1. Chapter 13 Bonds Payable and Investments in Bonds
Financial and Managerial Accounting
8th Edition
Warren Reeve Fess
© Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved.
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PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University

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3. After studying this chapter, you should be able to:
Objectives
1. Compute the potential impact of long-term borrowing on the earnings per share of a corporation.
2. Describe the characteristics of bonds.
3. Compute the present value of bonds payable.
4. Journalize entries for bonds payable.
5. Describe bond sinking funds.
After studying this chapter, you should be able to:

4. Objectives 6. Journalize entries for bond redemptions.
7. Journalize entries for the purchase, interest, discount, and premium amortization, and sale of bond investments.
8. Prepare a corporation balance sheet.
9. Compute and interpret the number of times interest charges are earned.

5. Financing
Corporations

6. Two Methods of Long-Term Financing
Resources = Sources
Liabilities
Debt Financing: Bondholders
Assets
Stockholders’
Equity
Equity Financing: Stockholders

7. Two Methods of Long-Term Financing
Bondholders
Stockholders
Why issue bonds rather than stock?
Bonds (debt)—Interest payments to bondholders are an expense that reduces taxable income.
Stock (equity)—Dividend payments are made from after tax net income and retained earnings.
Earnings per share on common stock can often be increased by issuing bonds rather than additional stock.

8. Alternative Financing Plans – $800,000 Earnings
Plan 1 Plan 2 Plan 3
12 % bonds — — $2,000,000
Preferred 9% stock, $50 par — $2,000,000 1,000,000
Common stock, $10 par $4,000,000 2,000,000 1,000,000
Total $4,000,000 $4,000,000 $4,000,000
Earnings before interest
and income tax $ 800,000 $ 800,000 $ 800,000
Deduct interest on bonds — — 240,000
Income before income tax $ 800,000 $ 800,000 $ 560,000
Deduct income tax 320, , ,000
Net income $ 480,000 $ 480,000 $ 336,000
Dividends on preferred stock — 180,000 90,000
Available for dividends $ 480,000 $ 300,000 $ 246,000
Shares of common stock ÷400,000 ÷200,000 ÷100,000
Earnings per share $ 1.20 $ 1.50 $ 2.46

9. Alternative Financing Plans – $440,000 Earnings
Plan 1 Plan 2 Plan 3
12 % bonds — — $2,000,000
Preferred 9% stock, $50 par — $2,000,000 1,000,000
Common stock, $10 par $4,000,000 2,000,000 1,000,000
Total $4,000,000 $4,000,000 $4,000,000
Earnings before interest
and income tax $ 440,000 $ 440,000 $ 440,000
Deduct interest on bonds — — 240,000
Income before income tax $ 440,000 $ 440,000 $ 200,000
Deduct income tax 176, ,000 80,000
Net income $ 264,000 $ 264,000 $ 120,000
Dividends on preferred stock — 180,000 90,000
Available for dividends $ 264,000 $ ,000 $ ,000
Shares of common stock ÷400,000 ÷200,000 ÷100,000
Earnings per share $ 0.66 $ 0.42 $ 0.30

10. Characteristics of Bonds Payable
A bond contract is called a bond indenture or trust indenture.
Long-term debt—repayable 10, 20, or 30 years after date of issuance.
Issued in face (principal) amounts of $1,000, or multiples of $1,000.
Contract interest rate is fixed for term (life) of the bond.
Face amount of bond repayable at maturity date.

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

12. The Present-Value Concept and 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.

13. The Present-Value Concept and Bonds Payable
MARKET RATE = CONTRACT RATE
Sell price of bond = $1,000
$1,000
10% payable
annually

14. – The Present-Value Concept and Bonds Payable $1,000
MARKET RATE > CONTRACT RATE
Sell price of bond < $1,000
$1,000
10% payable
annually
Discount –

15. The Present-Value Concept and Bonds Payable
MARKET < CONTRACT RATE
Sell price of bond > $1,000
$1,000
10% payable
annually
Premium +

16. A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years.
Interest payment
$100
$1,000
10% payable
annually
Interest payment
$100
Today
End of Year 1
End of Year 2
$90.91
$100 x
$82.65
$100 x
$1,000 x
$826.45
$1, (rounded)

