Bonds and Long-Term Notes
Overview
This chapter continues the presentation of liabilities. Specifically, the discussion focuses on the accounting treatment of long-term liabilities. Long-term notes and bonds are discussed, as well as the extinguishment of debt and troubled debt restructuring.
Learning Objectives
LO14-1Identify the underlying characteristics of debt instruments and describe the basic approach to accounting for debt.
LO14-2Account for bonds issued at par, at a discount, or at a premium, recording interest at the effective rate or by the straight-line method.
LO14-3Characterize the accounting treatment of notes, including installment notes, issued for cash or for noncash consideration.
LO14-4Describe the disclosures appropriate to long-term debt in its various forms.
LO14-5Record the early extinguishment of debt and its conversion into equity securities.
LO14-6Understand the option to report liabilities at their fair values.
LO14-7Discuss the primary differences between U.S. GAAP and IFRS with respect to accounting for bonds and long-term notes.
Lecture Outline
Part A: Bonds
I.Nature of Long-Term Debt (T14-1)
A.Liabilities signify creditors’ interest in a company’s assets.
B.Debt requires the future payment of cash in specified (or estimated) amounts, at specified (or projected) dates.
C.As time passes, interest accrues on debt.
D.Periodic interest is the effective interest rate times the amount of the debt outstanding during the interest period.
E.Reported at present value of its related cash flows (principal and/or interest payments), discounted at the effective rate of interest at issuance.
II.Bonds
A.Divide a large liability into many smaller liabilities (usually $1,000 per bond).
B.Obligate a company to repay a stated amount at a specified maturity date and periodic interest between the issue date and maturity.
C.Require periodic interest as a stated percentage of the face amount.
D.Pay interest semiannually (usually) on designated interest dates beginning six months after the day the bonds are “dated”
E.Make specific promises to bondholders who are described in a document called a bond indenture. (T14-2)
F.Represent a liability to the corporation that issues the bonds and an asset to a company that buys the bonds as an investment. (T14-3)
Issuer
Cash xxx
Bonds payable (face amount) xxx
Investor
Investment in bonds (face amount) xxx
Cash xxx
III.Pricing of Bonds (T14-4)
A.Supply and demand cause a bond to be priced to yield the market rate of interest for securities of similar risk and maturity.
1.Price can be calculated as the present value of all the cash flows required (principal and interest).
2.The discount rate is the market rate.
B.Other things being equal, the lower the perceived riskiness of the corporation issuing bonds, the higher the price those bonds will command.
C.When bond prices are quoted in financial media, they typically are stated in terms of a percentage of face amount. So, a price quote of 97 means a $1,000 bond will sell for $970; a bond priced at 102 will sell for $1,020.
IV.Interest
A.Interest accrues at the effective market rate of interest multiplied by the outstanding balance (during the interest period). (T14-5)
B.When only a portion of an expense is paid by the periodic cash interest payment, the remainder becomes a liability (or an addition to the already outstanding liability). So the difference increases the liability and is reflected as a reduction in the discount (a valuation account). (T14-6)
C.Because the balance of the debt changes each period, the dollar amount of interest (balance x rate) also will change each period. To keep up with the changing amounts, it usually is convenient to prepare a schedule that reflects the changes in the debt over its term to maturity. (T14-7)
D.If an accounting period ends between interest dates, it is necessary to record interest that has accrued since the last interest date. (T14-8)
- Alternatively, a company is permitted to allocate a discount or a premium equally to each period over the term to maturity if doing so produces results that are not materially different from the interest method. (T14-9)
V.Zero-Coupon Bonds
A zero-coupon bond pays no interest but, instead, offers a return in the form of a “deep discount” from the face amount.
VI.Debt Issue Costs Are Incurred in Connection with Issuing Bonds or Notes (T14-10)
A.They include legal and accounting fees and printing costs in addition to registration and underwriting fees.
