Chapter 14

Recording Bonds at Issuance, What does the Bonds represent for *Those that Issue the Bonds vs. Those who Buy the Bonds*

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.

Debenture Bonds

*• A debenture bond is secured only by the "full faith and credit" of the issuing corporation.* • Most corporate bonds are debenture bonds. • No specific assets are pledged as security. • Investors have the same standing as the firm's other general creditors unless it is a *subordinated debentures which are not entitled to receive any liquidation payments until the claims of other specified debt issues are satisfied*

Stated Rate

The periodic interest is a stated percentage of face amount (variously referred to as the *stated rate*, coupon rate, or nominal rate).

Nature of Long-Term Debt

• 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.* • This same principle applies regardless of the specific form of the liability—note payable, bonds payable, lease liability, pension obligation, or other debt instruments. *• 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.*

Callable Bonds (Redeemable bonds)

• Bonds that the issuing company can redeem (buy back) at a stated dollar amount prior to maturity. • 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 prespecified and often exceeds the bond's face amount (a call premium) sometimes declining as maturity is approached* • Sinking fund redemptions: The corporation may be required to redeem the bonds on a prespecified, year-by-year basis

Detachable Stock Purchase Warrants

• Detachable Stock Purchase Warrants are another (less common) way to sweeten a Bond Issue. Detachable Stock Purchase Warrants has benefits that entices investors, they are: *• Give 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 • Bear a lower interest rate *• Can be exercised independently or traded in the market separately from bonds, having their own market price, this very attractive to investors* • Issue price is allocated between the two different securities on the basis of their fair values*

Early Extinguishment of Debt

• Early Extinguishment of Debt refers to the transaction when debt is retired prior to its scheduled maturity date Accounting for early extinguishment: *• Account balances of the debt must be removed from the books • Difference between the book value of the debt and the reacquisition price represents either a gain or a loss. • 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.* *Decision makers should be alert to gains and losses that have nothing to do with a company's normal operating activities.*

Mortgage Bonds

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

Discounts and premiums on bonds

*Discount on Bonds: * • The discount on bonds lowers the amount of liability the bonds holds, however, as depicted in the amortization tables. *As the bonds gets closer to the maturity date, the amount of discount decreases, but increases the amount of liability.* Eventually at maturity, there will be no discount and the bonds at maturity will be at its face value. *• At Issuance, for the Issuer, Discounts on Bonds Payable will be a debit balance to reflect that it lowers the amount of liability of the bonds. However, for every Interest expense and cash interest payments are made, Discounts on Bonds Payable will be credited to reduce its amount and increase the amount of liability.* *Premium on Bonds: * • The premium on bonds increases the amount of liability the bonds holds, however, as depicted in the amortization tables. *As the bonds gets closer to the maturity date, the amount of premium decreases, but also decreases the amount of liability.* Eventually at maturity, there will be no premium and the bonds at maturity will be at its face value. *• At Issuance of the Bonds, on the Issuer side of Journal Entries, Premiums on Bonds payable is a credit account since it increases the amount of liability, as interest expense and cash interest payments are made, the Premium on Bonds Payable will be debited to decrease its value and decrease the Bonds' amount of liability.* • Bonds Sold At a Premium or as a Discount will be the face amount at maturity, as reflected on amortization tables. *The final period of payment will have an outstanding balance equals to the bond's face amount.*

Bond Indenture

*• A bond indenture describes the specific promises made to 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.

Zero-Coupon Bond

*• A zero-coupon bond pays no interest. Instead, it offers a return in the form of a "deep discount" from the face amount.* • Issuers can deduct for tax purposes the annual interest expense, even though no related cash outflow is incurred until the bonds mature • Investors receive no periodic cash interest, even though annual interest revenue is reportable for tax purposes • Zero-Coupon bonds, while popular, constitute a relatively small proportion of corporate debt.

Bonds

*• 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. • Medium and large-sized corporations often choose to borrow cash by issuing bonds to the public. *• 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. A bond consist of: • *Issuing corporation*, those that issue the bonds and are obligated to be repaid • *Principal, par value, stated amount, or maturity value* are different names that essentially means it is the *face amount *specified maturity date. • *Stated rate, coupon rate, or nominal rate* is the periodic interest for the time between the issue dated and maturity

Coupon Bonds (Bearer Bonds)

*• Coupon Bonds are bonds that do not have the name of the owner 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.

