bonds payable and investments in bonds

49
Chapter Chapter 15 15 Bonds Payable and Bonds Payable and Investments in Bonds Investments in Bonds Accounting, 21 st Edition Warren Reeve Fess PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University © 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.

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Page 1: Bonds Payable and Investments in Bonds

Chapter Chapter 1515Bonds Payable and Bonds Payable and

Investments in BondsInvestments in BondsAccounting, 21st Edition

Warren Reeve Fess

PowerPoint Presentation by Douglas CloudProfessor Emeritus of AccountingPepperdine University

© 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.

Page 2: Bonds Payable and Investments in Bonds

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.

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.

Page 3: Bonds Payable and Investments in Bonds

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.

ObjectivesObjectivesObjectivesObjectives

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

Page 4: Bonds Payable and Investments in Bonds

6. Journalize entries for bond redemptions.

ObjectivesObjectivesObjectivesObjectives

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.

Page 5: Bonds Payable and Investments in Bonds
Page 6: Bonds Payable and Investments in Bonds

Two Methods of Long-Term FinancingTwo Methods of Long-Term FinancingTwo Methods of Long-Term FinancingTwo Methods of Long-Term Financing

Resources = Sources

Stockholders’Equity

Assets

Liabilities

Equity Financing: Stockholders

Debt Financing: Bondholders

Page 7: Bonds Payable and Investments in Bonds

Bondholders

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.

Why issue bonds rather than stock?Why issue bonds rather than stock?

Stockholders

Two Methods of Long-Term FinancingTwo Methods of Long-Term FinancingTwo Methods of Long-Term FinancingTwo Methods of Long-Term Financing

Page 8: Bonds Payable and Investments in Bonds

Alternative Financing Plans – $800,000 EarningsAlternative Financing Plans – $800,000 EarningsPlan 1 Plan 2 Plan 3

12 % bonds — — $2,000,000Preferred 9% stock, $50 par — $2,000,000 1,000,000Common stock, $10 par $4,000,000 2,000,000 1,000,000Total $4,000,000 $4,000,000 $4,000,000Earnings before interest

and income tax $ 800,000 $ 800,000 $ 800,000Deduct interest on bonds — — 240,000

Income before income tax $ 800,000 $ 800,000 $ 560,000Deduct income tax 320,000 320,000 224,000

Net income $ 480,000 $ 480,000 $ 336,000Dividends on preferred stock — 180,000 90,000Available 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

Page 9: Bonds Payable and Investments in Bonds

Alternative Financing Plans – $440,000 EarningsAlternative Financing Plans – $440,000 EarningsPlan 1 Plan 2 Plan 3

12 % bonds — — $2,000,000Preferred 9% stock, $50 par — $2,000,000 1,000,000Common stock, $10 par $4,000,000 2,000,000 1,000,000Total $4,000,000 $4,000,000 $4,000,000Earnings before interest

and income tax $ 440,000 $ 440,000 $ 440,000Deduct interest on bonds — — 240,000

Income before income tax $ 440,000 $ 440,000 $ 200,000Deduct income tax 176,000 176,000 80,000

Net income $ 264,000 $ 264,000 $ 120,000Dividends on preferred stock — 180,000 90,000Available 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

Page 10: Bonds Payable and Investments in Bonds

Characteristics of Bonds PayableCharacteristics of Bonds PayableCharacteristics of Bonds PayableCharacteristics of Bonds PayableA 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.

Page 11: Bonds Payable and Investments in Bonds

Characteristics of Bonds PayableCharacteristics of Bonds PayableCharacteristics of Bonds PayableCharacteristics 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.

Page 12: Bonds Payable and Investments in Bonds

The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable

The Present-Value Concept The Present-Value Concept and Bonds Payableand 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.

Page 13: Bonds Payable and Investments in Bonds

The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable

The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable

MARKET RATE = CONTRACT RATE

Sell price of bond = $1,000

$1,00010% payable

annually

Page 14: Bonds Payable and Investments in Bonds

The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable

The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable

MARKET RATE > CONTRACT RATE

Sell price of bond < $1,000

–Discount

$1,00010% payable

annually

Page 15: Bonds Payable and Investments in Bonds

The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable

The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable

MARKET < CONTRACT RATE

Sell price of bond > $1,000

+Premium

$1,00010% payable

annually

Page 16: Bonds Payable and Investments in Bonds

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 payment

$100Interest payment

$100

$90.91 $100 x 0.90909

$1,00010%

payable annually

$82.65 $100 x 0.82645

$1,000 x 0.82645$826.45

$1,000.00 (rounded)

Page 17: Bonds Payable and Investments in Bonds

The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable

The Present-Value Concept The Present-Value Concept and Bonds Payableand 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 paymentsof 10% compounded annually: $100 x 1.73554 (PV of annuity of $1 for 2 yearsat 10%) 173.55

Total present value of bonds $1,000.00

Page 18: Bonds Payable and Investments in Bonds

Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting 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

Page 19: Bonds Payable and Investments in Bonds

Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable

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%.

