Chapter+16+Notes+-+Long-Term+Liabilities+(Bonds)


 * __SO 1__**
 * Homework:** SS1; BE16-1
 * Highlights:** **long-term liabilities** include **bonds, notes payable** and **lease obligations**

- **bonds** may be of varying lengths, and so only the portion of the bond not due within one year is considered a **long-term liability**

- bonds are essentially **interest-bearing notes payable** issued by **corporations and governments**, typically in denominations of **$1000**

- bonds can be defined by the amount borrowed (**principal** or **face value** or **maturity value** or **par value**), the **annual contractual rate of interest** (also known as the **coupon rate** or **stated rate**) and the **maturity date** (date on which principal must be repaid)

- **interest** is generally payable **semi-annually** or **annually**

- bonds provide short-term or long-term **debt financing** to corporations that are not interested in issuing shares (equity financing)

- in terms of providing long-term financing to corporations, **bonds may be preferable to shares** because bonds do not carry voting rights while common shares do, interest payable on bonds is tax deductible while dividends payable are not, and earnings per share is often higher because even though interest expense reduces net income, no additional shares are issued

- one major **disadvantage** of bonds is that **interest must be paid periodically** and **principal (face value of bond) must be repaid** upon maturity

- with **secured bonds**, specific assets of the **bond issuer (borrower)** are pledged as **collateral** in security of the debt, whereas **unsecured bonds** (e.g., debentures) are simply issued against the general credit history and reputation of the borrower as opposed to any specific asset

- the principal of a **term bond** matures (become due and payable) at a single specific future date, whereas the principal of **serial bonds** mature in periodic installments over the life of the term

- **registered bonds** are issued in the name of the **bondholder (lender**) and so interest payments are delivered directly to the registered holder by cheque or direct deposit (e.g., Canada Savings Bonds), whereas **bearer** or **coupon bonds** are not registered in the name of the holder (or any individual for that matter) and so holders must submit coupons to the issuer to receive periodic interest payments

- bearer bonds may easily be **transferred** to another party whereas registered bonds must be cancelled and reissued in the name of the new holder following transfer

- **convertible bonds** may be converted into shares of the issuing corporation at preset ratios at the request of the holder

- **redeemable (or callable) bonds** are subject to retirement (early repayment) at a preset value prior to maturity at the option of the __issuer__, whereas **retractable bonds** may be redeemed at a preset value prior to maturity at the option of the __holder__

- **junk bonds** are high-risk, unsecured debt instruments that offer above-average interest rates to investors, whereas **deep discount** or **zero interest bonds** pay little or no interest given their relative lack of risk - bond-rating agencies like Moody's or Standard and Poor's rate the highest-quality bonds as AAA (relatively risk-free given general creditworthiness of issuer) or AA (superior) or A (good) or BBB (satisfactory) while the lowest-quality bonds are rated BB to D - bonds rated below BBB are considered junk bonds/speculative grade/non-investment grade and raise serious concerns of potential default

- corporate bonds are issued with the authorization of the **board of directors** (and sometimes the shareholders) who must declare the maximum number of bonds authorized or available for issue, the face value per bond and the contractual interest rate

- terms and conditions of bond issue, including rights and responsibilities of both parties, are contained in legal document known as **bond indenture**

- bond instruments take the physical form of **bond certificates** which contains name of issuer, face value, contractual interest rate and maturity date

- bonds are often sold by **underwriters**, or investment firms who purchase the bonds directly from the issuer and then resell them to individual investors

- bond issue costs include legal, accounting, underwriting, registration and trustee fees

- **trustee** (financial institution) maintains bondholder records and custody of authorized yet unissued bonds on behalf of issuer

- corporate bonds are traded in **secondary markets** on organized securities exchanges much like corporate stocks are bought and sold on stock exchanges

- **journal entries** are only required for the **initial issue or redemption of bonds** in the primary market or the **payment or accrual of interest** on bonds, and not on the transfer of bonds among individual investors within the secondary market


 * __Example of corporate bond listing on secondary market__**
 * Air Canada debenture ** -- ** 6.5% coupon ** -- ** Maturity Jan 12/25 ** -- ** Bid Price 101.25 ** -- ** Yield 6.25% **

The above listing describes an Air Canada unsecured bond that matures on January 12, 2025 and pays an annual rate of interest of 6.5%. The bid price is expressed as a percentage of the face value of the bond (typically $1000) and so in this example, the bond is currently selling for $1012.50. The current yield or return is only 6.25% annually (which is lower than the coupon rate of interest) because the bid price is above 100.

