Prepared by: C. Douglas Cloud Professor Emeritus of Accounting Pepperdine University Long-Term Liabilities: Bonds and Notes Chapter 12

Learning Objectives 1.Compute the potential impact of long-term borrowing on earnings per share. 2.Describe the characteristics and terminology of bonds payable. 3.Journalize entries for bonds payable. 4.Describe and illustrate the accounting for installment notes. 5.Describe and illustrate the reporting of long-term liabilities including bonds and notes payable. 6.Describe and illustrate how the number of times interest charges are earned is used to evaluate a company’s financial condition.

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

LO 1  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

 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. LO 1

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

 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: LO 1 Financing Corporations Earnings per Share = Net Income - Preferred Dividends Number of Common Shares Outstanding

LO 1 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. The effect of the preceding financing plans is shown in Exhibit 1 (next slide). Financing Corporations

LO 1 Highest EPS Financing Corporations

LO 1 Financing Corporations Highest EPS

Learning Objective 2 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.  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.  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. LO 2

 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. LO 2 Bond Characteristics and Terminology

Proceeds from Issuing Bonds LO 2  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.  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.

 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. LO 2 Proceeds from Issuing Bonds

LO 2 Proceeds from Issuing Bonds

LO 2 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.  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). LO 2 Proceeds from Issuing Bonds

Learning Objective 3 Journalize entries for bonds payable.

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

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

Bonds Issued at Face Amount LO 3 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. EMC

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

Bonds Issued at a Discount LO 3 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: Western Wyoming Distribution

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

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. LO 3

 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. 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: LO 3 Amortizing a Bond Discount $100,000 × 12% × 6/12 Western Wyoming Distribution

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%. LO 3 Reminder: Northern Idaho Transportation

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, The combined entry is as follows: premium. Northern Idaho Transportation

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.  The carrying amount of bonds payable is the face amount of the bonds less any unamortized discount or plus any unamortized premium.

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

Learning Objective 4 Describe and illustrate the accounting for installment notes.

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 LO 4

 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. Installment Notes LO 4

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

Annual Payments $24,000 x 0.06

LO 4 Annual Payments $5,698 – $1,440

LO 4 Annual Payments $24,000 – $4,258

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: 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. LO 4 Annual Payments

Learning Objective 5 Describe and illustrate the reporting of long- term liabilities including bonds and notes payable.

LO 5 Reporting Long-Term Liabilities

Learning Objective 6 Describe and illustrate how the number of times interest charges are earned is used to evaluate a company’s financial condition.

Number of Times Interest Charges are Earned LO 6  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 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

Appendix 1: Present Value Concepts and Pricing Bonds Payable

 When a corporation issues bonds, the price that investors are willing to pay for the bonds depends on:  The face amount of the bonds, which is the amount due at the maturity date.  The periodic interest to be paid on the bonds.  The market rate of interest. Present Value Concept/Pricing Bonds Payable App 1

Present Value Concept  The time value of money concept recognizes that an amount of cash received today is worth more than the same amount of cash to be received in the future.  Present value is the current worth of a future sum of money or stream of cash flows given a specified rate of return.  The amount to be received in the future if you make a deposit now is the future value. App 1

Today One Year from TODAY $1,000 10% payable annually Present Value of an Amount A $1,000, 10% bond is purchased. It pays interest annually and will mature in one year. App 1 Present value of $1,000 to be received one year from today

Present Value of an Amount App 1

Today One Year from TODAY $1,000 10% payable annually Present Value of an Amount App 1 Present value of $1,000 to be received one year from today $1,000 X = $ $909.09

Today End of Year 1 End of Year 2 $1,000 10% payable annually A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years. App 1 Present value of $1,000 to be received two years from today Present Value of an Amount

App 1

Present Value of an Amount App 1 Today End of Year 1 End of Year 2 $1,000 10% payable annually Present value of $1,000 to be received two years from today $1,000 X = $ $826.45

Present Value of the Periodic Receipts App 1  A series of equal cash receipts spaced equally in time is called an annuity.  The present value of an annuity is the sum of the present values of each cash receipt.

