UGBA 120AB Chapter 14 Debt Spring 2020 With Solutions For BCourses

14-1
Bonds and Long-Term Notes

Chapter 14
Copyright © 2018 McGraw-Hill Education.Copyright

All rights ©
reserved.
2013 byNo reproduction
The McGraw-Hillor Companies,
distribution without prior written
Inc. All rights consent of McGraw-Hill Education.
reserved.
Questions to get you thinking…
• Why does a company borrow money?
• What is a bond?
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education.
Questions to get you thinking…
Why does a company borrow money?
• A company must raise funds to finance its operations and often the
expansion of those operations. Presumably, at least some of the
necessary funding can be provided by the company’s own operations,
though some funds must be provided by external sources. Ordinarily,
external financing includes some combination of equity and debt funding.
What is a bond?
• Bonds obligate the issuing corporation to repay a stated amount
(variously referred to as the principal, par value, face amount, or maturity
value) at a specified maturity date. Maturities for bonds typically range
from 10 to 40 years. In return for the use of the money borrowed, the
company also agrees to pay interest to bondholders between the issue
date and maturity. The periodic interest is a stated percentage of face
amount (variously referred to as the stated rate, coupon rate, or nominal
rate). Ordinarily, interest is paid semiannually on designated interest dates
beginning six months after the day the bonds are “dated.”
Review of Example Financial Statements and
Long Term Debt Footnote
…CONTINUED
Liabilities and stockholders’ equity
Current liabilities:
Short-term debt 2,000 0
Current portion of long-term debt 0 2,999
Accrued compensation
Income taxes
Short-term unearned revenue
Securities lending payable
Other
Total current liabilities
Long-term debt 20,645 12,601
Long-term unearned revenue
Deferred income taxes
Other long-term liabilities
Total liabilities
Commitments and contingencies
Total Long-term debt
Stockholders’ equity:
= 72,178 and 76,240
Common stock and paid-in capital – shares authorized 24,000; outstanding 8,239 and 8,328
Retained earnings
Accumulated other comprehensive income
Total stockholders’ equity
Total liabilities and stockholders’ equity
See accompanying notes.
Debt Footnote
NOTE 11 — DEBT
Short-term Debt
As of June 30, 2019 and 2018, we had no commercial paper issued or outstanding. Effective August
31, 2018, we terminated our credit facilities, which served as back-up for our commercial paper
program.
Long-term Debt
As of June 30, 2019, the total carrying value and estimated fair value of our long-term debt, including
the current portion, were $72.2 billion and $78.9 billion, respectively. As of June 30, 2018, the total
carrying value and estimated fair value of our long-term debt, including the current portion, were $76.2
billion and $77.5 billion, respectively. These estimated fair values are based on Level 2 inputs.
The components of our long-term debt, including the current portion, and the associated interest rates
were as follows:
What we’ll cover…
• Identify the underlying characteristics of debt instruments and describe the
basic approach to accounting for debt.
• Account for bonds issued at face value, at a discount, or at a premium,
recording interest using the effective interest method or using the straight-
line method.
• Characterize the accounting treatment of notes, including installment notes,
issued for cash or for noncash consideration.
• Describe the disclosures appropriate to long-term debt in its various forms
and calculate related financial ratios.
• Record the early extinguishment of debt and its conversion into equity
securities.
• Understand the option to report liabilities at their fair values.
• Discuss the primary differences between U.S. GAAP and IFRS with respect to
accounting for bonds and long-term notes.
LO14-1
Nature of Long-Term Debt

Internal Funds External
Source are required by a Source
company to finance
its operations
Net Income
• Equity
o n g-ter
m • Debt
l
al r ule, rted at
a gener are repo ues
As l i ties sent val
b i
l ia
e i r p re Present value Present value of its related
t h
= cash flows (principal and/or
of a liability
interest payments)
Discounted at the effective (market)
rate of interest at issuance
LO14-1
Bonds
Medium- and large-sized corporations often choose to
borrow cash by issuing bonds to the public.
Issuing Obligated to repay

corporation
Principal, par value, A face amount at a
stated amount, or specified maturity date
maturity value +
Stated rate, coupon Periodic interest for
rate, or nominal rate the time between the
issue dated and
maturity
LO14-1
Bond Indenture
• A bond indenture describes the specific promises
made to bondholders
• Held by a trustee (usually a commercial bank or
other financial institution, appointed by the
issuing firm to represent the rights of the
bondholders)
• If a company fails to live up to the terms of the

bond indenture, the trustee may bring legal action
against the company
LO14-1
Types of Bonds
Debenture bonds
• Secured only by the “full faith and credit” of the
issuing corporation
• No specific assets are pledged as security
• Investors have the same standing as the firm’s other
general creditors
Exception: Subordinated debentures not entitled to
receive any liquidation payments until the claims of
other specified debt issues are satisfied
Mortgage bonds
• Backed by a lien on specified real estate
• Due to less risk, typically commands a lower interest
rate
Convertible bonds
• Can be converted into shares of stock
LO14-1
Types of Bonds (continued)

Offers some
Callable bonds (Redeemable bonds) protection
• Call feature allows the issuing company to buy back, or against
being stuck
call, bonds before their scheduled maturity date with
• Call price must be prespecified and often exceeds the relatively
high-cost
bond’s face amount debt in the
• “No call” provisions usually prohibit calls during the event interest
rates fall
first few years of a bond’s life during the
Sinking fund debentures period before
maturity.
• The corporation may be required to redeem the bonds
on a pre-specified, year-by-year basis
Serial bonds
• Retired in installments during all or part of the life of the
issue with each bond having its own specified maturity
date
LO14-1
Concept Check: Types of Bonds

Which of the following statements is not true concerning
types of bonds?
a. A debenture bond is secured only by the “full faith and
credit” of the issuing corporation
b. A call feature on a callable (or redeemable) bond allows
the issuer to buy back outstanding bonds at a price to be
determined at the call date
c. A mortgage bond is backed by a lien on a specified real
estate owned by the issuer
d. Coupon (or bearer) bonds require the holder to clip a
coupon attached to the bond to redeem interest
payments
LO14-1
Concept Check: Types of Bonds

Which of the following statements is not true concerning
types of bonds?
a. A debenture bond is secured only by the “full faith and
credit” of the issuing corporation
b. A call feature on a callable (or redeemable) bond allows
the issuer to buy back outstanding bonds at a price to be
determined at the call date
c. A mortgage bond is backed by a lien on a specified real
estate owned by the issuer
d. Coupon (or bearer) bonds require the holder to clip a
coupon attached to the bond to redeem interest
payments
The correct answer is b. The call price must be pre-specified and often
exceeds the bond’s face amount.
LO14-2
Recording Bonds at Issuance
A liability Bonds An asset
To the corporation that To the investor who buys the
issues the bonds bonds as an investment
On January 1, 2018, Masterwear Industries issued $700,000 of 12%
bonds. Interest of $42,000 (700,000 x 12% = 84,000/2 = 42,000) is
payable semiannually on June 30 and December 31. The bonds
mature in three years. The entire bond issue was sold in a private
placement to United Intergroup, Inc., at the face amount.
Journal Entry Debit Credit

Masterwear (Issuer)
Cash 700,000
Bonds payable 700,000
United (Investor)
Investment in bonds 700,000
Cash 700,000
LO14-2
Determining the Selling Price

Bonds will sell for less Stated interest Market/Effective
cash than face amount (at rate interest rate
a discount) or more cash 12%
12%
than face amount (at a
premium), depending on
how the stated interest Face Amount
rate compares with the 12% 14%
prevailing market or
effective rate of interest.
For example, if 12% bonds are competing
Discount
in a market in which similar bonds are
providing a 14% return, the bonds could 12% 10%
be sold at a price less than $700,000.
On the other hand, if the market rate is
only 10%, the 12% stated rate would seem
relatively attractive and the bonds would
sell at a premium over face amount. Premium
Why do stated rates vary from market?
Which would be more likely to be called,

premium or discount bonds?
Why do stated rates vary from market?
Changes in market interest rates between writing and
issuing.
Which would be more likely to be called, premium or

discount bonds?
Premium bonds, because they pay higher, so if interest
rates decline, they will be called and refinanced.
LO14-2
Bond Ratings
S&P Moody’s
Investment Grades:
Highest AAA Aaa
High AA Aa
Medium A A
Minimum investment grade BBB Baa
“Junk” Ratings:
Speculative BB Ba
Very speculative B B
Default or near default CCC Caa
CC Ca
C C
* Adapted from Moodys.com and SPRatings.com D
Other things being equal:
Perceived riskiness of the corporation issuing bonds
Price of the company’s bonds in the secondary market
LO14-2
Determining the Selling Price (continued)
Present value of the Present value of

