Long Term Liabilities: Bonds & Notes Chapter 12 Long Term Liabilities: Bonds & Notes

Financing operations: Short term debt accounts payable Long term debt bonds or notes payable Equity common or preferred stock

Bond Security representing money borrowed by a corporation from investors Must be repaid at maturity Periodic Interest payments often paid semiannually Issuance is authorized by Board of Directors Ranks ahead of stockholders for claims on corporation’ s assets 3

Financing Corporation Consider: Effect on Earnings per share on common stock Calculated as: Net income – Preferred Dividends # of common shares outstanding

Earnings per share on common stock Interest expense is deductible, dividends are not When calculating earnings per share, start with: Earnings before interest and taxes, because the bond interest will lower the Income before income tax amount

Earnings per share on common stock Earnings before interest and income tax Deduct: interest on bonds (face amount X face rate of interest) = Income before income tax Deduct: income tax (income before income tax X tax rate) = Net income Less: Dividend on preferred stock (%X par X # of shares) = Available for dividends on common stock Divide by # of shares of common stock = Earnings per share on common stock

Earnings per share on common stock The earnings per share will change based on Different earnings levels Different financing plans 7

Bond Vocabulary Terms Bond Indenture: contract between corporation and shareholders Term bonds: all bonds of bond issue mature at the same time Serial Bonds: maturities of bonds from a bond issue are spread over several dates Convertible bonds: bonds can be exchanged for common stock

Bond Vocabulary Terms Callable bonds: bonds that corporation can redeem before maturity Debenture bonds: bonds issued on corporation’s general credit Contract rate of interest: face interest rate; the interest rate used to calculate periodic interest payments Market rate of interest (effective rate): determined by buyers and sellers of similar bonds Affected by investors’ expectations of economic conditions

Price of Bonds Stated in terms of a percentage of face value (principal amount of bonds) Take the price as a percentage and multiply it by the face value Bonds can be issued At face value Price = 100 Above face value Price is greater than 100 Below face value Price is lower than 100

Bonds issued at face value Price = 100 Cash received is 100% X face value Market rate = Contract rate Journal entry Dr. Cash Cr. Bonds Payable

Cash received from bond issuance is less than face value Price of bonds is less than 100 Bonds are issued at a discount Market rate is higher than the contract rate Investors can earn more interest if they invest in something else Corporation takes amount off price of bond equal to the difference between the market interest amount and the contract interest amount

Cash received from bond issuance is less than face value Ex.: $10,000 bonds issued at a price of 98

Cash received from bonds issued is more than face value Price of bonds is higher than 100 Bonds are issued at a premium Market rate is lower than contract rate Investors can earn more interest on the bond than if they invest in something else Corporation adds amount to price of bond equal to the difference between the face interest amount and the market interest amount

Cash received from bonds issued is more than face value Ex.: $10,000 bonds issued at a price of 103

Balance Sheet Presentation Long term Liabilities Bonds Payable (face amount) + Premium on Bonds Payable **contra account = Carrying Value of bonds OR - Discount on Bonds Payable **contra account

Premium or discount needs to be zero at the maturity date By maturity date, the carrying value of the bonds needs to equal face value amount Premium or discount needs to be zero at the maturity date Amortization reduces the premium or discount

Methods of amortizing Straight line Effective interest: required under GAAP But, Straight-line can be used if the results are not significantly different

Amortization of Bond discount Amortization turns the bond discount into interest expense over the life of the bond Bond discount + actual interest payments (using contract rate) = Interest expense amount using the market rate So in effect, the market rate of interest is paid Market rate is also called effective rate

Amortization of Bond discount Can be done Annually OR At the time the interest payments are made

Amortization of Bond discount Straight line amortization calculated as: Bond discount . total # of interest payments (# of payments per year X the life of the bond) = amount of credit to Discount on Bonds Payable at interest payment journal entry

Amortization of Bond discount Journal entry at interest payment date Dr. Interest expense * * Amount equals the sum of Cash payment and amortization of discount

Amortization of Bond discount Journal entry at interest payment date Dr. Interest expense Cr. Discount on Bonds Payable * * Total discount / # of interest pmts

Amortization of Bond discount Journal entry at interest payment date Dr. Interest expense Cr. Discount on Bonds Payable Cr. Cash P X R X T R = Contract rate

Example Dr. Cr. Garland Corporation issued $8,000,000 in 8.5%, 5 year bonds on January 1 at 96.

