Chapter 16 - Lecture Notes

Chapter 16 – Bonds Payable. Bonds -

-

Is an example of debt financing. The face (principle) amount of the bond will be repaid to the bondholders upon the bond’s maturity date. A method of raising large sums of capital Is classified as a long term liability on the balance sheet Form of interest bearing note Any bond interest will be calculated using the bond coupon rate and will be paid out semiannually Bondholders are deemed to be creditors of the company. They have a priority claim over the stockholders. This is illustrated in the expression of the Accounting Equation as follows: Assets – Liabilities = Stockholders Equity There is a legal obligation to pay the bond interest. If the company defaults on this obligation the bondholders can sue them. Note: Under equity financing a corporation is not legally obligated to issue dividends on stock. Dividends are a distribution of net income to the stockholders and a company cannot guarantee that it will generate a profit. Corporations sell bonds to an investment firm called and underwriter. This underwriter will sell the bonds to the public. Bonds are issued in denominations of $1000. Bonds are usually expressed as a percentage of the face value at issuance. (1) If Bond Is Issued at 100% - It is issued at par (face amount). (2) If Bond Is Issued Above 100% - It is issued at a premium. Amortization of the premium will occur over the life of the bond. - As amortization occurs bond interest income is recorded - As amortization occurs the bond carrying value decreases - At maturity the carrying value of the bond equals the face amount (3) If Bond Is Issued Below 100% - It is issued at a discount. - Amortization of the discount will occur over the life of the bond - As amortization occurs bond interest expense is recorded - As amortization occurs the bond carrying value increases - At maturity the carrying value of the bond will equal the face amount

1

Relationship Between the Bond Coupon Rate and The Prevailing Market Rate (Effective Interest Rate) (1) Bond coupon rate = Market Rate

(Bond is issued at PAR)

(2) Bond coupon rate > Market Rate

(Bond is issued at premium)

(3) Bond coupon rate < Market rate

(Bond is issued at discount)

If the bond is issued between interest payment dates, the bondholder will pay the amount of the bond and accrued interest. Any accrued interest received by the issuing corporation will be recorded as a current liability. This amount will be repaid to the bondholders along with the first payment (semi-annually) that is made. The payment made is allocated between accrued interest payable and bond interest expense. Example 1: Bond issued with a face amount of $100,000 for 10 years. Bond is issued at 88%. This bond is issued at a discount because it is less than 100%. Each bond issued 1,000 * 88% = 880 (1) Record entry for the issuance of the bond: Cash (100,000 * 88%) 88,000 Discount on Bonds 12,000 Bonds Payable (Face Amount) 1000,000 Discount on Bonds -

A contra-liability account Normal Balance is a debit. To increase the account it is debited. To decrease the account it is credited.

The total interest expense to be repaid over the life of the bonds is initially recorded in the discount on bonds account. As the bonds remain outstanding, interest expense must be recorded through the amortization of bond discount.

2

(2) Record Amortization Interest Expense 1200 Discount on Bonds

1200

AT END OF YEAR 1

Straight Line Amortization of Discount = Total Amount of Discount / Total Months in Bond Issue = 12,000 / 120 months (10 yrs. * 12 months) = 100 / month Annual bond amortization 100 / month * 12 months = $1,200 Carrying Value (For bonds issued at discount) At Issue

End of Yr.1

At Maturity

Bonds Payable

100,000

100,000

100,000

Unamortized Discount

12,000

↓ 10,800

0

Carrying Value

88,000

↑ 89,200

100,000

-

At issuance the carrying value will equal the proceeds received.

-

At maturity, the carrying value will equal the face amount of the bond.

Record the Amortized Bond Discount = Total Bond Discount / Number of Years = 12,000 / 10 = 1,200 / year

3

Record Annual Amortization (at a Discount) Year 1 (A) Bond Interest Rate Discount on Bonds

1200 1200

At Issue

Straight Line Method Bond Amortization of Discount = Total Amount of Discount / Total Months in Bond Issue = 12,000 / 120 months (10 yrs. * 12 months) = 100 per month of amortized discount Therefore annual bond amortization 100 / month * 12 months = $1,200 Journalize Bond Payment at Maturity Bonds Payable Cash

100,000 100,000

Repayment Amount Initially Borrowed Interest Expense

100,000 88,000 12,000

4

Example 2: A 10-year bond with a face amount of $100,000 is issued for 110,000. A bond premium exists in the amount of 10,000. Journal entry to record the issuance of the bond: Cash

110,000 Premium on Bonds Bonds Payable

10,000 100,000

At Issuance

End Year 1

At Maturity

Bonds Payable (Face Amount)

100,000

100,000

100,000

Add: Premium on Bonds

10,000

↓ 9,000

0

Carrying Value

110,000

109,000

100,000

At issuance, the carrying value of the bond is equal to the proceeds being received. At maturity, the carrying value of the bond is equal to the face amount. Record Annual Amortization of Bond Premium Total Premium / Total Years = 10,000 / 10 years Year 1 Amortization of Bond Premium Premium on Bonds 1,000 Bond Interest Income 1,000

5

Record Repayment of Bond At Maturity Bonds Payable Cash

100,000 100,000

Amount Initially Borrowed

110,000

Amount

100,000

Interest Income

10,000

Example: On January 1 a corporation issues for cash 100,000 for 12% five year bonds, with interest of $6000 paid semiannually. However, the market rate is 11%. The bond will therefore sell at a premium since the contract rate > market rate. For present value purposes the market rate is always used in determining the present value of the face amount at maturity and the semi annual interest payment.

6

Present Value of a Bond (1) The present value of face amount of 100,000 due in 5 years at 11% that is paid semiannually (This would equal 5.5% interest for 10 periods). 100,000 * 0.5854 = (PV of $1 for 10 periods at 5.5% interest)

58,540

(2) The present value of 10 semiannual interest (10 periods of 5.5%)payments 5 semiannually of $6000 at 11%. 6,000 * 7.5376 = (PV of annuity of $1 for 10 periods at 5.5%)

45,226

Total present value (issue price) of bonds =

103,766

7