Bond
= principal payable at + the periodic cash
price
maturity interest payments
Discounted at the market rate
Face amount × Stated rate

• Bond prices are typically stated in terms of a percentage
of face amounts
• Example: A price quote of 98 means a $1,000 bond will
sell for $980; a bond priced at 101 will sell for $1,010
Calculating Present Value Using Excel
=PV(rate,nper,pmt,fv,type)
“rate” is the interest rate per period. For example, if you obtain an automobile loan
at a 10 percent annual interest rate and make monthly payments, your interest rate
per month is 10%/12, or 0.83%. You would enter 10%/12, or 0.83%, or 0.0083, into the
formula as the rate.
“nper” is the total number of payment periods in an annuity. For example, if you get
a four-year car loan and make monthly payments, your loan has 4*12 (or 48) periods.
You would enter 48 into the formula for nper.
“pmt” is the payment made each period and cannot change over the life of the
annuity. pmt must be entered as a negative amount.
“fv” is the future value, or a cash balance you want to attain after the last payment
is made. fv must be entered as a negative amount.
“type” is the number 0 or 1 and indicates when payments are due. If type is omitted,
it is assumed to be 0 which represents at the end of the period. If payments are due
at the beginning of the period, type should be 1.
LO14-2
Bonds Sold at a Discount
On January 1, 2018, Masterwear Industries issued $700,000 of
12% bonds, dated January 1. Interest of (700,000 x 12% / 2)
$42,000 is payable semiannually on June 30 and December 31.
The bonds mature in three years. The market yield for bonds of
similar risk and maturity is 14%. The entire bond issue was
purchased by United Intergroup, Inc.
Calculation of the Price of the Bonds
Present Values
Interest $ 42,000 × 4.76654 = $200,195
Principal $700,000 × 0.66634 = 466,438
Present value (price) of the bonds $666,633
Present value of an ordinary Present value of $1:
annuity of $1: n = 6, i = 7% n = 6, i = 7%
Semiannual: n = 6 (3 × 2); i = 7% (14% ÷ 2)

Because the 12% rate would seem relatively unattractive in a 14% market, the bonds would command an issue price of less than
$700,000
LO14-2
Bonds Sold at a Discount (continued)

Calculation of the Price of the Bonds
Present Values
Interest $42,000 × 4.76654 = $200,195
Principal $700,000 × 0.66634 = 466,438
$200,195 $42,000 $42,000 $42,000 $42,000 $42,000 $42,000

Interest
466,438 $700,000
Principal
$666,633 Present value of interest and principal (face amount)
LO14-2
Bonds Sold at a Discount (cont. 2)

12% bonds, dated January 1. Interest of $42,000 is payable
semiannually on June 30 and December 31. The bonds mature in
three years. The market yield for bonds of similar risk and
maturity is 14%. The entire bond issue was purchased by United
Intergroup, Inc.
Masterwear (Issuer)
Cash (price calculated on previous slide) 666,633
Discount on bonds payable (difference) 33,367
Bonds payable (face amount) 700,000
United (Investor)
Investment in bonds (face amount) 700,000
Discount on bond investment (difference) 33,367
Cash (price calculated on slide 13) 666,633
LO14-2
Determining Interest: Effective Interest Method

Refers to recording interest each period as the effective market
rate of interest multiplied by the outstanding balance of the
debt (during the interest period)
Example:
In our previous illustration, the amount of debt when the bonds
were issued was $666,633. The effective interest rate was 14%.
The interest recorded (as expense to the issuer and revenue to
the investor) for the first six-month interest period is calculated
as:
Outstanding Effective Effective
× =
balance rate interest
$666,633 × [14% ÷ 2] = $46,664
LO14-2
Amortization Schedule—Discount
Cash Effective Increase in Outstanding
Date Interest Interest Balance Balance
(6% × (7% × (Discount
Face amount) Outstanding balance) reduction)
1/1/18 $666,633
6/30/18 $ 42,000 .07 (666,633) = $ 46,664 $ 4,664 671,297
12/31/18 42,000
6/30/19 42,000 7% × $666,633
12/31/19 42,000
6/30/20 42,000 $46,664 − 42,000
6% × $700,000
12/31/20 42,000
$252,000 $666,633 + 4,664
LO14-2
Amortization Schedule—Discount (continued)

(6% × (7% × (Discount
1/1/18 $666,633
6/30/18 $ 42,000 .07 (666,633) = $ 46,664 $ 4,664 671,297
12/31/18 42,000 .07 (671,297) = 46,991 4,991 676,288
6/30/19 42,000 .07 (676,288) = 47,340 5,340 681,628
12/31/19 42,000 .07 (681,628) = 47,714 5,714 687,342
6/30/20 42,000 .07 (687,342) = 48,114 6,114 693,456
12/31/20 42,000 .07 (693,456) = 48,544* 6,544 700,000
$252,000 $285,367 $33,367
* Rounded
LO14-2
Interest Payments and Expense

Masterwear (Issuer)
Interest expense (at o/s x effective) 46,664
Discount on bonds payable 4,664
Cash (at face x stated) 42,000
United (Investor)
Cash 42,000
Discount on bond investment 4,664
Interest revenue 46,664
LO14-2
Zero-Coupon Bonds
• Issuer makes no cash interest payments
• Offers a return to the investor in the form of a
“deep discount” from the face amount
• Accrue the interest expense (or revenue) each
period at the effective rate regardless of how
much cash interest actually is paid
• Issuers can deduct for tax purposes the annual interest expense,
even though no related cash outflow is incurred until the bonds
mature
• Investors receive no periodic cash interest, even though annual
interest revenue is reportable for tax purposes
• So those who invest in zero-coupon bonds usually have tax-
deferred or tax-exempt status, such as pension funds, individual
retirement accounts (IRAs), and charitable organizations
LO14-2
Zero-Coupon Bonds (continued)
Increase in Outstanding
Cash Interest Effective Interest
($ in millions) Balance Balance *
(0% × (2% × (Discount

Face amount) Outstanding debt) reduction)
1,501
2002 0 .02 (1,501) = 30 30 1,531
2003 0 .02 (1,531) = 31 31 1,561
2004 0 .02 (1,561) = 31 31 1,593
2021 0 .02 (2,143) = 43 43 2,186

2022 0 .02 (2,186) = 44 44 2,230
729 729
*Some numbers appear not to total because the underlying calculations are not rounded. Note that the final number in the schedule
($2,230 million) is the face amount payable at maturity.
LO14-2
Bonds Sold at a Premium
When bonds sell for more than their face amount
Intergroup, Inc.
Calculation of the price of the bonds
Interest $ 42,000 × 5.07569 = $213,179

Principal $700,000 × 0.74622 = 522,354
Present value of an ordinary annuity of $1: n = 6, i = 5%

Present value of $1: n = 6, i = 5%
Because the 12% rate would seem relatively attractive in a 10% market, the bonds would command an issue price of more than
$700,000
LO14-2
Bonds Sold at a Premium (continued)

Calculation of the price of the bonds
Present Values
Interest $42,000 × 5.07569 = $213,179
Principal $700,000 × 0.74622 = 522,354

Masterwear (Issuer)
Cash (price calculated above) 735,533
Premium on bonds payable (difference) 35,533
United (Investor)
Investment in bonds (face amount) 700,000
Premium on bond investment (difference) 35,533
Cash (price calculated above) 735,533
LO14-2
Amortization Schedule—Premium
Cash Effective Decrease in Outstanding

