Bonds and Long-Term Notes

Early Extinguishment of Debt

If there is a significant change in market interest rates an entity may be motivated to retire
outstanding bonds before the maturity date. Any gain or loss of the early extinguishment of such
debt is treated as Other Gains or Losses.

The reacquisition price of outstanding debt is the purchase price plus any call premium that
might have to be paid. A call premium is normally stated as a percentage of the fact amount of
the bonds.

The carrying amount of the bonds is the maturity value adjusted for unamortized premium or
discount and the unamortized issue costs. All such costs must be amortized up to the date of
reacquisition in order to determine the gain or loss on early extinguishment of the debt.

Example: On March 1, 2002 Spencer Company retired $900,000 of bonds at 101. At the time
of retirement the unamortized bond issue costs were $6,000 and the unamortized premium was
$27,000. The following journal is to record the reacquisition of the bonds.

Face value of bonds 900,000

Call premium 101
Reacquisition price 909,000
Net carrying amount of bonds redeemed:
Face value of bonds 900,000
Unamortized premium 27,000
Unamortized bond issue costs (6,000)
Net carrying amount 921,000
Gain on early extiguishment of bonds 12,000

ACCOUNT DEBIT CREDIT

Bonds payable 900,000
Premium on bonds payable 27,000
Unamortized bond issue costs 6,000
Gain on early extinguishment of bonds 12,000
Cash 909,000
To record the early extinguishment of debt on March
1, 2002 at a gain of $12,000

Convertible Bonds
Convertible bonds are issued by a corporation in order to raise capital. In addition to the features
of normal debt instruments, the holder of the bonds can convert them to common stock within a
specified time period. There are three important time periods related to accounting for
convertible debt.

1. At Time of Issuance

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Bonds and Long-Term Notes

Convertible bonds are recorded in the same manner as any other debt issue. Discount
or premiums are amortized over the life of the bonds. Although this does not take into
account the value of the conversion option, it is currently accepted practice.

2. At Time of Conversion
GAAP requires that we use the book value method in recording the conversion of
bonds to common stock. To record the transaction the carrying value of the bonds (face
amount plus premium or minus discount) is removed from the accounting records and
the par value of the common stock recorded with any excess credited to Additional
Paid-In Capital, Common Stock.

Example: Spencer Company issued convertible bonds with a face amount of $1,000 at
a discount of $10. The bonds were convertible into 100 shares of $5 par value common
stock. On the date of conversion the carrying value of the bonds was $991 (Face of
$1,000 less unamortized discount of $9. At the date of conversion the journal entry
would be as follows:

ACCOUNT DEBIT CREDIT

Bonds payable 1,000
Discount on bonds payable 9
Common stock 500
Additional paid-in capital, common stock 491

Under certain circumstances the corporation may provide an incentive to get the bond
holders to convert. This is called an induced conversion. The incentive paid by the
corporation is treated as a current expense (Debt Conversion Expense).

3. Retirement of Convertible Debt

The retirement of convertible debt is treated in the same way as the retirement of all
other debt. Any gain or loss is reported currently in the income statement. The recent
adoption of FAS #145 requires that the company evaluate the transaction. If it is
unusual in nature and infrequent in occurrence, it will be reported as an extraordinary
item, otherwise it is considered part of income from operations.

Based upon the previous information, answer the following questions:

Question 1
Convertible bonds
a. have priority over other indebtedness.
b. are usually secured by a first or second mortgage.
c. pay interest only in the event earnings are sufficient to cover the interest.
d. may be exchanged for equity securities.

Answer:
d. may be exchanged for equity securities.

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Bonds and Long-Term Notes

Question 2
The conversion of bonds is most commonly recorded by the
a. incremental method.
b. face value method.
c. market value method.
d. book value method.

Answer
d. book value method.

Bonds with Detachable Warrants

Warrants are options that entitle the holder to purchase shares of stock at a specified price within
a certain period. Stock Warrants may be acquired under the following circumstances;
1. As attachments to bonds or preferred stocks
2. Issued to existing common stockholders under the preemptive right to purchase
common stock in the event of an additional stock issue
3. As compensation to executives and employees

If stock warrants are issued with other securities and they are detachable (detachable stock
warrants) they need to be valued separately from the underlying securities. There are two
methods for accomplishing this valuation.

1. Proportional Method
If we know the fair market value of the underlying securities (bonds) and the detachable
warrants, the relative values are applied to the selling price of the combined security.

For example, Spencer Company issued 100, $1,000 bonds with detachable
warrants which allow the holder to purchase one share of stock at $65 per share. The
bonds were sold at par ($100,000). If the company were to issue the bonds without
warrants their fair market value would be $99,000. The market value of the detachable
warrants was $50 each. Use the following format to allocate the selling price between the
bonds and the warrants.

Relative Fair Market Values Amounts %

FMV of bonds without warrants 99,000 95%
FMV of warrants (100 * $50) 5,000 5%
104,000 100%

% Price Allocation
Allocated to bonds 95% ? ?
Allocated to warrants 5% ? ?
Total allocation 100% 100,000

Answer

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Bonds and Long-Term Notes

% Price Allocation
Allocated to bonds 95% 100,000 95,192
Allocated to warrants 5% 100,000 4,808
Total allocation 100% 100,000

2. Incremental Method
If we dont know the fair market value of each security then we might have to use the
incremental method. In this method we allocate the portion of the selling price to the
security for which we know the fair market value and allocate the balance to the other
security.

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