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15-1 L ONG-TERM F INANCING B ONDS CHAPTER 15 [After listening to the lecture comments for this slide, click anywhere outside the slide to continue.]

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Presentation on theme: "15-1 L ONG-TERM F INANCING B ONDS CHAPTER 15 [After listening to the lecture comments for this slide, click anywhere outside the slide to continue.]"— Presentation transcript:

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2 15-1 L ONG-TERM F INANCING B ONDS CHAPTER 15 [After listening to the lecture comments for this slide, click anywhere outside the slide to continue.]

3 15-2 Three Ways Corporations Can Raise Cash l Sell Stock l Borrow from Bank l Borrow from Investors (i.e., Sell Corporate Bonds) Forget U. S. Government Savings Bonds. They are very different from corporate bonds.

4 15-3 Seller Cash Bond Certificate Nature of Bond Transactions Never Never lose sight of the nature of a bond transaction! u Is long-term debt for issuing company u Is investment for purchasing companies or individuals Buyer A/K/A: Issuer Borrower A/K/A: Investor Lender

5 15-4 Seller Nature of Bond Transactions The seller agrees to pay and the buyer expects to get u Periodic interest at specified dates u Face value (i.e., principal) of bonds at maturity Buyer Face Value Payment at Maturity Interest Payments Every Six Months A/K/A: Issuer Borrower A/K/A: Investor Lender

6 15-5 Other Types of Loans What is the most familiar loan to you? Parents Auto Home

7 15-6 Level Periodic Payments (Includes principal & interest) Level Periodic Payments (Includes interest only) Auto or Home Loan vs. Bond Loan How does the repayment of an auto or home loan differ from the repayment of a bond loan? Last Pmt. Auto/Home Loan $ Time Bond Loan $ Time Last Pmt. Principal Payment (at maturity)

8 15-7 BONDS STOCK Bonds vs. Stock

9 15-8 BONDS ¶ Debt STOCK ¶ Equity Bonds vs. Stock

10 15-9 BONDS ¶ Debt · Maturity Date STOCK ¶ Equity · No Maturity Bonds vs. Stock

11 15-10 BONDS ¶ Debt · Maturity Date ¸ Interest STOCK ¶ Equity · No Maturity ¸ Dividends Bonds vs. Stock

12 15-11 Bonds vs. Stock BONDS ¶ Debt · Maturity Date ¸ Interest ¹ Bond Interest Expense Is Deductible for Taxes STOCK ¶ Equity · No Maturity ¸ Dividends ¹ Dividends Are Not Deductible for Taxes

13 15-12 l Know advantages of issuing debt (p. 545) u Does not dilute control of company u Interest is tax deductible u Favorable financial leverage A/K/A Trading on the equity l Know disadvantages of issuing debt (546) u Interest must be paid u Harder to withstand a major loss u Possibility of unfavorable financial leverage Bonds vs. Stock

14 15-13 Favorable Financial Leverage ( Using borrowed funds to increase EPS) (E.g. borrow at 10%; invest at 20%) P. 547

15 15-14 Characteristics of Bonds (PP ) l Secured or Unsecured Bonds l Registered or Unregistered Bonds l Coupon Bonds l Serial Bonds l Callable Bonds l Convertible Bonds l Bonds with Stock Warrants l Junk Bonds

16 15-15 Bonds Payable Terms BOND PAYABLE

17 15-16 BOND PAYABLE Face Value $1, Face Value = Maturity Value Bonds Payable Terms

18 15-17 BOND PAYABLE Face Value $1,000Interest 10% 1. Face Value = Maturity Value 2. Stated Interest Rate Bonds Payable Terms

19 15-18 BOND PAYABLE Face Value $1,000Interest 10% 6/30 & 12/31 1. Face Value = Maturity Value 2. Stated Interest Rate 3. Interest Payment Dates Bonds Payable Terms

20 15-19 BOND PAYABLE Face Value $1,000Interest 10% 6/30 & 12/31 Bond Date 12/31/94 1. Face Value = Maturity Value 2. Stated Interest Rate 3. Interest Payment Dates 4. Bond Date Bonds Payable Terms

