21–1McQuaig Bille

11College Accounting10th Edition

McQuaig Bille Nobles

© 2011 Cengage Learning

PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University

Chapter 21

Corporate Bonds

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Accounting LanguageAccounting Language A bond is a long-term obligation that provides

capital.

For all practical purposes, a bond is a long-term promissory note.

Bonds are recorded as Bonds Payable on the balance sheet of a corporation in the Long-Term Liabilities section.

A bond issue refers to the total number of bonds that a corporation issues at the same time.

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Accounting LanguageAccounting Language Bonds are issued in denominations of $1,000

or $5,000 each, with $1,000 being more common.

All bond payables have a face value, or the value that the corporation will pay at maturity.

The end of the life of a bond is called the maturity date and is the day the corporation agrees to pay the bondholders.

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Bonds Classified as to Time of PaymentBonds Classified as to Time of Payment

All term bonds of a particular issue have the same term, or time period to maturity.

Serial bonds of a particular issue have a series of maturity dates.

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Bonds Classified as to SecurityBonds Classified as to Security

When bonds are secured bonds, they are covered or collateralized by mortgages on real estate or by titles to personal property.

Unsecured bonds, also called debenture bonds, are backed only by the corporation’s credit standing, or good name.

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Advantages of Issuing BondsAdvantages of Issuing Bonds

1. The bond-issuing corporation has the prospect of earning a greater return on the money it raises than it has to pay out in interest. This is known as leverage.

2. Interest payments are tax-deductible expenses.

3. Bondholders cannot vote; therefore, the existing common stockholders retain control of the company’s affairs.

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Disadvantages of Issuing BondsDisadvantages of Issuing Bonds

1. Bondholders are creditors of the corporation, so interest payments must be made to bondholders each year.

2. The corporation must eventually pay back the principal of the bonds it issues, but does not have to repay the money it receives from issuing stock.

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Financing AlternativesFinancing Alternatives

Midwest Development Corp., which has 160,000 shares of $50-par common stock outstanding ($8,000,000), wishes to raise an additional $4,000,000 for expansion. Midwest Development Corp. is considering three alternatives for raising the money.

Plan 1 Issue an additional $4,000,000 of common stock, thereby increasing the total stock outstanding from 160,000 to 240,000 shares.

Plan 2 Issue $4,000,000 of 8 percent cumulative preferred stock.

Plan 3 Issue $4,000,000 of 7 percent bonds.

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Financing AlternativesFinancing Alternatives

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Accounting for the Issuance of BondsAccounting for the Issuance of Bonds

On January 1, Sean Construction Corporation issues $500,000 of 6 percent, 5-year bonds at face value, with interest payable semiannually, on June 30 and December 31.

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Accounting for the Issuance of BondsAccounting for the Issuance of Bonds

The interest payment is calculated as:

Face Value x Interest Rate x Time Period

The interest payment for the Sean Construction Corporation would be $15,000 ($500,000 x 0.06 x 6/12).

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Bonds Sold at a PremiumBonds Sold at a Premium

If a corporation offers a rate of interest that is higher than the market rate for similar securities, investors may be willing to pay a premium for the bonds.

On January 1, Sean Construction Corporation issues $750,000 of 9 percent, 10-year bonds at 103, with interest payable semiannually, on June 30 and December 31.

The term “103” refers to the price of the bonds, it is a percentage of the face value.

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Bonds Sold at a PremiumBonds Sold at a Premium

Selling the bonds at 103 provides $772,500 ($750,000 x 1.03) in cash.

Premium on Bond Payable represents the amount received over and above the face value of the bonds.

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Bonds Sold at a PremiumBonds Sold at a Premium

Premium on Bonds Payable is listed right below the bond account in the Long-Term Liabilities section of the balance sheet.

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Bonds Sold at a PremiumBonds Sold at a Premium

The corporation will write off or amortize Premium on Bonds Payable over the remaining life of the bond issue. Interest of $33,750 ($750,000 x 0.09 x 6/12) is paid on June 30.

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Bonds Sold at a PremiumBonds Sold at a Premium

The same entry is made again on December 31 to record the second semiannual interest payment.

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Adjusting Entry for Bonds Sold at a Premium

Adjusting Entry for Bonds Sold at a Premium

Amortization represents the write-off of the premium account and is calculated as:

Premium on Bonds Payable ÷ Bond Life The amortization each year for Sean Construction

Corporation would be $2,250 ($22,500 ÷ 10 years).

The entry in Slide 29 appears as an adjusting entry at the end of the fiscal period.

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Adjusting Entry for Bonds Sold at a Premium

Adjusting Entry for Bonds Sold at a Premium

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Adjusting Entry for Bonds Sold at a Premium

Adjusting Entry for Bonds Sold at a Premium

The balance in Interest Expense of $65,250 is the annual interest expense on the books.