(6% × (5% × (Premium
1/1/18 $735,533
6/30/18 $ 42,000 .05 (735,533) = $ 36,777 $ 5,223 730,310
12/31/18 42,000 .05 (730,310) = 36,516 5,484 724,826
6/30/19 42,000 .05 (724,826) = 36,241 5,759 719,067
12/31/19 42,000 .05 (719,067) = 35,953 6,047 713,020
6/30/20 42,000 .05 (713,020) = 35,651 6,349 706,671
12/31/20 42,000 .05 (706,671) = 35,329* 6,671 700,000
$252,000 $216,467 $35,533 * Rounded
LO14-2
Premium and Discount Amortization Compared
or Accretion
LO14-2
When Financial Statements Are Prepared
Between Interest Dates
When an accounting period ends between interest dates, it’s
necessary to record interest that has accrued since the last
interest date
Illustration:
semiannually on June 30 and December 31. The bonds mature
in three years. The market yield for bonds of similar risk and
Intergroup, Inc. The fiscal years of Masterwear and United end
on October 31 and interest was last paid and recorded on June
30.
…continued
LO14-2
Adjusting Entries to Accrue Interest
October 31
Masterwear (Issuer)
Interest expense (4⁄6 × 46,991) 31,327
Discount on bonds payable (4⁄6 × 4,991) 3,327
Interest payable (4⁄6 × 42,000) 28,000
United (Investor)
Interest receivable (4⁄6 × 42,000) 28,000
Discount on bond investment (4⁄6 × 4,991) 3,327
Interest revenue (4⁄6 × 46,991) 31,327
LO14-2
Adjusting Entries to Accrue Interest

December 31
Masterwear (Issuer)
Interest expense (2⁄6 × 46,991) 15,664
Interest payable (from adjusting entry) 28,000
Discount on bonds payable (2⁄6 × 4,991) 1,664
Cash (stated rate × face amount) 42,000
United (Investor)
Discount on bond investment (2⁄6 × 4,991) 1,664
Interest receivable (from adjusting entry) 28,000
Interest revenue (2⁄6 × 46,991) 15,664
LO14-2
The Straight-Line Method: A Practical Expedient
Intergroup, Inc.
$700,000 – 666,633 = $33,367 ÷ 6 periods = $5,561 per period
Journal Entry—At Each of 6 Interest Dates Debit Credit
Masterwear (Issuer)
Interest expense (to balance) 47,561
Discount on bonds payable (discount ÷ 6 periods) 5,561
United (Investor)
Discount on bond investment (discount ÷ 6 periods) 5,561
Interest revenue (to balance) 47,561
LO14-2
Amortization Schedule—Straight-Line Method

Cash Recorded Increase in Outstanding
(6% × Face (Cash +
amount) Discount reduction) ($33,367 ÷ 6)
1/1/18 $666,633
6/30/18 $ 42,000 (42,000 + 5,561) = $ 47,561 $ 5,561 672,194
12/31/18 42,000 (42,000 + 5,561) = 47,561 5,561 677,755
6/30/19 42,000 (42,000 + 5,561) = 47,561 5,561 683,316
12/31/19 42,000 (42,000 + 5,561) = 47,561 5,561 688,877
6/30/20 42,000 (42,000 + 5,561) = 47,561 5,561 694,438
12/31/20 42,000 (42,000 + 5,561) = 47,561 5,561 700,000
$252,000 $285,366 $33,366
The straight-line method is an application of the materiality concept, by
which an appropriate application of GAAP (e.g., the effective interest
method) can be bypassed for reasons of practical expediency in
situations when doing so has no material effect on the results.
LO14-2
Debt Issue Costs
Sale of bonds Costs: Legal and accounting fees

and printing costs
in addition to registration and
underwriting fees
Directly to a single investor (private placement)
E.g. Pension fund or an insurance company
• Issuing company incurs only issue costs
Indirectly through underwriters who:

Commit to purchase bonds at a set price then resell them to
other security dealers and the public (i.e. underwrite the risk)
E.g. Investment banks
• Issuing company pays underwriting fee
LO14-2
Debt Issue Costs (continued)

• Recorded by combining with any discount or premium;
combined valuation account is reported as a direct
deduction from the liability; amortized over the life of
the debt
On January 1, 2018, Masterwear Industries issued $700,000 of 12% bonds,
dated January 1. Interest of $42,000 is payable semiannually on June 30 and
December 31. The bonds mature in three years. The market yield for bonds
of similar risk and maturity is 10%. The entire bond issue was purchased by
United Intergroup, Inc. The company incurred the issue cost of $14,000.

Masterwear (Issuer)
Cash ($666,633 minus $14,000 issue costs) 652,633
Discount and debt issue costs ($33,367+14,000 or difference) 47,367
LO14-2
Debt Issue Costs (cont. 2)
Now, the effective rate is the one that would cause

the present value of the six interest payments and the
maturity amount of $700,000 to be $652,633. That
semiannual rate is 7.4389%.

Masterwear (Issuer)
Interest expense ($652,633 × 7.4389%) 48,549
Discount and debt issue costs (difference) 6,549
Cash ($700,000 × 6% stated rate) 42,000
LO14-2
Concept Check: Effective Interest Rate

On June 30, 2018, Mabry Corporation issued $15 million of its 8%
bonds for $13.8 million. The bonds were priced to yield 10%. The
bonds are dated June 30, 2018. Interest is payable semiannually on
December 31 and July 1. If the effective interest method is used, by
how much should the bond discount be reduced for the 6 months
ended December 31, 2018?
a. $48,000
b. $60,000
c. $69,000
d. $90,000
LO14-2
Concept Check: Effective Interest Rate

On June 30, 2018, Mabry Corporation issued $15 million of its 8%
bonds for $13.8 million. The bonds were priced to yield 10%. The
bonds are dated June 30, 2018. Interest is payable semiannually on
December 31 and July 1. If the effective interest method is used, by
how much should the bond discount be reduced for the 6 months
a. $48,000
b. $60,000
c. $69,000
d. $90,000
The correct answer is d:
Interest expense ($13,800,000 × .10 × 6/12) 690,000
Discount (difference) 90,000
Cash ($15,000,000 × .08 × 6/12) 600,000
LO14-2
Concept Check: Amortization Schedules

Chism Corporation issued $10 million face amount of bonds on January 1,
2018. The bonds have a 10-year term and pay interest semiannually. The
following is a partial bond amortization schedule for the bonds.
Payment Cash Effective Decrease in Outstanding
Interest Balance Balance
11,487,747
1 400,000 344,632 55,368 11,432,379
2 400,000 342,971 57,029 11,375,350
3 400,000 341,261 58,739 11,316,611
4 400,000
What is the interest expense on the bonds in 2019?
a. $119,241
b. $342,961
c. $680,759
d. $800,000
LO14-2
Concept Check: Amortization Schedules

Chism Corporation issued $10 million face amount of bonds on January 1,
2018. The bonds have a 10-year term and pay interest semiannually. The
following is a partial bond amortization schedule for the bonds.
Payment Cash Effective Decrease in Outstanding
Interest Balance Balance
11,487,747
7/1/18 400,000 344,632 55,368 11,432,379
12/31/18 400,000 342,971 57,029 11,375,350
7/1/19 400,000 341,261 58,739 11,316,611
12/31/19 400,000 339,498
What is the interest expense on the bonds in 2019?
a. $119,241
The correct answer is c:
b. $342,961
Semiannual effective rate = $344,632 ÷ $11,487,747 = 3%
c. $680,759
d. $800,000 Interest expense = $341,261 + ($11,316,611 × 3%) = $680,759
E14-5. Myriad Solutions, Inc., issued 10% bonds, dated
January 1, with a face amount of $320 million on January
1, 2018, for $283,294,720. The bonds mature on
December 31, 2027 (10 years). For bonds of similar risk
and maturity the market yield is 12%. Interest is paid
semiannually on June 30 and December 31.
1. What would be the net amount of the liability
Myriad would report in its balance sheet at
December 31, 2018?
2. What would be the amount related to the bonds
that Myriad would report in its income statement
for the year ended December 31, 2018?
3. What would be the amount(s) related to the bonds
that Myriad would report in its statement of cash
flows for the year ended December 31, 2018?
Calculations: SOLUTION
January 1, 2018*
Cash (price) 283,294,720
Discount on bonds payable (difference) 36,705,280
Bonds payable (face amount) 320,000,000
June 30, 2018**
Interest expense (6% x $283,294,720) 16,997,683
Cash (5% x $320,000,000) 16,000,000
December 31, 2018***
Interest expense (6% x [$283,294,720 + 997,683]) 17,057,544
Discount on bonds payable (difference) 1,057,544
Cash (5% x $320,000,000) 16,000,000
SOLUTION
1. Liability at December 31, 2018
Bonds payable (face amount) $320,000,000
Less: discount 36,705,280
Initial balance, January 1, 2018 $283,294,720
June 30, 2018 discount amortization 997,683**
Dec. 31, 2018 discount amortization 1,057,544***
December 31, 2018 net liability $285,349,947
2. Interest expense for year ended December 31, 2018
June 30, 2018 interest expense $16,997,683**
Dec. 31, 2018 interest expense 17,057,544***
Interest expense for 2018 $34,055,227
3. Statement of cash flows for year ended December 31, 2018
Myriad would report the cash inflow of $283,294,720* from the sale of the bonds as
a cash inflow from financing activities in its statement of cash flows.
The $32,000,000 ($16,000,000** + 16,000,000***) cash interest paid is cash
outflow from operating activities because interest is an income statement
(operating) item.
E14-12. On March 1, 2018, Stratford Lighting issued 14%
bonds, dated March 1, with a face amount of
$300,000. The bonds sold for $294,000 and mature on
February 28, 2038 (20 years). Interest is paid
semiannually on August 31 and February 28. Stratford
uses the straight-line method and its fiscal year ends
December 31.
1. Prepare the journal entry to record the issuance of
the bonds by Stratford Lighting on March 1, 2018.
2. Prepare the journal entry to record interest on
August 31, 2018.
3. Prepare the journal entry to accrue interest on
December 31, 2018.
4. Prepare the journal entry to record interest on
February 28, 2019.
SOLUTION
1. March 1, 2018
Cash (price given) 294,000
2. August 31, 2018

