1. John J. Wild Seventh Edition
Financial Accounting
John J. Wild
Seventh Edition
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1

2. Reporting and Analyzing Long-Term Liabilities
Chapter 10
Reporting and Analyzing
Long-Term Liabilities
In this chapter, we will learn about issuing bonds at par, at a discount, and at a premium. We also learn about various ways to structure the payments on notes payable.

3. Advantages of Bonds Bonds do not affect owner control.
Interest on bonds is tax deductible.
There are several advantages for issuing bonds instead of stock. Companies issue bonds because it is a way to raise needed capital without sacrificing ownership in the company. The interest on bonds is tax deductible, thereby reducing the actual taxes paid by the company. Issuing bonds can increase the return on equity if the company earns a higher return on the borrowed funds than it pays in interest.
Bonds can increase return on equity.
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4. Disadvantages of Bonds
Bonds require payments of both periodic interest and par value at maturity.
On the other hand, there are some disadvantages to issuing bonds. Bonds require regular payment of interest and repayment of the principal borrowed. These required cash payments may be difficult if a company faces tight cash flows. Bonds can also decrease the return on equity if the company pays more in interest than it earns on the borrowed funds.
Bonds can decrease return on equity when the company pays more in interest than it earns on the borrowed funds.
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5. Bond-Issuing ProceduresA1
. . .an investment firm called an underwriter, resells the bonds to
A company can sell the bonds to
Bonds are securities that can be readily bought and sold. A large number of bonds are traded on the New York Exchange and the American Exchange. Since bonds are bought and sold in the market, they have a market value, or price. For convenience, bond market values are expressed as a percent of their par (or face) value.
When an underwriter sells bonds to a large number of investors, a trustee monitors the bond issue and protects the bondholders’ interests.
A trustee monitors the bond issue.
. . . investors
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6. Bond Interest Payments
Basics of Bonds A1
Bond Interest Payments
Corporation
Investors
Bond Interest Payments
Bonds are debt. They are similar to other debts a company issues. However, one difference is that state and federal laws govern bond issues. The legal document identifying the rights and obligations of both the bondholders and the issuer is called the bond indenture. The bond indenture is the legal contract between the issuer and the bondholders and specifies how often interest is paid.
On the issue date, the bondholders give the company the market value, or selling price of the bond. The company gives the bondholders a bond certificate.
At regularly scheduled dates during the life of the bond, the company pays the bondholders interest. Interest is calculated as bond par value times the contract interest rate on the bond times the length of time the bond has been outstanding during the year. Just like all interest rates, the contract interest rate is expressed on an annual basis.
At the maturity date, the company pays the bondholders the bond’s par value. Now, let’s see how to account for a bond issue.
Interest payment =
Bond par value ´ Contract interest rate x Time
Bond Issue Date
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7. Issuing Bonds at Par P1
King Co. issues the following bonds on January 1, 2013
Par value = $1,000,000
Stated interest rate = 10%
Interest dates = 6/30 and 12/31
Bond date = Jan. 1, 2013
Maturity date = Dec. 31, 2032 (20 years)
King Company issues bonds at par value. This means that the stated (contract) interest rate on the bond and the market interest rate on the bond are equal. The market rate is the prevailing rate of interest of all other equal investments sold on the same day King Company’s bonds were issued. King’s bonds have a par value of $1 million, a stated interest rate of 10% with interest payable on June 30 and December 31. The bonds are dated January 1, 2013, and mature 20 years later on December 31, 2032.
On the issue date, King would debit Cash and credit Bonds Payable for $1 million. The Bonds Payable account is always credited for the par, or maturity value of the bonds.
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8. Interest Expense on Bonds at Par
The entry on June 30, 2013, to record the first semiannual interest payment is . . .
On the first interest payment date, King would debit Bond Interest Expense and credit Cash for $50,000. The interest was calculated as par value times stated rate times months outstanding.
King will actually make this entry every six months until the maturity date.
Interest payment is: $1,000,000 × 10% × ½ year = $50,000 This entry is made every six months until the bonds mature.
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9. The debt has now been extinguished.
