Chapter 14: Bonds and Long-Term Notes

Nature of Long-Term Debt

Companies require funds for operations, which can be acquired through equity or debt. A liability, such as a bond, is considered the present value of its related cash flows (principal and/or interest payments) discounted at the effective rate of interest at issuance. Bonds specifically represent a debt obligation of the issuing corporation, typically involving periodic interest payments between the issue date and maturity, and a face amount paid at a specified maturity date. The terms associated with the face amount include principal, par value, stated amount, or maturity value.

Bond Indenture

A bond indenture describes the specific promises made to bondholders. This document is held by a trustee, often a commercial bank or other financial institution, appointed by the issuing firm to represent the rights of the bondholders. If a company fails to fulfill the terms of the bond indenture, the trustee has the authority to initiate legal action against the company.

Types of Bonds

Bonds come in various types, each with distinct characteristics:

* Debenture bonds are secured only by the "full faith and credit" of the issuing corporation, meaning no specific assets are pledged as security. Investors typically have the same standing as the firm’s other general creditors, with an exception for subordinated debentures, which are not entitled to receive liquidation payments until other specified debt issues are satisfied.

* Mortgage bonds are backed by a lien on specified real estate, which typically leads to a lower interest rate due to reduced risk for investors.

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

* Sinking fund redemptions require the corporation to redeem the bonds on a prespecified, year-by-year basis.

* Serial bonds are retired in installments over all or part of the life of the issue, with each bond having its own specified maturity date.

* Convertible bonds offer investors the option to convert them into shares of stock. These bonds are issued to sell at a higher price, to be used as a medium of exchange in mergers and acquisitions, or to help smaller firms or debt-heavy companies gain access to the bond market.

Recording Bonds at Issuance

From an accounting perspective, bonds are a liability to the corporation that issues them and an asset to the investor who purchases them.

For example, when bonds are issued at their face amount:

• The issuer (e.g., Masterwear) would Debit Cash and Credit Bonds payable for the face amount.

• The investor (e.g., United) would Debit Investment in bonds and Credit Cash for the face amount.

Determining the Selling Price

Bonds will sell for more than their face amount (at a premium) or less than their face amount (at a discount), depending on how the stated interest rate compares with the prevailing market or effective rate of interest:

• A discount occurs when the stated interest rate is less than the market/effective interest rate.

• A premium occurs when the stated interest rate is greater than the market/effective interest rate.

• Bonds sell at face amount when the stated interest rate equals the market/effective interest rate.

The bond price is the sum of the present value of the periodic cash interest payments and the present value of the principal payable at maturity. These values are discounted at the market rate. Periodic interest payments are calculated as the face amount multiplied by the stated rate. Bond prices are typically expressed as a percentage of face amounts (e.g., a quote of 98 means a $1,000 bond sells for $980).

Bond Ratings

Bond ratings indicate the risk of the corporation issuing bonds, which directly influences the price of the company’s bonds. Ratings categorize bonds into "Investment Grades" (e.g., AAA/Aaa being highest, down to BBB/Baa as minimum investment grade) and “‘Junk’ Ratings” (speculative, very speculative, and default or near default categories).

Bonds Sold at a Discount

When bonds are sold at a discount, the cash received by the issuer is less than the face amount.

Journal Entry at Issuance (Issuer): Debit Cash (for the calculated price), Debit Discount on bonds payable (for the difference between face and price), and Credit Bonds payable (for the face amount).

Journal Entry at Issuance (Investor): Debit Investment in bonds (for the face amount), Credit Discount on investment in bonds (for the difference), and Credit Cash (for the price paid).

Determining Interest: Effective Interest Method

The effective interest method involves recording interest each period as the effective market rate of interest multiplied by the outstanding balance of the debt during that interest period. This method systematically amortizes any discount or premium over the life of the bond.

For a discount, the amortization schedule shows that cash interest paid remains constant, while effective interest and the increase in the bond’s outstanding balance (discount reduction) increase over time until the outstanding balance reaches the face amount at maturity.

Zero-Coupon Bonds

Zero-coupon bonds pay no interest periodically. Instead, they offer a return to investors in the form of a “deep discount” from their face amount. Issuers of zero-coupon bonds can deduct annual interest expense for tax purposes, even though no related cash outflow occurs until the bonds mature. Conversely, investors receive no periodic cash interest but must report annual interest revenue for tax purposes. The effective interest method is used to amortize the discount, increasing the outstanding balance towards the face amount.

Bonds Sold at a Premium

When bonds are sold at a premium, the cash received by the issuer is more than the face amount.

Journal Entry at Issuance (Issuer): Debit Cash (for the calculated price), Credit Bonds payable (for the face amount), and Credit Premium on bonds payable (for the difference between price and face).

Journal Entry at Issuance (Investor): Debit Investment in bonds (for the face amount), Debit Premium on bond investment (for the difference), and Credit Cash (for the price paid).

For a premium, the amortization schedule shows that cash interest paid remains constant, while effective interest and the decrease in the bond’s outstanding balance (premium reduction) increase over time until the outstanding balance reaches the face amount at maturity.

When Financial Statements Are Prepared Between Interest Dates

If an accounting period ends between interest dates, it is necessary to record interest that has accrued since the last interest date. This involves prorating the effective interest, the discount/premium amortization, and the cash interest to the end of the accounting period.

The Straight-Line Method: A Practical Expedient

The straight-line method is a simplified approach that amortizes the discount or premium by dividing the total amount by the number of periods. This method is an application of the materiality concept, allowing it to be used when the more appropriate effective interest method would not have a material effect on financial results, offering a practical expedient.

