Long-Term Liabilities: Bonds and Notes 12 Long-Term Liabilities: Bonds and Notes

1 Compute the potential impact of long-term borrowing on earnings per share. 12-2

1 Bond A bond is simply a form of an interest-bearing note. Like a note, a bond requires periodic interest payments, and the face amount must be repaid at the maturity date. When a company issues a bond, they are borrowing money. They then promise to pay the bond amount plus interest to the bond holder in the future.

1 Huckadee Corporation is considering the following plans to issue debt and equity: There are three plans Huckadee Corporation is considering to issue debt, bonds, and equity, stock. Plan one includes only issuing common stock. Plan 2 includes issuing both common and preferred stock. And plan 3 includes issuing common and preferred stock, as well as bonds. With all 3 plans, they raise the same amount of funds, so what is the difference? In plans 1 and 2, they are raising money by selling stocks. They only obligation they have is to pay dividends - but they can decide whether or not they want to declare dividends. In plan 3, they must pay interest regularly which is more costly. What might the advantages of issuing bonds be?

Net Income – Preferred Dividends Number of Common Shares Outstanding 1 Earnings per share (EPS) measure the income earned by each share of common stock. It is computed as follows: Net Income – Preferred Dividends Earnings per share = Number of Common Shares Outstanding Data for Huckadee Corporation: Earnings before interest and taxes are $800,000. The tax rate is 40%. All bonds or stocks are issued at their par or face value.

1 Effect of Alternative Financing Plans—$800,000 earnings. Exhibit 1 Notice the plans are the same until you deduct the interest on the bonds. This is extra money the company will have to pay which will, in return, lower their income before taxes. Lower income means they will owe fewer taxes. Because they owe fewer taxes in plan 3 and have issued fewer shares of common stock, their earnings per share is higher. This is the advantage of issuing bonds – a higher EPS (earnings per share). This is favorable to investors because they see that each share of stock is tied to a higher amount of earnings.

1 Effect of Alternative Financing Plans—$440,000 earnings. Exhibit 2 When earnings are lower, the interest payment on bonds has a bigger effect. Even though taxes are lower in plan 3, the low income overall affects the EPS and makes it less than plans 1 and 2.

1 Example Exercise 12-1 Alternative Financing Plans Gonzales Co., is considering the following alternative plans for financing their company: Plan 1 Plan 2 Issue 10% Bonds (at face) $2,000,000 Issue $10 Common Stock $3,000,000 $1,000,000 Income tax is estimated at 40% of income. Determine the earnings per share of common stock under the two alternative financing plans, assuming income before bond interest and income tax is $750,000. Use slides 6-7 for help!! It is a lot of work – but try it! 12-10

1 Follow My Example 12-1 For Practice: PE 12-1A, PE 12-1B 12-11 Example Exercise 12-1 (continued) 1 Follow My Example 12-1 Plan 1 Plan 2 Earnings before bond interest and income tax Bond interest Balance Income tax Net income Dividend on preferred stock Earnings available for common stock Number of common shares Earnings per share on common stock $750,000 300,000 $450,000 ÷300,000 $750,000 200,000 $550,000 220,000 $330,000 ÷100,000 (2,000,000 × 10%) ($750,000 × 40%) ($550,000 × 40%) Bring any questions about how to do this to class. The percentages come from slide 8. $ 1.50 $ 3.30 For Practice: PE 12-1A, PE 12-1B 12-11

Describe the characteristics and terminology of bonds payable. 2 Describe the characteristics and terminology of bonds payable. 12-10

Bond Characteristics and Terminology 2 Bond Characteristics and Terminology The underlying contract between the company issuing bonds and the bondholders is called a bond indenture or trust indenture. This is not something separate – it is assumed when a bond is sold/purchased

Bond Characteristics and Terminology 2 Bond Characteristics and Terminology Usually, the face value of each bond, called the principal, is $1,000 or a multiple of $1,000. Interest on bonds may be payable annually, semiannually, or quarterly. Most pay interest semiannually. Principal = what is being borrowed/loaned

Bond Characteristics and Terminology 2 Bond Characteristics and Terminology When all bonds of an issue mature at the same time, they are called term bonds. If the maturity dates are spread over several dates, they are called serial bonds. Bonds that may be exchanged for other securities are called convertible bonds. Other securities might be stocks.

Bond Characteristics and Terminology 2 Bond Characteristics and Terminology Bonds that a corporation reserves the right to redeem before their maturity are called callable bonds. Bonds issued on the basis of general credit of the corporation are debenture bonds.

Proceeds from Issuing Bonds 2 Proceeds from Issuing Bonds The market or effective rate of interest is determined by transactions between buyers and sellers of similar bonds. The market rate of interest is affected by a variety of factors, including investors’ expectations of current and future economic conditions. Make sure you study the vocab from slides 11-15

MARKET RATE = CONTRACT RATE 2 MARKET RATE = CONTRACT RATE Selling price of bond = $1,000 Contract rate is also called coupon rate. It is the rate of interest in the bond indenture (slide 11). The market may be demanding a different rate based on supply and demand or the economic conditions at the time. If the contract rate equals the market rate of interest, the bonds will sell at their face amount.

