BY R A C H E L L E A G AT H A , C PA , M B A

Bonds Payable & Investment in Bonds

Slides by Rachelle Agatha, CPA, with excerpts from Warren, Reeve, Duchac

2

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

2. Describe the characteristics, terminology, and pricing of bonds payable.

3. Journalize entries for bonds payable.

Objectives:

3

4. Describe and illustrate the payment and redemption of bonds payable.

5. Journalize entries for the purchase, interest, discount and premium amortization, and sale of bond investments.

6. Prepare a corporation balance sheet.

Objectives:

4

Compute the potential impact

of long-term borrowing on the

earnings per share of a

corporation.

Objective 1

5

Financing Corporations

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.

6

Plan 1 Plan 2 Plan 3

Issued 12% bonds$4 million$2 million$2 millionIssued 9% preferredstock, $50 par value $2 million $1 million

Issued common stock,$10 par value $1 million

$4 million$4 million $4 million

7

Effect of Alternative Financing Plans—$800,000 Earnings

8

8

Effect of Alternative Financing Plans—$440,000 Earnings

9

Gonzales Co., is considering the following alternative plans for financing their company:

Plan I Plan II Issue 10% Bonds (at face) $2,000,000

Issue $10 Common Stock $3,000,000 $1,000,000Income 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.

10

Earnings before bond interest and income taxBond interestBalanceIncome tax Net incomeDividend on preferred stockEarnings available for

common stockNumber of common sharesEarnings per share on

common stock

$750,000 200,000$550,000 220,000$330,000 0

$330,000/100,000

Plan II

$3.30

(2,000,000 x 10%)

($550,000 x 40%)

$750,000 0$750,000 300,000$450,000 0

$450,000 /300,000

Plan I

$1.50

($750,000 x 40%)

11

Describe the characteristics,

terminology, and pricing of bonds

payable.

Objective 2

12

Bonds Payable

A corporation that issues bonds enters into a contract (called a bond indenture or trust indenture) with the bondholders.

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.

13

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.

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Bonds issued on the basis of the general credit of the corporation are debenture bonds.

Bonds that a corporation reserves the right to redeem before their maturity are called callable bonds.

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Pricing of 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.

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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:

1. investors assessment of current economic conditions, and

2. future expectations.

17

MARKET RATE = CONTRACT RATE

Selling price of bond = $1,000

$1,00010% payable

annually

If the contract rate equals the market rate of interest, the bonds will sell at their face amount.

18

MARKET RATE > CONTRACT RATE

Selling price of bond < $1,000

–Discount

$1,00010% payable

annually

If the market rate is higher than the contract rate, the bonds will sell at a discount.

19

MARKET < CONTRACT RATESelling price of bond > $1,000

+Premium

$1,00010% payable

annually

If the market rate is lower than the contract rate, the bonds will sell at a premium.

20

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.

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Today End of Year 1

End of Year 2

Present Value of the Face Amount of Bonds

$1,00010% payable annually

A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years.

22

Present Value of $1 at Compound Interest

N = 2 rate =10%

23

Today End of Year 1

End of Year 2

$1,000 x 0.82645$826.4

5

Present Value of the Face Amount of Bonds

$1,00010% payable annually

A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years.

24

Using Exhibit 3 in your test, what is the present value of $4,000 to be received in 5 years, if the market rate of interest is 10%

compounded annually?

$4,000 x .62092* = $2,483.68*Present value of $1 for 5 periods at 10%

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Today End of Year 1

End of Year 2

Interest payment

$100 Interest

payment

$100

$90.91 $100 x 0.90909

$82.64$100 x 0.82645

Present Value of the Periodic Bond Interest Payments

Present value, at 10%, of $100 interest payments to be received each year for 2 years (rounded)

$173.55

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Present Value of Annuity of $1 at Compound Interest

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Present Value of 2-Year, 10% Bond

Present value of face value of $1,000 due in2 years at 10% compounded annually:$1,000 x 0.82645 (Exhibit 3: n = 2, i = 10%) $ 826.45

Present value of 2 annual interest paymentsof 10% compounded annually: $100 x 1.73554 (Exhibit 4: n = 2, i = 10%)

173.55Total present value of bond $1,000.00

28

Calculate the present value of a $20,000, 5%, 5-year bond that pays

$1,000 ($20,000 x 5%) interest annually, if the market rate of interest is 5%. Use Exhibits 3 and 4 for computing present

values.