17. The Present-Value Concept and Bonds PayableOR
Present value of face value of $1,000 due in 2 years at 10% compounded annually: $1,000 x $
Present value of 2 annual interest payments of 10% compounded annually: $100 x (PV of annuity of $1 for 2 years at 10%)
Total present value of bonds $1,000.00

18. Accounting for Bonds Payable
Bonds Issued at Face Amount
On January 1, 2005, 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
$ 55,840
Present value of 10 interest payments of $6,000
compounded semiannually: $6,000 x
(PV of annuity of $1 for 10 periods at 6%) ,160
Total present value of bonds $100,000

19. Accounting for Bonds Payable
Bonds Issued at Face Amount
On January 1, 2005, a corporation issues for cash $100,000 of 12%, five-year bonds; interest payable semiannual. The market rate of interest is 12%.
2005
Jan. 1 Cash
Bonds Payable
Issued $100,000 bonds payable at face amount.

20. Accounting for Bonds Payable
Bonds Issued at Face Amount
On June 30, an interest payment of $6,000 is made ($100,000 x .12 x 6/12).
June 30 Interest Expense
Cash
Paid six months’ interest on bonds.

21. Accounting for Bonds Payable
Bonds Issued at Face Amount
The bond matured on December 31, At this time, the corporation paid the face amount to the bondholder.
2009
Dec. 31 Bonds Payable
Cash
Paid bond principal at maturity date.

22. Accounting for Bonds Payable
Bonds Issued at a Discount
Assume that the market rate of interest is 13% on the $100,000 bond rather than 12%.
Present value of face amount of $100,000 due in 5
years at 13% compounded semiannually: $100,000
x (PV of $1 for 10 periods at 6½%) $53,273
Present value of 10 semiannual interest payments
of $6,000 compounded semiannually: $6,000 x
(PV of annuity of $1 for 10 periods at 6½%) 43,133
Total present value of bonds $96,406

23. Accounting for Bonds Payable
Bonds Issued at a Discount
On January 1, 2005, the firm issued $100,000 bonds for $96,406 (a discount of $3,594).
2005
Jan. 1 Cash
Discount on Bonds Payable
Bonds Payable
Issued $100,000 bonds at discount.

24. Accounting for Bonds Payable
Bonds Issued at a Discount
On June 30, 2005, six-months’ interest is paid and the bond discount is amortized using the straight-line method.
2005
June 30 Interest Expense
Discount on Bonds Payable
Cash
$3,594 ÷ 10
Paid semiannual interest and amortized 1/10 of discount.

25. Accounting for Bonds Payable
Bonds Issued at a Premium
If the market rate of interest is 11% and the contract rate is 12%, the bond would sell for $103,769.
Present value of face amount of $100,000 due in 5
years at 11% compounded annually: $100,000 x
(PV of $1 for 10 periods at 5½%) $ 58,543
Present value of 10 semiannual interest payments of
$6,000 at 11%compounded semiannually: $6,000 x
(PV of annuity of $1 for 10 periods at 5½%) ,226
Total present value of bonds $103,769

26. Accounting for Bonds Payable
Bonds Issued at a Premium
Sold $100,000 of bonds for $103,769 (a premium of $3,769).
2005
Jan. 1 Cash
Bonds Payable
Premium on Bonds Payable
Issued $100,000 bonds at a premium.

27. Accounting for Bonds Payable
Bonds Issued at a Premium
On June 30, paid the semiannual interest and amortized the premium.
2005
June 30 Interest Expense
Premium on Bonds Payable
Cash
$3,769 x 1/10
Paid semiannual interest and amortized 1/10 of bond premium.

28. Accounting for Bonds Payable
Zero-Coupon Bonds
Zero-coupon bonds do not provide for interest payments. Only the face amount is paid at maturity. Assume market rate is 13% at date of issue.
Present value of $100,000 due in 5 years at 13%
compounded semi annually: $100,000 x
(PV of $1 for 10 periods at 6½%) $53,273

29. Accounting for Bonds Payable
Zero-Coupon Bonds
On January 1, 2005, Issue 5-year, $100,000 zero-coupon bonds when the market rate of interest is 13%.
2005
Jan. 1 Cash
Discount on Bonds Payable
Bonds Payable
Issued $100,000 zero- coupon bonds.

30. The bond indenture may require that a fund for the payments of the face value of the bonds at maturity be set aside over the life of the bonds. This special fund is called a bond sinking fund.

