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

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

BONDS AND BONDS AND LONG-TERM NOTESLONG-TERM NOTES

Chapter 14

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LiabilitiesLiabilities

. . . Resulting from past

transactions or events.

. . . Resulting from past

transactions or events.

. . . Arising from present obligations

to other entities . . .

. . . Arising from present obligations

to other entities . . .

Probable future

sacrifices or economic

benefits . . .

Probable future

sacrifices or economic

benefits . . .

Some liabilities are not contractual obligations and may not be payable in cash.

Notice that the definition of a liability involves the present, the future, and the past. It is a present responsibility, to sacrifice assets in the future, caused by a transaction or other event that already has happened.

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Long-Term DebtLong-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.

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Nature of Long-Term DebtNature of Long-Term Debt

Obligations that extend Obligations that extend beyond one year or the beyond one year or the

operating cycle, operating cycle, whichever is longerwhichever is longer

Obligations that extend Obligations that extend beyond one year or the beyond one year or the

operating cycle, operating cycle, whichever is longerwhichever is longer

Mirror image of an Mirror image of an assetasset

Mirror image of an Mirror image of an assetasset

Accrue interest Accrue interest expenseexpense

Accrue interest Accrue interest expenseexpense

Reported at present Reported at present valuevalue

Reported at present Reported at present valuevalue

Loan agreement Loan agreement restrictionsrestrictions

Loan agreement Loan agreement restrictionsrestrictions

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Bonds Bonds

Bond Selling PriceBond Selling Price

Bond CertificateBond Certificate

Interest PaymentsInterest Payments

Face Value Payment at Face Value Payment at End of Bond TermEnd of Bond Term

At Bond Issuance DateAt Bond Issuance Date

Company Company Issuing Issuing BondsBonds


Subsequent PeriodsSubsequent Periods

Investor Investor Buying Buying BondsBonds






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Bonds Sold at Face AmountBonds Sold at Face AmountOn 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.

Date Description Debit CreditJan. 1 Cash 700,000

Bonds payable 700,000


Bonds payable 700,000

Masterwear - IssuerMasterwear - Issuer

At Issuance (January 1)

Date Description Debit CreditJan. 1 Investment in bonds 700,000

Cash 700,000


Cash 700,000

United - InvestorUnited - Investor

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Determining the Selling PriceDetermining the Selling Price

Stated interest rate is: The bonds sells:

Below market rateAt a discount

(Cash received is less than face amount)

Equal to market rateAt face amount

(Cash received is equal to face amount)

Above market rateAt a premium

(Cash received is greater than face amount)

Stated interest rate is: The bonds sells:

Below market rateAt a discount

(Cash received is less than face amount)

Equal to market rateAt face amount

(Cash received is equal to face amount)

Above market rateAt a premium

(Cash received is greater than face amount)

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Determining the Selling PriceDetermining the Selling PriceOn 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.

Present ValuesInterest $ 42,000 × 4.76654 = 200,195$ Principal $700000 × 0.66634 = 466,438

Present value (price) of bonds 666,633$

Calculation of the Price of the BondsPresent Values

Interest $ 42,000 × 4.76654 = 200,195$ Principal $700000 × 0.66634 = 466,438

Present value (price) of bonds 666,633$

Calculation of the Price of the Bonds

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 9

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Journal Entries at Issuance – Bonds Journal Entries at Issuance – Bonds Issued at a DiscountIssued at a Discount


Discount on bonds payable 33,367 Bonds payable 700,000


Discount on bonds payable 33,367 Bonds payable 700,000



Discount on bond investment 33,367 Cash 666,633


Discount on bond investment 33,367 Cash 666,633


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

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Journal Entries – The Interest MethodJournal 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)

Date Description Debit CreditJun. 30 Interest expense 46,664

Discount on bonds payable 4,664 Cash 42,000




Date Description Debit CreditJun. 30 Cash 42,000

Discount on bond investment 4,664 Interest revenue 46,664




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Change in Debt When Effective Interest Change in Debt When Effective Interest Exceeds Cash PaidExceeds Cash Paid

Outstanding Bonds Payable DiscountDate Interest Balance (Face Value) on Bonds

Jan. 1 666,633 = 700,000 – 33.367Accrued at 7%.07 × 666,633 = 46,664

Paid at 6%.06 × 700,000 = (42,000)

Unpaid

46,664 – 42,000 = (4,664)

Jun. 30 671,297 = 700,000 – 28,703

Jun. 30

Jun. 30

Jun. 30

Account BalancesOutstanding Bonds Payable Discount

Date Interest Balance (Face Value) on BondsJan. 1 666,633 = 700,000 – 33.367

Accrued at 7%.07 × 666,633 = 46,664

Paid at 6%.06 × 700,000 = (42,000)

Unpaid

46,664 – 42,000 = (4,664)

Jun. 30 671,297 = 700,000 – 28,703

Jun. 30

Jun. 30

Jun. 30

Account Balances

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.

