14 Long-Term Liabilities: Bonds and Notes Principles of Financial Accounting, 11e Reeve • Warren • Duchac

Describe the characteristics and terminology of bonds payable. 2 Describe the characteristics and terminology of bonds payable. 14-12

Bond Characteristics and Terminology 2 Bond Characteristics and Terminology The underlying contract between the company issuing bonds and the bondholders is called a bond indenture or trust indenture.

Proceeds from Issuing Bonds 2 Proceeds from Issuing Bonds The market 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.

MARKET RATE = CONTRACT RATE 2 MARKET RATE = CONTRACT RATE Selling price of bond = $1,000 If the contract rate equals the market rate of interest, the bonds will sell at their face amount.

MARKET RATE > CONTRACT RATE 2 MARKET RATE > CONTRACT RATE Selling price of bond < $1,000 Discount - If the market rate is higher than the contract rate, the bonds will sell at a discount.

MARKET < CONTRACT RATE 2 MARKET < CONTRACT RATE Selling price of bond > $1,000 Premium + If the market rate is lower than the contract rate, the bonds will sell at a premium.

Journalize entries for bonds payable. 3 Journalize entries for bonds payable. 14-21

Bonds Issued at Face Amount 3 Bonds Issued at Face Amount On January 1, 2009, Eastern Montana Communications Inc. issued for cash $100,000 of 12%, five-year bonds; interest payable semiannually. The market rate of interest is 12%.

3 Since the bond rate of interest and the market rate of interest are the same, the bonds will sell at their face amount.

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

3 The bond matured on December 31, 2013. At this time, the corporation paid the face amount to the bondholder.

Bonds Issued at a Discount 3 Bonds Issued at a Discount On January 1, 2009, Western Wyoming Distribution Inc. issued $100,000, 12% (paid semiannually on June 30 and December 31), five-year bonds when the market rate was 13%.

3 On January 1, 2009, the firm issued $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.

3 Example Exercise 14-2 Follow My Example 14-2 Follow My Example 6-1 Issuing Bonds at a Discount On the first day of the fiscal year, a company issues a $1,000,000, 6%, 5-year bond that pays semi-annual interest of $30,000 ($1,000,000 × 6% × ½), receiving cash of $936,420. Journalize the entry to record the issuance of the bonds. Follow My Example 6-1 Follow My Example 14-2 Cash…………………………………………… 936,420 Discount on Bonds Payable………………. 63,580 Bonds Payable………………………… 1,000,000 For Practice: PE 14-2A, PE 14-2B 14-28

Amortizing a Bond Discount 3 Amortizing a Bond Discount The two methods of computing amortization of a bond discount are as follows: 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.

Straight-Line Amortization 3 Straight-Line Amortization On June 30, 2009, six-months’ interest is paid and the bond discount is amortized ($3,594 × 1/10) on the five-year bond issued in Slide 27. * *$100,000 × 12% × 6/12

3 Example Exercise 14-3 Follow My Example 14-3 Discount Amortization Using the bond from Example Exercise 14-2 (Slide 28), journalize the first interest payment and the amortization of the related bond discount. Follow My Example 14-3 Interest Expense……………………………. 36,358 Discount on Bonds Payable………… 6,358 Cash…………...………………………… 30,000 Paid interest and amortized the bond discount ($63,580 ÷ 10). For Practice: PE 14-3A, PE 14-3B 14-31

Bonds Issued at a Premium 3 Bonds Issued at a Premium On January 1, 2009, Northern Idaho Transportation Inc. issued a $100,000, 12%, five-year bond for $103,769. The market rate of interest was 11%.

3 Example Exercise 14-4 Follow My Example 14-4 Follow My Example 6-1 Issuance of Bonds at a Premium A company issues a $2,000,000, 12%, five-year bond that pays semiannual interest of $120,000 ($2,000,000 × 12% × ½), receiving cash of $2,154,440. Journalize the bond issuance. Follow My Example 6-1 Follow My Example 14-4 Cash…………………………………………… 2,154,440 Premium on Bonds Payable...………. 154,440 Bonds Payable………………………… 2,000,000 For Practice: PE 14-4A, PE 14-4B 14-33

Amortizing a Bond Premium 3 Amortizing a Bond Premium The first entry to record the interest payment and the amortization of the $100,000, 12%, five-year bond issued on January 1, 2009 (Slide 32), is made on June 30, 2009. 6,000.00

3 Example Exercise 14-5 Follow My Example 14-5 Premium Amortization Using the bond from Example Exercise 14-4 (Slide 33), journalize the first interest payment and the amortization of the related bond premium. Follow My Example 14-5 Interest Expense………………..…………… 104,556 Premium on Bonds Payable...…………….. 15,444 Cash………………………… 120,000 For Practice: PE 14-5A, PE 14-5B 14-35

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

3 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. Gains and losses on the redemption of bonds are reported as Other Income (Loss).

3 The corporation calls the remaining $75,000 of outstanding bonds, which are held by a private investor, for $79,500 on July 1, 2009.

3 Example Exercise 14-6 Redemption of Bonds Payable A $500,000 bond issue on which there is an unamortized discount of $40,000 is redeemed for $475,000. Journalize the redemption of the bonds. Follow My Example 14-6 Bonds Payable...………………..………………. 500,000 Loss on Redemption of Bonds..……………... 15,000 Discount on Bonds Payable…………….. 40,000 Cash…………………………………………. 475,000 For Practice: PE 14-6A, PE 14-6B 14-39

Describe and illustrate the accounting for installment notes. 4 Describe and illustrate the accounting for installment notes. 14-40

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 consists of payment of a portion of the amount initially borrowed (the principal) and payment of interest on the outstanding balance.

Issuing an Installment Note 4 Issuing an Installment Note Lewis Company issues a $24,000, 6%, five-year note to City National Bank on January 1, 2008. The annual payment is $5,698.

4 Exhibit 3 Amortization of Installment Notes

4 The entry to record the first payment on December 31, 2008, is as follows: (Column C of Exhibit 3) (Column D of Exhibit 3)

4 The entry to record the second payment on December 31, 2009, is as follows: (Column C of Exhibit 3) (Column D of Exhibit 3)

4 The entry to record the final payment on December 31, 2012, is as follows: (Column C of Exhibit 3) (Column D of Exhibit 3) After the entry is posted, the balance in Notes Payable related to this note is zero.

4 Example Exercise 14-7 Journalizing Installment Notes On the first day of the fiscal year, a company issue a $30,000, 10%, five-year installment note that has annual payments of $7,914. The first payment consists of $3,000 of interest and $4,914 of principal repayment. Journalize the entry to record the issuance of the installment note. Journalize the first annual note payment. 14-47

4 Follow My Example 14-7 a. b. 14-48 For Practice: PE 14-7A, PE 14-7B Example Exercise 14-7 (continued) 4 Follow My Example 14-7 a. b. 14-48 For Practice: PE 14-7A, PE 14-7B