© 2007 McGraw-Hill Ryerson Ltd. Electronic Presentations in Microsoft® PowerPoint® Bonds and Long-Term Notes Payable CHAPTER 17 Slides Content 1-3 Learning objectives 4-10 Bond types and issuing procedures 11-12 Bond pricing 13-18 Issuing bonds at par 19-20 Mini-quiz 21 Bond pricing 22-29 Bond discounts Bond premiums 31-32 Mini-quiz 33-39 Retirement of bonds 40-42 Long-term notes payable 43-44 Liabilities from leasing (appendix 17B) 45-48 Appendix 17B 49 End slide © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Bond A written promise to pay an amount identified as the par value of the bond along with interest at a stated annual amount. © 2007 McGraw-Hill Ryerson Ltd.

Bonds The stated interest rate is also referred to as the contract rate, nominal rate, or coupon rate. The rate is quoted as an annual rate. Annual amount of interest paid Par value Stated of the x rate of bond interest = © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Bonds Advantages of Bonds Bonds do not affect shareholder control. Interest on bonds is tax deductible. Bonds can increase return on equity. Disadvantages of Bonds Bonds require payment of both annual interest and par value at maturity. Bonds can decrease return on equity. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Bond Types Secured Bonds Assets are pledged as collateral by the issuing company. Unsecured Bonds Not backed by specific assets but only by earning capacity and credit reputation. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Bond Types Term Bonds Principal of all bonds is due in a lump sum at a specified single date. Serial Bonds Principal is due in installments at several different dates. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Bond Types Registered Bonds Bonds are issued in the names of the buyers. Ownership records are kept up to date. Bearer Bonds Bonds are payable to whoever possesses them. No records are kept for change in ownership. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Bond Types Convertible Bonds Allow the buyer to exchange the bond for common shares at a fixed ratio. Callable Bonds May be called for early retirement at the option of the issuing corporation. Redeemable Bonds May be retired early at the option of the purchaser. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Bond Pricing The issue price of a bond is equal to the present value of the bond’s future cash payments. Bonds may be exchanged in the market at a price equal to, below, or above the face value of the bond. This occurs when the market rate of interest is different from the stated (contract) rate. Bond market values are expressed as a percent of their par (face) value. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Bond Pricing Contract rate is: Bond sells: Above market rate At a premium (> 100% of face value) Equal to market rate At par value (= 100% of face value) Below market rate At a discount (< 100% of face value) © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Illustration: Issuing Bonds at Par Barnes Corp. issues $800,000 of 9%, 20-year bonds. The bonds are dated January 1, 2011, and are due in 20 years on January 1, 2031. Interest is paid semi-annually each June 30 and December 31. All the bonds are sold at their par value. On January 1, 2011, the date of issuance, the entry would be: Cash 800,000 Bonds Payable 800,000 © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Illustration: Issuing Bonds at Par On June 30, 2011, the first interest payment date, the entry would be: Bond Interest Expense 36,000 Cash 36,000 ($800,000 x 9% x 6/12) = $36,000 On January 1, 2031, the maturity date, the entry would be: Bonds Payable 800,000 Cash 800,000 © 2007 McGraw-Hill Ryerson Ltd.

Issuing Bonds Between Interest Dates When bonds are sold at a date other than the interest payment date, the purchaser pays the purchase price plus accrued interest. The issuing company repays the interest on the next interest date. © 2007 McGraw-Hill Ryerson Ltd.

Illustration: Issuing Bonds Between Interest Dates Canadian Tire has $100,000 of 9% bonds available for sale on January 1. Interest is payable on each June 30 and December 31. If the bonds are sold at par on March 1, two months after the original issue date of January 1, the issuer collects two months’ interest from the buyer at the time of sale. Jan. 1 Mar. 1 June 30 Date of Sale First Interest Date Accrued interest Stated Issue Date ($100,000 x 9% x 2/12) = $1,500 Purchaser pays face value plus accrued interest. © 2007 McGraw-Hill Ryerson Ltd.