MARKET RATE > CONTRACT RATE 2 MARKET RATE > CONTRACT RATE Selling price of bond < $1,000 Discount – If the market rate is higher, that means the company has to pay more interest than it originally intended. Because of this, the bonds sell at a lower price. That way when the face value is redeemed, more interest is earned. Example – A $1000 bond sells for a discount of $900. When the bond is redeemed, they get the interest plus the $100 difference between the price and face value. If the market rate is higher than the contract rate, the bonds will sell at a discount.

MARKET < CONTRACT RATE 2 MARKET < CONTRACT RATE Selling price of bond > $1,000 Premium + The additional amount covers the different between the two rates. If the market rate is lower than the contract rate, the bonds will sell at a premium.

Journalize entries for bonds payable. 3 Journalize entries for bonds payable. 12-19

Bonds Issued at Face Amount 3 Bonds Issued at Face Amount On January 1, 2009, Eastern Montana Communications Inc. issued for cash $100,000 of 12%, five-year bonds; interest payable semiannually. The market rate of interest is 12%. Interest payable semiannually means that the company will pay the bondholder interest every six months. Notice that the market rate = the coupon rate. See slide 16 for review.

3 Since the bond rate of interest and the market rate of interest are the same, the bonds will sell at their face amount.

3 Every six months (on June 30 and December 31) after the bonds are issued, interest of $6,000 ($100,000 × .12 × 6/12) is paid. This is the semiannual bond payment. You would have to make this entry every 6 months until the bond matures.

3 The bond matured on December 31, 2013. At this time, the corporation paid the face amount to the bondholder. Now you are getting rid of your liability from slide 21 and paying the face value of the bond.

Bonds Issued at a Discount 3 Bonds Issued at a Discount On January 1, 2009, Western Wyoming Distribution Inc. issued $100,000, 12% (paid semiannually on June 30 and December 31), five-year bonds when the market rate was 13%. This is like practice exercises 12-2A and 12-2B that we did in class.

3 On January 1, 2009, the firm issued $100,000 bonds for $96,406 (a discount of $3,594). The discount may be viewed as the amount required by investors to accept a bond rate of interest below the market rate. The discount may be viewed as the amount required by investors to accept a bond rate of interest below the market rate.

3 Example Exercise 12-2 Follow My Example 12-2 Follow My Example 6-1 Issuing Bonds at a Discount On the first day of the fiscal year, a company issues a $1,000,000, 6%, 5-year bond that pays semi-annual interest of $30,000 ($1,000,000 × 6% × ½), receiving cash of $936,420. Journalize the entry to record the issuance of the bonds. Follow My Example 6-1 Follow My Example 12-2 Cash…………………………………………… 936,420 Discount on Bonds Payable………………. 63,580 Bonds Payable………………………… 1,000,000 The ½ is used in the PxRxT formula because interest is paid every 6 months, or ½ of a year. For Practice: PE 12-2A, PE 12-2B 12-26

Amortizing a Bond Discount 3 Amortizing a Bond Discount The two methods of computing amortization of a bond discount are as follows: 1. Straight-line method 2. Effective interest rate method, sometimes called the interest method Amortization is like depreciation for bonds. We have to write off the discount of the bond. We treat the discount as interest payments. We move it from the discount account to the interest expense account. It is a cost of issuing bonds. Both methods amortize the same total amount of discount over the life of the bonds.

Straight-Line Amortization 3 Straight-Line Amortization On June 30, 2009, six-months’ interest is paid and the bond discount is amortized ($3,594 × 1/10) on the five-year bond issued in Slide 24. * 6 months worth of interest is $6000 ($100,000 x 12% x ½) The discount amount is the total discount of $3,594 calculated on slide 25 times 1/10. We use 1/10 because it is a 5-year bond and we are going to amortize semiannually with the interest payments. That means twice every year (5 years x 2 times a year = 10). So each entry will have 1/10 of the amount journalized. We credit the discount to move it out of discounts and raise our interest expense. *$100,000 × 12% × 6/12

3 Example Exercise 12-3 Follow My Example 12-3 Discount Amortization Using the bond from Example Exercise 12-2 (Slide 26), journalize the first interest payment and the amortization of the related bond discount. Follow My Example 12-3 Interest Expense……………………………. 36,358 Discount on Bonds Payable………… 6,358 Cash…………...………………………… 30,000 Paid interest and amortized the bond discount ($63,580 ÷ 10). For Practice: PE 12-3A, PE 12-3B 12-29

Bonds Issued at a Premium 3 Bonds Issued at a Premium On January 1, 2009, Northern Idaho Transportation Inc. issued a $100,000, 12%, five-year bond for $103,769. The market rate of interest was 11%. This entry is just like the discount entry, but premiums are credited. You can tell because debits must equal credits. Also, a premium is like extra revenue, which is credited.

