Download Bonds Payable

Financial Accounting:
A Business Process Approach
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7-1
Accounting for Liabilities
Chapter 7
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7-2
Learning Objectives
When you are finished studying Chapter 7,
you will be able to:
1. Define definitely determinable liability and
explain how payroll is recorded.
2. Define estimated liability and explain how
warranties are recorded.
3. Explain how long-term notes and
mortgages work.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7-3
Learning Objectives
4. Record the issue of bonds and payment of
interest to bondholders.
5. Prepare financial statements that include
long-term debt.
6. Explain capital structure and compute the
debt-to-equity ratio.
7. Identify the major risk associated with longterm debt and the related controls.
8. (Appendix 7) Compute present value and
proceeds from a bond issue.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7-4
Ethics Matters
The question
of ethics
always
a legal
issue.
When
a company
wants isn’t
to borrow
large
sums
of money, it
Hundreds
people
in these
agencies
focused
on the
often
issuesof
bonds.
Similar
to issuing
stock,
issuing
bonds
deal
rather
than
the
credit
quality
of thecomplicated
securities
isAs
a way
to finance
a business
with
money
from
investors.
Frank
Raiter,
a former
managing
director
at Standard
&
financial
firms
were
putting
together
they
were
rating.
In
this
case,
the
goal
profit
For
months,
the(related
rating
firms
were
giving
AAA
ratings
However,
a bond
is
a debt
andof
doesn’t
Poor’s,
believes
the
credit
rating
agencies
could
have
debt
securities
toinstrument
subprime
mortgages),
the to
maximization
came
face-to-face
with
ethical
decision
complicated
debt
securities
without
actually
able
represent
ownership
like
stock
does.
Acame
bondholder—an
stopped
the
financial
meltdown
that
tobeing
a the
crisis
rating
agencies
were
hired
by
the
firms
to rate
making
and
the
consequences
involved
the
most
to
assess
the
riskiness
of those
securities.
ratings
investor
a
bond—is
loaning
money
toThe
the
company
point
inbuying
2008.
Simply
stated,
greed
got
the
best
of the
securities.
The
best
rating
is AAA
and
indicates
very
serious
crisis
the
Great
Depression
of
agencies
admit
now
that
they
just
didn’t
have
the
data
that
issues
the bond.
To since
help
investors
evaluate
the
risk
agencies.
Joseph
Stiglitz,
a Nobel
prize-winning
little
riskfinancial
with
an
investment.
(After
that,
the ratings
the
The
resulting
discussion
continues,
as
to
make
ratings.
But
they
were
getting
paid
to
doBB
the
associated
with
corporate
bonds,
rating
provide
economist,
called
the
ratings
“hocus
pocus.”
Raiter,
go
to1930s.
AA,the
A,
BBB,
BB,
B,
CCC,
CC,
and
C.agencies
Bonds
rated
Congress
and
the
SEC
continue
to
with
ratings.
The
more
AAA
ratings
they
gave,
more
credit
ratings
for
bonds.
Standard
&grapple
Poor’s,
Moody’s,
once
demoted
for
his unwillingness
tobonds.)
gothe
along
withand
and
below
are
sometimes
called
junk
changes
to resigned
this
industry
in than
an effort
to in
make
sure this
business
they
got.
Fitch
are the
three
most
well-known.
These
agencies
the
deceit,
rather
giving
to
the
doesn’t
happen
again.
played
a major
role
in the his
financial
crisis of 2008.
pressure
to compromise
standards.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7-5
Learning
Objective 1
Types of Liabilities
Estimated Liability:
Obligations that have some
uncertainty in the amount to
record for the obligation.
Warranty
Definitely determinable liability:
Obligations that can be
measured exactly.
Note Payable
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7-6
Payroll
Payroll is a common business expense that
results in a definitely determinable liability.
A company acts as an agent for the government;
it must withhold Social Security, Medicare,
federal, and state income taxes from its
employees’ paychecks.
After the withholdings are
deducted from an employee’s
gross pay, s/he will receive
net pay.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7-7
Payroll
Home Depot hires a security guard for a salary of $500
per week. The gross pay is subject to FIT, FICA, and
Medicare.
$500.00 - 50.00 – 31.00 – 7.25
= $411.75
Gross Pay – FIT – FICA – Medicare = Net Pay
•When Home Depot records the disbursement to the
employee, the payment affects the financial statements
as follows.