On March 1, the date of issuance, the entry would be: Cash 101,500 Bonds Payable 100,000 Interest Payable 1,500 Jan. 1 Mar. 1 June 30 Stated Issue Date Date of Sale First Interest Date Accrued interest ($100,000 x 9% x 2/12) = $1,500 Purchaser pays face value plus accrued interest. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. On June 30, the first interest payment, the entry would be: Interest Payable 1,500 Bond Interest Expense 3,000 Cash 4,500 Jan. 1 Mar. 1 June 30 Stated Issue Date Date of Sale First Interest Date Accrued interest Interest expense ($100,000 x 9% x 2/12) = $1,500 ($100,000 x 9% x 4/12) = $3,000 © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Mini-Quiz Barnes Company issues $750,000, 9%, 20-year bonds. The current market rate is 8.5%. The total amount of interest owed to the bondholders for the semiannual interest payment is: A)$67,500.   B)$63,750.   C)$37,500. D)$33,750.   E)$31,875. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Mini-Quiz Barnes Company issues $750,000, 9%, 20-year bonds. The current market rate is 8.5%. The total amount of interest owed to the bondholders for the semiannual interest payment is: A)$67,500.   B)$63,750.   C)$37,500. D)$33,750.  ($750,000 x 9% x 6/12) E)$31,875. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Bond Pricing The issue price of the bond equals the present value of the future cash payments. 0 Per. 1 Per. 2 Per. 3 Per. 4 Per. 5 … .. .Maturity Int.Pmt. Int.Pmt Int.Pmt. Int.Pmt. Int.Pmt. Int.Pmt. Par Value Bond Price = Present Value of Maturity Payment + Present Value of the Interest Payments © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Illustration: Present Value of a Discount Bond Fila Corp. announces an offer to issue bonds with a $100,000 par value, an 8% annual contract rate with interest payable semi-annually, and with a three-year life. The cash flows of the bond are: 0 6mo. 12mo. 18mo. 24mo. 30mo. 36mo. $4,000* $4,000 $4,000 $4,000 $4,000 $4,000 $100,000 *Semi-annual interest payment = $100,000 x 8% x 6/12 © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Illustration: Present Value of a Discount Bond The issue price of the bond equals the present value of the future cash payments. The market rate for Fila’s bonds is 10%. Since the market rate is higher than the contract rate of 8%, the bonds will sell at a discount. 0 6mo. 12mo. 18mo. 24mo. 30mo. 36mo. $4,000 $4,000 $4,000 $4,000 $4,000 $4,000 $100,000 The present value of these cash payments is $94,923. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Illustration: Present Value of a Discount Bond Assume the bonds were issued on December 31. The entry to record the issuance would be: Cash 94,923 Discount on Bonds Payable 5,077 Bonds Payable 100,000 © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Illustration: Amortizing a Bond Discount The discount of $5,077 is eventually paid to the bondholders and represents part of the cost of using the $94,923 for three years. The discount is amortized over the life of the bonds using either the Straight-Line Method or the Effective Interest Method. © 2007 McGraw-Hill Ryerson Ltd.

Straight-Line Method An equal portion of the discount is allocated to each period. This yields a constant dollar amount of interest expense each period. Discount to be amortized each period Bond Discount Number of periods = © 2007 McGraw-Hill Ryerson Ltd.

Illustration: Straight-Line Method Fila Corp.’s bond discount of $5,077 is amortized over the life of the bonds. Periodic Amortization Bond Discount Number of periods = $5,077 6 periods = = $846/period The entry to record each interest payment would be: Bond Interest Expense 4,846 Discount on Bonds Payable 846 Cash 4,000 ($100,000 x 8% x 6/12) = $4,000 © 2007 McGraw-Hill Ryerson Ltd.

Effective Interest Method This method allocates bond interest expense over the life of the bonds that yields a constant rate of interest. The interest expense increases each period since the balance in the liability account increases each period. Periodic interest expense Carrying Value of Bonds Periodic Market Rate = x © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Illustration: Effective Interest Method First period interest expense Carrying Value of Bonds Periodic Market Rate = x = ($100,000 - $5,077) x 5%* = $4,746 *Semi-annual market rate The entry to record the first interest payment would be: Bond Interest Expense 4,746 Discount on Bonds Payable 746 Cash 4,000 © 2007 McGraw-Hill Ryerson Ltd.

Issuing Bonds at a Premium If the contract rate on a bond is greater than the market rate of interest, the bond will sell at a price above the bond’s par value. The difference between par value and market value is known as a premium. The premium is amortized over the life of the bond using either the Straight-Line Method or the Effective Interest Method. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Mini-Quiz The market value of a bond is equal to: A)The present value of all future cash payments provided by a bond.   B)The present value of all future interest payments provided by a bond.   C)The present value of the principal of the bond.   D)The future value of all future cash payments provided by a bond.   E)The future value of all future interest payments provided by a bond. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Mini-Quiz The market value of a bond is equal to: A)The present value of all future cash payments provided by a bond.   B)The present value of all future interest payments provided by a bond.   C)The present value of the principal of the bond.   D)The future value of all future cash payments provided by a bond.   E)The future value of all future interest payments provided by a bond. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Bond Retirements Bonds may be retired: At maturity, Before maturity, or By converting them to shares. © 2007 McGraw-Hill Ryerson Ltd.

