978-1259722660 Chapter 14 Lecture Note Part 1

Unlock access to all the studying documents.

View Full Document

CHAPTER 14

BONDS AND LONG-TERM NOTES

Overview

This chapter continues the presentation of liabilities. While the discussion focuses on the

accounting treatment of long-term liabilities, the borrowers’ side of the same transactions is

presented as well. Long-term notes and bonds are discussed, as well as the extinguishment of debt

and debt convertible into stock.

Learning Objectives

LO14–1 Identify the underlying characteristics of debt instruments and describe the basic

approach to accounting for debt.

LO14–2 Account for bonds issued at face value, at a discount, or at a premium, recording interest

using the effective interest method or using the straight-line method.

LO14–3 Characterize the accounting treatment of notes, including installment notes, issued for

cash or for noncash consideration.

LO14–4 Describe the disclosures appropriate to long-term debt in its various forms and calculate

related financial ratios.

LO14–5 Record the early extinguishment of debt and its conversion into equity securities.

LO14–6 Understand the option to report liabilities at their fair values.

LO14–7 Discuss the primary differences between U.S. GAAP and IFRS with respect to accounting

for bonds and long-term notes.

Lecture Outline

I. The Nature of Long-Term Debt

A. Liabilities signify creditors’ interest in a company’s assets.

B. Debt requires the future payment of cash in specified (or estimated) amounts, at specified

(or projected) dates.

C. As time passes, interest accrues on debt.

D. Periodic interest is the effective interest rate times the amount of the debt outstanding

during the interest period.

E. Reported at present value of its related cash flows (principal and/or interest payments),

discounted at the effective rate of interest at issuance.

Part A: Bonds

I. The Bond Indenture

A. Divide a large liability into many smaller liabilities (usually $1,000 per bond).

B. Obligate a company to repay a stated amount at a specified maturity date and periodic

interest between the issue date and maturity.

C. Require periodic interest as a stated percentage of the face amount.

D. Pay interest semiannually (usually) on designated interest dates beginning six months after

the day the bonds are “dated.”

Instructors Resource Manual 14-1

McGraw-Hill Education.

E. Make specific promises to bondholders who are described in a document called a bond

indenture.

F. Represent a liability to the corporation that issues the bonds and an asset to a company that

buys the bonds as an investment.

Issuer

Cash ………………………………………………………………………… xxx

Bonds payable (face amount)………………………………. xxx

Investor

Investment in bonds (face amount)………………………………. xxx

Cash…………………………………………………………………. xxx

II. Recording Bonds at Issuance

A. Forces of supply and demand cause a bond issue to be priced to yield the market rate of

interest for securities of similar risk and maturity.

1. Price can be calculated as the present value of all the cash flows required (principal

and interest).

2. The discount rate is the market rate.

B. Other things being equal, the lower the perceived riskiness of the corporation issuing

bonds, the higher the price those bonds will command.

C. When bond prices are quoted in financial media, they typically are stated in terms of a

percentage of face amount. So, a price quote of 97 means a $1,000 bond will sell for $970;

a bond priced at 102 will sell for $1,020.

III. Determining Interest—Effective Interest Method

A. Interest accrues at the effective market rate of interest multiplied by the outstanding

balance (during the interest period).

B. When only a portion of an expense is paid by the periodic cash interest payment, the

remainder becomes a liability (or an addition to the already outstanding liability). The

difference increases the liability and is reflected as a reduction in the discount (a valuation

account).

C. Because the balance of the debt changes each period, the dollar amount of interest

(balance × rate) also will change each period. To keep up with the changing amounts, it

usually is convenient to prepare a schedule that reflects the changes in the debt over its

term to maturity.

D. A zero-coupon bond pays no interest but, instead, offers a return in the form of a “deep

discount” from the face amount.

E. If an accounting period ends between interest dates, it is necessary to record interest that

has accrued since the last interest date.

F. Alternatively, a company is permitted to allocate 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 interest method.

IV. The Straight-Line Method—A Practical Expediency

Instructors Resource Manual 14-2

McGraw-Hill Education.

A. 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.

V. Debt Issue Costs

A. They include legal and accounting fees and printing costs in addition to registration and

underwriting fees.

B. Costs of issuing debt securities are added to any discount or subtracted from any premium.

C. The combined valuation account is reported in the balance sheet as a direct deduction from

the liability.

Part B: Long-Term Notes

A. In concept, notes are accounted for in precisely the same

way as bonds.

B. 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.

A. When a note is issued with an unrealistic

interest rate, the effective market rate is

used both to determine the amount recorded in the transaction and to record periodic

interest thereafter.

1. Substance over form.

2. Accounting treatment is the same whether the amount is determined directly from the

market value of the asset acquired (and thus the note, also) or indirectly as the present

value of the note (and thus the value of the asset).

3. Also, both parties to the transaction should record periodic interest (interest expense

to the borrower, interest revenue to the lender) at the effective rate, rather than the

stated rate.

A. Installment notes are paid in installments, rather than by a

single amount at maturity.

1. Installment payments are equal amounts each period.

2. Each payment includes both an amount that represents interest and an amount that

represents a reduction of principal.

