Bonds Payable And Investments In Bonds

Chapter 15 Bonds Payable and Investments in Bonds Accounting, 21st Edition Warren Reeve Fess

PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University

© Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.

Some Some of of the the action action has has been been automated, automated, so so click click the themouse mouse when when you you see see this this lightning lightning bolt bolt in in the thelower lower right-hand right-hand corner corner of of the the screen. screen. You You can can point point and and click click anywhere anywhere on on the the screen. screen.

Objectives Objectives 1. Compute the potential impact of longAfter this After studying studying this term borrowing on the earnings per chapter, you should chapter, you share of a corporation.should be able to: be able to: 2. Describe the characteristics of bonds. 3. Compute the present value of bonds payable. 4. Journalize entries for bonds payable. 5. Describe bond sinking funds.

Objectives Objectives 6. Journalize entries for bond redemptions. 7. Journalize entries for the purchase, interest, discount, and premium amortization, and sale of bond investments. 8. Prepare a corporation balance sheet. 9. Compute and interpret the number of times interest charges are earned.

Two Two Methods Methods of of Long-Term Long-Term Financing Financing Resources

=

Sources

Liabilities Debt Financing: Bondholders Assets Stockholders’ Equity Equity Financing: Stockholders

Two Two Methods Methods of of Long-Term Long-Term Financing Financing Bondholders

Stockholders

Why issue bonds rather than stock? Bonds (debt)—Interest payments to bondholders are an expense that reduces taxable income. Stock (equity)—Dividend payments are made from after tax net income and retained earnings. Earnings per share on common stock can often be increased by issuing bonds rather than additional stock.

Alternative Financing Plans – $800,000 Earnings 12 % bonds Preferred 9% stock, $50 par Common stock, $10 par Total Earnings before interest and income tax Deduct interest on bonds Income before income tax Deduct income tax Net income Dividends on preferred stock Available for dividends Shares of common stock Earnings per share

Plan 1 — — $4,000,000 $4,000,000

Plan 2 — $2,000,000 2,000,000 $4,000,000

Plan 3 $2,000,000 1,000,000 1,000,000 $4,000,000

$ 800,000 — $ 800,000 320,000 $ 480,000 — $ 480,000 ÷400,000 $ 1.20

$ 800,000 — $ 800,000 320,000 $ 480,000 180,000 $ 300,000 ÷200,000 $ 1.50

$ 800,000 240,000 $ 560,000 224,000 $ 336,000 90,000 $ 246,000 ÷100,000 $ 2.46

Alternative Financing Plans – $440,000 Earnings 12 % bonds Preferred 9% stock, $50 par Common stock, $10 par Total Earnings before interest and income tax Deduct interest on bonds Income before income tax Deduct income tax Net income Dividends on preferred stock Available for dividends Shares of common stock Earnings per share

Plan 1 — — $4,000,000 $4,000,000

Plan 2 — $2,000,000 2,000,000 $4,000,000

Plan 3 $2,000,000 1,000,000 1,000,000 $4,000,000

$ 440,000 — $ 440,000 176,000 $ 264,000 — $ 264,000 ÷400,000 $ 0.66

$ 440,000 — $ 440,000 176,000 $ 264,000 180,000 $ 84,000 ÷200,000 $ 0.42

$ 440,000 240,000 $ 200,000 80,000 $ 120,000 90,000 $ 30,000 ÷100,000 $ 0.30

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

Characteristics Characteristics of of Bonds Bonds Payable 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.

The The Present-Value Present-Value Concept Concept and and Bonds Bonds Payable 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 rate or the coupon rate. 3. The market or effective rate of interest.

The The Present-Value Present-Value Concept Concept and and Bonds Bonds Payable Payable MARKET RATE = CONTRACT RATE

Sell price of bond = $1,000

$1,000 10% payable annually

The The Present-Value Present-Value Concept Concept and and Bonds Bonds Payable Payable MARKET RATE > CONTRACT RATE

Sell price of bond < $1,000

$1,000 10% payable annually

– Discount

The The Present-Value Present-Value Concept Concept and and Bonds Bonds Payable Payable MARKET < CONTRACT RATE

Sell price of bond > $1,000

$1,000 10% payable annually

+ Premium

A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years. $100

Today

Interest payment

Interest 10% payable payment annually

End of Year 1

End of Year 2

$90.91

$100 x 0.90909

$82.65

$100 x 0.82645

$826.45

$1,000 x 0.82645

$1,000.00 (rounded)

$100 $1,000

The The Present-Value Present-Value Concept Concept and and Bonds Bonds Payable 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

Accounting Accounting for for Bonds Bonds Payable 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 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%) Total present value of bonds

$ 55,840 44,160 $100,000

Accounting Accounting for for Bonds Bonds Payable 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 Issued $100,000 bonds payable at face amount.