Retirement of Bonds at Maturity The carrying value of bonds at maturity will always equal their par value. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Illustration: Retiring Bonds at Maturity Assume Hydro Quebec had $50,000 of bonds that matured on December 31, 2011, and that the final interest payment has already been made. The entry to record the retirement of the bonds would be: Bonds Payable 50,000 Cash 50,000 © 2007 McGraw-Hill Ryerson Ltd.

Retirement of Bonds Before Maturity Companies may wish to retire their bonds before maturity. This may be accomplished by either: Exercising a call option, or Purchasing the bonds on the open market. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Illustration: Retiring Bonds before Maturity Assume a company issued callable bonds with a par value of $100,000. The call option requires the issuer to pay a call premium of $3,000 to bondholders in addition to the par value. Assume all interest has been paid and the bonds have a carrying value of $104,500. The entry to record the retirement of the bonds would be: Bonds Payable 100,000 Premium on Bonds Payable 4,500 Gain on Retirement of Bonds 1,500* Cash 103,000 ($100,000 + $4,500) - $103,000 = $1500 © 2007 McGraw-Hill Ryerson Ltd.

Bond Retirement by Conversion to Shares Convertible bonds give bondholders the right to convert their bonds to a specified number of common shares. When conversion occurs, the carrying value of the bonds is transferred from long-term liability accounts to contributed capital accounts. No gain or loss on conversion is recorded. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Illustration: Bond Retirement by Conversion to Shares Assume a company has $100,000 par value bonds that have a $4,000 balance in the Discount on Bonds Payable account and these bonds are converted into 15,000 common shares. The entry to record the conversion of the bonds would be: Bonds Payable 100,000 Discount on Bonds Payable 4,000 Common Shares 96,000 © 2007 McGraw-Hill Ryerson Ltd.

Long-Term Notes Payable Notes payable are typically transactions with a single lender. Interest expense is allocated to each period. Interest expense for the period = Interest rate on the note x Beginning-of-period balance © 2007 McGraw-Hill Ryerson Ltd.

Long-Term Notes Payable Payment options: Interest and principal paid at maturity. Installment notes: Accrued interest plus equal principal payments. Equal payments. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Mortgage Notes A legal agreement that helps protect the lender if the borrower fails to make the required payments. Gives the lender the right to be paid out of the cash proceeds from the sale of the borrower’s assets specifically identified in the mortgage contract. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Review Compare the advantages and disadvantages of bond financing. Advantages of bond financing include tax-deductible interest, no dilution of shareholders' equity, and the increased earnings on shareholders' equity due to financial leverage. Disadvantages include repayment of principal, interest payments, and the risk of decreased earnings on shareholders' equity when operations are less profitable. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. Review Explain the amortization of bond discount. Bond discounts occur when bonds are sold for less than face or par value. The discount represents extra interest, since the full face value must be paid to bondholders at maturity. The amount of the bond discount is amortized over the life of the bond. The preferred method is the effective interest rate method. Bond interest expense is calculated by multiplying the bonds' beginning-of-the-period carrying value by the original market rate of the bonds. © 2007 McGraw-Hill Ryerson Ltd.

Lease Liabilities-Appendix 17B Leases may be classified as: Operating leases, or Capital leases. © 2007 McGraw-Hill Ryerson Ltd.

Lease Liabilities-Appendix 17B Operating Leases Lessee has obligation to make future lease payments but is not required to report this on the balance sheet. Note disclosure is required. Lessor retains all the risks of ownership. © 2007 McGraw-Hill Ryerson Ltd.

Lease Liabilities-Appendix 17B Capital Leases A lease qualifies as a capital lease if the lease terms meet any of the following criteria: The present value of the minimum lease payments is 90% or more of the fair value of the property at the inception of the lease. The lease term is 75% or more of the asset’s economic life. Ownership transfers to the lessee at the end of the lease term. The lease has a bargain purchase option allowing the lessee to purchase the asset at less than the fair market value. © 2007 McGraw-Hill Ryerson Ltd.

Lease Liabilities-Appendix 17B Capital Leases A capital lease is the economic equivalent of a purchase with financing arrangements. The lessee must report a leased asset and lease liability. Interest expense and amortization are reported on the income statement of the lessee. © 2007 McGraw-Hill Ryerson Ltd.

© 2007 McGraw-Hill Ryerson Ltd. End of Chapter © 2007 McGraw-Hill Ryerson Ltd.