Issuing Bonds at Par P1
On Dec. 31, 2032 when the bonds mature, King Co. makes the following entry . . .
On the maturity date, King will repay the par value of the bonds by debiting Bonds Payable and crediting Cash for $1 million. At this time, the debt is extinguished.
The debt has now been extinguished.
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10. Bond Discount or Premium
Contract rate
Dow Chemical Company
$1,000
8.875% paid semiannually on 6/30 and 12/31
Due (matures) on 2033
In almost all cases, the stated (contract) rate and the market rate of interest will not agree. When these two interest rates are different, it might make sense to you for us to just change our stated rate to equal the market rate and then everything would be fine. Well, we can’t do that. Remember that the bond certificate lists all of the specifics about the bond including the interest rate. Because we have to print the bond certificates in advance, we are stuck having to pay the interest printed on the bond certificate.
The only thing that is not printed on the bond certificate is the selling price. So, the issuing company and the bond investors come to an agreement on the selling price that incorporates the difference in the stated interest rate and the market interest rate.
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11. Issuing Bonds at a DiscountP2
Prepare the entry for Jan. 1, 2013, to record the following bond issue by Rose Co. Par value = $1,000,000 Issue price = % of par value Stated interest rate = 10% Market interest rate = 12% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013
Maturity date = Dec. 31, 2017 (5 years) }
Bond will sell at a discount.
In this example, Rose Company is issuing bonds with a par value of $1 million and a stated interest rate of 10% with interest payable semiannually on June 30 and December 31. However, the market interest rate on the issue date for financial instruments with similar risk is 12%.
Now, if our bond is paying 10% and the market is paying 12%, how many investors will want to buy our bonds? None! So, we have to make our bonds more attractive by reducing the selling price to make up the difference in the interest rates.
In this example, Rose Company sells its bonds for % of its par value. This discount in the selling price raises the effective interest rate that the investors will earn to 12%. The effective rate is the actual rate of return being earned by the bond holder.
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12. Issuing Bonds at a DiscountP2
$1,000,000 ´ %
Rose will receive cash of $926,405 from the bond investors. The difference between the par value of the bonds and the cash price received is the discount that we offered the bond investors.
Remember that the whole reason we offered the discount is because of the difference between the stated (contract) rate and the market rate of interest. As a result, the discount represents an additional interest factor that will be amortized or systematically allocated, to interest expense over the life of the bond. Amortizing the discount will increase the total interest expense recorded for the bond to equal 12%, the market rate of interest.
Amortizing the discount increases interest expense over the outstanding life of the bond.
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13. Issuing Bonds at a DiscountP2
On Jan. 1, 2013, Rose Co. would record the bond issue as follows:
On the issue date, Rose will debit Cash for the amount of the cash proceeds, credit Bonds Payable for the par value of the bonds issued, and debit Discount on Bonds Payable for the difference between the two.
Discount on Bonds Payable is a contra-liability account and has a normal debit balance. As can be seen on this slide, immediately after the issuance, the Bonds Payable account should have a credit balance and the Discount on Bonds Payable account would have a debit balance.
Discount on Bonds Payable
Bonds Payable
Contra-Liability
Account
1,000,000
73,595
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14. $73,595 ÷ 10 periods = $7,360* *(rounded)
Making the First Interest Payment and Amortizing the Discount P2
Maturity Value
On the balance sheet, the amount of the unamortized discount, or that which has not yet been allocated to interest expense, is subtracted from the par value of the bonds to arrive at the current carrying value of the bonds.
Using the straight-line method to amortize the discount, Rose will divide the amount of the discount by the number of interest payment periods during the bond’s life. Since this is a five-year bond and it pays interest semiannually, there are 10 interest payment periods. This calculation determines that the discount amortization will be $7,360 at every interest payment date.
Carrying Value
Using the straight-line method, the discount amortization will be $7,360 every six months.
$73,595 ÷ 10 periods = $7,360* *(rounded)
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15. Making the First Interest Payment and Amortizing the Discount
Make the following entry every six months to record the cash interest payment and the amortization of the discount.
