Long-term Debt: Bonds INTERMEDIATE ACCOUNTING II CHAPTER 14 – PART 1

Long-term Debt  Source of external financing for company operations.  Signifies creditors’ interest in a company’s assets.  Requires the future payment of cash in specified (or estimated) amounts, at specified (or projected) dates.  Common debt instruments are bonds and long-term notes.

Transference of Knowledge This chapter focuses on accounting for long-term liabilities from the perspective of the issuer. An opposite transaction is recorded by the investor. For example, the issuer will record a bond or note payable [liability] and the investor (lender) will record an investment (bond) or note receivable [asset]. The same is true for interest: The issuer will record interest expense while the investor records interest income.

Bonds  Divide a large liability into many smaller liabilities (usually $1,000 per bond).  Obligate a company to repay a stated amount at a specified maturity date and periodic interest between the issue date and maturity.  Require periodic interest (usually semiannually) as a stated percentage of the face amount.  Make specific promises to bondholders described in a document called a bond indenture.  Represent a liability to the corporation that issues the bonds and an asset to a company that buys the bonds as an investment.

Bond Pricing  Supply and demand cause a bond to be priced to yield the market rate of interest for securities of similar risk and maturity.  Bonds may be sold At par (face value) At a discount (less than face value) At a premium (more than face value)  The bond price can be calculated as the present value of all the cash flows (principal and interest) using the market interest rate.  Bond prices are typically stated in terms of a percentage of face value. A bond price of 97 means a $1,000 bond will sell for $970 A bond price of 102 means a $1,000 bond will sell for $1,020.  Other things being equal, the lower the perceived riskiness of the corporation issuing bonds, the higher the price those bonds will command.

On January 1, 2013, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup, Inc. Present value (price) of the bonds: Present Values Interest * $42,000 x ** = $200,195 Principal$700,000 x *** = 466,438 Present value (price) of the bonds$666,633 Determining the Bond Selling Price  Bond prices are determined as the sum of the present value of all future cash flows using the market interest rate. Interest is disbursed in payments throughout the bond indenture and is therefore an annuity – use the PVA table. Face value is repaid at the end of the bond indenture – use the PV table. Use the market interest rate. Since bond interest is generally paid semiannually, double the period and halve the interest rate. Illustration * Interest: $700,000 X.12 X 6/12 = $42,000 ** present value of an ordinary annuity of $1: n=6, i=7% *** present value of $1: n=6, i=7% Note:Because interest is paid semiannually, the present value calculations use: (a) the semiannual market rate (7%), and (b) 6 (3 x 2) semi-annual periods.

Brief Exercise 14–2, page 836 Interest: $80,000,000 X.05 X 6/12 *Present value of an ordinary annuity of $1: n = 40, i = 3%. (Table 4) **Present value of $1: n = 40, i = 3%. (Table 2) Interest$ 2,000,000 x * = $46,229,540 Principal$ 80,000,000 x ** = 24,524,800 Present value (price) of the bonds $70,754,340 Brief Exercise 14–3, page 837 When the stated rate and the market rate are equal, the bonds will sell at face value, $75 million in this instance. Brief Exercise 14–4, page 837 Interest$ 2,500,000 x * = $68,388,700 Principal$100,000,000 x ** = 45,289,000 Present value (price) of the bonds $113,677,700 Interest: $100,000,000 X.05 X 6/12 *Present value of an ordinary annuity of $1: n = 40, i = 2%. (Table 4) **Present value of $1: n = 40, i = 2%. (Table 2)

Brief Exercise 14–3, page 837 – Additional Requirement 1)Journalize the issuance of the bonds at par (face) value. Assume the bonds were issued Jan 1. 2)Journalize the first interest payment. Assume the bonds pay interest semiannually Jun 30 and Dec 31. Interest: $75,000,000 X.06 X 6/12 DateAccountDebitCredit Jan 1Cash75,000,000 Bonds Payable20,000,000 Dec 31Interest Expense2,250,000 Cash2,250,000 DateAccountDebitCredit Jan 1Investment in Bonds75,000,000 Cash20,000,000 Dec 31Cash2,250,000 Interest Revenue2,250,000 ISSUERINVESTOR

Brief Exercise 14–2, page 836 – Additional Requirement 1)Journalize the issuance of the bonds at a discount. Assume the bonds were issued Jan 1. Interest$ 2,000,000 x = $46,229,540 Principal$ 80,000,000 x = 24,524,800 Present value (price) of the bonds $70,754,340 Discount: Difference Between Par Value and Issue Price of Bonds $80,000,000 – $70,754,340 = $9,245,660 DateAccountDebitCredit Jan 1Cash70,754,340 Discount on Bonds Payable9,245,660 Bonds Payable80,000,000 ISSUER

Brief Exercise 14–4, page 837 – Additional Requirement 1)Journalize the issuance of the bonds at a discount. Assume the bonds were issued Jan 1. Premium: Difference Between Par Value and Issue Price of Bonds $100,000,000 – $113,677,700 = $13,677,700 DateAccountDebitCredit Jan 1Cash113,677,700 Premium on Bonds Payable13,677,700 Bonds Payable100,000,000 ISSUER Interest$ 2,500,000 x = $68,388,700 Principal$100,000,000 x = 45,289,000 Present value (price) of the bonds $113,677,700

Effective Interest Method  When bonds are sold at a discount or premium, that amount must be amortized over the bond indenture  Interest expense will be adjusted relative to the cash payment for interest based on the amount amortized Discounts increase interest expense Premiums decrease interest expense  Two methods  Make specific promises to bondholders described in a document called a bond indenture.  Represent a liability to the corporation that issues the bonds and an asset to a company that buys the bonds as an investment.

Discount/Premium Amortization  When bonds are sold at a discount or premium, that amount must be amortized to expense over the life of the bond.  Interest expense will be adjusted (relative to the cash payment) based on the amount amortized Discounts increase interest expense Premiums decrease interest expense  Two methods exist for amortizing the disount/premium Effective Interest Method Straight-line Method  At the end of the bond indenture, the balance in the discount or premium will be fully amortized and the account balance will be -0-.

To be continued…

Long-term Debt: Bonds INTERMEDIATE ACCOUNTING II - CHAPTER 14, PART 1 TO BE CONTINUED