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Previous Lecture

Previous Lecture. Liabilities Distinction Between Debt and Equity The Nature of Current Liabilities Notes Payable Interest Payable Contingent Liabilities Product Liability Accounting Treatment of Contingent Liabilities. Previous Lecture. Evaluating Liquidity Accounts Payable

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  1. Previous Lecture • Liabilities • Distinction Between Debt and Equity • The Nature of Current Liabilities • Notes Payable • Interest Payable • Contingent Liabilities • Product Liability • Accounting Treatment of Contingent Liabilities

  2. Previous Lecture • Evaluating Liquidity • Accounts Payable • Payroll Liabilities • Unearned Revenue • Long-Term Debt • Installment Notes Payable • Allocating Installment Payments Between Interest and Principal

  3. BONDS Chapter10

  4. Two Methods of Long-Term Financing Bonds (debt)—Interest paymentsto bondholders arean expense that reduces taxable income. Stock (equity)—Dividend paymentsare made from after tax net income and retained earnings. Earnings per shareon common stock can often be increased by issuing bonds rather than additional stock. Stockholders Bondholders Why issue bonds rather than stock?

  5. Alternative Financing Plans – $800,000 Earnings Plan 1 Plan 2 Plan 3 12 % bonds — — $2,000,000 Preferred 9% stock, $50 par — $2,000,000 1,000,000 Common stock, $10 par $4,000,000 2,000,000 1,000,000 Total $4,000,000 $4,000,000 $4,000,000 Earnings before interest and income tax $ 800,000 $ 800,000 $ 800,000 Deduct interest on bonds — — 240,000 Income before income tax $ 800,000 $ 800,000 $ 560,000 Deduct income tax 320,000 320,000 224,000 Net income $ 480,000 $ 480,000 $ 336,000 Dividends on preferred stock — 180,000 90,000 Available for dividends $ 480,000 $ 300,000 $ 246,000 Shares of common stock ÷400,000÷200,000 ÷100,000 Earnings per share $ 1.20 $ 1.50 $ 2.46

  6. Alternative Financing Plans – $440,000 Earnings Plan 1 Plan 2 Plan 3 12 % bonds — — $2,000,000 Preferred 9% stock, $50 par — $2,000,000 1,000,000 Common stock, $10 par $4,000,000 2,000,000 1,000,000 Total $4,000,000 $4,000,000 $4,000,000 Earnings before interest and income tax $ 440,000 $ 440,000 $ 440,000 Deduct interest on bonds — — 240,000 Income before income tax $ 440,000 $ 440,000 $ 200,000 Deduct income tax 176,000 176,000 80,000 Net income $ 264,000 $ 264,000 $ 120,000 Dividends on preferred stock — 180,000 90,000 Available for dividends $ 264,000 $ 84,000 $ 30,000 Shares of common stock ÷400,000÷200,000÷100,000 Earnings per share $ 0.66 $ 0.42 $ 0.30

  7. Bonds Payable • Bonds usually involve the borrowing of a large sum of money, called principal. • The principal is usually paid back as a lump sum at the end of the bond period. • Individual bonds are often denominated with apar value, or face value, of $1,000.

  8. Bonds Payable • Bonds usually carry a stated rate of interest, also called a contract rate. • Interest is normally paid semiannually. • Interest is computed as: Interest = Principal × Stated Rate × Time

  9. Bonds Payable • Bonds are issued through an intermediary called an underwriter. • Bonds can be sold on organized securities exchanges. • Bond prices are usually quoted as a percentage of the face amount. • For example, a $1,000 bond priced at 102 would sell for $1,020.

  10. Characteristics of Bonds Payable • A bond contract is called a bond indentureortrust indenture. • Long-term debt—repayable 10, 20, or 30 years after date of issuance. • Issued inface (principal) amounts of $1,000, or multiples of $1,000. • Contract interest rate is fixed for term (life) of the bond. • Face amountof bond repayable at maturity date.