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Amortization Schedule – DiscountAmortization Schedule – Discount

Since less cash is paid each period than the effective interest, theunpaid difference increases the outstanding balance of the debt.

Cash Effective Increase in OutstandingDate Interest Interest Balance Balance

(6% × Face (7% × Outstanding (DiscountAmount) Balance) Reduction)

01/01/09 666,633 06/30/09 42,000 .07 × 666,633 = 46,664 4,664 671,297 12/31/09 42,000 06/30/10 42,000 12/31/10 42,000 06/30/11 42,000 12/31/11 42,000

252,000



01/01/09 666,633 06/30/09 42,000 .07 × 666,633 = 46,664 4,664 671,297 12/31/09 42,000 06/30/10 42,000 12/31/10 42,000 06/30/11 42,000 12/31/11 42,000

252,000 6% × $700,000 $666,633 + 4,664

$46,664 – 42,0007% × $666,633

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Amortization Schedule – DiscountAmortization Schedule – DiscountCash Effective Increase in Outstanding

Date Interest Interest Balance Balance(6% × Face (7% × Outstanding (Discount

Amount) Balance) Reduction)01/01/09 666,633 06/30/09 42,000 .07 × 666,633 = 46,664 4,664 671,297 12/31/09 42,000 .07 × 671,633 = 46,991 4,991 676,288 06/30/10 42,000 .07 × 676,288 = 47,340 5,340 681,628 12/31/10 42,000 .07 × 681,628 = 47,714 5,714 687,342 06/30/11 42,000 .07 × 687,342 = 48,114 6,114 693,456 12/31/11 42,000 .07 × 693,456 = 48,544 6,544 700,000

252,000 285,367 33,367



01/01/09 666,633 06/30/09 42,000 .07 × 666,633 = 46,664 4,664 671,297 12/31/09 42,000 .07 × 671,633 = 46,991 4,991 676,288 06/30/10 42,000 .07 × 676,288 = 47,340 5,340 681,628 12/31/10 42,000 .07 × 681,628 = 47,714 5,714 687,342 06/30/11 42,000 .07 × 687,342 = 48,114 6,114 693,456 12/31/11 42,000 .07 × 693,456 = 48,544 6,544 700,000

252,000 285,367 33,367

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

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Zero-Coupon BondsZero-Coupon Bonds

These bonds do not pay interest. These bonds do not pay interest. Instead, they offer a return in the Instead, they offer a return in the

form of a “deep discount” from the form of a “deep discount” from the face amount. face amount.

These bonds do not pay interest. These bonds do not pay interest. Instead, they offer a return in the Instead, they offer a return in the

form of a “deep discount” from the form of a “deep discount” from the face amount. face amount.

Slide 16

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When Financial Statements Are Prepared When Financial Statements Are Prepared Between Interest DatesBetween Interest Dates

On 1/1/09, Masterwear Industries issues $700,000 face On 1/1/09, Masterwear Industries issues $700,000 face value bonds to United Intergroup. The market interest value bonds to United Intergroup. The market interest

rate is rate is 14%14%. . The bonds have the following terms:The bonds have the following terms:

Face Value of Each Bond = $1,000Face Value of Each Bond = $1,000

Maturity Date = 12/31/11 (3 years) Maturity Date = 12/31/11 (3 years)

Stated Interest Rate = Stated Interest Rate = 12%12%

Interest Dates = 6/30 & 12/31Interest Dates = 6/30 & 12/31

Bond Date = 1/1/09Bond Date = 1/1/09

On 1/1/09, Masterwear Industries issues $700,000 face On 1/1/09, Masterwear Industries issues $700,000 face value bonds to United Intergroup. The market interest value bonds to United Intergroup. The market interest

rate is rate is 14%14%. . The bonds have the following terms:The bonds have the following terms:

Face Value of Each Bond = $1,000Face Value of Each Bond = $1,000

Maturity Date = 12/31/11 (3 years) Maturity Date = 12/31/11 (3 years)

Stated Interest Rate = Stated Interest Rate = 12%12%

Interest Dates = 6/30 & 12/31Interest Dates = 6/30 & 12/31

Bond Date = 1/1/09Bond Date = 1/1/09

Assume Masterwear and United both have Assume Masterwear and United both have September 30September 30thth year-ends. year-ends.

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Recall the entries we prepared on June 30, 2009.Recall the entries we prepared on June 30, 2009.These entries will not change.These entries will not change.












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Year-end is on September 30, 2009, before the second Year-end is on September 30, 2009, before the second interest date of December 31, so we must accrue interest interest date of December 31, so we must accrue interest

for 3 months from June 30 to September 30.for 3 months from June 30 to September 30.

Date Description Debit CreditSep. 30 Interest expense ($46,991 × 1/2) 23,496

Discount on bonds payable 2,496 Interest payable ($42,000 × 1/2) 21,000

Date Description Debit CreditSep. 30 Interest expense ($46,991 × 1/2) 23,496

Discount on bonds payable 2,496 Interest payable ($42,000 × 1/2) 21,000


Date Description Debit CreditSep. 30 Interest receivable 21,000


Date Description Debit CreditSep. 30 Interest receivable 21,000




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On December 31, the next interest payment date,On December 31, the next interest payment date,the following entries would be recorded.the following entries would be recorded.

Date Description Debit CreditDec. 31 Interest expense ($46,991 × 1/2) 23,496

Interest payable ($42,000 × 1/2) 21,000 Discount on bonds payable 2,496 Cash ($700,000 × 6%) 42,000

Date Description Debit CreditDec. 31 Interest expense ($46,991 × 1/2) 23,496

Interest payable ($42,000 × 1/2) 21,000 Discount on bonds payable 2,496 Cash ($700,000 × 6%) 42,000


Date Description Debit CreditDec.31 Cash 42,000

Discount on bond investment 2,496 Interest receivable 21,000 Interest revenue 23,496

Date Description Debit CreditDec.31 Cash 42,000

Discount on bond investment 2,496 Interest receivable 21,000 Interest revenue 23,496


Slide 20

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The Straight-Line Method – A Practical The Straight-Line Method – A Practical ExpediencyExpediency

Date Description Debit CreditJun.30 Interest expense (to balance) 47,561

Discount on bonds payable (total discount ÷ 6 periods) 5,561 Cash (stated rate × face amount) 42,000

Date Description Debit CreditJun.30 Interest expense (to balance) 47,561

Discount on bonds payable (total discount ÷ 6 periods) 5,561 Cash (stated rate × face amount) 42,000





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

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Fair Value OptionFair 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.

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Fair Value Option – ExampleFair Value Option – Example

Date Description Debit CreditDec. 31 Interest expense ($180,000 × 5%) 9,000

Discount on bonds payable 1,000 Cash ($200,000 × 4%) 8,000

Date Description Debit CreditDec. 31 Interest expense ($180,000 × 5%) 9,000

Discount on bonds payable 1,000 Cash ($200,000 × 4%) 8,000

Bonds payable 200,000$ Less: Unamortized discount (19,000) Book value 181,000$

Bonds payable 200,000$ Less: Unamortized discount (19,000) Book value 181,000$

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:

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On December 31, the fair value of the bonds was $183,000.

Bonds payable 200,000$ Less: Unamortized discount (19,000) Book value 181,000 Fair value of bonds 183,000 Fair value adjustment needed 2,000

Bonds payable 200,000$ Less: Unamortized discount (19,000) Book value 181,000 Fair value of bonds 183,000 Fair value adjustment needed 2,000

Fair Value Option – ExampleFair Value Option – Example

Rather than increasing the bonds payable account itself, we increase it indirectly with a valuation allowance (or contra) account:

Date Description Debit CreditDec. 31 Unrealized holding loss 2,000

Fair value adjustment 2,000

Date Description Debit CreditDec. 31 Unrealized holding loss 2,000

Fair value adjustment 2,000

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.

