Long-term Liabilities

Basic issues: Determine the issue price of the bond.

Determine and amortize any premium/discount.
Settle bond early.

New issues : issuing bonds between interest dates.

Early extinguishment of bonds.
Issue costs.

1. What are the characteristics of a bond? Why do they qualify as a liability?

2. In general liabilities are valued at the present value of cash payments (or cash
equivalents) that must be provided, discounted at an interest rate consistent with the
risk of the cash flows. Exceptions:

3. Financial liabilities are recorded initially at the fair value of what is received. Most
financial liabilities are accounted for at their amortized cost, using the effective
interest method.

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4. For Bonds, what is the difference between a bond’s coupon rate and the prevailing
market rate (yield)?

Coupon rate Æ

Market rate (yield) Æ

5. What determines the market rate (yield) of a particular bond?

• Risk of bankruptcy

• Macroeconomic factors

• Duration of the bond

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6. What are the 3 scenarios that can materialize when a bond is sold to an investor?

Bond Market Market Value Relative to

Coupon Yield Face Value
Rate
8% 8% Price equal to face value (Par)
8% 10% Price less than face value (Discount)
8% 6% Price greater than face value (Premium)

7. What are the important dates in a bond’s life?

- Issue date

- Coupon date(s)

- Issuer’s year-end date

- Expiry (maturity) date

8. How should bond issue costs be accounted for? Why is this appropriate?

9. Why would a company choose to retire bonds early (i.e., before their maturity date)?

Market rates (yields) have decreased

Company can buy back old bonds by issuing new ones at a lower rate (effective yield).
This generally means lower annual coupon payments and less interest expense on the
income statement. However, keep in mind that the company will then have to redeem a
higher face value (principal) upon maturity of the new bonds which essentially negates
the lower interest expense. To circumvent this problem, many companies include a call
provision whereby they can redeem the bonds at a fixed price (usually at 101%, 102%,
etc. of par value). If market rates drop significantly, then the company can exercise the
call option and redeem the bonds for less than what they would have to pay otherwise.

Market rates (yields) have increased

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Generally, it does not make sense for companies to redeem bonds early if yields have
gone up. This is because they have effectively “locked in” their financing at the lower,
historical rate. However, here are some reasons why companies might wish to redeem
bonds early in this situation:
• Redeeming bonds early when yields have gone up usually results in an accounting
gain. This gain serves to inflate earnings and some key ratios (although an efficient
market should be able to see through this “window dressing”).

• The company may have excess cash on hand and no investment opportunities that
generate returns greater than the after-tax cost of their bond financing. In this case,
redeeming the bonds could help to increase shareholder value.

• The company may be close to violating certain debt covenants that are impacted by
the amount of debt outstanding. Redeeming bonds could help keep the company
onside and reduce contracting costs.

Do questions 1 to 5

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Present Value of a Single $

n 5% 6% 7% 8% 9% 10% 12% 14%

1 0.95238 0.94339 0.93457 0.92592 0.91743 0.90909 0.89285 0.87719
2 0.90702 0.88999 0.87343 0.85733 0.84168 0.82644 0.79719 0.76946
3 0.86383 0.83961 0.81629 0.79383 0.77218 0.75131 0.71178 0.67497
4 0.82270 0.79209 0.76289 0.73503 0.70842 0.68301 0.63551 0.59208
5 0.78352 0.74725 0.71298 0.68058 0.64993 0.62092 0.56742 0.51936
6 0.74621 0.70496 0.66634 0.63017 0.59626 0.56447 0.50663 0.45558
7 0.71068 0.66505 0.62275 0.58349 0.54703 0.51315 0.45234 0.39963
8 0.67683 0.62741 0.58200 0.54026 0.50186 0.46650 0.40388 0.35055
9 0.64460 0.59189 0.54393 0.50024 0.46042 0.42409 0.36061 0.30750
10 0.61391 0.55839 0.50834 0.46319 0.42241 0.38554 0.32197 0.26974
11 0.58467 0.52678 0.47509 0.42888 0.38753 0.35049 0.28747 0.23661
12 0.55683 0.49696 0.44401 0.39711 0.35553 0.31863 0.25667 0.20755
13 0.53032 0.46883 0.41496 0.36769 0.32617 0.28966 0.22917 0.18206
14 0.50506 0.44230 0.38781 0.34046 0.29924 0.26333 0.20462 0.15971
15 0.48101 0.41726 0.36244 0.31524 0.27453 0.23939 0.18269 0.14009
16 0.45811 0.39365 0.33873 0.29189 0.25187 0.21763 0.16312 0.12289
17 0.43630 0.37136 0.31657 0.27027 0.23107 0.19785 0.14564 0.10780
18 0.41552 0.35034 0.29586 0.25025 0.21199 0.17986 0.13004 0.09456
19 0.39573 0.33051 0.27651 0.23171 0.19449 0.16351 0.11611 0.08294
20 0.37689 0.31180 0.25842 0.21455 0.17843 0.14864 0.10367 0.07276