Interest expense ($21,000 + 150) 21,150
Discount on bonds payable ($6,000 ÷ 40) 150
Cash (7% x $300,000) 21,000
3. December 31, 2018

Interest expense (4/6 x $21,150) 14,100
Discount on bonds payable (4/6 x $150) 100
Interest payable (4/6 x $21,000) 14,000
4. February 28, 2019

Interest expense (2/6 x $21,150) 7,050
Interest payable (4/6 x $21,000) 14,000
Discount on bonds payable (2/6 x $150) 50
Cash (7% x $300,000) 21,000
P14-3. On January 1, 2018, Bradley Recreational Products
issued $100,000, 9%, four-year bonds. Interest is paid
semiannually on June 30 and December 31. The bonds
were issued at $96,768 to yield an annual return of 10%.
1. Prepare an amortization schedule that determines
interest at the effective interest rate.
2. Prepare an amortization schedule by the straight-line
method.
3. Prepare the journal entries to record interest expense
on June 30, 2020, by each of the two approaches.
4. Explain why the pattern of interest differs between
the two methods.
5. Assuming the market rate is still 10%, what price
would a second investor pay the first investor on June
30, 2020, for $10,000 of the bonds?
SOLUTION
1. A. Cash B. Effective B-A=C. Increase Outstanding
Payment Interest in BalanceBalance
4.5% x Face Amount 5% x Outstanding Balance
D. 96,768
1 4,500 .05(96,768)=4,838 338 97,106 D-C.
2 4,500 .05(97,106)=4,855 355 97,461
3 4,500 .05(97,461)=4,873 373 97,834
4 4,500 .05(97,834)=4,892 392 98,226
5 4,500 .05(98,226)=4,911 411 98,637
6 4,500 .05(98,637)=4,932 432 99,069
7 4,500 .05(99,069)=4,953 453 99,522
8 4,500 .05(99,522)=4,978* 478 100,000
36,000 39,232 3,232
* rounded.
2.
A. Cash A+C=B. Recorded C. Increase in Outstanding
Payment Interest Balance Balance
4.5% x Face Amount Cash plus $3,232 ÷ 8
Discount Reduction
D. 96,768
1 4,500 (4,500 + 404) =4,904 404 97,172 D-C.
2 4,500 (4,500 + 404) =4,904 404 97,576
3 4,500 (4,500 + 404) =4,904 404 97,980
4 4,500 (4,500 + 404) =4,904 404 98,384
5 4,500 (4,500 + 404) =4,904 404 98,788
6 4,500 (4,500 + 404) =4,904 404 99,192
7 4,500 (4,500 + 404) =4,904 404 99,596
8 4,500 (4,500 + 404)=4,904 404 100,000
36,000 39,232 3,232
3.
(2020 with effective interest amortization)

Interest expense (5% x $98,226) 4,911
Discount on bonds payable (difference) 411
Cash (4.5% x $100,000) 4,500
(2020 with straight-line amortization)

Interest expense ($4,500 + 404) 4,904
Discount on bonds payable ($3,232 ÷ 8) 404
Cash (4.5% x $100,000) 4,500
4. • By the straight-line method, a company determines interest
indirectly by allocating a discount or a premium equally to each
period over the term to maturity. This is allowed if doing so
produces results that are not materially different from the
interest method. The decision should be guided by whether the
straight-line method would tend to mislead investors and
creditors in the particular circumstance.
• Allocating the discount or premium equally over the life of the
bonds by the straight-line method results in an unchanging dollar
amount of interest each period. By the straight-line method, the
amount of the discount to be reduced periodically is calculated,
and the effective interest is the “plug” figure.
• Unchanging dollar amounts like these are not produced when the
effective interest approach is used. By that approach, the dollar
amounts of interest vary over the term to maturity because the
percentage rate of interest remains constant, but is applied to a
changing debt balance.
• Remember that the “straight-line method,” is not an alternative
method of determining interest in a conceptual sense, but is an
application of the materiality concept. The appropriate
application of GAAP, the effective interest method, is by-passed
as a practical expediency in situations when doing so has no
“material” effect on the results.
5. The amortization schedule in requirement 1 gives us the
present value, which represents fair value since the market rate
still is 10%. The outstanding debt balance after the June 30,
2020, interest payment (line 5) is the present value at that time
($98,637) of the remaining payments. Since $10,000 face
amount of the bonds is 10% of the entire issue, we take 10% of
the table amount to arrive at $9,864.
This can be confirmed by calculating the present value:
Interest $450# x 2.72325 * = $1,225

Principal$10,000 x 0.86384 ** = 8,638
Present value (price) of the bonds $9,864 (rounded)
# 4.5% x $10,000
* Present value of an ordinary annuity of $1: n = 3, i = 5% (Table 4)
** Present value of $1: n = 3, i = 5% (Table 2)
LO14-3
Long-Term Notes
When a company borrows cash from a bank and
signs a promissory note, the firm’s liability is
reported as a note payable
Borrower Long-term Lender

Notes
Notes Notes
payable receivable
LO14-3
Note Issued for Cash

On January 1, 2018, Skill Graphics, Inc., a product-labeling and
The interest rate graphics firm, borrowed $700,000 cash from First BancCorp
stated in a note is and issued a three-year, $700,000 promissory note. Interest of
likely to be equal $42,000 was payable semiannually on June 30 and December
to the market rate 31.
because the rate
At issuance
usually is
negotiated at the
time of the loan. Journal Entry Debit Credit
So discounts and Skill Graphics (Borrower)
premiums are less
likely for notes Cash 700,000
than for bonds. Notes payable (face amount) 700,000
Therefore, the First BancCorp (Lender)
present value is
Notes receivable (face amount) 700,000
equal to the face
value. Cash 700,000
1/1/1 12/31/1 12/31/2 12/31/3
$ 700,000
12% stated
Present
interest rate
$ 700,000
value $ 42,000
$ 42,000
$ 42,000
12% market
interest rate
LO14-3
Note Issued for Cash (continued)

graphics firm, borrowed $700,000 cash from First BancCorp
and issued a three-year, $700,000 promissory note. Interest of
$42,000 was payable semiannually on June 30 and December
31.
At each of the six interest dates

Skill Graphics (Borrower)
Interest expense 42,000
First BancCorp (Lender)
Interest revenue 42,000
LO14-3
Note Issued for Cash (concluded)

graphics firm, borrowed $700,000 cash from First BancCorp
and issued a three-year, $700,000 promissory note. Interest of
$42,000 was payable semiannually on June 30 and December
31.
At maturity

Notes payable 700,000
Cash (face amount) 700,000
First BancCorp (Lender)

Cash (face amount) 700,000
Notes receivable 700,000
LO14-3
Notes Exchanged for Assets or Services

Skill Graphics purchased a package-labeling machine from
Hughes–Barker Corporation by issuing a 12%, $700,000, three-
year note that requires interest to be paid semiannually. The
machine could have been purchased at a cash price of
$666,633.
Calculation of the price of the note
Interest $42,000 × 4.76654 = $200,195

Principal $700,000 × 0.66634 = 466,438
Present value of the note $666,633

Implicit rate of interest is 14%
LO14-3
Notes Exchanged for Assets or Services (continued)
• Implicit rate of interest: Rate is not expressly stated in the agreement

