Module 10 Bonds and Long Term Notes Payable

SAP 2007 / SAP University Alliances Introductory Accounting Learning Objectives Compare bond versus share financing.Explain the types of bonds and their issuing procedures.Prepare entries to record bonds issued at par.Determine the price of a bond.Prepare entries to record bonds issued at a discount.Prepare entries to record bonds issued at a premium.Record the retirement of bonds.Explain and record notes.Run an SAP demonstration.Practise entering bond transactions in SAP.

SAP 2007 / SAP University Alliances Introductory Accounting A written promise to pay an amount identified as the par value of the bond along with interest at a stated annual amount. Bond

SAP 2007 / SAP University Alliances Introductory Accounting The stated interest rate is also referred to as the contract rate, nominal rate, or coupon rate. The rate is quoted as an annual rate. Annual amount of interest paid Par value Stated of the x rate of bond interest = Bonds

SAP 2007 / SAP University Alliances Introductory Accounting Advantages of Bonds Bonds do not affect shareholder control. Interest on bonds is tax deductible. Bonds can increase return on equity. Disadvantages of Bonds Bonds require payment of both annual interest and par value at maturity. Bonds can decrease return on equity. Bonds

SAP 2007 / SAP University Alliances Introductory Accounting Secured Bonds Assets are pledged as collateral by the issuing company. Unsecured Bonds Not backed by specific assets but only by earning capacity and credit reputation. Bond Types

SAP 2007 / SAP University Alliances Introductory Accounting Term Bonds Principal of all bonds is due in a lump sum at a specified single date. Serial Bonds Principal is due in installments at several different dates. Bond Types

SAP 2007 / SAP University Alliances Introductory Accounting Registered Bonds Bonds are issued in the names of the buyers. Ownership records are kept up to date. Bearer Bonds Bonds are payable to whoever possesses them. No records are kept for change in ownership. Bond Types

SAP 2007 / SAP University Alliances Introductory Accounting Convertible Bonds Allow the buyer to exchange the bond for common shares at a fixed ratio. Bearer Bonds May be called for early retirement at the option of the issuing corporation. Redeemable Bonds May be retired early at the option of the purchaser. Bond Types

SAP 2007 / SAP University Alliances Introductory Accounting...an investment firm called an underwriter. The underwriter sells the bonds to... A company sells the bonds to investors. Bond Issuing Procedures A trustee monitors the bond issue.

SAP 2007 / SAP University Alliances Introductory Accounting The issue price of a bond is equal to the present value of the bond’s future cash payments. Bonds may be exchanged in the market at a price equal to, below, or above the face value of the bond. This occurs when the market rate of interest is different from the stated (contract) rate. Bond market values are expressed as a percent of their par (face) value. Bond Pricing

Contract rate is:Bond sells: Above market rateAt a premium (> 100% of face value) Equal to market rateAt par value (= 100% of face value) Below market rateAt a discount (< 100% of face value) Bond Pricing SAP 2007 / SAP University Alliances Introductory Accounting

SAP 2007 / SAP University Alliances Introductory Accounting Illustration: Issuing Bonds at Par Barnes Corp. issues $800,000 of 9%, 20-year bonds. The bonds are dated January 1, 2005, and are due in 20 years on January 1, Interest is paid semi-annually each June 30 and December 31. All the bonds are sold at their par value. On January 1, 2005, the date of issuance, the entry would be: Cash 800,000 Bonds Payable 800,000

SAP 2007 / SAP University Alliances Introductory Accounting Illustration: Issuing Bonds at Par On June 30, 2005, the first interest payment date, the entry would be: Bond Interest Expense 36,000 Cash 36,000 ($800,000 x 9% x 6/12) = $36,000 On January 1, 2025, the maturity date, the entry would be: Bonds Payable 800,000 Cash 800,000

SAP 2007 / SAP University Alliances Introductory Accounting When bonds are sold at a date other than the interest payment date, the purchaser pays the purchase price plus accrued interest. The issuing company repays the interest on the next interest date. Issuing Bonds Between Interest Dates

