Long-Term Liabilities: Bonds and Notes

12 Long-Term Liabilities: Bonds and Notes

1 Compute the potential impact of long-term borrowing on earnings per share. 12-2

1 Bond 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.

1 Huckadee Corporation is considering the following plans to issue debt and equity:

Data for Huckadee Corporation: • Earnings before interest and taxes are $800,000. • The tax rate is 40%. • All bonds or stocks are issued at their par or face value. 1 Earnings per share (EPS) measure the income earned by each share of common stock. It is computed as follows: Net Income – Preferred Dividends Earnings per share = Number of Common Shares Outstanding

1 Effect of Alternative Financing Plans—$800,000 earnings. Exhibit 1

1 Effect of Alternative Financing Plans—$440,000 earnings. Exhibit 2

1 Example Exercise 12-1 Alternative Financing Plans Gonzales Co., is considering the following alternative plans for financing their company: Plan 1 Plan 2 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. 12-10

Follow My Example 12-1 For Practice: PE 12-1A, PE 12-1B 1 Example Exercise 12-1 (continued) Plan1 Plan 2 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 $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 × 10%) ($750,000 × 40%) ($550,000 × 40%) $ 1.50 $ 3.30 12-11

2 Describe the characteristics and terminology of bonds payable. 12-10

2 Bond Characteristics and Terminology The underlying contract between the company issuing bonds and the bondholders is called a bond indenture or trust indenture.

2 Bond Characteristics and Terminology 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.

2 Bond Characteristics and Terminology • 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.

2 Bond Characteristics and Terminology • Bonds that a corporation reserves the right to redeem before their maturity are called callable bonds. • Bonds issued on the basis of general credit of the corporation are debenture bonds.

2 Proceeds from Issuing Bonds 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’ expectations of current and future economic conditions.

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.

Discount 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.

Premium 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.

3 Journalize entries for bonds payable. 12-19

3 Bonds Issued at Face Amount On January 1, 2009, Eastern Montana Communications Inc. issued for cash $100,000 of 12%, five-year bonds; interest payable semiannually. The market rate of interest is 12%.

3 Since the bond rate of interest and the market rate of interest are the same, the bonds will sell at their face amount.

3 Every six months (on June 30 and December 31) after the bonds are issued, interest of $6,000 ($100,000 × .12 × 6/12) is paid.

3 The bond matured on December 31, 2013. At this time, the corporation paid the face amount to the bondholder.

3 Bonds Issued at a Discount On January 1, 2009, Western Wyoming Distribution Inc. issued $100,000, 12% (paid semiannually on June 30 and December 31), five-year bonds when the market rate was 13%.

The discount may be viewed as the amount required by investors to accept a bond rate of interest below the market rate. 3 On January 1, 2009, the firm issued $100,000 bonds for $96,406 (a discount of $3,594).

Follow My Example 12-2 Cash…………………………………………… 936,420 Discount on Bonds Payable………………. 63,580 Bonds Payable………………………… 1,000,000 Follow My Example 6-1 For Practice: PE 12-2A, PE 12-2B 3 Example Exercise 12-2 Issuing Bonds at a Discount 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 × 6% × ½), receiving cash of $936,420. Journalize the entry to record the issuance of the bonds. 12-26

3 Amortizing a Bond Discount The two methods of computing amortization of a bond discount are as follows: 1.Straight-line method 2.Effective interest rate method, sometimes called the interest method Both methods amortize the same total amount of discount over the life of the bonds.

3 Straight-Line Amortization On June 30, 2009, six-months’ interest is paid and the bond discount is amortized ($3,594 × 1/10) on the five-year bond issued in Slide 24. * *$100,000 × 12% × 6/12

Follow My Example 12-3 Interest Expense……………………………. 36,358 Discount on Bonds Payable………… 6,358 Cash…………...………………………… 30,000 Paid interest and amortized the bond discount ($63,580 ÷ 10). For Practice: PE 12-3A, PE 12-3B 3 Example Exercise 12-3 Discount Amortization Using the bond from Example Exercise 12-2 (Slide 26), journalize the first interest payment and the amortization of the related bond discount. 12-29

3 Bonds Issued at a Premium On January 1, 2009, Northern Idaho Transportation Inc. issued a $100,000, 12%, five-year bond for $103,769. The market rate of interest was 11%.

