Long-Term Liabilities: Bonds and Notes 12

Learning Objective Describe the nature of the adjusting process. Learning Objective Describe the nature of the adjusting process. Insert Chapter Objectives Long-Term Liabilities: Bonds and Notes 1 Compute the potential impact of long- term borrowing on earnings per share. 2 Describe the characteristics, and terminology of bonds payable. After studying this chapter, you should be able to: Journalize entries for bonds payable.

Describe and illustrate the reporting of long-term liabilities including bonds and notes payable Long-Term Liabilities: Bonds and Notes (continued) 4 Describe and illustrate the accounting for installment notes.

Compute the potential impact of long-term borrowing on earnings per share

Bond A bond is simply 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.

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

Earnings per share (EPS) measure 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 Data for Huckadee Corporation : 1.Earnings before interest and taxes are $800, The tax rate is 40%. 3.All bonds or stocks are issued at their par or face value. 1

Effect of Alternative Financing Plans—$800,000 earnings. 1 Exhibit 1

Effect of Alternative Financing Plans—$440,000 earnings. Exhibit 2

Gonzales Co., is considering the following alternative plans for financing their company: Plan 1 Plan 2 Issue 10% Bonds (at face)$2,000,000 Issue $10 Common Stock$3,000,000$1,000,000 Income tax is estimated at 40% of income. Determine the earnings per share of common stock under the two alternative financing plans, assuming income before bond interest and income tax is $750,000. Example Exercise 12-1 Alternative Financing Plans

Example Exercise 12-1 (continued) 1 Earnings before bond interest and income tax Bond interest Balance Income tax Net income Dividend on preferred stock Earnings available for common stock Number of common shares Earnings per share on common stock $750, ,000 $550, ,000 $330,000 0 $330,000 ÷100,000 Plan 2 (2,000,000 × 10%) ($550,000 × 40%) $750,000 0 $750, ,000 $450,000 0 $450,000 ÷300,000 Plan 1 $ 1.50 ($750,000 × 40%) $ For Practice: PE 12-1A, PE 12-1B Follow My Example 12-1

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. 2

Usually, the face value 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. 2 Bond Characteristics and Terminology

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. 2 Bond Characteristics and Terminology Bonds that may be exchanged for other securities are called convertible bonds.

Bonds that a corporation reserves the right to redeem before their maturity are called callable bonds. 2 Bonds issued on the basis of general credit of the corporation are debenture bonds. Bond Characteristics and Terminology

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. Proceeds from Issuing Bonds 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. 2

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

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

Journalize entries for bonds payable

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%. Bonds Issued at Face Amount 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, At this time, the corporation paid the face amount to the bondholder. 3

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%. Bonds Issued at a Discount 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 12-2 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 For Practice: PE 12-2A, PE 12-2B Follow My Example 6-1 Follow My Example 12-2 Cash……………………………………………936,420 Discount on Bonds Payable……………….63,580 Bonds Payable…………………………1,000,000

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. 3

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. Straight-Line Amortization * *$100,000 × 12% × 6/12 3

Example Exercise 12-3 Discount Amortization Using the bond from Example Exercise 12-2 (Slide 28), journalize the first interest payment and the amortization of the related bond discount For Practice: PE 12-3A, PE 12-3B Follow My Example 12-3 Interest Expense…………………………….36,358 Discount on Bonds Payable…………6,358 Cash…………...…………………………30,000 Paid interest and amortized the bond discount ($63,580 ÷ 10).