• Imputing an interest rate: Deciding the appropriate rate when value of
asset or service is not readily determinable
Example:
The machine exchanged for the 12% note is custom-made so that no customary cash price is
available with which to work backwards to find the implicit rate. In such a case, how do we impute
interest rate?
Solution:
• Appropriate rate would have to be found externally
• Use of substance over form
It might be determined, for instance, that a more realistic interest rate for a transaction of this
type, at this time, would be 14%. Then it would be apparent that the buyer actually paid less than
$700,000 for the machine and that part of the face amount of the note in effect makes up for the
lower than normal (market) interest rate.
LO14-3
Journal Entries at Issuance—
Note with Unrealistic Interest Rate
Calculation of the Price of the Note
Present Values
Interest $ 42,000 × 4.76654 = $200,195
Principal $700,000 × 0.66634 = 466,438
Present value of the note $666,633
Skill Graphics (Buyer/Issuer)
Machinery (cash price) 666,633
Discount on notes payable (difference) 33,367
Notes payable (face amount) 700,000
Hughes–Barker (Seller/Lender)
Notes receivable (face amount) 700,000
Discount on notes receivable (difference) 33,367
Sales revenue (cash price) 666,633
LO14-3
Journal Entries—The Interest Method

At the First Interest Date (June 30)

Interest expense (effective rate × outstanding 46,664
balance)
Discount on notes payable (difference) 4,664
Discount on notes receivable (difference) 4,664
Interest revenue (effective rate × 46,664
outstanding balance)
LO14-3
Amortization Schedule—Note

(6% × Face (7% × Outstanding (Discount
amount) balance) reduction)
1/1/18 $666,633
6/30/18 $ 42,000 .07 (666,633) = $ 46,664 $ 4,664 671,297
12/31/18 42,000 .07 (671,297) = 46,991 4,991 676,288
6/30/19 42,000 .07 (676,288) = 47,340 5,340 681,628
12/31/19 42,000 .07 (681,628) = 47,714 5,714 687,342
6/30/20 42,000 .07 (687,342) = 48,114 6,114 693,456
12/31/20 42,000 .07 (693,456) = 48,544 6,544 700,000
$252,000 $285,367 $33,367
LO14-3
Installment Notes
• Installment payments are equal amounts each
period
• Periodic reduction of the balance is sufficient that
at maturity the note is completely paid
Each payment
Interest
Includes both an
amount that
represents Principal reduction
LO14-3
Installment Notes (continued)
• The periodic amount is easily calculated by dividing the amount of the

loan by the appropriate discount factor for the present value of an
annuity
Skill Graphics purchased a package-labeling machine from Hughes–Barker
Corporation by issuing a 12%, $700,000, three-year note that requires interest to
be paid semiannually. Let’s also assume that the machine could have been
purchased at a cash price of $666,633.
$666,633 ÷ 4.76654 = $139,857

Amount of loan Present value of an Installment
ordinary annuity of $1 payment
n = 6, i = 7%
LO14-3
Amortization Schedule—Installment Note

Cash Effective Decrease in Outstanding
Date Payment Interest Balance Balance
(7% × Outstanding
balance)
1/1/18 $666,633
6/30/18 $ 139,857 .07 (666,633) = $ 46,664 $ 93,193 573,440
12/31/18 139,857 .07 (573,440) = 40,141 99,716 473,724
6/30/19 139,857 .07 (473,724) = 33,161 106,696 367,028
12/31/19 139,857 .07 (367,028) = 25,692 114,165 252,863
6/30/20 139,857 .07 (252,863) = 17,700 122,157 130,706
12/31/20 139,857 .07 (130,706) = 9,151 130,706 0
$839,142 $172,509 $666,633
LO14-3
Journal Entries at Issuance—Installment Note

Skill Graphics (Buyer/Issuer)
Machinery 666,633
Note payable 666,633
Note receivable 666,633
Sales revenue 666,633
LO14-3
Journal Entries at Issuance—Installment Note
(continued)
At the First Interest Date (June 30)

Interest expense (effective rate × outstanding balance) 46,664
Notes payable (difference) 93,193
Cash (installment payment) 139,857
Cash (installment payment) 139,857
Notes receivable (difference) 93,193
Interest revenue (effective rate × outstanding 46,664
balance)
LO14-3
Concept Check:
Calculation of Installment Payments
Kazali Industries purchased a machine from Keefe Corporation
on October 1, 2018. In payment for the $432,000 purchase,
Kazali issued a one-year installment note to be paid in equal
monthly payments at the end of each month. The payments
include interest at the rate of 12%. Monthly installment
payments are:
a. $36,000
b. $37,335
c. $38,004
d. $38,382
PV of an annuity for 12 periods at 1% is 11.25508
LO14-3
Concept Check:
Calculation of Installment Payments
Kazali Industries purchased a machine from Keefe Corporation
Kazali issued a one-year installment note to be paid in equal
monthly payments at the end of each month. The payments
include interest at the rate of 12%. Monthly installment
payments are:
a. $36,000
b. $37,335
c. $38,004 The correct answer is d:
d. $38,382 $432,000 ÷ 11.25508 = $38,382
amount (PV of annuity) installment
of loan n=12, i=1% payment
LO14-3
Concept Check:
Installment Notes and Principal
In each subsequent cash payment on an installment note:
a. The amount of principal paid decreases
b. The amount of principal paid increases
c. The amount of interest paid increases
d. The amounts paid for both interest and principal increase
proportionately
LO14-3
Concept Check:
Installment Notes and Principal
In each subsequent cash payment on an installment note:
a. The amount of principal paid decreases
b. The amount of principal paid increases
c. The amount of interest paid increases
d. The amounts paid for both interest and principal increase
proportionately
The correct answer is b:

Interest expense (effective rate times a declining balance) xxx
Notes payable (difference) xxx
Cash (equal payment each period) xxx
LO14-3
Concept Check:
Interest on Installment Notes
Vernois Company purchased a machine from Chunn Corporation
Vernois issued a one-year installment note to be paid in equal
monthly payments of $51,176 at the end of each month. The
payments include interest at the rate of 12%. The amount of
interest expense that Vernois will report in its income statement
for the year ended December 31, 2018, is:
a. $5,118
b. $5,760
c. $11,066
d. $11,520
LO14-3
Concept Check:
Interest on Installment Notes
Vernois Company purchased a machine from Chunn Corporation
Vernois issued a one-year installment note to be paid in equal
monthly payments of $51,176 at the end of each month. The
payments include interest at the rate of 12%. The amount of
interest expense that Vernois will report in its income statement
for the year ended December 31, 2018, is:
The correct answer is c:
a. $5,118 November:
b. $5,760 Interest expense (1% × outstanding balance) 5,760
Note payable (difference) 45,416
c. $11,066 Cash (payment) 51,176
d. $11,520 November (1% × $576,000) $ 5,760

December (1% × [$576,000 − 45,416]) 5,306
2018 interest expense $11,066
E14-21. LCD Industries purchased a supply of electronic
components from Entel Corporation on November 1,
2018. In payment for the $24 million purchase, LCD
issued a 1-year installment note to be paid in equal
monthly payments at the end of each month. The
payments include interest at the rate of 12%.
1. Prepare the journal entry for LCD’s purchase of the
components on November 1, 2018.
2. Prepare the journal entry for the first installment
payment on November 30, 2018.
3. What is the amount of interest expense that LCD
will report in its income statement for the year
SOLUTION
1. November 1, 2018
Component inventory 24,000,000
Notes payable 24,000,000
2. November 30, 2018
Interest expense (1% x outstanding balance) 240,000
Notes payable (difference) 1,892,370
Cash (payment determined below) 2,132,370
Calculation of installment payment:
$24,000,000 ÷ 11.25508 = $2,132,370
amount (from Table 4) installment
of loan n = 12, i = 1% payment
3. December 31, 2018
November (1% x $24,000,000) $240,000
December (1% x [$24,000,000 – 1,892,370]) 221,076
2018 interest expense $461,076
Journal entry (not required):
Interest expense (1% x [$24,000,000 – 1,892,370]) 221,076
Notes payable (difference) 1,911,294
Cash (payment determined above) 2,132,370
LO14-4
Financial Statement Disclosures

