Bonds Payable and Investments in Bonds

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13
Bonds Payable and Investments in Bonds
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After studying this chapter, you should be able
to

• Compute the potential impact of long-term
  borrowing on the earnings per share of a
  corporation.

• Describe the characteristics, terminology, and
  pricing of bonds payable.
• Journalize entries for bonds payable.

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After studying this chapter, you should be able
to

• Describe and illustrate the payment and
  redemption of bonds payable.

• Journalize entries for the purchase, interest,
  discount and premium amortization, and sale of
  bond investments.
• Prepare a corporations balance sheet.

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13-1
Objective 1
Compute the potential impact of long-term
borrowing on the earnings per share of a
corporation.
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13-1
Financing Corporations
A bond is simply a form of an interest-bearing
note. Like a note, a bond requires periodic
interest payments, and the face amount must be
repaid at the maturity date.
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Plan 1 Plan 2 Plan 3
Issued 12 bonds 4 million 2 million 2
million Issued 9 preferred stock, 50 par
value 2 million 1 million Issued common
stock, 10 par value 1 million 4 million 4
million 4 million
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Effect of Alternative Financing Plans800,000
Earnings
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Effect of Alternative Financing Plans440,000
Earnings
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13-1
Gonzales Co., is considering the following
alternative plans for financing their company
Plan I Plan II
Issue 10 Bonds (at face) 2,000,000 Issue 10
Common Stock 3,000,000 1,000,000
Income tax is estimated at 40 of
income. Determine the earnings per share of
common stock under the two alternative financing
plans, assuming income before bond interest and
income tax is 750,000.
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13-1
Earnings before bond interest and income
tax Bond interest Balance Income tax Net
income Dividend on preferred stock Earnings
available for common stock Number of common
shares Earnings per share on common stock
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For Practice PE 13-1A, PE 13-1B
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13-2
Objective 2
Describe the characteristics, terminology, and
pricing of bonds payable.
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13-2
Bonds Payable

• A corporation that issues bonds enters into a
  contract (called a bond indenture or trust
  indenture) with the bondholders.

• Usually, the face value of each bond, called the
  principal, is 1,000 or a multiple of 1,000.
• Interest on bonds may be payable annually,
  semiannually, or quarterly. Most pay interest
  semiannually.

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13-2

• 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.

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13-2

• Bonds that a corporation reserves the right to
  redeem before their maturity are called callable
  bonds.

• Bonds issued on the basis of the general credit
  of the corporation are debenture bonds.

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Pricing of 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 rate or the coupon rate. 3. The
market or effective rate of interest.
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The market or effective rate of interest is
determined by transactions between buyers and
sellers of similar bonds. The market rate of
interest is affected by a variety of factors,
including

• investors assessment of current economic
  conditions, and
• future expectations.

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13-2
MARKET RATE CONTRACT RATE
Selling price of bond 1,000
If the contract rate equals the market rate of
interest, the bonds will sell at their face
amount.
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13-2
MARKET RATE gt CONTRACT RATE
Selling price of bond lt 1,000

If the market rate is higher than the contract
rate, the bonds will sell at a discount.
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13-2
MARKET lt CONTRACT RATE
Selling price of bond gt 1,000

If the market rate is lower than the contract
rate, the bonds will sell at a premium.
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13-2
Time Value of Money
The time value of money concept recognizes that
an amount of cash to be received today is worth
more than the same amount of cash to be received
in the future.
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13-2
Present Value of the Face Amount of Bonds
Assume that you are to receive the face value of
a 1,000 bonds in two years with interest of 10.
What is the present value of this bond?
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13-2
Using Exhibit 3 in your text, what is the present
value of 4,000 to be received in 5 years, if the
market rate of interest is 10 compounded
annually?
4,000 x .62092 2,483.68 Present value of 1
for 5 periods at 10
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For Practice PE 13-2A. PE 13-2B
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13-2
Present Value of the Periodic Bond Interest
Payments
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13-2
Present Value of 2-Year, 10 Bond
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13-2
Calculate the present value of a 20,000, 5,
5-year bond that pays 1,000 (20,000 x 5)
interest annually, if the market rate of interest
is 5. Use Exhibits 3 and 4 for computing
present values.
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13-2
Present value of face value of 20,000 due in 5
years at 5 compounded annually 20,000 x
.78353 (present value factor of 1 for 5 periods
at 5)
15,671
Present value of 5 annual interest payments of
1,000 at 5 interest compounded annually
1,000 x 4.32948 (present value of annuity of
1 for 5 periods at 5).
4,329
Rounded to the nearest dollar
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For Practice PE 13-3A, PE 13-3B
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13-3
Objective 3
Journalize entries for bonds payable.
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13-3
Bonds Issued at Face Amount
On January 1, 2007, a corporation issues for cash
100,000 of 12, five-year bonds interest
payable semiannually. The market rate of
interest is 12.
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13-3
Because the present value tables are rounded to
five decimal places, minor rounding differences
may appear in this illustration.
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13-3
On January 1, 2007, a corporation issues for cash
100,000 of 12, five-year bonds interest
payable semiannual. The market rate of interest
is 12.
Bonds Payable 100 000 00
Issued 100,000 bonds payable at face amount.
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13-3
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.
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13-3
The bond matured on December 31, 2011. At this
time, the corporation paid the face amount to the
bondholder.
Cash 100 000 00
Paid bond principal at maturity date.
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13-3
Bonds Issued at a Discount
Assume that the market rate of interest is 13 on
the 100,000 bonds rather than 12. What would
be the present value of these bonds?
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13-3
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13-3
On January 1, 2007, the firm issued 100,000
bonds for 96,406 (a discount of 3,594).
Discount on Bonds Payable 3 594 00
Bonds Payable 100 000 00
Issued 100,000 bonds at discount.
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13-3
On the first day of the fiscal year, a company
issues a 1,000,000, 6, 5-year bond that pays
semi-annual interest of 30,000 (1,000,000 x 6
x ½), receiving cash of 845,562. Journalize the
entry to record the issuance of the bonds.
Cash 845,562 Discount on Bonds Payable 154,438
Bonds Payable 1,000,000
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For Practice PE 13-4A, PE 13-4B
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13-3
Amortizing a Bond Discount
There are two methods of amortizing a bond
discount

