©CourseCollege.com 1 18 In depth: Bonds Bonds are a common form of debt financing for publicly traded corporations Learning Objectives 1.Explain market pricing of bonds 2.Account for bonds sold at a discount 3.Account for bonds sold at a premium 4.Account for bond retirement and redemption

©CourseCollege.com 2 Bond types Registered Secured Callable Unsecured Bonds (debentures) not secured by collateral Bonds (debentures) not secured by collateral Bonds which are secured by collateral Bonds which are secured by collateral Issuer has a right (option) to retire the bond before maturity Issuer has a right (option) to retire the bond before maturity Bond owners are tracked and recorded Bond owners are tracked and recorded O11B

©CourseCollege.com 3 Bond types (continued) Term Convertible Serial Zero coupon Interest payments are made only at maturity, none during bond term Interest payments are made only at maturity, none during bond term Holders have an option to convert bonds to other firm securities (stock) Holders have an option to convert bonds to other firm securities (stock) Principal reductions are made during bond term Principal reductions are made during bond term All bond principal is repaid at bond maturity All bond principal is repaid at bond maturity O11B

©CourseCollege.com 4 Bond risk Investment grade High yield or Junk bonds Default risk –the risk that the issuer will be unable to repay bond obligations –rating agencies classifications are shown below O11B

©CourseCollege.com 5 Compare stocks & bonds Bond holders are creditors to whom the firm must pay interest and matured amounts due. Stockholders are owners and the firm can decide whether to pay dividends or not. O11B

©CourseCollege.com 6 Objective 18.1: Explain market pricing of bonds O18.1 Bond* issuers make two promises ( *term bonds) 2. To repay bond face value at maturity 1. To make periodic interest payments

©CourseCollege.com 7 Investor’s yield O11B.1 Annual Yield to Investor = Amount invested Annual interest earned* Reduce amount invested and increase yield. *from both repayment promises

©CourseCollege.com 8 Example – increase yield O11B.1 Example: $7 interest earned, $100 invested $7 / $100 = 7% yield Reduce the $100 to $87.50 Raises the yield $7 / $87.50 = 8%

©CourseCollege.com 9 Example – decrease yield O11B.1 Example: $6 interest earned, $100 invested $6 / $100 = 6% yield Increase the $100 to $120 Lowers the yield $6 / $120 = 5%

©CourseCollege.com 10 How are bonds priced? O11B.1 Bond buyers offer prices for bonds based on the yield that will result from the price offered. Recall that yield is determined by the interest earned and the amount invested to earn that interest. The $ price paid for a bond is set by the yield. The yield is set by the market – the equilibrium of supply and demand

©CourseCollege.com 11 How does yield affect price? O11B.1 The yield (rate) is used to discount to their present value, the two promises made by the issuer: The return of the face value of the bond at maturity and; The periodic payment of interest (coupon) during the term of the bond

©CourseCollege.com 12 Bond pricing O11B.1 $ $ Present Value Single amount – payment of face amount of the bond $$ Annuity - payment of periodic coupon interest Total Present Value The market rate (yield) is used to discount

©CourseCollege.com 13 Example –price less than face value Sold at a discount 10 periods, 4% per period

©CourseCollege.com 14 Example –price greater than face value 20 periods, 4% per period Sold at a premium

©CourseCollege.com 15 Objective 18.2: Account for bonds sold at a discount O18.2 When the market yields on the day of the bond sale are higher than the coupon rate of the bond, the bond will sell at a discount. The issuer receives less cash than the face amount of bond

©CourseCollege.com 16 Bond sold at discount O18.2 Market yields were higher than the coupon rate Therefore, the bond sold at a discount

©CourseCollege.com 17 Recording bonds sold at a discount O18.2 To record bonds sold at a discount a contra liability account is used. This allows the recording of the face amount of the bond which will be due at bond maturity and provides a mechanism to balance the cash received with the bond issuance on the date of the sale. The contra liability account has a normal debit balance.

©CourseCollege.com 18 Contra liability account O11B.2 Discount on Bonds Payable 42,651 Carrying value 957,349 Bonds Payable 1,000,000 The carrying value equals the the amount of cash received at bond issuance

©CourseCollege.com 19 Journal entry –bond issuance at discount O11B.2

©CourseCollege.com 20 Journal entry –coupon interest payments O11B.2 The effective interest method uses the market rate at the time of bond issuance to determine recorded interest expense Coupon payment promised: 5%/2 x $1,000,000 = $25,000 Recorded interest expense: 6%/2 x $957,349 = $28,720 Coupon payment promised: 5%/2 x $1,000,000 = $25,000 Recorded interest expense: 6%/2 x $957,349 = $28,720 Both amounts must be recorded Market Rate Carrying Value

©CourseCollege.com 21 Journal entry –coupon interest payments O11B.2 The entry to balance is a reduction in Discount on Bonds Payable Coupon $ received by bond holders

©CourseCollege.com 22 Discount on Bonds Payable O11B.2 Discount on Bonds Payable 42,651 Carrying value 957,349 Bonds Payable 1,000,000 The discount must be amortized to each coupon payment period

©CourseCollege.com 23 Amortizing the Discount Distributing some of the Discount to each payment period increases amount recorded for interest expense each period. $3,720 O18.2

©CourseCollege.com 24 Journal entry –coupon interest payments O11B.2 The recorded interest expense is higher than the coupon payment Coupon $ received by bond holders

©CourseCollege.com 25 Discount Amortization schedule O18.2 Carrying value increases to amount due to bond holders at maturity

©CourseCollege.com 26 Objective 18.3: Account for bonds sold at a premium O18.3 When the market yields on the day of the bond sale are lower than the coupon rate of the bond, the bond will sell at a premium. The issuer receives more cash than the face amount of bond

©CourseCollege.com 27 Bond sold at premium O18.3 Market yields were lower than the coupon rate Therefore, the bond sold at a premium

©CourseCollege.com 28 Recording bonds sold at a premium O18.3 To record bonds sold at a premium an adjunct liability account is used. This allows the recording of the face amount of the bond which will be due at bond maturity and provides a mechanism to balance the cash received with the bond issuance on the date of the sale. The adjunct liability account has a normal credit balance.

©CourseCollege.com 29 Adjunct liability account O11B.3 The carrying value equals the the amount of cash received at bond issuance Premium on Bonds Payable 42,651 Carrying value 1,042,651 Bonds Payable 1,000,000

©CourseCollege.com 30 Journal entry –bond issuance at premium O11B.3

©CourseCollege.com 31 Journal entry –coupon interest payments O11B.3 The effective interest method uses the market rate at the time of bond issuance to determine recorded interest expense Coupon payment promised: 7%/2 x $1,000,000 = $35,000 Recorded interest expense: 6%/2 x $1,042,651 = $31,280 Coupon payment promised: 7%/2 x $1,000,000 = $35,000 Recorded interest expense: 6%/2 x $1,042,651 = $31,280 Both amounts must be recorded Market Rate Carrying Value

©CourseCollege.com 32 Journal entry –coupon interest payments O11B.3 Coupon $ received by bond holders The entry to balance is a reduction in Premium on Bonds Payable

©CourseCollege.com 33 Premium on Bonds Payable O11B.3 Premium on Bonds Payable 42,651 Carrying value 1,042,651 Bonds Payable 1,000,000 The premium must be amortized to each coupon payment period

©CourseCollege.com 34 Amortizing the Premium Distributing some of the Premium to each payment period decreases amount recorded for interest expense each period. $3,720 O18.3

©CourseCollege.com 35 Journal entry –coupon interest payments O11B.3 The recorded interest expense is lower than the coupon payment Coupon $ received by bond holders

©CourseCollege.com 36 Premium Amortization schedule O18.3 Carrying value decreases to amount due to bond holders at maturity

©CourseCollege.com Bond obligations are satisfied in several ways including: scheduled retirement conversion early payoff or redemption Objective 18.4: Account for bonds retirement and redemption

©CourseCollege.com Retirement vs Redemption 1.Bonds paid in full at maturity 2.Convertible bonds are retired and converted to other securities from the firm (usually stock) 1.Bonds purchased on the open market by the issuer firm 2.Bonds (with call feature) are redeemed by the issuer after paying call premiums, if any, to the bond holders RETIREMENT REDEMPTION

©CourseCollege.com 39 Retire or Redeem Bonds Bond Holder (Investor) Bond Issuer (Firm) Bond 18.4

©CourseCollege.com 40 Bond retirement 18.4 Bond Sinking Funds – Bond indenture contracts often include a fund in which the issuer firm deposits cash periodically in order to build up sufficient amounts to retire bonds at maturity.

©CourseCollege.com 41 Bond retirement 18.4 Conversion – Some bonds give holders the option of converting the bonds to stock using a conversion formula detailed in the bond indenture agreement. Bondholders benefit if the market price of the stock appreciates substantially. Conversion – Some bonds give holders the option of converting the bonds to stock using a conversion formula detailed in the bond indenture agreement. Bondholders benefit if the market price of the stock appreciates substantially.

©CourseCollege.com 42 Bond Conversion Bond Holder (Investor) Bond Issuer (Firm) Bond 18.4 Stock

©CourseCollege.com 43 Bond Conversion 18.4 # of shares depends on the bond indenture agreement Notice no cash is involved in the conversion. A liability has been moved to equity.

©CourseCollege.com 44 Bond redemption 18.4 Open market purchases -Bond redemption is the pay off of bonds by the issuing firm before the bonds mature. Redemption can occur for any bond through the purchase of bonds on the open market by the issuing firm.

©CourseCollege.com 45 Bond redemption 18.4 Accounting for bond redemptions – The central issue in accounting for bond redemptions is whether a gain or loss has occurred as a result of the redemption. In this question, the carrying value (net Bonds Payable) of the bond becomes important... Accounting for bond redemptions – The central issue in accounting for bond redemptions is whether a gain or loss has occurred as a result of the redemption. In this question, the carrying value (net Bonds Payable) of the bond becomes important...

©CourseCollege.com 46 Bond redemption 18.4 Cash assets –are given up to satisfy the carrying value of the bond liability. If more assets are given up than liabilities paid, a loss occurs. If more liabilities are paid than assets given up, a gain occurs.

©CourseCollege.com 47 Reporting gains and losses 18.4 Gains and losses from bond redemption and retirement are reported as extraordinary gains and losses. That is they are reported net of income tax effects and shown separately from continuing operations.

©CourseCollege.com 48 Bond redemption -loss Carrying value of Bonds Payable Whistle Corporation has a call provision in their $2,000,000 bonds which requires them to pay bondholders the face value of the bonds plus 2%. On June 30 Whistle exercises the call with the up to date account balances as shown below: Bonds Payable$2,000,000 Discount on Bonds Payable (15,000) Net Bonds Payable $1,985,000 Cash required to exercise call option: Face value = $2,000,000 x 1.02 = $2,040,

©CourseCollege.com 49 Bond redemption -loss The loss balances the journal entry 18.4

©CourseCollege.com 50 Bond redemption -gain Carrying value of Bonds Payable Stop Corporation has a call provision in their $5,000,000 bonds which requires them to pay bondholders the face value of the bonds plus 1.5%. On April 30 Whistle exercises the call with the up to date account balances as shown below: Bonds Payable $5,000,000 Premium on Bonds Payable 100,000 Net Bonds Payable $5,100,000 Cash required to exercise call option: Face value = $5,000,000 x = $5,075,

©CourseCollege.com 51 Bond redemption -gain 18.4 The gain balances the journal entry

©CourseCollege.com 52 End Unit 18