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NETA POWERPOINT PRESENTATIONS TO
ACCOMPANY
VOLUME 2
Accounting
Second Canadian Edition
BY WARREN/REEVE/DUCHAC/ELWORTHY/KRISTJANSON/TOBER
Adapted by Sheila Elworthy
and Tana Kristjanson
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1
CHAPTER 14
Long-Term Liabilities:
Bonds and Notes
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Long-Term Liabilities:
Bonds and Notes
After studying this chapter, you should be able to:
1. Describe the characteristics and
terminology of bonds payable,
and the potential impact of
borrowing on earnings per share.
2. Journalize entries for bonds
payable.
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3
Long-Term Liabilities:
Bonds and Notes
After studying this chapter, you should be able to:
3. Describe and illustrate the
accounting for installment notes.
4. Describe and illustrate the
reporting and analysis of longterm liabilities.
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1
Describe the characteristics
and terminology of bonds
payable, and the potential
impact of borrowing on
earnings per share.
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Bond
A bond is a form of an interestbearing note that a corporation may
issue as a way to borrow on a longterm basis.
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Bond
• The corporation borrows money
from the bondholder.
• Over the life of the bond, the
corporation will pay interest for the
use of the money.
• At the end of the bond’s life, the
face amount must be repaid to the
bondholder.
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Bond Characteristics and Terminology
The underlying contract between the
company issuing bonds and the
bondholders is called a bond
indenture.
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Bond Characteristics and Terminology
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.
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Bond Characteristics and Terminology
The price of a bond is quoted as a
percentage of the bond’s face value.
• For example, a $1,000 bond quoted
at 98 could be purchased or sold
for $980 ($1,000 × 0.98).
• Likewise, a bond quoted at 109
could be purchased or sold for
$1,090 ($1,000 × 1.09).
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Bond Characteristics and Terminology
• 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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Bond Characteristics and Terminology
• Bonds that a corporation reserves the
right to redeem before their maturity
are called callable bonds.
• Bonds that the purchaser may redeem
before maturity are called redeemable
bonds.
• Bonds issued on the basis of general
credit of the corporation are debenture
bonds.
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Financing Corporations
Corporations finance their operations
using the following:
• Debt such as purchasing on account or
issuing bonds or notes payable.
• Equity such as issuing common shares
and, in some cases, preferred shares.
• Debt and equity combined.
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Advantages of Issuing Bonds
• No impact on ownership—bondholders
have no ownership of the corporation.
• Tax-deductible interest—interest paid
on bonds is tax-deductible, whereas
dividends are paid out of after-tax
income.
• Positive impact on earnings per share—
issuing bonds can result in an increase
to earnings per share.
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Highland Corporation is considering the
following plans to issue debt and equity:
Plan 1: Sell 40,000 common shares at $100
each.
Plan 2: Issue $4,000,000 5% bonds
Plan 3: Sell 20,000 common shares and
issue $2,000,000 5% bonds
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Earnings per share (EPS) measure
the income earned by each common
share. It is computed as follows:
Earnings per share =
Net Income – Preferred
Dividends
Weighted Average Number of
Common Shares Outstanding
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Data for Highland Corporation:
• Earnings before interest and taxes
are $1,000,000.
• The tax rate is 30%.
• Highland Corporation has 100,000
outstanding common shares.
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Disadvantages of Issuing Bonds
• Mandatory interest payments—a
corporation must make interest
payments whereas a corporation is
not obligated to pay dividends.
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Disadvantages of Issuing Bonds
• Mandatory principal repayment—
at maturity the principal amount of
the bond must be repaid whereas
the amount received for shares is
not repaid.
• Negative impact on earnings per
share—issuing bonds can result in
a decrease to earnings per share.
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EXAMPLE EXERCISE 14-1
Financing with Bonds versus Shares
Greenfield Co. is planning a new business,
which is expected to generate $750,000
income before interest and income taxes.
Greenfield is considering the following
alternative plans for financing its expansion:
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EXAMPLE EXERCISE 14-1
Financing with Bonds versus Shares
Determine the earnings per share under the
two alternative financing plans, assuming an
income tax rate of 30%.
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FOLLOW MY EXAMPLE 14-1
Financing with Bonds versus Shares
For Practice: PE 14-1
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Proceeds from Issuing Bonds
When a corporation issues bonds,
the proceeds received for the bonds
depends on the following:
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Proceeds from Issuing Bonds
1. The principal amount or face
value of the bonds, which is the
amount due at the maturity date.
