Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Bonds and Long-Term
Notes
14
14-2
Learning Objectives
Identify the underlying characteristicsof debt instruments and describe the
basic approach to accounting for debt.
14-3
Nature 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
14-4
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
Company Company Issuing Issuing BondsBonds
Subsequent PeriodsSubsequent Periods
Investor Investor Buying Buying BondsBonds
Investor Investor Buying Buying BondsBonds
Company Company Issuing Issuing BondsBonds
Company Company Issuing Issuing BondsBonds
Investor Investor Buying Buying BondsBonds
Investor Investor Buying Buying BondsBonds
14-5
The Bond Indenture
Debenture BondDebenture BondDebenture BondDebenture Bond Mortgage BondMortgage BondMortgage BondMortgage Bond
Subordinated Subordinated DebentureDebenture
Subordinated Subordinated DebentureDebenture
Coupon BondsCoupon BondsCoupon BondsCoupon Bonds
CallableCallableCallableCallable
Sinking FundSinking FundSinking FundSinking Fund Serial BondsSerial BondsSerial BondsSerial Bonds
Convertible BondsConvertible BondsConvertible BondsConvertible Bonds
The The indentureindenture is the written specific promises is the written specific promises made by the company to the bondholders.made by the company to the bondholders.
Types of BondsTypes of Bonds
14-6
Bonds
BOND PAYABLEBOND PAYABLE
Face Value $1,000Face Value $1,000 Interest 10%
6/30 & 12/316/30 & 12/31
Maturity Date 12/31/15Maturity Date 12/31/15Bond Date 1/1/06Bond Date 1/1/06
1. 1. Face value (maturity or par value)Face value (maturity or par value)2. 2. Maturity DateMaturity Date3. 3. Stated Interest RateStated Interest Rate 4.4. Interest Payment DatesInterest Payment Dates5. Bond Date5. Bond Date
Other Factors:Other Factors:6. Market Interest Rate6. Market Interest Rate7. Issue Date7. Issue Date
14-7
Learning Objectives
Account for bonds issued at par, at a discount,or at a premium, recording interest at the
effective rate or by the straight-line method.
14-8
Recording Bonds at Issuance
On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to Apex, Inc. The market interest rate is 10%. The bonds Apex, Inc. The market interest rate is 10%. The bonds
have the following terms:have the following terms:
Face Value = $1,000Face Value = $1,000
Maturity Date = 12/31/10 (5 years) Maturity Date = 12/31/10 (5 years)
Stated Interest Rate = 10%Stated Interest Rate = 10%
Interest Dates = 6/30 & 12/31Interest Dates = 6/30 & 12/31
Bond Date = 1/1/06Bond Date = 1/1/06
On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to Apex, Inc. The market interest rate is 10%. The bonds Apex, Inc. The market interest rate is 10%. The bonds
have the following terms:have the following terms:
Face Value = $1,000Face Value = $1,000
Maturity Date = 12/31/10 (5 years) Maturity Date = 12/31/10 (5 years)
Stated Interest Rate = 10%Stated Interest Rate = 10%
Interest Dates = 6/30 & 12/31Interest Dates = 6/30 & 12/31
Bond Date = 1/1/06Bond Date = 1/1/06
Record the issuance of the bonds on 1/1/06.Record the issuance of the bonds on 1/1/06.
14-9
Recording Bonds at Issuance
Date Description Debit CreditJan. 1 Cash 1,000,000
Bonds payable 1,000,000
Date Description Debit CreditJan. 1 Cash 1,000,000
Bonds payable 1,000,000
Matrix, Inc. - IssuerMatrix, Inc. - Issuer
Date Description Debit CreditJan. 1 Investment in bonds 1,000,000
Cash 1,000,000
Date Description Debit CreditJan. 1 Investment in bonds 1,000,000
Cash 1,000,000
Apex, Inc. - InvestorApex, Inc. - Investor
14-10
Bonds Issued Between Interest Dates
Interest begins to accrue on the date the bonds Interest begins to accrue on the date the bonds are dated. If the bonds are issued after the day are dated. If the bonds are issued after the day they are dated, the investor would be asked to they are dated, the investor would be asked to
pay the company accrued interest. On the pay the company accrued interest. On the interest payment date, the investor will receive a interest payment date, the investor will receive a
check for the full period’s interest.check for the full period’s interest.