B.Costs of issuing debt securities are recorded as a debit to an asset account, "debt issue costs."
C.The cost is amortized to expense over the term to maturity.
Part B: Long-Term Notes
I.Accounting for Notes
A.In concept, notes are accounted for in precisely the same way as bonds. (T14-11)
B.When a note is issued with an unrealistic interest rate, the effective market rate is used both to determine the amount recorded in the transaction and to record periodic interest thereafter. (T14-12)
1.Substance over form.
2.Accounting treatment is the same whether the amount is determined directly from the market value of the asset acquired (and thus the note, also) or indirectly as the present value of the note (and thus the value of the asset.
3.Also, both parties to the transaction should record periodic interest (interest expense to the borrower, interest revenue to the lender) at the effective rate, rather than the stated rate.
C.Installment notes are paid in installments, rather than by a single amount at maturity. (T14-13)
1.Installment payments are equal amounts each period.
2.Each payment includes both an amount that represents interest and an amount that represents a reduction of principal.
3.The periodic reduction of principal is sufficient that, at maturity, the note is completely paid.
- The installment amount is easily calculated by dividing the amount of the loan by the appropriate discount factor for the present value of an annuity.
II.Financial Statement Disclosure (T14-14)
A.On the balance sheet, disclosure should include, for all long-term borrowings, the aggregate amounts maturing and sinking fund requirements (if any) for each of the next five years.
B.Supplemental disclosures are needed for:
1.Off-balance-sheet credit or market risk.
2.Concentrations of credit risk.
3.The fair value of financial instruments.
Decision-Makers’ Perspective
A.Failure to properly consider risk in business decisions is one of the most costly, yet one of the most common, mistakes investors and creditors can make.
B.Long-term debt is one of the first places decision makers should look when trying to get a handle on risk.
C.Generally speaking, debt increases risk.
1.The debt to equity ratio, total liabilities/shareholders’ equity, often is calculated to measure the degree of risk.
2.Other things being equal, the higher the debt to equity ratio, the higher the risk.
D.Debt also can be an advantage by enhancing the return to shareholders.
1.This concept is known as leverage.
2.“Favorable financial leverage” occurs when a company earns a return on borrowed funds in excess of the cost of borrowing the funds, shareholders are provided with a total return greater than what could have been earned with equity funds alone.
E.Failure to pay interest as scheduled may cause several adverse consequences including bankruptcy.
1.One way to measure a company's ability to pay its obligations is by comparing interest payments with income available to pay those charges.
2.The times interest earned ratio is determined by dividing income before subtracting interest expense or income tax expense by interest expense.
- “Off-balance-sheet” financing and other commitments can increase risk.
Part C: Debt Retired Early, Convertible into Stock, or Providing an Option to Buy Stock
I.Early Extinguishment of Debt
A.A gain or loss on early extinguishment of debt should be recorded for the difference between the reacquisition price and the carrying amount of the debt.
- The gain or loss should be classified on the income statement as an extraordinary item only if it meets criteria for such reporting by being both (1) unusual and (2) infrequent.(T14-15)
II.Convertible Debt
- Convertible bonds are accounted for as straight debt.
- Stock or other financial instruments that a company is obligated to buy back (manditorily redeemable), must be reported in the balance sheet as a liability, not as shareholders’ equity.
III.Bonds With Detachable Warrants
The value of the equity feature is recorded separately for bonds issued with detachable warrants.
Part D: Fair Value Option
I.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.
