Balance Sheet Disclosure of Bonds

Bonds payable and unamortized discounts or premiums are typically shown on the balance sheet as long-term liabilities. Bond discount is reported as a direct deduction from - and bond premium as a direct addition to - the face value of the bond. If a bond issue will mature within a year, it should be reported as a current liability if the issue will be retired using current assets. However, the issue should continue to be reported as a long-term liability if it is to be replaced with another bond issue, converted into stock, or paid off with noncurrent assets.

Financial statement footnotes provide more information on the type and nature of a company's debt: stated and effective interest rates, maturity dates, restrictions imposed by creditors, and collateral pledged (if any). An MD&A also provides other information on a company's capital resources, such as debt financing and off-balance-sheet financing.

For bonds issued at a premium or discount, reporting coupon payments as cash outflow from operations is inappropriate. For example, if a bond is sold at a premium, part of the coupon payment is used to amortize the premium and reduce the principal, and therefore should be treated as a financing cash outflow. As a result, CFO is understated and CFF is overstated by the amortization amount of the bond's premium.

Debt with Equity Features

A company can issue a bond that is convertible into shares or a bond with a warrant attached. The reason for doing this is to add a sweetener to a bond issue. Because of the benefit to the investor (the ability to obtain shares of the company), the issuer is able to issue the bonds at a lower interest rate than would be the case for a straight bond.

Practice Question 1

On a statement of cash flows, bonds issued at a premium would be shown as follows:

A. The entire proceeds would be shown in the operating section as an addition.
B. The entire proceeds would be shown in the investing section as an addition.
C. The entire proceeds would be shown in the financing section as an addition.

Correct Answer: C

All of the proceeds would be shown in the financing section as an addition, an increase in cash flows.

Practice Question 2

Disclosure of information under SFAS No. 107 regarding the market values of both financial assets and liabilities is required for ______.

A. financial instruments that involve debt-to-equity swaps only
B. financial instruments with off-balance-sheet market risk only
C. financial instruments with off-balance-sheet risk of accounting losses only
D. all financial instruments

Correct Answer: D

SFAS No. 107 requires disclosures of market values for all assets deemed to be financial instruments.

Practice Question 3

Which of the following conditions would allow a firm to classify a short-term liability as a long-term debt?

I. The firm has issued a long-term note with the stated purpose of extinguishing the short-term debt when it matures. The note is cancelable if there are violations of certain operating provisions.
II. The firm has entered into a binding agreement with a bank to refinance the short-term debt with a long-term liability.
III. The firm has announced that it will continue to refinance the debt with available credit for the next 2 years.

Correct Answer: II only

If these agreements have any provisions for cancellation which are either ambiguous or which have a good probability of being violated, then the short-term debt cannot be classified as long-term debt. That's why (I) is not a valid choice. (III) is not acceptable because there is no demonstration of credible intent or ability to be able to refinance the debt.

Practice Question 4

Which statement(s) is (are) true?

I. Short-term obligations may be classified as long-term if the company intends to refinance them on a long-term basis and can demonstrate the ability to do so.
II. Companies must disclose the fair market value of their debt in footnotes.

Correct Answer: Both are true.

Practice Question 5

When bonds with warrants are issued, the reported interest expense will be ______

A. lower than that of the convertible bond issued at the same price.
B. lower than that of the non-convertible bond issued at the same price.
C. the same as that of the convertible bond issued at the same price.

Correct Answer: B

When bonds are issued with warrants, their proceeds are allocated between the liability and equity. This usually causes the bonds to be issued at a discount. Thus, the value of the liability will be lower, which will cause the interest expense to be lower than that of non-convertible bonds.

Practice Question 6

Which statement(s) is (are) true?

I. The Black-Scholes option pricing model may be used to price a warrant if the underlying stock does pay dividends.
II. The YTM on a straight bond will always be higher than the YTM on a corresponding convertible bond.

Correct Answer: I and II

Practice Question 7

Select the correct statements.

I. The economic effect of issuing a convertible bond is substantially the same as that of issuing a debt instrument with an early settlement provision and options to purchase shares.
II. When bonds are converted, there is no effect on cash flows.
III. Convertible bonds would change both the numerator and denominator of the debt-to-equity ratio.

Correct Answer: All of the above

Practice Question 8

According to GAAP, a separate value must be assigned to the equity feature included with the following debt securities:

I. convertible bonds
II. bonds issued with warrants

A. Neither of these bonds
B. I and II
C. II only

Correct Answer: C

When convertible bonds are sold, all of the proceeds are assigned to the liability. When bonds with warrants are sold, a portion of the proceeds is assigned to equity.

Practice Question 9

Which of the following statements regarding factors that influence the attractiveness of financing with warrants and convertibles is false?

A. These hybrid securities are generally unsecured by the issuer.
B. If management expects future growth prospects to outweigh risks, then issuing convertible bonds or bonds with warrants would be deemed more prudent than issuing straight bonds.
C. These hybrid securities are more commonly issued by either smaller companies or companies that are facing financial distress.

Correct Answer: B

Since a convertible bond will always be higher in price than a corresponding straight bond, its YTM will always be lower than that of a straight bond.

If management expects future growth prospects to outweigh risks, then issuing convertible bonds or bonds with warrants would imply that these future earnings will have to be shared among new shareholders as well. Thus, the more prudent move would be to issue straight bonds so that the exiting shareholders may keep those increased earnings amongst themselves.