Every six months, Rose will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. It is calculated as par value times the stated interest rate times one half of a year. The credit to the Discount on Bonds Payable account is determined using the straight-line method we discussed on the previous slide. The debit to Bond Interest Expense is the total of the two credit amounts in this entry.
$73,595 ÷ 10 periods = $7,360 (rounded)
$1,000,000 × 10% × ½ = $50,000
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16. Straight-Line Amortization of Bond DiscountP2
An amortization table illustrates the interest payment, interest expense, discount amortization, unamortized discount balance, and the carrying value of the bond for each interest payment period over the life of the bond.
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17. Straight-Line and Effective Interest MethodsP2
Straight-Line and Effective Interest Methods
Periodic interest amounts will differ but total interest expense, over the life of the bond, will be the same. $
Instead of using the straight-line method to amortize the discount, some companies use the effective interest method. The effective interest method applies the market interest rate to the carrying value of the bond to determine the amount of amortization for the period. The effective interest method of amortizing a discount or premium is discussed in the appendix of your textbook. In the graph depicted on this slide, the amount of interest expense will vary if a company uses the effective method, but under the straight-line method, the interest expense is the same each period.
Whether a company uses the straight-line method or the effective interest method, the total interest expense recorded over the life of the bond is the same.
Life of the Bond
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18. Issuing Bonds at a Premium
Prepare the entry for Jan. 1, 2013, to record the following bond issue by Rose Co. Par value = $1,000,000 Issue price = % of par value Stated interest rate = 10% Market interest rate = 8% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013
Maturity date = Dec. 31, 2017 (5 years) }
Bond will sell at a premium.
In this example, Rose Company is issuing bonds with a par value of $1 million, a stated interest rate of 10 percent with interest payable semiannually on June 30 and December 31. However, the market interest rate on the issue date for financial instruments with similar risk is 8%.
Now, if our bond is paying 10%, and the market is paying 8%, how many investors will want to buy our bonds? All of them! So, we can increase the price of our bonds and they will still be attractive to the bond investors.
In this example, Rose company sells its bonds for % of its par value. This premium in the selling price reduces the effective interest rate that the investors will earn to 8%.
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19. Issuing Bonds at a Premium
$1,000,000 ´ %
Rose will receive cash of $1,081,145 from the bond investors. The difference between the par value of the bonds and the cash price received is the premium we charged the bond investors.
Remember that the whole reason we could offer the premium is because of the difference between the stated rate and the market rate of interest. As a result, the premium represents a reduction in the interest expense recorded over the life of the bond. Amortizing the premium will decrease the total interest expense recorded for the bond to equal 8%, the market rate of interest.
Amortizing the premium decreases interest expense over the life of the bond.
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20. Issuing Bonds at a Premium
On Jan. 1, 2013, Rose Co. would record the bond issue as follows.
On the issue date, Rose will debit Cash for the amount of the cash proceeds, credit Bonds Payable for the par value of the bonds issued, and credit Premium on Bonds Payable for the difference between the two.
Premium on Bonds Payable is an adjunct-liability, or accretion account, and has a normal credit balance.
The T-accounts illustrate how the Bonds Payable account and the Premium on Bonds Payable account would look immediately after the issuance of the bond.
Adjunct-Liability
(or accretion)
Account
Premium on Bonds Payable
Bonds Payable
1,000,000
81,145
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21. $81,145 ÷ 10 periods = $8,115 (rounded)
Making the First Interest Payment and Amortizing the Bond Premium P3
Maturity Value
Using the straight-line method, the premium amortization will be $8,115 every six months.
$81,145 ÷ 10 periods = $8,115 (rounded)
On the balance sheet, the premium account is added to the par value of the bonds to arrive at the current carrying value of the bonds.
Using the straight-line method to amortize the premium, Rose will divide the premium by the number of interest payment periods during the bond’s life. Since this is a five-year bond and it pays interest semiannually, there are 10 interest payment periods. This calculation determines that the premium amortization will be $8,115 at every interest payment date.
