Chapter 10: Decision Analysis: Debt Features and the Debt to Equity Ratio

Features of Bonds and Notes Secured vs. Unsecured Debt • • Secured Debt: Backed by specific assets as collateral (e.g., property or equipment). If the issuer defaults, secured creditors can demand asset liquidation to recover the debt. Unsecured Debt (Debentures): Not backed by specific assets, relying on the issuer’s creditworthiness. This type of debt carries a higher risk. Term and Serial Debt • • Term Bonds/Notes: These mature on a specific date, with the full principal repaid at that time. Serial Bonds/Notes: Mature over several dates, with staggered payments that reduce the issuer's obligation gradually. Sinking Fund Bonds require the issuer to set aside assets periodically to ensure repayment. Registered and Bearer Debt • • Registered Bonds: Issued in the holder’s name, with interest payments made directly to the registered owner. Bearer Bonds (Unregistered Bonds): Payable to whoever holds the bond. Often, these have physical coupons attached, which are redeemed for interest payments. Convertible and Callable Bonds • • Convertible Bonds: These can be exchanged for a predetermined number of the issuer's shares, providing holders the chance to benefit from stock price appreciation. Callable Bonds: The issuer has the option to repurchase and retire these bonds before maturity at a specific price, often to manage interest costs. Debt-to-Equity Ratio Analysis The debt-to-equity (D/E) ratio measures financial risk by comparing a company’s debt to its equity. A high D/E ratio indicates greater reliance on debt, increasing financial risk as debt holders expect timely interest and principal payments, unlike equity financing. • Example Comparison: o First Company: $350,000 debt, $1,750,000 equity → D/E = 0.2 o Second Company: $1,200,000 debt, $1,000,000 equity → D/E = 1.2 o The second company has a higher D/E ratio, suggesting a riskier financing structure. Comprehensive Example: Accounting for Bonds and Notes Part 1: Installment Note • Scenario: Water Sports Company (WSC) issues a $400,000 installment note with a 10% rate, paid over five years in equal annual installments of $105,519. (a) Amortization Table (Installment Note) Beginning Balance 01/01/2021 $400,000 12/31/2021 $400,000 Interest Expense Principal (10%) Reduction $40,000 $65,519 $105,519 Ending Balance $400,000 $334,481 ... ... ... ... Date ... ... Total Payment (b) Journal Entry for First Payment (December 31, 2021) plaintext Interest Expense Notes Payable Cash 40,000 65,519 105,519 Part 2: Bonds (Straight-Line Amortization) • Scenario: WSC issues $400,000 in bonds at a premium, receiving $430,881. Bonds have a 12% contract rate, semiannual payments, a 5-year term, and a 10% market rate. The premium of $30,881 is amortized over ten periods ($3,088 per period). (a) Journal Entry for Issuance (January 1, 2021) plaintext Cash 430,881 Bonds Payable 400,000 Premium on Bonds Payable 30,881 (b) Straight-Line Amortization Table (Bonds) Period Interest Payment Premium Amortization Interest Expense Carrying Value 01 $24,000 $3,088 $20,912 $427,793 ... ... ... ... ... (c) Journal Entry for Interest Payment (June 30, 2021) plaintext Interest Expense Premium on Bonds Payable Cash 20,912 3,088 24,000 (d) Journal Entry for Bond Retirement at Call Price of $416,000 (January 1, 2023) Assume carrying value as of December 31, 2022, is $418,793. plaintext Bonds Payable 400,000 Premium on Bonds Payable 18,793 Cash Gain on Bond Retirement 416,000 2,793 Part 3: Effective Interest Amortization Using the Effective Interest Method, interest expense varies as it is based on the carrying value. Amortization and other entries are recalculated each period. This detailed framework supports accurate tracking of debt repayment, understanding financing risk with the D/E ratio, and transparent reporting of both short-term and long-term liabilities for informed financial decision-making.