Present Value of an Ordinary Annuity

n 5% 6% 7% 8% 9% 10% 12% 14%
1 0.95238 0.94339 0.93457 0.92592 0.91743 0.90909 0.89285 0.87719
2 1.85941 1.83339 1.80801 1.78326 1.75911 1.73553 1.69005 1.64666
3 2.72324 2.67301 2.62431 2.57709 2.53129 2.48685 2.40183 2.32163
4 3.54595 3.46510 3.38721 3.31212 3.23972 3.16986 3.03734 2.91371
5 4.32947 4.21236 4.10019 3.99271 3.88965 3.79078 3.60477 3.43308
6 5.07569 4.91732 4.76654 4.62288 4.48591 4.35526 4.11140 3.88866
7 5.78637 5.58238 5.38928 5.20637 5.03295 4.86841 4.56375 4.28830
8 6.46321 6.20974 5.97129 5.74663 5.53481 5.33492 4.96764 4.63886
9 7.10782 6.80169 6.51523 6.24688 5.99524 5.75902 5.32825 4.94637
10 7.72173 7.36008 7.02358 6.71008 6.41765 6.14456 5.65022 5.21611
11 8.30641 7.88687 7.49867 7.13896 6.80519 6.49506 5.93769 5.45273
12 8.86325 8.38384 7.94268 7.53607 7.16072 6.81369 6.19437 5.66029
13 9.39357 8.85268 8.35765 7.90377 7.48690 7.10335 6.42354 5.84236
14 9.89864 9.29498 8.74546 8.24423 7.78615 7.36668 6.62816 6.00207
15 10.37966 9.71224 9.10791 8.55947 8.06068 7.60608 6.81086 6.14216
16 10.83777 10.10590 9.44665 8.85137 8.31256 7.82371 6.97399 6.26506
17 11.27407 10.47726 9.76322 9.12164 8.54363 8.02155 7.11963 6.37286
18 11.68959 10.82760 10.05909 9.37189 8.75563 8.20141 7.24967 6.46742
19 12.08532 11.15812 10.33560 9.60360 8.95012 8.36492 7.36578 6.55040
20 12.46221 11.46992 10.59401 9.81815 9.12855 8.51356 7.46944 6.62313

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Question #1 Bond pricing
On 4/1/2005, Burke Ltd. issued $10,000,000 of 12% bonds that pay interest semi-
annually on March 31st and September 30th. The bonds have a maturity date of March 31,
2010. On the date of issue, bonds of similar risk and duration were yielding 14%. Burke
has a December 31st year-end.

Required:
(a) Determine the price that the bond will sell for on 4/1/2005.
(b) Repeat (a), but now assume that the bonds were sold to yield 10%.
(c) Repeat (a), but now assume that the bonds were sold to yield 12%.

(a) PV of Principal (Face) = 10,000,000 x PV$1(7%; 10) =

PV of Coupons = 600,000* x PVA(7%; 10) =
$

(b) PV of Principal (Face) = 10,000,000 x PV$1(5%; 10) =

PV of Coupons = 600,000 x PVA(5%; 10) =
$

(c) No calculations req’d. The bond will sell at PAR.

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Question #2 Bond accounting and early extinguishment
Revisit the facts presented in Question 1 (a) and (b).