Carrying Value
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22. $81,145 ÷ 10 periods = $8,115 (rounded)
Making the First Interest Payment and Amortizing the Bond Premium P3
This entry is made every six months to record the cash interest payment and the amortization of the premium.
Every six months, Rose will make this entry. The credit to Cash is for the actual amount of cash interest paid to the bondholders. It is calculated as par value times the stated interest rate times one-half of a year. The debit to the Premium on Bonds Payable account is determined using the straight-line method we discussed on the previous slide. The debit to Bond interest expense is the amount of the cash credit less the bond premium amortization.
$81,145 ÷ 10 periods = $8,115 (rounded)
$1,000,000 × 10% × ½ = $50,000
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23. Straight-Line Amortization of Bond Premium
An amortization table illustrates the interest payment, interest expense, premium amortization, unamortized premium balance, and the carrying value of the bond for each interest payment period over the life of the bond.
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24. P4
Bond Retirement
The carrying value of the bond at maturity always equals its par value.
Sometimes bonds are retired prior to their maturity.
Two common ways to retire bonds before maturity are through the exercise of a callable option or through purchasing them on the open market.
Callable bonds present several accounting issues including calculating gains and losses.
Bonds are eventually retired. This can be through the payment of the principal at maturity or through calling the bond in before maturity. Bonds may also be retired early if there is a conversion feature that allows the bonds to be retired in exchange for stock.
When bonds are paid off at maturity, the carrying value of the bond will equal the par value and the journal entry to record the transaction simply involves a debit to Bonds Payable and a credit to Cash.
Issuers sometimes wish to retire some or all of their bonds prior to maturity. Most of the time this results in a gain or loss depending on what the price of the bond is at the time it is called. Two common ways to retire bonds before maturity are through the exercise of a callable option or through repurchasing them on the open market. These types of early retirements usually result in gains or losses that require additional calculations and journal entries.
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25. Bond Retirement Before MaturityP4
Before Maturity
Carrying value > Retirement price = Gain
Carrying value < Retirement price = Loss
On the maturity date, the issuing company debits Bonds Payable and credits Cash for the par value of the bond.
If bonds are retired before the maturity date, a gain or loss is recorded. The gain or loss is determined by comparing the carrying value of the bond on the retirement date with the cash price paid to retire the bonds.
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26. Long-Term Notes PayableC1
Cash
Note Payable
Company
Lender
When is the repayment of the principal and interest going to be made?
Now, let’s change topics and discuss long-term notes payable.
Notes are typically transacted between a company and a single lender, such as a bank.
When the note payable is issued, the lender provides the cash to the company and the company signs a note payable contract agreeing to repay the principal plus interest.
Let’s look at two common ways to structure the repayment of the principal and the interest.
Note Issuance Date
Note Maturity Date
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27. Long-Term Notes PayableC1
Single Payment of Principal plus Interest (at maturity)
Company
Lender
Single Payment of Principal plus Interest
For some notes, the note principal and interest are paid in a single payment at the end of the note term.
Note Issuance Date
Note Maturity Date
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28. Long-Term Notes PayableC1
Regular Payments of Principal plus Interest
(Over the life of the bond)
Company
Lender
Regular Payments of Principal plus Interest
Other notes require regular payments during the note term. In some cases, the regular payments consist of equal principal payments plus interest. In other cases, the regular payments consist of equal payments that include both principal payments and interest payments.
Most car loans are like this latter example. The payment is the same every month and consists of interest and some principal payment.
Payments can either be equal principal payments plus interest or equal payments.
Note Issuance Date
Note Maturity Date
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29. Installment Notes with Equal Principal Payments
C1, P5
Annual payments decrease.
In cases where the payments include equal principal payments, the payment amounts decrease over time as interest expense decreases. The journal entry to record the payment would include a debit to Note Payable for $10,000 for the principal being paid, a debit to the Interest Expense account for the amount of interest, and a credit to Cash for the total payment being made.
The principal payments are $10,000 each year.
Interest expense decreases each year.
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30. Installment Notes with Equal PaymentsC1
Annual payments are constant.
In cases where the payments are equal, the amount of the principal payment increases each year as the interest expense payment decreases.