Interest begins to accrue on the date the bonds Interest begins to accrue on the date the bonds are dated. If the bonds are issued after the day are dated. If the bonds are issued after the day they are dated, the investor would be asked to they are dated, the investor would be asked to
pay the company accrued interest. On the pay the company accrued interest. On the interest payment date, the investor will receive a interest payment date, the investor will receive a
check for the full period’s interest.check for the full period’s interest.
1/1/06
BondsDated
1/12/06
BondsSold
6/30/06
First InterestPayment Date
14-11
Bonds Issued Between Interest Dates
On On 1/12/061/12/06, Matrix, Inc. issues 1,000 bonds at face value plus , Matrix, Inc. issues 1,000 bonds at face value plus accrued interest to Apex, Inc. The market interest rate is accrued interest to Apex, Inc. The market interest rate is
10%. The bonds have the following terms:10%. The bonds have the following terms:
Face Value = $1,000Face Value = $1,000
Maturity Date = 12/31/10 (5 years) Maturity Date = 12/31/10 (5 years)
Stated Interest Rate = 10%Stated Interest Rate = 10%
Interest Dates = 6/30 & 12/31Interest Dates = 6/30 & 12/31
Bond Date = Bond Date = 1/1/061/1/06
On On 1/12/061/12/06, Matrix, Inc. issues 1,000 bonds at face value plus , Matrix, Inc. issues 1,000 bonds at face value plus accrued interest to Apex, Inc. The market interest rate is accrued interest to Apex, Inc. The market interest rate is
10%. The bonds have the following terms:10%. The bonds have the following terms:
Face Value = $1,000Face Value = $1,000
Maturity Date = 12/31/10 (5 years) Maturity Date = 12/31/10 (5 years)
Stated Interest Rate = 10%Stated Interest Rate = 10%
Interest Dates = 6/30 & 12/31Interest Dates = 6/30 & 12/31
Bond Date = Bond Date = 1/1/061/1/06
14-12
Bonds Issued Between Interest Dates
Accrued InterestAccrued Interest$1,000,000 $1,000,000 × 10% = $100,000 × 10% = $100,000 ÷ 360 days = ÷ 360 days =
$277.78 interest per day$277.78 interest per day
11 days × $277.78 = $3,055.5611 days × $277.78 = $3,055.56
Matrix - IssuerMatrix - Issuer
Apex - InvestorApex - Investor
14-13
Bonds Issued Between Interest Dates
At the first interest dateAt the first interest date$1,000,000 $1,000,000 × 10% × ½ = $50,000 cash× 10% × ½ = $50,000 cash
Date Description Debit CreditJun. 30 Interest expense 46,944
Interest payable 3,056 Cash 50,000
Matrix - IssuerMatrix - Issuer
Date Description Debit CreditJun. 30 Cash 50,000
Interest receivable 3,056 Interest revenue 46,944
Apex - InvestorApex - Investor
14-14
Determining the Selling Price
Stated interest rate is The bonds sells:
Above market rateAt a premium
(Cash received is greater than face amount)
Equal to market rateAt face amount
(Cash received is equal to face amount)
Below market rateAt a discount
(Cash received is less than face amount)
Stated interest rate is The bonds sells:
Above market rateAt a premium
(Cash received is greater than face amount)
Equal to market rateAt face amount
(Cash received is equal to face amount)
Below market rateAt a discount
(Cash received is less than face amount)
14-15
Determining the Selling Price
On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to Apex, Inc. The market interest rate is Apex, Inc. The market interest rate is 12%12%. The bonds . The bonds
have the following terms:have the following terms:
Face Value = $1,000Face Value = $1,000
Maturity Date = 12/31/10 (5 years) Maturity Date = 12/31/10 (5 years)
Stated Interest Rate = Stated Interest Rate = 10%10%
Interest Dates = 6/30 & 12/31Interest Dates = 6/30 & 12/31
Bond Date = 1/1/06Bond Date = 1/1/06
On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to Apex, Inc. The market interest rate is Apex, Inc. The market interest rate is 12%12%. The bonds . The bonds
have the following terms:have the following terms:
Face Value = $1,000Face Value = $1,000
Maturity Date = 12/31/10 (5 years) Maturity Date = 12/31/10 (5 years)
Stated Interest Rate = Stated Interest Rate = 10%10%
Interest Dates = 6/30 & 12/31Interest Dates = 6/30 & 12/31
Bond Date = 1/1/06Bond Date = 1/1/06
What is the selling price of these bonds?What is the selling price of these bonds?
