Chapter 13 Bonds Payable and Investments in Bonds Financial and Managerial Accounting 8th Edition Warren Reeve Fess © 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. PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University

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.

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

Objectives 6. Journalize entries for bond redemptions. 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.

Financing Corporations

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

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

Alternative Financing Plans – $800,000 Earnings Plan 1 Plan 2 Plan 3 12 % bonds — — $2,000,000 Preferred 9% stock, $50 par — $2,000,000 1,000,000 Common stock, $10 par $4,000,000 2,000,000 1,000,000 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 bonds — — 240,000 Income before income tax $ 800,000 $ 800,000 $ 560,000 Deduct income tax 320,000 320,000 224,000 Net income $ 480,000 $ 480,000 $ 336,000 Dividends on preferred stock — 180,000 90,000 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

Alternative Financing Plans – $440,000 Earnings Plan 1 Plan 2 Plan 3 12 % bonds — — $2,000,000 Preferred 9% stock, $50 par — $2,000,000 1,000,000 Common stock, $10 par $4,000,000 2,000,000 1,000,000 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 tax 176,000 176,000 80,000 Net income $ 264,000 $ 264,000 $ 120,000 Dividends on preferred stock — 180,000 90,000 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

Characteristics of Bonds Payable A bond contract is called a bond indenture or trust indenture. Long-term debt—repayable 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.

Characteristics of Bonds Payable When 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. Bonds that may be exchanged for other securities are called convertible bonds. Bonds that a corporation reserves the right to redeem before maturity are callable bonds. Bonds issued on the basis of the general credit of the corporations are debenture bonds.

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.

The Present-Value Concept and Bonds Payable MARKET RATE = CONTRACT RATE Sell price of bond = $1,000 $1,000 10% payable annually

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

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

A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years. Interest payment $100 $1,000 10% payable annually Interest payment $100 Today End of Year 1 End of Year 2 $90.91 $100 x 0.90909 $82.65 $100 x 0.82645 $1,000 x 0.82645 $826.45 $1,000.00 (rounded)

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 0.82645 $ 826.45 Present value of 2 annual interest payments of 10% compounded annually: $100 x 1.73554 (PV of annuity of $1 for 2 years at 10%) 173.55 Total present value of bonds $1,000.00

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 0.55840 $ 55,840 Present value of 10 interest payments of $6,000 compounded semiannually: $6,000 x 7.3609 (PV of annuity of $1 for 10 periods at 6%) 44,160 Total present value of bonds $100,000

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 semiannual. The market rate of interest is 12%. 2005 Jan. 1 Cash 100 000 00 Bonds Payable 100 000 00 Issued $100,000 bonds payable at face amount.

Accounting for Bonds Payable Bonds Issued at Face Amount On June 30, an interest payment of $6,000 is made ($100,000 x .12 x 6/12). June 30 Interest Expense 6 000 00 Cash 6 000 00 Paid six months’ interest on bonds.

Accounting for Bonds Payable Bonds Issued at Face Amount The bond matured on December 31, 2009. At this time, the corporation paid the face amount to the bondholder. 2009 Dec. 31 Bonds Payable 100 000 00 Cash 100 000 00 Paid bond principal at maturity date.

Accounting for Bonds Payable Bonds Issued at a Discount Assume that the market rate of interest is 13% on the $100,000 bond rather than 12%. Present value of face amount of $100,000 due in 5 years at 13% compounded semiannually: $100,000 x 0.53273 (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 7.18883 (PV of annuity of $1 for 10 periods at 6½%) 43,133 Total present value of bonds $96,406

Accounting for Bonds Payable Bonds Issued at a Discount On January 1, 2005, the firm issued $100,000 bonds for $96,406 (a discount of $3,594). 2005 Jan. 1 Cash 96 406 00 Discount on Bonds Payable 3 594 00 Bonds Payable 100 000 00 Issued $100,000 bonds at discount.

Accounting for Bonds Payable Bonds Issued at a Discount On June 30, 2005, six-months’ interest is paid and the bond discount is amortized using the straight-line method. 2005 June 30 Interest Expense 6 359 40 Discount on Bonds Payable 359 40 Cash 6 000 00 $3,594 ÷ 10 Paid semiannual interest and amortized 1/10 of discount.

Accounting for Bonds Payable Bonds Issued at a Premium If the market rate of interest is 11% and the contract rate is 12%, the bond would sell for $103,769. Present value of face amount of $100,000 due in 5 years at 11% compounded annually: $100,000 x 0.58543 (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 7.53763 (PV of annuity of $1 for 10 periods at 5½%) 45,226 Total present value of bonds $103,769

Accounting for Bonds Payable Bonds Issued at a Premium Sold $100,000 of bonds for $103,769 (a premium of $3,769). 2005 Jan. 1 Cash 103 769 00 Bonds Payable 100 000 00 Premium on Bonds Payable 3 769 00 Issued $100,000 bonds at a premium.