21 15-20 BOND PAYABLE Face Value $1,000Interest 10% 6/30 & 12/31 Maturity Date 12/31/99 Bond Date 12/31/94 1. Face Value = Maturity Value 2. Stated Interest Rate 3. Interest Payment Dates 4. Bond Date 5. Maturity Date Bonds Payable Terms

22 15-21 BOND PAYABLE Face Value $1,000Interest 10% 6/30 & 12/31 Maturity Date 12/31/99 Bond Date 12/31/94 1. Face Value = Maturity Value 2. Stated Interest Rate 3. Interest Payment Dates 4. Bond Date 5. Maturity Date We also need to know the sale or issue date of the bond. Bonds Payable Terms

23 15-22 Bonds Issued at Face Value on Bond Date - Example On 12/31/94 Graphics Inc. issues 10 bonds at face value. The market interest rate is 10%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/99 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 12/31/94

24 15-23 Prepare the journal entry to record the issuance of the bonds on 12/31/94. Bonds Issued at Face Value on Bond Date

25 15-24 Prepare the journal entry to record the issuance of the bonds on 12/31/94. Long-term Liability Bonds Issued at Face Value on Bond Date

26 15-25 Prepare the journal entry required every 6/30 and 12/31 to pay interest. Bonds Issued at Face Value on Bond Date

27 15-26 Prepare the journal entry required every 6/30 and 12/31 to pay interest. Bonds Issued at Face Value on Bond Date

28 15-27 Prepare the journal entry to record the maturity of the bond on 12/31/99. Bonds Issued at Face Value on Bond Date

29 15-28 Prepare the journal entry to record the maturity of the bond on 12/31/99. Bonds Issued at Face Value on Bond Date

30 15-29 In the previous example, the bonds were sold on the bond date. But this is not always the case. Are you ready to see what happens when we sell bonds between the bond’s interest dates? Bonds Issued Between Interest Dates

31 15-30 between When bonds are sold between the interest dates, the bond issuer collects cash for: ¶ The face value of the bonds AND · The accrued interest since the bonds’ date Bonds Issued Between Interest Dates

32 15-31 Then, on the next interest payment date, the bond issuer pays bondholders a full 6 months of interest. Bonds Issued Between Interest Dates

33 15-32 The 6 month interest payment to the bondholders is composed of: ¶ Repayment of the interest received from the bondholders when the bonds were originally sold AND · Interest earned by the bondholders since the bonds were sold Bonds Issued Between Interest Dates Why is it done this way?

34 15-33 On 4/1/95 Graphics Inc. issues 1,000 bonds at face value. The bonds have the following terms: Face Value = $1,000 Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 12/31/94 Maturity Date = 12/31/99 (5 years) Bonds Issued Between Interest Dates - Example

35 15-34 How much cash is Graphics Inc. going to receive for the entire issue of the bonds? Cash Price of Bonds: $1,000 × 1,000 =1,000,000$ Accrued Interest: $1,000,000 × 10% ×3/12 =25,000 Total Cash Received1,025,000$ Bonds Issued Between Interest Dates

36 15-35 What does the $25,000 in accrued interest represent for Graphics Inc.? Interest Payable Bonds Issued Between Interest Dates

37 15-36 Prepare the journal entry to record the bond issue on 4/1/95. Bonds Issued Between Interest Dates

38 15-37 Prepare the journal entry to record the bond issue on 4/1/95. Bonds Issued Between Interest Dates

39 15-38 Prepare the journal entry to record the bond interest payment on 6/30/95. Bonds Issued Between Interest Dates

40 15-39 Prepare the journal entry to record the bond interest payment on 6/30/95. Bond Interest Expense is for the three months April, May, and June. ($1,000,000 × 10% × 3 / 12 = $25,000) Bonds Issued Between Interest Dates