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
(411.75) cash
50.00 FIT Payable
31.00 FICA Payable
7.25 Medicare Taxes
Payable
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
Retained
Earnings
(500) salary
expense
7-8
Payroll
Home Depot will match the FICA and Medicare amounts.
When Home Depot records the payment to the
government for federal income taxes and social security,
the payment affects the financial statements as follows:
Assets
= Liabilities
+ Shareholders’ Equity
Contributed
Capital
(126.50)
cash
(50.00) FIT Payable
(31.00) FICA
Payable
(7.25) Medicare
Taxes Payable
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
Retained
Earnings
(38.25)
payroll tax
expense
7-9
Your Turn 7-1
Sandy’s
paycheck
will at
beher
in the
of $1,085.25.
Sandy earned
$1,500
jobamount
at Paula’s
Bookstore
The
transaction
recorded
follows:
during
February.would
Sandybe
has
20% ofas
her
gross pay
withheld for federal income taxes, 6.2% withheld for
social security (FICA) taxes, and 1.45% withheld for
Assets
= Liabilities
+ Shareholders’ Equity
Medicare taxes.
Contributed
Capital
Retained
Earnings
What will be the net amount of Sandy’s February
(1,085.25)
1,500.00
paycheck? 300.00 FIT Payable
cash
How will
Sandy in
93.00 FICA Taxes
Payable
Paula’s Bookstore
record the
21.75 Medicare
the accounting
equation?
Taxes Payable
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
salary
expense
payment to
7 - 10
Learning
Objective 2
Warranties
Companies provide warranties as
a sales or marketing tool.
An accountant estimates the
future repairs and replacement
costs related to current sales.
Warranty expense is estimated
and a liability (warranties
payable) is created.
We will
repair or
replace this
item...
Warranty
When a warranty is honored in the
future, the warranties payable
account will be reduced for the
costs.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 11
Warranties
A company sold $4,000 worth of merchandise
with a warranty. The accountant estimated that
$100 of warranty cost will be incurred over the
next two years on the goods sold.
Liabilities increase by $100 and
Retained Earnings decrease by $100.
Assets



=
Liab. + Cont. Cap.
+
Ret. Earnings
+100
(100)
Income Statement: Decreases income
Statement of Changes in Equity: No effect on cash flow
Statement of Cash Flows: Decreases equity
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 12
Warranties
A customer returned goods under
warranty for Repair. The cost of the
repair was $30 cash.
Assets and liabilities decrease by $30.
Assets = Liab. + Cont. Cap. + Ret. Earnings
(30)
(30)
 Income Statement: No effect
 Statement of Changes in Equity: No effect
 Statement of Cash Flows: Decreases cash flow
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 13
Your Turn 7-2
Suppose that Brooke’s Bike Company did
some repairs related to warranties on
previous sales. The total spent was $500. The
1. No warranty expense would be on the
July 31 liability (warranty payable) is $2,750.
August income statement.
What amount of warranty expense would
appear on Brooke’s Bike Company’s income
2. The liability would be $2,250 ($2,750 –
statement for the month ended August 31?
$500).
What is the amount of the August 31 liability
(warranty payable or estimated warranty
liability)?
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 14
Learning
Objective 3
Notes Payable and Mortgages
When a company borrows money (issues a
note payable) from the bank for longer than
a year, the obligation is called a long-term
note payable.
The borrower receives the principal and
promises to repay the principal plus interest.
These obligations are frequently repaid in equal
installments, part of which are repayment of
principal and part of which are interest.
A mortgage is a special kind of “note” payable-one issued for property.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 15
Payments of Interest and Principal
Suppose you sign, January 1, a $100,000, 3-year
mortgage with an 8% annual interest rate.
The annual payment is $38,803.35. How much
of the first payment is interest and how much is
principal?
Interest is the cost of using someone else’s money.
Annual
Interest
Balance
Outstanding
Principal
Interest
Rate
$100,000
X
.08 x
Time
1 (year)
$8,000
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 16
Payments of Interest and
Principal
After three payments, the interest and
principal will be repaid. Notice the amount of
interest owed the bank is smaller each year
because the outstanding balance is smaller.
Mortgage
Balance
Beginning Balance
After 1st payment
After 2nd payment
After 3rd payment
$100,000
$69,196.65
$35,929.03
$0.00
Interest
Amount of
Annual
Portion - 8% Mortgage
Payment
of Balance Reduction
$38,803.35 $8,000.00 $30,803.35
$38,803.35 $5,535.73 $33,267.62
$38,803.35 $2,874.32 $35,929.03
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 17
Learning
Objective 4
Characteristics of Bonds
Payable
A bond is an interest-bearing long-term note
payable issued by corporations, universities,
and governmental agencies to borrow money
from individual investors.
