Bonds and Long-Term Notes

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


Subsequent PeriodsSubsequent Periods

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







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


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


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


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:





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:





Bond Date = Bond Date = 1/1/061/1/06

14-12


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


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


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




Stated Interest Rate = Stated Interest Rate = 10%10%



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







What is the selling price of these bonds?What is the selling price of these bonds?

14-16


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%


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


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



Discount on bond investment 73,605 Cash 926,395


Discount on bond investment 73,605 Cash 926,395


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


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


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



Discount on bonds payable 5,584 Cash 50,000


Discount on bonds payable 5,584 Cash 50,000



Discount on bond investment 5,584 Interest revenue 55,584


Discount on bond investment 5,584 Interest revenue 55,584


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:






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:






What is the selling price of these bonds?What is the selling price of these bonds?

14-23


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


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%


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



Premium on bonds payable 81,105 Bonds payable 1,000,000


Premium on bonds payable 81,105 Bonds payable 1,000,000



Premium on bond investment 81,105 Cash 1,081,105


Premium on bond investment 81,105 Cash 1,081,105


14-25


Period Cash


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:


Premium on bonds payable 6,756 Cash 50,000


Premium on bonds payable 6,756 Cash 50,000



Premium on bond investment 6,756 Interest revenue 43,244




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


Financial Statements Prepared Between Interest Dates

Date Description Debit CreditSep. 30 Interest receivable 25,000


Date Description Debit CreditSep. 30 Interest receivable 25,000



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


Date Description Debit CreditDec. 31 Cash 50,000

Interest receivable 25,000 Interest revenue 21,487 Premium on bond investment 3,513


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


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


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


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


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


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


Entries for the first interest period.Entries for the first interest period.


Discount on note payable 2,317 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


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.


Notes payable 10,933 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.

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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.

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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.

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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

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Description Debit CreditCash 10,000,000 Discount on bonds payable 161,000 Bonds payable 10,000,000 Paid-in capital from warrants 161,000







Journal entry at date of issuance of the bonds.

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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.

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Appendix 14

Troubled Debt Restructuring

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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.

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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 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.

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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.

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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.

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End of Chapter 14

Bonds and Long-Term Notes

Documents

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