Assume that $100 is to be received annually for two years and that the market rate of interest is 10%. The next slide illustrates that the present value of the amount ($100) at 10% for one year and the present value of the amount ($100) at 10% for two years is summed to arrive at the present value of the annuity. Present Value of the Periodic Receipts App 1

Today End of Year 1 End of Year 2 Interest paymen t $100 Interest payment $100 $90.91 $100 × $ $100 × Present value, at 10%, of $100 interest payments to be received each year for 2 years (rounded) $ App 1 Present Value of the Periodic Receipts

 When the present value of an annuity (a series of equal cash receipts at fixed intervals) is involved, the present value of an annuity of $1 at compound interest (Exhibit 5) can be used. App 1 Present Value of the Periodic Receipts

App 1 $100 x = $ The same amount as derived earlier Present Value of the Periodic Receipts

Pricing Bonds Southern Utah Communications Inc. issued $100,000, 12%, five-year bonds on January 1, The bonds pay interest semiannually on June 30 and December 31. App 1

Market Rate of Interest at 12% Present value of face amount of $100,000 due in 5 years = $ ? App 1 6% used because the bonds are semiannual

Present value of face amount of $100,000 due in 5 years = $ ? App 1 10 semiannual periods in 5 years Market Rate of Interest at 12%

Present value of face amount of $100,000 due in 5 years ($100,000 × ) = $55,840. This amount gives us one part of the total present value of the bonds. App 1

Market Rate of Interest at 12% Next, we need to determine the present value of 10 semiannual interest payments of $6,000 at 12% compounded semiannually. App 1

Market Rate of Interest at 12% Present value of 10 semiannual interest payments of $6,000 at 12% compounded semiannually ($6,000 x ) = $ 44,160 App 1

When the face interest rate is the same as the market rate of interest, the total present value of the bonds will equal the total face value. Market Rate of Interest at 12% Present value of face amount of $100,000 due in 5 years ($100,000 × ) = $ 55,840 Present value of 10 semiannual interest payments of $6,000 at 12% compounded semiannually ($6,000 × ) = 44,160 Total present value of bonds$100,000 App 1

Market Rate of Interest at 13% Present value of face amount of $100,000 due in 5 years ($100,000 × ) = $ 53,273 App 1

Market Rate of Interest at 13% Present value of face amount of $100,000 due in 5 years ($100,000 × ) = $ 53,273 Present value of 10 semiannual interest payments of $6,000, at 13% compounded semiannually ($6,000 × ) = 43,133 App 1

Market Rate of Interest at 13% Present value of face amount of $100,000 due in 5 years ($100,000 × ) = $ 53,273 Present value of 10 semiannual interest payments of $6,000, at 13% compounded semiannually ($6,000 × ) = 43,133 Total present value of bonds $96,406 App 1

Market Rate of Interest at 11% Present value of face amount of $100,000 due in 5 years ($100,000 × ) = $58,543. App 1

Market Rate of Interest at 11% Present value of face amount of $100,000 due in 5 years ($100,000 × ) = $ 58,543 Present value of 10 semiannual interest payments of $6,000 at 11% compounded semiannually ($6,000 × ) = 45,226 App 1

Market Rate of Interest at 11% Present value of face amount of $100,000 due in 5 years ($100,000 × ) = $ 58,543 Present value of 10 semiannual interest payments of $6,000 at 11% compounded semiannually ($6,000 × ) = 45,226 Total present value of bonds $103,769 App 1

Appendix 2: Effective Interest Rate Method of Amortization

Effective Interest Rate Method  The effective interest rate method of amortization, sometimes called the interest method, provides for a constant rate of interest over the life of the bonds. App 2

Amortization of Discount App 2

The entry to record the first interest payment on June 30, 2011, and the related discount amortization is as follows: Amortization of Discount App 2

Amortization of Premium

The entry to record the first interest payment on June 30, 2011, and the related premium amortization is as follows: App 2