14-16
Determining the Selling Price
n = 5 years n = 5 years × 2 payments per year = × 2 payments per year = 1010i = 12% ÷ 2 payments per year = i = 12% ÷ 2 payments per year = 6%6%
Interest annuity = $1,000,000 × 10% ÷ 2 = Interest annuity = $1,000,000 × 10% ÷ 2 = $50,000$50,000
Principal 1,000,000$
PV $1* 0.55839 558,390$
Interest 50,000$
PV annuity $1* 7.36009 368,005
Bond issue price 926,395$
*n = 10, i = 6%
Principal 1,000,000$
PV $1* 0.55839 558,390$
Interest 50,000$
PV annuity $1* 7.36009 368,005
Bond issue price 926,395$
*n = 10, i = 6%
Bonds issued at a Bonds issued at a discountdiscount..
14-17
Determining the Selling Price
Date Description Debit CreditJan. 1 Cash 926,395
Discount on bonds payable 73,605 Bonds payable 1,000,000
Date Description Debit CreditJan. 1 Cash 926,395
Discount on bonds payable 73,605 Bonds payable 1,000,000
Matrix, Inc. - IssuerMatrix, Inc. - Issuer
Date Description Debit CreditJan. 1 Investment in bonds 1,000,000
Discount on bond investment 73,605 Cash 926,395
Date Description Debit CreditJan. 1 Investment in bonds 1,000,000
Discount on bond investment 73,605 Cash 926,395
Apex, Inc. - InvestorApex, Inc. - Investor
14-18
Determining Interest
Effective Interest MethodEffective Interest Method(Effective rate multiplied by the outstanding balance of the debt)(Effective rate multiplied by the outstanding balance of the debt)
Period Cash
Interest Effective Interest
Increase in Balance
Outstanding Balance
1/1/06 926,395$
6/30/06 50,000$ 55,584 5,584 931,979
$926,395 × 6%$926,395 × 6%
$55,584 - $50,000 $55,584 - $50,000
$926,395 + $5,584 $926,395 + $5,584
14-19
Determining Interest
Effective Interest MethodEffective Interest Method(Effective rate multiplied by the outstanding balance of the debt)(Effective rate multiplied by the outstanding balance of the debt)
Period Cash
Interest Effective Interest
Increase in Balance
Outstanding Balance
1/1/06 926,395$
6/30/06 50,000$ 55,584 5,584 931,979
12/31/06 50,000 55,919 5,919 937,898
6/30/07 50,000 56,274 6,274 944,171
12/31/07 50,000 56,650 6,650 950,821
6/30/08 50,000 57,049 7,049 957,871
12/31/08 50,000 57,472 7,472 965,343
6/30/09 50,000 57,921 7,921 973,263
12/31/09 50,000 58,396 8,396 981,660 6/30/10 50,000 58,900 8,900 990,560
12/31/10 50,000 59,440 * 9,440 1,000,000
* rounded
14-20
Determining Interest
Date Description Debit CreditJun. 30 Interest expense 55,584
Discount on bonds payable 5,584 Cash 50,000
Date Description Debit CreditJun. 30 Interest expense 55,584
Discount on bonds payable 5,584 Cash 50,000
Matrix, Inc. - IssuerMatrix, Inc. - Issuer
Date Description Debit CreditJun. 30 Cash 50,000
Discount on bond investment 5,584 Interest revenue 55,584
Date Description Debit CreditJun. 30 Cash 50,000
Discount on bond investment 5,584 Interest revenue 55,584
Apex, Inc. - InvestorApex, Inc. - Investor
14-21
Zero-Coupon Bonds
These bonds do not pay interest. Instead, These bonds do not pay interest. Instead, they offer a return in the form of a “deep they offer a return in the form of a “deep discount” from the face amount. Those discount” from the face amount. Those
who invest in zero-coupon bonds who invest in zero-coupon bonds usually have tax-deferred or tax-exempt usually have tax-deferred or tax-exempt
status. status.
These bonds do not pay interest. Instead, These bonds do not pay interest. Instead, they offer a return in the form of a “deep they offer a return in the form of a “deep discount” from the face amount. Those discount” from the face amount. Those
who invest in zero-coupon bonds who invest in zero-coupon bonds usually have tax-deferred or tax-exempt usually have tax-deferred or tax-exempt
status. status.
14-22
Bonds Sold at a Premium
On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to Apex, Inc. The market interest rate is Apex, Inc. The market interest rate is 8%8%. The bonds have . The bonds have
the following terms:the following terms:
Face Value = $1,000Face Value = $1,000
Maturity Date = 12/31/10 (5 years) Maturity Date = 12/31/10 (5 years)
Stated Interest Rate = Stated Interest Rate = 10%10%
Interest Dates = 6/30 & 12/31Interest Dates = 6/30 & 12/31
Bond Date = 1/1/06Bond Date = 1/1/06
On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to On 1/1/06, Matrix, Inc. issues 1,000 bonds at face value to Apex, Inc. The market interest rate is Apex, Inc. The market interest rate is 8%8%. The bonds have . The bonds have
the following terms:the following terms:
Face Value = $1,000Face Value = $1,000
Maturity Date = 12/31/10 (5 years) Maturity Date = 12/31/10 (5 years)
Stated Interest Rate = Stated Interest Rate = 10%10%
Interest Dates = 6/30 & 12/31Interest Dates = 6/30 & 12/31
Bond Date = 1/1/06Bond Date = 1/1/06
What is the selling price of these bonds?What is the selling price of these bonds?
14-23
Bonds Sold at a Premium
n = 5 years n = 5 years × 2 payments per year = × 2 payments per year = 1010i = 8% ÷ 2 payments per year = i = 8% ÷ 2 payments per year = 4%4%
Interest annuity = $1,000,000 × 10% ÷ 2 = Interest annuity = $1,000,000 × 10% ÷ 2 = $50,000$50,000
Principal 1,000,000$
PV $1* 0.67556 675,560$
Interest 50,000$
PV annuity $1* 8.11090 405,545
Bond issue price 1,081,105$
*n = 10, i = 4%
Principal 1,000,000$
PV $1* 0.67556 675,560$
Interest 50,000$
PV annuity $1* 8.11090 405,545
Bond issue price 1,081,105$
*n = 10, i = 4%Bonds issued at a Bonds issued at a premiumpremium..
14-24
Bonds Sold at a Premium
Date Description Debit CreditJan. 1 Cash 1,081,105
Premium on bonds payable 81,105 Bonds payable 1,000,000
Date Description Debit CreditJan. 1 Cash 1,081,105
Premium on bonds payable 81,105 Bonds payable 1,000,000
Matrix, Inc. - IssuerMatrix, Inc. - Issuer
Date Description Debit CreditJan. 1 Investment in bonds 1,000,000
Premium on bond investment 81,105 Cash 1,081,105
Date Description Debit CreditJan. 1 Investment in bonds 1,000,000
Premium on bond investment 81,105 Cash 1,081,105
Apex, Inc. - InvestorApex, Inc. - Investor
14-25
Bonds Sold at a Premium
Period Cash
Interest Effective Interest
Decrease in Balance
Outstanding Balance
1/1/06 1,081,105$
6/30/06 50,000$ 43,244 6,756 1,074,349
12/31/06 50,000 42,974 7,026 1,067,323
6/30/07 50,000 42,693 7,307 1,060,016
12/31/07 50,000 42,401 7,599 1,052,417
6/30/08 50,000 42,097 7,903 1,044,514
12/31/08 50,000 41,781 8,219 1,036,295
6/30/09 50,000 41,452 8,548 1,027,747
12/31/09 50,000 41,110 8,890 1,018,857 6/30/10 50,000 40,754 9,246 1,009,611
12/31/10 50,000 40,389 * 9,611 1,000,000
* rounded
14-26Financial Statements Prepared Between Interest Dates
Assume that in our previous example, Matrix, Inc. Assume that in our previous example, Matrix, Inc. and Apex, Inc. both have fiscal years that end on and Apex, Inc. both have fiscal years that end on
September 30. Let’s look at the June 30 entry:September 30. Let’s look at the June 30 entry:
Date Description Debit CreditJun. 30 Interest expense 43,244
Premium on bonds payable 6,756 Cash 50,000
Date Description Debit CreditJun. 30 Interest expense 43,244
Premium on bonds payable 6,756 Cash 50,000
Matrix, Inc. - IssuerMatrix, Inc. - Issuer
Date Description Debit CreditJun. 30 Cash 50,000
Premium on bond investment 6,756 Interest revenue 43,244
Date Description Debit CreditJun. 30 Cash 50,000
Premium on bond investment 6,756 Interest revenue 43,244
Apex, Inc. - InvestorApex, Inc. - Investor
14-27
Year-end is on September 30, 2006, before the Year-end is on September 30, 2006, before the second interest date of December 31.second interest date of December 31.
