Chapter ACCT 201 10 Reporting and Analyzing LongTerm

Chapter ACCT 201 10 Reporting and Analyzing Long-Term Liabilities ACCT 201 UAA – ACCT 201 Principles of Financial Accounting Dr. Fred Barbee 1

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Chapter 10 - Day 1 - Agenda Topic Basics of Bonds Bond Issuances Present Value of Bonds and Notes LO Read HW A 1, C 1 422425 QS 1 P 1, P 2, P 3 425436 E 1, 2, 3, 4, 5, 6; P 1 C 3, C 4 445448 None No Homework Due Today! 3

ACCT 201 Basics of Bonds ACCT 201 Bond 4

Basics of Bonds Bond Selling Price Company Bond Certificate at Par Value Investors Bond Issue Date ACCT 201 5

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 6

Basics of Bonds Bond Par Value at maturity date Company Investors Bond Issue Date ACCT 201 Bond Maturity Date ACCT 201 7

ACCT 201 Advantages of Bonds ACCT 201 Bonds do not affect owner control. ACCT 201 Bonds can increase ROE. Interest on bonds is tax deductible. Bond 8

ACCT 201 Disadvantages of Bonds ACCT 201 Bonds require periodic payment of interest. ACCT 201 Bonds can decrease ROE. Bonds require payment of principal at maturity. Bond 9

Convertible and Callable Secured and Unsecured Types of Bonds Term and Serial Registered and Bearer 10

ACCT 201 Bond Trading ACCT 201 Bond market values are expressed as a percent of their par value. ACCT 201 11

ACCT 201 Bond Issuances ACCT 201 Bond 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. 13

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 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 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 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 28

ACCT 201 Bonds Issued at a Discount 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 30

ACCT 201 Bonds Issued at a Premium 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 32

ACCT 201 Example #1 ACCT 201 Bonds Issued At Par Value 33

ACCT 201 Issuing Bonds at Par ACCT 201 Par Value = $1, 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 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 The journal entry to record the issuance of bonds at par. ACCT 201 36

Issuing Bonds at Par 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 37

Issuing Bonds at Par On Dec. 31, 202, when the bonds mature, the following entry would be made. ACCT 201 38

ACCT 201 Example #2 ACCT 201 Bonds Issued at A Discount 39

ACCT 201 Issuing Bonds at a Discount ACCT 201 Par Value = $1, 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 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 $1, 000 92. 6405% Amortizing the discount increases Interest Expense over the outstanding life of the bond. ACCT 201 42

Issuing Bonds at a Discount On Jan. 1, 2002, the bond issue would be recorded as follows. Contra-Liability Account ACCT 201 43

Issuing Bonds at a Discount Maturity Value Carrying Value ACCT 201 44

Issuing Bonds at a Discount Using the straight-line method, the discount amortization will be $7, 360 every six months. $73, 595 ÷ 10 periods = $7, 360 (rounded) ACCT 201 45

Issuing Bonds at a Discount This entry will be made every six months to record the interest payment and the amortization of the discount. $73, 595 ÷ 10 periods = $7, 360 (rounded) $1, 000 × 10% × ½ = $50, 000 ACCT 201 46

$1, 000 x 10% x 1/2 $50, 000 + $7, 360 $73, 595/10 = $7, 360 (rounded) $66, 235 $7, 360 $1, 000 $58, 875 47

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ACCT 201 What if the company used the effective interest method to amortize the discount? ACCT 201 49

ACCT 201 Effective Interest Method 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

$1, 000 x 10% x 1/2 $931, 989 x 12% x 1/2 $55, 919 $50, 000 $68, 011 $5, 919 $1, 000 - $62, 092; or $931, 989 + $5, 919 51

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Comparing Straight-Line and Effective Interest Methods Annual Interest Expense Both methods report the same amount of interest expense over the life of the bond. 53

ACCT 201 Example #3 ACCT 201 Bonds Issued at A Premium 54

ACCT 201 Issuing Bonds at a Premium Par Value = $1, 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 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 $1, 000 108. 1145% Amortizing the premium decreases Interest Expense over the outstanding life of the bond. ACCT 201 57

Issuing Bonds at a Premium On Jan. 1, 2002, the company would record the bond issue as follows. Adjunct-Liability Account ACCT 201 58

Issuing Bonds at a Premium Using the straight-line method, the premium amortization will be $8, 115 every six months. $81, 145 ÷ 10 periods = $8, 115 (rounded) ACCT 201 59

Issuing Bonds at a Premium The semiannual interest payment over the life of the bonds. $81, 145 ÷ 10 periods = $8, 115 (rounded) $1, 000 × 10% × ½ = $50, 000 ACCT 201 60

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ACCT 201 Let’s look at the effective interest method amortization table for this bond. ACCT 201 62

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Issuing Bonds Between Interest Dates Apr. 1, 2002 June 30, 2002 Bond Issue Date Jan. 1, 2002 Bond Date Accrued interest First Interest Payment Earned interest Investor pays bond purchase price plus accrued interest. Investor receives 6 months’ interest. 64

ACCT 201 Issuing Bonds Between Interest Dates ACCT 201 Par Value = $1, 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? 66

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. 67

Issuing Bonds Between Interest Dates Here is the journal entry to record the bond issue on April 1, 2002. Now, prepare the entry for June 30, 2002. 68

Issuing Bonds Between Interest Dates Here is the entry to record the interest payment on June 30, 2002. $1, 000 × 10% × ½ = $50, 000 69

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. 70