Sales of Bonds Directly

*• Directly to a single investor (private placement)* • Ex: Pension fund or an insurance company *• Issuing company incurs only issue costs*

Installment payments

*• Installment payments are equal amounts each period, typically.* • Periodic reduction of the balance is sufficient that at maturity the note is completely paid • Each payment includes both an amount that represents interest and an amount that represents a reduction of the outstanding balance (principal reduction). • The periodic reduction of the balance is sufficient that at maturity the note is completely paid. *• In each subsequent cash payment on an installment note, the amount of principal paid increases while interest paid decreases* *• 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*

if a company elects the fair value option

*• It's not necessary to report all of the financial instruments at fair value or even all instruments of a particular type at fair value* • It can "mix and match" on an instrument-by-instrument basis • It must make the election when the item originates

Determining Interest: Effective Interest Method

*• 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. * • The effective interest method is simply an application of the accrual concept, consistent with accruing all expenses as they are incurred. *• Interest expense (issuer) and revenue (investor) are calculated on the outstanding debt balance at the effective (or market) rate. * *• Interest paid (Cash Interest) is the amount specified in the bond indenture—the stated rate times the face amount.*

Registered Bonds

*• Registered Bonds are owned by investors whose names and addresses are recorded by the issuer; interest payments are made to the registered owners.* • Most corporate bonds are registered bonds. Interest checks are mailed directly to the owner of the bond, whose name is registered with the issuing company.

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. Two ways to Induced Conversion: *• Through the 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.* *• 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.*

Convertible Bonds Issuance Example

On January 1, 2018, HTL Manufacturers issued $100 million of 8% convertible debentures due 2038 at 103 (103% of face value). The bonds are convertible at the option of the holder into no par common stock at a conversion ratio of 40 shares per $1,000 bond. HTL recently issued nonconvertible, 20-year, 8% debentures at 98. *Journal Entries ($ in millions)* Cash (103% × $100 million)----------------------103 ---Convertible bonds payable (face amount)------100 ---Premium on bonds payable (difference)---------3

When the Conversion Option is Exercised Example:

On January 1, 2018, HTL Manufacturers issued $100 million of 8% convertible debentures due 2038 at 103 (103% of face value). The bonds are convertible at the option of the holder into no par common stock at a conversion ratio of 40 shares per $1,000 bond. HTL recently issued nonconvertible, 20-year, 8% debentures at 98. *• Half the convertible bonds issued by HTL Manufacturers are converted at a time when the remaining unamortized premium is $2 million.* At Conversion Journal Entries ($ in millions) Convertible bonds payable (1/2 the account balance)--50 Premium on bonds payable (1/2 the account balance)---1 ---Common stock (to balance)--------------------------------51 *• If 50,000 convertible bonds were held by a single investor* Investment in common stock---------------------------51 ---Investment in convertible bonds (account balance)--50 ---Premium on bond investment (account balance)-------1

Calculating the Price of the Bond Example

On January 1, 2018, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup, Inc. Calculation of the Price of the Bonds Present Values Interest: $ 42,000 × 4.76654*= $ 200,195 Financial Calculator & Excel (N = 6, I/Y = 7, PMT = -42,000 x 6%, FV = 0) Principal: $700,000 × 0.66634†= 466,438 Financial Calculator & Excel (N = 6, I/Y = 7, PMT = 0, FV = -700,000) Present value (price, Interest + Principal) of the bonds = $666,633 Financial Calculator & Excel (N = 6, I/Y = 7, PMT = -42,000, FV = -700,000) *Present value of an ordinary annuity of $1: n = 6, i = 7% (Table 4). †Present value of $1: n = 6, i = 7% (Table 2).

Straight-Line Method Example

On January 1, 2018, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup, Inc. Journal Entry - For Issuance Masterwear (Issuer) Cash (PV (0.07, 6, -42,000, -700,000, 0)---------$666,633 DIscount on bonds payable (To Balance)--------33,337 ----Bonds Payable------------------------------------------700,000 *Journal Entry—At Each of 6 Interest Dates:* Masterwear (Issuer) Interest expense (Balance)----------------------47,561 ---Discount on bonds payable (33,777 / 6)-----------5,561 ---Cash (Stated Rate x Face Amount)-------------------42,000

Recording Bonds at Issuance, Journal Entries Example for the Issuer of Bonds vs. Investor/Buyer of Bonds