$42,974 $42,974 × ½ = $21,487 (3 months interest)× ½ = $21,487 (3 months interest)$ 7,026 × ½ = $ 3,513 (3 months amortization)$ 7,026 × ½ = $ 3,513 (3 months amortization)
Date Description Debit CreditSep. 30 Interest expense 21,487
Premium on bonds payable 3,513 Interest payable 25,000
Date Description Debit CreditSep. 30 Interest expense 21,487
Premium on bonds payable 3,513 Interest payable 25,000
Matrix, Inc. - IssuerMatrix, Inc. - Issuer
Financial Statements Prepared Between Interest Dates
Date Description Debit CreditSep. 30 Interest receivable 25,000
Premium on bond investment 3,513 Interest revenue 21,487
Date Description Debit CreditSep. 30 Interest receivable 25,000
Premium on bond investment 3,513 Interest revenue 21,487
Apex, Inc. - InvestorApex, Inc. - Investor
14-28Financial Statements Prepared Between Interest Dates
The entries at December 31, 2006.The entries at December 31, 2006.
Date Description Debit CreditDec. 31 Interest expense 21,487
Interest payable 25,000 Premium on bonds payable 3,513 Cash 50,000
Matrix, Inc. - IssuerMatrix, Inc. - Issuer
Date Description Debit CreditDec. 31 Cash 50,000
Interest receivable 25,000 Interest revenue 21,487 Premium on bond investment 3,513
Apex, Inc. - InvestorApex, Inc. - Investor
14-29
Straight-Line Method
The discount or The discount or premium is premium is
allocated allocated equallyequally to each period to each period
over the over the outstanding life outstanding life
of the bond.of the bond.
ConsideredConsideredpracticalpractical
andandexpedient.expedient.
ConsideredConsideredpracticalpractical
andandexpedient.expedient.
14-30
Straight-Line Method
In our last example, straight-lineIn our last example, straight-linepremium amortization would be:premium amortization would be:
$81,105 $81,105 ÷ 10 = ÷ 10 = $8,111 every six months$8,111 every six months..
In our last example, straight-lineIn our last example, straight-linepremium amortization would be:premium amortization would be:
$81,105 $81,105 ÷ 10 = ÷ 10 = $8,111 every six months$8,111 every six months..
14-31
Straight-Line Method
Period Cash
Interest Recorded
Interest Decrease in
Balance Outstanding
Balance 1/1/06 1,081,105$
6/30/06 50,000$ 41,889 8,111 1,072,994
12/31/06 50,000 41,889 8,111 1,064,883
6/30/07 50,000 41,889 8,111 1,056,772
12/31/07 50,000 41,889 8,111 1,048,661
6/30/08 50,000 41,889 8,111 1,040,550
12/31/08 50,000 41,889 8,111 1,032,439
6/30/09 50,000 41,889 8,111 1,024,328
12/31/09 50,000 41,889 8,111 1,016,217 6/30/10 50,000 41,889 8,111 1,008,106
12/31/10 50,000 41,894 * 8,106 1,000,000
* rounded
14-32
Debt Issue Costs
LegalLegal AccountingAccounting UnderwritingUnderwriting CommissionCommission EngravingEngraving PrintingPrinting RegistrationRegistration Promotion Promotion
14-33
Debt Issue Costs
These costs should be recorded These costs should be recorded separately and amortized over the term separately and amortized over the term of the related debt.of the related debt.
Straight-line amortization is often used. Straight-line amortization is often used.
These costs should be recorded These costs should be recorded separately and amortized over the term separately and amortized over the term of the related debt.of the related debt.
Straight-line amortization is often used. Straight-line amortization is often used.
14-34
Learning Objectives
Characterize the accounting treatment of notes including installment notes, issued for cash or
for noncash consideration.
14-35
Long-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.
14-36
Notes Exchanged for Assets or Services
On 1/1/06, Matrix, Inc. issued a $100,000, 3-year, On 1/1/06, Matrix, Inc. issued a $100,000, 3-year, 6% note in exchange for equipment owned by 6% note in exchange for equipment owned by Apex, Inc. Interest is paid every 12/31. The Apex, Inc. Interest is paid every 12/31. The
equipment does not have a ready market value. equipment does not have a ready market value. The appropriate rate of interest for notes of this The appropriate rate of interest for notes of this
type is 9%.type is 9%.
Let’s determine the present value of the note.Let’s determine the present value of the note.
