14.01 Notes and Bonds Payable

Question 1

What is a bond?

Answer 1

A bond is a debt security issued to investors willing to lend money to the issuer for a certain period of time. In return, the issuer promises to pay interest over the life of the bond and repay the principal (i.e. par value) when the bond matures.

Question 2

What characteristics are bonds classified by?

Answer 2

Maturity pattern, secured vs unsecured, ownership, and redemption.

Question 3

What are the maturity patterns of bonds?

Answer 3

Term bond - single maturity date at end of term
Serial bond - matures in stated amounts at regular intervals

Question 4

What does it mean when a bond is secured or unsecured?

Answer 4

Debentures - backed by borrower’s general credit
Collateralized - backed by specific assets

Question 5

What are the ownership types of a bond?

Answer 5

Registered - issued to specific owner
Bearer (coupon bonds) - not registered

Question 6

What are the types of bond redemptions?

Answer 6

Callable - bonds can be repurchased by issuer before maturity
Convertible - bonds can be converted into equity securities at the option of the buyer
Sinking - bonds can be repurchased in limited quantities periodically at specified prices

Question 7

To account for a bond, what information must be known?

Answer 7

Face (or maturity) value; stated (or coupon) interest rate; interest payment dates; yield (or market or effective) rate; issuance date; maturity date

Question 8

How is a bond payable reported on the balance sheet?

Answer 8

The portion of a bond payable that will not be paid within the upcoming year is classified as a noncurrent liability on the balance sheet. The portion that will be paid within the upcoming year is classified as a current liability.

Question 9

What is the face (or maturity) value of a bond?

Answer 9

The amount to be paid to the bondholder at maturity. This is also called the bond principal.

Question 10

What is the stated (or coupon) interest rate?

Answer 10

The contractual rate listed in the note. This is the rate at which the bond pays cash interest.

Question 11

What are the interest payment dates of a bond?

Answer 11

The dates that the bond pays cash interest.

Question 12

What is the yield (or market or effective) rate of a bond?

Answer 12

The rate that investors demand to earn for loaning their money. This rate is also the rate of return for comparable bonds (it is determined by the market).

Question 13

What is the issuance date of a bond?

Answer 13

The date that the bond is issued.

Question 14

What is the maturity date of a bond?

Answer 14

The date that the maturity value is paid, the end of the bond term.

Question 15

What is the selling price of a bond?

Answer 15

The selling price of a bond is equal to the present value (PV) of future cash flows from the bond’s principal and interest. This is the amount of cash that the bond issuer will receive today (also called bond proceeds). In calculating the PV, the market interest rate is used. Interest rates and time periods should reflect the schedule of the note. Interest rates are typically expressed annually and will need to be adjusted.

Question 16

How is interest expense on debt recorded?

Answer 16

Interest expense on debt is recorded in the period incurred (time period the debt was outstanding). Interest rates on debt are (by default) expressed in annual rates, even if the term of the debt is less than one year.
Under the effective interest method, periodic interest expense is calculated as follows: Bond payable outstanding balance × Market rate × Time (e.g. fraction of year elapsed)

Question 17

What does it mean if a bond is issued at par?

Answer 17

If the stated interest rate is equal to the market interest rate, the bonds are issued at par (or face value). There is no discount or premium on the note payable. Interest expense recorded in the financial statements will be equal to the amount of interest paid (or payable) each period.

Question 18

What does it mean if a bond is issued at a discount?

Answer 18

When the state rate is below the market rate (i.e. 12% market rate > 10% coupon), it is priced at a discount.

Question 19

What does it mean if a bond is issued at a premium?

Answer 19

When the stated rate is greater than the market rate (i.e. 10% coupon > 8% market rate), it is priced at a premium.

Question 20

What is the inverse relationship between market interest rates and bond prices?

Answer 20

As market rates increase, the bond price decreases, and vice versa.

Question 21

What is the amortization period of the discount or premium on a bond issue?

Answer 21

The discount or premium on a bond issue is amortized over the bond term. At the maturity date, the book value of the bond issue must equal face value because that is the amount paid to retire the bonds.

