FA John Topic 9 2014

Wild Chapter 10McGraw-Hill/Irwin
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In this chapter, we will learn about issuing bonds at par, at a discount, and at a premium. We also learn about various ways to structure the payments on notes payable.
© The McGraw-Hill Companies, Inc., 2010
McGraw-Hill/Irwin
C1: Explain the types and payment patterns of notes
C2: Appendix 10A: Explain and compute the present value of an amount to be paid at a future date
C3: Appendix 10C: Describe the accrual of bond interest when bond payments do not align with accounting periods
C4: Appendix 10D: Describe accounting for leases
McGraw-Hill/Irwin
A3: Compute the debt-to-equity ratio and explain its use
Analytical Learning Objectives
McGraw-Hill/Irwin
P1: Prepare entries to record bond issuance and bond interest expense
P2: Compute and record amortization of bond discount
P3: Compute and record amortization of bond premium
P4: Record the retirement of bonds
P5: Prepare entries to account for notes
Procedural Learning Objectives
McGraw-Hill/Irwin
Advantages of Bonds
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There are several advantages for issuing bonds instead of stock. Companies issue bonds because it is a way to raise needed capital without sacrificing ownership in the company. The interest on bonds is tax deductible, thereby reducing the actual taxes paid by the company. Issuing bonds can increase the return on equity if the company earns a higher return on the borrowed funds than it pays in interest.
McGraw-Hill/Irwin
Bonds require payment of both periodic interest and par value at maturity.
Bonds can decrease return on equity when the company pays more in interest than it earns on the borrowed funds.
Disadvantages of Bonds
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On the other side of the issue, there are some disadvantages to issuing bonds. Bonds require regular payment of interest and repayment of the principal borrowed. These required cash payments may be difficult if a company faces tight cash flows. Bonds can also decrease the return on equity if the company pays more in interest than it earns on the borrowed funds.
McGraw-Hill/Irwin
Bond market values are expressed as a percent of their par value.
Bond Trading
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Bonds are securities that can be readily bought and sold. A large number of bonds are traded on the New York Exchange and the American Exchange. Since bonds are bought and sold in the market, they have a market value, or price. For convenience, bond market values are expressed as a percent of their par value.
McGraw-Hill/Irwin
. . .an investment firm called an underwriter. The underwriter sells the bonds to. . .
A trustee monitors the bond issue.
A company sells the
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When an underwriter sells bonds to a large number of investors, a trustee monitors the bond issue and protects the bondholders’ interests.
McGraw-Hill/Irwin
Corporation
Investors
2
2
Bonds are debt. They are similar to other debts a company issues. However, one difference is that state and federal laws govern bond issues. The legal document identifying the rights and obligations of both the bondholders and the issuer is called the bond indenture. The bond indenture is the legal contract between the issuer and the bondholders.
On the issue date, the bondholders give the company the market value, or selling price of the bond. The company gives the bondholders a bond certificate.
McGraw-Hill/Irwin
Basics of Bonds
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2
At regularly scheduled dates during the life of the bond, the company pays the bondholders interest. Interest is calculated as Bond Par Value times the Stated Interest Rate on the bond times the length of time the bond has been outstanding during the year.
Just like all interest rates, the stated interest rate is expressed on an annual basis. As a result, in this slide, we can assume that interest payments are made annually since the interest payment computation does not have a time component in it.
McGraw-Hill/Irwin
2
2
At the maturity date, the company pays the bondholders the bond’s par value.
Now, let’s see how to account for a bond issue.
McGraw-Hill/Irwin
King Co. issues the following bonds on January 1, 2008
Par Value = $1,000,000
Maturity Date = Dec. 31, 2027 (20 years)
Issuing Bonds at Par
11
King Company issues bonds at par value. This means that the stated interest rate on the bond and the market interest rate on the bond are equal. King’s bonds have a par value of one million dollars, a stated interest rate of ten percent with interest payable on June 30th and December 31st. The bonds are dated January 1, 2008 and mature twenty years later on December 31, 2027.
On the issue date, King would debit Cash and credit Bonds Payable for one million dollars. The Bonds Payable account is always credited for the par value, or maturity value, of the bonds.