2. The interest rate on the bonds.
3. The market rate of interest.
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Proceeds from Issuing Bonds
The interest rate to be paid on the
face value of the bond is called the
stated rate, contract rate, or coupon
rate.
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Proceeds from Issuing Bonds
The market or effective rate of
interest is the rate determined by
transactions between buyers and
sellers of similar bonds. The market
rate of interest is affected by a
variety of factors, including investors’
expectations of current and future
economic conditions.
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Proceeds from Issuing Bonds
The interest rate to be
paid on the face value
of the bond is called
the stated rate,
contract rate, or
coupon rate.
The market or effective
rate of interest is the
rate determined by
transactions between
buyers and sellers of
similar bonds.
Often a bond’s stated rate of interest differs from
the market rate of interest.
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If the market rate equals the contract
rate, the bonds will sell at their face
value.
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If the market rate is higher than the
contract rate, the bonds will sell at a
discount.
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If the market rate is lower than the
contract rate, the bonds will sell at a
premium.
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2
Journalize entries for bonds
payable.
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Bonds Issued at Face Value
On January 1, 2014, Muskoka
Communications Inc. issued for cash
$100,000 of 6%, five-year bonds;
interest payable semiannually. The
market rate of interest is 6%.
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Since the stated rate of interest and
the market rate of interest are the
same, the bonds will sell at their face
value or at par.
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Every six months (on June 30 and
December 31) after the bonds are
issued, interest of $3,000 ($100,000 ×
0.06 × 6/12) is paid.
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The bond matured on December 31,
2018. At this time, the corporation
will pay the face value to the
bondholder.
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EXAMPLE EXERCISE 14-2
Issuing Bonds at Face Value
On July 1, when the market rate of interest
was 4%, a company issued a $3,000,000, 4%,
10-year bond that pays semiannual interest
on December 31 and June 30, receiving cash
of $3,000,000. Journalize the entries to
record (a) the issuance of the bonds and (b)
the first interest payment.
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FOLLOW MY EXAMPLE 14-2
Issuing Bonds at Face Value
For Practice: PE 14-2
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Bonds Issued between Interest Dates
If bonds are sold between interest
dates, the amount of interest earned
to date is calculated and added to
the selling price.
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Assume that the Muskoka
Communications Ltd. bonds in the prior
example were sold on March 1, 2014 at
par value.
The bondholder will receive an interest
payment of $3,000 for six months on June
30, even though they will have owned the
bonds for only four months.
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In order to reduce the interest
received to four months’ interest, the
purchaser of the bonds will pay for
the bonds plus two months’ interest.
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The interest payment on June 30,
2014, is recorded as follows:
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EXAMPLE EXERCISE 14-3
Bonds Issued between Interest Dates
On May 1, a company issued at face value a
$1,200,000, 3%, five-year bond that pays
semiannual interest on March 31 and
September 30. Journalize (a) the sale of the
bond and (b) the interest payment on
September 30.
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FOLLOW MY EXAMPLE 14-3
Bonds Issued between Interest Dates
For Practice: PE 14-3
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Bonds Issued at a Discount
On January 1, 2014, New Brunswick
Distribution Ltd. issued $100,000, 6%
(paid semiannually on June 30 and
December 31), five-year bonds when
the market rate was 7%.
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On January 1, 2014, the firm issued
$100,000 bonds for $95,842 (a
discount of $4,158).
The discount may be viewed as the
amount required by investors to
accept a contract rate of interest
below the market rate.
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Using T accounts, the $95,842
carrying value of the bond is
reflected in the two accounts as
follows:
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EXAMPLE EXERCISE 14-4
Issuing Bonds at a Discount
On the first day of the fiscal year, a company
issues a $1,000,000, 6%, five-year bond that
pays semiannual interest of $30,000
($1,000,000 × 6% × ½), receiving cash of
$936,420. Journalize the entry to record the
issuance of the bonds.
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FOLLOW MY EXAMPLE 14-4
Issuing Bonds at a Discount
For Practice: PE 14-4
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Amortizing a Bond Discount
The two methods of computing
amortization of a bond discount are as
follows:
1. Straight-line method
2. Effective interest method (Required for
IFRS)
Both methods amortize the same total
amount of discount over the life of the
bonds.
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Straight-Line Amortization
• May be used by businesses that
report according to ASPE.
• Provides for a constant amount of
amortization each period.
