Chapter 10

Describe bonds payable

 Large companies issue bonds to public to raise money ◦ Multiple lenders = bondholders  Each bondholder receives bond certificate that shows  Amount borrowed (principal)  Maturity date  Interest rate  Company pays interest (usually semi-annually) to bondholders ◦ Bondholders receive interest 3Copyright (c) 2009 Prentice Hall. All rights reserved.

4 Principal or Maturity value Amount borrower must pay back on maturity date Maturity date Date on which borrower must pay principal to the bondholders Stated interest rate Annual rate of interest borrower pays to bondholders Copyright (c) 2009 Prentice Hall. All rights reserved.

 Term bonds ◦ All mature at same date  Serial bonds ◦ Mature in installments at regular intervals  Secured bonds ◦ Bondholder has right to assets if company fails to pay principal or interest, e.g. mortgage  Debenture ◦ Unsecured; not backed by company’s assets, by goodwill only 5Copyright (c) 2009 Prentice Hall. All rights reserved.

Maturity(par) value $1,000 bond issued for $1,000 No discount or premium Discount $1,000 bond issued for $980 Issued below maturity value Premium $1,000 bond issued for $1,015 Issued above maturity value 6Copyright (c) 2009 Prentice Hall. All rights reserved.

 Quoted as a percent of maturity value  Issue price determines cash company receives  Company must pay maturity value at maturity date 7 A $1,000 bond quoted a price of would sell for $1,015 A $1,000 bond quoted a price of would sell for $ Copyright (c) 2009 Prentice Hall. All rights reserved.

 Money earns income over time  Investors will pay less than $1,000 now to receive $1,000 in the future Present value: Today’s price $750 Future value: Maturity value $1,000 Present value is always less than future value Copyright (c) 2009 Prentice Hall. All rights reserved.

Stated interest rateMarket interest rate  Determines amount of cash interest borrower pays each year  Remains constant  Rate investors demand for loaning money  Varies daily 9 Stated interest rate Market interest rate Issue price of bonds payable 9%= Maturity value 9%<10% Discount (below maturity value) 9%>8% Premium (above maturity value) Copyright (c) 2009 Prentice Hall. All rights reserved.

Review Question 7. Which of the following types of bonds are backed by the company’s assets? A. Term bonds B. Serial bonds C. Mortgage bonds D. Debentures Copyright ©2009 Prentice Hall. All rights reserved.10

7.Which of the following types of bonds are backed by the company’s assets? A.Term bonds B.Serial bonds C.Mortgage bonds D.Debentures Copyright ©2009 Prentice Hall. All rights reserved.11

8. If a company issues a bond at a price greater than its maturity value, it is said to be sold at: A. a premium. B. a discount. C. face value. D. none of the above. Copyright ©2009 Prentice Hall. All rights reserved.12

8.If a company issues a bond at a price greater than its maturity value, it is said to be sold at: A.a premium. B.a discount. C.face value. D.none of the above. Copyright ©2009 Prentice Hall. All rights reserved.13

9. If the stated interest rate of a bond is less than the market rate, it will be issued at: A. a premium. B. a discount. C. maturity value. Copyright ©2009 Prentice Hall. All rights reserved.14

9.If the stated interest rate of a bond is less than the market rate, it will be issued at: A.a premium. B.a discount. C.maturity value. Copyright ©2009 Prentice Hall. All rights reserved.15

Measure interest expense on bonds using the straight-line amortization method

17 GENERAL JOURNAL DATEDESCRIPTIONDEBITCREDIT Cash100,000 Bonds payable100,000 To record issuance of 8% bonds at maturity value Interest expense4,000 Cash4,000 To record semi-annual interest payment Issue date $100,000 x 8% x 1/2 Int. pmt dates Copyright (c) 2009 Prentice Hall. All rights reserved.

18 GENERAL JOURNAL DATEDESCRIPTIONDEBITCREDIT Bond payable100,000 Cash100,000 To record payment of bonds at maturity Maturity date Copyright (c) 2009 Prentice Hall. All rights reserved.

19 GENERAL JOURNAL DATEDESCRIPTIONDEBITCREDIT Cash98,000 Discount on bonds payable2,000 Bonds payable100,000 To record issuance of $100,000, 10-year, 8% bonds at 98 Issue date Contra account to Bonds payable Copyright (c) 2009 Prentice Hall. All rights reserved.

Long-term liabilities Bonds payable $100,000 Less: Discount on bonds payable ( $2,000)$98, Carrying value Copyright (c) 2009 Prentice Hall. All rights reserved.

21 GENERAL JOURNAL DATEDESCRIPTIONDEBITCREDIT Interest expense4,100 Discount on bonds payable100 Cash4,000 Int. pmt date $100,000 x 8% x 6/12 $2,000/10 x 6/12 Copyright (c) 2009 Prentice Hall. All rights reserved.

22 GENERAL JOURNAL DATEDESCRIPTIONDEBITCREDIT Cash104,000 Premium on bonds payable4,000 Bonds payable100,000 To record issuance of $100,000, 10-year, 8% bonds at 98 Issue date Companion account to Bonds payable Copyright (c) 2009 Prentice Hall. All rights reserved.

