This chapter continues the presentation of liabilities. Specifically, the discussion focuses on the accounting treatment of long-term liabilities. Long-term notes and bonds are discussed, as well as the extinguishment of debt and debt convertible into stock.
Chapter 14 BONDS AND LONG-TERM NOTES © 2013 The McGraw-Hill Companies, Inc Slide Liabilities Probable Probable future future transfer transferof of economic economic benefits benefits Arising Arising from frompresent present obligations obligations to toother other entities entities Resulting Resulting from frompast past transactions transactions or orevents events Some liabilities are not contractual obligations and may not be payable in cash Notice that the definition of a liability involves the present, the future, and the past It is a present responsibility, to transfer assets or services in the future, caused by a transaction or other event that already has happened © 2013 The McGraw-Hill Companies, Inc Slide Long-Term Debt Creditors’ interests in a company’s assets Obligation for future payments at specified (or estimated) amounts, at specified (or projected) dates Interest accrues on debt over time Periodic interest is the effective interest rate times the amount of the debt outstanding during the interest period Debt is reported at the present value of principal and/or interest payments, discounted at the effective rate of interest at issuance © 2013 The McGraw-Hill Companies, Inc Slide Nature of Long-Term Debt Loan Loan agreement agreement restrictions restrictions Mirror Mirror image image of of an an asset asset Obligations Obligations that that extend extend beyond beyond one one year year or or the the operating operating cycle, cycle, whichever whichever is is longer longer Reported Reported at at present present value value Accrue Accrue interest interest expense expense © 2013 The McGraw-Hill Companies, Inc Slide Bonds At Bond Issuance Date Company Company Issuing Issuing Bonds Bonds Bond Selling Price Bond Certificate Investor Investor Buying Buying Bonds Bonds Subsequent Periods Company Company Issuing Issuing Bonds Bonds Interest Payments Principal Value Payment at End of Bond Term Investor Investor Buying Buying Bonds Bonds © 2013 The McGraw-Hill Companies, Inc Slide Bonds Sold at Par On January 1, 2012, 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, at principal amount (i.e at par) At Issuance (January 1) Masterwear - Issuer Date Description Jan Cash Bonds payable (principal) United - Investor Date Description Jan Investment in bonds Cash (principal) Debit 700,000 Credit 700,000 Debit 700,000 Credit 700,000 © 2013 The McGraw-Hill Companies, Inc Slide Determining the Selling Price Stated interest rate is: Below market rate Equal to market rate Above market rate The bonds sells: At a discount (Cash received is less than principal amount) At principal amount (Cash received is equal to principal amount) At a premium (Cash received is greater than principal amount) © 2013 The McGraw-Hill Companies, Inc Slide Determining the Selling Price On January 1, 2012, Masterwear Industries issued $700,000 of 12% bonds, dated January Interest 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 Present value of an ordinary annuity of $1: n=6, i=7% Calculation of the Price of the Bonds Interest Principal $ 42,000 × 4.76654 = $700000 × 0.66634 = Present value (price) of bonds Present Values $ 200,195 466,438 $ 666,633 present value of $1: n=6, i=7% Because interest is paid semiannually, the present value calculations use: (a) the semiannual stated rate (6%), (b) the semiannual market rate (7%), and (c) (3 x 2) semi-annual periods © 2013 The McGraw-Hill Companies, Inc Slide Journal Entries at Issuance – Bonds Issued at a Discount Masterwear - Issuer Date Description Jan Cash Discount on bonds payable (contra liability account) Bonds payable Debit 666,633 Credit 33,367 700,000 United - Investor Date Description Jan Investment in bonds Discount on bond investment Cash Debit 700,000 Credit 33,367 666,633 © 2013 The McGraw-Hill Companies, Inc Slide 10 Determining Interest – Effective Interest Method Interest accrues on an outstanding debt at a constant percentage of the debt each period Interest each period is recorded as the effective interest rate multiplied by the outstanding balance of the debt (during the interest period) Interest is recorded as expense to the issuer and revenue to the investor For the first six-month interest period the amount is calculated as follows: 666,633 Outstanding Balance × (14% ÷ 2) Effective Rate = $46,664 Effective Interest The bond indenture calls for semiannual interest payments of only $42,000 – the stated rate (6%) times the principal value of $700,000 The difference ($4,664) increases the liability and is reflected as a reduction in the discount (a valuation account) © 2013 The McGraw-Hill Companies, Inc Slide 36 Financial Statement Disclosures LongTerm Debt Matrix Ltd Partial Balance Sheet December 31, 2012 Long-term liabilities Bonds payable, face amount Less: unamortized discount unamortized issue costs Bonds payable, net $ $ 50,000,000 (244,875) (127,500) 49,627,625 For all long-term borrowing, disclosures should include the aggregate amounts maturing and sinking fund requirement, if any, for each of the next five years © 2013 The McGraw-Hill Companies, Inc Slide 37 Decision Makers’ Perspective Longterm debt impacts several key financial ratios Rate of return on Net income = shareholders’ equity Shareholders’ equity Times interest Net income + interest + taxes earned ratio = Interest Debt to Total liabilities = equity ratio Shareholders’ equity Rate of return = Net income on assets Total assets © 2013 The McGraw-Hill Companies, Inc Slide 38 Convertible Bonds Some bonds may be converted into ordinary shares at the option of the holder They are accounted for as both debt and equity Bonds into Stock © 2013 The McGraw-Hill Companies, Inc Slide 39 Accounting for Convertible Bonds At Issuance The entire issue price of the convertible bonds is split between debt and equity, which are recorded separately Illustration – On January 1, 2012, HTL Manufacturers issued $100 million of 8% convertible debentures due 2032 at 103 (103% of face