Accounting for Bonds Payable Bonds Issued at a Premium On June 30, paid the semiannual interest and amortized the premium. 2005 June 30 Interest Expense 5 623 10 Premium on Bonds Payable 376 90 Cash 6 000 00 $3,769 x 1/10 Paid semiannual interest and amortized 1/10 of bond premium.

Accounting for Bonds Payable 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 0.53273 (PV of $1 for 10 periods at 6½%) $53,273

Accounting for Bonds Payable Zero-Coupon Bonds On January 1, 2005, Issue 5-year, $100,000 zero-coupon bonds when the market rate of interest is 13%. 2005 Jan. 1 Cash 53 273 00 Discount on Bonds Payable 46 727 00 Bonds Payable 100 000 00 Issued $100,000 zero- coupon bonds.

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.

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. 2005 June 30 Bonds Payable 25 000 00 Premium on Bonds Payable 1 000 00 Cash 24 000 00 Gain on redemption of Bonds 2 000 00 Retired bonds for $24,000.

Bond Redemption Instead, assume that the firm reacquired all of the bonds, paying $105,000. 2005 June 30 Bonds Payable 100 000 00 Premium on Bonds Payable 4 000 00 Loss on Redemption of Bonds 1 000 00 Cash 105 000 00 Retired bonds for $105,000.

Investments in Bonds

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.

Investments in Bonds On April 2, 2005, Purchased a $1,000 Lewis Company bond at 102 plus a brokerage fee of $5.30 and accrued interest of $10.20. 2005 Apr. 2 Investment in Lewis Co. Bonds. 1 025 30 Note that the brokerage fee is added to the cost of the investment. Interest Revenue 10 20 Cash 1 035 50 Invested in a Lewis Company bond.

Investments in Bonds To assist your understanding, let’s look at an extended illustration for Crenshaw, Inc.

Investments in Bonds 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, 2005. 2005 July 1 Investment in Deitz Corp. Bonds. 41 706 00 Interest Revenue 1 000 00 $50,000 x 8% x 3/12 Cash 42 706 00 Purchased investment in bonds, plus accrued interest.

Investments in Bonds Received semiannual interest for April 1 to October 1 ($50,000 x 8% x 6/12). Oct. 1 Cash 2 000 00 Interest Revenue 2 000 00 Received semiannual interest for April 1 to October 1.

Investments in Bonds Adjusting entry for interest accrued from October 1 to December 31 ($50,000 x 8% x 3/12). Dec. 31 Interest Receivable 1 000 00 Interest Revenue 1 000 00 Adjusting entry for interest accrued from October 1 to December 31.

Rounded to nearest dollar ($79 a month) Investments in Bonds Adjusting entry for amortization of discount for July 1 to December 31: ($50,000 –$41,706)/105 x 6 months. Dec. 31 Investment in Deitz Corp. Bonds 474 00 Interest Revenue 474 00 Rounded to nearest dollar ($79 a month) Adjusting entry for amortization of discount from July 1 to December 31.

Investments in Bonds Investment Revenue Oct. 1 2,000 July 1 1,000 Dec. 31 1,000 31 474 3,474 Bal. 2,474

Investments in Bonds 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). 2012 June 30 Investment in Deitz Corp. Bonds 474 00 $79 x 6 Interest Revenue 474 00 Amortized discount for current year.

Investment in Deitz Corporation Bonds Investments in Bonds Investment in Deitz Corporation Bonds 2005 July 1 41,706 Dec. 31 474 Dec. 31 948 Dec. 31 948 June 30 474 48,342 $79 x 6 The investment account after all amortization entries have been made, including the June 30, 2012 adjusting entry. $79 x 12 2006 2007 2008 2009 2010 2011 2012

Investments in Bonds 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). $50,000 x 8% x 3/12 2012 June 30 Cash 48 350 00 Loss on Sale of Investment 992 00 Interest Revenue 1 000 00 Investment in Deitz Corp. Bonds 48 342 00

Financial Analysis and Interpretation Number of Times Interest Charges Earned

Solvency Measures—The Long-Term Creditor Number of Times Interest Charges Earned 2006 2005 Income before income tax $ 900,000 $ 800,000 Add interest expense 300,000 250,000 Amount available for interest $1,200,000 $1,050,000 Income before income tax + Interest expense Interest Expense $800,000 + $250,000 $250,000 2005 = 4.2 times

Solvency Measures—The Long-Term Creditor Number of Times Interest Charges Earned 2006 2005 Income before income tax $ 900,000 $ 800,000 Add interest expense 300,000 250,000 Amount available for interest $1,200,000 $1,050,000 Income before income tax + Interest expense Interest Expense $900,000 + $300,000 $300,000 2006 = 4.0 times

The purpose of the ratio is to assess the risk to debtholders in terms of number of times interest charges were earned.

Chapter 13 The End