Follow My Example 12-4 Cash…………………………………………… 2,154,440 Premium on Bonds Payable...………. 154,440 Bonds Payable………………………… 2,000,000 Follow My Example 6-1 For Practice: PE 12-4A, PE 12-4B 3 Example Exercise 12-4 Issuance of Bonds at a Premium A company issues a $2,000,000, 12%, five-year bond that pays semiannual interest of $120,000 ($2,000,000 × 12% × ½), receiving cash of $2,154,440. Journalize the bond issuance. 12-31

3 Amortizing a Bond Premium The first entry to record the interest payment and the amortization of the $100,000, 12%, five-year bond issued on January 1, 2009 (Slide 30) is made on June 30, 2009. 6,000.00

Follow My Example 12-5 Interest Expense………………..…………… 104,556 Premium on Bonds Payable...…………….. 15,444 Bonds Payable………………………… 120,000 For Practice: PE 12-5A, PE 12-5B 3 Example Exercise 12-5 Premium Amortization Using the bond from Example Exercise 12-4, journalize the first interest payment and the amortization of the related bond premium. 12-33

3 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.

3 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. Gains and losses on the redemption of bonds are reported as Other Income (Loss).

3 The corporation calls the remaining $75,000 of outstanding bonds, which are held by a private investor, for $79,500 on July 1, 2009.

Follow My Example 12-6 Bonds Payable...………………..………………. 500,000 Loss on Redemption of Bonds..……………... 15,000 Discount on Bonds Payable…………….. 40,000 Cash…………………………………………. 475,000 For Practice: PE 12-6A, PE 12-6B 3 Example Exercise 12-6 Redemption of Bonds Payable 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. 12-37

4 Describe and illustrate the accounting for installment notes. 12-38

4 Installment Notes An installment note is a debt that requires the borrower to make equal periodic payments to the lender for the term of the note. Unlike bonds, a note payment consists of payment of a portion of the amount initially borrowed (the principal) and payment of interest on the outstanding balance.

4 Issuing an Installment Note Lewis Company issues a $24,000, 6%, five-year note to City National Bank on January 1, 2008. The annual payment is $5,698.

4 Amortization of Installment Notes

4 The entry to record the first payment on December 31, 2008, is as follows: (Column C of Exhibit 3) (Column D of Exhibit 3)

4 The entry to record the second payment on December 31, 2009, is as follows: (Column C of Exhibit 3) (Column D of Exhibit 3)

4 The entry to record the final payment on December 31, 2012, is as follows: (Column C of Exhibit 3) (Column D of Exhibit 3) After the entry is posted, the balance in Notes Payable related to this note is zero.

4 Example Exercise 12-7 JournalizingInstallment Notes On the first day of the fiscal year, a company issue a $30,000, 10%, five-year installment note that has annual payments of $7,914. The first payment consists of $3,000 of interest and $4,914 of principal repayment. • Journalize the entry to record the issuance of the installment note. • Journalize the first annual note payment. 12-45

Follow My Example 12-7 4 Example Exercise 12-7 (continued) a. b. 12-46 For Practice: PE 12-7A, PE 12-7B

5 Describe and illustrate the reporting of long-term liabilities including bonds and notes payable. 12-47

Number of Times Interest Charges are Earned $152,366,000 + $42,091,000 $42,091,000 = Number of Times Interest Charges are Earned = 4.62 5 Number of Times Interest Charges are Earned Income Before Income Tax + Interest Expense Interest Expense Number of Times Interest Charges are Earned = Briggs and Stratton Corporation

Long-Term Liabilities: Bonds and Notes