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CPA, MBA BY RACHELLE AGATHA, CPA, MBA Long-Term Liabilities: Bonds and Notes Slides by Rachelle Agatha, CPA, with excerpts from Warren, Reeve, Duchac

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2 1. Overview of Long Term Liabilities 2. Describe the characteristics, terminology, and pricing of bonds payable. 3. Accounting for bonds payable. Objectives:

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3 4. Bonds issued at Discount vs Premium. 5. Accounting for Premium and Discount. 6. Installment Notes. 7. Financial Statement presentation of LTL Objectives:

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4 Compute the potential impact of long-term borrowing on the earnings per share of a corporation. Objective 1

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5 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.

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6 Effect of Alternative Financing Plans— $800,000 Earnings

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7 8 Effect of Alternative Financing Plans— $440,000 Earnings

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8 Describe the characteristics, terminology, and pricing of bonds payable. Objective 2

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9 Bonds Payable A corporation that issues bonds enters into a contract (called a bond indenture or trust 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.

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10 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.

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11 Bonds issued on the basis of the general credit of the corporation are debenture bonds. Bonds that a corporation reserves the right to redeem before their maturity are called callable bonds.

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12 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 rate or the coupon rate. 3.The market or effective rate of interest.

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13 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: 1.investors assessment of current economic conditions, and 2.future expectations.

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14 MARKET RATE = CONTRACT RATE Selling price of bond = $1,000 $1,000 10% payable annually If the contract rate equals the market rate of interest, the bonds will sell at their face amount.

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15 MARKET RATE > CONTRACT RATE Selling price of bond < $1,000 – Discount $1,000 10% payable annually If the market rate is higher than the contract rate, the bonds will sell at a discount.

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16 MARKET < CONTRACT RATE Selling price of bond > $1,000 + Premium $1,000 10% payable annually If the market rate is lower than the contract rate, the bonds will sell at a premium.

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17 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.

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18 Today End of Year 1 End of Year 2 Present Value of the Face Amount of Bonds $1,000 10% payable annually A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years.

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Present Value of $1 at Compound Interest 19 N = 2 rate =10%

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20 Today End of Year 1 End of Year 2 $1,000 x $ Present Value of the Face Amount of Bonds $1,000 10% payable annually A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years.

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21 Using Exhibit 3 in your test, 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, *Present value of $1 for 5 periods at 10%

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22 Today End of Year 1 End of Year 2 Interest payment $100 Interest payment $100 $90.91$100 x $82.64 $100 x Present Value of the Periodic Bond Interest Payments Present value, at 10%, of $100 interest payments to be received each year for 2 years (rounded) $

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Present Value of Annuity of $1 at Compound Interest 23

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24 Present Value of 2-Year, 10% Bond Present value of face value of $1,000 due in 2 years at 10% compounded annually: $1,000 x (Exhibit 3: n = 2, i = 10%)$ Present value of 2 annual interest payments of 10% compounded annually: $100 x (Exhibit 4: n = 2, i = 10%) Total present value of bond$1,000.00

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25 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.

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26 Present value of face value of $20,000 due in 5 years at 5% compounded annually: $20,000 x (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 (present value of annuity of $1 for 5 periods at 5%). *Rounded to the nearest dollar 4,329* $20,000

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27 Journalize entries for bonds payable. Objective 3

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28 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%. Bonds Issued at Face Amount

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29 Present value of face amount of $100,000 due in 5 years at 12% compounded annually: $100,000 x (Exhibit 3: n = 10, i = 6%) $ 55,840 Present value of 10 interest payments of $6,000 at 12% compounded semiannually: $6,000 x (Exhibit 4: n = 10; i = 6%) 44,160* Total present value of bonds$100,000 *Because the present value tables are rounded to five decimal places, minor rounding differences may appear in this illustration.

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30 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%. Issued $100,000 bonds payable at face amount. Bonds Payable Jan. 1Cash

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31 On June 30, an interest payment of $6,000 is made ($100,000 x.12 x 6/12). June 30Interest Expense Cash Paid six months’ interest on bonds.