II.If a company chooses the option to report at fair value, then it reports changes in fair value in its income statement. (T14-16)
IV.International Financial Reporting Standards
A.Differences in the definitions and requirements under these standards can result in the same instrument being classified differently between debt and equity under IFRS and U.S. GAAP. Most preferred stock (preference shares) is reported under IFRS as debt with the dividends reported in the income statement as interest expense. Under U.S. GAAP, that’s the case only for “manditorily redeemable” preferred stock. (T14-17)
B.Under IFRS, convertible debt is divided into its liability and equity elements. Under US GAAP, the entire issue price is recorded as debt. (T14-18)
Appendix A: Bonds Issued between Interest Dates
A.All bonds sell at their price plus any interest that has accrued since the last interest date. (T14-19)
B.face annual fraction of theaccrued
value xrate xannual period=interest
Appendix B: Troubled Debt Restructuring
A.The way a troubled debt restructuring is recorded depends on whether
1.The debt is settled at the time of the restructuring, or (T14-20)
2.The debt is continued, but with modified terms where the total cash to be paid
a.Is less than the carrying amount of the debt or (T14-21)
b.Exceeds the carrying amount of the debt. (T14-22)
PowerPoint Slides
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Teaching Transparency Masters
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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.
Reported at present value of its related cash flows (principal and/or interest payments), discounted at the effective rate of interest at issuance.
T14-1
Bonds
Debenturebond – secured only by the "full faith and credit" of the issuing corporation. No specific assets are pledged as security.
Mortgage bond – backed by a lien on specified real estate owned by the issuer.
Subordinated debenture – not entitled to receive any liquidation payments until the claims of other specified debt issues are satisfied.
Registered bond – interest checks are mailed directly to the owner, who is “registered” with the issuing company.
Callable (or redeemable) bonds – the call feature allows the issuing company to buy back, or "call", outstanding bonds from bondholders before their scheduled maturity date.
Serial bonds – retired in installments over all or part of the life of the issue. Each bond has its own specified maturity date.
Convertible bonds – retired as a consequence of bondholders choosing to convert them into shares of stock.
T14-2
Bonds Sold at Face Amount
On January 1, 2013, 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.
At Issuance (January 1)
Masterwear (Issuer)
Cash 700,000
Bonds payable (face amount) 700,000
United (Investor)
Investment in bonds (face amount) 700,000
Cash 700,000
T14-3
Determining the Selling Price
A bond issue will be priced by the marketplace to yield the market rate of interest for securities of similar risk and maturity.
Illustration – On January 1, 2013, 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 threeyears. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup, Inc.
Present value (price) of the bonds:
Present Values
Interest$42,000x 4.76654 * =$200,195
Principal$700,000x 0.66634 ** =466,438
Present value (price) of the bonds$666,633
*present value of an ordinary annuity of $1: n=6, i=7%
**present value of $1: n=6, i=7%
Note: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.
T14-4
JOURNAL ENTRIES AT ISSUANCE –
BONDS SOLD AT DISCOUNT
Masterwear (Issuer)
Cash (price calculated above) 666,633
Discount on bonds payable(difference) 33,367
Bonds payable (face amount) 700,000
United (Investor)
Investment in bonds (face amount) 700,000
Discount on bond investment (difference) 33,367
Cash (price calculated above) 666,633
T14-4 (continued)
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).
Continuing the previous example, interest recorded (as expense to the issuer and revenue to the investor) for the first six-month interest period is $46,664:
$666,633x[14% ÷ 2]=$46,664
Outstanding BalanceEffective Rate Effective Interest
However, the bond indenture calls for semiannual interest payments of only $42,000 – the stated rate (6%) times the face value ($700,000). The difference – $4,664 – increases the liability and is reflected as a reduction in the discount (a valuation account).
T14-5
Change in Debt When
Effective Interest Exceeds Cash Paid
The “unpaid” portion of the effective interest increases the existing liability.
Account Balances
Outstanding Bonds payable Discount on
Balance(face value)bonds
January 1 $ 666,633 = $700,000 less 33,367
Interest accrued at 7% 46,664
Portion of interest paid (42,000) (4,664)
June 30 $ 671,297 = $700,000 less 28,703
Interest accrues on the outstanding debt at the effective rate. Interest paid is the amount specified in the bond indenture – the stated rate times the face value.