Larson
DR
CR
Preferred
Common
Preferred
Common
$ 9,000
2.
McGraw-Hill/Irwin
$1,000,000 × 10% × ½ year = $50,000
This entry is made every six months until the bonds mature.
The entry on June 30, 2008, to record the first semiannual interest payment is . . .
P1
13
On the first interest payment date, King would debit Bond Interest Expense and credit Cash for fifty thousand dollars. The interest was calculated as Par value times stated rate times months outstanding.
King will actually make this entry every six months until the maturity date.
Larson
DR
CR
Preferred
Common
Preferred
Common
$ 9,000
2.
McGraw-Hill/Irwin
On Dec. 31, 2027, the bonds mature, King Co. makes the following entry . . .
P1
13
On the maturity date, King will repay the par value of the bonds by debiting Bonds Payable and crediting Cash for one million dollars. At this time, the debt is extinguished.
Larson
DR
CR
T- Account
Company Name
Financial Statement
Preferred
Common
Preferred
Common
$ 9,000
2.
McGraw-Hill/Irwin
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In almost all cases, the stated (contract) rate and the market rate of interest will not agree. When these two interest rates are different, it might make sense to you for us to just change our stated rate to equal the market rate and then everything would be fine. Well, we can’t do that. Remember that the bond certificate lists all of the specifics about the bond including the interest rate. Because we have to print the bond certificates in advance, we are stuck having to pay the interest printed on the bond certificate.
The only thing that is not printed on the bond certificate is the selling price. So, the issuing company and the bond investors come to an agreement on the selling price that incorporates the difference in the stated interest rate and the market interest rate.
Sheet1
McGraw-Hill/Irwin
Prepare the entry for Jan. 1, 2008, to record the following bond issue by Rose Co.
Par Value = $1,000,000
Stated Interest Rate = 10%
Market Interest Rate = 12%
Issuing Bonds at a Discount
}
P2
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In this example, Rose Company is issuing bonds with a par value of one million dollars, a stated interest rate of ten percent with interest payable semiannually on June thirtieth and December thirty-first. However, the market interest rate on the issue date for financial instruments with similar risk is twelve percent.
Now, if our bond is paying ten percent and the market is paying twelve percent, how many investors will want to buy our bonds? None! So, we have to make our bonds more attractive by reducing the selling price to make up the difference in the interest rates.
In this example, Rose Company sells its bonds for 92.6405% of its par value. This discount in the selling price raises the effective interest rate that the investors will earn to twelve percent.
McGraw-Hill/Irwin
Amortizing the discount increases Interest Expense over the outstanding life of the bond.
$1,000,000 ´ 92.6405%
P2
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Rose will receive cash of nine hundred twenty six thousand, four hundred five dollars from the bond investors. The difference between the par value of the bonds and the cash price received is the discount that we offered the bond investors.
Remember that the whole reason we offered the discount is because of the difference between the stated rate and the market rate of interest. As a result, the discount represents an additional interest factor that will be amortized to Interest Expense over the life of the bond. Amortizing the discount will increase the total Interest Expense recorded for the bond to equal twelve percent, the market rate of interest.
Sheet1
McGraw-Hill/Irwin
Contra-Liability
Account
On Jan. 1, 2008, Rose Co. would record the bond issue as follows.
P2
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On the issue date, Rose will debit Cash for the amount of the cash proceeds, credit Bonds Payable for the par value of the bonds issued, and debit Discount on Bonds Payable for the difference between the two.
Discount on Bonds Payable is a contra-liability account and has a normal debit balance.
Larson
DR
CR
T- Account
Company Name
Financial Statement
Preferred
Common
Preferred
Common
$ 9,000
2.
McGraw-Hill/Irwin
Using the straight-line method, the discount amortization will be $7,360 every six months.
$73,595 ÷ 10 periods = $7,360* *(rounded)
P2
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On the balance sheet, the amount of the unamortized discount is subtracted from the par value of the bonds to arrive at the current carrying value of the bonds.
Using the straight-line method to amortize the discount, Rose will divide the amount of the discount by the number of interest payment periods during the bond’s life. Since this is a 5 year bond and it pays interest semiannually, there are 10 interest payment periods. This calculation determines that the discount amortization will be seven thousand, three hundred sixty dollars at every interest payment date.