Jan. 1 Cash 100 000 00

Issued $100,000 bonds

payable at face amount.

Bonds Payable 100 000 00

2005

Bonds Issued at Face Amount

Page 20: Bonds Payable and Investments in Bonds

Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable

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

Paid six months’ interest on

bonds.

Cash 6 000 00

Bonds Issued at Face Amount

Page 21: Bonds Payable and Investments in Bonds

The bond matured on December 31, 2009. At this time, the corporation paid the face

amount to the bondholder.

Dec. 31 Bonds Payable 100 000 00

Paid bond principal at

maturity date.

Cash 100 000 00

2009

Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable

Bonds Issued at Face Amount

Page 22: Bonds Payable and Investments in Bonds

Assume that the market rate of interest is 13% on the $100,000 bond rather than 12%.

Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable

Bonds Issued at a Discount

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

Page 23: Bonds Payable and Investments in Bonds

On January 1, 2005, the firm issued $100,000 bonds for $96,406 (a discount of $3,594).

Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable

Jan. 1 Cash 96 406 00

Discount on Bonds Payable 3 594 00

Issued $100,000 bonds at

discount.

Bonds Payable 100 000 00

2005

Bonds Issued at a Discount

Page 24: Bonds Payable and Investments in Bonds

On June 30, 2005, six-months’ interest is paid and the bond discount is amortized using the straight-line method.

June 30 Interest Expense 6 359 40

Paid semiannual interest and

amortized 1/10 of discount.

Discount on Bonds Payable 359 40

Cash 6 000 00

2005

$3,594 ÷ $3,594 ÷ 1010

$3,594 ÷ $3,594 ÷ 1010

Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable

Bonds Issued at a Discount

Page 25: Bonds Payable and Investments in Bonds

If the market rate of interest is 11% and the contract rate is 12%, the bond would sell for $103,769.

Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable

Bonds Issued at a PremiumBonds Issued at a Premium

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

Page 26: Bonds Payable and Investments in Bonds

Sold $100,000 of bonds for $103,769 (a premium of $3,769).

Jan. 1 Cash 103 769 00

Issued $100,000 bonds at a

premium.

Bonds Payable100 000 00

Premium on Bonds Payable3 769 00

2005

Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable

Bonds Issued at a PremiumBonds Issued at a Premium

Page 27: Bonds Payable and Investments in Bonds

On June 30, paid the semiannual interest and amortized the premium.

June 30 Interest Expense 5 623 10

Premium on Bonds Payable 376 90

Paid semiannual interest and

amortized 1/10 of bond premium.

Cash 6 000 00

2005

$3,769 x 1/10$3,769 x 1/10$3,769 x 1/10$3,769 x 1/10

Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable

Bonds Issued at a PremiumBonds Issued at a Premium

Page 28: Bonds Payable and Investments in Bonds

Zero-Coupon BondsZero-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.

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 PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable

Page 29: Bonds Payable and Investments in Bonds

On January 1, 2005, Issue 5-year, $100,000 zero-coupon bonds when the

market rate of interest is 13%.

On January 1, 2005, Issue 5-year, $100,000 zero-coupon bonds when the

market rate of interest is 13%.

Jan. 1 Cash 53 273 00

Discount on Bonds Payable 46 727 00

Issued $100,000 zero-

coupon bonds.

Bonds Payable100 000 00

2005

Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable

Zero-Coupon BondsZero-Coupon Bonds

Page 30: Bonds Payable and Investments in 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.

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.

Page 31: Bonds Payable and Investments in Bonds

Bond RedemptionBond RedemptionBond RedemptionBond 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.

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.

June 30 Bonds Payable 25 000 00

Premium on Bonds Payable 1 000 00

Retired bonds for $24,000.

Cash 24 000 00

Gain on redemption of Bonds2 000 00

2005

Page 32: Bonds Payable and Investments in Bonds

Bond RedemptionBond RedemptionBond RedemptionBond Redemption

Instead, assume that the firm reacquired all of the bonds, paying $105,000.

Instead, assume that the firm reacquired all of the bonds, paying $105,000.

June 30 Bonds Payable 100 000 00

Premium on Bonds Payable 4 000 00

Loss on Redemption of Bonds 1 000 00

Retired bonds for $105,000.

