1. Long Term Liabilities: Bonds & Notes
Chapter 12
Long Term Liabilities:
Bonds & Notes

2. Financing operations:
Short term debt
accounts payable
Long term debt
bonds or notes payable
Equity
common or preferred stock

3. Bond
Security representing money borrowed by a corporation from investors
Must be repaid at maturity
Periodic Interest payments
often paid semiannually
Issuance is authorized by Board of Directors
Ranks ahead of stockholders for claims on corporation’ s assets 3

4. Financing Corporation
Consider:
Effect on Earnings per share on common stock
Calculated as:
Net income – Preferred Dividends
# of common shares outstanding

5. Earnings per share on common stock
Interest expense is deductible, dividends are not
When calculating earnings per share, start with:
Earnings before interest and taxes, because the bond interest will lower the Income before income tax amount

6. Earnings per share on common stock
Earnings before interest and income tax
Deduct: interest on bonds (face amount X face rate of interest)
= Income before income tax
Deduct: income tax (income before income tax X tax rate)
= Net income
Less: Dividend on preferred stock (%X par X # of shares)
= Available for dividends on common stock
Divide by # of shares of common stock
= Earnings per share on common stock

7. Earnings per share on common stock
The earnings per share will change based on
Different earnings levels
Different financing plans 7

8. Bond Vocabulary Terms
Bond Indenture: contract between corporation and shareholders
Term bonds: all bonds of bond issue mature at the same time
Serial Bonds: maturities of bonds from a bond issue are spread over several dates
Convertible bonds: bonds can be exchanged for common stock

9. Bond Vocabulary Terms
Callable bonds: bonds that corporation can redeem before maturity
Debenture bonds: bonds issued on corporation’s general credit
Contract rate of interest: face interest rate; the interest rate used to calculate periodic interest payments
Market rate of interest (effective rate): determined by buyers and sellers of similar bonds
Affected by investors’ expectations of economic conditions

10. Price of Bonds
Stated in terms of a percentage of face value (principal amount of bonds)
Take the price as a percentage and multiply it by the face value
Bonds can be issued
At face value Price = 100
Above face value Price is greater than 100
Below face value Price is lower than 100

11. Bonds issued at face value
Price = 100
Cash received is 100% X face value
Market rate = Contract rate
Journal entry
Dr. Cash
Cr. Bonds Payable

12. Cash received from bond issuance is less than face value
Price of bonds is less than 100
Bonds are issued at a discount
Market rate is higher than the contract rate
Investors can earn more interest if they invest in something else
Corporation takes amount off price of bond equal to the difference between the market interest amount and the contract interest amount

13. Cash received from bond issuance is less than face value
Ex.: $10,000 bonds issued at a price of 98

14. Cash received from bonds issued is more than face value
Price of bonds is higher than 100
Bonds are issued at a premium
Market rate is lower than contract rate
Investors can earn more interest on the bond than if they invest in something else
Corporation adds amount to price of bond equal to the difference between the face interest amount and the market interest amount

15. Cash received from bonds issued is more than face value
Ex.: $10,000 bonds issued at a price of 103

16. Balance Sheet Presentation
Long term Liabilities
Bonds Payable (face amount)
+ Premium on Bonds Payable **contra account
= Carrying Value of bonds OR
- Discount on Bonds Payable **contra account

17. Premium or discount needs to be zero at the maturity date
By maturity date, the carrying value of the bonds needs to equal face value amount
Premium or discount needs to be zero at the maturity date
Amortization reduces the premium or discount

18. Methods of amortizing Straight line
Effective interest: required under GAAP
But, Straight-line can be used if the results are not significantly different

19. Amortization of Bond discount
Amortization turns the bond discount into interest expense over the life of the bond
Bond discount
+ actual interest payments (using contract rate)
= Interest expense amount using the market rate
So in effect, the market rate of interest is paid
Market rate is also called effective rate

20. Amortization of Bond discount
Can be done
Annually OR
At the time the interest payments are made

21. Amortization of Bond discount
Straight line amortization calculated as:
Bond discount
total # of interest payments (# of payments per year X the life of the bond)
= amount of credit to Discount on Bonds Payable at interest payment journal entry