100 000 00

Accounting Accounting for for Bonds Bonds Payable 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 Cash Paid six months’ interest on bonds.

6 000 00 6 000 00

Accounting Accounting for for Bonds Bonds Payable 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 Cash

100 000 00 100 000 00

Paid bond principal at maturity date.

Accounting Accounting for for Bonds Bonds Payable 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

Accounting Accounting for for Bonds Bonds Payable 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 Bonds Payable Issued $100,000 bonds at discount.

3 594 00 100 000 00

Accounting Accounting for for Bonds Bonds Payable 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 Discount on Bonds Payable Cash

6 359 40 359 40 6 000 00

Paid semiannual interest and amortized 1/10 of discount.

$3,594 $3,594÷÷ 10 10

Accounting Accounting for for Bonds Bonds Payable 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

Accounting Accounting for for Bonds Bonds Payable 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 Premium on Bonds Payable Issued $100,000 bonds at a premium.

100 000 00 3 769 00

Accounting Accounting for for Bonds Bonds Payable Payable Bonds Issued at a Premium On June 30, paid the semiannual interest and amortized the premium. 2005

June 30 Interest Expense Premium on Bonds Payable Cash Paid semiannual interest and amortized 1/10 of bond premium.

5 623 10 376 90 6 000 00

$3,769 $3,769xx1/10 1/10

Accounting Accounting for for Bonds Bonds Payable Payable Zero-Coupon Bonds Zero-coupon Zero-coupon bonds bonds do do not not provide provide for for interest interest payments. payments. Only Only the the face face amount amount isis paid paid at at maturity. maturity. Assume Assume market market rate rate isis 13% 13% at at date date of of issue. issue. 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 Accounting for for Bonds Bonds Payable Payable Zero-Coupon Bonds On On January January 1, 1, 2005, 2005, Issue Issue 5-year, 5-year, $100,000 $100,000 zero-coupon zero-coupon bonds bonds when when the the market market rate rate of of interest interest isis 13%. 13%. 2005

Jan. 1 Cash

53 273 00

Discount on Bonds Payable Bonds Payable Issued $100,000 zerocoupon bonds.

46 727 00 100 000 00

The The bond bond indenture indenture may may require require that that aa fund fund for for the the payments payments of of the the face face value value of of the the bonds bonds at at maturity maturity be be set set aside aside over over the the life life of of the the bonds. bonds. This This special special fund fund isis called called aa bond bond sinking sinking fund. fund.

Bond Bond Redemption Redemption On On June June 30, 30, aa corporation corporation has has aa bond bond issue issue of of $100,000 $100,000 outstanding outstanding on on which which there there isis an an unamortized unamortized premium premium of of $4,000. $4,000. The The corporation corporation purchases purchases one-fourth one-fourth of of the the bonds bonds for for $24,000. $24,000. 2005

June 30 Bonds Payable Premium on Bonds Payable Cash Gain on redemption of Bonds Retired bonds for $24,000.

25 000 00 1 000 00 24 000 00 2 000 00

Bond Bond Redemption Redemption Instead, Instead, assume assume that that the the firm firm reacquired reacquired all all of of the the bonds, bonds, paying paying $105,000. $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 Retired bonds for $105,000.

105 000 00

Investments Investments in in Bonds 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 A premium premium or or discount discount on on aa bond bond investment investment isis recorded recorded in in aa single single investment investment account account and and isis amortized amortized over over the the remaining remaining life life of of the the bonds. bonds.

Investments Investments in in Bonds Bonds On On April April 2, 2, 2005, 2005, Purchased Purchased aa $1,000 $1,000 Lewis Lewis Company Company bond bond at at 102 102 plus plus aa brokerage brokerage fee fee of of $5.30 $5.30 and and accrued accrued interest interest of of $10.20. $10.20. 2005

Apr. 2 Investment in Lewis Co. Bonds. Interest Revenue Cash

1 025 30 10 20 1 035 50

Invested in a Lewis Company bond.

Note that the brokerage fee is added to the cost of the investment.