3. The periodic reduction of principal is sufficient that, at maturity, the note is

completely paid.

4. The installment amount is easily calculated by dividing the amount of the loan by the

appropriate discount factor for the present value of an annuity.

A. On the balance sheet, disclosure should include,

for all long-term borrowings, the aggregate amounts maturing and sinking fund

requirements (if any) for each of the next five years.

B. Supplemental disclosures are needed for:

1. Off-balance-sheet credit or market risk.

Instructors Resource Manual 14-3

McGraw-Hill Education.

I. Note Issued for Cash

II. Note Exchanged for Assets or Services

III. Installment Notes

IV. Financial Statement Disclosure

2. Concentrations of credit risk.

3. The fair value of financial instruments.

Decision-Makers’ Perspective

A. Failure to properly consider risk in business decisions is one of the most costly, yet one of

the most common, mistakes investors and creditors can make.

B. Long-term debt is one of the first places decision makers should look when trying to get a

handle on risk.

C. Generally speaking, debt increases risk.

1. The debt to equity ratio, total liabilities/shareholders’ equity, often is calculated to

measure the degree of risk.

2. Other things being equal, the higher the debt to equity ratio, the higher the risk.

D. Debt also can be an advantage by enhancing the return to shareholders.

1. This concept is known as leverage.

2. “Favorable financial leverage” occurs when a company earns a return on borrowed

funds in excess of the cost of borrowing the funds, shareholders are provided with a

total return greater than what could have been earned with equity funds alone.

E. Failure to pay interest as scheduled may cause several adverse consequences including

bankruptcy.

1. One way to measure a company’s ability to pay its obligations is by comparing interest

payments with income available to pay those charges.

2. The times interest earned ratio is determined by dividing income before subtracting

interest expense or income tax expense by interest expense.

F. “Off-balance-sheet” financing and other commitments can increase risk.

Part C: Debt Retired Early, Convertible into Stock, or Providing an Option to

Buy Stock

I. Early Extinguishment of Debt

A. A gain or loss on early extinguishment of debt should be recorded for the difference

between the reacquisition price and the book value of the debt.

B. The gain or loss should be classified on the income statement as an extraordinary item

only if it meets criteria for such reporting by being both (1) unusual and (2) infrequent.

II. Convertible Bonds

A. Convertible bonds are accounted for as straight debt.

B. Stock or other financial instruments that a company is obligated to buy back (mandatorily

redeemable), must be reported in the balance sheet as a liability, not as shareholders’ equity.

C. Under IFRS, convertible debt is divided into its liability and equity elements. Under U.S.

GAAP, the entire issue price is recorded as debt.

III. Bonds with Detachable Warrants

A. The value of the equity feature is recorded separately for bonds issued with detachable

warrants.

Part D: Option to Report Liabilities at Fair Value

Instructors Resource Manual 14-4

McGraw-Hill Education.

A. A company is not required to, but has the option to, value some or all of its financial assets

and liabilities, including bonds and notes, at fair value.

B. If a company chooses the option to report at fair value, then it reports changes in fair value

as OCI (net of tax) in its statement of other comprehensive income.

Appendix A: Bonds Issued Between Interest Dates

A. All bonds sell at their price plus any interest that has accrued since the last interest date.

B. Face Annual Fraction of the Accrued

amount × rate × annual period = interest

Appendix B: Troubled Debt Restructuring

A. The way a troubled debt restructuring is recorded depends on whether:

1. The debt is settled at the time of the restructuring or

2. The debt is continued but with modified terms where the total cash to be paid:

a. Is less than the book value of the debt or

b. Exceeds the book value of the debt.

Instructors Resource Manual 14-5

McGraw-Hill Education.

PowerPoint Slides

Two PowerPoint presentations of the chapter are available in the Connect Library:

1. With “Concept Checks” useful for classroom presentation, permitting the

instructor to intersperse in the presentation short exercises students can be asked

to solve individually or in small groups before the solution is “revealed” by the

instructor. {These are available only within Instructor Resources.}

2. Without the “Concept Checks” so students don’t have the solutions before being

asked to solve individually or in small groups.

3. Accessible PowerPoint Presentations. Accessibility is becoming even more

important in the education marketplace. Students and instructors with

disabilities use many different assistive technologies, and McGraw-Hill

Education is working to increase compatibility and access that will not only

help those with disabilities achieve better learning outcomes, but also serve the

institutions that are teaching these students. Accessible PowerPoint allows slide

content to be read by a screen reader and provides alternative text descriptions

for any image files used that enrich the learning experience. Accessible

PowerPoint is also designed with high-contrast color palettes and uses texture

when possible, instead of color to denote different aspects of the imagery used

within the slide.

Note: The slides are intended to provide comprehensive coverage of the

chapter, but they can be easily edited to allow instructors to change numbers

and content in illustrations or to delete slides pertaining to topics they choose to

omit or deemphasize. (Using your students’ names for company names in the

Concept Checks or Illustrations can be fun.)

Instructors Resource Manual 14-6

McGraw-Hill Education.