Under the straight-line method, cash interest, effective interest, and the increase/decrease in the outstanding balance are all constant amounts per period, and the outstanding balance changes by a fixed amount each period.

Debt Issue Costs

When bonds are issued, companies incur debt issue costs, such as legal and accounting fees, printing costs, registration fees, and underwriting fees. These costs are recorded by combining them with any discount or premium. The combined valuation account is reported as a direct deduction from the liability and amortized over the life of the debt.

For example, if bonds are issued at a discount and incur issue costs, the cash received by the issuer is the calculated bond price minus the issue costs. The "Discount and debt issue costs" account would be debited for the total reduction from the face amount (discount + issue costs).

Long-Term Notes

Long-term notes are another common form of debt. When a company borrows cash from a bank and signs a promissory note, the liability is reported as a note payable by the borrower and notes receivable by the lender.

Notes Issued for Cash: If a note is issued at face amount for cash, the journal entries for issuance, periodic interest payments, and maturity are straightforward, debiting/crediting cash and the note payable/receivable accounts, along with interest expense/revenue.

Notes Exchanged for Assets or Services:

• If a customary cash price for the asset is available, that cash price is used to determine the present value of the note, and an implicit rate of interest can be calculated.

• If the value of the asset or service is not readily determinable, an appropriate interest rate would have to be found externally (imputing an interest rate), applying the substance over form principle. The accounting for these notes often mirrors that of bonds sold at a discount.

Installment Notes: Installment payments are equal amounts each period and include both an amount representing interest and an amount representing principal reduction. The periodic payment is calculated by dividing the loan amount by the appropriate discount factor for the present value of an annuity. The amortization schedule for installment notes shows that the cash payment is constant, effective interest decreases, and principal reduction increases over time, leading the outstanding balance to decrease to zero at maturity.

COVID-19: Accounting and Reporting Implications (CARES Act/PPP Loans)

The CARES Act provided stimulus relief to businesses affected by COVID-19, notably through the Paycheck Protection Program (PPP), which offered forgivable loans to small businesses for expenses like payroll, mortgages, rent, and utilities. There was initial uncertainty on how firms should account for this government assistance due to a lack of formal U.S. GAAP guidance for government grants.

Companies initially recorded the funding as debt (Debit Cash, Credit Notes payable). How and when this debt was adjusted depended on the chosen accounting guidance:

Accounting for debt (U.S. GAAP—ASC 405-20/470-50): When conditions for forgiveness were met, the liability was debited, and a gain on extinguishment of debt was credited.

Accounting for grants to not-for-profit organizations (U.S. GAAP—ASC 958-605): When conditions were substantially met, the liability was debited, and grant revenue was credited.

Accounting for grants to business organizations (IFRS—IAS 20): When reasonable assurance existed, the liability was debited, and "other income" was credited as an offset to related expenses (e.g., compensation expense).

If forgiveness conditions were not met, the loan, along with 1% accrued interest, had to be repaid. Extensive disclosure is required in the notes to the financial statements regardless of the approach taken, detailing accounting policies, amount received, expected repayment/forgiveness, due date, interest rate, interest expense, and the balance sheet/income statement line items where the loan and forgiven amounts are recognized.

Financial Statement Disclosures

The fair value of financial instruments must be disclosed either in disclosure notes or in the body of the financial statements. Disclosure notes should comprehensively cover the nature of the company’s liabilities, interest rates, maturity dates, call provisions, conversion options, restrictions imposed by creditors, and assets pledged as collateral.

Decision Makers’ Perspective

Understanding risk is fundamental to business decision-making. Companies aim for favorable financial leverage, which occurs if a company earns a return on borrowed funds that exceeds the cost of borrowing. This allows shareholders to achieve a greater total return than could be earned with equity funds alone. Unfavorable financial leverage arises when the return is less than the borrowed cost.

Financial Ratios

Several financial ratios help assess a company’s leverage and solvency:

* Debt to Equity Ratio: Calculated as Total liabilities ÷ Shareholders’ equity, this ratio measures the degree of default risk, indicating the likelihood a company will default on its obligations.

* For example, Coca-Cola had a debt to equity ratio of 3.1, while PepsiCo had 4.3.

* Rate of Return on Assets: Calculated as Net income ÷ Total assets.

* Coca-Cola's rate was 10.4%, and PepsiCo's was 9.4%.

* Rate of Return on Shareholders’ Equity: Calculated as Net income ÷ Shareholders’ equity.

* Coca-Cola's rate was 42.6%, and PepsiCo's was 49.5%.

* Times Interest Earned Ratio: Calculated as (Net income + Interest + Taxes) ÷ Interest. This ratio measures a company's ability to meet its interest obligations.

* Coca-Cola had a times interest earned ratio of 12.4 times, while PepsiCo had 9.2 times.

Early Extinguishment of Debt

Early extinguishment of debt 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. Any difference between the outstanding debt and the amount paid to retire that debt represents either a gain or a loss.

For example, if Masterwear calls bonds at a price higher than their book value, it results in a loss on early extinguishment. The journal entry would involve debiting Bonds payable (face amount), debiting Loss on early extinguishment, crediting Discount on bonds payable (if applicable), and crediting Cash (call price).

Convertible Bonds (Exercise of Option)

When the conversion option of a convertible bond is exercised, the issuer records the transaction by debiting the Convertible bonds payable account and any related Premium on bonds payable (or crediting Discount on bonds payable) for the portion being converted, and then crediting Common stock to balance the entry. For an investor, exercising the option would involve debiting Investment in common stock and crediting Investment in convertible bonds and any related Premium on bond investment.