Sheet1
Long-term Liabilities:
73,595
$ 926,405
&A
McGraw-Hill/Irwin
$1,000,000 × 10% × ½ = $50,000
Make the following entry every six months to record the cash interest payment and the amortization of the discount.
P2
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Every six months, Rose will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. It is calculated as par value times the stated interest rate times one half of a year. The credit to the Discount on Bonds Payable account is determined using the straight-line method we discussed on the previous slide. The debit to Bond Interest Expense is the total of the two credit amounts in this entry.
Larson
DR
CR
T- Account
Company Name
Financial Statement
Preferred
Common
Preferred
Common
$ 9,000
2.
McGraw-Hill/Irwin
P2
An amortization table illustrates the interest payment, interest expense, discount amortization, unamortized discount balance, and the carrying value of the bond for each interest payment period over the life of the bond.
Sheet1
A
B
C
D
E
Interest
Interest
Discount
Unamortized
Book
Date
Payment
Expense
Amortization
Discount
Value
1/1/X1
$ 73,595
$ 926,405
6/30/X1
$ 50,000
$ 55,584
$ 5,584
68,011
931,989
12/31/X1
50,000
55,919
5,919
62,102
937,898
6/30/X2
50,000
56,274
6,274
55,828
944,172
12/31/X2
50,000
56,650
6,650
49,178
950,822
6/30/X3
50,000
57,049
7,049
42,128
957,872
12/31/X3
50,000
57,472
7,472
34,656
965,344
6/30/X4
50,000
57,921
7,921
26,736
973,264
12/31/X4
50,000
58,396
8,396
18,340
981,660
6/30/X5
50,000
58,900
8,900
9,440
990,560
12/31/X5
50,000
59,434
9,440
0
1,000,000
McGraw-Hill/Irwin
interest expense over the life of the bond.
Straight-Line and Effective Interest Methods
P2
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Instead of using the straight-line method to amortize the discount, some companies use the effective interest method. The effective interest method applies the market interest rate to the carrying value of the bond to determine the amount of amortization for the period. As indicated in this graph, as the carrying value increases toward the par value, the amount of annual amortization increases.
Whether a company uses the straight-line method or the effective interest method, the total interest expense recorded over the life of the bond is the same.
Chart1
Sheet1
12/31/08
12/31/09
12/31/10
12/31/11
12/31/12
McGraw-Hill/Irwin
Prepare the entry for Jan. 1, 2008, to record the following bond issue by Rose Co.
Par Value = $1,000,000
Stated Interest Rate = 10%
Market Interest Rate = 8%
Issuing Bonds at a Premium
}
P3
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In this example, Rose Company is issuing bonds with a par value of one million dollars, a stated interest rate of ten percent with interest payable semiannually on June 30th and December 31st. However, the market interest rate on the issue date for financial instruments with similar risk is eight percent.
Now, if our bond is paying ten percent, and the market is paying eight percent, how many investors will want to buy our bonds? All of them! So, we can increase the price of our bonds and they will still be attractive to the bond investors.
In this example, Rose company sells its bonds for 108.1145% of its par value. This premium in the selling price reduces the effective interest rate that the investors will earn to eight percent.
McGraw-Hill/Irwin
Amortizing the premium decreases Interest Expense over the life of the bond.
$1,000,000 ´ 108.1145%
P3
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Rose will receive cash of one million, eighty-one thousand, one hundred forty-five dollars from the bond investors. The difference between the par value of the bonds and the cash price received is the premium we charged the bond investors.
Remember that the whole reason we could offer the premium is because of the difference between the stated rate and the market rate of interest. As a result, the premium represents a reduction in the Interest Expense recorded over the life of the bond. Amortizing the premium will decrease the total Interest Expense recorded for the bond to equal eight percent, the market rate of interest.
Sheet1
McGraw-Hill/Irwin
Adjunct-Liability
Account
On Jan. 1, 2008, Rose Co. would record the bond issue as follows.
P3
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On the issue date, Rose will debit Cash for the amount of the cash proceeds, credit Bonds Payable for the par value of the bonds issued, and credit Premium on Bonds Payable for the difference between the two.