On 1/1/06, Matrix, Inc. issued a $100,000, 3-year, On 1/1/06, Matrix, Inc. issued a $100,000, 3-year, 6% note in exchange for equipment owned by 6% note in exchange for equipment owned by Apex, Inc. Interest is paid every 12/31. The Apex, Inc. Interest is paid every 12/31. The
equipment does not have a ready market value. equipment does not have a ready market value. The appropriate rate of interest for notes of this The appropriate rate of interest for notes of this
type is 9%.type is 9%.
Let’s determine the present value of the note.Let’s determine the present value of the note.
14-37
Notes Exchanged for Assets or Services
Principal 100,000$
PV $1- n=3, i=9% 0.77218 77,218$
Interest ($100,000 x 6%) 6,000$
PV annuity $1 - n=3, i=9 2.53129 15,188
PV of note 92,406$
Principal 100,000$
PV $1- n=3, i=9% 0.77218 77,218$
Interest ($100,000 x 6%) 6,000$
PV annuity $1 - n=3, i=9 2.53129 15,188
PV of note 92,406$
14-38
Notes Exchanged for Assets or Services
Cash Effective Increase in OutstandingDate Interest Interest Balance Balance1/1/06 92,406$
12/31/06 6,000$ 8,317$ 2,317$ 94,723 12/31/07 6,000 8,525 2,525 97,248 12/31/08 6,000 8,752 2,752 100,000
Let’s prepare the entries on January 1.Let’s prepare the entries on January 1.
Amortization ScheduleAmortization Schedule
14-39
Notes Exchanged for Assets or Services
Date Description Debit CreditJan. 1 Equipment 92,406
Discount on note payable 7,594 Notes payable 100,000
Matrix, Inc. - PurchaserMatrix, Inc. - Purchaser
Date Description Debit CreditJan. 1 Notes receivable 100,000
Discount on notes receivable 7,594 Sales revenue 92,406
Apex, Inc. - SellerApex, Inc. - Seller
14-40
Notes Exchanged for Assets or Services
Entries for the first interest period.Entries for the first interest period.
Date Description Debit CreditDec. 31 Interest expense 8,317
Discount on note payable 2,317 Cash 6,000
Matrix, Inc. - PurchaserMatrix, Inc. - Purchaser
Date Description Debit CreditDec. 31 Cash 6,000
Discount on notes receivable 2,317 Interest revenue 8,317
Apex, Inc. - SellerApex, Inc. - Seller
14-41
Installment 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
14-42
Installment Notes
On January 1, 2006, Matrix, Inc. purchased a truck by On January 1, 2006, Matrix, Inc. purchased a truck by issuing a 4-year note payable to Apex Motors. The issuing a 4-year note payable to Apex Motors. The truck cost $50,000 and is financed at a 9% interest truck cost $50,000 and is financed at a 9% interest rate. Payments are made at the end of each of the rate. Payments are made at the end of each of the
next four years. Let’s calculate the annual payment.next four years. Let’s calculate the annual payment.
$50,000 $50,000 ÷ 3.23972 = $15,433 (rounded)÷ 3.23972 = $15,433 (rounded)$50,000 $50,000 ÷ 3.23972 = $15,433 (rounded)÷ 3.23972 = $15,433 (rounded)
PV of annuity of $1, n = 4, i = 9%PV of annuity of $1, n = 4, i = 9%
14-43
Installment Notes
Date Cash
Payment Effective Interest
Decrease in Debt
Outstanding Balance
1/1/06 50,000$
12/31/06 15,433$ 4,500$ 10,933$ 39,067
12/31/07 15,433 3,516 11,917 27,150
12/31/08 15,433 2,444 12,989 14,161
12/31/09 15,433 1,272 14,161 -
Here is our loan amortization table.Here is our loan amortization table.
14-44
Installment Notes
The entries on date of purchase are:The entries on date of purchase are:
Date Description Debit CreditJan. 1 Delivery truck 50,000
Notes payable 50,000
Matrix, Inc. - PurchaserMatrix, Inc. - Purchaser
Date Description Debit CreditJan. 1 Notes receivable 50,000
Sales revenue 50,000
Apex Motors - SellerApex Motors - Seller
14-45
Installment Notes
Date of first payment.Date of first payment.