- determining ** market value ** of bonds requires complex calculation of ** present value ** of future cash flows (periodic interest payments) and repayment of principal on maturity date - present value represents how much money must be invested today at specified interest rate over specified time frame to correspond with future cash payments - ** present value of bond determines its market value on securities exchange ** - market value is function of (i) future payments [interest and principal] to be received (ii) term or life of investment (iii) market interest rate or current yield representing current rate of interest demanded by lenders - process of determining present value is known as ** discounting future payments ** - present value of bond always equals principal or face value when current market interest rate is identical to contractual interest rate

**Highlights:** bonds may be issued at **face value, below face value** or **above face value**
 * __SO 2__ **
 * Homework: ** SS2, SS3, SS4, SS5; BE16-2, BE16-3, BE16-4, BE16-5

- when the contractual (stated) interest rate of a bond is __identical__ to the prevailing market interest rate at the time of issue, bonds will be issued (sold to the public) at face value - bonds issued at face value are relatively easy to account for in the books of the issuing corporation (borrower)
 * __(1) Bonds issued at face value__**

ABC Ltd. issues ten $1,000, five-year, 5% bonds on January 1 at 100 (100% of face value) with interest payable semi-annually (every six months) on Jan 1 and July 1
 * __Example of bonds issued at face value__**

**Bonds Payable - cr - 10,000**
 * Jan 1 - Cash - dr - 10,000**
 * To record issue of bonds at face value**

**Cash - cr - 250**
 * Jul 1 - Bond Interest Expense - dr - 250**
 * To record payment of semi-annual bond interest**

**Bond Interest Payable - cr - 250** **To record accrual of semi-annual bond interest payable on Jan 1** (Bond Interest Payable will be debited and Cash credited the following day once interest is paid)
 * Dec 31 - Bond Interest Expense - dr - 250**

- bonds may also be issued (sold to the public) either __above__ or __below__ face value in the event that the contractual (stated) interest rate of a bond is __not__ identical to the prevailing market interest rate at the time of issue
 * __Bonds issued above or below face value__ **

- market interest rates change daily based on numerous factors including economic factors, company performance and industry conditions

- differences between contractual and market interest rates are more likely when there is a significant time lag between the printing of a particular bond issue and the actual sale of that same bond issue

- when contractual interest rates on bonds are __below__ market interest rates, bonds sell at a discount (below face value) because potential investors will demand reduced prices in order to invest their money in an investment vehicle offering relatively weaker returns
 * __(2) Bonds issued at a discount (below face value)__ **

ABC Ltd. issues ten $1,000, five-year, 5% bonds on January 1 at 96 (96% of face value) with interest payable semi-annually (every six months) on Jan 1 and July 1
 * __Example of bonds issued at a discount (below face value)__**

--- **Bonds Payable - cr - 10,000**
 * Jan 1 - Cash - dr - 9,600**
 * Discount on Bonds Payable - dr - 400**
 * To record issue of bonds at a discount**


 * Discount on Bonds Payable** is a **contra liability account** which is deducted from Bonds Payable on the balance sheet to arrive at the **carrying (book) value** of the bonds ($9,600) - on the date of issue, the carrying value of the bonds is equal to the sale price - the issuance of bonds at a discount __increases the cost of borrowing__ because the issuing corporation must now pay not only the semi-annual interest payments at the contractual interest rate (5%) but also the difference between the issue price ($9,600) and the face value ($10,000) which is represented by the bond discount totaling $400 in the above example - put another way, the issuing corporation may have only borrowed $9,600 but they must still repay the face value of $10,000 upon maturity - pursuant to the matching principle, this additional cost of borrowing ($400) must now be allocated (or amortized) to bond interest expense over the term of the bond using one of two available methods, namely the **straight-line method** or the **effective interest method**

