Debt Contracts

Question: Notes and bonds are contracts that facilitate the borrowing of money. They are produced with great care by attorneys who are knowledgeable in contract law. What legal terms are typically included in a debt instrument?

 

Answer: The specific terms written into a loan indenture vary considerably depending on what a debtor is willing to promise in hopes of enticing a creditor to turn over needed financial resources. Some of the most common are as follows.

Face valueMonetary amount of a note or bond to be repaid at the end of the contract; it serves as the basis for computing interest payments and is also known as the maturity value. (or maturity value). The noteA written contract to convey money as a loan at a specified interest rate and repayment schedule between two parties. or bondA written contract created by a debtor that is issued (to specific parties or to the members of the general public) to raise money; the contract specifies the amount and time of repayment as well as other terms and covenants promised by the debtor. will specify the amount to be repaid at the end of the contract term. A $1,000 bond, for example, has a face value of $1,000—the payment to be made on a designated maturity date. The face value can be set at any figure of the debtor’s choosing.

Payment pattern. With some debts, no part of the face value is scheduled for repayment until the conclusion of the contract period. These loans are often referred to as term notes or term bondsA type of debt instrument where interest is paid at regular time intervals with the entire face value due at the end of the contract period.. The entire amount of the face value is paid when the contract reaches the end of its term (sometimes referred to as a balloon payment). For many debtors, accumulating this amount of cash at one time might pose a significant financial burden.

Other loans, known as serial debtsA type of debt instrument where a set repayment is to be made each period to cover both interest and a portion of the face value; home mortgages and automobile loans are common examples., require many individual payments of the face value to be made periodically over time. Home mortgages, for example, are commonly structured as serial notes. Part of each scheduled payment reduces the face value of the obligation so that no large amount remains to be paid on the maturity date.

Notes and bonds can also be set up to allow the debtor the choice of repaying part or all of the face value prior to the due date. Such debts are referred to as “callable.” This feature is popular because it permits refinancing if interest rates fall. If a new loan can be obtained at a cheaper interest rate, the money is used to pay off any callable debt that charges a higher interest rate. Sometimes a penalty payment is required if a note or bond is paid prematurely.

Interest rate. Creditors require the promise of interest before they are willing to risk loaning money to a debtor. Therefore, within the debt contract, a stated cash interest rateThe rate for interest on a debt can be identified by any of several terms. Cash rate, stated rate, contract rate, and coupon rate are all examples of the same information: the rate of interest to be paid by the debtor at specified times. is normally included. A loan that is identified as having a $100,000 face value with a stated annual interest rate of 5 percent informs both parties that $5,000 in interest ($100,000 × 5 percent) will be conveyed from debtor to creditor each year.

For example, the 2010 financial statements for the Intel Corporation indicated that the company had issued over $1 billion in bonds during 2009 that paid a stated annual interest ratePercentage rate established in a debt contract to be paid by the debtor in addition to the face value usually at specified time intervals; it is also called the cash rate, contract rate or coupon rate. of 3.25 percent with a maturity date in 2039.

Interest payment dates. The stated amount of interest is paid at the times identified in the contract. Payments can range from monthly to quarterly to semiannually to annually to the final day of the debt term.

Security. Many companies are not able to borrow money (or cannot borrow money without paying a steep rate of interest) unless some additional security is provided for the creditor. Any reduction of risk makes a note or bond instrument more appealing to potential lenders.

For example, some loans (often dealing with the purchase of real estate) are mortgage agreements that provide the creditor with an interest in identified property. Although specific rights can vary based on state law and the wording of the contract, this type of security usually allows the creditor to repossess the property or force its liquidation if the debtor fails to make payments in a timely manner. The recent downturn in the housing market has seen many debtor defaults that have led to bank foreclosures on homes across the country because of such mortgage agreements.

A debentureA debt contract that does not contain any type of security for the creditor; these contracts are usually offered by debtors that are considered financially strong so that no additional security is required by creditors to reduce their chance of loss. is a debt contract that does not contain any security. The debtor is viewed as so financially strong that money can be obtained at a reasonable interest rate without having to add extra security agreements to the contract.

CovenantsPromises made by the issuer of a debt contract to help ensure that sufficient money will be available to make required payments at their scheduled times. and other terms. Notes and bonds can contain an almost infinite list of other agreements. In legal terms, a covenant is a promise to do a certain action or a promise not to do a certain action. Most loan covenants are promises made by the debtor to help ensure that adequate money will be available to make required payments when they come due. For example, the debtor might agree to limit the size of any dividend payments, keep its current ratio above a minimum standard, or not exceed a maximum amount of debt.

Debts can also be convertible so that the creditor can swap them for something else of value (often the capital stock of the debtor) if that seems a prudent move. The notes to the financial statements for the Ford Motor Company as of December 31, 2010, and the year then ended describe one such noncurrent liability. “At December 31, 2010, we had outstanding $883 million principal of 4.25% Senior Convertible Notes due December 15, 2016 (‘2016 Convertible Notes’). The 2016 Convertible Notes pay interest semiannually at a rate of 4.25% per annum. The 2016 Convertible Notes are convertible into shares of Ford Common Stock, based on a conversion rate (subject to adjustment) of 107.5269 shares per $1,000 principal amount.”

Recording a Note Issued at Face Value

Question: The financial reporting of a debt contract appears to be fairly straightforward. Assume, for example, that Brisbane Company borrows $400,000 in cash from a local bank on May 1, Year One. The face value of this loan is to be repaid in exactly five years. In the interim, interest payments at an annual rate of 6 percent will be made every six months beginning on November 1, Year One. What journal entries are appropriate to record a debt issued for a cash amount equal to the face value of the contract?

 

Answer: Brisbane receives $400,000 in cash but also accepts a noncurrent liability for the same amount. The resulting journal entry is shown in Figure 14.1 "May 1, Year One—Cash of $400,000 Borrowed on Long-term Note Payable".

The first semiannual interest payment will be made on November 1, Year One. Because the 6 percent interest rate stated in the contract is for a full year, it must be adjusted to calculate the payment that covers each six-month interval. These payments will be for $12,000 ($400,000 face value × 6 percent annual stated interest rate × 6/12 year). The recording of the first payment is presented in Figure 14.2 "November 1, Year One—Payment of Interest for Six Months".

By December 31, Year One, when financial statements are to be prepared, interest for two additional months (November and December) has accrued. This amount ($4,000 or $400,000 × 6 percent × 2/12 year) is recognized at that time so (a) the amount due on the balance sheet date will be presented fairly and (b) the cost of the debt for these two months is included on the Year One income statement. No transaction occurs on that date but the adjusting entry in Figure 14.3 "December 31, Year One—Accrual of Interest for Two Months" brings all reported figures up to date.

When the next $12,000 interest payment is made by Brisbane on May 1, Year Two, the recorded $4,000 liability is extinguished and interest for four additional months (January through April) is recognized. The appropriate expense for this period is $8,000 ($400,000 × 6 percent × 4/12 year). Mechanically, this payment could be recorded in more than one way but the journal entry shown in Figure 14.4 "May 1, Year Two—Payment of Interest for Six Months" is probably the easiest to follow. Interest expense for the first two months was recorded in Year One with interest for the next four months recorded here in Year Two.

Interest payments and the recording process will continue in this same way until all five years have passed and the face value is paid.

Except for the initial entry, these events are recorded in an identical fashion if Brisbane had signed this same note to acquire an asset—such as a piece of machinery—directly from the seller. The only reporting difference is that the asset replaces cash in Figure 14.1 "May 1, Year One—Cash of $400,000 Borrowed on Long-term Note Payable" above.

Issuance of Bonds between Interest Dates

Question: Bonds can be issued to a group of known investors or to the public in general. Often, companies will print bond indentures but not offer them to buyers until monetary levels run low. Thus, bonds are frequently issued on a day that falls between two interest dates. Payment must still be made to creditors as specified by the contract regardless of the length of time that the debt has been outstanding. If an interest payment is required, the debtor is legally obligated.

To illustrate, assume that the Brisbane Company plans to issue bonds with a face value of $400,000 to a consortium of twenty wealthy individuals. As in the previous example, these bonds pay a 6 percent annual interest rate with payments every May 1 and November 1. However, this transaction is not finalized until October 1, Year One, when Brisbane has need for the cash.

The first six-month interest payment must still be made on November 1 as stated in the contract. After just one month, the debtor is forced to pay interest for six months. That is not fair, and Brisbane would be foolish to agree to this arrangement. How does a company that issues a bond between interest payment dates ensure that the transaction is fair to both parties?

 

Answer: As indicated in this question, the issuance of a bond between interest dates is common. Thus, a standard system of aligning the first interest payment with the time that the debt has been outstanding is necessary. Because of the terms of the contract, Brisbane must pay interest for six months on November 1 even though the cash proceeds have been held for only one month. In this first payment, the creditor receives interest for an extra five months.

Consequently, such bonds are normally issued for a stated amount plus accrued interest. The accrued interest is measured from the previous interest payment date to the present and is charged to the buyer. Later, when the first payment is made, the net effect reflects just the time that the bond has been outstanding. If issued on October 1, Year One, the creditors should pay for the bonds plus five months of accrued interest. Later, when Brisbane makes the first required interest payment on November 1 for six months, the net effect is interest for one month—the period that has passed since the date of issuance (six months minus five months).

Assume that the creditors buy these bonds on October 1, Year One, for face value plus accrued interest. Because five months have passed since the previous interest date (May 1), interest on the bonds as of the issuance date is $10,000 ($400,000 × 6 percent × 5/12 year). Thus, the creditors pay $400,000 for the bond and an additional $10,000 for the interest that has accrued to that date. Once again, the actual recording can be made in more than one way but the entry presented in Figure 14.5 "Issuance of Bond on October 1 at Face Value plus Accrued Interest Recognized for Five Months" seems easiest.

One month later, Brisbane makes the first interest payment of $12,000. However, interest expense of only $2,000 is actually recognized in the entry in Figure 14.6 "November 1, Year One—Payment of First Interest Payment". That amount is the appropriate interest for the month of October ($400,000 × 6 percent × 1/12 year). This expense reflects the cost associated with the period that the bond has been outstanding. Interest of $10,000 for five months was collected initially by Brisbane. Interest of $12,000 was later paid by Brisbane for the entire six month period. Interest expense of $2,000 is the net result for that one month.

After this entry, the recording of interest follows the process demonstrated previously in Figure 14.3 "December 31, Year One—Accrual of Interest for Two Months" and Figure 14.4 "May 1, Year Two—Payment of Interest for Six Months".