Fair value of financial instruments must be disclosed either in the body
of the financial statements or disclosure note
Fair values are available for bonds and Disclosure note should include:
other securities traded on market
exchanges in the form of quoted market • Nature of the company liabilities
prices.
• Interest rates
Financial instruments not traded on • Maturity dates
market exchanges require other evidence • Call provisions
of market value. For example, the market • Conversion options
value of a note payable might be • Restrictions by creditors
approximated by the present value of
• Assets pledged as collateral
principal and interest payments using a
current discount rate commensurate with • Amounts payable next 5 years
the risks involved.
A Few Debt Related Financial Ratios
LO14-4
Condensed Financial Statements—
Coca-Cola, PepsiCo
Balance Sheets
($ in millions)
Coca-Cola PepsiCo
Assets
Current assets $33,395 $23,031
Property, plant, and equipment (net) 12,571 16,317
Intangibles and other assets 44,127 30,319
Total assets $90,093 $69,667
Liabilities and Shareholders’ Equity
Current liabilities $26,930 $17,578
Long-term liabilities 37,399 40,059
Total liabilities $64,329 $57,637
Shareholders’ equity 25,764 12,030
Total liabilities and shareholders’ equity $90,093 $69,667
LO14-4
Condensed Financial Statements—
Coca-Cola, PepsiCo (continued)
Income Statements
($ in millions)
Coca-Cola PepsiCo
Net sales $44,294 $63,056

Cost of goods sold (17,482) (28,384)
Gross profit $26,812 $34,672
Operating and other expenses (16,366) (26,309)
Interest expense (856) (970)
Income before taxes $ 9,590 $ 7,393
Tax expense (2,239) (1,941)
Net income $ 7,351 $ 5,452
LO14-4
Debt to Equity Ratio

• Measures the degree of risk. Generally debt increases risk. WHY?
• The type of risk measured is the default risk
• It presumably indicates the likelihood a company will default on its
obligations
Total liabilities
Debt to equity ratio =
Shareholders’ equity
Coca-Cola PepsiCo
Total liabilities $64,329 $57,637
Shareholders’ equity 25,764 12,030
$64,329 $57,637
Debt to equity ratio =
$25,764 $12,030 Risk
not necessarily a positive
= 2.5 4.8 or a negative, by itself
LO14-4
Debt to Equity Ratio

• Measures the degree of risk. Generally debt increases risk. WHY? As an owner,
debt would place you
• The type of risk measured is the default risk in a subordinate
• It presumably indicates the likelihood a company will default on relative
position its to
obligations creditors because the
claims of creditors
Total liabilities
Debt to equity ratio = must be satisfied first
Shareholders’ equity in case of liquidation.
Debt requires
Coca-Cola PepsiCo
payment, usually on
Total liabilities $64,329 $57,637 specific dates. Failure
Shareholders’ equity 25,764 12,030 to pay debt interest
and principal on a
$64,329 $57,637 timely basis may
Debt to equity ratio = result in default and
$25,764 $12,030 Risk even
perhaps
not necessarily a positive
= 2.5 4.8 bankruptcy.
or a negative, by itself
LO14-4
Rate of Return on Assets
Net income
Rate of return on assets =
Total assets
Coca-Cola PepsiCo
Net income $ 7,351 $ 5,452
Total assets $90,093 $69,667
$7,351 $5,452
Rate of return on assets =
$90,093 $69,667
= 8.2% 7.8%
Return on assets measures the success of the company in generating income for
its shareholders, without regard to how the assets are financed. Coca-Cola’s
profitability is slightly higher than PepsiCo’s.
LO14-4
Decision Makers’ Perspective

Business decisions involve risk:
Return on assets in
excess of borrowed cost
t u r n t r ad e -off
Risk-r e
Return on assets less

than borrowed cost
Favorable financial leverage: if a company earns a return on borrowed
funds in excess of the cost of borrowing the funds, shareholders are
provided with a total return greater than what could have been earned
with equity funds alone
LO14-4
Rate of Return on Shareholders’ Equity
Rate of return on shareholders’ equity = Net income
Shareholders’ equity
Coca-Cola PepsiCo
Net income $ 7,351 $ 5,452
Shareholders’ equity $25,764 $12,030
Rate of return on
$7,351 $5,452
shareholders’ equity =
$25,764 $12,030
= 28.5% 45.3%
Rate of return on shareholders’ equity indicates the effectiveness of employing resources provided by owners. Coca-Cola’s
return on assets is 5% higher than PepsiCo’s, but its return on shareholders’ equity is 37% less. The reason is that higher leverage
has been used by PepsiCo to provide a relatively greater return to shareholders. PepsiCo increased its return to shareholders
5.8 times (45.3% / 7.8%) the return on assets. Coca-Cola increased its return to shareholders 3.5 times (28.5% / 8.2%) the return on
assets. Interpret this with caution, though. PepsiCo’s higher leverage means higher risk as well. In down times, PepsiCo’s return
to shareholders will suffer proportionally more than will Coca-Cola’s.
LO14-4
Times Interest Earned Ratio

Net income + Interest + Taxes
Times Interest Earned Ratio =
Interest
Coca-Cola PepsiCo
Net income $7,351 $5,452
Interest expense $ 856 $ 970
Tax expense $2,239 $1,941
$10,446 $8,363
Times Interest Earned Ratio =
$856 $970
$7,351 + $856 + $2,239 = 12.2 times 8.6 times

$5,452 + $970 + $1,941
From the perspective of a creditor, we might look at which company offers the most comfortable margin of safety in terms of its
ability to pay fixed interest charges.
In this regard, Coca-Cola provides a greater margin of safety. And, PepsiCo has more debt in its capital structure relative to Coca-
Cola. However, PepsiCo clearly is able to pay the cost of borrowing and provide an impressive return to its shareholders. Both
firms, though, earn quite favorably on their leverage.
LO14-4
Concept Check:
Which of the following is true concerning financial statement
disclosure for debt instruments?
a. The fair value of financial instruments must be disclosed
either in the body of the financial statements or in
disclosure notes
b. Disclosures should include the aggregate amounts payable
for each of the next five years for any long-term borrowing
c. Both the issuer and the investor report interest as an
operating activity on the statement of cash flows
d. All of the above
LO14-4
Concept Check:
Which of the following is true concerning financial statement
disclosure for debt instruments?
a. The fair value of financial instruments must be disclosed
either in the body of the financial statements or in
disclosure notes
b. Disclosures should include the aggregate amounts payable
for each of the next five years for any long-term borrowing
c. Both the issuer and the investor report interest as an
operating activity on the statement of cash flows
d. All of the above
The correct answer is d. Disclosures should include the fair value of
financial instruments and the aggregate amounts payable for the next five
years on long-term borrowing, while interest is reported as an operating
activity on the statement of cash flows.
LO14-5
Early Extinguishment of Debt
• Refers to the transaction when debt is retired

A call feature
accompanies prior to its scheduled maturity date
most bonds to
protect the
• Accounting for early extinguishment:
issuer against – Account balances of the debt must be removed
declining
interest rates. from the books
Even when – Difference between the book value of the debt
bonds are not
callable, the and the reacquisition price represents either a
issuing company gain or a loss
can retire bonds
early by – be alert to gains and losses that have nothing
purchasing them to do with a company’s normal operating
on the open
market.
activities
LO14-5
Early Extinguishment of Debt (continued)

On January 1, 2019, Masterwear Industries called its
$700,000, 12% bonds when their book value was $676,288.
The indenture specified a call price of $685,000. The
bonds were issued previously at a price to yield 14%.

Loss on early extinguishment ($685,000 − 676,288) 8,712
Discount on bonds payable ($700,000 − 676,288) 23,712
Cash (call price) 685,000
Why would a company knowingly choose a financial statement loss?
LO14-5
Concept Check:
Enterprise Group issued $100,000 of 3-year, 6% bonds outstanding
on December 31, 2019, for $106,000. Enterprise uses straight-line
amortization. On May 1, 2020, $10,000 of the bonds were retired at
110. As a result of the retirement, Enterprise will report a:
a. $400 loss
b. $467 loss
c. $1,100 loss
d. $1,100 gain
LO14-5
Concept Check:
Enterprise Group issued $100,000 of 3-year, 6% bonds outstanding
on December 31, 2019, for $106,000. Enterprise uses straight-line
amortization. On May 1, 2020, $10,000 of the bonds were retired at
110. As a result of the retirement, Enterprise will report a:
a. $400 loss
The correct answer is b:
b. $467 loss Interest expense (to balance) 133
Bonds payable ([$6,000 × 1/3 × 4/12)] × 10% ) 67 Bring it
c. $1,100 loss Interest payable ([$100,000 × 6% × 4/12 ] × 10%) 200 current,
d. $1,100 gain then
Bonds payable (book value) 10,553 retire
Loss on early extinguishment (to balance) 467
Cash (call price) 11,000
Paid at redemption: $10,000 × 110% = $11,000

Book value: [$106,000 − ($6,000 × 1/3 × 4/12)] × 10% = 10,533
Loss $ 467
LO14-5
Convertible Bonds
• Can be exchanged for shares of stock at the
option of the investor
• Issued to:
– Sell bonds at higher price (effective interest
lower than stated interest)
– Use as a medium of exchange in mergers and
acquisitions
– Enable smaller firms or debt-heavy companies
to obtain access to the bond market (when
there is shareholder resistance to direct issuance
of additional equity)
A hybrid security has features of both debt and equity The owner has a fixed-income
security that can become common stock if and when the firm’s prosperity makes that
feasible. This increases the investor’s upside potential while limiting the downside risk.
LO14-5
Convertible Bonds (continued)

On January 1, 2018, HTL Manufacturers issued $100 million of 8%
convertible debentures due 2038 at 103 (103% of face value).
The bonds are convertible at the option of the holder into no par
common stock at a conversion ratio of 40 shares per $1,000 bond.
HTL recently issued nonconvertible, 20-year, 8% debentures at 98.
($ in millions)
Cash (103% × $100 million) 103
Convertible bonds payable (face amount) 100
Premium on bonds payable (difference) 3
LO14-7
International Financial Reporting Standards—
Convertible Bonds
U.S. GAAP IFRS
U.S. GAAP treats convertible Convertible debt is divided into
debt the same as its liability and equity elements.
nonconvertible debt.
($ in millions)
IFRS Journal Entry Debit Credit
Cash (103% × $100 million) 103
Convertible bonds payable (value of debt only) 98
Equity − conversion option (to balance) 5
LO14-5
When the Conversion Option is Exercised

On January 1, 2018, HTL Manufacturers issued $100 million of 8%
convertible debentures due 2038 at 103 (103% of face value). The
bonds are convertible at the option of the holder into no par
common stock at a conversion ratio of 40 shares per $1,000 bond.
HTL recently issued nonconvertible, 20-year, 8% debentures at 98.
Half the convertible bonds issued by HTL Manufacturers are
converted at a time when the remaining unamortized
premium is $2 million.
Recorded at Conversion by the issuer ($ in millions)
Convertible bonds payable (1/2 the account balance) 50
Premium on bonds payable (1/2 the account balance) 1
40 shares per Common stock (to balance) 51
50M bonds =
2M shares
issued
LO14-5
When the Conversion Option is Exercised (continued)

On January 1, 2018, HTL Manufacturers issued $100 million of
8% convertible debentures due 2036 at 103 (103% of face
value). The bonds are convertible at the option of the holder
into no par common stock at a conversion ratio of 40 shares
per $1,000 bond. HTL recently issued nonconvertible, 20-year,
8% debentures at 98.
If the 50,000 convertible bonds were held by a single investor

($ in millions)
Investment in common stock 51
Investment in convertible bonds (account balance) 50
Premium on bond investment (account balance) 1
LO14-5
Induced Conversion
to reduce debt and
become a better risk
Induced Conversion to potential lenders
or achieve a lower
debt-to-equity ratio
Through the call provision Encouraging voluntary

When the specified call conversion
price is less than the By offering an added
conversion value of the inducement in the form of
bonds (market value of cash, stock warrants, or a
shares) more attractive conversion
ratio
Calling the convertible bonds provides When additional consideration is provided to induce
bondholders with incentive to convert conversion, the fair value of that consideration is considered
an expense incurred to bring about the conversion.
LO14-5
Detachable Stock Purchase Warrants
• Give the investor an option to purchase a stated number of shares

of common stock at a specified option price, often within a given
period of time
• Usually bond bears a lower interest rate
• Can be exercised independently or traded in the market separately
from bonds, having their own market price
• Issue price is allocated between the two different securities on the
basis of their fair values
LO14-5
Bonds with Detachable Warrants

On January 1, 2018, HTL Manufacturers issued $100 million of 8% debentures due
2022 at 103 (103% of face value). Accompanying each $1,000 bond were 20
warrants. Each warrant permitted the holder to buy one share of no par common
stock at $25 per share. Shortly after issuance, the warrants were listed on the
stock exchange at $3 per warrant.
($ in millions)
Cash (103% × $100 million) 103
Discount on bonds payable (difference) 3
Bonds payable (face amount) 100
Equity—stock warrants (100,000 bonds × 20 6
warrants × $3)
LO14-5
Exercise of Detachable Warrants

On January 1, 2018, HTL Manufacturers issued $100 million of 8% debentures due 2022 at
103 (103% of face value). Accompanying each $1,000 bond were 20 warrants. Each warrant
permitted the holder to buy one share of no par common stock at $25 per share. Shortly
after issuance, the warrants were listed on the stock exchange at $3 per warrant.
If one-half of the warrants (one million) are exercised when the market value of HTL’s
common stock is $30 per share, one million shares would be issued for one warrant each
plus the exercise price of $25 per share.
($ in millions)
Cash 25
Equity—stock warrants 3
Common stock (to balance) 28
(1,000,000 warrants × $25) (1,000,000 warrants × $3)

E14-24. On January 1, 2018, Gless Textiles issued $12 million
of 9%, 10-year convertible bonds at 101. The bonds pay
interest on June 30 and December 31. Each $1,000 bond is
convertible into 40 shares of Gless’s no par common stock.
Bonds that are similar in all respects, except that they are
nonconvertible, currently are selling at 99 (that is, 99% of
face amount). Century Services purchased 10% of the issue
as an investment.
1. Prepare the journal entries for the issuance of the
bonds by Gless and the purchase of the bond
investment by Century.
2. Prepare the journal entries for the June 30, 2022,
interest payment by both Gless and Century assuming
both use the straight-line method.
3. On July 1, 2023, when Gless’s common stock had a
market price of $33 per share, Century converted the
bonds it held. Prepare the journal entries by both Gless
and Century for the conversion of the bonds (book
value method).
SOLUTION
1. Gless (Issuer)
Cash (101% x $12 million) 12,120,000
Convertible bonds payable (face amount)
12,000,000
Premium on bonds payable (difference)
120,000
Century (Investor)
Investment in convertible bonds (10% x $12 million)
1,200,000
Premium on bond investment (difference)
12,000
Cash (101% x $1.2 million) 1,212,000
2. Gless (Issuer)
Interest expense ($540,000 – 6,000) 534,000
Premium on bonds payable ($120,000 ÷ 20)
6,000
Cash (4.5% x $12,000,000) 540,000
Century (Investor)
Cash (4.5% x $1,200,000) 54,000
Premium on bond investment ($12,000 ÷ 20)
600
Interest revenue ($54,000 – 600)
53,400
[Using the straight-line method, each interest
entry is the same.]
3. Gless (Issuer)
Convertible bonds payable (10% of the account
balance) 1,200,000
Premium on bonds payable
(($120,000 – [$6,000 x 11]) x 10%) 5,400
Common stock (to balance) 1,205,400
Century (Investor)
Investment in common stock 1,205,400
Investment in convertible bonds (account
balance) 1,200,000
Premium on bond investment
($12,000 – [$600 x 11]) 5,400
LO14-6
Liabilities at Fair Value
Company Invests Issues General

Bonds
“A” Motors
Asset Liability
• The market forces that influence the fair value of an

investment in debt securities (interest rates, credit risk, etc.)
influences the fair value of liabilities
• Companies are not required to, but have the option to, value
some or all of their financial assets and liabilities at fair value
LO14-6
Reporting Changes in Fair Value

• If the fair value option is elected, a change in fair value creates a gain or
loss e.g. Debit (reduce) Debt, Credit Gain
• Any portion of that gain or loss that is a result of a change in the
general (risk-free) interest rate is reported as part of net income
• Any portion of that gain or loss that is a result of a change in the
“credit risk” of the debt is reported as other comprehensive income
(OCI) WHY?
• Credit risk: The risk that the investor in the bonds will not receive the
promised interest and maturity amounts at the times they are due.
e.g. credit ratings decline
• Any change in fair value that exceeds the amount caused by a change
in the general (risk-free) interest rate is the result of credit risk changes
LO14-6
Effect of Interest Rates on Fair Value