• To illustrate, amortization of the
preceding bond discount is
computed on the next slide.
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Straight-Line Amortization
Discount on bonds payable . . . $4,158.00
Term of bonds . . . . . . . . . . . . . . 5 years
Semiannual amortization . . . . . $415.80
($4,158/10 periods)
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Straight-Line Amortization
On June 30, 2014 (and each
subsequent interest payment date),
six-months’ interest is paid and the
bond discount is amortized
($4,158/10).
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Straight-Line Amortization
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Straight-Line Amortization
The effect of the discount
amortization is to increase the
interest expense from $3000.00 to
$3,415.80, which effectively raises
the bond rate of interest from 6% to
a rate of interest that approximates
the market rate of 7%.
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Using T accounts, the $96,257.80
carrying value of the bond is
reflected in the two accounts as
follows:
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EXAMPLE EXERCISE 14-5
Discount Amortization—Straight-Line Method
Using the bond from Example Exercise 14-4,
journalize the first interest payment and the
amortization of the related bond discount,
using the straight-line method for discount
amortization.
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60
FOLLOW MY EXAMPLE 14-5
Discount Amortization—Straight-Line Method
For Practice: PE 14-5
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Effective Interest Method
• Provides for a constant rate of
interest over the life of the bonds.
• Better reflection of reality as the
interest rate stays constant:
conceptually superior results to the
straight-line method.
• Required for companies reporting
under IFRS.
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Amortization of Discount by Effective
Interest Method
New Brunswick Distribution Ltd. bonds
issued at a discount have the following
data:
Face value of 6%, 5-year bonds,
interest compounded semiannually
$100,000
Present value of bonds at
effective (market) rate of interest of 7%
95,842
Discount on bonds payable
4,158
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The entry to record the first interest
payment on June 30, 2014, and the
related discount amortization is as
follows:
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EXAMPLE EXERCISE 14-6
Discount Amortization—Effective Interest Method
A company issued a $2,000,000, 4%, five-year
bond that pays semiannual interest of
$40,000 ($2,000,000 × 4% × 1/2), receiving
cash of $1,912,479, for an effective interest
rate of 5%. Journalize the first interest
payment.
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FOLLOW MY EXAMPLE 14-6
Discount Amortization—Effective Interest Method
For Practice: PE 14-6
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Adjusting Entry for Interest Expense
When the interest payment dates of
bonds differ from the company’s
fiscal year-end, an adjusting entry is
needed.
Using the same New Brunswick
Distribution Ltd. example, the
December 31, 2014, payment would
be recorded as follows:
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Adjusting Entry for Interest Expense
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Adjusting Entry for Interest Expense
If the company’s fiscal year-end was
August 31, 2014, interest expense
needs to be recorded for the two
months from the last interest
payment.
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Adjusting Entry for Interest Expense
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Bonds Issued at a Premium
On January 1, 2014, Newfoundland
Transportation Ltd. issued $100,000,
6% (paid semiannually on June 30
and December 31), five-year bonds
when the market rate was 5%.
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On January 1, 2014, the firm issued
$100,000 bonds for $104,376 (a
premium of $4,376).
The premium may be viewed as the extra amount
investors are willing to pay for bonds that have higher
rate of interest than the market rate.
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Using T accounts, the $104,376
carrying value of the bond is
reflected in the two accounts as
follows:
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EXAMPLE EXERCISE 14-7
Issuing Bonds at a Premium
A company issued a $2,000,000, 6%, five-year
bond that pays semiannual interest of
$60,000 ($2,000,000 × 6% × 1/2), receiving
cash of $2,087,521. Journalize the bond
issuance.
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FOLLOW MY EXAMPLE 14-7
Issuing Bonds at a Premium
For Practice: PE 14-7
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Amortizing a Bond Premium
Like bond discounts, bond premiums must
be amortized over the life of the bond.
The premium can be amortized on its own:
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Amortizing a Bond Premium
Or the premium can be amortized
combined with the semiannual
interest payment, as seen on the
following slide.
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Straight-Line Method of Amortization
Premium on bonds payable . .
$4,376
Term of bonds . . . . . . . . . . . . .
5 years
Semiannual amortization. . . . .
$437.60
($4,376/10 periods)
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Straight-Line Method of Amortization
The entry to record the first interest
payment on June 30, 2014, and the related
premium amortization is as follows:
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Using T accounts, the $103,938.40
carrying value of the bond is
reflected in the two accounts as
follows:
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Premium Amortization
The effect of the premium
amortization is to decrease the
interest expense from $3000.00 to
$2,562.40, which effectively reduces
the bond rate of interest from 6% to
a rate of interest that approximates
the market rate of 5%.
