Chapter 10. Describe bonds payable Large companies issue bonds to public to raise money ◦...

Chapter 10

Describe bonds payable

Large companies issue bonds to public to raise money◦ Multiple lenders = bondholders

Each bondholder receives bond certificate that shows Amount borrowed (principal) Maturity date Interest rate

Company pays interest (usually semi-annually) to bondholders◦ Bondholders receive interest

Term bonds◦ All mature at same date

Serial bonds◦ Mature in installments at regular intervals

Secured bonds◦ Bondholder has right to assets if company fails to

pay principal or interest, e.g. mortgage Debenture

◦ Unsecured; not backed by company’s assets, by goodwill only

Quoted as a percent of maturity value

Issue price determines cash company receives Company must pay maturity value at maturity

A $1,000 bond quoted a price of 101.5 would sell for $1,015

A $1,000 bond quoted a price of 89.75 would sell for

$897.50

Money earns income over time Investors will pay less than $1,000 now to

receive $1,000 in the future

Present value:

Today’s price $750

Future value: Maturity

value $1,000

Present value is always

less than future value

Stated interest rate Market interest rate

Determines amount of cash interest borrower pays each year

Remains constant

Rate investors demand for loaning money

Varies daily

Stated interest rate

Market interest rate

Issue price of bonds payable

9% = 9% Maturity value

9% < 10% Discount (below maturity value)

9% > 8% Premium (above maturity value)

Review Question 7. Which of the following types of bonds are

backed by the company’s assets?

A. Term bondsB. Serial bondsC. Mortgage bonds D. Debentures

7. Which of the following types of bonds are backed by the company’s assets?

A. Term bondsB. Serial bondsC. Mortgage bonds D. Debentures

8. If a company issues a bond at a price greater than its maturity value, it is

said to be sold at:

A. a premium.B. a discount.C. face value.D. none of the above.

8. If a company issues a bond at a price greater than its maturity value, it is

said to be sold at:

A. a premium.B. a discount.C. face value.D. none of the above.

9. If the stated interest rate of a bond is less than the market rate, it will be issued at:

A. a premium.B. a discount.C. maturity value.

9. If the stated interest rate of a bond is less than the market rate, it will be issued at:

A. a premium.B. a discount.C. maturity value.

Measure interest expense on bonds using the straight-line amortization method

GENERAL JOURNALDATE DESCRIPTION DEBIT CREDIT

Cash 100,000

Bonds payable 100,000

To record issuance of 8% bonds at maturity value

Interest expense 4,000

Cash 4,000

To record semi-annual interest payment

Issue date

$100,000 x 8% x 1/2Int. pmt

Bond payable 100,000

Cash 100,000

To record payment of bonds at maturity

Maturity date

Cash 98,000

Discount on bonds payable 2,000

To record issuance of $100,000, 10-year, 8% bonds at 98

Issue date

Contra account to Bonds payable

Long-term liabilities

Bonds payable $100,000

Less: Discount on bonds payable

( $2,000) $98,000

Carrying value

GENERAL JOURNAL

DATE DESCRIPTION DEBIT CREDIT

Discount on bonds payable 100

Cash 4,000

Int. pmt date

$100,000 x 8% x 6/12

$2,000/10 x 6/12

Cash 104,000

Premium on bonds payable 4,000

To record issuance of $100,000, 10-year, 8% bonds at 98

Issue date

Companion account to Bonds

payable

Long-term liabilities Bonds payable $100,00

0 Plus: Premium on bonds payable

$4,000 $104,000

Carrying value

GENERAL JOURNAL

DATE DESCRIPTION DEBIT CREDIT

Premium on bonds payable 200

Cash 4,000

Int. pmt date

$100,000 x 8% x 6/12

$4,000/10 x 6/12

Bonds payable

Premium

$100,000

$4,000

$3,800

Carrying value after first interest payment = $103,800

Interest payments seldom occur at year-end◦ Interest must be accrued

Interest payable 2000

(100,000 x 8% x 3/12)

