ACCOUNTING
Chapter 14
Financing Liabilities: Bonds and Long-Term Notes Payable
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Learning Objectives
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Leverage: A Double-Edged Sword
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Why Companies Issue Long-Term Liabilities
Learning Objective #1
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Bonds Payable: Terminology
Learning Objective #2
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The Bond Issue Process
Serial bonds are bonds that are issued at one time, but may
contain provisions that require the issuer to repay the face
value in periodic installments over a number of years.
Serial bonds may be especially attractive in cases where the
bond issue is used to finance a particular project, because the
issuer can use the yearly cash flow from that project to retire
the bond issue.
Because there are no generally accepted principles for
determining whether different interest should be assigned to
each individual installment, it is assumed that the same rate of
interest applies to the entire serial bond and each of the
installments.
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Computing the Issue Price of Bonds Payable
Learning Objective #3 (Slide 1 of 3)
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Computing the Issue Price of Bonds Payable
(Slide 2 of 3)
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Computing the Issue Price of Bonds
Payable (Slide 3 of 3)
Present value of principal: $100,000 0.508349 $50,834.90
Present value of interest: $6,000 7.2023582 42,141.49
Selling Price $92.976.39
Face value $100,000.00
Selling price (92,976.39)
Discount $ 7,023.61
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Bond Yields versus Contract Rates
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Recording the Issuance of Bonds Payable
Learning Objective #4
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Recording the Issuance of Bonds Payable
(Slide 2 of 2)
Cash 107,721.71
Bonds Payable 100,000.00
Premium on Bonds Payable 7,721.71
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Bond Issued between Interest Payment Dates
(Slide 1 of 2)
Cash 816,000
Interest Expense 16,000
Bonds Payable 800,000
$800,000 0.12 2/12
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Bond Issued between Interest Payment Dates
(Slide 2 of 2)
$800,000 0.12
6/12
As a result of the
two journal entries,
Interest Expense
has a debit balance
of $32,000 .
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Amortizing Discounts and Premiums
Learning Objective #5
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Effective Interest Method
(Slide 1 of 4)
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Effective Interest Method
(Slide 2 of 4)
After this first interest entry, the book value of the bonds
payable would increase by $508.35, which is the amount
of discount amortized from $93,976.39 to $94,484.74.
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Effective Interest Method
(Slide 3 of 4)
After this interest date, Jet would decrease the book value
of its bonds payable by $613.91 from $107,721.71 to
$107,107.80. The new book value will be used to
determine interest expense for the next interest period:
December 31, 2016
Interest Expense ($107,107.80 0.10 ) 5,355.39
Premium on Bonds Payable ($6,000.00
$5,355.39) 644.61
Cash ($100,000 0.12 ) 6,000.00
After the first two interest dates, the book value of
$106,463.19 is equal to the discounted cash flows over the
remaining eight interest periods:
Present value of principal: $100,000 0.676839 $ 67,683.90
Present value of interest: $6,000 6.463213 38,779.29
Selling price $106,463.19
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Bond Issue Costs
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Interest Expense and Discount Amortization Schedule:
Effective Interest Method
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Straight-Line Method
(Slide 2 of 4)
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Straight-Line Method
(Slide 3 of 4)
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Accruing Bond Interest
(Slide 1 of 3)
Cash 185,279.87
Discount on Bonds Payable 14,720.13
Bonds Payable 200,000.00
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Accruing Bond Interest
(Slide 2 of 3)
At the end of the fiscal year, December 31, 2015, Olivia must
accrue interest and amortize the discount for the months of
October, November, and December.
Olivia records this adjusting entry (assuming straight-line
amortization) as follows:
Interest Expense 5,736.01
Discount on Bonds Payable 736.01
Interest Payable ($200,000 0.10 3/12) 5,000.00
Example Assume the same facts as before, but this time
assume that Olivia uses the effective interest method.
In order to record the interest entry at December 3, 2016, Olivia first
calculates the amount of semiannual interest as follows.
[($14,720.13
$185,279.87 0.12 = $11,116.79 5) 3/12]
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Accruing Bond Interest
(Slide 3 of 3)
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Zero Coupon Bonds
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Extinguishment of Liabilities
Learning Objective #6
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Bonds Retired Prior to Maturity
(Slide 1 of 4)
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Bonds Retired Prior to Maturity
(Slide 2 of 4)
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Bonds Retired Prior to Maturity
(Slide 4 of 4)
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Bonds with Equity Characteristics
Learning Objective #7
Stock warrants (also called stock rights) give holders the option
to purchase a specific number of common shares at a
predetermined price for a period of time.
A conversion right allows bondholders to exchange bonds for
common equity shares at a predetermined exchange ratio.
The bondholder has acquired a dual set of rights:
The right to receive interest and principal repayments on the
bond
The right to acquire common stock, either by exercising the
warrants and purchasing shares or by exchanging bonds for
shares, and to participate in future dividends and future
appreciation of the market value of the companys common
stock
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Bonds Issued with Detachable Stock Warrants
(Slide 1 of 4)
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Bonds Issued with Detachable Stock Warrants
(Slide 2 of 4)
follows:
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Bonds Issued with Detachable Stock Warrants
(Slide 3 of 4)
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Bonds Issued with Detachable Stock Warrants
(Slide 4 of 4)
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Accounting for Convertible Bonds
(Slide 2 of 2)
If all the bonds are converted into common stock while the
market value of Shannons common stock is $26.50 per share, it
may record the alternative journal entries:
Book Value Method
Bonds Payable 10,000
Premium on Bonds Payable 500
Common Stock (40 10 $20) 8,000
Additional Paid-in Capital from Bond
Conversion ($10,500 $8,000) 2,500
Market Value Method
Bonds Payable 10,000
Premium on Bonds Payable 500
Loss on Conversion ($10,600 $10,500) 100
Common Stock (40 10 $20) 8,000
Additional Paid-in Capital from Bond
Conversion ($40 10 $6.50) 2,600
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Induced Conversions
(Slide 1 of 3)
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Induced Conversions
(Slide 2 of 3)
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Induced Conversions
(Slide 3 of 3)
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Convertible Bonds that Require Recognition of
an Equity Component (Slide 1 of 3)
A cash or partial cash settlement usually occurs when
the bond has an artificially low interest rate and an
attractive conversion feature.