Premium on Bonds Payable is an adjunct-liability account and has a normal credit balance.
Larson
DR
CR
T- Account
Company Name
Financial Statement
Preferred
Common
Preferred
Common
$ 9,000
2.
McGraw-Hill/Irwin
Using the straight-line method, the premium amortization will be $8,115 every six months.
$81,145 ÷ 10 periods = $8,115 (rounded)
P3
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On the balance sheet, the premium account is added to the par value of the bonds to arrive at the current carrying value of the bonds.
Using the straight-line method to amortize the premium, Rose will divide the premium by the number of interest payment periods during the bond’s life. Since this is a five-year bond and it pays interest semiannually, there are ten interest payment periods. This calculation determines that the premium amortization will be eight thousand, one hundred fifteen dollars at every interest payment date.
Sheet1
Long-term Liabilities:
81,145
$ 1,081,145
&A
McGraw-Hill/Irwin
$1,000,000 × 10% × ½ = $50,000
This entry is made every six months to record the cash interest payment and the amortization of the premium.
P3
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Every six months, Rose will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. It is calculated as par value times the stated interest rate times one half of a year. The debit to the Premium on Bonds Payable account is determined using the straight-line method we discussed on the previous slide. The debit to Bond Interest Expense is amount of the cash credit less the bond premium amortization.
Larson
DR
CR
Preferred
Common
Preferred
Common
$ 9,000
2.
McGraw-Hill/Irwin
P3
An amortization table illustrates the interest payment, interest expense, premium amortization, unamortized premium balance, and the carrying value of the bond for each interest payment period over the life of the bond.
Sheet1
A
B
C
D
E
Interest
Interest
Discount
Unamortized
Book
Date
Payment
Expense
Amortization
Discount
Value
1/1/X1
$ 73,595
$ 926,405
6/30/X1
$ 50,000
$ 55,584
$ 5,584
68,011
931,989
12/31/X1
50,000
55,919
5,919
62,102
937,898
6/30/X2
50,000
56,274
6,274
55,828
944,172
12/31/X2
50,000
56,650
6,650
49,178
950,822
6/30/X3
50,000
57,049
7,049
42,128
957,872
12/31/X3
50,000
57,472
7,472
34,656
965,344
6/30/X4
50,000
57,921
7,921
26,736
973,264
12/31/X4
50,000
58,396
8,396
18,340
981,660
6/30/X5
50,000
58,900
8,900
9,440
990,560
12/31/X5
50,000
59,434
9,440
0
1,000,000
McGraw-Hill/Irwin
Interest Payment Dates
At year-end, an adjusting entry is necessary to recognize bond interest expense accrued since the most recent interest payment.
3 months’ accrued interest
Accruing Bond Interest Expense
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When bond interest payment dates do not fall at year-end, an adjusting entry is required to record the bond interest expense and the bond interest payable that has accrued since the last interest payment date.
McGraw-Hill/Irwin
Par Value = $1,000,000
Present Value of a Discount Bond
C2
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In our previous examples, we provided the selling price of the bonds. But how did we determine those prices? To compute the price of a bond, we apply present value concepts.
We know the following information related to the bond:
Par value to be received at maturity.
Interest payments determined using the stated interest rate.
Number of interest payment periods.
Market rate of interest.
Let’s see how we use this information to determine the price of a bond.
McGraw-Hill/Irwin
1. Semiannual rate = 6% (Market rate 12% ÷ 2)
2. Semiannual periods = 10 (Bond life 5 years × 2)
$1,000,000 × 10% × ½ = $50,000
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The price of the bond is made up of two factors:
The present value of the par value paid at maturity.
The present value of the series of interest payments over the life of the bond.
For Rose, the par value is one million dollars. To find the present value of the par value, we can use the Present Value of One Table or a calculator. The future value is one million dollars, the time is ten periods, and the market interest rate for each semiannual period is six percent. If we use the Present Value of One Table, we find an interest factor of 0.5584. When we multiply this interest factor times the par value of one million dollars, we get the present value.