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32 The bond matured on December 31, At this time, the corporation paid the face amount to the bondholder. Cash Paid bond principal at maturity date. Dec. 31Bonds Payable

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33 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? Bonds Issued at a Discount

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34 Present value of face amount of $100,000 due in 5 years at 13% compounded semiannually: $100,000 x $53,273 Present value of 10 interest payments of $6,000, at 13% compounded semiannually: $6,000 x (present value of annuity of $1 for 10 periods at 6%) 43,133 Total present value of bonds $96,406

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35 On January 1, 2007, the firm issued $100,000 bonds for $96,406 (a discount of $3,594). Issued $100,000 bonds at discount. Bonds Payable Jan.1Cash Discount on Bonds Payable

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36 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. Cash845,562 Discount on Bonds Payable154,438 Bonds Payable1,000,000

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37 Amortizing a Bond Discount There are two methods of amortizing a bond discount: 1)The straight-line method and 2)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.

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38 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 June30Interest Expense Amortizing a Bond Discount Cash Paid semiannual interest and amortized 1/10 of bond discount.

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39 Interest Expense45,444 Discount on Bonds Payable15,444 Cash30,000 Paid interest and amortized the bond discount ($154,438 ÷ 10).

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40 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. Bonds Issued at a Premium

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41 Present value of face amount of $100,000 due in 5 years at 11% compounded semiannually: $100,000 x (Exhibit 3: n =10, i = 5½%) $ 58,543 Total present value of bonds$103,769 Present value of 10 interest payments of $6,000, at 11% compounded semiannually: $6,000 x (Exhibit 4: n = 10, i = 5½%) 45,226

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42 Issued $100,000 of bonds for $103,769 (a premium of $3,769). The entry to record this information is as follows: Issued $100,000 bonds at a premium. Bonds Payable Premium on Bonds Payable Jan.1Cash

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43 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. Cash2,154,435 Premium on Bonds Payable154,438 Bonds Payable2,000,000

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44 On June 30, 2007, paid the semiannual interest and amortized the premium. The firm uses straight-line amortization. Paid semiannual interest and amortized 1/10 of bond prem. Cash June 30Interest Expense $3,769 x 1/10 Amortizing a Bond Premium Premium on Bonds Payable376 90

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45 Using the bond from previous example, journalize the first interest payment and the amortization of the related bond premium. Interest Expense104,556 Premium on Bonds Payable15,444 Bonds Payable120,000 Paid interest and amortize the bond premium ($154,435/10).

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46 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. Zero-Coupon Bonds Present value of $100,000 due in 5 years at 13% compounded semiannually: $100,000 x (PV of $1 for 10 periods at 6½%) = $53,273

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47 On January 1, 2007, issue 5-year, $100,000 zero-coupon bonds when the market rate of interest is 13%. Issued $100,000 zero- coupon bonds. Bonds Payable Jan.1Cash Discount on Bonds Payable

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48 Describe and illustrate the payment and redemption of bonds payable. Objective 4

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49 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.

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50 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.

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51 Retired bonds for $24,000. Cash Gain on Redemption of Bonds June 30Bonds Payable 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. Premium on Bonds Payable

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52 Cash June 30Bonds Payable Premium on Bonds Payable Loss on Redemption of Bonds Redeemed $100,000 bonds for $105,000. Instead, assume that on June 30 the corporation calls all of the bonds, paying $105,000.

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53 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 Payable500,000 Loss on Redemption of Bonds15,000 Discount on Bonds Payable40,000 Cash475,000

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54 Installment Notes Objective 5

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55 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.

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

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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 57

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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 58

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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 59

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61 Financial Statement Presentation Objective 6

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5 62

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Number of Times Interest Charges are Earned = Income Before Income Tax + Interest Expense Interest Expense 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 Briggs and Stratton Corporation 5

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Summary Financing Corporations Bond terms & Characteristics Time Value of Money Accounting for Bonds Accounting for Notes Payable Financial Statement Presentation

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