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Bonds Sold at a Premium with Interest Payment Dates That Do Not Coincide

with the End of the Fiscal Year

Bonds Sold at a Premium with Interest Payment Dates That Do Not Coincide

with the End of the Fiscal Year On March 1, George’s Electronics issues $6,000,000

worth of 20-year, 9 percent bonds, at 104, dated March 1, with interest payable semiannually on September 1 and March 1.

The corporation’s fiscal year ends on December 31.

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Bonds Sold at a Premium with Interest Payment Dates That Do Not Coincide

with the End of the Fiscal Year

Bonds Sold at a Premium with Interest Payment Dates That Do Not Coincide

with the End of the Fiscal Year

The entry for March 1 of the first year, in general journal form, is shown below.

The remaining entries for the first year:

Bonds Sold at a Premium . . .Bonds Sold at a Premium . . . The amortization of the premium on December 31 is

for only part of a year. The next year, amortization will be for a full year.

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Bonds Sold at a Premium . . .Bonds Sold at a Premium . . .

Because the adjusting entry for accrued interest opened a new balance sheet account, Interest Payable, George’s Electronics’ accountant should make a reversing entry.

The reversing entry enables the accountant to follow the regular routine for the payment of six months’ interest on March 1.

The entries for the rest of the second year:

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The relevant T accounts from the previous year:

Bonds Sold at a DiscountBonds Sold at a Discount A corporation can also issue bonds that will pay a rate of

interest that is less than the prevailing market rate of interest for comparable bonds.

If this happens, the corporation is said to sell its bonds at a discount.

On January 1, Stewart, Inc., issues 6 percent , 20-year bonds with a face value of $700,000 at 96, with interest to be paid semiannually on June 30 and December 31.

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Bonds Sold at a DiscountBonds Sold at a Discount

Discount on Bonds Payable is a contra-liability account; it is listed on a classified balance sheet as a deduction from Bonds Payable.

Bonds Sold at a DiscountBonds Sold at a DiscountThe journal entries for the payment of interest semiannually on June 30 and December 31:

Adjusting Entry for Bonds Sold at a Discount

Adjusting Entry for Bonds Sold at a Discount

The amortization of Discount on Bonds Payable is calculated as:

Discount on Bonds Payable ÷ Bond Life

The adjusting entry to amortize one year of the $28,000 discount on the 20-year bonds issued by Stewart, Inc.:

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Adjusting Entry for Bonds Sold at a Discount

Adjusting Entry for Bonds Sold at a Discount

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Adjusting Entry for Bonds Sold at a Discount

Adjusting Entry for Bonds Sold at a Discount

The balance in Interest Expense of $43,400 is the annual interest expense on the books.

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Bond Sinking FundBond Sinking Fund

To provide greater security for bondholders, the bond agreement may specify that the issuing corporation make annual deposits of cash into a special fund—called a sinking fund—to be used to pay off the bond issue when it comes due.

The sinking fund may be controlled by either the corporation or a trustee—usually a bank.

Both Sinking Fund Cash and Sinking Fund Investments are classified as investment accounts.

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Bond Sinking FundBond Sinking Fund

Flores Development issues $800,000 worth of 10-year bonds dated January 1, with the provision that at the end of each of the 10 years, it will make an equal deposit into a sinking fund.

The company will manage it owns sinking fund; expecting to earn 6 percent each year.

An annual deposit of $60,693 will accumulate to approximately $800,000 in 10 years, given the 6 percent annual interest rate.

Bond Sinking FundBond Sinking Fund• Annual deposit of cash in bond sinking fund

• Purchase of investments

Bond Sinking FundBond Sinking Fund• Sale of investments

• Payment of bonds

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Bond Sinking FundBond Sinking Fund

• Receipt of income from investments

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Redemption of BondsRedemption of Bonds To protect itself against a decline in market interest

rates, a corporation may issue callable bonds. Callable bonds give the corporation the right—as

stipulated in the bond indenture, or agreement—too redeem or buy back the bonds at a specified figure—the call price—that is ordinarily higher than the face value.

When a corporation redeems its bonds at a price that is less than their book value, it realizes a gain.

If a corporation redeems its bonds at a price that is more than their book value, it incurs a loss.

The book value is the sum of Bonds Payable and Premium on Bonds Payable (or Bonds Payable less Discount on Bonds Payable).

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Seneri, Inc., has $500,000 worth of callable bonds outstanding on December 31, with a call price of 105; there is an unamortized discount of $2,000. Interest is paid on December 31 and exercises it options on the same date.

Redemption of BondsRedemption of Bonds

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Redemption of BondsRedemption of Bonds

Even if a corporation’s bonds are not callable, the firm can buy back the bonds—all of them, or as many as it can find, on the open market.

Vince Fabrics has $1,000,000 worth of 7 percent bonds outstanding, on which there is an unamortized premium of $30,000. On July 15, Vince Fabrics buys $100,000 of bonds (one-fourth of the original issue) in the open market at 97, plus15 days’ accrued interest.

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Redemption of BondsRedemption of Bonds

Gain on Redemption of Bonds is listed on the income statement under the Other Income heading.