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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.

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 corporation’s balance sheet.

13-1

Objective 1

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

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.

13-1

Plan 1Plan 2Plan 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

6

0

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.

9

Plan II

Follow My Example 13-1

$750,000

0

$750,000

300,000

$450,000

0

$450,000

/300,000

$750,000

200,000

$550,000

220,000

$330,000

0

$330,000

/100,000

(2,000,000 x 10%)

($750,000 x 40%)

($550,000 x 40%)

$1.50

$3.30

0

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

10

For Practice: PE 13-1A, PE 13-1B

13-2

Bonds Payable

- A corporation that issues bonds enters into a contract (called a bond indentureortrust 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.

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.

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 debenturebonds.

13-2

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 rateor thecoupon rate.

3. Themarket or effective rate of interest.

13-2

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.

10% payable

annually

0

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.

17

10% payable

annually

Discount

0

13-2

MARKET RATE > CONTRACT RATE

Selling price of bond < $1,000

–

If the market rate is higher than the contract rate, the bonds will sell at a discount.

18

10% payable

annually

Premium

0

13-2

MARKET < CONTRACT RATE

Selling price of bond > $1,000

+

If the market rate is lower than the contract rate, the bonds will sell at a premium.

19

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.

End of Year 2

Today

$1,000

10% payable

annually

$1,000 x 0.82645

$826.45

0

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?

21

Follow My Example 13-2

0

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%

22

For Practice: PE 13-2A. PE 13-2B

$100

Interest payment

Interest payment

End of Year 1

End of Year 2

Today

$90.91

$100 x 0.90909

$100 x 0.82645

$82.64

Present value, at 10%, of $100 interest payments to be received each year for 2 years (rounded)

$173.55

0

13-2

Present Value of the Periodic Bond Interest Payments

23

Present value of face value of $1,000 due in

2 years at 10% compounded annually: $1,000 x 0.82645 (Exhibit 3: n = 2,

i = 10%)(Slide 21) $ 826.45

Present value of 2 annual interest payments

of 10% compounded annually: $100 x 1.73554 (Exhibit 4: n = 2, i = 10%) (Slide 23) 173.55

Total present value of bond $1,000.00

0

13-2

Present Value of 2-Year, 10% Bond

24

0

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.

25

$20,000

0

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

26

For Practice: PE 13-3A, PE 13-3B

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%.

Present value of face amount of $100,000 due in 5 years at 12% compounded annually: $100,000 x 0.55840 (Exhibit 3: n = 10, i = 6%)

$ 55,840

Present value of 10 interest payments of $6,000 at 12% compounded semiannually: $6,000 x 7.36009 (Exhibit 4: n = 10; i = 6%)

44,160*

Total present value of bonds $100,000

0

13-3

*Because the present value tables are rounded to five decimal places, minor rounding differences may appear in this illustration.

29

Jan. 1 Cash 100 000 00

0

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.

30

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.

31

Dec. 31 Bonds Payable 100 000 00

0

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.

32

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?

Present value of face amount of $100,000 due in 5 years at 13% compounded semiannually: $100,000 x 0.53273

$53,273

Present value of 10 interest payments of $6,000, at 13% compounded semiannually: $6,000 x 7.18883 (present value of annuity of $1 for 10 periods at 6%)

43,133

Total present value of bonds $96,406

0

13-3

34

Jan. 1 Cash 96 406 00

0

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.

35

Follow My Example 13-4

0

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

36

For Practice: PE 13-4A, PE 13-4B

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.

June 30 Interest Expense 6 359 40

0

13-3

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.

38

Using the bond from Example Exercise 13-4, journalize the first interest payment and the amortization of the related bond discount.

Follow My Example 13-5

Interest Expense 45,444

Discount on Bonds Payable 15,444

Cash 30,000

Paid interest and amortized the bond discount ($154,438/10).

0

13-3

Click on this button to go to Example Exercise 13-4. To return to this slide, type “39” and press “Enter.”

39

For Practice: PE 13-5A, PE 13-5B

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.

Present value of face amount of $100,000 due in 5 years at 11% compounded semiannually: $100,000 x 0.58543 (Exhibit 3: n =10, i = 5½%)

$ 58,543

Present value of 10 interest payments of $6,000, at 11% compounded semiannually: $6,000 x 7.53763 (Exhibit 4: n = 10, i = 5½%)

45,226

Total present value of bonds $103,769

0

13-3

41

Jan. 1 Cash 103 769 00

0

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.

42

Follow My Example 13-6

0

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

43

For Practice: PE 13-6A, PE 13-6B

June 30 Interest Expense 5 623 10

0

13-3

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.

44

Follow My Example 13-7

0

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

Paid interest and amortize the

bond premium ($154,435/10).

45

For Practice: PE 13-7A, PE 13-7B

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

46

Jan. 1 Cash 53 273 00

Discount on Bonds Payable 46 727 00

0

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.

47

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.

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.

June 30 Bonds Payable 25 000 00

Premium on Bonds Payable 1 000 00

0

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.

51

June 30 Bonds Payable 100 000 00

Premium on Bonds Payable 4 000 00

Loss on Redemption of Bonds 1 000 00

0

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.

52

Follow My Example 13-8

0

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

53

For Practice: PE 13-8A, PE 13-8B

13-5

Objective 5

Journalize entries for the purchase, interest, discount, and premium amortization, and sale of bond investments.

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.

Apr. 2 Investment in Lewis Co. Bonds 1 025 30

Interest Revenue 10 20

0

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.

56

Apr. 2 Investment in Lewis Co. Bonds 1 025 30

Interest Revenue 10 20

Cash 1 035 50

Invested in a Lewis Company bond.

0

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.

57

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).

July 1 Investment in Deitz Corp. Bonds 41 706 00

0

13-5

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.

59

0

13-5

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.

60

Dec. 31 Interest Receivable 1 000 00

0

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.

61

31 Investment in Deitz Corp. Bonds 474 00

0

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.

62

The effect of these entries on Interest Revenue is as follows:

Interest Revenue

Oct. 1 2,000

Dec. 31 Adj. 1,000

31 Adj. 474

2,474

July 1 1,000

Adj. Bal.

0

13-5

63

13-5

Accounting for Bond Investments—Sale

The Deitz bonds are sold for $47,350 plus accrued interest on June 30, 2014. The carryingamountof the bond as of January 1, 2014 is $47,868 [$41,706 + ($79 per month x 78 months)].

June 30 Investment in Deitz Corp. Bonds 474 00

0

13-5

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.

65

13-5

The next slide shows theInvestment in DietzCorp. Bondsaccount after all amortization entries have been made, including the June 30, 2014 adjusting entry.

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 47448,342

2008

2009

2010

2011

2012

2013

2014

67

0

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.

68

0

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.

69

2008

2008

a.

Investment in Watson Corp. Bonds 8,341

Interest Revenue 150

Cash 8,491

Investment in Watson Corp. Bonds 42*

Interest Revenue 42

Oct. 1

Dec. 1

b.

*[($10,000 – $8,341)/111 months] x 3 months

0

13-5

For Practice: PE 13-9A, PE 13-9B

70

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.

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.

13-6

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.

Income Before Income Tax + Interest Expense

$174,315,000 + $36,883,000

Interest Expense

$36,883,000

0

13-6

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

77

(Continued)

13-6

The number of times interestcharges are earned is5.73.

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.

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