Date Description Debit CreditDec. 31 Interest expense 4,500
Notes payable 10,933 Cash 15,433
Matrix, Inc. - PurchaserMatrix, Inc. - Purchaser
Date Description Debit CreditDec. 31 Cash 15,433
Interest revenue 4,500 Notes receivable 10,933
Apex Motors - SellerApex Motors - Seller
14-46
Learning Objectives
Describe the disclosures appropriateto long-term debt in its various forms.
14-47
Financial 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, 2006
For all long-term borrowing, disclosures should include For all long-term borrowing, disclosures should include the aggregate amounts maturing and sinking fund the aggregate amounts maturing and sinking fund
requirement, if any, for each of the next five years.requirement, if any, for each of the next five years.
14-48
Decision 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 Rate of return on assetson assets
Net incomeNet incomeTotal assetsTotal assets
==
Rate of return on Rate of return on shareholders’ equityshareholders’ equity
Net incomeNet incomeShareholders’ equityShareholders’ equity==
Times interest Times interest earned ratioearned ratio ==
Net income + interest + taxesNet income + interest + taxesInterestInterest
14-49
Learning Objectives
Record the early extinguishment of debtand its conversion into equity securities.
14-50
Early 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
14-51
Convertible Bonds
Some bonds may be converted into common Some bonds may be converted into common stock at the options of the holder. When stock at the options of the holder. When bonds are converted the issuer updates bonds are converted the issuer updates
interest expense and amortization of discount interest expense and amortization of discount or premium to the date of conversion. The or 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
14-52
Convertible Bonds
The Book Value MethodThe Book Value Method Record new stock at the Record new stock at the book valuebook value of the convertible of the convertible
bonds. No gain or loss is recognized.bonds. No gain or loss is recognized.
On December 31, 2006, all of the bondholders of Matrix, On December 31, 2006, all of the bondholders of Matrix, Inc. convert their bonds into common stock. There are Inc. convert their bonds into common stock. There are 10,000 bonds outstanding with a face value of $1,000 10,000 bonds outstanding with a face value of $1,000 each. Each bond is convertible into 50 shares of the each. Each bond is convertible into 50 shares of the
company’s $1 par value common stock. There is company’s $1 par value common stock. There is $1,500,000 on unamortized discount associated with the $1,500,000 on unamortized discount associated with the
bonds that are converted. Interest and discount bonds that are converted. Interest and discount amortization have been brought up to December 31.amortization have been brought up to December 31.
Let’s look at the entry to record the conversion.Let’s look at the entry to record the conversion.
On December 31, 2006, all of the bondholders of Matrix, On December 31, 2006, all of the bondholders of Matrix, Inc. convert their bonds into common stock. There are Inc. convert their bonds into common stock. There are 10,000 bonds outstanding with a face value of $1,000 10,000 bonds outstanding with a face value of $1,000 each. Each bond is convertible into 50 shares of the each. Each bond is convertible into 50 shares of the
company’s $1 par value common stock. There is company’s $1 par value common stock. There is $1,500,000 on unamortized discount associated with the $1,500,000 on unamortized discount associated with the
bonds that are converted. Interest and discount bonds that are converted. Interest and discount amortization have been brought up to December 31.amortization have been brought up to December 31.
Let’s look at the entry to record the conversion.Let’s look at the entry to record the conversion.
14-53
Convertible Bonds
Date Description Debit CreditDec. 31 Bonds payable 10,000,000
Discount on bonds payable 1,500,000 Common stock 500,000 Paid-in capital in excess of par 8,000,000
10,000 10,000 × 50 shares × $1 par value× 50 shares × $1 par value10,000 10,000 × 50 shares × $1 par value× 50 shares × $1 par value
The carrying value of the bonds is The carrying value of the bonds is assigned to the stock.assigned to the stock.
14-54
Induced 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.
14-55
Bonds With Detachable Warrants
Stock warrants provide the option to purchase Stock warrants provide the option to purchase a specified number of shares of common stock a specified number of shares of common stock at a specified option price per share within a at a specified option price per share within a stated period.stated period.
A portion of the selling price of the bonds is A portion of the selling price of the bonds is allocated to the detachable stock warrants.allocated to the detachable stock warrants.
Stock warrants provide the option to purchase Stock warrants provide the option to purchase a specified number of shares of common stock a specified number of shares of common stock at a specified option price per share within a at a specified option price per share within a stated period.stated period.
A portion of the selling price of the bonds is A portion of the selling price of the bonds is allocated to the detachable stock warrants.allocated to the detachable stock warrants.
