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Chapter 13 Bonds Payable and Investments in Bonds Financial and Managerial Accounting 8th Edition Warren Reeve Fess PowerPoint Presentation by Douglas.

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Presentation on theme: "Chapter 13 Bonds Payable and Investments in Bonds Financial and Managerial Accounting 8th Edition Warren Reeve Fess PowerPoint Presentation by Douglas."— Presentation transcript:

1 Chapter 13 Bonds Payable and Investments in Bonds Financial and Managerial Accounting 8th Edition Warren Reeve Fess PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University © Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.

2 Some of the action has been automated, so click the mouse when you see this lightning bolt in the lower right-hand corner of the screen. You can point and click anywhere on the screen.

3 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. ObjectivesObjectives After studying this chapter, you should be able to:

4 6.Journalize entries for bond redemptions. ObjectivesObjectives 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.

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

7 Bondholders 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. Why issue bonds rather than stock? Why issue bonds rather than stock? Stockholders Two Methods of Long-Term Financing

8 Alternative Financing Plans – $800,000 Earnings Plan 1Plan 2Plan 3 12 % bonds$2,000,000 Preferred 9% stock, $50 par$2,000,0001,000,000 Common stock, $10 par$4,000,0002,000,0001,000,000 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 bonds240,000 Income before income tax$ 800,000$ 800,000$ 560,000 Deduct income tax320, ,000224,000 Net income$ 480,000$ 480,000$ 336,000 Dividends on preferred stock180,00090,000 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 1Plan 2Plan 3 12 % bonds$2,000,000 Preferred 9% stock, $50 par$2,000,0001,000,000 Common stock, $10 par$4,000,0002,000,0001,000,000 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 tax176,000176,00080,000 Net income$ 264,000$ 264,000$ 120,000 Dividends on preferred stock180,00090,000 Available for dividends$ 264,000$ 84,000$ 30,000 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 debtrepayable 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 4When 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. 4Bonds that may be exchanged for other securities are called convertible bonds. 4Bonds that a corporation reserves the right to redeem before maturity are callable bonds. 4Bonds 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 MARKET RATE > CONTRACT RATE Sell price of bond < $1,000 – Discount $1,000 10% payable annually

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

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

17 The Present-Value Concept and Bonds Payable OR 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%) 44,160 Total present value of bonds$100,000

19 Accounting for Bonds Payable 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%. Jan. 1Cash Issued $100,000 bonds payable at face amount. Bonds Payable Bonds Issued at Face Amount

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

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

22 Assume that the market rate of interest is 13% on the $100,000 bond rather than 12%. Accounting for Bonds Payable Bonds Issued at a Discount 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 On January 1, 2005, the firm issued $100,000 bonds for $96,406 (a discount of $3,594). Accounting for Bonds Payable Jan.1Cash Discount on Bonds Payable Issued $100,000 bonds at discount. Bonds Payable Bonds Issued at a Discount

24 On June 30, 2005, six-months interest is paid and the bond discount is amortized using the straight-line method. June30Interest Expense Paid semiannual interest and amortized 1/10 of discount. Discount on Bonds Payable Cash $3,594 ÷ 10 Accounting for Bonds Payable Bonds Issued at a Discount

25 If the market rate of interest is 11% and the contract rate is 12%, the bond would sell for $103,769. Accounting for Bonds Payable Bonds Issued at a Premium 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%) 45,226 Total present value of bonds$103,769

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

27 On June 30, paid the semiannual interest and amortized the premium. June30Interest Expense Premium on Bonds Payable Paid semiannual interest and amortized 1/10 of bond premium. Cash $3,769 x 1/10 Accounting for Bonds Payable Bonds Issued at a Premium

28 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 Accounting for Bonds Payable

29 On January 1, 2005, Issue 5-year, $100,000 zero-coupon bonds when the market rate of interest is 13%. Jan.1Cash Discount on Bonds Payable Issued $100,000 zero- coupon bonds. Bonds Payable Accounting for Bonds Payable 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. June 30Bonds Payable Premium on Bonds Payable Retired bonds for $24,000. Cash Gain on redemption of Bonds

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

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

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

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

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

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

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

41 Investment Revenue Oct.12,000 Dec. 311, ,474 July 11,000 Bal. 2,474 Investments in Bonds

42 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). June 30Investment in Deitz Corp. Bonds Amortized discount for current year. Interest Revenue Investments in Bonds $79 x 6

43 Investment in Deitz Corporation Bonds July 141,706 Dec Dec June , The investment account after all amortization entries have been made, including the June 30, 2012 adjusting entry. Investments in Bonds $79 x 6 $79 x 12

44 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). June 30Cash Loss on Sale of Investment Interest Revenue Investment in Deitz Corp. Bonds Investments in Bonds $50,000 x 8% x 3/12

45 Number of Times Interest Charges Earned Financial Analysis and Interpretation

46 Solvency MeasuresThe Long-Term Creditor Number of Times Interest Charges Earned Income before income tax$ 900,000$ 800,000 Add interest expense 300, ,000 Amount available for interest$1,200,000$1,050,000 Income before income tax + Interest expense Interest Expense $800,000 + $250,000 $250, = 4.2 times

47 Solvency MeasuresThe Long-Term Creditor Number of Times Interest Charges Earned Income before income tax$ 900,000$ 800,000 Add interest expense 300, ,000 Amount available for interest$1,200,000$1,050,000 Income before income tax + Interest expense Interest Expense $900,000 + $300,000 $300, = 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 The End Chapter 13


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