Question 22

What is the method used to amortize premiums and discounts?

Answer 22

Under GAAP, the amortization of premiums and discounts is accomplished through the use of the effective interest method. However, companies are allowed to employ the straight-line amortization method. The straight-line method is acceptable only if the results do not depart materially from the effective interest method.

Question 23

How is interest expense affected under the effective interest method (amortization)?

Answer 23

Under the effective interest method, interest expense aligns with the carrying value of the bond each period.

Question 24

How is interest expense affected under the straight-line method (amortization)?

Answer 24

Under the straight-line method, interest expense is constant each period. The constant amount overstates interest expense in early years.

Question 25

How is bond interest expense calculated?

Answer 25

Bond interest expense under the effective interest method:
Interest expense = Bond carrying value x Effective interest rate x Time period

Question 26

For a bond issued at discount, how is amortization calculated?

Answer 26

Bond discount amortization under the effective interest method:
Bond discount amortization = Interest expense - Cash interest payment
Bond discount amortization = (Bond carrying value x Effective interest rate) - (Bond face value x Stated coupon rate)

Question 27

For a bond issued at a premium, how is amortization calculated?

Answer 27

Bond premium amortization under the effective interest method:
Bond premium amortization = Cash interest payment - Interest expense
Bond premium amortization = (Bond face value x Stated coupon rate) - (Bond carrying value x Effective interest rate)

Question 28

When can the straight-line method be used to amortize a discount or premium?

Answer 28

The straight-line method can be used when the results don’t differ materially from the effective interest method. Under the straight-line method, amortization is the same each period.

Question 29

What is a zero coupon bond?

Answer 29

Zero coupon bonds pay no interest (i.e. the coupon rate is zero). The accounting for the bonds remains the same, except that no cash is paid during the bond term. The entire amount of interest is included in the face value. GAAP requires that interest is imputed on the bond.

Question 30

What happens when the bond date precedes the issue date?

Answer 30

If the bond date precedes the issue date, the purchase amount will include accrued interest because the buyer will receive the entire interest payment in the next scheduled payment. The total cash received by the company issuing the bonds (i.e. the bond “proceeds”) is calculated as follows: Selling price of the bond + Interest (at the stated rate) accrued since the last interest date.

Question 31

When is interest payable recorded?

Answer 31

If the bond payment schedule does not align with the bond issuer’s reporting period, interest payable will be recorded.

Question 32

What are bond issuance costs?

Answer 32

Bond issuance costs are the various costs that a bond issuer incurs to bring the bonds to market.

Question 33

What are examples of bond issuance costs?

Answer 33

Printing and engraving bond certificates; Legal and accounting fees; Underwriter commissions; Promotion costs (printing the prospectus); Registration.

Question 34

What is the accounting for bond issuance costs?

Answer 34

Reduce the net proceeds received by the bond issuer; Typically added tot he bond discount or netted against the bond premium. These costs are deductions from the carrying amount of the bond; Amortized using the effective interest method, according to GAAP. The straight-line method can be used to amortize the costs when the results don’t materially differ from the effective interest method.

Question 35

What are notes payable?

Answer 35

Notes payable are written promises to pay an amount of money on a specified future date. Notes can be classified as current or noncurrent.

Question 36

How are current notes payable reported?

Answer 36

Current notes payable are reported at the amount due when they mature.

Question 37

How are noncurrent notes payable reported?

Answer 37

Noncurrent notes payable are reported at the present value of future payments, discounted at the prevailing interest rate at time of issuance.

Question 38

What are the two rates of interest relevant to notes payable?

Answer 38

State rate - the contractual rate listed in the note, which determines the cash interest payments
Yield or market rate - the rate on notes of similar risk and term

Question 39

What is a non-interest-bearing note?

Answer 39

A non-interest-bearing note is on that lacks a stated annual rate (i.e. face rate or discount rate) of interest but does bear interest. Although an interest rate is not stated, a lender expects the borrower to pay for the use of its money (i.e. interest). These notes are recorded at the PV of future cash flows; GAAP requires the use of an imputed rate equivalent to the market rate.

Question 40

What is an installment note?

