Intermediate Chapter 14

Bonds Sold at Face Amount

Most bonds these days are issued on the day they are dated (date printed in the indenture contract)

A mortgage bond,

-is backed by a lien on specified real estate owned by the issuer. - Because a mortgage bond is considered less risky than debentures, it typically will command a lower interest rate.

Among the reasons for issuing convertible bonds rather than straight debt are

(a) to sell the bonds at a higher price (which means a lower effective interest cost) (b) to use as a medium of exchange in mergers and acquisitions, and (c) to enable smaller firms or debt-heavy companies to obtain access to the bond market. Sometimes convertible bonds serve as an indirect way to issue stock when there is shareholder resistance to direct issuance of additional equity.

The Nature of Long-Term Debt

- A company must raise funds to finance its operations and often the expansion of those operations. Presumably, at least some of the necessary funding can be provided by the company's own operations, though some funds must be provided by external sources. Ordinarily, external financing includes some combination of equity and debt funding

Other things being equal, the lower the perceived riskiness of the corporation issuing bonds, the higher the price those bonds will command.

- Forces of supply and demand cause a bond issue to be priced to yield the market rate. -In other words, an investor paying that price will earn an effective rate of return on the investment equal to the market rate. - The price is calculated as the present value of all the cash flows required of the bonds, where the discount rate used in the present value calculation is the market rate. Specifically, the price will be the present value of the periodic cash interest payments (face amount × stated rate) plus the present value of the principal payable at maturity, both discounted at the market rate.

Determining Interest—Effective Interest Method

- Interest accrues on an outstanding debt at a constant percentage of the debt each period. - Of course, under the concept of accrual accounting, the periodic effective interest is not affected by the time at which the cash interest actually is paid. -Recording interest each period as the effective market rate of interest multiplied by the outstanding balance of the debt (during the interest period) is referred to as the effective interest method.

Induced Conversion

- Investors often are reluctant to convert bonds to stock, even when share prices have risen significantly since the convertible bonds were purchased. - This is because the market price of the convertible bonds will rise along with market prices of the stock. So companies sometimes try to induce conversion. - The motivation might be to reduce debt and become a better risk to potential lenders or achieve a lower debt-to-equity ratio.

Bonds obligate the issuing corporation to repay a stated amount (variously referred to as the principal, par value, face amount, or maturity value) at a specified maturity date

- Maturities for bonds typically range from 10 to 40 years. - In return for the use of the money borrowed, the company also agrees to pay interest to bondholders between the issue date and maturity. -The periodic interest is a stated percentage of face amount (variously referred to as the stated rate, coupon rate, or nominal rate). - Ordinarily, interest is paid semiannually on designated interest dates beginning six months after the day the bonds are "dated."

Bonds

- Medium- and large-sized corporations often choose to borrow cash by issuing bonds to the public - In fact, the most common form of corporate debt is bonds. - A bond issue, in effect, breaks down a large debt (large corporations often borrow hundreds of millions of dollars at a time) into manageable parts—usually $1,000 or $5,000 units. -This avoids the necessity of finding a single lender who is both willing and able to loan a large amount of money at a reasonable interest rate.

Early Extinguishment of Debt

- Sometimes companies choose to retire debt before its scheduled maturity. In that case, a gain or a loss may result. - Earlier we noted that a call feature accompanies most bonds to protect the issuer against declining interest rates. Even when bonds are not callable, the issuing company can retire bonds early by purchasing them on the open market. - Regardless of the method, when debt of any type is retired prior to its scheduled maturity date, the transaction is referred to as early extinguishment of debt.

Note Issued for Cash

- The interest rate stated in a note is likely to be equal to the market rate because the rate usually is negotiated at the time of the loan. So discounts and premiums are less likely for notes than for bonds.

Determining the Selling Price

- The price of a bond issue at any particular time is not necessarily equal to its face amount. -The $700,000, 12% bond issue in the previous illustration, for example, may sell for more than face amount (at a premium) or less than face amount (at a discount), depending on how the 12% stated interest rate compares with the prevailing market or effective rate of interest (for securities of similar risk and maturity). - The reason the stated rate often differs from the market rate, resulting in a discount or premium, is the inevitable delay between the date the terms of the issue are established and the date the issue comes to market.