41 15-40 Prepare the journal entry to record the bond interest payment on 6/30/95. Total Bond Interest Paid is for the six months January through June ($1,000,000 × 10% × 6 / 12 = $50,000) Bonds Issued Between Interest Dates

42 15-41 Prepare the journal entry to record the bond interest payment on 6/30/95. The debit to Bond Interest Payable is for the accrued interest that was collected when the bonds were sold. Bonds Issued Between Interest Dates

43 15-42 “Interesting” Terminology The two sets of interest terms used with bonds are: Market Rate - A/K/A: Effective Rate Yield Rate APR "True" Rate Compound Rate Contract Rate - A/K/A: Stated Rate Coupon Rate Nominal Rate Face Rate Simple Rate

44 15-43 Bond Prices and Interest Rates l Market rate = contract rate Bonds sell at face or par value l Market rate > contract rate Bonds sell at a discount (i.e., below face value) l Market rate < contract rate Bonds sell at a premium (i.e., above face value)

45 15-44 What happens when the market interest rate is different from the bond’s contract interest rate? For example, the market is earning 12%. Would you want to invest in Graphics Inc.’s 10% bond? YES! Market Interest Rate vs. Contract Interest Rate NO!

46 15-45 How could Graphics Inc. make their bonds more attractive to you? They cannot change any terms of the bonds payable. The only thing they can change is the selling price of the bonds. Market Interest Rate vs. Contract Interest Rate

47 15-46 So, if the bond is paying 10% interest and the market is paying 12% interest, Graphics Inc. would: Sell the bond below face value (i.e., at a discount) BUT Pay interest on the full face value AND Repay the full face value at maturity Market Interest Rate vs. Contract Interest Rate

48 15-47 increase This arrangement will increase the effective interest rate of Graphics Inc. bonds to the market rate. Market Interest Rate vs. Contract Interest Rate Therefore, Graphics Inc.’s 10% bonds would be just as attractive as the market investments earning 12%. How can this happen? (Proof is on next slide)

49 15-48 Illustration 15.3, P. 550 (Slightly modified) 12%10% Proof of Concept Assumptions: Face amount (i.e., loan) = $1,000 Length of loan = 1 yr. Market rate = 12% Contract rate = 10% Market Interest Rate vs. Contract Interest Rate

50 15-49 Market Interest Rate vs. Contract Interest Rate Proof of Concept Interest = Principal x Rate x Time 100** = P x.12* x 1 P = 833 **1,000 x 10% contract rate Assumptions: Face amount (i.e., loan) = $1,000 Length of loan = 1 yr. Market rate = 12%* Contract rate = 10%

51 15-50 On 12/31/94 Graphics Inc. sells 1,000 bonds at % of face value. The market interest rate is 12%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/99 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 12/31/94 Bonds Sold at a Discount on Bond Date

52 15-51 How much cash is Graphics Inc. going to receive for the entire bond issue? Bonds Sold at a Discount

53 15-52 How much cash is Graphics Inc. going to receive for the entire bond issue? $1,000 face value × 1,000 bonds sold = $1,000,000 face amount $1,000,000 × % = $926,395 cash proceeds How much does Graphics Inc. agree to repay at maturity? Bonds Sold at a Discount

54 15-53 Graphics Inc. agrees to repay the full face value at maturity. $1,000 face value × 1,000 bonds sold = $1,000,000 Bonds Sold at a Discount

55 15-54 The difference between the face value of the bonds and the cash received is the discount. $1,000,000 - $926,395 = $73,605 outstanding life The discount causes additional interest expense factor for Graphics Inc but does not affect interest paid. The discount will be amortized to Bond Interest Expense over the outstanding life of the bonds. Bonds Sold at a Discount

56 15-55 Prepare the journal entry to record the issue of the bonds on 12/31/94. Bonds Sold at a Discount

57 15-56 Prepare the journal entry to record the issue of the bonds on 12/31/94. Contra-Liability Account Bonds Sold at a Discount