SAP 2007 / SAP University Alliances Introductory Accounting Illustration: Issuing Bonds Between Interest Dates Canadian Tire has $100,000 of 9% bonds available for sale on January 1. Interest is payable on each June 30 and December 31. If the bonds are sold at par on March 1, two months after the original issue date of January 1, the issuer collects two months’ interest from the buyer at the time of sale. Stated Issue Date Jan. 1 Mar. 1 June 30 Date of Sale First Interest Date Accrued interest ($100,000 x 9% x 2/12) = $1,500 Purchaser pays face value plus accrued interest.

SAP 2007 / SAP University Alliances Introductory Accounting Jan. 1 Mar. 1 June 30 Stated Issue Date Date of Sale First Interest Date Accrued interest On March 1, the date of issuance, the entry would be: Cash 101,500 Bonds Payable 100,000 Interest Payable 1,500 ($100,000 x 9% x 2/12) = $1,500 Purchaser pays face value plus accrued interest.

SAP 2007 / SAP University Alliances Introductory Accounting Jan. 1 Mar. 1 June 30 Stated Issue Date Date of Sale First Interest Date Accrued interest On June 30, the first interest payment, the entry would be: Interest Payable 1,500 Bond Interest Expense 3,000 Cash 4,500 ($100,000 x 9% x 2/12) = $1,500 ($100,000 x 9% x 4/12) = $3,000 Interest expense

SAP 2007 / SAP University Alliances Introductory Accounting The issue price of the bond equals the present value of the future cash payments. 0 Per. 1 Per. 2 Per. 3 Per. 4 Per. 5 …...Maturity Int.Pmt. Int.Pmt Int.Pmt. Int.Pmt. Int.Pmt. Int.Pmt. Par Value Bond Price= Present Value of Maturity Payment + Present Value of the Interest Payments Bond Pricing

SAP 2007 / SAP University Alliances Introductory Accounting Illustration: Present Value of a Discount Bond Fila Corp. announces an offer to issue bonds with a $100,000 par value, an 8% annual contract rate with interest payable semi-annually, and with a three-year life. The cash flows of the bond are: 0 6mo. 12mo. 18mo. 24mo. 30mo. 36mo. $4,000* $4,000 $4,000 $4,000 $4,000 $4,000 $100,000 *Semi-annual interest payment = $100,000 x 8% x 6/12

SAP 2007 / SAP University Alliances Introductory Accounting Illustration: Present Value of a Discount Bond The issue price of the bond equals the present value of the future cash payments. The market rate for Fila’s bonds is 10%. Since the market rate is higher than the contract rate of 8%, the bonds will sell at a discount. 0 6mo. 12mo. 18mo. 24mo. 30mo. 36mo. $4,000 $4,000 $4,000 $4,000 $4,000 $4,000 $100,000 The present value of these cash payments is $94,923.

SAP 2007 / SAP University Alliances Introductory Accounting Illustration: Present Value of a Discount Bond Assume the bonds were issued on December 31. The entry to record the issuance would be: Cash 94,923 Discount on Bonds Payable 5,077 Bonds Payable 100,000

SAP 2007 / SAP University Alliances Introductory Accounting Illustration: Amortizing a Bond Discount The discount of $5,077 is eventually paid to the bondholders and represents part of the cost of using the $94,923 for three years. The discount is amortized over the life of the bonds using either the Straight-Line Method or the Effective Interest Method.

SAP 2007 / SAP University Alliances Introductory Accounting An equal portion of the discount is allocated to each period. This yields a constant dollar amount of interest expense each period. Discount to be amortized each period = Bond Discount Number of periods Straight Line Method

SAP 2007 / SAP University Alliances Introductory Accounting Illustration: Straight-Line Method Bond Interest Expense 4,846 Discount on Bonds Payable 846 Cash 4,000 ($100,000 x 8% x 6/12) = $4,000 Periodic Amortization = Bond Discount Number of periods = $5,077 6 periods = $846/period The entry to record each interest payment would be: Fila Corp.’s bond discount of $5,077 is amortized over the life of the bonds.

