Download Day One

Chapter
ACCT 201
ACCT 201
10
Reporting and
Analyzing Long-Term
Liabilities
ACCT 201
UAA – ACCT 201
Principles of Financial Accounting
Dr. Fred Barbee
1
Chapter 10 - Day 1 - Agenda
Topic
Basics of Bonds
Bond Issuances
Present Value of
Bonds and Notes
LO
Read
HW
A1, C1
422425
QS1
P1,
P2, P3
425436
E1,2,3,
4,5,6;
P1
C3, C4
445448
None
No Homework Due Today!
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Basics of Bonds
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4
Basics of Bonds
Bond Selling Price
Company
Bond Certificate
at Par Value
Investors
Bond Issue
Date
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Basics of Bonds
Bond Interest
Payments
Company
Bond Issue
Date
Bond Interest Payments
Investors
Interest Payment =
Bond Par Value x
Stated Interest Rate
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Basics of Bonds
Bond Par Value
at maturity date
Company
Investors
Bond Issue
Date
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Bond
Maturity
Date
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Advantages of Bonds
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Bonds do not
affect owner
control.
Interest on
bonds is tax
deductible.
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Bonds can
increase
ROE.
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Disadvantages of Bonds
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Bonds require
periodic payment
of interest.
Bonds require
payment of principal
at maturity.
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Bonds can
decrease ROE.
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Convertible
and Callable
Secured
and
Unsecured
Types
of
Bonds
Term and
Serial
Registered
and Bearer
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Bond Trading
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Bond market values
are expressed as a
percent of their par
value.
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Bond Issuances
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Bond Issuing Procedures
A company sells the
bonds to. . .
An investment firm
called an underwriter.
The underwriter sells
the bonds to . . .
. . . investors
A trustee
monitors
the bond
issue.
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Interest Rates and
the Issue Price
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The Market Rate . . .
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The rate of interest currently being
demanded in the market, i.e., the rate
that investors expect to earn on their
investment.
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The Market Rate . . .
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The market rate is often referred to
by other terms . . .
The Effective Rate
The Yield
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The Market Rate . . .
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The rate used to compute the
present values of the two components
of the price of a bond:
The Present Value of the interest
payments; and
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The Present Value of the face value at
maturity.
17
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The Contract Rate . . .
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The interest rate specified on the
face of the bond and in the bond
indenture.
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The Contract Rate . . .
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The contract rate is often referred
to by other names:
The Stated Rate
The Nominal Rate
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The Coupon Rate
19
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The Contract Rate . . .
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The contract rate is used only to
calculate the amount of interest to
be paid to the bondholders at each
interest period.
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Interest Rates and
the Issue Price
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What Determines
the Market Rate?
21
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The Market Rate . . .
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In most cases the market price of
bonds is influenced by . . .
The riskiness of the bonds; and
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The interest rate at which the bonds are
issued.
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Riskiness of the Bonds
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The risk factor is a combination of:
The general economic conditions; and
The financial status of the company
selling the bonds,
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Moody’s, or
Standard and Poors
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Interest Rate on the Bonds
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The interest rate on the bonds is
primarily determined by the riskiness
of the bonds . . .
The higher the risk,
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The higher the interest rate.
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Issuing Bonds
Payable
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What Determines
the Issue Price?
25
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Issuing Bonds Payable
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When issuing bonds payable, there
are three possibilities. Bonds may be
issued . . .
At face value (par);
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At a discount (less than par); or
At a premium (greater than par).
26
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Bonds Issued at Face Value
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If the market rate is equal
to the contract rate, the
bonds will sell at face value
(i.e., at par).
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Issuing Bonds Payable
Market Rate = Contract Rate
Effective
Market
Yield
Coupon
Contract
Nominal
Bonds will sell at
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Bonds Issued at a Discount
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If the market rate is
higher than the contract
rate, the bonds will sell at
a discount (less than face
value).
29
Issuing Bonds Payable
Market Rate > Contract Rate
Effective
Market
Yield
Coupon
Contract
Nominal
Bonds will sell at a
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Bonds Issued at a Premium
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If the market rate is lower
than the contract rate, the
bonds will sell at a premium
(more than face value)
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Issuing Bonds Payable
Market Rate < Contract Rate
Effective
Market
Yield
Coupon
Contract
Nominal
Bonds will sell at
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Example #1
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Bonds Issued At
Par Value
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Issuing Bonds at Par
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Par Value = $1,000,000
Stated Interest Rate = 10%
Market Interest Rate = 10%
Interest Dates = 6/30 & 12/31
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Bond Date = Jan. 1, 2002
Maturity Date = Dec. 31, 2021
(20 years)
34
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Bonds Issued at Face Value
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If the market rate is equal
to the contract rate, the
bonds will sell at face value
(i.e., at par).