The Bond Indenture

- The specific promises made to bondholders are described in a document called a bond indenture - Because it would be impractical for the corporation to enter into a direct agreement with each of the many bondholders, the bond indenture is held by a trustee, usually a commercial bank or other financial institution, appointed by the issuing firm to represent the rights of the bondholders. -If the company fails to live up to the terms of the bond indenture, the trustee may bring legal action against the company on behalf of the bondholders.

Central to each of these reasons for issuing convertible debt is that the conversion feature is attractive to investors.

- This hybrid security has features of both debt and equity. - The owner has a fixed-income security that can become common stock if and when the firm's prosperity makes that feasible. - This increases the investor's upside potential while limiting the downside risk. - The conversion feature has monetary value. -Just how valuable it is depends on both the conversion terms and market conditions.

Long-Term Notes

- When a company borrows cash from a bank and signs a promissory note (essentially an IOU), the firm's liability is reported as a note payable. - Or a note might be issued in exchange for a noncash asset—perhaps to purchase equipment on credit. - In concept, notes are accounted for in precisely the same way as bonds.

Installment Notes

- You may have recently purchased a car, or maybe a house. If so, unless you paid cash, you signed a note promising to pay a portion of the purchase price over, say, five years for the car, or 30 years for the house. -Car and house notes usually call for payment in monthly installments rather than by a single amount at maturity. - Corporations, too, often borrow using installment notes. - Typically, installment payments are equal amounts each period. Each payment includes both an amount that represents interest and an amount that represents a reduction of the outstanding balance (principal reduction).

A note payable and a note receivable are two sides of the same coin.

- a liability requires the future payment of cash in specified (or estimated) amounts, at specified (or projected) dates. As time passes, interest accrues on debt. As a general rule, the periodic interest is the effective interest rate times the amount of the debt outstanding during the period. - Also, as a general rule, long-term liabilities are reported at their present values. The present value of a liability is the present value of its related cash flows (principal and/or interest payments), discounted at the effective rate of interest at issuance

Example

- if the 12% bonds are competing in a market in which similar bonds are providing a 14% return, the bonds could be sold only at a price less than $700,000. On the other hand, if the market rate is only 10%, the 12% stated rate would seem relatively attractive and the bonds would sell at a premium over face amount

For example,

- let's assume Skill Graphics purchased a package-labeling machine from Hughes-Barker Corporation by issuing a 12%, $700,000, three-year note that requires interest to be paid semiannually. Let's also assume that the machine could have been purchased at a cash price of $666,633. - exchanging this $700,000 note for a machine with a cash price of $666,633 implies an annual market rate of interest of 14%. That is, 7% is one-half the discount rate that yields a present value of $666,633 for the note's cash flows

To record the extinguishment,

- the account balances pertinent to the debt obviously must be removed from the books. - Of course cash is credited for the amount paid—the call price or market price. - The difference between the book value of the debt and the reacquisition price represents either a gain or a loss on the early extinguishment of debt. - When the debt is retired for less than book value, the debtor is in a favorable position and records a gain. The opposite occurs for a loss

For example, suppose the machine exchanged for the 12% note is custom-made for Skill Graphics so that no customary cash price is available with which to work backwards to find the implicit rate.

- the appropriate rate would have to be found externally. - It might be determined, for instance, that a more realistic interest rate for a transaction of this type, at this time, would be 14%. Then it would be apparent that Skill Graphics actually paid less than $700,000 for the machine and that part of the face amount of the note in effect makes up for the lower than normal interest rate. - the accountant should look beyond the form of this transaction and record its substance. - The amount actually paid for the machine is the present value of the cash flows called for by the loan agreement, discounted at the market rate—imputed in this case to be 14%. So both the asset acquired and the liability used to purchase it should be recorded at the real cost, $666,633.

accounting

- the currently accepted practice is to record the entire issue price as debt in precisely the same way as for nonconvertible bonds. -Treating the features as two inseparable parts of a single security avoids the practical difficulty of trying to measure the separate values of the debt and the conversion option. - Because of the inseparability of their debt and equity features, the entire issue price of convertible bonds is recorded as debt, as if they are nonconvertible bonds.