Required:
(a) Provide all of the necessary journal entries for 4/1/2005 through to 3/31/2006.
(b) Repeat (a) but now assume that the bonds were sold to yield 10% as in 1 (b).
(c) Assume the facts in part (a). On 4/1/2006, Burke went into the market and
repurchased (with cash) all of the outstanding bonds. On that day, the market rate on
the bonds had risen to 16%. Provide the journal entry for the repurchase/redemption.

(a)
4/1/2005
DR Cash
DR Discount
CR Bonds payable

9/30/2005
DR Interest expense *
CR Cash
CR Discount

12/31/2005
DR Interest expense **
CR Interest payable
CR Discount

**

3/31/2006
DR Interest payable
DR Interest expense ***
CR Cash
CR Discount

***

Long‐term Liabilities  Page 7 
(b)
4/1/2005
DR Cash
CR Bonds payable
CR Premium

9/30/2005
DR Interest expense *
DR Premium
CR Cash

12/31/2005
DR Interest expense **
DR Premium
CR Interest payable

**

3/31/2006
DR Interest payable
DR Interest expense ***
DR Premium
CR Cash

***

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(c) Whenever a company goes into the bond market to buy back/redeem bonds, we
need to recalculate the FMV of the bonds on the date of redemption. This
recalculation needs to incorporate the new market rate (yield) of the bond as well
as the reduced number of periods outstanding.

PV of Principal (Face) = 10,000,000 x PV$1(8%; 8) =

PV of Coupons = 600,000 x PVA(8%; 8) =
$

Unamortized discount on 4/1/2006 = 702,358

(50,835) 4/1/2005 - 9/30/2005
(27,197) 10/1/2005 - 12/31/2005
(27,197) 1/1/2006 - 3/31/2006
597,129

DR Bonds payable
CR Discount
CR Cash
CR Gain on bond redemption*

* May be unusual but not extraordinary.

Long‐term Liabilities  Page 9 
Question #3 Bonds issued between interest dates
In 2006, D’Amato Ltd. decided to raise capital by issuing $1,000,000 of 8% bonds that
pay interest semi-annually on June 30 and December 31. The bonds have a life of 10
years. Due to administrative delays in bringing the bonds to market, the bonds were not
sold until March 1, 2005 (even though they are dated January 1st). Including the accrued
interest, the bonds sold for $889,137 on March 1 (a yield of 10%). D’Amato has a
December 31 year-end.

Required:
Prepare all of the necessary journal entries for 2006.

March 1
DR Cash
CR Interest payable *
CR Bonds payable
DR Discount

June 30
DR Interest expense **
DR Interest payable
CR Cash
CR Discount

**

December 31
DR Interest expense ***
CR Cash
CR Discount

***

Long‐term Liabilities  Page 10 
Question #4 Bonds, issue costs and early extinguishment
On January 1, 2005, Milton Inc. issued $10,000,000 of 10% bonds when bonds of similar
risk and duration were yielding 8%. Milton’s bonds pay interest annually on December
31 and mature on December 31, 2034. The company also paid $240,000 of bond issue
costs to its underwriters. Milton has a December 31 year-end.

On January 1, 2025, Milton decided to repurchase 40% of the outstanding bonds (after
making the coupon payment on December 31, 2024). On this day, yields are 12%.

Required:
(a) Provide all of the necessary journal entries for fiscal 2005.
(b) Provide the journal entry to record the bond retirement.
(c) Repeat (b) but now assume that yields are 6%.

(a)
PV of Principal (Face) = 10,000,000 x PV$1(8%; 30) =
PV of Coupons = 1,000,000 x PVA(8%; 30) =
$

January 1, 2005
DR Cash
CR Bonds payable
CR Premium

DR Deferred bond issue costs (B/S)

CR Cash

December 31, 2005

DR Interest expense *
DR Premium
CR Cash

DR Amort. Exp. – bond issue costs **

CR Deferred bond issue costs

**

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(b) For a bond redemption, remember that we need to know two amounts: (1) the FMV
of the bonds on the redemption date (or the callable amount if a call provision
exists), and (2) the NBV value of the bonds on the redemption date.