  11. Characteristics of Bonds Payable • When all bonds of an issue mature at the same time, they are called term bonds. If the maturity dates are spread over several dates, they are called serial bonds. • Bonds that may be exchanged for other securities are called convertible bonds. • Bonds that a corporation reserves the right to redeem before maturity are callable bonds. • Bonds issued on the basis of the general credit of the corporations are debenture bonds.

  12. Types of Bonds Mortgage Bonds Debenture Bonds Convertible Bonds Junk Bonds

  13. Accounting for Bonds Payable Bonds Issued at Face Amount On January 1, 2005, a corporation issues for cash $100,000 of 12%, five-year bonds; interest payable semiannually. The market rate of interest is 12%. Present value of face amount of $100,000 due in 5 years at 12% compounded annually: $100,000 x 0.55840 $ 55,840 Present value of 10 interest payments of $6,000 compounded semiannually: $6,000 x 7.3609 (PV of annuity of $1 for 10 periods at 6%) 44,160 Total present value of bonds $100,000

  14. Accounting for Bonds Payable Bonds Issued at Face Amount On January 1, 2005, a corporation issues for cash $100,000 of 12%, five-year bonds; interest payable semiannual. The market rate of interest is 12%. 2005 Jan. 1 Cash 100 000 00 Bonds Payable 100 000 00 Issued $100,000 bonds payable at face amount.

  15. Accounting for Bonds Payable Bonds Issued at Face Amount On June 30, an interest payment of $6,000 is made ($100,000 x .12 x 6/12). June 30 Interest Expense 6 000 00 Cash 6 000 00 Paid six months’ interest on bonds.

  16. Accounting for Bonds Payable Bonds Issued at Face Amount The bond matured on December 31, 2009. At this time, the corporation paid the face amount to the bondholder. 2009 Dec. 31 Bonds Payable 100 000 00 Cash 100 000 00 Paid bond principal at maturity date.

  17. Accounting for Bonds Payable Bonds Issued at a Discount Assume that the market rate of interest is 13% on the $100,000 bond rather than 12%. Present value of face amount of $100,000 due in 5 years at 13% compounded semiannually: $100,000 x 0.53273 (PV of $1 for 10 periods at 6½%) $53,273 Present value of 10 semiannual interest payments of $6,000 compounded semiannually: $6,000 x 7.18883 (PV of annuity of $1 for 10 periods at 6½%) 43,133 Total present value of bonds $96,406

  18. Accounting for Bonds Payable Bonds Issued at a Discount On January 1, 2005, the firm issued $100,000 bonds for $96,406 (a discount of $3,594). 2005 Jan. 1 Cash 96 406 00 Discount on Bonds Payable 3 594 00 Bonds Payable 100 000 00 Issued $100,000 bonds at discount.

  19. Accounting for Bonds Payable Bonds Issued at a Discount On June 30, 2005, six-months’ interest is paid and the bond discount is amortized using the straight-line method. 2005 June 30 Interest Expense 6 359 40 Discount on Bonds Payable 359 40 Cash 6 000 00 $3,594 ÷ 10 Paid semiannual interest and amortized 1/10 of discount.

  20. Accounting for Bonds Payable Bonds Issued at a Premium If the market rate of interest is 11% and the contract rate is 12%, the bond would sell for $103,769. Present value of face amount of $100,000 due in 5 years at 11% compounded annually: $100,000 x 0.58543 (PV of $1 for 10 periods at 5½%) $ 58,543 Present value of 10 semiannual interest payments of $6,000 at 11%compounded semiannually: $6,000 x 7.53763 (PV of annuity of $1 for 10 periods at 5½%) 45,226 Total present value of bonds $103,769

  21. Accounting for Bonds Payable Bonds Issued at a Premium Sold $100,000 of bonds for $103,769 (a premium of $3,769). 2005 Jan. 1 Cash 103 769 00 Bonds Payable 100 000 00 Premium on Bonds Payable 3 769 00 Issued $100,000 bonds at a premium.

