iote ,aableN...........................................#,%%%,%%%Gain on debt restru-turin3NNN.+,%%%,%%%Iote ,aableN......................................... $,%%%,%%%CashNNNNNNNNNNNN $,%%%,%%%At the date of the new agreement6 the following Kornal entry is re,iredB+he debit to notes payable is for the diference between the old face amont of E$767776777 and the total ftre cash payments of E2;67776777At each of the neAt two interest payments6 we will ma.e the following entryB14-1$Debt is Continued, but with Modifed TermsAt matrity6 the developer will ma.e the following entryBIote ,aableN......................................... $B,%%%,%%%CashNNNNNNNNNNNN $B,%%%,%%%14-14End of Chapter 14