31. Bond Redemption
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.
2005
June 30 Bonds Payable
Premium on Bonds Payable
Cash
Gain on redemption of Bonds
Retired bonds for $24,000.

32. Bond Redemption
Instead, assume that the firm reacquired all of the bonds, paying $105,000.
2005
June 30 Bonds Payable
Premium on Bonds Payable
Loss on Redemption of Bonds
Cash
Retired bonds for $105,000.

33. Investments
in Bonds

34. Investments in Bonds
Bonds are purchased directly from the issuing corporation or through an organized bond exchange. Bond prices are quoted as a percentage of the face amount.
A premium or discount on a bond investment is recorded in a single investment account and is amortized over the remaining life of the bonds.

35. Investments in Bonds
On April 2, 2005, Purchased a $1,000 Lewis Company bond at 102 plus a brokerage fee of $5.30 and accrued interest of $10.20.
2005
Apr. 2 Investment in Lewis Co. Bonds
Note that the brokerage fee is added to the cost of the investment.
Interest Revenue
Cash
Invested in a Lewis Company bond.

36. Investments in Bonds
To assist your understanding, let’s look at an extended illustration for Crenshaw, Inc.

37. Investments in Bonds
On July 1, 2005, 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, 2005.
2005
July 1 Investment in Deitz Corp. Bonds
Interest Revenue
$50,000 x 8% x 3/12
Cash
Purchased investment in bonds, plus accrued interest.

38. Investments in Bonds
Received semiannual interest for April 1 to October 1 ($50,000 x 8% x 6/12).
Oct. 1 Cash
Interest Revenue
Received semiannual interest for April 1 to October 1.

39. Investments in Bonds
Adjusting entry for interest accrued from October 1 to December 31 ($50,000 x 8% x 3/12).
Dec. 31 Interest Receivable
Interest Revenue
Adjusting entry for interest accrued from October 1 to December 31.

40. Rounded to nearest dollar ($79 a month)
Investments in Bonds
Adjusting entry for amortization of discount for July 1 to December 31: ($50,000 –$41,706)/105 x 6 months.
Dec. 31 Investment in Deitz Corp. Bonds
Interest Revenue
Rounded to nearest dollar ($79 a month)
Adjusting entry for amortization of discount from July 1 to December 31.

41. Investments in Bonds Investment Revenue Oct. 1 2,000 July 1 1,000
Dec. 31 1,000
3,474
Bal. 2,474

42. Investments in Bonds
The Deitz bonds are sold on June 30, 2012 for $47,350 plus accrued interest. It has been six months since the last amortization entry, so amortization for the current year must be recorded (6 months).
2012
June 30 Investment in Deitz Corp. Bonds
$79 x 6
Interest Revenue
Amortized discount for current year.

43. Investment in Deitz Corporation Bonds
Investments in Bonds
Investment in Deitz Corporation Bonds
2005
July 1 41,706
Dec
Dec
Dec
June ,342
$79 x 6
The investment account after all amortization entries have been made, including the June 30, 2012 adjusting entry.
$79 x 12
2006
2007
2008
2009
2010
2011
2012

44. Investments in Bonds
This investment was sold on June 30, 2009 for $47,350 plus accrued interest. It has been six months since the last amortization entry, so amortization for the current year must be recorded (6 months).
$50,000 x 8% x 3/12
2012
June 30 Cash
Loss on Sale of Investment
Interest Revenue
Investment in Deitz Corp. Bonds

45. Financial Analysis and Interpretation
Number of Times Interest Charges Earned

46. Solvency Measures—The Long-Term Creditor
Number of Times Interest Charges Earned
Income before income tax $ 900,000 $ 800,000
Add interest expense , ,000
Amount available for interest $1,200,000 $1,050,000
Income before income tax + Interest expense
Interest Expense
$800,000 + $250,000
$250,000
2005
= 4.2 times

47. Solvency Measures—The Long-Term Creditor
Number of Times Interest Charges Earned
Income before income tax $ 900,000 $ 800,000
Add interest expense , ,000
Amount available for interest $1,200,000 $1,050,000
Income before income tax + Interest expense
Interest Expense
$900,000 + $300,000
$300,000
2006
= 4.0 times

48. The purpose of the ratio is to assess the risk to debtholders in terms of number of times interest charges were earned.

49. Chapter 13
The End