For installment notes,

- the outstanding balance of the note does not eventually become its face amount as it does for notes with designated maturity amounts. - Instead, at the maturity date the balance is zero. - The procedure is the same as for a note whose principal is paid at maturity, but the periodic cash payments are larger and there is no lump-sum payment at maturity. We calculated the amount of the payments so that after covering the interest on the existing debt each period, the excess would exactly amortize the debt to zero at maturity (rather than to a designated maturity amount).

implicit rate of interest

- the rate implicit in the agreement. It may be that the implicit rate is not apparent. Sometimes the value of the asset (or service) is not readily determinable, but the interest rate stated in the transaction is unrealistic relative to the rate that would be expected in a similar transaction under similar circumstances. Deciding what the appropriate rate should be is called imputing an interest rate.

A debenture bond

-Most corporate bonds are debenture bonds. -A debenture bond is secured only by the "full faith and credit" of the issuing corporation. - No specific assets are pledged as security. -Investors in debentures usually have the same standing as the firm's other general creditors. -So in case of bankruptcy, debenture holders and other general creditors would be treated equally

Note Exchanged for Assets or Services

-Occasionally the stated interest rate is not indicative of the market rate at the time a note is negotiated. - The value of the asset (cash or noncash) or service exchanged for the note establishes the market rate

By the straight-line method, interest (expense and revenue) is a plug figure, resulting from calculating the amount of discount reduction.

Allocating the discount or premium equally over the life of the bonds by the straight-line method results in a constant dollar amount of interest each period. An amortization schedule, then, would serve little purpose.

Determining interest by allocating the discount (or premium) on a straight-line basis is a practical expediency permitted in some situations by the materiality concept.

Also, be sure to realize that the straight-line method is not an alternative method of determining interest in a conceptual sense. Instead, it is an application of the materiality concept, by which an appropriate application of GAAP (e.g., the effective interest method) can be bypassed for reasons of practical expediency in situations when doing so has no material effect on the results. Based on the frequency with which the straight-line method is used in practice, we can infer that managers very frequently conclude that its use has no material impact on investors' decisions.

Bonds with Detachable Warrants

Another (less common) way to sweeten a bond issue is to include detachable stock purchase warrants as part of the security issue. A stock warrant gives the investor an option to purchase a stated number of shares of common stock at a specified option price, often within a given period of time. Like a conversion feature, warrants usually mean a lower interest rate and often enable a company to issue debt when borrowing would not be feasible otherwise.

One way is through the call provision.

As we noted earlier, most corporate bonds are callable by the issuing corporation. 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.

Recording Bonds at Issuance

Bonds represent a liability to the corporation that issues the bonds and an asset to an investor who buys the bonds as an investment. Each side of the transaction is the mirror image of the other

When the Conversion Option Is Exercised

If and when the bondholder exercises his or her option to convert the bonds into shares of stock, the bonds are removed from the accounting records and the new shares issued are recorded at the same amount (in other words, at the book value of the bonds).

Whether bonds are issued at a premium or a discount, the outstanding balance becomes zero at maturity.

In practice, corporate bonds rarely are issued at a premium.3 Because of the delay between the date the terms of the bonds are established and when the bonds are issued, it's difficult to set the stated rate equal to the ever-changing market rate. Knowing that, for marketing reasons, companies deliberately set the terms to more likely create a small discount rather than a premium at the issue date. Some investors are psychologically prone to prefer buying at a discount rather than a premium even if the yield is the same (the market rate).

The Straight-Line Method—A Practical Expediency

In some circumstances the profession permits an exception to the conceptually appropriate method of determining interest for bond issues. A company is allowed to determine interest indirectly by allocating a discount or a premium equally to each period over the term to maturity—if doing so produces results that are not materially different from the usual (and preferable) interest method. The decision should be guided by whether the straight-line method would tend to mislead investors and creditors in the particular circumstance.

The difference between the effective interest and the interest paid increases the existing liability.

