Long-Term Debt

By the end of today’s class you should understand…– Bond terminology– the effective interest rate method

of accounting for long term bonds– basic long-term debt accounting

Long-Term Debt

The Balance Sheet Line Items:– Secured Bonds (with collateral)– Debentures ( unsecured)– Capital Lease Obligations

At what value are these obligations carried in the B/S

How do we measure interest expense?– Cash Paid?– Effective Interest?

Definition

Bond?– An obligation to make a series of payments to

the bondholder. The payments are described in terms of principal and interest

Debenture?– An unsecured bond. That is, there is no

collateral backing any default

Zero coupon bond?– A bond that does not make periodic interest

payments eg. U.S. Savings bond

Convertible bond?– A bond that can be converted into another

security, typically common shares. Convertible bonds can be thought of as Bonds with Embedded Call Options

Definitions (cont)

Subordinated Bond?– A bond that, in the event of the issuing

company’s default cannot be paid until more “senior” claims have been paid

Fixed rate bond?– A bond with an interest rate will not vary with

changing economic conditions

Floating rate bond?– A bond with an interest rate that can vary. It

might vary as a function of the prime rate,

LIBOR, or even the results of a division’s operations

Bond Terminology

Par Value, Face Value or Principal– The amount that will be paid at the end of the

term of the bond

Coupon Rate, Stated Rate, or Nominal rate– The interest rate used to determine the coupon

payment

Coupon Payment– The amount of the periodic interest payments

– Determined by multiplying the coupon rate times the face value of the bond

Effective Rate, Yield, or Implicit Rate– The discount or interest rate that equates the

present value of the remaining payments with the market value of the security

Bonds as a Stream of Payments

Periodic Payments of Interest and Principal

Discount the Cash Flows to Determine Proceeds of Debt Issuance

Account for Payments using the Effective Interest Rate Method– rate used is the original market

rate NOT the current market ( or the coupon) rate

Bond Valuation - Basics

On issuance, proceeds to issuer equal PV of future cash flows for interest and principal

Market value will fluctuate over the life of the bond

Accountants ignore the fluctuation

Bond Accounting - Example 1

Issue a bond on Jan 1. It has a 2 year term, $1,000 face value, a 10% coupon rate, with interest payable semiannually.

Assume the bond is issued to yield 12% i.e.., bondholders require a 12% return compounded semiannually (6% every six months)

The company will receive $965 when it issues the bond

– PV of $1,000, n = 4, r = 6% => 792

– PV of pmt = $50, n=4, r=6% => 173 965

– Journal Entry on issuance» Dr Cash $ 965» Dr. Discount 35

Cr. Bond Payable $1,000

Example 1 (contd)

Interest Expense for the first 6 months– BV of Bond * Effective Rate

» $965*6% = $57.9

Interest Payment for the first 6 months– Face Value * Coupon Rate

» $1000 * 5% = $50

Journal Entry – Dr. Interest Expense 57.9

– Cr. Discount 7.9

– Cr. Cash 50.0

Repeat for each interest payment

Bond Accounting - Example 1 - Contd

Interest Expense for second 6 months– BV of Bond * Effective Rate

» [$965+7.9} * 6% = $58.37

Journal Entry– Dr. Interest Expense $58.37

– Cr. Discount 8.37

– Cr. Cash 50.0

Interest Expense for third 6 months– BV of Bond *Effective Rate– [$965 + 7.9 +8.37] * 6% = $58.88

Journal Entry– Dr. Interest Expense $58.88

– Cr. Discount 8.88

– Cr. Cash 50.0

Example 1 (contd)

Interest Expense for final 6 months– BV of Bond * Effective Rate

» [$965 + 7.9 + 8.37 + 8.88]* 6% = 59.41

Journal Entry– Dr. Interest Expense $59.41

– Cr. Discount 9.41

– Cr. Cash 50

Repay the bond– Dr. Bond payable 1000

– Cr. Cash 1000

Bond discount account = 0 35 - 7.9 - 8.37- 8.88 - 9.41 (difference is due to rounding)

Bond Retirement

Buyback from the market Exercise call provision Convertible bonds In-substance defeasance

Accounting for Bonds -Main Points

Use effective interest rate method Amortize discount or premium over the life

of the bond Effective interest rate method ensures that

interest rate does not fluctuate over the life of the debt ( as it would if the premium or discount were amortized using straight line)

The effective rate used is the effective rate at the time the debt was issued

The market rate will likely change over the term of the bond– If a bond is paid off early, there will be a gain or

loss ( considered an extraordinary item) unless the market rate at the time is the same as the effective rate at the date of issuance (highly unlikely)

Bonds - Useful Information

Interest Expense = Book Value of Bond * Interest Rate

Interest paid = Annuity= Face Value of Bond * Coupon Rate

Discount = Face Value - Book Value => FV > BV

Premium = Book Value - Face Value => BV > FV

Book Value = Present Value of future cash flows => PV at time 0 is the price or cash proceeds of the bond.

Total interest expense = Annuity*Number

of payments + Face Value - Cash Proceeds

Take Home Point

You should understand…– Basic bond terminology– Basic long-term debt accounting– accountants use the effective

interest rate method to account for long-term debt

– effective rate and current market rate may differ

– Understand the long-term debt section in the F/S