Example Jordy Company issues a $1,000 bond that
pays annual interest of 1% and is convertible into 50
shares of its $5 par value common stock at the end of
3 years.
It sells the bond for its face value of $1,000.
At the date of issuance, the companys common stock is selling
for $18 per share, so the stock price only has to increase by at least
$2 per share before the conversion becomes in the money (50 shares
$20 = $1,000).
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Convertible Bonds that Require Recognition of
an Equity Component (Slide 2 of 3)
Jordy Company estimates that the current market rate on a 3-year
bond is 12%. Then, it would value the bond as follows:
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Convertible Bonds that Require Recognition of
an Equity Component (Slide 3 of 3)
At the end of the first year, Jordy records the interest:
Interest Expense (735.80 0.12) 88.30
Discount on Bonds Payable 78.30
Cash 10.00
If the bond owner chooses the cash settlement at the end of
three years, Jennings would record the cash outlay:
Bonds Payable 1,000.00
Cash 1,000.00
If the bond owner chooses the conversion feature at the
end of three years, Jennings would record the conversion:
Bonds Payable 1,000.00
Additional Paid-in Capital Conversion Feature 264.20
Common Stock 250.00
Additional Paid-in Capital from Bond Conversion 1,014.20
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Long-Term Notes Payable
Learning Objective #8
Cash 5,694.24
Discount on Bonds Payable 2,305.76
Notes Payable 8,000.00
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Notes Payable Issued for Cash
(Slide 3 of 4)
Backes must solve for the interest rate that equates the present
value of $5,694.24 with the future value of $8,000 at the end of
three year by solving the following formula for the present value
of 1 factor: Present Value = Future Value PV of 1(3 periods, i = ?)
$5,694.24 = $8,000 PV of 1(3 periods, i = ?)
$5,694.24 $8,000 = PV of a 1(3 periods, i =?)
0.711780 = PV of a single sum (3 periods, i =?)
From the Present Value of $1 table, the imputed interest rate is 12%.
Backes computes the interest expense as follows:
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Notes Payable Issued for Cash
(Slide 4 of 4)
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Notes Payable Exchanged for Cash
and Rights and Privileges (Slide 2 of 2)
Rose makes entries at the end of the first and second years
to properly recognize both the revenue and expense
components:
End of First Year
Interest Expense ($71,178 0.12) 8,541.36
Discount on Notes Payable 8,541.36
Unearned Revenue ($28,822 5) 5,764.40
Sales Revenue 5,764.40
End of Second Year
Interest Expense [($71,178 + $8,541.36) 0.12] 9,566.32
Discount on Notes Payable 9,566.32
Unearned Revenue 5,764.40
Sales Revenue 5,764.40
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Notes Payable Exchanged for
Property, Goods, or Services (Slide 1 of 3)
When a note is exchanged solely for property, goods, or
services in exchange for property, goods, or services in an
external transaction, GAAP says that the stated rate of interest
should be presumed fair.
This presumption can be overcome only if:
no interest is stated, or
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Notes Payable Exchanged for
Property, Goods, or Services (Slide 2 of 3)
Example On January 1, 2016, Madsen Company purchases
used equipment from Jordy Company, issuing a non-interest-
bearing, $10,000, 5-year note in exchange.
Neither the fair value of the equipment nor that of the note
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Notes Payable Exchanged for
Property, Goods, or Services (Slide 3 of 3)
January 1, 2016
Equipment 5,674.27
Discount on Notes Payable 4,325.73
Notes Payable 10,000.00
December 31, 2016
Interest Expense [($10,000 $4,325.72) 0.12] 680.91
Discount on Notes Payable 680.91
Depreciation Expense 567.43
Accumulated Depreciation ($5,674.27 10) 567.43
December 31, 2017
Interest Expense {[$10,000 ($4,325.72
$680.91)]) 0.12} 762.62
Discount on Notes Payable 762.62
Depreciation Expense 567.43
Accumulated Depreciation 567.43
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Disclosure of Long-Term Liabilities
Learning Objective #9
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Real Report: Disclosures of Debt
(Slide 2 of 4)
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Real Report: Disclosures of Debt
(Slide 3 of 4)
Questions:
1. As of May 31, 2013, approximately what percentage of Nikes long-
term debt will be coming due over its next 5 fiscal years?
$242 million of Nikes debt comes due over the next 5 fiscal years;
this is approximately 19.1% of the companys total long-term debt
($242 million/$1,267 million).
2. Was Nikes long-term corporate bonds payable due in 2023 and
2024 issued at a premium or discount?
These corporate bonds were issued at a discount, given that the
book values provided are less than the original principal (face
values) of the bonds.
3. What amount of interest does Nike pay each month on its
promissory notes?
The 2023 and 2024 promissory notes would pay $206,667 and
$107,583 per month, respectively.
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Troubled Debt Restructuring
Learning Objective #10
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Troubled Debt Restructuring
(Slide 2 of 2)
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