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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! ACCT 201 Basics of Bonds ACCT 201 ACCT 201 4 Basics of Bonds Bond Selling Price Company Bond Certificate at Par Value Investors Bond Issue Date ACCT 201 ACCT 201 ACCT 201 Basics of Bonds Bond Interest Payments Company Bond Issue Date Bond Interest Payments Investors Interest Payment = Bond Par Value x Stated Interest Rate ACCT 201 ACCT 201 ACCT 201 Basics of Bonds Bond Par Value at maturity date Company Investors Bond Issue Date ACCT 201 ACCT 201 Bond Maturity Date ACCT 201 ACCT 201 Advantages of Bonds ACCT 201 Bonds do not affect owner control. Interest on bonds is tax deductible. ACCT 201 Bonds can increase ROE. 8 ACCT 201 Disadvantages of Bonds ACCT 201 Bonds require periodic payment of interest. Bonds require payment of principal at maturity. ACCT 201 Bonds can decrease ROE. 9 Convertible and Callable Secured and Unsecured Types of Bonds Term and Serial Registered and Bearer ACCT 201 Bond Trading ACCT 201 Bond market values are expressed as a percent of their par value. ACCT 201 ACCT 201 Bond Issuances ACCT 201 ACCT 201 12 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. ACCT 201 ACCT 201 Interest Rates and the Issue Price ACCT 201 14 ACCT 201 The Market Rate . . . ACCT 201 The rate of interest currently being demanded in the market, i.e., the rate that investors expect to earn on their investment. ACCT 201 15 ACCT 201 The Market Rate . . . ACCT 201 The market rate is often referred to by other terms . . . The Effective Rate The Yield ACCT 201 16 ACCT 201 The Market Rate . . . ACCT 201 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 ACCT 201 The Present Value of the face value at maturity. 17 ACCT 201 The Contract Rate . . . ACCT 201 The interest rate specified on the face of the bond and in the bond indenture. ACCT 201 18 ACCT 201 The Contract Rate . . . ACCT 201 The contract rate is often referred to by other names: The Stated Rate The Nominal Rate ACCT 201 The Coupon Rate 19 ACCT 201 The Contract Rate . . . ACCT 201 The contract rate is used only to calculate the amount of interest to be paid to the bondholders at each interest period. ACCT 201 20 ACCT 201 ACCT 201 Interest Rates and the Issue Price ACCT 201 What Determines the Market Rate? 21 ACCT 201 The Market Rate . . . ACCT 201 In most cases the market price of bonds is influenced by . . . The riskiness of the bonds; and ACCT 201 The interest rate at which the bonds are issued. 22 ACCT 201 Riskiness of the Bonds ACCT 201 The risk factor is a combination of: The general economic conditions; and The financial status of the company selling the bonds, ACCT 201 Moody’s, or Standard and Poors 23 ACCT 201 Interest Rate on the Bonds ACCT 201 The interest rate on the bonds is primarily determined by the riskiness of the bonds . . . The higher the risk, ACCT 201 The higher the interest rate. 24 ACCT 201 ACCT 201 Issuing Bonds Payable ACCT 201 What Determines the Issue Price? 25 ACCT 201 Issuing Bonds Payable ACCT 201 When issuing bonds payable, there are three possibilities. Bonds may be issued . . . At face value (par); ACCT 201 At a discount (less than par); or At a premium (greater than par). 26 ACCT 201 Bonds Issued at Face Value ACCT 201 ACCT 201 If the market rate is equal to the contract rate, the bonds will sell at face value (i.e., at par). 27 Issuing Bonds Payable Market Rate = Contract Rate Effective Market Yield Coupon Contract Nominal Bonds will sell at ACCT 201 ACCT 201 ACCT 201 ACCT 201 Bonds Issued at a Discount ACCT 201 ACCT 201 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 ACCT 201 ACCT 201 ACCT 201 ACCT 201 Bonds Issued at a Premium ACCT 201 ACCT 201 If the market rate is lower than the contract rate, the bonds will sell at a premium (more than face value) 31 Issuing Bonds Payable Market Rate < Contract Rate Effective Market Yield Coupon Contract Nominal Bonds will sell at ACCT 201 ACCT 201 ACCT 201 ACCT 201 ACCT 201 Example #1 ACCT 201 Bonds Issued At Par Value 33 ACCT 201 Issuing Bonds at Par ACCT 201 Par Value = $1,000,000 Stated Interest Rate = 10% Market Interest Rate = 10% Interest Dates = 6/30 & 12/31 ACCT 201 Bond Date = Jan. 1, 2002 Maturity Date = Dec. 31, 2021 (20 years) 34 ACCT 201 Bonds Issued at Face Value ACCT 201 ACCT 201 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. ACCT 201 ACCT 201 ACCT 201 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. ACCT 201 ACCT 201 ACCT 201 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 ACCT 201 Credit 1,000,000 ACCT 201 ACCT 201 ACCT 201 ACCT 201 Example #2 ACCT 201 Bonds Issued at A Discount 39 ACCT 201 Issuing Bonds at a Discount ACCT 201 ACCT 201 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 ACCT 201 Bonds Issued at a Discount ACCT 201 ACCT 201 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. ACCT 201 ACCT 201 ACCT 201 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 ACCT 201 Credit ACCT 201 ACCT 201 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 ACCT 201 ACCT 201 ACCT 201 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) ACCT 201 ACCT 201 ACCT 201 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 ACCT 201 Credit ACCT 201 ACCT 201 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 ACCT 201 What if the company used the effective interest method to amortize the discount? ACCT 201 ACCT 201 ACCT 201 Effective Interest Method ACCT 201 ACCT 201 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. ACCT 201 ACCT 201 Example #3 ACCT 201 Bonds Issued at A Premium 54 ACCT 201 Issuing Bonds at a Premium Par Value = $1,000,000 ACCT 201 Issue Price = 108.1145% of par value Stated Interest Rate = 10% Market Interest Rate = 8% ACCT 201 Interest Dates = 6/30 & 12/31 Bond Date = Jan. 1, 2002 Maturity Date = Dec. 31, 2006 (5 years) 55 ACCT 201 Bonds Issued at a Premium ACCT 201 ACCT 201 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. ACCT 201 ACCT 201 ACCT 201 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 ACCT 201 Credit ACCT 201 ACCT 201 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) ACCT 201 ACCT 201 ACCT 201 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 ACCT 201 Credit ACCT 201 ACCT 201 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 ACCT 201 Let’s look at the effective interest method amortization table for this bond. ACCT 201 ACCT 201 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. ACCT 201 Issuing Bonds Between Interest Dates ACCT 201 ACCT 201 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.