Long-Term Liabilities: Bonds and Notes Chapter 14 These slides should be viewed using the presentation mode (click the icon to start presentation).

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

Financing Corporations LO 1 Financing Corporations Corporations finance their operations using the following sources: Short-term debt, such as purchasing goods or services on account. Long-term debt, such as issuing bonds or notes payable. Equity, such as issuing common or preferred stock.

Financing Corporations LO 1 Financing Corporations A bond is 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.

Financing Corporations LO 1 Financing Corporations Huckadee Corporation is considering the following plans to issue debt and equity:

Financing Corporations LO 1 Financing Corporations In deciding among financing plans, the effect on earnings per share is often considered. Earnings per share (EPS) measures the income earned by each share of common stock. It is computed as follows: Earnings per Share = Net Income - Preferred Dividends Number of Common Shares Outstanding

Financing Corporations LO 1 Financing Corporations Assume the following data for Huckadee Corporation: Earnings before interest and income taxes are $800,000. The tax rate is 40%. All bonds or stocks are issued at their par or face amount.

Learning Objective 2 Compute the potential impact of long-term borrowing on earnings per share. Describe the characteristics and terminology of bonds payable.

Bond Characteristics and Terminology The underlying contract between the company issuing bonds and the bondholders is called a bond indenture or trust indenture.

Bond Characteristics and Terminology Usually, the face amount 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.

Bond Characteristics and Terminology When all bonds of an issue mature at the same time, they are called term bonds. If they mature over several dates, they are called serial bonds. Bonds that may be exchanged for other securities are called convertible bonds.

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

Proceeds from Issuing Bonds LO 2 Proceeds from Issuing Bonds When a corporation issues bonds, the proceeds received for the bonds depend on: The face amount of the bonds, which is the amount due at the maturity date. The interest rate on the bonds. The market rate of interest for similar bonds.

Proceeds from Issuing Bonds LO 2 Proceeds from Issuing Bonds The face amount and the interest rate on the bonds are identified in the bond indenture. The interest rate to be paid on the face amount of the bond is called the contract rate or coupon rate.

Proceeds from Issuing Bonds LO 2 Proceeds from Issuing Bonds The market rate of interest, 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 investors’ expectations of current and future economic conditions.

Proceeds from Issuing Bonds LO 2 Proceeds from Issuing Bonds Summary If the market rate equals the contract rate, bonds will sell at the face amount. If the selling price of the bonds is less than the face amount, the bonds are selling at a discount. If the selling price of the bonds is more than the face amount, the bonds are selling at a premium.

Proceeds from Issuing Bonds LO 2 Proceeds from Issuing Bonds The price of a bond is quoted as a percentage of the bond’s face value. A $1,000 bond quoted at 98 could be purchased or sold for $980 ($1,000 x 0.98). A $1,000 bond quoted at 109 could be purchased or sold for $1,090 ($1,000 x 1.09).

Learning Objective 3 Compute the potential impact of long-term borrowing on earnings per share. Describe the characteristics and terminology of bonds payable. Journalize entries for bonds payable.

Bonds Issued at Face Amount LO 3 Bonds Issued at Face Amount On January 1, 2011, Eastern Montana Communications Inc. issued the following bonds:

Bonds Issued at Face Amount LO 3 Bonds Issued at Face Amount Since the contract rate of interest and the market rate of interest are the same, the bonds will sell at their face amount.

Bonds Issued at Face Amount LO 3 Bonds Issued at Face Amount Every six months (on June 30 and December 31) after the bonds are issued, interest of $6,000 ($100,000 × 0.12 × 6/12) is paid.

Bonds Issued at Face Amount LO 3 Bonds Issued at Face Amount The bond matures on December 31, 2015. At this time, the corporation pays the face amount to the bondholders.

Bonds Issued at a Discount LO 3 Bonds Issued at a Discount On January 1, 2011, Western Wyoming Distribution Inc. issued $100,000, 12%, five-year bonds when the market rate was 13%. (Interest will be paid semiannually on June 30 and December 31.) Reminder:

Bonds Issued at a Discount LO 3 Bonds Issued at a Discount The firm issued the $100,000 bonds for $96,406 (a discount of $3,594). The discount may be viewed as the amount required by investors to accept a bond rate of interest below the market rate.

Amortizing a Bond Discount LO 3 Amortizing a Bond Discount The two methods of computing the amortization of a bond discount are: 1. Straight-line method 2. Effective interest rate method, sometimes called the interest method Both methods amortize the same total amount of discount over the life of the bonds.