35
Issuing Bonds at Par
GENERAL JOURNAL
Date
Description
Jan. 1 Cash
PR
Page 34
Debit
Credit
1,000,000
Bonds Payable
1,000,000
The journal entry to record the issuance of
bonds at par.
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Issuing Bonds at Par
GENERAL JOURNAL
Date
Description
Jun. 30 Bond Interest Expense
PR
Page 39
Debit
Credit
50,000
Cash
50,000
$1,000,000  10% 1/2
The journal entry to record the six-month
interest payment on June 30.
This entry will be made every six months
until the bonds mature.
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Issuing Bonds at Par
On Dec. 31, 202, when the bonds mature,
the following entry would be made.
GENERAL JOURNAL
Date
Description
Dec. 31 Bonds Payable
PR
Page 88
Debit
1,000,000
Cash
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Credit
1,000,000
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Example #2
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Bonds Issued at
A Discount
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Issuing Bonds at a Discount
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Par Value = $1,000,000, 5 Years
Issue Price = 92.6405% of par value
Stated Interest Rate = 10%
Market Interest Rate = 12%
Interest Dates = 6/30 & 12/31
Bond Date = Jan. 1, 2002
Maturity Date = Dec. 31, 2006
40
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Bonds Issued at a Discount
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If the market rate is
higher than the contract
rate, the bonds will sell at
a discount (less than face
value).
41
Issuing Bonds at a Discount
Par Value
$1,000,000
Cash
Proceeds
- $ 926,405
Discount
= $ 73,595
$1,000,000 92.6405%
Amortizing the discount increases
Interest Expense over the
outstanding life of the bond.
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Issuing Bonds at a Discount
On Jan. 1, 2002, the bond issue would
be recorded as follows.
GENERAL JOURNAL
Date
Description
PR
Jan. 1 Cash
Page 3
Debit
926,405
Discount on Bonds Payable
73,595
Bonds Payable
1,000,000
Contra-Liability
Account
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Credit
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Issuing Bonds at a Discount
Partial Balance Sheet as of Jan. 1, 2002
Long-term Liabilities:
Bonds Payable
Less: Discount on Bonds Payable
$ 1,000,000
73,595
$ 926,405
Maturity Value
Carrying Value
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Issuing Bonds at a Discount
Partial Balance Sheet as of Jan. 1, 2002
Long-term Liabilities:
Bonds Payable
Less: Discount on Bonds Payable
$ 1,000,000
73,595
$ 926,405
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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Issuing Bonds at a Discount
This entry will be made every six months to
record the interest payment and the
amortization of the discount.
GENERAL JOURNAL
Date
Description
Jun. 30 Interest Expense
Page 33
PR
Debit
57,360
Discount on Bonds Payable
7,360
Cash
50,000
$73,595 ÷ 10 periods = $7,360 (rounded)
$1,000,000 × 10% × ½ = $50,000
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Credit
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Straight-Line Amortization Table
A
B
C
D
E
Interest
Interest
Discount Unamortized Carrying
Date
Payment Expense Amortization* Discount
Value
1/1/2002
$
73,595 $ 926,405
6/30/2002 $ 50,000 $ 57,360 $
7,360
66,235
933,765
12/31/2002
50,000
57,360
7,360
58,875
941,125
$1,000,000
x 10% x 1/2
$50,000 +
$7,360
$73,595/10
= $7,360
(rounded)
$66,235 $7,360
$1,000,000 $58,875
Date
1/1/2002
6/30/2002
12/31/2002
6/30/2003
12/31/2003
6/30/2004
12/31/2004
6/30/2005
12/31/2005
6/30/2006
12/31/2006
Straight-Line Amortization Table
A
B
C
D
E
Interest
Interest
Discount Unamortized Carrying
Payment Expense Amortization* Discount
Value
$
73,595 $ 926,405
$ 50,000 $ 57,360 $
7,360
66,235
933,765
50,000
57,360
7,360
58,875
941,125
50,000
57,360
7,360
51,515
948,485
50,000
57,360
7,360
44,155
955,845
50,000
57,360
7,360
36,795
963,205
50,000
57,360
7,360
29,435
970,565
50,000
57,360
7,360
22,075
977,925
50,000
57,360
7,360
14,715
985,285
50,000
57,360
7,360
7,355
992,645
50,000
57,355
7,355
0 1,000,000
$ 500,000 $ 573,595 $
73,595
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What if the company
used the effective
interest method to
amortize the
discount?