To find the present value of the interest payments, we can use the Present Value of an Annuity of One Table or a calculator. The annuity is fifty thousand dollars, the time is ten periods, and the market interest rate for each semiannual period is six percent. If we use the Present Value of an Annuity of One Table, we find an interest factor of 7.3601. When we multiply this interest factor times the interest annuity of fifty thousand dollars, we get the present value.
If we add the two present value amounts calculated together, we get the selling price of the bond.
Sheet1
PV of $1
7.3601
50,000
368,005
McGraw-Hill/Irwin
Bond Retirement
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On the maturity date, the issuing company debits Bonds Payable and credits Cash for the par value of the bond.
If bonds are retired before the maturity date, a gain or loss is recorded. The gain or loss is determined by comparing the carrying value of the bond on the retirement date with the cash price paid to retire the bonds.
Larson
DR
CR
T- Account
Company Name
Financial Statement
Preferred
Common
Preferred
Common
$ 9,000
2.
McGraw-Hill/Irwin
Bond Retirement
The carrying value of the bond at maturity should equal its par value.
Sometimes bonds are retired prior to their maturity.
Two common ways to retire bonds are through the exercise of a callable option or through purchasing them on the open market.
Callable bonds present several accounting issues including calculating gains and losses.
P4
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Bonds are eventually retired. This can be through the payment of the principal at maturity, or through calling the bond in before maturity. Bonds may also be retired early if there is a conversion feature that allows the bonds to be retired in exchange for stock.
When bonds are paid off at maturity, the carrying value of the bond will equal the par value and the journal entry to record the transaction simply involves a debit to bonds payable and a credit to cash.
Issuers sometimes wish to retire some or all of their bonds prior to maturity. Most of the time this results in a gain or loss depending on what the price of the bond is at the time it is called. Two common ways to retire bonds are through the exercise of a callable option or through re-purchasing them on the open market. These types of early retirements usually result in gains or losses which requires additional calculations and journal entries.
McGraw-Hill/Irwin
Long-Term Notes Payable
Now, let’s change topics and discuss long-term notes payable.
McGraw-Hill/Irwin
Note Date
When is the repayment of the principal and interest going to be made?
Long-Term Notes Payable
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Notes are typically between a company and a single lender, such as a bank.
When the note payable is issued, the lender provides the cash to the company and the company signs a note payable contract agreeing to repay the principal plus interest.
Let’s look at two common ways to structure the repayment of the principal and the interest.
McGraw-Hill/Irwin
C1
2
2
For some notes, the note principal and interest are paid in a single payment at the end of the note term.
McGraw-Hill/Irwin
Regular Payments of Principal plus Interest
Payments can either be equal principal payments plus interest or equal payments.
Regular Payments of Principal plus Interest
C1
2
2
Other notes require regular payments during the note term. In some cases, the regular payments consist of equal principal payments plus interest. In other cases, the regular payments consist of equal payments that include both principal payments and interest payments.
Most car loans are like this latter example. The payment is the same every month and consists of interest and some principal payment.
McGraw-Hill/Irwin
The principal payments are $10,000 each year.
Interest expense decreases each year.
Annual payments decrease.
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In cases where the payments include equal principal payments, the payment amounts decrease over time as interest expense decreases.
McGraw-Hill/Irwin
Installment Notes with Equal Payments
The principal payments increase each year. Interest expense decreases each year.
Annual payments are constant.
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In cases where the payments are equal, the amount of the principal payment increases each year as the interest expense payment decreases.
McGraw-Hill/Irwin
There are several common types of bonds.
Secured bonds have specific assets of the issuer pledged as collateral. Unsecured bonds are backed by the issuer’s general credit standing.
Term bonds are scheduled for maturity on one specified date. Serial bonds mature at more than one date.
Registered bonds are issued in the names and addresses of their holders. Bearer bonds are payable to whoever holds the bond.
Convertible bonds can be exchanged for a fixed number of common shares of the issuing corporation. Callable bonds have an option exercisable by the issuer to retire them at a stated dollar amount prior to maturity.
McGraw-Hill/Irwin
A legal agreement that helps protect the lender if the borrower fails to make the required payments.
Gives the lender the right to be paid out of the cash proceeds from the sale of the borrower’s assets specifically identified in the mortgage contract.