On January 1, 2018, Masterwear Industries issued $700,000 of 12% bonds,
dated January 1. Interest of $42,000 is payable semiannually on June 30 and
December 31. The bonds mature in three years. The market yield for bonds
of similar risk and maturity is 14%. The entire bond issue was purchased by
United Intergroup, Inc.
Suppose six months later, the market rate of interest has fallen to 11%, and
June 30 is the end of Masterwear’s fiscal year.
Present Values
Interest $ 42,000 × 4.27028 = $179,352
Principal $700,000 × 0.76513 = 535,591
Present value of the bonds $714,943
Present value of an ordinary annuity of $1: n = 5, i = 5.5%
Present value of $1: n = 5, i = 5.5%

LO14-6
Reporting Changes in Fair Value (continued)

semiannually on June 30 and December 31. The bonds mature
in three years. The market yield for bonds of similar risk and
Intergroup, Inc.
Journal Entry – June 30, 2018 Debit Credit
Interest expense 46,664
Discount on bonds payable 4,664
Cash 42,000
January 1 book value and fair value $666,633

Increase from discount amortization 4,664
June 30 book value (amortized initial amount) $671,297
LO14-6
Reporting Changes in Fair Value (cont. 2)

Fair Value Rises (due to changed interest rates):
• If the fair value at June 30, 2018 is $714,943
June 30 fair value $714,943
June 30 book value (amortized initial amount) 671,297
Fair value adjustment needed $ 43,646
Unrealized holding loss—NI 43,646
Fair value adjustment 43,646
The new book value of the bonds is now the fair value:
Bonds payable $700,000
Less: Discount $33,367 − 4,664 (28,703)
Amortization schedule value $671,297
Plus: Fair value adjustment 43,646
Book value, June 30 $714,943
LO14-6
Reporting Changes in Fair Value (cont. 2)

Fair Value Rises (if not due to interest rates):
Unrealized holding loss—OCI 43,646
The new book value of the bonds is now the fair value:
Less: Discount $33,367 − 4,664 (28,703)
Plus: Fair value adjustment 43,646
LO14-6
Reporting Changes in Fair Value (concluded)
Fair Value Falls (if not due to interest rates):
Unrealized holding gain—OCI 21,297
The new book value of the bonds is the fair value:
Less: Discount $33,367 − 4,664 (28,703)
Plus: Fair value adjustment (21,297)
LO14-6
Mix and Match
If a company elects the fair value option

• It’s not necessary to report all of the financial
instruments at fair value or even all instruments of a
particular type at fair value
• It can “mix and match” on an instrument-by-
instrument basis
• It must make the election when the item originates
LO14-6
Concept Check:
Zimmern Foods has bonds outstanding during a year in which
the general (risk-free) rate of interest has not changed.
Zimmern elected the fair value option for the bonds upon
issuance. What will Zimmern report for the bonds in its income
statement for the year?
a. Interest expense and a gain
b. Interest expense and a loss
c. A gain and no interest expense
d. Interest expense and no gain or loss
LO14-6
Concept Check:
Zimmern Foods has bonds outstanding during a year in which
the general (risk-free) rate of interest has not changed.
Zimmern elected the fair value option for the bonds upon
issuance. What will Zimmern report for the bonds in its income
statement for the year?
a. Interest expense and a gain
b. Interest expense and a loss
c. A gain and no interest expense
d. Interest expense and no gain or loss
The correct answer is d. Because general interest rates did not

change, we assume any change in the fair value is due to a
change in credit risk, so any gain or loss would be reported as
OCI, not part of net income.
LO14-6
Concept Check: When Fair Value Falls

Monk Investigations issued 11% bonds, dated January 1, with a face amount of
$800,000 on January 1, 2019. The bonds sold for $740,000. For bonds of similar
risk and maturity the market yield was 12%. Interest is paid semiannually on June
30 and December 31. Monk determines interest at the effective rate and elected
the option to report these bonds at their fair value. On December 31, 2019, the
fair value of the bonds was $730,000, with $4,000 of the change due to a change
in general interest rates. Monk’s statement of comprehensive income will
include:
a. A gain from change in the fair value of debt of $10,824
b. A loss from change in the fair value of debt of $6,824
c. A gain from change in the fair value of debt of $4,000
d. A gain from change in the fair value of debt of $6,824
LO14-6
Concept Check: When Fair Value Falls

Monk Investigations issued 11% bonds, dated January 1, with a face amount of $800,000 on January 1,
2019. The bonds sold for $740,000. For bonds of similar risk and maturity the market yield was 12%.
Interest is paid semiannually on June 30 and December 31. Monk determines interest at the effective
rate and elected the option to report these bonds at their fair value. On December 31, 2019, the fair
value of the bonds was $730,000, with $4,000 of the change due to a change in general interest rates.
Monk’s statement of comprehensive income will include:
a. A gain from change in the fair value of debt of $10,824
b. A loss from change in the fair value of debt of $6,824 Comprehensive income includes
c. A gain from change in the fair value of debt of $4,000 both net income and OCI.
d. A gain from change in the fair value of debt of $6,824

Less: Discount
The correct answer is a: (60,000 − 400 − 424) 59,176
Interest expense ($740,000 × 12% × 6/12) 44,400 Book value $740,824
Discount on bonds payable 400 Gain–NI 4,000
Cash ($800,000 × 11% × 6/12) 44,000 Gain–OCI 6.824
Interest expense ([$740,000 + 400] × 12% × 6/12) 44.424 Fair value $730,000
Discount on bonds payable 424
Cash ($800,000 × 11% × 6/12) 44,000
Readings and Exercises
• Read Chapter 14
• In class exercises: E14-5, E14-12, E14-21, E14-24, P14-3, P14-4
• Discussion exercises: BE14-5, BE14-7, BE14-11, BE14-14
• On your own exercises: E14-6, E14-20, E14-23, P14-5, P14-6
Any Questions?

UGBA 120AB Chapter 14 Debt Spring 2020 With Solutions For BCourses

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

UGBA 120AB Chapter 14 Debt Spring 2020 With Solutions For BCourses

Uploaded by

Copyright:

Available Formats

14-1

Bonds and Long-Term Notes

Copyright © 2018 McGraw-Hill Education.Copyright

Liabilities and stockholders’ equity

See accompanying notes.

Nature of Long-Term Debt

Issuing Obligated to repay

• If a company fails to live up to the terms of the

Types of Bonds (continued)

Concept Check: Types of Bonds

Concept Check: Types of Bonds

Journal Entry Debit Credit

Determining the Selling Price

Which would be more likely to be called,

Which would be more likely to be called, premium or

Determining the Selling Price (continued)

Present value of the Present value of

Discounted at the market rate

Face amount × Stated rate

Semiannual: n = 6 (3 × 2); i = 7% (14% ÷ 2)

Bonds Sold at a Discount (continued)

$200,195 $42,000 $42,000 $42,000 $42,000 $42,000 $42,000

Bonds Sold at a Discount (cont. 2)

Determining Interest: Effective Interest Method

$666,633 × [14% ÷ 2] = $46,664

Amortization Schedule—Discount (continued)

Interest Payments and Expense

Journal Entry Debit Credit

(0% × (2% × (Discount

2021 0 .02 (2,143) = 43 43 2,186

Interest $ 42,000 × 5.07569 = $213,179

Present value of an ordinary annuity of $1: n = 6, i = 5%

Bonds Sold at a Premium (continued)

Journal Entry Debit Credit

Cash Effective Decrease in Outstanding

Premium and Discount Amortization Compared

Adjusting Entries to Accrue Interest

Amortization Schedule—Straight-Line Method

Debt Issue Costs

Sale of bonds Costs: Legal and accounting fees

Indirectly through underwriters who:

Debt Issue Costs (continued)

Journal Entry Debit Credit

Debt Issue Costs (cont. 2)

Now, the effective rate is the one that would cause

Journal Entry Debit Credit

Concept Check: Effective Interest Rate

Concept Check: Effective Interest Rate

Concept Check: Amortization Schedules

Concept Check: Amortization Schedules

2. August 31, 2018

3. December 31, 2018

4. February 28, 2019

(2020 with effective interest amortization)

(2020 with straight-line amortization)

Interest $450# x 2.72325 * = $1,225

Borrower Long-term Lender

Note Issued for Cash

Note Issued for Cash (continued)

Journal Entry Debit Credit

Note Issued for Cash (concluded)

Journal Entry Debit Credit

First BancCorp (Lender)