29

Present value of face value of $20,000 due in 5 years at 5% compounded annually: $20,000 x .78353 (present value factor of $1 for 5 periods at 5%) $15,671*

Present value of 5 annual interest payments of $1,000 at 5% interest compounded annually: $1,000 x 4.32948 (present value of annuity of $1 for 5 periods at 5%).

*Rounded to the nearest dollar

4,329*

$20,000

30

Journalize entries for bonds

payable.

Objective 3

31

On January 1, 2007, a corporation issues for cash $100,000 of 12%,

five-year bonds; interest payable semiannually.

The market rate of interest is 12%.

Bonds Issued at Face Amount

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Present value of face amount of $100,000 due in 5 years at 12% compounded annually: $100,000 x 0.55840 (Exhibit 3: n = 10, i = 6%)

$ 55,840

Present value of 10 interest payments of $6,000 at 12% compounded semiannually: $6,000 x 7.36009 (Exhibit 4: n = 10; i = 6%)

44,160*

Total present value of bonds $100,000*Because the present value tables are rounded to

five decimal places, minor rounding differences may appear in this illustration.

33

On January 1, 2007, a corporation issues for cash $100,000 of 12%, five-year

bonds; interest payable semiannual. The market rate of interest is 12%.

Issued $100,000 bonds payable at face amount.

Bonds Payable 100 000 00

Jan. 1 Cash 100 000 002007

34

On June 30, an interest payment of $6,000 is made ($100,000 x .12 x 6/12).

June 30 Interest Expense 6 000 00Cash 6 000 00Paid six months’ interest

on bonds.

35

The bond matured on December 31, 2011. At this time, the corporation

paid the face amount to the bondholder.

Cash 100 000 00Paid bond principal at

maturity date.

Dec. 31 Bonds Payable100 000 00

2011

36

Assume that the market rate of interest is 13% on the

$100,000 bonds rather than 12%. What would be the

present value of these bonds?

Bonds Issued at a Discount

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Present value of face amount of $100,000 due in 5 years at 13% compounded semiannually: $100,000 x 0.53273 $53,273

Present value of 10 interest payments of $6,000, at 13% compounded semiannually: $6,000 x 7.18883 (present value of annuity of $1 for 10 periods at 6%)

43,133

Total present value of bonds $96,406

38

On January 1, 2007, the firm issued $100,000 bonds for $96,406 (a discount of

$3,594).

Issued $100,000 bonds at discount.

Bonds Payable 100 000 00

Jan.1 Cash 96 406 002007

Discount on Bonds Payable3 594 00

39

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 x 6% x ½),

receiving cash of $845,562. Journalize the entry to record the issuance of the

bonds.Cash 845,562Discount on Bonds Payable154,438 Bonds Payable 1,000,000

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Amortizing a Bond Discount

There are two methods of amortizing a bond discount:

1) The straight-line method and2) The effective interest rate

method, often called the interest method.

Both methods amortize the same total amount of discount over the life of the bonds.

41

On June 30, 2007, six-months’ interest is paid and the bond discount is amortized ($3,594 x 1/10) using the straight-line method.

Discount on Bonds Payable 359 40

June30Interest Expense 6 359 402007

Amortizing a Bond Discount

Cash 6 000 00

Paid semiannual interest and amortized 1/10 of bond discount.

42

Interest Expense 45,444Discount on Bonds Payable 15,444

Cash 30,000Paid interest and amortized the bond discount ($154,438 ÷ 10).

43

If the market rate of interest is 11% and the

contract rate is 12%, on the five year, $100,000 bonds,

the bonds will sell for $103,769.