58 15-57 Discount on Bonds Payable bal. 73,605 Bonds Sold at a Discount

59 15-58 Partial Balance Sheet at 12/31/94 Long-term Liabilities: Bonds Payable1,000,000$ Less: Discount on Bonds Payable73, ,395$ Carrying Value Face (Maturity) Value Bonds Sold at a Discount

60 15-59 Definition of Carrying Value? Face/Maturity Value - unamortized discount (current example) or + unamortized premium (later example) Bonds Sold at a Discount

61 15-60 Prepare the journal entries required every 6/30 and 12/31. Use straight-line amortization of the discount. Effective interest method will be discussed later in the lecture. Bonds Sold at a Discount

62 15-61 GENERAL JOURNAL Page 1 DateDescriptionPRDebitCredit 6/30Bond Interest Expense57,360 Discount on Bonds Payable7,360 Cash 50,000 To record bond interest payment $1,000,000 × 10% × ½ = $50,000 To record discount amortization $73,605 ÷ 5 yrs. = $14,721 per year $14,721 ÷ 2 = $7,360 rounded Bonds Sold at a Discount

63 15-62 Discount on Bonds Payable bal. 73,605 Bonds Sold at a Discount 7,360 Amortization on bal. 66,245

64 15-63 As the discount is amortized, the carrying value of the bonds payable increases toward the maturity value. (i.e. we subtract a smaller and smaller contra account on the B/S.) Partial Balance Sheet at 6/30/95 Long-term Liabilities: Bonds Payable1,000,000$ Less: Discount on Bonds Payable66, ,755$ Bonds Sold at a Discount

65 15-64 Up from $926,395 Partial Balance Sheet at 6/30/95 Long-term Liabilities: Bonds Payable1,000,000$ Less: Discount on Bonds Payable66, ,755$ Down from $73,605 Bonds Sold at a Discount

66 15-65 Compound Interest Concepts Before we go any further, let’s make sure we understand the compound interest concepts in the appendix!

67 15-66 Compound Interest Concepts Example #1 Future Value (Worth) of $1 Today Year 1Year 2 + $1 - ? - $ (From Table A.1) + $1,000 - X 1 = ,000 X X = 1, Example is related to Illustration 15-6 Interest Rate = 12% No. Periods = 2 years

68 15-67 Future Value of an Annuity of $1 Compound Interest Concepts Example #2 Today Pd. 1 Pd. 2 Pd. 3 + $1 + $1 + $1 - ? - $ (From Table A.2) + $100 + $100 + $100 - X 1 = X X = Example is related to Illustration 15-7 Interest Rate = 6% No. Periods = 3

69 15-68 Present Value (Worth) of $1 Compound Interest Concepts Example #3 Two Perspectives: Text Rice Today Year 1Year 2 Text Today Year 1Year 2 Rice

70 15-69 Present Value (Worth) of $1 Compound Interest Concepts Example #3 Today Year 1Year 2 Rice + ? - $1 + $.7972 (From Table A.3) + X - $1, = 1. X 1,000 X = Example is related to Illustration 15-8 Interest Rate = 12% No. Periods = 2 years

71 15-70 Present Value of an Annuity of $1 Compound Interest Concepts Example #4 Today Pd. 1 Pd. 2 Pd. 3 + ? - $1 - $1 - $1 + $2.673 (From Table A.4) + X - $100 - $100 - $ = 1. X 100 X = Example is related to Illustration 15-9 Interest Rate = 6% No. Periods = 3

72 15-71 So, What Does All of This Have to do With Bonds? The bond investor is buying the right to receive two things: X - The present value of the maturity amount of the bonds (i.e., the face amount) Y - The present value of the periodic bond interest payments

73 15-72 Z = Total Present Value of Bonds (i.e., Total Market Price) + X - 100, ,496 A/K/A, the cost to the investor and the proceeds to the issuer. So, What Does All of This Have to do With Bonds? Example below uses data from bottom p. 550 Facts: Interest Rate = 6% No. Periods = 6 Maturity/Face Amount = $100,000 Issue Date Pd. 1Pd. 2Pd. 3Pd. 4Pd. 5Pd. 6 Maturity Date + Y - 6, , , , , , , ,000 QUESTION: This bond was sold at a (click one): Premium DiscountFace Amount