The principal payments increase each year. Interest expense decreases each year.
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31. Mortgage Notes and BondsP5
A legal agreement that helps protect the lender if the borrower fails to make the required payments.
Gives the lender the right to be paid out of the cash proceeds from the sale of the borrower’s assets specifically identified in the mortgage contract.
A mortgage is a legal agreement that helps protect a lender if the borrower fails to make required payments on bonds or notes.
A mortgage gives the lender the right to be paid from the cash proceeds of the sale of a borrower’s assets specifically identified in the mortgage contract.
Most home loans have a mortgage contract that gives the lender the right to sell the house and be paid out of the cash proceeds if the borrower defaults on the loan payments.
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32. Convertible and/or Callable
Types of Bonds A2
Secured or Unsecured
Convertible and/or Callable
Term or Serial
Registered or Bearer
There are several common types of bonds.
Secured bonds have specific assets of the issuer pledged as collateral. Unsecured bonds are backed by the issuer’s general credit standing.
Term bonds are scheduled for maturity on one specified date. Serial bonds mature at more than one date.
Registered bonds are issued in the names and addresses of their holders. Bearer bonds are payable to whoever holds the bond.
Convertible bonds can be exchanged for a fixed number of shares of the issuing corporation’s common stock. Callable bonds have an option exercisable by the issuer to retire them at a stated dollar amount prior to maturity.
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33. Debt-to-Equity Ratio A3
Total liabilities
Debt-to- Equity ratio =
Total equity
A measure to assess the risk of a company’s financing structure.
Industries that are more variable and less stable tend to have lower ratios, while more stable industries tend to have higher ratios.
Beyond assessing different characteristics of debt, investors want to know the level of debt, especially in relation to total equity. Such knowledge helps them assess the risk of a company’s financing structure. A company financed mainly with debt is more risky because liabilities must be repaid—usually with periodic interest—whereas equity financing does not. A measure to assess the risk of a company’s financing structure is the debt-to-equity ratio.
We calculate the ratio by dividing total liabilities by total equity.
The debt-to-equity ratio varies across companies and industries. Industries that are more variable and less stable tend to have lower ratios, while more stable industries tend to have higher ratios.
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34. Figuring the Present Value of a BondC2
Figuring the Present Value of a Bond
Calculate the issue price of Rose Co.’s bonds.
Par value = $1,000,000
Issue price = ?
Stated interest rate = 10%
Market interest rate = 12%
Interest dates = 6/30 and 12/31
Bond date = Jan. 1, 2013
Maturity date = Dec. 31, 2017 (5 years)
In our previous examples, we provided the selling price of the bonds. But how did we determine those prices? To compute the price of a bond, we apply present value concepts.
We know the following information related to the bond:
Par value to be received at maturity.
Interest payments determined using the stated interest rate.
Number of interest payment periods.
Market rate of interest.
Let’s see how we use this information to determine the price of a bond.
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35. Figuring the Present Value of a BondC2
1. Semiannual rate = 6% (Market rate 12% ÷ 2)
2. Semiannual periods = 10 (Bond life 5 years × 2)
The price of the bond is made up of two factors:
 The present value of the par value paid at maturity.
 The present value of the series of interest payments over the life of the bond.
For Rose, the par value is $1 million. To find the present value of the par value, we can use the Present Value of 1 Table or a calculator. The future value is $1 million, the time is 10 periods, and the market interest rate for each semiannual period is 6%. If we use the Present Value of 1 table, we find an interest factor of When we multiply this interest factor times the par value of $1 million, we get the present value.
To find the present value of the interest payments, we can use the Present Value of an Annuity of 1 table or a calculator. The annuity is $50,000, the time is 10 periods, and the market interest rate for each semiannual period is 6%. If we use the Present Value of an Annuity of 1 table, we find an interest factor of When we multiply this interest factor times the interest annuity of $50,000, we get the present value of the bonds.
If we add the two present value amounts calculated together, we get the selling price of the bond.