Cash105 000 00

2005

Page 33: Bonds Payable and Investments in Bonds
Page 34: Bonds Payable and Investments in Bonds

Investments in BondsInvestments in BondsInvestments in BondsInvestments 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.

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.

Page 35: Bonds Payable and 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.

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.

Apr. 2 Investment in Lewis Co. Bonds. 1 025 30

Invested in a Lewis

Company bond.

Cash1 035 50

2005

Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds

Interest Revenue 10 20

Note that the brokerage fee is added to the cost of the investment.

Page 36: Bonds Payable and Investments in Bonds

Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds

To assist your understanding, let’s look at an extended illustration for

Crenshaw, Inc.

To assist your understanding, let’s look at an extended illustration for

Crenshaw, Inc.

Page 37: Bonds Payable and 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.

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.

July 1 Investment in Deitz Corp. Bonds. 41 706 00

Interest Revenue 1 000 00

Purchased investment in

bonds, plus accrued interest.

Cash42 706 00

2005

Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds

$50,000 x 8% x 3/12$50,000 x 8% x 3/12

Page 38: Bonds Payable and Investments in Bonds

Received semiannual interest for April 1 to October 1 ($50,000 x 8% x 6/12).

Received semiannual interest for April 1 to October 1 ($50,000 x 8% x 6/12).

Oct. 1 Cash 2 000 00

Received semiannual

interest for April 1 to

October 1.

Interest Revenue2 000 00

Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds

Page 39: Bonds Payable and Investments in Bonds

Adjusting entry for interest accrued from October 1 to December 31

($50,000 x 8% x 3/12).

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

Adjusting entry for interest

accrued from October 1 to

December 31.

Interest Revenue1 000 00

Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds

Page 40: Bonds Payable and Investments in Bonds

Adjusting entry for amortization of discount for July 1 to December 31: ($50,000 –$41,706)/105 x 6 months.

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

Adjusting entry for

amortization of discount

from July 1 to December 31.

Interest Revenue474 00

Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds

Rounded to Rounded to nearest dollar nearest dollar ($79 a month)($79 a month)

Page 41: Bonds Payable and Investments in Bonds

Investment RevenueOct. 1 2,000Dec. 31 1,000

31 4743,474

July 1 1,000

Bal. 2,474

Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds

Page 42: Bonds Payable and 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).

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).

June 30 Investment in Deitz Corp. Bonds 474 00

Amortized discount for

current year.

Interest Revenue474 00

2012

Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds

$79 x 6$79 x 6

Page 43: Bonds Payable and Investments in Bonds

Investment in Deitz Corporation Bonds

July 1 41,706Dec. 31 474Dec. 31 948Dec. 31 948Dec. 31 948Dec. 31 948Dec. 31 948Dec. 31 948June 30 474

48,342

2005

2006

2007

2008

2009

2010

2011

2012

The investment account after all

amortization entries have been made,

including the June 30, 2012

adjusting entry.

Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds

$79 x 6$79 x 6$79 x 12$79 x 12

Page 44: Bonds Payable and 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).

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).

June 30 Cash 48 350 00

Loss on Sale of Investment 992 00

Interest Revenue1 000 00

Investment in Deitz Corp. Bonds48 342 00

2012

Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds

$50,000 $50,000 x 8% x x 8% x

3/123/12

Page 45: Bonds Payable and Investments in Bonds

Number of Times Interest Charges Earned

Number of Times Interest Charges Earned

Financial Analysis and Interpretation

Page 46: Bonds Payable and Investments in Bonds

Solvency MeasuresSolvency Measures——The Long-Term CreditorThe Long-Term Creditor

Number of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges Earned

2006 2005

Income before income tax $ 900,000 $ 800,000Add interest expense 300,000 250,000Amount available for interest $1,200,000 $1,050,000

Income before income tax + Interest expenseInterest Expense

$800,000 + $250,000$250,000

2005200520052005 = 4.2 times

Page 47: Bonds Payable and Investments in Bonds

Solvency MeasuresSolvency Measures——The Long-Term CreditorThe Long-Term Creditor

Number of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges Earned

2006 2005

Income before income tax $ 900,000 $ 800,000Add interest expense 300,000 250,000Amount available for interest $1,200,000 $1,050,000

Income before income tax + Interest expenseInterest Expense

$900,000 + $300,000$300,000

2006200620062006 = 4.0 times

Page 48: Bonds Payable and Investments in Bonds

The purpose of the ratio is to assess the risk to debtholders in

terms of number of times interest charges were earned.

The purpose of the ratio is to assess the risk to debtholders in

terms of number of times interest charges were earned.

Page 49: Bonds Payable and Investments in Bonds

The EndThe End

Chapter 15Chapter 15