Bonds Issued at a Premium

44

Present value of face amount of $100,000 due in 5 years at 11% compounded semiannually: $100,000 x 0.58543 (Exhibit 3: n =10, i = 5½%)

$ 58,543

Total present value of bonds $103,769

Present value of 10 interest payments of $6,000, at 11% compounded semiannually: $6,000 x 7.53763 (Exhibit 4: n = 10, i = 5½%)

45,226

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

The entry to record this information is as follows:

Issued $100,000 bonds at a premium.

Bonds Payable100 000 00Premium on Bonds Payable3 769 00

Jan. 1 Cash 103 769 002007

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A company issues a $2,000,000, 12%, 5-year bond that pays semiannual interest of $120,000 ($2,000,000 x 12% x ½), receiving cash of $2,154,435. Journalize the bond issuance.

Cash 2,154,435Premium on Bonds Payable 154,438

Bonds Payable2,000,000

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On June 30, 2007, paid the semiannual interest and amortized the premium. The firm uses straight-line amortization.

Paid semiannual interest and amortized 1/10 of bond prem.

Cash6 000 00

June 30 Interest Expense 5 623 102007

$3,769 x 1/10

Amortizing a Bond Premium

Premium on Bonds Payable

376 90

48

Using the bond from previous example, journalize the first interest payment and the amortization of the related bond premium.

Interest Expense 104,556Premium on Bonds Payable 15,444

Bonds Payable 120,000Paid interest and amortize thebond premium ($154,435/10).

49

Zero-coupon bonds do not provide for interest payments. Only the face amount is paid at

maturity. Assume that the market rate is 13% at date of issue.

Zero-Coupon Bonds

Present value 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

50

On January 1, 2007, issue 5-year, $100,000 zero-coupon bonds when the market rate of interest is 13%.

Issued $100,000 zero-coupon bonds.

Bonds Payable100 000 00

Jan. 1 Cash 53 273 002007

Discount on Bonds Payable 46 727 00

51

Describe and illustrate the payment and

redemption of bonds payable.

Objective 4

52

Since the payment of bonds normally involves a large amount of cash, a bond

indenture may require that cash be periodically

transferred into a special cash fund, called a sinking

fund, over the life of the bond issue.

53

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.

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Retired bonds for $24,000.

Cash24 000 00

Gain on Redemption of Bonds2 000 00

June 30 Bonds Payable 25 000 00

2007

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.

Premium on Bonds Payable 1 000 00

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Cash105 000 00

June 30 Bonds Payable 100 000 00

2007

Premium on Bonds Payable 4 000 00

Loss on Redemption of Bonds 1 000 00

Redeemed $100,000 bonds for $105,000.

Instead, assume that on June 30 the corporation calls all of the bonds, paying

$105,000.

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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.

Bonds Payable 500,000Loss on Redemption of Bonds15,000 Discount on Bonds Payable

40,000Cash 475,000

57

Journalize entries for the purchase, interest, discount,

and premium amortization, and

sale of bond investments.

Objective 5

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Bonds may be purchased either directly from the issuing corporation or

through an organized bond exchange. Prices for bonds

are quoted as a percentage of the face

amount.

Accounting for Bond Investments

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On April 2, 2007, an investor purchases a $1,000 Lewis Company bond at 102 plus a

brokerage fee of $5.30 and accrued interest of $10.20.

Cash1 035 50

Apr. 2 Investment in Lewis Co. Bonds 1 025 302007

Interest Revenue 10 20

Invested in a Lewis Company bond.

60

Cash1 035 50

Apr. 2 Investment in Lewis Co. Bonds 1 025 302007

Interest Revenue 10 20

Invested in a Lewis Company bond.

On April 2, 2007, an investor purchases a $1,000 Lewis Company bond at 102 plus a

brokerage fee of $5.30 and accrued interest of $10.20.

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

investment.

61

On July 1, 2007, 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, 2007

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

Extended Illustration for Crenshaw, Inc.

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Interest Revenue 1 000 00Cash 42 706 00

Purchased investment in bonds, plus accrued interest.

July 1 Investment in Deitz Corp. Bonds41 706 002007

The entry to record the investment is as follows:

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

Interest Revenue 2 000 00Received semiannual interest for April 1 to October 1.