Mortgage Notes and Bonds
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A mortgage is a legal agreement that helps protect a lender if the borrower fails to make required payments on bonds or notes.
A mortgage gives the lender the right to be paid from the cash proceeds of the sale of a borrower’s assets specifically identified in the mortgage contract.
Most home loans have a mortgage contract that give the lender the right to sell the house and be paid out of the cash proceeds if the borrower defaults on the loan payments.
McGraw-Hill/Irwin
This ratio helps investors determine the risk of investing in a company by dividing its total liabilities by total equity.
Debt-to-Equity Ratio
=
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The Debt-to-Equity Ratio helps investors determine the risk of investing in a company’s bonds by dividing the company’s total liabilities by its total equity. A high Debt-to-Equity Ratio (over 1) indicates the company’s liabilities outweigh its equity. The lower the number, the safer the investment will be.
McGraw-Hill/Irwin
Jan. 1, 2008
C3
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One complicating factor that can occur is when a company issues bonds between interest dates. This is a common occurrence because bonds are sold when there is a willing buyer and seller, and that can take place on any date, not just an interest payment date.
When bonds are issued between interest payment dates, the investor pays for the bond PLUS the accrued interest since the last interest payment date. This allows the issuing company to pay all the investors the same interest amount on the interest payment date.
McGraw-Hill/Irwin
June 30, 2008
First Interest Payment
Earned interest
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On the interest payment date, the investor receives the full interest payment for the period even though the bond was only outstanding for a portion of the period. The interest payment actually represents two factors. One is a mere repayment of the accrued interest that the investor paid on the purchase date of the bond. The other is interest earned since the bond was purchased.
Let’s look at an example.
McGraw-Hill/Irwin
Prepare the entry to record the following bond issue by King Co. on Apr. 1, 2008.
Par Value = $1,000,000
Issuing Bonds Between Interest Dates
C 3
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In this example, King Company is issuing bonds with a par value of one million dollars, a stated interest rate of ten percent with interest payable semiannually on June 30th and December 31st. The market interest rate on the issue date for financial instruments with similar risk is ten percent. The issue date for this bond is April 1st, which is between interest payment dates.
Since the bonds will sell at par value, the cash amount received will include one million dollars as the price for the bonds. The cash amount received will also include accrued interest since the last interest date. In this example, that would be twenty five thousand dollars. It is calculated as par value times stated interest rate times the time since the last interest payment date.
Sheet1
McGraw-Hill/Irwin
At the date of issue the following entry is made:
Issuing Bonds Between Interest Dates
The first interest payment on June 30, 2005 is:
C3
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On the issue date, King will debit Cash for the total cash received as determined on the previous slide. It will credit Bonds Payable for the par value of the bonds and Interest Payable for the accrued interest amount received.
On the next interest payment date, King will credit Cash for the entire amount of interest due for six months. It will debit Interest Payable for the amount of the interest payment that represents a repayment of the accrued interest received on the issue date. And, it will debit Bond Interest Expense for the interest incurred since the bonds were issued.
Larson
DR
CR
T- Account
Company Name
Financial Statement
Preferred
Common
Preferred
Common
$ 9,000
2.
Preferred
Common
Preferred
Common
$ 9,000
2.
McGraw-Hill/Irwin
*
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In this chapter we learned about issuing bonds at par, at a discount, and at a premium. We also learned about various ways to structure the payments on notes payable.
DRCR
Contract rate is:Bond sells:
Equal to market rateAt par value
Below market rateAt a discount
Par Value
Long-term Liabilities: DR CR
DR CR
Cash 50,000
Straight-Line Amortization Table
Interest InterestDiscount UnamortizedCarrying
12/31/201250,000 57,355 7,355 01,000,000
Effective Interest Method55,919 56,650 57,472 58,396
54,000
55,000
56,000
57,000
58,000
59,000
60,000
20082009201020112012
Bonds payable 1,000,000
Long-term Liabilities: DR CR
Premium on bonds payable8,115
12/31/201250,000 41,890 8,110 01,000,000
Interest (annuity)
$-
Interest
Principal
Interest
Principal
DR CR

Documents

FA John Topic 9 2014