On January 1, 2018, Masterwear Industries issued $700,000 of 12% bonds. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years (an unrealistically short maturity to shorten the illustration). The entire bond issue was sold in a private placement to United Intergroup, Inc., at the face amount. At Issuance (January 1): Masterwear (Issuer) Cash-----------------------------------700,000 ---Bonds payable (face amount)--------------700,000 United (Investor/Buyer) Investment in bonds (face amount)--700,000 ---Cash-----------------------------------------700,000

Note Issued for Cash Example

On January 1, 2018, Skill Graphics, Inc., a product-labeling and graphics firm, borrowed $700,000 cash from First BancCorp and issued a three-year, $700,000 promissory note. Interest of $42,000 was payable semiannually on June 30 and December 31. *At Issuance* Skill Graphics (Borrowers) Cash---------------------------------700,000 ---Notes Payable (Face Amount)-----------700,000 First BancCorp (Lender) Notes receivables (Face Amount)--700,000 ---Cash----------------------------------------700,000 *At each of the six interest dates* Skills Graphics (Borrower) Interest expense---------------------42,000 ---Cash (stated rate x face amount)---------42,000 First BancCorp (Lender) Cash (Stated Rate x Face Amount)--42,000 ---Interest Revenue--------------------------42,000 *At Maturity* Skills Graphics (Borrower) Notes Payable (Face Amount)-------700,000 ---Cash----------------------------------------700,000 First BancCorp (Lender) Cash-----------------------------------700,000 ---Notes receivables (Face Amount)---------700,000

Early Extinguishment of Debt Example

On January 1, 2019, Masterwear Industries called its $700,000, 12% bonds when their book value was $676,288. The indenture specified a call price of $685,000. The bonds were issued previously at a price to yield 14%. Journal Entries Bonds payable (face amount)-------------------------700,000 Loss on early extinguishment ($685,000 − 676,288)--8,712 ---Discount on bonds payable ($700,000 − 676,288)-------------23,712 ---Cash (call price)------------------------------------------------685,000

Financial Statement Disclosures

The fair value of financial instruments must be disclosed either in *the body of the financial statements or in disclosure notes.* The disclosure note for debt includes: *• Nature of the company liabilities • Interest rates • Maturity dates • Call provisions • Conversion options • Restrictions by creditors • Assets pledged as collateral* For all long-term borrowings, disclosures also should include the aggregate amounts payable for each of the next five years.

Reporting Changes in Fair Value

• If the fair value option is elected, a change in fair value creates a gain or loss *• Any portion of that gain or loss that is a result of a change in the "credit risk" of the debt is reported as other comprehensive income (OCI), or its states that the change in denb is not due to a decline or increase of general interest Rate* *• Any portion of that gain or loss that is a result of a change in the general (risk-free) interest rate is reported as part of net income* • Credit risk: The risk that the investor in the bonds will not receive the promised interest and maturity amounts at the times they are due • Any change in fair value that exceeds the amount caused by a change in the general (risk-free) interest rate is the result of credit risk changes

Straight-line Method

• In some circumstances the profession permits an exception to the conceptually appropriate method of determining interest for bond issues. Though very rare. • 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 Straight-line Method is recording interest each period at the same dollar amount.*

Sales of Bonds Indirectly

• Indirectly through underwriters who: Commit to purchase bonds at a set price then resell them to other security dealers and the public • Ex: Investment banks • Issuing company pays underwriting fee

Serial Bonds

• 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.

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.* Among the reasons for issuing convertible bonds rather than straight debt are: *• Sell bonds at higher price • Use as a medium of exchange in mergers and acquisitions • 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. • 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. *• Cash is never used when converting bonds into equity (common stock). you are converting a liability into an equity. The cash account is never touched*

Liabilities at Fair Value

• The market forces that influence the fair value of an investment in debt securities (interest rates, credit risk, etc.) influences the fair value of liabilities • Companies are not required to, but have the option to, value some or all of their financial assets and liabilities at fair value

Finding Periodic Amount of Installment Notes

• The periodic amount is easily calculated by dividing the amount of the loan by the appropriate discount factor for the present value of an annuity *Example * 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. • This is calculated by dividing $666,633, the amount of loan, by 4.76654, present value of an ordinary annuity of $1 − n = 6 years, i = 7%. Amount of loan / Present value of an ordinary annuity of $1 = Installment payment *666,633 / 4.76654 = $139,857* Journal Entries at Issuance—Installment Note Skill Graphics (Buyer/Issuer)------------------------666,663 ---Note Payable------------------------------------------------------666,663 Journal Entries At the First Interest Date (June 30) Interest expense (effective rate x outstanding balance)---46,664 Notes payable-----------------------------------------93,193 ---Cash (Installment payment)------------------------------------139,857