T14-6
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)
Interest expense (market rate x outstanding bal.) 46,664
Discount on bonds payable (difference) 4,664
Cash(stated rate x face amount) 42,000
United (Investor)
Cash (stated rate x face amount) 42,000
Discount on bond investment (difference) 4,664
Interest revenue (market rate x outstanding bal.) 46,664
T14-6 (continued)
Amortization Schedule – Discount
Since less cash is paid each period than the effective interest, the unpaid difference increases the outstanding balance of the debt.
CashEffectiveIncrease inOutstanding
InterestInterestBalanceBalance
6% x Face Value7% x Outstanding DebtDiscount Reduction
1/01/13666,633
6/30/1342,000.07(666,633)=46,6644,664671,297
12/31/1342,000.07(671,297)=46,9914,991676,288
6/30/1442,000.07(676,288)=47,3405,340681,628
12/30/1442,000.07(681,628)=47,7145,714687,342
6/30/1442,000.07(687,342)=48,1146,114693,456
12/30/1442,000.07(693,456)= 48,544*6,544700,000
252,000285,36733,367
* rounded
T14-7
When Financial Statements Are Prepared Between Interest Dates
When an accounting period ends between interest dates, it is necessary to record interest that has accrued since the last interest date. For instance, if the fiscal years of Masterwear and United end on October 31, and interest was last paid and recorded on June 30, four months' interest must be accrued in a year-end adjusting entry. Since interest is recorded for only a portion of a semiannual period, amounts recorded are simply the amounts shown in the amortization schedule times the appropriate fraction of the semiannual period (in this case 4/6).
At October 31
Masterwear (Issuer)
Interest expense (4/6 x 46,991) 31,327
Discount on bonds payable (4/6 x 4,991) 3,327
Interest payable (4/6 x 42,000) 28,000
United (Investor)
Interest receivable (4/6 x 42,000) 28,000
Discount on bond investment (4/6 x 4,991) 3,327
Interest revenue (4/6 x 46,991) 31,327
T14-8
When Financial Statements Are Prepared Between Interest Dates
(continued)
Two months later, when semiannual interest is paid next, the remainder of the semiannual interest is allocated to the first two months of the next accounting year – November and December:
At the December 31 Interest Date
Masterwear (Issuer)
Interest expense (2/6 x 46,991) 15,664
Interest payable (from adjusting entry) 28,000
Discount on bonds payable (2/6 x 4,991) 1,664
Cash(stated rate x face amount) 42,000
United (Investor)
Cash (stated rate x face amount) 42,000
Discount on bond investment (2/6 x 4,991) 1,664
Interest receivable (from adjusting entry) 28,000
Interest revenue (2/6 x 46,991) 15,664
T14-8 (continued)
The Straight-Line Method – A Practical Expediency
By 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
Masterwear (Issuer)
Interest expense (to balance) 47,561
Discount on bonds payable (discount ÷ 6 periods) 5,561
Cash (stated rate x face amount) 42,000
United (Investor)
Cash (stated rate x face amount) 42,000
Discount on bond investment (discount ÷ 6 periods) 5,561
Interest revenue (to balance) 47,561
T14-9
Debt Issue Costs
With either publicly or privately sold debt, the issuing company will incur costs in connection with issuing bonds or notes, such as legal and accounting fees and printing costs in addition to registration and underwriting fees. These debt issue costs are recorded separately and are amortized over the term of the related debt.
For example, let’s assume issue costs in the previous illustration had been $12,000. The entries for the issuance of the bonds would include a separate asset account for the issue costs:
Cash (price minus issue costs) 723,530
Debt issue costs 12,000
Bonds payable (face value) 700,000
Premium on bonds payable (price minus face value) 35,530
Semiannual amortization of the asset would be:
Debt issue expense ($12,000 ÷ 6) 2,000
Debt issue costs 2,000
A conceptually more appealing treatment would be to reduce the recorded amount of the debt by the debt issue costs instead of recording the costs separately as an asset.