• The straight-line method and
• The effective interest rate method, often called
  the interest method.

Both methods amortize the same total amount of
discount over the life of the bonds.
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Amortizing a Bond Discount
On June 30, 2007, six-months interest is paid
and the bond discount is amortized (3,594 x
1/10) using the straight-line method.
Discount on Bonds Payable 359 40
Cash 6 000 00
Paid semiannual interest and amortized 1/10 of
bond discount.
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13-3
Click on this button to go to Example Exercise
13-4. To return to this slide, type 39 and
press Enter.
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For Practice PE 13-5A, PE 13-5B
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13-3
Bonds Issued at a Premium
If the market rate of interest is 11 and the
contract rate is 12, on the five year, 100,000
bonds, the bonds will sell for 103,769.
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13-3
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13-3
Issued 100,000 of bonds for 103,769 (a premium
of 3,769). The entry to record this information
is as follows
Bonds Payable 100 000 00 Premium on Bonds
Payable 3 769 00
Issued 100,000 bonds at a premium.
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13-3
A company issues a 2,000,000, 12, 5-year bond
that pays semiannual interest of 120,000
(2,000,000 x 12 x ½), receiving cash of
2,154,435. Journalize the bond issuance.
Cash 2,154,435 Premium on Bonds
Payable 154,438 Bonds
Payable 2,000,000
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For Practice PE 13-6A, PE 13-6B
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Amortizing a Bond Premium
On June 30, 2007, paid the semiannual interest
and amortized the premium. The firm uses
straight-line amortization.
Premium on Bonds Payable 376 90
3,769 x 1/10
Cash 6 000 00
Paid semiannual interest and amortized 1/10 of
bond prem.
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13-3
Using the bond from Example Exercise 13-6 (Slide
43), journalize the first interest payment and
the amortization of the related bond premium.
Interest Expense 104,556 Premium on Bonds
Payable 15,444 Bonds Payable 120,000 P
aid interest and amortize the bond premium
(154,435/10).
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For Practice PE 13-7A, PE 13-7B
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13-3
Zero-Coupon Bonds
Zero-coupon bonds do not provide for interest
payments. Only the face amount is paid at
maturity. Assume that the market rate is 13 at
date of issue.
Present value 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
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13-3
On January 1, 2007, issue 5-year, 100,000
zero-coupon bonds when the market rate of
interest is 13.
Bonds Payable 100 000 00
Issued 100,000 zero-coupon bonds.
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13-4
Objective 4
Describe and illustrate the payment and
redemption of bonds payable.
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13-4
Since the payment of bonds normally involves a
large amount of cash, a bond indenture may
require that cash be periodically transferred
into a special cash fund, called a sinking fund,
over the life of the bond issue.
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13-4
Bond Redemption
A corporation may call or redeem bonds before
they mature. Callable bonds can be redeemed by
the issuing corporation within the period of time
and the price stated in the bond indenture.
Normally, the call price is above the face value.
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13-4
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.
Cash 24 000 00 Gain on Redemption of
Bonds 2 000 00
Retired bonds for 24,000.
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13-4
Instead, assume that on June 30 the corporation
calls all of the bonds, paying 105,000.
Cash 105 000 00
Redeemed 100,000 bonds for 105,000.
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13-4
A 500,000 bond issue on which there is an
unamortized discount of 40,000 is redeemed for
475,000. Journalize the redemption of the bonds.
Bonds Payable 500,000 Loss on Redemption of
Bonds 15,000 Discount on Bonds
Payable 40,000 Cash 475,000
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For Practice PE 13-8A, PE 13-8B
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13-5
Objective 5
Journalize entries for the purchase, interest,
discount, and premium amortization, and sale of
bond investments.
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13-5
Accounting for Bond Investments
Bonds may be purchased either directly from the
issuing corporation or through an organized bond
exchange. Prices for bonds are quoted as a
percentage of the face amount.
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13-5
On April 2, 2007, an investor purchases a 1,000
Lewis Company bond at 102 plus a brokerage fee of
5.30 and accrued interest of 10.20.
Cash 1 035 50
Invested in a Lewis Company bond.
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13-5