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82
EXAMPLE EXERCISE 14-8
Premium Amortization—Straight-Line Method
Using the bond from Example Exercise 14-7,
journalize the first interest payment and the
amortization of the related bond premium,
using the straight-line method of
amortization.
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FOLLOW MY EXAMPLE 14-8
Premium Amortization—Straight-Line Method
For Practice: PE 14-8
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Amortization of Premium by Effective
Interest Method
Newfoundland Transportation Ltd. bonds
issued at a discount has the following data:
Present value of bonds at effective
(market) rate of interest of 5% $104,376
Face value of 6%, semiannual,
5-year bonds:
100,000
Premium on bonds payable
$ 4,376
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EXAMPLE EXERCISE 14-9
Premium Amortization—Effective Interest Method
A company issued a $2,000,000, 6%, five-year
bond that pays semiannual interest of
$60,000 ($2,000,000 × 6% × ½), receiving
cash of $2,087,521, for an effective interest
rate of 5%. Journalize the first interest
payment and premium amortization, using
the effective interest method.
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87
FOLLOW MY EXAMPLE 14-9
Premium Amortization—Effective Interest Method
For Practice: PE 14-9
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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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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.
Gains and losses on the redemption of bonds are
normally reported as Other Income (Loss).
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The corporation calls the remaining
$75,000 of outstanding bonds, which
are held by a private investor, for
$79,500 on July 1, 2014.
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EXAMPLE EXERCISE 14-10
Redemption of Bonds Payable
A $500,000 bond with an unamortized
discount of $40,000 is redeemed for
$475,000. Journalize the redemption of the
bonds.
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FOLLOW MY EXAMPLE 14-10
Redemption of Bonds Payable
For Practice: PE 14-10
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3
Describe and illustrate the
accounting for installment
notes.
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Installment Notes
An installment note is a debt that
requires the borrower to make equal
periodic payments to the lender for
the term of the note.
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Installment Notes
Unlike bonds, a note payment
consists of payment of a portion of
the amount initially borrowed (the
principal) and payment of interest on
the outstanding balance.
At the end of the note’s term, the
principle will have been repaid in full.
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Issuing an Installment Note
Lewis Company issues a $24,000, 6%, fiveyear note to TD Bank on January 1, 2013.
The annual payment is $5,698.
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The entry to record the first payment
on December 31, 2013, is as follows:
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The entry to record the second
payment on December 31, 2014, is as
follows:
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The entry to record the final payment
on December 31, 2017, is as follows:
After the entry is posted, the balance
in Notes Payable related to this note
is zero.
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EXAMPLE EXERCISE 14-11
Journalizing Installment Notes
On the first day of the fiscal year, a company
issues a $30,000, 10%, five-year installment
note that has annual payments of $7,914.
a. Journalize the entry to record the issuance
of the installment note.
b. Journalize the first annual note payment,
which consists of both interest and
principal repayment.
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FOLLOW MY EXAMPLE 14-11
Journalizing Installment Notes
For Practice: PE 14-11
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4
Describe and illustrate the
reporting and analysis of longterm liabilities.
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Reporting Long-Term Liabilities
The reporting of long-term liabilities is the
same under both IFRS and ASPE
accounting standards.
Any portion due within one year is
reported as a current liability.
A description of bonds or notes should be
reported on the face of the financial
statements or in the accompanying notes.
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Times Interest Earned
Income Before Income Taxes
+ Interest Expense
Times Interest
=
Earned
Interest Expense
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WestJet Airlines Ltd.
Times Interest
Earned
=
Times Interest
=
Earned
$208,006 + $60,911
$60,911 (in thousands)
4.41
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EXAMPLE EXERCISE 14-12
Times Interest Earned
Harris Industries reported the following on the
company’s income statement in 2015 and 2014:
a. Determine the times interest earned for 2015
and 2014. Round to one decimal place.
b. Is the times interest earned improving or
declining?
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FOLLOW MY EXAMPLE 14-12
Times Interest Earned
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FOLLOW MY EXAMPLE 14-12
Times Interest Earned
b. The times interest earned has increased
from 5.0 in 2014 to 6.0 in 2015. Thus, the
debtholders have improved confidence in
the company’s ability to make its interest
payments.
For Practice: PE 14-12
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The End
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