Bonds usually involve the
borrowing of a large sum of
money, called principal.
The principal is usually paid back as a
lump sum at the end of the bond period.
Individual bonds are often denominated
with a par value, or face value, of $1,000.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 19
Bonds
This is the information shown
on a bond certificate...
$1,000—principal
10%—interest rate (annual)
5yrs.—time to maturity
annual—interest payments
The cash flows associated with the bonds are
defined by the terms on the face of the bond.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 20
Characteristics of Bonds Payable
Bonds usually carry a stated rate of interest.
Interest is normally paid semiannually. Interest
is computed as:
Interest = Principal × Stated Rate × Time
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 21
Characteristics of Bonds Payable
The new bondholder receives a bond
certificate.
The bond certificate identifies the par
value, the stated interest rate, the
interest dates, and the maturity date.
The trustee makes sure the issuing
company fulfills all of the provisions of
the bond indenture, or agreement.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 22
Bond Classifications
Unsecured bonds (also called
debentures) do not have
pledged assets as a guarantee
of repayment at maturity.
Secured bonds include a pledge
of specific assets as a
guarantee of repayment at
maturity.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 23
Bond Classifications
Ordinary bonds (also called singlepayment bonds)
The full face amount is
paid at the maturity.
Serial bonds
The principal is paid in installments
on a series of specified maturity
dates.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 24
Bond Classifications
Callable bonds
May be retired and repaid (called) at any
time at the option of the issuer.
Redeemable bonds
May be turned in at any time for repayment
at the option of the bondholder.
Convertible bonds
May be exchanged for other securities of
the issuer (usually shares of common
stock) at the option of the bondholder.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 25
Bond Classifications
Registered bonds
Payment of interest is made
by check and mailed directly
to the bondholder whose
name must be registered.
Coupon bonds
Coupons are attached to the
bond for each interest
payment.
The bondholder “clips” each
coupon and presents it for
payment on the interest date.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 26
Trading Bonds
When a bondholder sells a
bond, there is no effect on
the books of the issuing
company.
Bondholders trade among
themselves in the bond
market.
Changes in the market
rate of interest and the
risk related to specific
bonds cause the prices of
bonds to change.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 27
Bonds Payable and Interest Expense
The interest rate used to compute the
present value is the market interest rate
(also called yield, effective rate, or true
rate).
Creditors demand a certain rate of interest
to compensate them for the risks related
to bonds.
The stated rate, or coupon rate, is only
used to compute the periodic interest
payments.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 28
Issuing Bonds
When the market rate of interest and the
stated rate of interest are NOT the same
•the market rate of interest is used to
calculate the issue price of the bonds,
and
•the stated rate of interest is (always)
used to calculate the interest payments
to the bondholders.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 29
Determining the Selling Price
Bonds sell at:
“Par” (100% of face value)
less than par (discount)
more than par (premium)
Market rate of interest vs. bond’s stated rate
of interest determines the selling price
(market price of the bond)
Therefore, if
market rate > stated rate: Discount
market rate < stated rate: Premium
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 30
Cash Flows Associated with a Bond
Bonds that sell below 100 are issued for less
than the face value. They are called bonds
issued at a discount.
The price of a bond when it is issued is
calculated by the bond market and is stated in
Bonds that sell for more than 100 are issued
terms of a percentage of the face value. The
for more than the face value. They are called
cash the company receives when issuing a bond
bonds issued at a premium.
is call the proceeds.
Bonds that sell at 100 are issued at exactly the
face amount of the bond. They are called
bonds issued at par.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 31
Bonds
Bond Premium:
is an adjunct-liability
that is added to bonds
payable on the balance
sheet; it is the
difference between the
face value of the bond
and its selling price,
when the selling price
is more than the face
(par) value.
Bond Discount:
is a contra-liability that
is deducted from bonds
payable on the balance
sheet; it is the
difference between the
face value of the bond
and its selling price
when the selling price
is less than the face
(par) value.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 32
Your Turn 7-4
If a $1,000 bond is selling for 95.5, how much
cash does the bondholder pay for the bond?
If a $1,000 bond is selling for 102, how much
cash does the bondholder pay for the bond?
A $1,000 bond issued at 95.5 will sell for $955.
A $1,000 bond issued at 102 will sell for
$1,020.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 33
Bonds Sold at a Discount
$1,000, 5% stated rate.
