Chapter 12

Long Term Liabilities:

Bonds & Notes

Financing operations:

1. Short term debt – accounts payable

2. Long term debt– bonds or notes payable

3. Equity– common or preferred stock

Bond

• Security representing money borrowed by a corporation from investors

• Must be repaid at maturity

• Periodic Interest payments

often paid semiannually

• Issuance is authorized by Board of Directors

• Ranks ahead of stockholders for claims on corporation’ s assets

Financing Corporation

Consider:• Effect on Earnings per share on common

stock

Calculated as:

Net income – Preferred Dividends # of common shares outstanding

Earnings per share on common stock

• Interest expense is deductible, dividends are not

When calculating earnings per share, start with:

Earnings before interest and taxes, because the bond interest will lower the Income before income tax amount

Earnings per share on common stock

Earnings before interest and income taxDeduct: interest on bonds (face amount X face rate of interest)

= Income before income taxDeduct: income tax (income before income tax X tax rate)

= Net incomeLess: Dividend on preferred stock (%X par X # of shares)

= Available for dividends on common stockDivide by # of shares of common stock = Earnings per share on common stock

Earnings per share on common stock

The earnings per share will change based on– Different earnings levels

– Different financing plans

Bond Vocabulary Terms

• Bond Indenture: contract between corporation and shareholders

• Term bonds: all bonds of bond issue mature at the same time

• Serial Bonds: maturities of bonds from a bond issue are spread over several dates

• Convertible bonds: bonds can be exchanged for common stock

Bond Vocabulary Terms

• Callable bonds: bonds that corporation can redeem before maturity

• Debenture bonds: bonds issued on corporation’s general credit

• Contract rate of interest: face interest rate; the interest rate used to calculate periodic interest payments

• Market rate of interest (effective rate): determined by buyers and sellers of similar bonds– Affected by investors’ expectations of economic

conditions

Price of Bonds

• Stated in terms of a percentage of face value (principal amount of bonds)

• Take the price as a percentage and multiply it by the face value

• Bonds can be issued– At face value Price = 100– Above face valuePrice is greater than 100– Below face value Price is lower than 100

Bonds issued at face value

• Price = 100

• Cash received is 100% X face value

• Market rate = Contract rate

Journal entry

Dr. Cash

Cr. Bonds Payable

Cash received from bond issuance is less than face value

Price of bonds is less than 100Bonds are issued at a discountMarket rate is higher than the contract rateInvestors can earn more interest if they

invest in something elseCorporation takes amount off price of bond

equal to the difference between the market interest amount and the contract interest amount

Cash received from bond issuance is less than face value

Ex.: $10,000 bonds issued at a price of 98

Cash received from bonds issued is more than face value

Price of bonds is higher than 100Bonds are issued at a premiumMarket rate is lower than contract rateInvestors can earn more interest on the

bond than if they invest in something elseCorporation adds amount to price of bond

equal to the difference between the face interest amount and the market interest amount

Cash received from bonds issued is more than face value

Ex.: $10,000 bonds issued at a price of 103

Balance Sheet Presentation

• Long term LiabilitiesBonds Payable (face amount)

+ Premium on Bonds Payable **contra account

= Carrying Value of bonds

OR

Bonds Payable (face amount)

- Discount on Bonds Payable **contra account

= Carrying Value of bonds

• By maturity date, the carrying value of the bonds needs to equal face value amount

• Premium or discount needs to be zero at the maturity date– Amortization reduces the premium or discount

Methods of amortizing

1) Straight line

2) Effective interest: required under GAAP

But, Straight-line can be used if the results are not significantly different

Amortization of Bond discount

• Amortization turns the bond discount into interest expense over the life of the bond

Bond discount

+ actual interest payments (using contract rate)

= Interest expense amount using the market rate

So in effect, the market rate of interest is paid – Market rate is also called effective rate

Amortization of Bond discount

• Can be done

– Annually

OR

– At the time the interest payments are made

Amortization of Bond discount

• Straight line amortization calculated as:

Bond discount .

total # of interest payments (# of payments per year X the life of the bond)

= amount of credit to Discount on Bonds Payable at interest payment journal entry

Amortization of Bond discount

• Journal entry at interest payment date

Dr. Interest expense *

* Amount equals the sum of Cash payment and amortization of discount

Amortization of Bond discount

• Journal entry at interest payment date

Dr. Interest expense

Cr. Discount on Bonds Payable *

* Total discount / # of interest pmts

Amortization of Bond discount

• Journal entry at interest payment date

Dr. Interest expense

Cr. Discount on Bonds Payable

Cr. Cash P X R X T

R = Contract rate

Example Dr. Cr.