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Effective Interest Method
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The effective interest method
allocates bond interest expense
over the life of the bonds in a
way that yields a constant rate
of interest.
50
Effective Interest Amortization Table
A
B
C
D
E
Interest
Interest
Discount Unamortized Present
Date
Payment Expense* Amortization* Discount
Value
1/1/2002
$
73,595 $ 926,405
6/30/2002 $ 50,000 $ 55,584 $
5,584
68,011
931,989
12/31/2002
50,000
55,919
5,919
62,092
937,908
$1,000,000
x 10% x 1/2
$931,989 x
12% x 1/2
$55,919 $50,000
$68,011 $5,919
$1,000,000 - $62,092; or
$931,989 + $5,919
Date
1/1/2002
6/30/2002
12/31/2002
6/30/2003
12/31/2003
6/30/2004
12/31/2004
6/30/2005
12/31/2005
6/30/2006
12/31/2006
* Rounded.
Effective Interest Amortization Table
A
B
C
D
E
Interest
Interest
Discount Unamortized Present
Payment Expense* Amortization* Discount
Value
$
73,595 $ 926,405
$ 50,000 $ 55,584 $
5,584
68,011
931,989
50,000
55,919
5,919
62,092
937,908
50,000
56,274
6,274
55,818
944,182
50,000
56,651
6,651
49,167
950,833
50,000
57,050
7,050
42,117
957,883
50,000
57,473
7,473
34,644
965,356
50,000
57,921
7,921
26,723
973,277
50,000
58,396
8,397
18,326
981,674
50,000
59,426
8,900
9,426
990,574
50,000
59,430
9,426
0 1,000,000
$ 500,000 $ 573,595 $
73,595
Comparing Straight-Line and
Effective Interest Methods
$60,000
$59,000
$58,000
$57,000
Straight-Line Method
$56,000
Effective Interest
Method
$55,000
$54,000
12/31/06
6/30/06
12/31/05
6/30/05
12/31/04
6/30/04
12/31/03
6/30/03
12/31/02
$53,000
6/30/02
Annual Interest Expense
Both methods report the same amount of
interest expense over the life of the bond.
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Example #3
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Bonds Issued at
A Premium
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Issuing Bonds at a Premium
Par Value = $1,000,000
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Issue Price = 108.1145% of par value
Stated Interest Rate = 10%
Market Interest Rate = 8%
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Interest Dates = 6/30 & 12/31
Bond Date = Jan. 1, 2002
Maturity Date = Dec. 31, 2006 (5 years)
55
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Bonds Issued at a Premium
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If the market rate is lower
than the contract rate, the
bonds will sell at a premium
(more than face value)
56
Issuing Bonds at a Premium
Cash
Proceeds
$1,081,145
Par Value
- $ 1,000,000
Premium
= $ 81,145
$1,000,000 108.1145%
Amortizing the premium decreases
Interest Expense over the
outstanding life of the bond.
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Issuing Bonds at a Premium
On Jan. 1, 2002, the company would
record the bond issue as follows.
GENERAL JOURNAL
Date
Description
Page 3
PR
Jan. 1 Cash
Debit
1,081,145
Premium on Bonds Payable
81,145
Bonds Payable
1,000,000
Adjunct-Liability
Account
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Credit
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Issuing Bonds at a Premium
Partial Balance Sheet as of Jan. 1, 2002
Long-term Liabilities:
Bonds Payable
Add: Premium on Bonds Payable
$ 1,000,000
81,145
$ 1,081,145
Using the straight-line method, the premium
amortization will be $8,115 every six months.
$81,145 ÷ 10 periods = $8,115 (rounded)
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Issuing Bonds at a Premium
The semiannual interest payment over the life
of the bonds.