SAP 2007 / SAP University Alliances Introductory Accounting This method allocates bond interest expense over the life of the bonds that yields a constant rate of interest. The interest expense increases each period since the balance in the liability account increases each period. = Periodic interest expense Carrying Value of Bonds x Periodic Market Rate Effective Interest Method

SAP 2007 / SAP University Alliances Introductory Accounting Illustration: Effective Interest Method Bond Interest Expense 4,746 Discount on Bonds Payable 746 Cash 4,000 The entry to record the first interest payment would be: First period interest expense = ($100,000 - $5,077) x 5%* =$4,746 *Semi-annual market rate = Carrying Value of Bonds x Periodic Market Rate

SAP 2007 / SAP University Alliances Introductory Accounting If the contract rate on a bond is greater than the market rate of interest, the bond will sell at a price above the bond’s par value. The difference between par value and market value is known as a premium. The premium is amortized over the life of the bond using either the Straight-Line Method or the Effective Interest Method. Issuing Bonds at a Premiume

SAP 2007 / SAP University Alliances Introductory Accounting Bonds may be retired: At maturity, Before maturity, or By converting them to shares. Bond Retirements

SAP 2007 / SAP University Alliances Introductory Accounting The carrying value of bonds at maturity will always equal their par value. Retirement of Bonds at Maturity

SAP 2007 / SAP University Alliances Introductory Accounting Illustration: Retiring Bonds at Maturity Assume Hydro Quebec had $100,000 of bonds that matured on December 31, 2009, and that the final interest payment has already been made. The entry to record the retirement of the bonds would be: Bonds Payable 100,000 Cash 100,000

SAP 2007 / SAP University Alliances Introductory Accounting This may be accomplished by either: Exercising a call option, or Purchasing the bonds on the open market. Companies may wish to retire their bonds before maturity. Retirement of Bonds before Maturity

SAP 2007 / SAP University Alliances Introductory Accounting Illustration: Retiring Bonds before Maturity Assume a company issued callable bonds with a par value of $100,000. The call option requires the issuer to pay a call premium of $3,000 to bondholders in addition to the par value. Assume all interest has been paid and the bonds have a carrying value of $104,500. The entry to record the retirement of the bonds would be: Bonds Payable 100,000 Premium on Bonds Payable 4,500 Gain on Retirement of Bonds 1,500* Cash 103,000 ($100,000 + $4,500) - $103,000 = $1500

SAP 2007 / SAP University Alliances Introductory Accounting Convertible bonds give bondholders the right to convert their bonds to a specified number of common shares. When conversion occurs, the carrying value of the bonds is transferred from long-term liability accounts to contributed capital accounts. No gain or loss on conversion is recorded. Retirement of Bonds by Conversion to Shares

SAP 2007 / SAP University Alliances Introductory Accounting Illustration: Bond Retirement by Conversion to Shares Assume a company has $100,000 par value bonds that have a $4,000 balance in the Discount on Bonds Payable account and these bonds are converted into 15,000 common shares. The entry to record the conversion of the bonds would be: Bonds Payable100,000 Discount on Bonds Payable4,000 Common Shares96,000

SAP 2007 / SAP University Alliances Introductory Accounting Notes payable are typically transactions with a single lender. Interest expense is allocated to each period. Interest expense for the period = Interest rate on the note x Beginning-of- period balance Long Term Notes Payable

SAP 2007 / SAP University Alliances Introductory Accounting Payment options:Interest and principal paid at maturity.Installment notes: Accrued interest plus equal principal payments. Equal payments. Long Term Notes Payable

SAP 2007 / SAP University Alliances Introductory Accounting A legal agreement that helps protect the lender if the borrower fails to make the required payments. Gives the lender the right to be paid out of the cash proceeds from the sale of the borrower’s assets specifically identified in the mortgage contract. Mortgage Notes