  22. Accounting for Bonds Payable Bonds Issued at a Premium On June 30, paid the semiannual interest and amortized the premium. 2005 June 30 Interest Expense 5 623 10 Premium on Bonds Payable 376 90 $3,769 x 1/10 Cash 6 000 00 Paid semiannual interest and amortized 1/10 of bond premium.

  23. Present value of $100,000 due in 5 years at 13% compounded semi annually: $100,000 x 0.53273 (PV of $1 for 10 periods at 6½%) $53,273 Accounting for Bonds Payable Zero-Coupon Bonds Zero-coupon bonds do not provide for interest payments. Only the face amount is paid at maturity. Assume market rate is 13% at date of issue.

  24. Accounting for Bonds Payable Zero-Coupon Bonds On January 1, 2005, Issue 5-year, $100,000 zero-coupon bonds when the market rate of interest is 13%. 2005 Jan. 1 Cash 53 273 00 Discount on Bonds Payable 46 727 00 Bonds Payable 100 000 00 Issued $100,000 zero-coupon bonds.

  25. Bonds Sold Between Interest Dates • Bonds are often sold between interest dates. • The selling price of the bond is computed as:

  26. $1,000 invested today at 10%. In 5 years it will be worth $1,610.51. In 25 years it will be worth $10,834.71! The Concept of Present Value Present Value Future Value Money can grow over time, because it can earn interest.

  27. The Concept of Present Value How much is a future amount worth today? How much is a future amount worth today? Three pieces of information must be known to solve a present value problem: • The future amount. • The interest rate (i). • The number of periods (n) the amount will be invested. Present Value FutureValue Interest compounding periods Today

  28. The Concept of Present Value Two types of cash flows are involved with bonds: • Periodic interest payments called annuities. Today Maturity • Principal payment at maturity.

  29. The selling price of the bond is determined by the market basedon the time value of money. = = < < > > The Present Value Concept and Bond Prices

  30. The Present-Value Concept and Bonds Payable When a corporation issues bonds, the price that buyers are willing to pay depends upon three factors: 1.The face amount of the bonds, which is the amount due at the maturity date. 2. The periodic interest to be paid on the bonds. This is called the contract rateor the coupon rate. 3. The market or effective rate of interest.

  31. $1,000 10% payable annually The Present-Value Concept and Bonds Payable MARKET RATE = CONTRACT RATE Sell price of bond = $1,000

  32. $1,000 10% payable annually Discount The Present-Value Concept and Bonds Payable MARKET RATE > CONTRACT RATE Sell price of bond < $1,000 –

  33. $1,000 10% payable annually Premium The Present-Value Concept and Bonds Payable MARKET < CONTRACT RATE Sell price of bond > $1,000 +

  34. $100 $100 Interest payment Interest payment End of Year 1 End of Year 2 Today $1,000 10% payable annually $90.91 $100 x 0.90909 $100 x 0.82645 $82.65 $1,000 x 0.82645 $826.45 A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years. $1,000.00 (rounded)

  35. The Present-Value Concept and Bonds Payable OR Present value of face value of $1,000 due in 2 years at 10% compounded annually: $1,000 x 0.82645 $ 826.45 Present value of 2 annual interest payments of 10% compounded annually: $100 x 1.73554 (PV of annuity of $1 for 2 years at 10%) 173.55 Total present value of bonds $1,000.00

  36. Bond Redemption On June 30, a corporation has a bond issue of $100,000 outstanding on which there is an unamortized premium of $4,000. The corporation purchases one-fourth of the bonds for $24,000. 2005 June 30 Bonds Payable 25 000 00 Premium on Bonds Payable 1 000 00 Cash 24 000 00 Gain on redemption of Bonds 2 000 00 Retired bonds for $24,000.

  37. Bond Redemption Instead, assume that the firm reacquired all of the bonds, paying $105,000. 2005 June 30 Bonds Payable 100 000 00 Premium on Bonds Payable 4 000 00 Loss on Redemption of Bonds 1 000 00 Cash 105 000 00 Retired bonds for $105,000.