74 15-73 Let’s apply what we just learned. Bonds Sold at a Discount

75 15-74 Calculate how Graphics, Inc. would determine the selling price of its bonds. Bonds Sold at a Discount NOTE: The $926,395 selling price of the bonds on the next slide was previously calculated on slide #52 as a simple percentage of face amount. The current calculation is a conceptual one which builds on the present value concepts in the appendix and on the last few slides. A calculation of bond selling price will be on the next test.

76 15-75 Face Value1,000,000$ Stated Interest Rate10% Number of Periods (5 yrs. × 2)10 Market Interest Rate12% Selling Price of Bonds926,395$ Facts Interest Payments50,000$ PV Ann. $1, 10 periods, 6%× PV of Interest Payments (rounded)368,005 Present Value of Bonds on Issuance Date: Principal1,000,000$ PV $1, 10 periods, 6%× PV of Principal558,390$ Bonds Sold at a Discount

77 15-76 Now, what happens when the market interest rates are lower than the bond’s contract interest rate? For example, the market is earning 8%. Would you want to invest in Graphics Inc.’s 10% bond? Market Interest Rate vs. Contract Interest Rate (again) YES!NO!

78 15-77 So, if the bond is paying 10% interest and the market is paying 8% interest, Graphics Inc. would: Sell the bond above face value (i.e., at a premium) BUT Pay interest on only the face value AND Repay only the face value at maturity Market Interest Rate vs. Contract Interest Rate

79 15-78 decrease Based on the logic explained earlier, this arrangement will decrease the effective interest rate of Graphics Inc. bonds to the market rate. Therefore, Graphics Inc.’s 10% bonds would provide a return to the investor/lender equal to the market’s 8%. Market Interest Rate vs. Contract Interest Rate

80 15-79 On 12/31/94 Graphics Inc. sells 1,000 bonds at % of face value. The market interest rate is 8%. The bonds have the following terms: Face Value = $1,000 Maturity Date = 12/31/99 (5 years) Stated Interest Rate = 10% Interest Dates = 6/30 & 12/31 Bond Date = 12/31/94 Bonds Sold at a Premium

81 15-80 How much cash is Graphics Inc. going to receive for the entire bond issue? Bonds Sold at a Premium

82 15-81 How much cash is Graphics Inc. going to receive for the entire bond issue? $1,000 face value × 1,000 sold = $1,000,000 face amount $1,000,000 × % = $1,081,105 cash proceeds Bonds Sold at a Premium

83 15-82 How much does Graphics Inc. agree to repay at maturity? $1,000 face value × 1,000 sold = $1,000,000 How much cash interest does Graphics Inc. agree to pay at each interest date? $1,000,000 × 10% contract rate × 6/12 = $50,000 Bonds Sold at a Premium This is the cash amount which will be paid regardless of whether the bonds were issued at face, a discount or a premium!

84 15-83 In this case, the difference between the face value of the bonds and the cash received is the premium. $1,081,105 - $1,000,000 = $81,105 reduction The premium causes a reduction in the interest expense for Graphics but not in the interest paid. The premium will be amortized to bond interest expense over the life of the bonds. Bonds Sold at a Premium

85 15-84 Prepare the journal entry to record the issue of the bonds on 12/31/94. Bonds Sold at a Premium

86 15-85 Prepare the journal entry to record the issue of the bonds on 12/31/94. Adjunct-Liability Account Bonds Sold at a Premium

87 15-86 Premium on Bonds Payable 81,105 Bal Bonds Sold at a Premium

88 15-87 Carrying Value Partial Balance Sheet at 12/31/94 Long-term Liabilities: Bonds Payable1,000,000$ Add: Premium on Bonds Payable81,105 1,081,105$ Maturity Value Bonds Sold at a Premium

89 15-88 Prepare the journal entries required every 6/30 and 12/31. Use straight-line amortization of the premium. Bonds Sold at a Premium Again, effective interest method will be discussed later in lecture.

