Chapter 14: Bonds and Long-Term Notes

Long term debt

Funds a company may require to finance its operations, sourced through either equity or debt. It represents a liability

How is the Present Value of a Liability determined?

the present value of its related cash flows (principal and/or interest payments), discounted at the effective rate of interest at issuance

Bond indenture

A document that describes the specific promises made to bondholders. It is held by a trustee (usually a commercial bank or financial institution), appointed by the issuing firm to represent the rights of the bondholders. If the company fails to meet the terms, the trustee may bring legal action.

Debenture Bonds

Bonds secured only by the "full faith and credit" of the issuing corporation. No specific assets are pledged as security, meaning investors have the same standing as the firm’s other general creditors, with the exception of subordinated debentures.

Mortgage Bonds

Bonds backed by a lien on specified real estate. Due to less risk, they typically command a lower interest rate.

Callable Bonds

Bonds that include a call feature, allowing the issuing company to buy back, or call, the bonds before their scheduled maturity date. The call price must be prespecified and often exceeds the bond’s face amount.

Serial Bonds

Bonds that are retired in installments during all or part of the life of the issue, with each bond having its own specified maturity date

Convertible Bonds

Bonds that can be exchanged for shares of stock at the option of the investor. They are issued to sell bonds at a higher price, used as a medium of exchange in mergers and acquisitions, or to enable smaller or debt-heavy companies to access the bond market.

How are bonds recorded by the issuer and investor at issuance?

To the corporation that issues the bonds: A liability.

To the investor who buys the bonds: An asset

How is the price of a bond calculated?

The bond price is the present value of the periodic cash interest payments plus the present value of the principal payable at maturity, both discounted at the market rate

Explain the Effective Interest Method for recording bond interest.

This method records interest each period as the effective market rate of interest multiplied by the outstanding balance of the debt during that period. This calculation yields a changing interest expense/revenue and a gradual reduction of the discount or premium over the bond's life.

Zero-Coupon Bonds

Bonds that pay no interest periodically. They offer a return in the form of a "deep discount" from their face amount. Issuers can deduct the annual interest expense for tax purposes even without cash outflow, while investors report annual interest revenue without receiving periodic cash.

What is the Straight-Line Method for amortizing bond discounts or premiums?

A practical expedient where the discount or premium is amortized in equal amounts each period. This method can be bypassed for reasons of practical expediency when it has no material effect on financial results, as an application of the materiality concept.

How are Debt Issue Costs accounted for?

Costs such as legal, accounting, printing, registration, and underwriting fees. They are recorded by combining them with any discount or premium on the bond, reported as a direct deduction from the liability, and amortized over the life of the debt.

Installment Note

A long-term note where payments are equal amounts each period. Each payment includes both an amount that represents interest and a periodic reduction of the principal, ensuring the note is completely paid at maturity.

How are Paycheck Protection Program (PPP) loans initially accounted for?

Despite their potential for forgiveness, these government assistance funds are initially recorded as debt.

What must companies disclose about their liabilities in financial statement notes?

Disclosures must include the fair value of financial instruments, and specific details about liabilities such as: nature of liabilities, interest rates, maturity dates, call provisions, conversion options, restrictions imposed by creditors, and assets pledged as collateral

Favorable Financial Leverage

It occurs when a company earns a return on borrowed funds that exceeds the cost of borrowing those funds. This provides shareholders with a total return greater than what could have been earned with equity funds alone.

What happens in an Early Extinguishment of Debt?

This refers to the transaction when debt is retired prior to its scheduled maturity date. When this occurs, the account balances of the debt must be removed from the books, and any difference between the outstanding debt's book value and the amount paid to retire it represents either a gain or a loss on early extinguishment.

Subordinated debenture

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

Coupon Bond

name of the owner was not registered; the holder actually clipped an attached coupon and redeemed it in accordance with instructions on the indenture (pays interest)

Sinking fund debentures

bonds that must be redeemed on a prespecified year-by-year basis; administered by a trustee who repurchases bonds in the open market

Premium

arises when bonds are sold for more than face amount

Discount

arises when bonds are sold for less than face amount

Implicit rate of interest

rate implicit in the agreement

Detachable stock purchase warrants

the investor has the option to purchase a stated number of shares of common stock at a specified option price, within a given period of time

Accrued interest

interest that has accrued since the last interest date

Troubled debt restructuring

the original terms of a debt agreement are changed as a result of financial difficulties experienced by the debtor (borrower)

Stock warrant

grants an investor the right to buy a certain number of shares of stock at a certain price, usually within a certain time frame

If a company chooses to report liabilities at fair value, they must report all financial instruments at fair value

False

In the early extinguishment of a debt, if the book value of the debt is higher than the amount to retire the debt, the debtor records a gain

True

A 5,000 bond is issued at face value semi-annual payments of 150 and a stated rate of 6%. The current market is 8%. What is the purchase price of the bond?

5,000

The purchase price of a bond issued at face value is the face value of the bond.

Which type of bond is backed only by the “full faith and credit” of the issuing company?

debenture bond

When a non interest bearing note is issued in exchange for an asset, the asset should be recorded at

the present value of the cash flows agreed to in the note