Bonds and Notes Payable Study Guide

Definition: Bonds are a form of long-term debt where a company borrows money from investors at a fixed interest rate and typically repayable over a set period.
Issuance of Bonds:
- Bonds may be issued directly to a single investor (often termed "private placement"), such as pension funds or insurance companies.
- Costs Incurred: If bonds are issued this way, the issuing company incurs only issuance costs.
- If bonds are sold indirectly through underwriters (such as investment banks), those underwriters pay a fee to purchase the bonds and the issuing company pays the underwriting fee.

Payment Responsibility: The issuing company is always responsible for some costs associated with the bond issue, but the amount varies based on the issuance method.
Accounting for Costs:
- When recording the bond issue, costs must be combined with any discounts or premiums as deductions from the liability and then amortized.
Example Provided:
- Masterware Industries issued $700,000 of 12% bonds, interest of $42,000 payable semi-annually, maturing in three years.
- Market yield on similar bonds = 14%.
- Entire issue purchased by United Intergroup Incorporated, leading to incurred issue costs of $14,000 and an increase in discount on bonds.

Definition: Notes payable are similar to bonds but typically refer to borrowing from banks with terms longer than one year.
Promissory Notes: Issued by the company as a liability reported as "notes payable."
Differences in Bonds vs. Notes:
- Bonds are often traded on the market, while notes payable typically pertain to loans from banks.
- Interest rates on notes are generally equal to market rates with less complexity regarding premiums and discounts.

Definition: Implicit rate of interest is not directly stated in agreements but can be inferred based on market rates.
Asset or Service Exchange: A scenario where a note reflects an exchange of assets or services. For example, a custom machine purchased via a 12% note.
A reasonable interest rate is determined, and when no cash price is available, an external rate is sought.

If the stated interest rate differs from the market rate, a discount or premium may need to be documented for the note.
At issuance, the difference influences accounting entries.

Amber Mining and Milling Example:
- Company contracts for a custom lab and exchanges using a $600,000 note.
- Interest rate implicit in transactions calculated at 12%, with payments impacting both cash flow and statements of earnings significantly.
Journal Entries: Upon maturity and payment of the note, effective interest method must be followed for proper recording of expenses and cash flow.

Definition: Installment notes involve regular payments that include both principal and interest, contrasting with notes payable where principal is paid at maturity only.
Example: Corbin Construction’s $8,000,000 loan for playground construction.
- An installment payment calculation involves amortizing the loan using present value factors.
- Payments are calculated using annuity present value factors, ensuring total payoff over three years.

Return on Equity (ROE): Highlighted as key in understanding debt financing. A higher ROE typically reflects effective utilization of borrowed funds.
Leverage Ratios: important metrics to assess a company's financial health and risk exposure.
- Debt to Equity Ratio: Total liabilities divided by shareholder's equity, indicating the proportion of debt used in financing.
- Times Interest Earned Ratio: Measures a company's ability to meet its interest obligations.

Companies that over-leverage may face bankruptcy if unable to meet interest payments, leading to liquidation or reorganization.
Examples of Consequences: Historical references to companies like Quiznos Subs and Del Webb highlight real-world implications of unsustainable debt levels and management.

Understanding financial leverage and default risk is essential in developing strategies for effective debt management in any business context.
Key indicators always include the nature of liabilities, terms of maturity, payment stipulations, and collateral requirements which must all be clearly disclosed in financial statements.