$1,000,000 × 10% × ½ = $50,000
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36. Effective Interest Method of Amortizing a Discount or Premium
P6, P7
The effective interest method allocates total bond interest expense over a changing carrying value. It yields a constant rate of interest over the life of the bond equal to the market rate at time of issuance.
The method discussed earlier to write-off or amortize a bond’s discount or premium was called the straight-line method. There is an alternative method to write-off the discount or premium. It is called the effective interest method. The straight-line method yields changes in the bonds’ carrying value while the amount for bond interest expense remained constant.
The effective interest method allocates total bond interest expense over the bonds’ life in a way that yields a constant rate of interest. This constant rate of interest is the market rate at the issue date. Thus, bond interest expense for a period equals the carrying value of the bond at the beginning of that period multiplied by the market rate when issued, times the period of time for which interest is being figured.
Interest Expense =
Carrying Value of the bond x Market Rate x Time
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37. Issuing Bonds between Interest DatesC3
Apr. 1, 2013 Bond Issue Date
June 30, 2013 First Interest Payment
Jan. 1, Bond Date
Accrued interest
One complicating factor that can occur is the issuing of bonds between interest dates. This is a common occurrence because bonds are sold when there is a willing buyer and seller, and that can take place on any date, not just an interest payment date.
When bonds are issued between interest payment dates, the investor pays for the bond PLUS the accrued interest since the last interest payment date. This allows the issuing company to pay all the investors the same interest amount on the interest payment date.
Investor pays bond purchase price + accrued interest.
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38. Issuing Bonds between Interest DatesC3
Apr. 1, 2013 Bond Issue Date
June 30, 2013 First Interest Payment
Jan. 1, Bond Date
Accrued interest
Earned interest
On the interest payment date, the investor receives the full interest payment for the period even though the bond was only outstanding for a portion of the period. The interest payment actually represents two factors. One is a mere repayment of the accrued interest that the investor paid on the purchase date of the bond. The other is interest earned since the bond was purchased.
Let’s look at an example.
Investor receives 6 months’ interest.
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39. Issuing Bonds between Interest DatesC3
Issuing Bonds between Interest Dates
Prepare the entry to record the following bond issue by King Co. on Apr. 1, Par value = $1,000,000 Stated interest rate = 10% Market interest rate = 10% Interest dates = 6/30 and 12/31 Bond date = Jan. 1, 2013 Maturity date = Dec. 31, 2017 (5 years)
In this example, King Company is issuing bonds with a par value of $1 million and a stated interest rate of 10% with interest payable semiannually on June 30 and December 31. The market interest rate on the issue date for financial instruments with similar risk is 10%. The issue date for this bond is April 1, which is between interest payment dates.
Since the bonds will sell at par value, the cash amount received will include $1 million as the price for the bonds. The cash amount received will also include accrued interest since the last interest date. In this example, that would be $25,000. It is calculated as par value times stated interest rate times the time since the issue date of the bonds or the last interest payment date.
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40. Issuing Bonds between Interest DatesC3
At the date of issue, the following entry is made:
The first interest payment on June 30, 2013 is:
On the issue date, King will debit Cash for the total cash received as determined on the previous slide. It will credit Bonds Payable for the par value of the bonds and Interest Payable for the accrued interest amount received.
On the next interest payment date, King will credit Cash for the entire amount of interest due for six months. It will debit Interest Payable for the amount of the interest payment that represents a repayment of the accrued interest received on the issue date. And, it will debit Bond Interest Expense for the interest incurred since the bonds were issued.
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41. C3
Accruing Bond Interest Expense at Year End for a Partial Bond Interest Period.
End of accounting period
Interest Payment Dates
Jan. 1
Apr. 1
Oct. 1
Dec. 31
3 months’ accrued interest
When bond interest payment dates do not fall at year-end, an adjusting entry is required to record the bond interest expense and the bond interest payable that has accrued since the last interest payment date.
At year-end, an adjusting entry is necessary to recognize bond interest expense accrued since the most recent interest payment.
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42. End of Chapter 10
In this chapter we learned about issuing bonds at par, at a discount, and at a premium. We also learned about various ways to structure the payments on notes payable.
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