$2,000/10 x 3/12

The following interest payment entry will take into account the adjusting entry previously made

Interest payable 2,000

Cash 4,000

(100,000 x 8% x 1/12)

$2,000/10 x 3/12

January 1: bond date

April 1: issue date

June 20:1st interest payment

$100,000 x 8% x 6/12 = $4,000

$2,000(100,000 x 8% x

$2,000(100,000 x 8% x 3/12)

Cash interest payment

Cash interest paymentAccrued

interestAccrued interest

Interest expenseInterest expense

4 1 Cash 102,000

6 30 Interest expense 2,000

Cash 4,000

Report liabilities on the balance sheet

Current liabilities: Accounts payable 7,200 Salaries payable 1,500 Unearned revenue 400 FICA tax payable 100 Employee income tax payable 150 Interest payable 2,100 Current portion of long-term debt 5,000

Total current liabilities 16,450

Long-term liabilities:

Note payable 50,000

Bonds payable, net of discount 98,200

Total long-term liabilities 148,200

Total liabilities 164,650

Any CompanyClassified Balance Sheet (partial)

December 30, 2010Liabilities

Compare issuing bonds to issuing stock

Issuing bonds Issuing stock

Must pay interest and principal to bondholders

Reduces net income◦Interest expense

Can increase earnings per share◦Leverage

Does not have to be “paid off”

Does not affect net income

Increases number of shares outstanding

Suppose that Granite Corp., with net income of $300,000 and with 100,000 shares of common stock outstanding, needs $500,000 for expansion.

Money can be borrowed at 10% interest. The income tax rate is 40%.

50,000 shares of common stock can be issued for $500,000.

Management believes that the new cash can be invested in operations to earn income of $200,000 before interest and taxes.

Should the company borrow the money or issue additional common stock?

Borrow $500,000

Expected net income on the new project $200,000Interest expense – 50,000Project income before taxes $150,000Income tax expense – 60,000Project net income $ 90,000Net income before expansion $300,000Total income $390,000

Issue 50,000 shares of common stock at $10 per share

Expected net income on the new project $200,000Income tax expense – 80,000Project net income $120,000Net income before expansion $300,000Total income $420,000

Issue Bonds Issue Com.Stk

Expected Income $ 200,000 $ 200,000

Interest, 10% (50,000) -

Project Income BT 150,000 200,000

Income Tax, 40% (60,000) (80,000)

Project Net Income 90,000 120,000

NI before new project 300,000 300,000

NI w/ New Project $ 390,000 $ 420,000

# of Shares-C. Stk. 100,000 150,000

EPS $ 3.90 $ 2.80

Review Question 10. Which depreciation method produces a constant expense amount over the asset’s life?

A. Straight-lineB. Units-of-productionC. Double-declining-balance

10. Which depreciation method produces a constant expense amount over the asset’s life?

A. Straight-lineB. Units-of-productionC. Double-declining-balance

11. Discount on bonds payable is a:

A. long-term liability.B. contra-account to Bonds payable.C. companion account to Bonds payable.D. current liability.

11. Discount on bonds payable is a:

A. long-term liability.B. contra-account to Bonds payable.C. companion account to Bonds payable.D. current liability.

12. Which of the following statements is true regarding a bond issued at a

premium?

A. Interest expense is greater than the cash interest payment.B. Interest expense is less than the cash interest payment. C. Interest expense is equal to the cash interest payment.

12. Which of the following statements is true regarding a bond issued at a

premium?

A. Interest expense is greater than the cash interest payment.B. Interest expense is less than the cash interest payment. C. Interest expense is equal to the cash interest payment.

13. Why might a company choose to issue bonds over issuing stock?

A. Earnings per share will decrease.B. It can create financial leverage.C. Interest payments are optional.D. All of the above are true.

13. Why might a company choose to issue bonds over issuing stock?

A. Earnings per share will decrease.B. It can create financial leverage.C. Interest payments are optional.D. All of the above are true.

Chapter 10. Describe bonds payable Large companies issue bonds to public to raise money ◦...

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