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Debt Issue CostsDebt Issue Costs

LegalLegal AccountingAccounting UnderwritingUnderwriting CommissionCommission EngravingEngraving PrintingPrinting RegistrationRegistration Promotion Promotion

Slide 25

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Long-Term NotesLong-Term Notes

Present value techniques are used for Present value techniques are used for valuation and interest recognition.valuation and interest recognition.

The procedures are similar to those we The procedures are similar to those we encountered with bonds. encountered with bonds.

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Long-Term NotesLong-Term Notes

On January 1, 2009, Skill Graphics, Inc., a product labelingand 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.


Notes payable 700,000


Notes payable 700,000

Skill Graphics (Borrower)

At Issuance

Date Description Debit CreditJan. 1 Notes receivable 700,000

Cash 700,000


Cash 700,000

First BancCorp (Lender)

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Long-Term Notes (continued)Long-Term Notes (continued)At Each of the Six Interest Dates

Date Description Debit CreditInterest expense 42,000 Cash 42,000

Date Description Debit CreditInterest expense 42,000 Cash 42,000


Date Description Debit CreditCash 42,000 Interest revenue 42,000

Date Description Debit CreditCash 42,000 Interest revenue 42,000


At Maturity

Date Description Debit CreditNotes payable 700,000 Cash 700,000

Date Description Debit CreditNotes payable 700,000 Cash 700,000


Date Description Debit CreditCash 700,000 Notes receivable 700,000

Date Description Debit CreditCash 700,000 Notes receivable 700,000


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Note Exchanged for Assets or ServicesNote Exchanged for Assets or Services


Present value (price) of note 666,633$


Present value (price) of note 666,633$

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).

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Note Exchanged for Assets or ServicesNote Exchanged for Assets or ServicesAt the Purchase Date (January 1)

Skill Graphics(Buyer/Issuer)

Date Description Debit CreditJan. 1 Machinery 666,633

Discount on notes payable 33,367 Notes payable 700,000

Date Description Debit CreditJan. 1 Machinery 666,633

Discount on notes payable 33,367 Notes payable 700,000


Discount on notes receivable 33,367 Sales revenue 666,633


Discount on notes receivable 33,367 Sales revenue 666,633

Hughes–Barker(Seller/Lender

At the First Interest Date (June 30)

Skill Graphics(Buyer/Issuer)


Discount on notes payable 33,367 4,644 Cash 42,000


Discount on notes payable 33,367 4,644 Cash 42,000


Discount on notes receivable 4,644 Interest revenue 46,664


Discount on notes receivable 4,644 Interest revenue 46,664

Hughes–Barker(Seller/Lender

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Installment NotesInstallment Notes

o To compute cash payment use To compute cash payment use present value tables.present value tables.

o Interest expense or revenue:Interest expense or revenue: Effective interest rateEffective interest rate× Outstanding balance of debt× Outstanding balance of debt Interest expense or revenueInterest expense or revenue

o Principal reduction:Principal reduction: Cash amountCash amount– – Interest componentInterest component Principal reduction per periodPrincipal reduction per period

o To compute cash payment use To compute cash payment use present value tables.present value tables.

o Interest expense or revenue:Interest expense or revenue: Effective interest rateEffective interest rate× Outstanding balance of debt× Outstanding balance of debt Interest expense or revenueInterest expense or revenue

o Principal reduction:Principal reduction: Cash amountCash amount– – Interest componentInterest component Principal reduction per periodPrincipal reduction per period

Slide 31

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Installment NotesInstallment Notes

Cash Effective Decrease OutstandingDate Payment Interest in Debt Balance

(7% × OutstandingBalance)

01/01/09 666,633 06/30/09 139,857 .07 × 666,633 = 46,664 93,193 573,440 12/31/09 139,857 .07 × 573,440 = 40,141 99,716 473,724 06/30/10 139,857 .07 × 473,724 = 33,161 106,696 367,028 12/31/10 139,857 .07 × 367,028 = 25,692 114,165 252,863 06/30/11 139,857 .07 × 252,863 = 17,700 122,157 130,706 12/31/11 139,857 .07 × 130,706 = 9,151 130,706 -

839,142 172,509 666,633

Cash Effective Decrease OutstandingDate Payment Interest in Debt Balance

(7% × OutstandingBalance)

01/01/09 666,633 06/30/09 139,857 .07 × 666,633 = 46,664 93,193 573,440 12/31/09 139,857 .07 × 573,440 = 40,141 99,716 473,724 06/30/10 139,857 .07 × 473,724 = 33,161 106,696 367,028 12/31/10 139,857 .07 × 367,028 = 25,692 114,165 252,863 06/30/11 139,857 .07 × 252,863 = 17,700 122,157 130,706 12/31/11 139,857 .07 × 130,706 = 9,151 130,706 -

839,142 172,509 666,633

$666,633 ÷ 4.76654 = $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

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Early Extinguishment of DebtEarly Extinguishment of Debt

Debt retired at maturity results Debt retired at maturity results in no gains or losses. in no gains or losses.