The market rate of interest is 6%.
Who will buy this bond at face value?
Nobody. It will have to sell (issue) at a
discount, e.g., bondholders will give me
less than face value for the bond.
Bonds sell at 95.1.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 34
Cash Flows Associated with a Bond
Interest payments of $50 (that’s 5%
of the $1,000 face value) each year for
6 years.
A lump sum payment of $1,000 (the
face amount of the bonds) in 6 years.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 35
Bond Discount
The discount must be amortized over
the outstanding life of the bonds.
The discount amortization increases
the periodic interest expense for the
issuer.
Two methods are commonly used:
Effective-interest amortization
Straight-line amortization
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 36
Straight-Line Amortization of a
Bond Discount
Identify the amount of the bond
discount.
Divide the bond discount by the
number of interest periods.
Include the discount amortization
amount as part of the periodic interest
expense entry.
The discount will be reduced to zero by
the maturity date.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 37
Straight-Line Amortization of
Bond Discount
Bonds sell for $951. 00
Discount is 49.00
Interest payment is always $50.00
Discount amortization is $49.00 = $8.17.
6
That means that the discount will be
amortized by $8.17 every time a
payment is made.
Interest expense will be $58.17 each
time a payment is made.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 38
Reporting A Bond Sold at a
Discount
If we prepared a balance sheet on the
date of issue, the bond would be
reported like this:
Bonds Payable
$ 1,000.00
Less Discount on B/P
49.17
Net Bonds Payable
$ 950.83
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 39
Bonds Sold at a Premium
$1,000, 5% stated rate.
The market rate of interest is 4%.
Who will buy these bonds at face value?
EVERYONE!
So the market will bid up the price of the bond;
e.g., it will sell for a premium since it has such
good cash flows.
Bondholders will pay more than the face value.
Bonds sell at 105.2.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 40
Bonds Issued at a Premium
The premium must be amortized
over the term of the bonds.
The premium amortization
decreases the periodic interest
expense for the issuer.
Two methods are commonly used:
Effective-interest amortization
Straight-line amortization
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 41
Straight-Line Amortization of
Bond Premium
Identify the amount of the bond
premium.
Divide the bond premium by the number
of interest periods.
Include the premium amortization
amount as part of the periodic interest
expense entry.
The premium will be reduced to zero by
the maturity date.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 42
Amortization of Bond Premium
Bonds sell for $1,052.00
Interest payment is always $50.
Premium amortization is $52.00 = $8.67.
6
That means that the premium will be
amortized by $8.67 every time a payment
is made.
Interest expense will be $41.33 each
time a payment is made.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 43
Bond Amortization
Effective-interest method of
amortization is preferred by GAAP.
Straight-line amortization may be used
if it is not materially different from
effective interest amortization.
Most companies do not disclose the
method used for bond interest
amortization.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 44
Carrying Value Of BONDS PAYABLE
While the specific long-term
liability (Bonds Payable) is
always recorded (and kept) at
face value, the Discount or
Premium (on Bonds Payable)
will be either subtracted
(discount) or added
(premium) to the BP amount
to get the carrying value of
the bond at any given date.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 45
Learning
Objective 5
Capital Structure
Two ways to finance a business are debt and
equity. The combination of debt and equity
is called its capital structure. Closely related
is the concept of financial leverage, the use
of borrowed funds to increase earnings.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 46
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 47
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 48
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 49
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 50
Learning
Objective 6
Ratio Analysis
The debt-to-equity ratio measures a company’s
debt position and its ability to meet its interest
payments. It compares the amount of creditors’
claims to the assets of the firm with the owners’
claims to those assets.
The Home Depot, Inc. had $23,387 in total debt
and total shareholders’ equity of $17,777 as of
2/1/2009.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 51
Learning
Objective 7
Business Risk, Control, and Ethics
The risks associated with long-term debt is the
risk of not being able to make the debt
payments.
Two major things a company can do to minimize
the risk associated with long-term debt:
1.
2.
Be sure that a thorough business analysis
accompanies any decision to borrow money.
Study the characteristics of various types of debt
- terms, interest rates, ease of obtaining the
money - and evaluate their attractiveness in your
specific circumstances, given the purpose of the
loan and the financial situation of the company.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 52
All rights reserved. No part of this publication may
be reproduced, stored in a retrieval system, or
transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording,
or otherwise, without the prior written permission
of the publisher. Printed in the United States of
America.
Copyright © 2011 Pearson Education, Inc.
publishing as Prentice Hall
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall
7 - 53