90 15-89 GENERAL JOURNAL Page 1 DateDescriptionPRDebitCredit 6/30Bond Interest Expense41,889 Premium on Bonds Payable8,111 Cash 50,000 To record bond interest payment $1,000,000 × 10% × ½ = $50,000 To record premium amortization $81,105 ÷ 5 yrs. = $16,221 per year $16,221 ÷ 2 = $8,111 rounded Bonds Sold at a Premium

91 15-90 Premium on Bonds Payable 81,105 Bal amort. 8,111 72,994 Bal Bonds Sold at a Premium

92 15-91 Partial Balance Sheet at 6/30/95 Long-term Liabilities: Bonds Payable1,000,000$ Add: Premium on Bonds Payable72,994 1,072,994$ Carrying Value Adjunct-liability account Bonds Sold at a Premium Down from $81,105 Down from $1,081,105

93 15-92 As the premium is amortized, the carrying value of the bonds payable decreases toward the maturity value. (i.e. we add a smaller and smaller adjunct account on the B/S.) Partial Balance Sheet at 6/30/95 Long-term Liabilities: Bonds Payable1,000,000$ Add: Premium on Bonds Payable72,994 1,072,994$ Bonds Sold at a Premium

94 15-93 Again, let’s calculate how Graphics, Inc. would determine the selling price of the bonds. Bonds Sold at a Premium The $1,081,105 selling price of the bonds on the following slide was previously calculated on slide #81 as a simple percentage of face amount. As before, the following calculation is a conceptual one which builds on present value concepts in the appendix.

95 15-94 Face Value1,000,000$ Stated Interest Rate10% Number of Periods (5 yrs. × 2)10 Market Interest Rate8% Selling Price of Bonds1,081,105$ Facts Interest Payments50,000$ PV Ann. $1, 10 periods, 4%× PV of Interest Payments (rounded)405,545 Present Value of Bonds on Issuance Date: Principal1,000,000$ PV $1, 10 periods, 4%× PV of Principal675,560$ Bonds Sold at a Premium

96 15-95 Examples of Simple Sales Entries Sold at Face Cash 1,000 Bonds Payable 1,000 Sold at Discount Cash 900 Discount on Bonds Payable 100 Bonds Payable 1,000 Sold at Premium Cash 1,100 Premium on Bonds Payable 100 Bonds Payable 1,000

97 15-96 Methods of Amortization Straight-Line vs. Effective Interest l Which is preferred for GAAP? Effective interest method l So, when can straight-line be used? When the results are not materially different from the effective interest method. l How do the two methods differ?

98 15-97 Conceptual difference given a discount situation. $ Time $ Straight-lineEffective Interest ? ? Methods of Amortization Straight-Line vs. Effective Interest

99 15-98 $ Time $ Straight-line Int. Exp. Conceptual difference given a discount situation. Methods of Amortization Straight-Line vs. Effective Interest Effective Interest Interest expense: constant amount Interest expense: constant rate CV

100 15-99 Effective Interest Method (For Either Premium or Discount) l Calculate bond interest expense at the date of each semiannual interest payment as follows beginning Bond interest expense = Carrying value of bond at beginning of period X Market/effective/yield rate of interest X 6/12 l The amortization amount, then, is simply the difference between the interest expense and the cash interest payment.

101 From an earlier example, Graphics Inc. sold 10% bonds with a face value of $1,000,000 for $926,395. Market rate = 12%. Amortization entry 6 months later Bond Interest Expense *55,584 Cash ($1,000,000 x.10 x 6/12) 50,000 Discount on Bonds Payable 5,584 *($926,395 x.12 X 6/12) To do the next amortization entry, one ideally needs what? Effective Interest Method Discount Example