Amortizing Bond Premium Amortization of the bond premium reduces interest expense over the life of the bond Bond premium - actual interest payments (using contract rate) = Interest expense amount using the market rate So in effect, the market rate of interest is paid to bondholders

Amortization of Bond premium Can be done Annually OR At the time the interest payments are made

Amortizing Bond Premium Straight line amortization calculated as: Bond premium . total # of interest payments (# of payments per year X the life of the bond) = amount of debit to Premium on Bonds Payable at interest payment journal entry

Amortization of Bond Premium Journal entry at interest payment date Dr. Interest expense * * Amount equals the Cash payment minus amortization of premium

Amortization of Bond Premium Journal entry at interest payment date Dr. Interest expense Dr. Premium on Bonds Payable * * Total premium / # of interest pmts

Amortization of Bond Premium Journal entry at interest payment date Dr. Interest expense Dr. Premium on Bonds Payable Cr. Cash P X R X T R = Contract rate

Example Dr. Cr. Meyer Inc. issued $1,000,000 in 6%, 10 year bonds on January 1 at 103. 32

Bond Redemption Callable bonds Bond indenture states the call price the price corporation has to pay to redeem the bonds Call price is typically above face value

Bond Redemption Compare carrying value of bonds to the cash paid to redeem the bonds to determine gain or loss Carrying value = Cash Paid to redeem the bonds = Face amount X Call Price as a %

Bond Redemption If Carrying value is greater than Cash Paid to redeem the bonds, then there will be a _______ If Cash Paid to redeem the bonds is greater than Carrying Value, then there will be a ________ Gains and losses on the redemption of bonds are reported as Other Income (Loss) on the Income Statement.

Bond Redemption Example: Bonds Payable has a balance of $100,000 and Discount on Bonds Payable has a balance of $1,250 Bonds are redeemed at 98 Cash Paid to redeem the bonds = Carrying value of bonds = Dr. Cr.

Bond Redemption Example: Bonds Payable has a balance of $100,000 and Premium on Bonds Payable has a balance of $2,800 Bonds are redeemed at 101 Cash Paid to redeem the bonds = Carrying value of bonds = Dr. Cr. 37

Installment Notes Used to: buy assets, such as equipment borrow cash Usually issued by a bank Mortgage note: secured by pledge of assets lender can take possession of the asset if borrower doesn’t pay

Installment notes Require a series of equal periodic payments to the lender A set periodic payment is calculated at the issuance of the note The payment is to be made at installment dates

Installment notes Each payment consists of: Principal: pay back a portion of the amount borrowed Interest on the outstanding balance

Interest portion of periodic payment Interest on the outstanding balance = Carrying value X interest rate % Carrying value of the note = outstanding balance = amount still owed on the note For the first payment, the carrying value = face value

Principal portion of periodic payment Periodic payment – Interest portion = Principal portion The carrying value of the note is reduced by the principal portion of the periodic payment For period’s after the first payment, the carrying value for the period = last period’s carrying value – last period’s principal portion of payment

Installment notes journal entries Dr. Cr. Issue notes: Asset being acquired (face amount) Notes Payable (face amount) Make periodic payments Interest Expense (CV X %) Notes Payable (Paymnent amount – interest) Cash (set payment amount)

Installment note example On the first day of the fiscal year, a company issue a $30,000, 10%, five-year installment note that for cash. The installment note has annual payments of $7,914.

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