14-56
Bonds With Detachable Warrants
Matrix issues at par 10,000, $1,000 face value, 8% debt with Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the holder to purchase detachable warrants that permit the holder to purchase
one share of stock for $18 per share. Immediately after the one share of stock for $18 per share. Immediately after the issue the bonds were selling for 98 without the warrants issue the bonds were selling for 98 without the warrants
and the warrants have a market value of $16. and the warrants have a market value of $16.
Matrix issues at par 10,000, $1,000 face value, 8% debt with Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the holder to purchase detachable warrants that permit the holder to purchase
one share of stock for $18 per share. Immediately after the one share of stock for $18 per share. Immediately after the issue the bonds were selling for 98 without the warrants issue the bonds were selling for 98 without the warrants
and the warrants have a market value of $16. and the warrants 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
14-57
Bonds With Detachable Warrants
Description Debit CreditCash 10,000,000 Discount on bonds payable 161,000 Bonds payable 10,000,000 Paid-in capital from warrants 161,000
Matrix issues at par 10,000, $1,000 face value, 8% debt with Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the holder to purchase detachable warrants that permit the holder to purchase
one share of stock for $18 per share. Immediately after the one share of stock for $18 per share. Immediately after the issue the bonds were selling for 98 without the warrants issue the bonds were selling for 98 without the warrants
and the warrants have a market value of $16. and the warrants have a market value of $16.
Matrix issues at par 10,000, $1,000 face value, 8% debt with Matrix issues at par 10,000, $1,000 face value, 8% debt with detachable warrants that permit the holder to purchase detachable warrants that permit the holder to purchase
one share of stock for $18 per share. Immediately after the one share of stock for $18 per share. Immediately after the issue the bonds were selling for 98 without the warrants issue the bonds were selling for 98 without the warrants
and the warrants have a market value of $16. and the warrants have a market value of $16.
Journal entry at date of issuance of the bonds.
14-58
Bonds With Detachable Warrants
Date Description Debit CreditCash 180,000 Paid-in capital from warrants 161,000 Common stock 10,000 Paid-in capital in excess of par 331,000
Assume that all 10,000 warrants are exercised Assume that all 10,000 warrants are exercised and Matrix received $180,000 (10,000 and Matrix received $180,000 (10,000 × $18 × $18 per share) and issues 10,000 shares of its $1 per share) and issues 10,000 shares of its $1
par value common stock.par value common stock.
Assume that all 10,000 warrants are exercised Assume that all 10,000 warrants are exercised and Matrix received $180,000 (10,000 and Matrix received $180,000 (10,000 × $18 × $18 per share) and issues 10,000 shares of its $1 per share) and issues 10,000 shares of its $1
par value common stock.par value common stock.
14-59
Appendix 14
Troubled Debt Restructuring
14-60
Troubled Debt Restructuring
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 time at timeof restructuring.of restructuring.
SettledSettled at time at timeof restructuring.of restructuring.
Continued Continued withwithmodifiedmodified terms.terms.
Continued Continued withwithmodifiedmodified terms.terms.
14-61
Troubled Debt Restructuring
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 reportsDebtor reports ordinary gainordinary gain
or loss or loss on onadjustment to adjustment to
fair value of thefair value of theasset transferred.asset transferred.
Debtor reportsDebtor reports ordinary gainordinary gain
or loss or loss on onadjustment to adjustment to
fair value of thefair value of theasset transferred.asset transferred.
14-62
Troubled Debt Restructuring
ContinuedContinued with with modified modified terms.terms.ContinuedContinued with with modified modified terms.terms.
ReduceReduce or delay or delayinterest interest payments.payments.ReduceReduce or delay or delay
interest interest payments.payments.ReduceReduce or delay or delay
maturitymaturity payment. payment.ReduceReduce or delay or delay
maturitymaturity payment. payment.
Accounting treatment depends on a comparison of Accounting treatment depends on a comparison of total cash payments after restructuring with the book total cash payments after restructuring with the book
value of the original debt.value of the original debt.
Accounting treatment depends on a comparison of Accounting treatment depends on a comparison of total cash payments after restructuring with the book total cash payments after restructuring with the book
value of the original debt.value of the original debt.
14-63
Troubled Debt Restructuring
ContinuedContinued with with modifiedmodified terms.terms.ContinuedContinued with with modifiedmodified terms.terms.
Cash payments Cash payments less less thanthanbook value of debt.book value of debt.
Cash payments Cash payments less less thanthanbook 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.
14-64
End of Chapter 14