Answer 40

An installment note is one that requires the borrower to repay the lender in specified amounts at specified time intervals.

Question 41

If an entity plans to refinance a short-term obligation to longer than one year, how should that be presented?

Answer 41

However, if an entity plans to refinance a short-term obligation to longer than one year, the obligation is reclassified from current to long-term if the intent and ability to refinance can be demonstrated.
Intent to refinance? No - report as current
Intent to refinance? Yes, Ability to refinance? No - report as current
Intent to refinance? Yes, Ability to refinance? Yes - report as noncurrent

Question 42

Why is the classification between current and noncurrent important?

Answer 42

The classification is important because it affects financial ratios and provides information to FS users about an entity’s capacity to pay its most pressing obligations.

Question 43

What changes may be made to a debt instrument?

Answer 43

Amending the terms or cash flows of a debt instrument; Exchanging an existing debt instrument for a new debt instrument with the same lender; Repaying an existing debt obligation and issuing new debt to the same lender.

Question 44

When are changes in debt instruments classified as a troubled debt restructuring?

Answer 44

These changes in debt instruments are classified as a troubled debt restructuring if the borrower is experiencing financial difficulty; and the lender grants the borrower a concession.

Question 45

How should a debtor determine if they are experiencing financial difficulty?

Answer 45

To determine if the debtor is experiencing financial difficulty, the debtor should consider if its creditworthiness has deteriorated since the debt was issued. Other factors that indicate financial difficulty include inability to repay old debt, declaring bankruptcy, and significant doubt as to whether the debtor will continue to be a going concern.

Question 46

When has a lender deemed to have granted a concession?

Answer 46

A lender is deemed to have granted a concession when the effective borrowing rate on the restructured debt is less than the effective borrowing rate on the original debt.

Question 47

What are the three troubled debt restructuring options?

Answer 47

Transfer of property; Transfer of equity; Modification of debt terms.

Question 48

What does a transfer of property mean as a troubled debt restructuring option?

Answer 48

Debtor transfers an asset and removes the asset from the books.
When TDR occurs through transfer of property, two gains (or losses) may be recorded: a restructuring gain is recognized for the excess of the carrying value of the debt over the FV of the asset transferred in settlement; a gain/loss on transfer of the asset is recognized for the difference between the asset’s FV and its carrying value.

Question 49

What does a transfer of equity interest in a debtor mean as a troubled debt restructuring option?

Answer 49

Debtor records equity as if issued for its fair value with increases to common stock and APIC.
When TDR occurs through a transfer of equity a restructuring gain is recognized for the excess of the carrying value of the equity and the FV of the equity transferred in settlement.

Question 50

What does modification of debt terms mean as a troubled debt restructuring option?

Answer 50

Interest rate is reduced; Due date of one or more payments is delayed; Face amount, accrued interest, or both are reduced.
When a TDR occurs by modifying the terms of the debt, the sum of the total future cash payments under the new terms for the debtor is compared with the existing debt’s carrying value to determine a restructuring gain/loss. If the future payments are less than the carrying value, the debtor is relieved of a portion of the debt and will record a restructuring gain.

Question 51

What is the difference between a modification of terms and an extinguishment of debt?

Answer 51

Debtors must determine if the change in the debt terms is considered substantial. To determine if the change in the debt terms is considered to be substantial, the PV of the new loan’s cash flows is compared to the PV of the old loan’s cash flows. If there is at least a 10% difference between these two figures, the change in debt terms is considered to be substantial and is, therefore, an extinguishment. If the difference is less than 10%, the change in debt terms is not considered to be substantial and is, therefore, a modification of terms.

Question 52

True or false: a firm can retire a bond before maturity?

Answer 52

True. Firms may retire their debt at any time (before maturity) unless the debt agreement prohibits it. An issuer may choose to retire its outstanding debt when interest rates change or if it has excess cash reserves. The amount paid to retire debt early reflects the current yield rate and may be different from the book value of the debt on the retirement date. When debt is redeemed prior to maturity, the difference between its carrying value and the amount paid is reported as a gain or loss on the issuer’s income statement as part of continuing operations.