Amortizing a Bond Discount LO 3 Amortizing a Bond Discount The effective interest rate method is required by generally accepted accounting principles. However, the straight-line method may be used if the results do not differ significantly from the interest method.

Amortizing a Bond Discount LO 3 Amortizing a Bond Discount On June 30, 2011, Western Wyoming Distribution Inc. pays six-months’ interest on the five-year bond issued earlier, and the bond discount is amortized ($3,594 × 1/10). The interest payment and amortization entries can be combined as follows: *$100,000 × 12% × 6/12

Bonds Issued at a Premium LO 3 Bonds Issued at a Premium On January 1, 2011, Northern Idaho Transportation Inc. issued $100,000, 12%, five-year bonds for $103,769. The market rate of interest is 11%. Reminder:

Amortizing a Bond Premium LO 3 Amortizing a Bond Premium The entry to record the first interest payment and the amortization of the premium on the $100,000, 12%, five-year bonds issued on January 1, 2011, is made on June 30, 2011. The combined entry is as follows: premium.

LO 3 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 at the price stated in the bond indenture. Normally, the call price is above the face value.

LO 3 Bond Redemption The carrying amount of bonds payable is the face amount of the bonds less any unamortized discount or plus any unamortized premium.

A gain or loss may be realized on a bond redemption as follows: A gain is recorded if the price paid for the redemption is below the bond carrying amount. A loss is recorded if the price paid for the redemption is above the carrying amount.

LO 3 Bond Redemption On June 30, 2011, a corporation has a bond issue of $100,000 outstanding, on which there is an unamortized premium of $4,000. The corporation redeems one-fourth of the bonds for $24,000. Gains on the redemption of bonds are reported in the Other Income section of the income statement.

LO 3 Bond Redemption The corporation calls the remaining $75,000 of outstanding bonds, which are held by a private investor, for $79,500 on July 1, 2011. Losses on the redemption of bonds are reported in the Other Loss section of the income statement.

Learning Objective 4 Compute the potential impact of long-term borrowing on earnings per share. Describe the characteristics and terminology of bonds payable. Journalize entries for bonds payable. Describe and illustrate the accounting for installment notes.

Payment of interest on the outstanding balance LO 4 Installment Notes 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 includes the following: Payment of a portion of the amount initially borrowed, called the principal Payment of interest on the outstanding balance

When a note is secured by an asset, it is called a mortgage note. LO 4 Installment Notes Installment notes are often used to purchase specific assets, such as equipment, and are often secured by the purchased asset. When a note is secured by an asset, it is called a mortgage note. If the borrower fails to pay a mortgage note, the lender has the right to take possession of the pledged asset.

Issuing an Installment Note LO 4 Issuing an Installment Note Lewis Company issues a $24,000, 6%, five-year note to City National Bank on January 1, 2010. The annual payment is $5,698.

The entry to record the first payment on LO 4 Annual Payments The entry to record the first payment on December 31, 2010, is as follows:

LO 4 Annual Payments The entry to record the second payment on December 31, 2011, is as follows:

The entry to record the final payment on LO 4 Annual Payments The entry to record the final payment on December 31, 2014, is as follows: After the entry is posted, the balance in Notes Payable related to this note is zero.

Learning Objective 5 Compute the potential impact of long-term borrowing on earnings per share. Describe the characteristics and terminology of bonds payable. Journalize entries for bonds payable. Describe and illustrate the accounting for installment notes. Describe and illustrate the reporting of long-term liabilities including bonds and notes payable.

Reporting Long-Term Liabilities

Learning Objective 6 Compute the potential impact of long-term borrowing on earnings per share. Describe the characteristics and terminology of bonds payable. Journalize entries for bonds payable. Describe and illustrate the accounting for installment notes. Describe and illustrate the reporting of long-term liabilities including bonds and notes payable. Describe and illustrate how the number of times interest charges are earned is used to evaluate a company’s financial condition.

LO 6 Number of Times Interest Charges are Earned Analysts assess the risk that bondholders will not receive their interest payments by computing the number of times interest charges are earned during the year as follows: Number of Times Interest Charges are Earned = Income Before Income Tax + Interest Expense Interest Expense

Number of Times Interest Charges are Earned LO 6 Number of Times Interest Charges are Earned Under Armour, Inc.’s 2008 annual report stated that the firm had interest expense of $850,000 and income before income taxes of $69,900,000. The number of times interest charges are earned for Under Armour, Inc., is computed as follows: Number of Times Interest Charges are Earned = $69,900,000 + $850,000 $850,000 = 83.24

Long-Term Liabilities: Bonds and Notes The End