3 Example Exercise 12-4 Follow My Example 12-4 Follow My Example 6-1 Issuance of Bonds at a Premium A company issues a $2,000,000, 12%, five-year bond that pays semiannual interest of $120,000 ($2,000,000 × 12% × ½), receiving cash of $2,154,440. Journalize the bond issuance. Follow My Example 6-1 Follow My Example 12-4 Cash…………………………………………… 2,154,440 Premium on Bonds Payable...………. 154,440 Bonds Payable………………………… 2,000,000 For Practice: PE 12-4A, PE 12-4B 12-31

Amortizing a Bond Premium 3 Amortizing a Bond Premium The first entry to record the interest payment and the amortization of the $100,000, 12%, five-year bond issued on January 1, 2009 (Slide 30) is made on June 30, 2009. This time we amortize the premium. We debit it to move it out of premiums and lower our interest expense. 6,000.00

3 Example Exercise 12-5 Follow My Example 12-5 Premium Amortization Using the bond from Example Exercise 12-4, journalize the first interest payment and the amortization of the related bond premium. Follow My Example 12-5 Interest Expense………………..…………… 104,556 Premium on Bonds Payable...…………….. 15,444 Bonds Payable………………………… 120,000 For Practice: PE 12-5A, PE 12-5B 12-33

3 Bond Redemption A corporation may call or redeem bonds before they mature. Callable bonds can be redeemed by the issuing corporation within the period of time and the price stated in the bond indenture. Normally, the call price is above the face value. In this case, the company is paying off their loan early. The call price is above face value because the bondholder will not receive any remaining interest payments when the company pays the bond off early.

3 On June 30, a corporation has a bond issue of $100,000 outstanding on which there is an unamortized premium of $4,000. The corporation purchases one-fourth of the bonds for $24,000. We debit the Premium on Bonds Payable for $1,000 because the total unamortized premium is $4,000 – but we are only calling ¼ of them. Therefore, we only need to write off ¼ of the unamortized premium. Gains and losses on the redemption of bonds are reported as Other Income (Loss).

3 The corporation calls the remaining $75,000 of outstanding bonds, which are held by a private investor, for $79,500 on July 1, 2009.

3 Example Exercise 12-6 Follow My Example 12-6 Redemption of Bonds Payable A $500,000 bond issue on which there is an unamortized discount of $40,000 is redeemed for $475,000. Journalize the redemption of the bonds. Follow My Example 12-6 Bonds Payable...………………..………………. 500,000 Loss on Redemption of Bonds..……………... 15,000 Discount on Bonds Payable…………….. 40,000 Cash…………………………………………. 475,000 For Practice: PE 12-6A, PE 12-6B 12-37

Describe and illustrate the accounting for installment notes. 4 Describe and illustrate the accounting for installment notes. 12-38

4 Installment Notes An installment note is a debt that requires the borrower to make equal periodic payments to the lender for the term of the note. Unlike bonds, a note payment consists of payment of a portion of the amount initially borrowed (the principal) and payment of interest on the outstanding balance.

Issuing an Installment Note 4 Issuing an Installment Note Lewis Company issues a $24,000, 6%, five-year note to City National Bank on January 1, 2008. The annual payment is $5,698.

4 Amortization of Installment Notes

4 The entry to record the first payment on December 31, 2008, is as follows: (Column C of Exhibit 3) (Column D of Exhibit 3)

4 The entry to record the second payment on December 31, 2009, is as follows: (Column C of Exhibit 3) (Column D of Exhibit 3)

4 The entry to record the final payment on December 31, 2012, is as follows: (Column C of Exhibit 3) (Column D of Exhibit 3) After the entry is posted, the balance in Notes Payable related to this note is zero.

4 Example Exercise 12-7 Journalizing Installment Notes On the first day of the fiscal year, a company issue a $30,000, 10%, five-year installment note that has annual payments of $7,914. The first payment consists of $3,000 of interest and $4,914 of principal repayment. Journalize the entry to record the issuance of the installment note. Journalize the first annual note payment. 12-45

4 Follow My Example 12-7 a. b. 12-46 For Practice: PE 12-7A, PE 12-7B Example Exercise 12-7 (continued) 4 Follow My Example 12-7 a. b. 12-46 For Practice: PE 12-7A, PE 12-7B

5 Describe and illustrate the reporting of long-term liabilities including bonds and notes payable. 12-47

5

Number of Times Interest Charges are Earned 5 Number of Times Interest Charges are Earned Income Before Income Tax + Interest Expense Interest Expense Number of Times Interest Charges are Earned = Briggs and Stratton Corporation Number of Times Interest Charges are Earned = $152,366,000 + $42,091,000 $42,091,000 Number of Times Interest Charges are Earned = 4.62