GENERAL JOURNAL
Date
Description
Jun. 30 Interest Expense
Page 33
PR
Debit
41,885
Premium on Bonds Payable
8,115
Cash
50,000
$81,145 ÷ 10 periods = $8,115 (rounded)
$1,000,000 × 10% × ½ = $50,000
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Credit
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Date
01/01/2002
06/30/2002
12/31/2002
06/30/2003
12/31/2003
06/30/2004
12/31/2004
06/30/2005
12/31/2005
06/30/2006
12/31/2006
* Rounded.
Straight-Line Amortization Table
A
B
C
D
E
Interest
Interest
Premium Unamortized Carrying
Payment Expense Amortization* Premium
Value
$
81,145 $ 1,081,145
$ 50,000 $ 41,885 $
8,115
73,030
1,073,030
50,000
41,885
8,115
64,915
1,064,915
50,000
41,885
8,115
56,800
1,056,800
50,000
41,885
8,115
48,685
1,048,685
50,000
41,885
8,115
40,570
1,040,570
50,000
41,885
8,115
32,455
1,032,455
50,000
41,885
8,115
24,340
1,024,340
50,000
41,885
8,115
16,225
1,016,225
50,000
41,885
8,115
8,110
1,008,110
50,000
41,890
8,110
0
1,000,000
$ 500,000 $ 418,855 $
81,145
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Let’s look at the
effective interest
method
amortization table
for this bond.
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Date
01/01/2002
06/30/2002
12/31/2002
06/30/2003
12/31/2003
06/30/2004
12/31/2004
06/30/2005
12/31/2005
06/30/2006
12/31/2006
* Rounded.
Effective Interest Method Amortization Table
A
B
C
D
E
Interest
Interest
Premium Unamortized
Present
Payment Expense* Amortization* Premium
Value
$
81,145 $ 1,081,145
$ 50,000 $ 43,246 $
6,754
74,391
1,074,391
50,000
42,976
7,024
67,367
1,067,367
50,000
42,695
7,305
60,062
1,060,062
50,000
42,402
7,598
52,464
1,052,464
50,000
42,099
7,901
44,563
1,044,563
50,000
41,783
8,217
36,346
1,036,346
50,000
41,454
8,546
27,800
1,027,800
50,000
41,112
8,888
18,912
1,018,912
50,000
40,756
9,244
9,668
1,009,668
50,000
40,332
9,668
0
1,000,000
$ 500,000 $ 418,855 $
81,145
Issuing Bonds Between Interest Dates
Apr. 1, 2002
June 30, 2002
Bond
Issue
Date
First
Interest
Payment
Jan. 1, 2002
Bond
Date
Accrued interest
Earned interest
Investor pays
bond purchase
price plus
accrued
interest.
Investor
receives 6
months’
interest.
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Issuing Bonds Between
Interest Dates
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Par Value = $1,000,000
Stated Interest Rate = 10%
Market Interest Rate = 10%
Interest Dates = 6/30 & 12/31
Bond Date = Jan. 1, 2002
Maturity Date = Dec. 31, 2006 (5
years)
65
Issuing Bonds Between Interest Dates
How much cash will the company receive for
the entire issue of the bonds?
Issue Price of Bonds
$
Accrued Interest
$1,000,000 × 10% × 3/12 =
Total Cash Received
1,000,000
25,000
$
1,025,000
Issuing Bonds Between Interest Dates
What does the $25,000 in accrued interest
represent for the company?
Prepare the
journal entry to
record the
bond issue on
April 1, 2002.
Issuing Bonds Between Interest Dates
Here is the journal entry to record the bond
issue on April 1, 2002.
GENERAL JOURNAL
Date
Description
Apr. 1 Cash
Interest Payable
Bonds Payable
Page 33
PR
Debit
Credit
1,025,000
25,000
1,000,000
Now, prepare the entry for June 30, 2002.
Issuing Bonds Between Interest Dates
Here is the entry to record the interest
payment on June 30, 2002.
GENERAL JOURNAL
Date
Description
Page 43
PR
Debit
Jun. 30 Interest Payable
25,000
Interest Expense
25,000
Cash
$1,000,000 × 10% × ½ = $50,000
Credit
50,000
Accruing Bond Interest Expense
Jan. 1
End of
accounting
Interest Payment Dates
period
Apr. 1
Oct. 1
Dec. 31
3 months’
accrued interest
At year-end, an adjusting entry is
necessary to recognize bond interest
expense accrued since the most recent
interest payment.