Debt retired at maturity results Debt retired at maturity results in no gains or losses. in no gains or losses.

Debt retired before maturity may result in an Debt retired before maturity may result in an gaingain or lossor loss on extinguishment. on extinguishment.

Cash Proceeds – Book Value = Gain or LossCash Proceeds – Book Value = Gain or Loss

Debt retired before maturity may result in an Debt retired before maturity may result in an gaingain or lossor loss on extinguishment. on extinguishment.

Cash Proceeds – Book Value = Gain or LossCash Proceeds – Book Value = Gain or Loss

BUTBUT

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Early ExtinguishmentEarly Extinguishment

Date Description Debit CreditJan. 1 Bonds payable 700,000

Loss on early extinguishment 8,710 Discount on bonds payable 23,710 Cash 685,000

Date Description Debit CreditJan. 1 Bonds payable 700,000

Loss on early extinguishment 8,710 Discount on bonds payable 23,710 Cash 685,000

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

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Financial Statement DisclosuresFinancial Statement Disclosures

Long-Term DebtLong-Term Debt

Long-term liabilities Bonds payable, face amount 50,000,000$ Less: unamortized discount (244,875) unamortized issue costs (127,500) Bonds payable, net 49,627,625$

Matrix, Inc.Partial Balance Sheet

December 31, 2009

For all long-term borrowing, disclosures should For all long-term borrowing, disclosures should include the aggregate amounts maturing and include the aggregate amounts maturing and

sinking fund requirement, if any, for each of the sinking fund requirement, if any, for each of the next five years.next five years.

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Times interest Times interest earned ratioearned ratio ==

Net income + interest + taxesNet income + interest + taxesInterestInterest

Decision Makers’ PerspectiveDecision Makers’ Perspective

Long-term debt impacts several key Long-term debt impacts several key financial ratios.financial ratios.

Debt toDebt toequity ratioequity ratio

Total liabilitiesTotal liabilitiesShareholders’ equityShareholders’ equity==

Rate of return on Rate of return on shareholders’ equityshareholders’ equity

Net incomeNet incomeShareholders’ equityShareholders’ equity==

Rate of return Rate of return on assetson assets

Net incomeNet incomeTotal assetsTotal assets

==

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Convertible BondsConvertible Bonds

Some bonds may be converted into common Some bonds may be converted into common stock at the option of the holder. When bonds stock at the option of the holder. When bonds

are converted the issuer updates interest are converted the issuer updates interest expense and amortization of discount or expense and amortization of discount or premium to the date of conversion. The premium to the date of conversion. The

bonds are reduced and shares of common bonds are reduced and shares of common stock are increased.stock are increased.

Bonds into Stock

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Induced ConversionInduced Conversion

Companies sometimes try to induce conversion of their bonds into stock. One

way to induce conversion is through a “call” provision. When the specified call

price is less than the conversion value of the bonds (the market value of the

shares), calling the convertible bonds provides bondholders with incentive to convert. Bondholders will choose the

shares rather than the lower call price.

Companies sometimes try to induce conversion of their bonds into stock. One

way to induce conversion is through a “call” provision. When the specified call

price is less than the conversion value of the bonds (the market value of the

shares), calling the convertible bonds provides bondholders with incentive to convert. Bondholders will choose the

shares rather than the lower call price.

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Bonds With Detachable WarrantsBonds With Detachable Warrants

Stock warrants provide the option Stock warrants provide the option to purchase a specified number of to purchase a specified number of shares of common stock at a shares of common stock at a specified option price per share specified option price per share within a stated period.within a stated period.

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

Stock warrants provide the option Stock warrants provide the option to purchase a specified number of to purchase a specified number of shares of common stock at a shares of common stock at a specified option price per share specified option price per share within a stated period.within a stated period.