22. Amortization of Bond discount
Journal entry at interest payment date
Dr. Interest expense *
* Amount equals the sum of Cash payment and amortization of discount

23. Amortization of Bond discount
Journal entry at interest payment date
Dr. Interest expense
Cr. Discount on Bonds Payable *
* Total discount / # of interest pmts

24. Amortization of Bond discount
Journal entry at interest payment date
Dr. Interest expense
Cr. Discount on Bonds Payable
Cr. Cash P X R X T
R = Contract rate

25. Example Dr. Cr.
Garland Corporation issued $8,000,000 in 8.5%, 5 year bonds on January 1 at 96.

26. Amortizing Bond Premium
Amortization of the bond premium reduces interest expense over the life of the bond
Bond premium
- actual interest payments (using contract rate)
= Interest expense amount using the market rate
So in effect, the market rate of interest is paid to bondholders

27. Amortization of Bond premium
Can be done
Annually OR
At the time the interest payments are made

28. Amortizing Bond Premium
Straight line amortization calculated as:
Bond premium
total # of interest payments (# of payments per year X the life of the bond)
= amount of debit to Premium on Bonds Payable at interest payment journal entry

29. Amortization of Bond Premium
Journal entry at interest payment date
Dr. Interest expense *
* Amount equals the Cash payment minus amortization of premium

30. Amortization of Bond Premium
Journal entry at interest payment date
Dr. Interest expense
Dr. Premium on Bonds Payable *
* Total premium / # of interest pmts

31. Amortization of Bond Premium
Journal entry at interest payment date
Dr. Interest expense
Dr. Premium on Bonds Payable
Cr. Cash P X R X T
R = Contract rate

32. Example Dr. Cr.
Meyer Inc. issued $1,000,000 in 6%, 10 year bonds on January 1 at 103. 32

33. Bond Redemption Callable bonds Bond indenture states the call price
the price corporation has to pay to redeem the bonds
Call price is typically above face value

34. Bond Redemption
Compare carrying value of bonds to the cash paid to redeem the bonds to determine gain or loss
Carrying value =
Cash Paid to redeem the bonds =
Face amount X Call Price as a %

35. Bond Redemption
If Carrying value is greater than Cash Paid to redeem the bonds, then there will be a _______
If Cash Paid to redeem the bonds is greater than Carrying Value, then there will be a ________
Gains and losses on the redemption of bonds are reported as Other Income (Loss) on the Income Statement.

36. Bond Redemption
Example: Bonds Payable has a balance of $100,000 and Discount on Bonds Payable has a balance of $1,250
Bonds are redeemed at 98
Cash Paid to redeem the bonds =
Carrying value of bonds =
Dr. Cr.

37. Bond Redemption
Example: Bonds Payable has a balance of $100,000 and Premium on Bonds Payable has a balance of $2,800
Bonds are redeemed at 101
Cash Paid to redeem the bonds =
Carrying value of bonds =
Dr. Cr. 37

38. Installment Notes Used to: buy assets, such as equipment borrow cash
Usually issued by a bank
Mortgage note: secured by pledge of assets
lender can take possession of the asset if borrower doesn’t pay

39. Installment notes
Require a series of equal periodic payments to the lender
A set periodic payment is calculated at the issuance of the note
The payment is to be made at installment dates

40. Installment notes Each payment consists of:
Principal: pay back a portion of the amount borrowed
Interest on the outstanding balance

41. Interest portion of periodic payment
Interest on the outstanding balance = Carrying value X interest rate % Carrying value of the note = outstanding balance = amount still owed on the note For the first payment, the carrying value = face value

42. Principal portion of periodic payment
Periodic payment – Interest portion = Principal portion The carrying value of the note is reduced by the principal portion of the periodic payment For period’s after the first payment, the carrying value for the period = last period’s carrying value – last period’s principal portion of payment

43. Installment notes journal entries
Dr Cr.
Issue notes:
Asset being acquired (face amount)
Notes Payable (face amount)
Make periodic payments
Interest Expense (CV X %)
Notes Payable (Paymnent amount – interest)
Cash (set payment amount)

44. Installment note example
On the first day of the fiscal year, a company issue a $30,000, 10%, five-year installment note that for cash. The installment note has annual payments of $7,914.

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