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© 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. Chapter 15. Bonds Payable and Investments in Bonds. Accounting, 21 st Edition

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© 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.

Chapter 15

Bonds Payable and Investments in Bonds

Accounting, 21st Edition

Warren Reeve Fess

PowerPoint Presentation by Douglas CloudProfessor Emeritus of AccountingPepperdine University


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


Objectives when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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.

After studying this chapter, you should be able to:


Objectives when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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.


Financing when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

Corportions


Debt Financing: Bondholders when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

Equity Financing: Stockholders

Two Methods of Long-Term Financing

Resources = Sources

Liabilities

Assets

Stockholders’

Equity


Two Methods of Long-Term Financing when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

Stockholders

Bondholders

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.

Why issue bonds rather than stock?


Alternative Financing Plans – $800,000 Earnings when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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


Alternative Financing Plans – $440,000 Earnings when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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


Characteristics of Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

  • 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.


Characteristics of Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

  • 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 present value concept and bonds payable
The Present-Value Concept and Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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.


$1,000 when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

10% payable

annually

The Present-Value Concept and Bonds Payable

MARKET RATE = CONTRACT RATE

Sell price of bond = $1,000


$1,000 when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

10% payable

annually

Discount

The Present-Value Concept and Bonds Payable

MARKET RATE > CONTRACT RATE

Sell price of bond < $1,000


$1,000 when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

10% payable

annually

Premium

The Present-Value Concept and Bonds Payable

MARKET < CONTRACT RATE

Sell price of bond > $1,000

+


$100 when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

$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)


The Present-Value Concept and Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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 for bonds payable
Accounting for Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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


Accounting for Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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.


Accounting for Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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.


Accounting for Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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.


Accounting for Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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 for Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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.


Accounting for Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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.


Accounting for Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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 for Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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.


Accounting for Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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.


Present value of $100,000 due in 5 years at 13% when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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.


Accounting for Bonds Payable when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

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.


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.


Bond Redemption of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

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.


Bond redemption
Bond Redemption of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

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.


Investments of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

in Bonds


Investments in bonds
Investments in Bonds of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

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.


Note that the brokerage fee is added of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a 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.


Investments in Bonds of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

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


Investments in Bonds of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

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.


Investments in Bonds of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

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.


Investments in Bonds of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

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.


Investments in Bonds of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

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.


Investments in Bonds of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

Investment Revenue

Oct. 1 2,000

Dec. 31 1,000

31 474

3,474

July 1 1,000

Bal. 2,474


Investments in Bonds of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

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.


Investments in Bonds of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

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


Investments in Bonds of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

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


Financial Analysis and Interpretation of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

Number of Times Interest Charges Earned


Income before income tax + Interest expense of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

Interest Expense

$800,000 + $250,000

$250,000

2005

= 4.2 times

Solvency Measures—The 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


Income before income tax + Interest expense of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a

Interest Expense

$900,000 + $300,000

$300,000

2006

= 4.0 times

Solvency Measures—The 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


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


Chapter 15 debtholders in terms of number of times interest charges were earned.

The End


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