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

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Bonds With Detachable WarrantsBonds With Detachable Warrants

Matrix issues at par 10,000, $1,000 face value, 8% Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the debt with detachable warrants that permit the

holder to purchase one share of stock for $18 per holder to purchase one share of stock for $18 per share. Immediately after issue the bonds were share. Immediately after issue the bonds were

selling for 98 without the warrants and the warrants selling for 98 without the warrants and the warrants have a market value of $16. have a market value of $16.

Matrix issues at par 10,000, $1,000 face value, 8% Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the debt with detachable warrants that permit the

holder to purchase one share of stock for $18 per holder to purchase one share of stock for $18 per share. Immediately after issue the bonds were share. Immediately after issue the bonds were

selling for 98 without the warrants and the warrants selling for 98 without the warrants and the warrants have a market value of $16. have a market value of $16.

Fair value of bonds without warrants 9,800,000$ 98.39%Fair value of the warrants 160,000 1.61%Aggregrate fair value 9,960,000$ 100.00%

Allocate to bonds $10,000,000 x 98.39% $ 9,839,000 Allocate to warrants $10,000,000 x 1.61% 161,000 Total face value $ 10,000,000

Proportional Method

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Troubled Debt Restructuring - AppendixTroubled Debt Restructuring - Appendix

Troubled debt may beTroubled debt may berestructured in one of two ways:restructured in one of two ways:

Troubled debt may beTroubled debt may berestructured in one of two ways:restructured in one of two ways:

SettledSettled at timeat timeof restructuring.of restructuring.

SettledSettled at timeat timeof restructuring.of restructuring.

Continued Continued withwithmodifiedmodified terms.terms.

Continued Continued withwithmodifiedmodified terms.terms.

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SettledSettled at time of restructuring.at time of restructuring.SettledSettled at time of restructuring.at time of restructuring.

Book value of the debtBook value of the debt

– – Fair value of asset transferredFair value of asset transferred

GainGain on restructuring on restructuring

Book value of the debtBook value of the debt

– – Fair value of asset transferredFair value of asset transferred

GainGain on restructuring on restructuring

Debtor reports Debtor reports ordinary gain or lossordinary gain or loss on onadjustment to fair value of the asset transferred.adjustment to fair value of the asset transferred.

Debtor reports Debtor reports ordinary gain or lossordinary gain or loss on onadjustment to fair value of the asset transferred.adjustment to fair value of the asset transferred.

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ContinuedContinued with with modified modified terms.terms.ContinuedContinued with with modified modified terms.terms.

ReduceReduce or delay or delayinterestinterest payments. payments.ReduceReduce or delay or delay

interestinterest payments. payments.ReduceReduce or delay or delay

maturitymaturity payment. payment.ReduceReduce or delay or delay

maturitymaturity payment. payment.

Accounting treatment depends on a comparison Accounting treatment depends on a comparison of total cash payments after restructuring with of total cash payments after restructuring with

the book value of the original debt.the book value of the original debt.

Accounting treatment depends on a comparison Accounting treatment depends on a comparison of total cash payments after restructuring with of total cash payments after restructuring with

the book value of the original debt.the book value of the original debt.

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Troubled Debt RestructuringTroubled Debt Restructuring

ContinuedContinued withwith modifiedmodified terms.terms.ContinuedContinued withwith modifiedmodified terms.terms.

Cash payments Cash payments lessless than thanbook value of debt.book value of debt.

Cash payments Cash payments lessless than thanbook value of debt.book value of debt.

Cash payments Cash payments moremore than thanbook value of debt.book value of debt.

Cash payments Cash payments moremore than thanbook value of debt.book value of debt.

Debtor reports differenceDebtor reports differenceas a gain.as a gain.

All cash payments areAll cash payments arereductions in principal.reductions in principal.

(No interest)(No interest)

Debtor reports differenceDebtor reports differenceas a gain.as a gain.

All cash payments areAll cash payments arereductions in principal.reductions in principal.

(No interest)(No interest)

No gain reported.No gain reported.

Compute newCompute neweffective interest rate.effective interest rate.

Record annualRecord annualinterest at new rate.interest at new rate.

No gain reported.No gain reported.

Compute newCompute neweffective interest rate.effective interest rate.

Record annualRecord annualinterest at new rate.interest at new rate.

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

End of Chapter 14End of Chapter 14

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