Garland Corporation issued $8,000,000 in 8.5%, 5 year bonds on January 1 at 96.

Amortizing Bond Premium

• Amortization of the bond premium reduces interest expense over the life of the bond

Bond premium- actual interest payments (using contract rate)= Interest expense amount using the market rate

• So in effect, the market rate of interest is paid to bondholders

Amortization of Bond premium

• Can be done

– Annually

OR

– At the time the interest payments are made

Amortizing Bond Premium

• Straight line amortization calculated as:

Bond premium .

total # of interest payments (# of payments per year X the life of the bond)

= amount of debit to Premium on Bonds Payable at interest payment journal entry

Amortization of Bond Premium

• Journal entry at interest payment date

Dr. Interest expense *

* Amount equals the Cash payment minus amortization of premium

Amortization of Bond Premium

• Journal entry at interest payment date

Dr. Interest expense

Dr. Premium on Bonds Payable *

* Total premium / # of interest pmts

Amortization of Bond Premium

• Journal entry at interest payment date

Dr. Interest expense

Dr. Premium on Bonds Payable

Cr. Cash P X R X T

R = Contract rate

Example Dr. Cr.

Meyer Inc. issued $1,000,000 in 6%, 10 year bonds on January 1 at 103.

Bond Redemption

• Callable bonds

• Bond indenture states the call price– Call Price:

• the price corporation has to pay to redeem the bonds

• Call price is typically above face value

Bond Redemption

• Compare carrying value of bonds to the cash paid to redeem the bonds to determine gain or loss

Carrying value =

Cash Paid to redeem the bonds =

Face amount X Call Price as a %

Bond Redemption

• If Carrying value is greater than Cash Paid to redeem the bonds, then there will be a _______

• If Cash Paid to redeem the bonds is greater than Carrying Value, then there will be a ________

Gains and losses on the redemption of bonds are reported as Other Income (Loss) on the Income Statement.

Bond Redemption

Example: Bonds Payable has a balance of $100,000 and Discount on Bonds Payable has a balance of $1,250

Bonds are redeemed at 98

Cash Paid to redeem the bonds = Carrying value of bonds = Dr. Cr.

Bond Redemption

Example: Bonds Payable has a balance of $100,000 and Premium on Bonds Payable has a balance of $2,800

Bonds are redeemed at 101

Cash Paid to redeem the bonds = Carrying value of bonds = Dr. Cr.

Installment Notes

Used to:buy assets, such as equipmentborrow cash

Usually issued by a bank

Mortgage note: secured by pledge of assetslender can take possession of the asset if borrower doesn’t pay

Installment notes

• Require a series of equal periodic payments to the lender– A set periodic payment is calculated at the

issuance of the note– The payment is to be made at installment

dates

Installment notes

• Each payment consists of:– Principal: pay back a portion of the amount

borrowed– Interest on the outstanding balance

Interest portion of periodic payment

Interest on the outstanding balance =

Carrying value X interest rate %

Carrying value of the note = outstanding balance = amount still owed on the note

For the first payment, the carrying value = face value

Principal portion of periodic payment

Periodic payment – Interest portion = Principal portion

The carrying value of the note is reduced by the principal portion of the periodic payment

For period’s after the first payment, the carrying value for the period = last period’s carrying value – last period’s principal portion of payment

Installment notes journal entries

Dr. Cr.Issue notes:

Asset being acquired (face amount)

Notes Payable (face amount)

Make periodic paymentsInterest Expense (CV X %)

Notes Payable (Paymnent amount – interest)

Cash (set payment amount)

Installment note example

On the first day of the fiscal year, a company issue a $30,000, 10%, five-year installment note that for cash. The installment note has annual payments of $7,914.

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