- in this class, we will focus on the less complicated and more popular ** straight-line method of amortizing bond discount ** which allocates the discount __ evenly __ over the term of the bond, so that in the above example the $400 discount will be divided (credited) over ten semi-annual interest periods (each period six months in duration over five years) of $40 each - the semi-annual interest expense will therefore include both the contractual interest payment of 5% (or $250) and the amortized bond discount of $40

--- **Cash - cr - 250** --- **Discount on Bonds Payable - cr - 40**
 * Jul 1 - Bond Interest Expense - dr - 290**
 * To record payment of semi-annual bond interest and amortization of bond discount**

**Bond Interest Payable - cr - 250** **Discount on Bonds Payable - cr - 40** **To record accrual of semi-annual bond interest payable on Jan 1 and amortization of bond discount**
 * Dec 31 - Bond Interest Expense - dr - 290**

(note that the bond interest payment of $250, which is based on the contractual interest rate of 5%, is not the same as the bond interest expense, the latter of which takes into account the __increased__ cost of borrowing given the issue below face value)

(note also that as the bond discount is gradually amortized [reduced] over the term of the bond, the carrying (book) value of the bonds slowly rises towards the bond's face value - once the bond discount has been entirely eliminated, the carrying value of the bond will be identical to its face value)

(under the more complicated and less popular **effective interest method of amortization,** the amortization of bond discount [or bond premium] is __not__ evenly allocated over the term of the bond because the overall periodic interest expense must remain equal to a constant percentage of the bond's carrying value - the result is __varying__ amounts of interest expense and bond discount [or bond premium] amortization per period over the term of the bond)

__ **(3) Bonds issued at a premium (above face value)** __ - when contractual interest rates on bonds are __ above __ market interest rates, bonds sell at a premium (above face value) because potential investors will pay increased prices in order to invest their money in an investment vehicle offering relatively stronger returns

ABC Ltd. issues ten $1,000, five-year, 5% bonds on January 1 at 104 (104% of face value) with interest payable semi-annually (every six months) on Jan 1 and July 1
 * __Example of bonds issued at a premium (above face value)__ **

--- ** Bonds Payable - cr - 10,000 ** --- ** Premium on Bonds Payable - cr - 400 **
 * Jan 1 - Cash - dr - 10,400**
 * To record issue of bonds at a premium **


 * Premium on Bonds Payable** is an adjunct liability account which is added to Bonds Payable on the balance sheet to arrive at the **carrying (book) value** of the bonds ($10,400) - on the date of issue, the carrying value of the bonds is equal to the sale price - the issuance of bonds at a premium __decreases the cost of borrowing__ because while the issuing corporation must still pay the semi-annual interest payments at the contractual interest rate (5%), such periodic payments will be offset by the difference between the issue price ($10,400) and the face value ($10,000) which is represented by the bond premium totaling $400 in the above example - put another way, the issuing corporation borrowed $10,400 but must only repay the face value of $10,000 upon maturity - this reduction in the cost of borrowing ($400) must now be allocated (or amortized) to bond interest expense over the term of the bond using one of two available methods, namely the **straight-line method** or the **effective interest method**

- in this class, we will focus on the less complicated and more popular ** straight-line method of amortizing bond premium ** which allocates the premium __ evenly __ over the term of the bond, so that in the above example the $400 premium will be divided (debited) over ten semi-annual interest periods (each period six months in duration over five years) of $40 each - the semi-annual interest expense will therefore recognize both the contractual interest payment of 5% (or $250) and the amortized bond premium of $40

- ** Cash - cr - 250 **
 * Jul 1 - Bond Interest Expense - dr - 210 **
 * Premium on Bonds Payable - dr - 40 **
 * To record payment of semi-annual bond interest and amortization of bond premium **

--- ** Bond Interest Payable - cr - 250 **
 * Dec 31 - Bond Interest Expense - dr - 210 **
 * Premium on Bonds Payable - dr - 40 **
 * To record accrual of semi-annual bond interest payable on Jan 1 and amortization of bond premium **

(note that the bond interest payment of $250, which is based on the contractual interest rate of 5%, is not the same as the bond interest expense, the latter of which takes into account the __reduced__ cost of borrowing given the issue above face value)