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 12-4 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 12-4 Cash……………………………………………2,154,440 Premium on Bonds Payable...……….154,440 Bonds Payable…………………………2,000, For Practice: PE 12-4A, PE 12-4B 3

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, Amortizing a Bond Premium 3 6,000.00

Example Exercise 12-5 Premium Amortization Using the bond from Example Exercise 12-4, journalize the first interest payment and the amortization of the related bond premium. Follow My Example 12-5 Interest Expense………………..……………104,556 Premium on Bonds Payable...……………..15,444 Bonds Payable…………………………120, For Practice: PE 12-5A, PE 12-5B 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,

Example Exercise 12-6 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 12-6 Bonds Payable...………………..……………….500,000 Loss on Redemption of Bonds..……………...15,000 Discount on Bonds Payable……………..40,000 Cash………………………………………….475, For Practice: PE 12-6A, PE 12-6B 3

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 consists of payment of a portion of the amount initially borrowed (the principal) and payment of interest on the outstanding balance. 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. 4

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 12-7 Journalizing Installment Notes 4 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. a.Journalize the entry to record the issuance of the installment note. b.Journalize the first annual note payment

Example Exercise 12-7 (continued) 4 a. b. For Practice: PE 12-7A, PE 12-7B Follow My Example 12-7

Describe and illustrate the reporting of long-term liabilities including bonds and notes payable

Number of Times Interest Charges are Earned = Income Before Income Tax + Interest Expense Interest Expense Number of Times Interest Charges are Earned = $152,366,000 + $42,091,000 $42,091,000 Number of Times Interest Charges are Earned = 4.62 Briggs and Stratton Corporation 5

Appendix 1: Present Value Concepts and Pricing Bonds Payable 12-52

Time Value of Money The time value of money concept recognizes that an amount of cash to be received today is worth more than the same amount of cash to be received in the future.

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

Present Value of $1 at Compound Interest Table value = Exhibit 4

Today End of Year 1 End of Year 2 $1,000 × $ Present Value of an Amount $1,000 10% payable annually A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years.

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

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.

Present Value of Annuity of $1 at Compound Interest $100 × = $ (the same answer that was determined by steps in Slide 57). Exhibit 5

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.

Present Value of $1 at Compound Interest Market Rate of Interest at 12% Exhibit 4 Present value of face amount of $100,000 due in 5 years……………….……………$ ?

Market Rate of Interest at 12% Present value of face amount of $100,000 due in 5 years ($100,000 × )…………... $ 55,840 Exhibit 4 Present Value of $1 at Compound Interest

Present Value of Annuity of $1 at Compound Interest Market Rate of Interest at 12% Exhibit 5 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………………………………………..?

Present value of 10 semiannual interest payments of $6,000 at 12% compounded semiannually ($6,000 × )………………..44,160 Market Rate of Interest at 12% Present Value of Annuity of $1 at Compound Interest Exhibit 5 Present value of face amount of $100,000 due in 5 years ($100,000 × )…………. $ 55,840

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 10 semiannual interest payments of $6,000 at 12% compounded semiannually ($6,000 × )……………….. 44,160 Total present value$100,000 Present value of face amount of $100,000 due in 5 years ($100,000 × )………….. $ 55,840

Present value of face amount of $100,000 due in 5 years ($100,000 × )……………$ 53,273 Market Rate of Interest at 13% Exhibit 4 Present Value of $1 at Compound Interest

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 Market Rate of Interest at 13% Present Value of Annuity of $1 at Compound Interest Exhibit 5

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 Market Rate of Interest at 13%

Present value of face amount of $100,000 due in 5 years ($100,000 × )…………$ 58,543 Market Rate of Interest at 11% Exhibit 4 Present Value of $1 at Compound Interest

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 Market Rate of Interest at 11% Present Value of Annuity of $1 at Compound Interest Exhibit 5

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 Market Rate of Interest at 11%

Appendix 2: Effective Interest Rate Method of Amortization 12-72

Effective Interest Rate Method The effective interest rate method of amortization provides for a constant rate of interest over the life of the bonds.

Amortization of Discount on Bonds PayableExhibit 6

The entry to record the first interest payment on June 30, 2009, and the related discount amortization is as follows:

Amortization of Premium on Bonds PayableExhibit 7

The entry to record the first interest payment on June 30, 2009, and the related premium amortization is as follows: