Financial Accounting Lesson 9 Accounting for Bonds Ben
Financial Accounting Lesson 9: Accounting for Bonds Ben Trnka/Boz Bostrom www. benandboz. com
Focus Company – Disney!
Overview Understand terminology used when discussing bonds Understand how to record bond transactions when bonds are issued: At Par At a Discount At a Premium
Bonds - Big Picture Why would a company issue bonds instead of issuing new shares of stock? Avoid diluting ownership Cheaper form of financing than providing shareholders with their required return Interest is tax deductible Why would a company issue bonds instead of borrowing directly from a bank? Raise more money than from relying on a bank Additional borrowing options can reduce interest rates Issuing debt is riskier than issuing shares (equity) Locked into interest payments and principal repayment
Bond Terminology – Big Picture Secured vs. Unsecured Secured bonds are backed by collateral Unsecured bonds (debenture bonds) are not Term vs. Serial Bonds Term bonds are paid off at the end of the loan with a large lump sum Serial Bonds are paid off throughout the loan Callable/Redeemable vs. Convertible Callable/Redeemable bonds could be paid off early by the company - if the company wants Convertible bonds can be converted into stock of the company – if the bondholder wants
Bond Terminology – Smaller Picture Principal – the amount investors provide the issuing company Coupon Rate – the interest rate the issuing company will pay to investors throughout the term of the loan Market Rate – the rate of interest the market believes an issuing company should pay for a given bond Bond Indenture – Legal contract with all provisions of a specific bond issuance Prospectus – Document provided by the company in order to detail bond information to potential investors
Bonds Selling at Par When a bond is issued at par, the Stated Rate of interest equals the Market Rate of interest. In this scenario, the company will receive the full amount it is asking for Interest expense recorded on the income statement will equal the cash interest paid each period Example: Disney wants to create new movie, and it is raising $2, 000 through a new bond issuance. The bonds have a stated interest rate of 3%, and they mature in 10 years. Disney will pay interest semi-annually. The market rate of interest is 3%. What is the initial journal entry when Disney issues these bonds?
Bonds Selling at Par - Example Calculate present value of principal Calculate present value of interest payments
Bonds Selling at Par - Example Calculate present value of principal $2, 000 x 0. 74247 (interest paid twice per year - 20 periods, 1. 5% rate) $1, 484, 940 Calculate present value of interest payments
Bonds Selling at Par - Example Calculate present value of principal $2, 000 x 0. 74247 (interest paid twice per year - 20 periods, 1. 5% rate) $1, 484, 940 Calculate present value of interest payments $30, 000 ($2, 000 * 3% * 6/12) x 17. 16864 $515, 059. 20 $2, 000 (rounded)
Bonds Selling at Par – Example At the time of issuance, Disney records the following entry: Dr Cr Every 6 months, Disney will make the following journal entry Dr Cr At the end of the 10 years (the 20 th payment), Disney will make the following journal entry: Dr Interest Expense $30, 000 ($2, 000 * 3% * 6/12) Dr Bonds Payable $2, 000 Cr Cash Bonds Payable Interest Expense Cash $2, 000, 000 $30, 000 ($2, 000 * 3% * 6/12) $30, 000 $2, 030, 000
Bonds Selling at a Discount When a bond is issued at a discount, the Stated Rate of interest is less than the Market Rate of interest. In this scenario, the company will receive less than the full amount it is asking for Interest expense recorded on the income statement will be greater than the cash interest paid each period Example: Disney wants to create new movie, and it is raising $2, 000 through a new bond issuance. The bonds have a stated interest rate of 3%, and they mature in 10 years. Disney will pay interest semi-annually. The market rate of interest is 4%. What is the initial journal entry when Disney issues these bonds?
Bonds Selling at a Discount - Example: Disney wants to create new movie, and it is raising $2, 000 through a new bond issuance. The bonds have a stated interest rate of 3%, and they mature in 10 years. Disney will pay interest semi-annually. The market rate of interest is 4%. What is the initial journal entry when Disney issues these bonds? Disney needs to record the bonds at the present value of future payments Future payments include both interest and principal Dr Cash Dr Discount on Bonds Payable $163, 514. 33 Cr Bonds Payable $1, 836, 485. 67 $2, 000. 00
Bonds Selling at a Discount – Example What happens when Disney needs to make an interest payment 6 months later? We are going to use the Effective Interest method, because that is what most companies use Dr Interest Expense Cr Discount on Bonds Payable $6, 729. 71 Cr Cash $30, 000. 00 What happens when Disney needs to make an interest payment 6 months after that? Dr Cr Discount on Bonds Payable $6, 864. 31 Cr Cash $30, 000. 00 Interest Expense $36, 729. 71 $36, 864. 31
Bonds Selling at a Premium When a bond is issued at a premium, the Stated Rate of interest is greater than the Market Rate of interest. In this scenario, the company will receive more than the full amount it is asking for Interest expense recorded on the income statement will be less than the cash interest paid each period Example: Disney wants to create new movie, and it is raising $2, 000 through a new bond issuance. The bonds have a stated interest rate of 3%, and they mature in 10 years. Disney will pay interest semi-annually. The market rate of interest is 2%. What is the initial journal entry when Disney issues these bonds?
Bonds Selling at a Premium - Example: Disney wants to create new movie, and it is raising $2, 000 through a new bond issuance. The bonds have a stated interest rate of 3%, and they mature in 10 years. Disney will pay interest semi-annually. The market rate of interest is 2%. What is the initial journal entry when Disney issues these bonds? Disney needs to record the bonds at the present value of future payments Future payments include both interest and principal Dr Cash $2, 180, 455. 53 Cr Premium on Bonds Payable $180, 455. 53 Cr Bonds Payable $2, 000. 00
Bonds Selling at a Premium – Example What happens when Disney needs to make an interest payment 6 months later? Dr Interest Expense Dr Premium on Bonds Payable Cr What happens when Disney needs to make an interest payment 6 months after that? Dr Interest Expense Dr Premium on Bonds Payable Cr $21, 804. 56 $8, 195. 44 Cash $30, 000. 00 $21, 722. 60 $8, 277. 40 $30, 000. 00
Summary Bonds Issued at Par a Discount Bonds Issued at a Premium Par Value 2, 000, 000 2, 000 Cash Received at Issuance 2, 000 1, 836, 485. 67 2, 180, 455. 53 Cash Payment – period 1 30, 000 Interest Expense – period 1 30, 000 36, 729. 71 21, 804. 56
Key Takeaways Many companies use bonds to finance capital expenditures instead of issuing new stock. Bonds can be issued at par, at a discount, or for a premium Companies need to record long term liabilities at the present value of all future payments, including interest and principal Thanks for tuning in!
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