On April 2, 2007, an investor purchases a 1,000
Lewis Company bond at 102 plus a brokerage fee of
5.30 and accrued interest of 10.20.
Note that the brokerage fee is added to the cost
of the investment.
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13-5
Extended Illustration for Crenshaw, Inc.
On July 1, 2007, 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, 2007 (50,000 x 8 x 3/12).
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The entry to record the investment is as follows
Interest Revenue 1 000 00
Cash 42 706 00
Purchased investment in bonds, plus accrued
interest.
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Crenshaw, Inc. received semiannual interest for
April 1 to October 1 (50,000 x 8 x 6/12).
Interest Revenue 2 000 00
Received semiannual interest for April 1 to
October 1.
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13-5
Adjusting entry for interest accrued from October
1 to December 31 (50,000 x 8 x 3/12).
Interest Revenue 1 000 00
Adjusting entry for interest accrued from October
1 to December 31.
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13-5
Adjusting entry for amortization of discount for
July 1 to December 31 (50,000 41,706)/105
79 (rounded) x 6 months.
Interest Revenue 474 00
Adjusting entry for amortization of discount for
July 1 to December 31.
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Accounting for Bond InvestmentsSale
The Deitz bonds are sold for 47,350 plus accrued
interest on June 30, 2014. The carrying amount
of the bond as of January 1, 2014 is 47,868
41,706 (79 per month x 78 months).
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It has been six months since the last
amortization entry, so amortization for this
period is recorded (6 months).
Interest Revenue 474 00
Amortized discount for current year.
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13-5
The next slide shows the Investment in Dietz
Corp. Bonds account after all amortization
entries have been made, including the June 30,
2014 adjusting entry.
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13-5
Investment in Deitz Corp. Bonds
2007
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 30 474 48,342
2008
2009
2010
2011
2012
2013
2014
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13-5
This investment is sold on June 30, 2014 for
47,350 plus accrued interest of 1,000 (50,000
x 8 x 3/12) .
Loss on Sale of Investments 992 00
Interest Revenue 1 000 00
Investment in Deitz Co. Bonds 48 342 00
Received interest and proceeds from sale of bonds.
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13-5
On October 1, 2008 Viewtec Corporation purchases
10,000 of 6 bonds of Watson Corporation due in
9¼ years. The bonds were purchased at a price of
8,341 plus interest of 150 (10,000 x 6 x
3/12) accrued from July 1, 2008, the date of the
last semiannual interest payment.

• Journalize the purchase of the bonds plus accrued
  interest.
• Journalize the entry to record the amortization
  of the discount on December 31.

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For Practice PE 13-9A, PE 13-9B
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13-6
Objective 6
Prepare a corporations balance sheet.
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13-6
Balance Sheet of a Corporation
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(Continued)
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13-6
Balance Sheet of a Corporation
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(Concluded)
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13-6
Held-to-Maturity Securities
Investments in bonds or other debt securities
that management intends to hold to their maturity
are called held-to-maturity securities.
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13-6
Balance Sheet Presentation of Bond Investments

• Such securities are classified as long-term
  investments under the caption Investments.

• These investments are reported at their cost less
  any amortized premium or plus any amortized
  discount.
• The market (fair) value of the bond investment
  should be disclosed, either on the face of the
  balance sheet or in an accompanying note.

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Financial Analysis and Interpretation
Some corporations have a high ratio of debt to
stockholders equity. For such corporations,
analysts often assess the relative risk of the
debtholders in terms of the number of times the
interest charges are earned during the year.
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Number of Times the Interest Charges Earned
To illustrate, assume the following data
Interest expense 36,883,000 Income before
income tax 174,315,000
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(Continued)
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The number of times interest charges are earned
is 5.73.
This ratio indicates that the debtholders have
adequate protection against a potential drop in
earnings jeopardizing their receipt of interest
payments. A full analysis should involve a
comparison with industry averages.