Interest expense (issuer) and revenue (investor) are calculated on the outstanding debt balance at the effective (or market) rate. Interest paid is the amount specified in the bond indenture—the stated rate times the face amount.

Liabilities signify borrowers' interests in a company's assets.

Realize, though, that the mirror image of a liability is an asset (bonds payable/investment in bonds, note payable/note receivable, etc.). So as we discuss accounting for debts from the viewpoint of the issuers of the debt instruments (borrowers), we also will take the opportunity to see how the lender deals with the corresponding asset. Studying the two sides of the same transaction in tandem will emphasize their inherent similarities.

Convertible Bonds

Sometimes corporations include a convertible feature as part of a bond offering. Convertible bonds can be converted into (that is, exchanged for) shares of stock at the option of the bondholder.

Most corporate bonds are callable (or redeemable)

The call feature allows the issuing company to buy back, or call, outstanding bonds from bondholders before their scheduled maturity date. This feature affords the company some protection against being stuck with relatively high-cost debt in the event interest rates fall during the period before maturity. The call price must be pre-specified and often exceeds the bond's face amount (a call premium), sometimes declining as maturity is approached.

Years ago, it was typical for bonds to be structured as coupon bonds (sometimes called bearer bonds)

The name of the owner of a coupon bond was not registered. Instead, to collect interest on a coupon bond the holder actually clipped an attached coupon and redeemed it in accordance with instructions in the indenture. A carryover effect of this practice is that we still sometimes see the term coupon rate in reference to the stated interest rate on bonds.

However, unlike the conversion feature for convertible bonds, warrants can be separated from the bonds.

This means they can be exercised independently or traded in the market separately from bonds, having their own market price. In essence, two different securities—the bonds and the warrants—are sold as a package for a single issue price. Accordingly, the issue price is allocated between the two different securities on the basis of their fair values. If the independent market value of only one of the two securities is reliably determinable, that value establishes the allocation.

The essential point to remember is that the effective interest method is

a straightforward application of the accrual concept, whereby interest expense (or revenue) is accrued periodically at the effective rate. We record that amount of interest expense or revenue accrued even though the cash interest is a different amount.

Since we make no provision for the separate value of the conversion option,

all subsequent entries, including the periodic reduction of the premium, are exactly the same as if these were nonconvertible bonds. So the illustrations and examples of bond accounting we discussed earlier would pertain equally to nonconvertible or convertible bonds.

Convertible bonds

are retired as a consequence of bondholders choosing to convert them into shares of stock

Occasionally,

corporations may try to encourage voluntary conversion by offering an added inducement in the form of cash, stock warrants, or a more attractive conversion ratio. When additional consideration is provided to induce conversion, the fair value of that consideration is considered an expense incurred to bring about the conversion

The periodic reduction of the balance

is sufficient that at maturity the note is completely paid. This amount is easily calculated by dividing the amount of the loan by the appropriate discount factor for the present value of an annuity

Serial bonds

provide a more structured (and less popular) way to retire bonds on a piecemeal basis. Serial bonds are retired in installments during all or part of the life of the issue. Each bond has its own specified maturity date. So for a typical 30-year serial issue, 25 to 30 separate maturity dates might be assigned to specific portions of the bond issue.

Premium

the debt declines each period. As the premium is reduced by amortization, the book value of the bonds declines toward face value. This is because the effective interest each period is less than the cash interest paid. Remember, this is precisely the opposite of when the bonds are at a discount, when the effective interest each period is more than the cash paid. As the discount is reduced by amortization, the book value of the bonds increases toward face value

Consequently,

the significance is lost of maintaining separate balances for the face amount (in a note account) and the discount (or premium). So an installment note typically is recorded at its net book value in a single note payable (or receivable) account:

"No call" provisions

usually prohibit calls during the first few years of a bond's life. Very often, calls are mandatory. That is, the corporation may be required to redeem the bonds on a pre-specified, year-by-year basis. Bonds requiring such sinking fund redemptions often are labeled sinking fund debentures.

An exception is the subordinated debenture,

which is not entitled to receive any liquidation payments until the claims of other specified debt issues are satisfied.