(note also that as the bond premium is gradually amortized [reduced] over the term of the bond, the carrying (book) value of the bonds slowly falls towards the bond's face value - once the bond premium has been entirely eliminated, the carrying value of the bond will be identical to its face value)


 * __ SO 3 & SO 4 __**
 * Homework: SS8; BE16-8, BE16-9 **
 * Highlights: **

- when bonds are issued __between__ interest payment dates, the bond purchaser will typically pay the market price for the bonds __plus__ any interest accrued since the last interest payment date - at the next interest payment date, the corporation will then pay the full amount of interest due for the entire period, which eliminates the need for the issuing corporation to calculate the precise amount of interest due to any bondholder who purchased between interest payment dates
 * __ SO 3 - Bonds issued between interest payment dates __**

ABC Ltd. issues one $1,000,000, five-year, 5% bond at face value (100) plus accrued interest on March 1 where interest is payable semi-annually (every six months) on Jan 1 and July 1
 * __ Example of issuing bonds between interest dates __**

-- ** Bonds Payable - cr - 1,000,000 ** -- ** Bond Interest Payable - cr - 8,333 **
 * Mar 1 Cash - dr - 1,008,333 **
 * To record sale of bonds at face value plus two months (January, February) of accrued interest of $8,333 ($1,000,000 x 5% x 2/12) **

- ** Cash - cr - 25,000 **
 * July 1 Bond Interest Payable - dr - 8,333 **
 * Bond Interest Expense - dr - 16,667 **
 * To record payment of bond interest ($1,000,000 x 5% x 6/12) and recognition of bond interest expense of four months (March, April, May, June) and removal of bond interest liability **

- in the above example, the bond issuing corporation collects the bond interest that has accrued between the last interest date and the actual issue date ($8,333) as part of the sale price and then makes payment of a full period's interest ($25,000) at the next interest payment date - the net result is that the bond purchaser receives his/her fair share of four months (March, April, May, June) of actual interest earned

- bonds may be **retired** (removed from the corporation's books) when they are **redeemed** (repaid in full) either (i) **upon maturity** or (ii) upon **purchase on the open market by the issuing corporation __prior__ to maturity**
 * __ SO 4 - Redemption of bonds upon maturity or prior to maturity __**

- ** Cash - cr - 1,000,000 **
 * __ Example of bonds redeemed upon maturity __**
 * Jan 1 Bonds Payable - dr - 1,000,000 **
 * To redeem bonds at maturity at face value assuming interest for last interest period has already been paid and recorded **

- alternatively, a corporation may elect to redeem bonds __ before maturity __ in order to reduce interest obligations or to remove debt from the balance sheet, assuming the bonds are redeemable or callable at the option of the issuer in the first place - bonds redeemed prior to maturity are typically purchased on the open market at a __premium__ (above face value) in order to compensate the bondholder for lost interest - when bonds are retired early, the issuing corporation must (i) recognize any accrued interest expense if bonds are redeemed between interest payment dates (ii) eliminate the carrying (book) value of the bonds at the redemption date (face value minus unamortized bond discount or face value plus unamortized bond premium) (iii) record the cash paid for the bonds on the redemption date (iv) recognize the gain or loss on bond redemption (difference between redemption price paid and carrying value of bonds on date of redemption)

** Cash - cr - 1,030,000 **
 * __ Example of bonds redeemed before maturity __**
 * Jan 1 Bonds Payable - dr - 1,000,000 **
 * Premium on Bonds Payable - dr - 9,000 **
 * Loss on Bond Redemption - dr - 21,000 **
 * To record early redemption of bonds at 103 ($1,030,000) with no accrued interest expense as redemption occurred immediately following payment of semi-annual interest, assuming bonds were originally issued at a premium and had a carrying value of $1,009,000 ($1,000,000 + $9,000) at the redemption date, thereby resulting in a loss on redemption of $21,000 ($1,030,000 - $1,090,000) **

- please note that when retiring a liability like Bonds Payable, a loss results (Loss on Bond Redemption) when the redemption price paid is __greater__ than the carrying value of the liability