Oct.1 Cash 2 000 00

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Adjusting entry for interest accrued from October 1 to December 31 ($50,000 x 8% x

3/12).

Interest Revenue 1 000 00Dec.31 Interest Receivable 1 000 00

Adjusting entry for interest accrued from October 1 to December 31.

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Adjusting entry for amortization of discount for July 1 to December 31:

($50,000 –$41,706)/105 = $79 (rounded) x 6 months.

Interest Revenue 474 0031 Investment in Deitz Corp. Bonds474 00

Adjusting entry for amortization of discount for July 1 to December 31.

66

Interest RevenueOct. 1 2,000Dec. 31 Adj. 1,000

31 Adj. 4742,474

July 1 1,000

Adj. Bal.

The effect of these entries on Interest Revenue is as follows:

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The Deitz bonds are sold for $47,350 plus accrued

interest on June 30, 2014. The carrying amount of the bond as of January 1,

2014 is $47,868 [$41,706 + ($79 per month x 78

months)].

Accounting for Bond Investments—Sale

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It has been six months since the last amortization entry, so amortization for

this period is recorded (6 months).

Interest Revenue474 00

June30 Investment in Deitz Corp. Bonds 474 002014

Amortized discount for current year.

69

The next slide shows the

Investment in Dietz Corp. Bonds

account after all amortization entries

have been made, including the June 30, 2014 adjusting

entry.

70

Investment in Deitz Corp. Bonds

July 1 41,706Dec. 31 474Dec. 31

948Dec. 31

948Dec. 31

948Dec. 31

948Dec.31 948Dec.31 948June 30 474

48,342

2007

2008

2009

2010

2011

2012

2013

2014

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This investment is sold on June 30, 2014 for $47,350 plus accrued interest of $1,000

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

30 Cash 48 350 00 Loss on Sale of Investments 992 00

Interest Revenue1 000 00 Investment in Deitz Co. Bonds48 342 00 Received interest

and proceeds from sale of bonds.

72

On October 1, 2008 Viewtec Corporation purchases $10,000 of 6% bonds of Watson Corporation due in 9¼ years. The bonds were purchased at a price of $8,341 plus interest of $150 ($10,000 x 6% x 3/12) accrued from July 1, 2008, the date of the last semiannual interest payment.

a. Journalize the purchase of the bonds plus accrued interest.

b. Journalize the entry to record the amortization of the discount on December 31.

73

Investment in Watson Corp. Bonds 8,341Interest Revenue

150 Cash 8,491

Oct. 1

2008a.

Investment in Watson Corp. Bonds 42*Interest Revenue42

Dec. 1

2008b.

*[($10,000 – $8,341)/111 months] x 3 months

74

Prepare a corporation

balance sheet.

Objective 6

75

Balance Sheet of a Corporation

(Continued)

76

Balance Sheet of a Corporation

(Concluded)

77

Held-to-Maturity Securities

Investments in bonds or other debt securities that

management intends to hold to their maturity are called

held-to-maturity securities.

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Such securities are classified as long-term investments under the caption Investments.

These investments are reported at their cost less any amortized premium or plus any amortized discount.

The market (fair) value of the bond investment should be disclosed, either on the face of the balance sheet or in an accompanying note.

Balance Sheet Presentation of Bond Investments

79

Some corporations have a high ratio of debt to stockholders’ equity. For such corporations, analysts often

assess the relative risk of the debtholders in terms of the number of times the interest charges are

earned during the year.

Financial Analysis and Interpretation

80

To illustrate, assume the following data:

Interest expense $ 36,883,000Income before income tax174,315,000

Income before income tax + Interest expenseInterest expense

$174,315,000 + $36,883,000$36,883,000

Number of Times the Interest Charges Earned

(Continued)

81

The number of times interest charges are earned is 5.73.

This ratio indicates that the debtholders have adequate protection against a

potential drop in earnings jeopardizing their receipt of interest payments. A full analysis should involve a comparison with

industry averages.

Summary Financing Corporations Bond terms & Characteristics Time Value of Money Accounting for Bonds Investment in Bonds Financial Statement Presentation