The Price of the Bond

• 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 the Selling Price of a Bond

• The price of a bond issue at any particular time is not necessarily equal to its face amount. • For example, a $700,000, 12% bond issue. *If it sold for more than face amount, it is a premium* or *sold for less than face amount, then it is a discount.* This can also be depended on how the stated interest rate compares with the prevailing market or effective rate of interest (for securities of similar risk and maturity). • For instance, 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. *Thus a Discount occurs if the slated interest rate is lower than the market interest rate.* • 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. *A premium occurs if the slated interest rate is higher than the market interest rate.* • 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. • In the indenture of bonds, the market rate for a specific bond issue is influenced by the creditworthiness of the company issuing the bonds. • Also, *the lower the perceived riskiness of the corporation issuing bonds, the higher the price those bonds will command* due to the reliability that the corporation paying back its debt. The opposite is true, if the *perceived riskiness of the corporation issuing bonds is very high, the price of the bonds will be low.*

Long-Term Notes Payable

• 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

When Financial Statements Are Prepared Between Interest Dates

• When an accounting period ends between interest dates, it's necessary to record interest that has accrued since the last interest date For example: On January 1, 2018, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup, Inc. The fiscal years of Masterwear and United end on October 31 and interest was last paid and recorded on June 30. *Adjusting Entries to Accrue Interest—October 31:* Masterwear (Issuer) Interest expense (4/6 x 46,991)--------------31,327 ---Discount on bonds payable (4/6 x 4,991)-------3,227 ---Interest payable (4/6 x 42,000)------------------28,000 *Adjusting Entries to Accrue Interest—December 31:* Masterwear (Issuer) Interest expense (2/6 x 46,991)--------------15,664 Interest payable (4/6 x 42,000)------------------28,000 ---Discount on bonds payable (2/6 x 4,991)-----------1664 ---Cash (Stated Rate x Face Amount)--------------42,000

Debt Issue Costs

• When issuing bonds or notes, the issuing company will incur costs, such as *legal and accounting fees, printing costs, and registration and underwriting fees. * *• These costs are recorded by combining them with any discount or subtracting them from any premium on the debt.* The combined valuation account is reported in the balance sheet as a direct deduction from the liability and then amortized over the life of the debt. • Debt issue costs reduce the cash proceeds from the issuance of debt, however, it also reflect a higher cost of borrowing. By deducting debt issue costs, we lower the carrying amount of the debt, which effectively increases the interest rate on that debt. *For Example:* On January 1, 2018, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest of $42,000 is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 10%. The entire bond issue was purchased by United Intergroup, Inc. The company incurred the issue cost of $14,000. Masterwear (Issuer) *Cash (666,633 - 14,000 issue costs)*---------652,633 Discount and debt issue costs (difference)--47,367 ---Bonds payable (face amount)-------------------------700,000

The intrinsic value of a conversion option

• While we normally don't separate the conversion option from the debt for convertible bonds, an exception is when the conversion option is deemed to be a "beneficial conversion feature." That's the case when the conversion option has a positive "intrinsic value" at the time the bonds are issued, meaning the fair value of the stock into which the bonds are convertible exceeds the face amount of the bonds. • For example: On January 1, 2018, HTL Manufacturers issued $100 million of 8% convertible debentures due 2038 at 103 (103% of face value). The bonds are convertible at the option of the holder into no par common stock at a conversion ratio of 40 shares per $1,000 bond. HTL recently issued nonconvertible, 20-year, 8% debentures at 98. HTL's stock has determined a fair value of $30 per share when the bonds are issued. This implies an intrinsic value of the conversion feature of $5 per share: • Price per share to convert: $1,000 ÷ 40 shares = $25 per share • Fair value of stock at issue date = $30 • Conversion price for shares = 25 Intrinsic value of beneficial conversion option per share (30 - 5) = $ 5 Intrinsic value of beneficial conversion feature: 100,000 bonds × 40 shares = 4,000,000 shares × $5 per share = $20,000,000 The intrinsic value of the conversion option is recorded separately: *Journal Entries of Conversion with Positive Intrinsic Value($ in millions)* Cash (103% × $100 million)-------------------103 Discount on bonds (to balance)-------------17 ---Convertible bonds payable (face amount)---100 ---Equity—conversion option (intrinsic value)----20