value) The bonds are convertible at the option of the holder at a conversion ratio of 40 shares per $1,000 bond HTL recently issued nonconvertible, 20-year, 8% debentures at 98 Date Description Jan 01 Cash Discount on bonds payable Convertible bonds payable Equity option Debit 103 Credit 100 *all values in millions Note: The bond will have to be amortized as a pure bond On 31 st December 2014, the bond’s carrying value is $98,139,248 © 2013 The McGraw-Hill Companies, Inc Slide 40 Accounting for Convertible Bonds Upon Conversion If and when the bondholder exercises his or her option to convert the bonds into shares: • The bonds and the equity options are removed from the accounting records • New shares are issued, and are recorded at the amount equal to the book value of the bonds and the book value of the equity options Illustration – Assume that the convertible bonds issued by HTL Manufacturers are converted on December 31, 2014: Date Description Dec 31 Convertible bonds payable Equity option Discount on bonds payable Share Capital Debit 100 Credit 1.860752 103.139248 *all values in millions © 2013 The McGraw-Hill Companies, Inc Slide 41 Accounting for Convertible Bonds Early Extinguishment Upon early extinguishment: • Both the debt and equity components in a convertible bond have to be removed • The loss on extinguishment of a convertible debt has to be allocated to the debt and equity components using a process similar to that of allocating the initial proceeds on issue date • The loss attributable to the debt component is taken to the income statement while the loss attributable to the equity component remains in equity (although it may be re-classified from equity options to another component in equity) • The loss on equity is not taken to the income statement as the loss relates to transactions with owners in their capacity as owners © 2013 The McGraw-Hill Companies, Inc Slide 42 Accounting for Convertible Bonds Early Extinguishment Illustration –assume that HTL Manufacturers has a right to redeem its convertible bonds from December 31, 2014 onwards at 106 and chooses to so on this date: The market interest rate of HTL’s pure bond on 31/12/2014 was 7.95% Based on this rate, the present value of the remaining cash flows from the bond is $100,457,607 Compared to the book value of $98,139,248, this means a loss of $2,318,359 on the debt component As the proceeds from redemption is $106,000,000, the value of the equity component is $5,542,393 Compared to the book value of $5,000,000, this means a loss of $542,393 on the equity component Date Description Dec 31 Convertible bonds payable Loss on redemption of debt Equity options* Unamortized Discount Cash Debit 100,000,000 2,318,359 5,542,393 Credit 1,860,752 106,000,000 *Note that this results in a deficit in equity, but will still remain in equity (unless transferred to another line item in equity) © 2013 The McGraw-Hill Companies, Inc Slide 43 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 Any additional consideration provided to induce conversion of convertible debt is recorded as an expense of the period Slide 44 Bonds With Detachable Warrants Stock Stock warrants warrants provide provide the the option option to to purchase purchase aa specified specified number number of of shares shares of of ordinary ordinary shares shares at at aa specified specified option option price price per per share share within within aa stated stated period period The The issue issue price price of of bonds bonds with with detachable detachable warrants warrants is is allocated allocated between between the the two two different different securities securities on on the the basis basis of of their their market market values values © 2013 The McGraw-Hill Companies, Inc Slide 45 Bonds With Detachable Warrants Matrix Matrix issues issues at at par par 10,000, 10,000, $1,000 $1,000 face face value, value, 8% 8% debt debt with with detachable detachable warrants warrants that that permit permit the the holder holder to to purchase purchase aa share share unit unit for for $18 $18 per per share share Immediately Immediately after after issue issue the the bonds bonds were were selling selling for for 98 98 without without the the warrants warrants and and the the warrants warrants have have aa market market value value of of $16 $16 Pr o p o r tio nal Me th o d Fair value of bonds without warrants Fair value of the warrants Aggregrate fair value $ 9,800,000 160,000 $ 9,960,000 Allocate to bonds $10,000,000 x 98.39% Allocate to warrants $10,000,000 x 1.61% Total face value $ 9,839,000 161,000 $ 10,000,000 98.39% 1.61% 100.00% © 2013 The McGraw-Hill Companies, Inc Slide 46 Debt Restructuring – Appendix B Troubled Troubled debt debt may may be be restructured restructured in in one one of of two two ways: ways: Settled Settled at at time time of of restructuring restructuring Continued Continued with with modified modified terms terms © 2013 The McGraw-Hill Companies, Inc Slide 47 Debt Restructuring – Appendix B Settled at time of restructuring Book value of the debt – Fair value of asset transferred Gain on restructuring Debtor Debtor reports reports gain gain or or loss loss on on adjustment adjustment to to fair fair value value of of the the asset asset transferred transferred © 2013 The McGraw-Hill Companies, Inc Slide 48 Debt Restructuring – Appendix B Continued with modified terms © 2013 The McGraw-Hill Companies, Inc Slide 49 Debt Restructuring – Appendix B Continued with modified terms © 2013 The McGraw-Hill Companies, Inc End of Chapter 14 McGraw-Hill /Irwin © 2013 The McGraw-Hill Companies, Inc ... measure, non-trading financial assets and liabilities, including bonds and notes, at fair value if any of the following conditions exist ◦ An accounting mismatch exists between financial assets and financial... The McGraw-Hill Companies, Inc Slide 28 Long-Term Notes On January 1, 2012, Skill Graphics, a product labeling and graphics firm, borrowed 700,000 cash from First BancCorp and issued a 3-year,... $48,544 is rounded to cause outstanding balance to be exactly $700,000 on 12/31/14 © 2013 The McGraw-Hill Companies, Inc Slide 15 Zero-Coupon Bonds These These bonds bonds do not pay interest interest