  38. Investments in Bonds Bonds are purchased directly from the issuing corporation or through an organized bond exchange. Bond prices are quoted as a percentage of the face amount. A premium or discount on a bond investment is recorded in a single investment account and is amortized over the remaining life of the bonds.

  39. Note that the brokerage fee is added to the cost of the investment. Investments in Bonds On April 2, 2005, Purchased a $1,000 Lewis Company bond at 102 plus a brokerage fee of $5.30 and accrued interest of $10.20. 2005 Apr. 2 Investment in Lewis Co. Bonds. 1 025 30 Interest Revenue 10 20 Cash 1 035 50 Invested in a Lewis Company bond.

  40. Investments in Bonds To assist your understanding, let’s look at an extended illustration for Crenshaw, Inc.

  41. Investments in Bonds On July 1, 2005, Crenshaw Inc. purchases $50,000 of 8% bonds of Deitz Corporation due in 8 3/4 years. The effective interest rate is 11%. The purchase price is $41,706 plus interest of $1,000 accrued from April 1, 2005. 2005 July 1 Investment in Deitz Corp. Bonds. 41 706 00 Interest Revenue 1 000 00 $50,000 x 8% x 3/12 Cash 42 706 00 Purchased investment in bonds, plus accrued interest.

  42. Investments in Bonds Received semiannual interest for April 1 to October 1 ($50,000 x 8% x 6/12). Oct. 1 Cash 2 000 00 Interest Revenue 2 000 00 Received semiannual interest for April 1 to October 1.

  43. Investments in Bonds Adjusting entry for interest accrued from October 1 to December 31 ($50,000 x 8% x 3/12). Dec. 31 Interest Receivable 1 000 00 Interest Revenue 1 000 00 Adjusting entry for interest accrued from October 1 to December 31.

  44. Investments in Bonds Adjusting entry for amortization of discount for July 1 to December 31: ($50,000 –$41,706)/105 x 6 months. Dec. 31 Investment in Deitz Corp. Bonds 474 00 Interest Revenue 474 00 Rounded to nearest dollar ($79 a month) Adjusting entry for amortization of discount from July 1 to December 31.

  45. Investments in Bonds Investment Revenue Oct. 1 2,000 Dec. 31 1,000 31 474 3,474 July 1 1,000 Bal. 2,474

  46. Investments in Bonds The Deitz bonds are sold on June 30, 2012 for $47,350 plus accrued interest. It has been six months since the last amortization entry, so amortization for the current year must be recorded (6 months). 2012 June 30 Investment in Deitz Corp. Bonds 474 00 $79 x 6 Interest Revenue 474 00 Amortized discount for current year.

  47. Investments in Bonds Investment in Deitz Corporation Bonds 2005 July 1 41,706 Dec. 31 474 Dec. 31 948 Dec. 31 948 Dec. 31 948 Dec. 31 948 Dec. 31 948 Dec. 31 948 June 30 47448,342 $79 x 6 The investment account after all amortization entries have been made, including the June 30, 2012 adjusting entry. $79 x 12 2006 2007 2008 2009 2010 2011 2012

  48. Investments in Bonds This investment was sold on June 30, 2009 for $47,350 plus accrued interest. It has been six months since the last amortization entry, so amortization for the current year must be recorded (6 months). $50,000 x 8% x 3/12 2012 June 30 Cash 48 350 00 Loss on Sale of Investment 992 00 Interest Revenue 1 000 00 Investment in Deitz Corp. Bonds 48 342 00

  49. Early Retirement of Debt Gains or losses incurred as a result of retiring bonds should be reported as extraordinary items on the income statement.

  50. Lease agreement transfers risks and benefits associated with ownership to lessee. Lessor retains risks and benefits associated with ownership. Lessee records rent expense as incurred. Lessee records a leased asset and lease liability. Lease Payment Obligations Operating Leases Capital Leases

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