FMV is fairly straightforward. Simply discount the remaining cash flows using the
market rate (yield) on the date of redemption (CURRENT rate).

NBV for this problem can be calculated by doing 20 years of amortization

calculations (have fun with that!). Or, the quicker (and more elegant) method is to
discount the remaining cash flows using the HISTORICAL rate.

FMV
PV of Principal (Face) = 10,000,000 x PV$1(12%; 10) = 3,219,732
PV of Coupons = 1,000,000 x PVA(12%; 10) = 5,650,223
$ 8,869,955

NBV
PV of Principal (Face) = 10,000,000 x PV$1(8%; 10) =
PV of Coupons = 1,000,000 x PVA(8%; 10) =
$

Therefore, the NBV of the bonds is $________________ on January 1, 2025. This means
that the unamortized balance of the premium is $__________________.

January 1, 2025
DR Bonds payable *
DR Premium **
CR Cash ***
CR Deferred bond issue costs ****
CR Gain on bond redemption

*
**
***
****

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(c)

FMV
PV of Principal (Face) = 10,000,000 x PV$1(6%; 10) = 5,583,948
PV of Coupons = 1,000,000 x PVA(6%; 10) = 7,360,087
$ 12,944,035

NBV
PV of Principal (Face) = 10,000,000 x PV$1(8%; 10) = 4,631,935
PV of Coupons = 1,000,000 x PVA(8%; 10) = 6,710,081
$ 11,342,016

Therefore, the NBV of the bonds is $ 11,342,016 on January 1, 2025. This means that the
unamortized balance of the premium is $ 1,342,016.

January 1, 2025
DR Bonds payable 4,000,000*
DR Premium 536,806**
CR Cash 5,177,614***
CR Deferred bond issue costs 32,000 ****
DR Loss on bond redemption 672,808

* 10,000,000 x 40%
** 1,324,016 x 40%
*** 12,944,035 x 40%
**** 240,000 x (10/30) x 40%

NOTE: What if the company had included a provision whereby the bonds could be called
back at 105? What would the journal entry look like now?

January 1, 2025
DR Bonds payable 4,000,000
DR Premium 536,806
CR Cash
CR Deferred bond issue costs 32,000 ****
CR Gain on bond redemption

Long‐term Liabilities  Page 13 
Question #5 Early Redemption & Issuance of New Bonds (Self-Review)
Most students can intuitively understand why companies would not wish to redeem bonds
when yields have gone up. However, I often get asked: “Why doesn’t a company simply
redeem old bonds when yields have gone down and reissue new ones at a lower rate?
That way they will save money right?”. The answer is actually NO.

Facts:
• On January 1, 2006, ABC Ltd. issues $1,000,000 of 10 year, 10% coupon bonds
that pay interest annually on December 31. Yields are 10% on this day.
• One year later on January 1, 2007, yields have dropped to 8%. ABC Ltd. redeems
the old bonds and reissues new ones with a life of 9 years and a coupon rate of 8%.

Question:
Is ABC Ltd. any better off (financially/economically) after the redemption?

One year later, the OLD bonds are selling for:

PV of Principal (Face) = 1,000,000 x PV$1(8%; 9) = 500,249
PV of Coupons = 100,000 x PVA(8%; 9) = 624,689
$ 1,124,938

To redeem the OLD bonds, ABC Ltd. has to issue $ 1,124,938 of the 8% NEW bonds.

The OLD bonds make coupon payments of $100,000 per year. The NEW bonds will now
make coupon payments of $89,995 ($1,124,938 x 8%) per year. That is an annual savings
of $10,005 per year. Discounted at 8% for 9 periods, the PV of the coupon savings equals
$62,500.

At first glance, it seems as though ABC would be better off. However, the face value of
the NEW bonds is greater than the OLD bonds by $124,938. If you discount this amount
at 8% for 9 periods you get $62,500.

To summarize:

PV of annual coupon savings $62,500

PV of higher principal payment upon maturity (62,500)
Net economic benefit of refinancing $ -

Note, however, that if ABC Ltd. had included a call provision of say 102, it would be
better off economically since it can redeem the old bonds for less than their fair value.

Long‐term Liabilities  Page 14