102 Effective Interest Method Discount Amortization Table A: $1,000,000 × 10% × ½ = $50,000 B: $931,979 × 6% = $55,919 C: $55,919 - $50,000 = $5,919 D: $68,021 - $5,919 = $62,102 E: $1,000,000 - $62,102 = $937,898 (A)(B)(C)(D)(E) Interest DiscountUnamortizedCarrying DatePaymentExpenseAmortizationDiscountValue 1/1/9573,605$ 926,395$ 6/30/9550,000$ 55,584$ 5,584$ 68, ,979 12/31/9550,000 55,919 5,919 62, ,898

103 Effective Interest Method Discount Amortization Table (A)(B)(C)(D)(E) Interest DiscountUnamortizedCarrying DatePaymentExpenseAmortizationDiscountValue 1/1/9573,605$ 926,395$ 6/30/9550,000$ 55,584$ 5,584$ 68, ,979 12/31/9550,000 55,919 5,919 62, ,898 6/30/9650,000 56,274 6,274 55, ,172 12/31/9650,000 56,650 6,650 49, ,822 6/30/9750,000 57,049 7,049 42, ,871 12/31/9750,000 57,472 7,472 34, ,343 6/30/9850,000 57,921 7,921 26, ,264 12/31/9850,000 58,396 8,396 18, ,660 6/30/9950,000 58,900 8,900 9, ,560 12/31/9950,000 59,434 9,440 01,000,000 * * Adjusted.

104 From an earlier example, Graphics Inc. sold 10% bonds with a face value of $1,000,000 for $1,081,105. Market rate = 8%. Amortization entry 6 months later Bond Interest Expense *43,244 Premium on Bonds Payable 6,756 Cash ($1,000,000 x.10 x 6/12) 50,000 *($1,081,105 x.08 X 6/12) Effective Interest Method Premium Example And now, the amortization table...

105 (A)(B)(C)(D)(E) Interest PremiumUnamortizedCarrying DatePaymentExpenseAmortizationPremiumValue A: $1,000,000 × 10% × ½ = $50,000 B: $1,074,349 × 4% = $42,974 C: $50,000 - $42,974 = $7,026 D: $74,349 - $7,026 = $67,323 E: $1,000,000 + $67,323 = $1,067,323 1/1/9581,105$ 1,081,105$ 6/30/9550,000$ 43,244$ 6,756$ 74,349 1,074,349 12/31/9550,000 42,974 7,026 67,323 1,067,323 Effective Interest Method Premium Amortization Table

106 Interest PremiumUnamortizedCarrying DatePaymentExpenseAmortizationPremiumValue 1/1/9581,105$ 1,081,105$ 6/30/9550,000$ 43,244$ 6,756$ 74,349 1,074,349 12/31/9550,000 42,974 7,026 67,323 1,067,323 6/30/9650,000 42,693 7,307 60,016 1,060,016 12/31/9650,000 42,401 7,599 52,417 1,052,417 6/30/9750,000 42,097 7,903 44,514 1,044,514 12/31/9750,000 41,781 8,219 36,295 1,036,295 6/30/9850,000 41,452 8,548 27,747 1,027,747 12/31/9850,000 41,110 8,890 18,857 1,018,857 6/30/9950,000 40,754 9,246 9,611 1,009,611 12/31/9950,000 40,389 9, ,000,000 * * Rounded (A)(B)(C)(D)(E) Effective Interest Method Premium Amortization Table

107 l When they mature, make the simple entry Bonds Payable(DEBIT) Cash (CREDIT) l If paid before maturity u Compare carrying value of the bonds with the cash paid to retire the bonds If retirement price < carrying value, have gain If retirement price > carrying value, have loss Is a loss a debit or credit? Redeeming (Paying Off) Bonds Payable u Gain or loss reported where? Early extinguishment (retirement) of debt (Chap.13) DebitCredit

108 Bond Redemption Sinking Fund May be required by bond indenture i.e., contract Fund is used to redeem bonds and pay interest Classified as “Investments” or “Other Assets” Sinking Fund

109 KmbekibekKmbekibek; Have we bitten off more than we can chew? Rice’s Students Only Click the keypad to answer required virtual keypad questions.


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