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

Investments Investments in in Bonds Bonds On On July July 1, 1, 2005, 2005, Crenshaw Crenshaw Inc. Inc. purchases purchases $50,000 $50,000 of of 8% 8% bonds bonds of of Deitz Deitz Corporation Corporation due due in in 88 3/4 3/4 years. years. The The effective effective interest interest rate rate isis 11%. 11%. The Thepurchase purchase price price isis $41,706 $41,706 plus plus interest interest of of $1,000 $1,000 accrued accrued from from April April 1, 1, 2005. 2005. 2005

July 1 Investment in Deitz Corp. Bonds.

41 706 00

Interest Revenue

1 000 00

Cash Purchased investment in

42 706 00

$50,000 x 8% x 3/12

bonds, plus accrued interest.

Investments Investments in in Bonds Bonds Received Received semiannual semiannual interest interest for for April April 11 to to October October 11 ($50,000 ($50,000 xx 8% 8% xx 6/12). 6/12). Oct. 1 Cash

2 000 00

Interest Revenue Received semiannual interest for April 1 to October 1.

2 000 00

Investments Investments in in Bonds Bonds Adjusting Adjusting entry entry for for interest interest accrued accrued from from October October 11 to to December December 31 31 ($50,000 ($50,000 xx 8% 8% xx 3/12). 3/12). Dec. 31 Interest Receivable Interest Revenue Adjusting entry for interest accrued from October 1 to December 31.

1 000 00 1 000 00

Investments Investments in in Bonds Bonds Adjusting Adjusting entry entry for for amortization amortization of of discount discount for for July July 11 to to December December 31: 31: ($50,000 ($50,000 –$41,706)/105 –$41,706)/105 xx 66 months. months. Dec. 31 Investment in Deitz Corp. Bonds Interest Revenue Adjusting entry for amortization of discount from July 1 to December 31.

474 00 474 00

Rounded to nearest dollar ($79 a month)

Investments Investments in in Bonds Bonds Investment Revenue July 1

1,000

Oct. 1 Dec. 31 31 Bal. 2,474

2,000 1,000 474 3,474

Investments Investments in in Bonds Bonds The The Deitz Deitz bonds bonds are are sold sold on on June June 30, 30, 2012 2012 for for $47,350 $47,350 plus plus accrued accrued interest. interest. ItIt has has been been six six months months since since the the last last amortization amortization entry, entry, so so amortization amortization for for the the current current year year must must be be recorded recorded (6 (6 months). months). 2012

June 30 Investment in Deitz Corp. Bonds

474 00

Interest Revenue Amortized discount for current year.

474 00

$79 x 6

Investments Investments in in Bonds Bonds Investment in Deitz Corporation Bonds 2005

July 1 Dec. 31 2006 Dec. 31 2007 Dec. 31 2008 Dec. 31 2009 Dec. 31 2010 Dec. 31 2011 Dec. 31 2012 June 30

41,706 474 948 948 948 948 948 948 474 48,342

The investment $79 x 6 account after all $79 x 12 amortization entries have been made, including the June 30, 2012 adjusting entry.

Investments Investments in in Bonds Bonds This This investment investment was was sold sold on on June June 30, 30, 2009 2009 for for $47,350 $47,350 plus plus accrued accrued interest. interest. ItIt has has been been six six months months since since the the last last amortization amortization entry, entry, so so amortization amortization for for the the current current year year $50,000 must must be be recorded recorded (6 (6 months). months). x 8% x 2012

June 30 Cash Loss on Sale of Investment Interest Revenue Investment in Deitz Corp. Bonds

48 350 00

3/12

992 00 1 000 00 48 342 00

Financial Analysis and Interpretation Number Number of of Times Times Interest Interest Charges Charges Earned Earned

Solvency Measures—The Long-Term Creditor Number Number of of Times Times Interest Interest Charges Charges Earned Earned Income before income tax Add interest expense Amount available for interest

2006 2005 $ 900,000 $ 800,000 300,000 250,000 $1,200,000 $1,050,000

Income before income tax + Interest expense Interest Expense $800,000 + $250,000 2005 2005 = 4.2 times $250,000

Solvency Measures—The Long-Term Creditor Number Number of of Times Times Interest Interest Charges Charges Earned Earned Income before income tax Add interest expense Amount available for interest

2006 2005 $ 900,000 $ 800,000 300,000 250,000 $1,200,000 $1,050,000

Income before income tax + Interest expense Interest Expense $900,000 + $300,000 2006 2006 = 4.0 times $300,000

The The purpose purpose of of the the ratio ratio isis to to assess assess the the risk risk to to debtholders debtholders in in terms terms of of number number of of times times interest interest charges charges were were earned. earned.

Chapter 15 The The End End