Bonds Payable and Investments in Bonds

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Chapter 13
Bonds Payable and Investments in Bonds
Financial and Managerial Accounting 8th
Edition Warren Reeve Fess
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Objectives
1. Compute the potential impact of long-term
borrowing on the earnings per share of a
corporation. 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.
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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.
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Financing Corporations
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Two Methods of Long-Term Financing
Resources Sources
Liabilities
Assets
Stockholders Equity
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Two Methods of Long-Term Financing
Stockholders
Bondholders
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.

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Alternative Financing Plans 800,000 Earnings
Plan 1 Plan 2 Plan 3 12 bonds 2,000,000 P
referred 9 stock, 50 par 2,000,000 1,000,000
Common stock, 10 par 4,000,000 2,000,000 1,000,0
00 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

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Alternative Financing Plans 440,000 Earnings
Plan 1 Plan 2 Plan 3 12 bonds 2,000,000 P
referred 9 stock, 50 par 2,000,000 1,000,000
Common stock, 10 par 4,000,000 2,000,000 1,000,0
00 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

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Characteristics of Bonds Payable

• A bond contract is called a bond indenture or
  trust indenture.
• Long-term debtrepayable 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.

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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.

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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 rate or the coupon rate. 3. The
market or effective rate of interest.
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The Present-Value Concept and Bonds Payable
MARKET RATE CONTRACT RATE
Sell price of bond 1,000
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The Present-Value Concept and Bonds Payable
MARKET RATE gt CONTRACT RATE
Sell price of bond lt 1,000

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The Present-Value Concept and Bonds Payable
MARKET lt CONTRACT RATE
Sell price of bond gt 1,000

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A 1,000, 10 bond is purchased. It pays interest
annually and will mature in two years.
1,000.00 (rounded)
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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
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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
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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.
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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.
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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.
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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
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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.
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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
Paid semiannual interest and amortized 1/10 of
discount.
3,594 10
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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 11compounded
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
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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.
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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.
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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.
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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.
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The bond indenture may require that a fund for
the payments of the face value of the bonds at
maturity be set aside over the life of the bonds.
This special fund is called a bond sinking fund.
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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.
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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.
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Investments in Bonds
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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.
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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.
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Investments in Bonds
To assist your understanding, lets look at an
extended illustration for Crenshaw, Inc.
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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
Cash 42 706 00
50,000 x 8 x 3/12
Purchased investment in bonds, plus accrued
interest.
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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.
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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.
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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.
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Investments in Bonds
Investment Revenue
Oct. 1 2,000 Dec. 31 1,000 31 474 3,474
July 1 1,000
Bal. 2,474
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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.
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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 30 474 48,342
The investment account after all amortization
entries have been made, including the June 30,
2012 adjusting entry.
79 x 6
2006
2007
2008
79 x 12
2009
2010
2011
2012
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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
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Financial Analysis and Interpretation
Number of Times Interest Charges Earned
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Solvency MeasuresThe Long-Term Creditor
Number of Times Interest Charges Earned
2006 2005
Income before income tax 900,000
800,000 Add interest expense 300,000
250,000 Amount available for interest 1,200,000
1,050,000
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Solvency MeasuresThe Long-Term Creditor
Number of Times Interest Charges Earned
2006 2005
Income before income tax 900,000
800,000 Add interest expense 300,000
250,000 Amount available for interest 1,200,000
1,050,000
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The purpose of the ratio is to assess the risk to
debtholders in terms of number of times interest
charges were earned.
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Chapter 13
The End