Long-term liabilities Bonds payable $100,000 Plus: Premium on bonds payable $4,000$104, Carrying value Copyright (c) 2009 Prentice Hall. All rights reserved.

24 GENERAL JOURNAL DATEDESCRIPTIONDEBITCREDIT Interest expense3,800 Premium on bonds payable200 Cash4,000 Int. pmt date $100,000 x 8% x 6/12 $4,000/10 x 6/12 Copyright (c) 2009 Prentice Hall. All rights reserved.

25 Bonds payablePremium $100,000$4,000$200 $3,800 Carrying value after first interest payment = $103,800 Carrying value after first interest payment = $103,800 Copyright (c) 2009 Prentice Hall. All rights reserved.

 Interest payments seldom occur at year-end ◦ Interest must be accrued 26 GENERAL JOURNAL DATEDESCRIPTIONDEBITCREDIT 1231Interest expense2,050 Discount on bonds payable50 Interest payable2000 (100,000 x 8% x 3/12) $2,000/10 x 3/12 Copyright (c) 2009 Prentice Hall. All rights reserved.

 The following interest payment entry will take into account the adjusting entry previously made 27 GENERAL JOURNAL DATEDESCRIPTIONDEBITCREDIT 331Interest payable2,000 Interest expense2,050 Discount on bonds payable50 Cash4,000 (100,000 x 8% x 1/12) $2,000/10 x 3/12 Copyright (c) 2009 Prentice Hall. All rights reserved.

28 January 1: bond date April 1: issue date June 20: 1 st interest payment $ 100,000 x 8% x 6/12 = $4,000 $2,000 (100,000 x 8% x 3/12) $2,000 (100,000 x 8% x 3/12) Cash interest payment Accrued interest Interest expense Copyright (c) 2009 Prentice Hall. All rights reserved.

29 GENERAL JOURNAL DATEDESCRIPTIONDEBITCREDIT 41Cash102,000 Bonds payable100,000 Interest payable2, Interest expense2,000 Interest payable2,000 Cash4,000 Copyright (c) 2009 Prentice Hall. All rights reserved.

Report liabilities on the balance sheet

31Copyright (c) 2009 Prentice Hall. All rights reserved.

Compare issuing bonds to issuing stock

Issuing bonds Issuing stock  Must pay interest and principal to bondholders  Reduces net income ◦ Interest expense  Can increase earnings per share ◦ Leverage  Does not have to be “paid off”  Does not affect net income  Increases number of shares outstanding 33Copyright (c) 2009 Prentice Hall. All rights reserved.

34  Suppose that Granite Corp., with net income of $300,000 and with 100,000 shares of common stock outstanding, needs $500,000 for expansion.  Money can be borrowed at 10% interest.  The income tax rate is 40%.

35  50,000 shares of common stock can be issued for $500,000.  Management believes that the new cash can be invested in operations to earn income of $200,000 before interest and taxes.  Should the company borrow the money or issue additional common stock?

36 Borrow $500,000 Expected net income on the new project$200,000 Interest expense– 50,000 Project income before taxes$150,000 Income tax expense– 60,000 Project net income$ 90,000 Net income before expansion$300,000 Total income$390,000

37 Issue 50,000 shares of common stock at $10 per share Expected net income on the new project$200,000 Income tax expense– 80,000 Project net income$120,000 Net income before expansion$300,000 Total income$420,000

38 Issue BondsIssue Com.Stk Expected Income $ 200,000 Interest, 10% (50,000) - Project Income BT 150, ,000 Income Tax, 40% (60,000) (80,000) Project Net Income 90, ,000 NI before new project 300,000 NI w/ New Project $ 390,000 $ 420,000 # of Shares-C. Stk. 100, ,000 EPS $ 3.90 $ 2.80

Review Question 10. Which depreciation method produces a constant expense amount over theasset’s life? A.Straight-line B.Units-of-production C.Double-declining-balance Copyright ©2009 Prentice Hall. All rights reserved.39

10.Which depreciation method produces a constant expense amount over the asset’s life? A.Straight-line B.Units-of-production C.Double-declining-balance Copyright ©2009 Prentice Hall. All rights reserved.40

11. Discount on bonds payable is a: A. long-term liability. B. contra-account to Bonds payable. C. companion account to Bonds payable. D. current liability. Copyright ©2009 Prentice Hall. All rights reserved.41

11.Discount on bonds payable is a: A.long-term liability. B.contra-account to Bonds payable. C.companion account to Bonds payable. D.current liability. Copyright ©2009 Prentice Hall. All rights reserved.42

12. Which of the following statements is true regarding a bond issued at a premium? A. Interest expense is greater than the cash interest payment. B. Interest expense is less than the cash interest payment. C. Interest expense is equal to the cash interest payment. Copyright ©2009 Prentice Hall. All rights reserved.43

12.Which of the following statements is true regarding a bond issued at a premium? A.Interest expense is greater than the cash interest payment. B.Interest expense is less than the cash interest payment. C.Interest expense is equal to the cash interest payment. Copyright ©2009 Prentice Hall. All rights reserved.44

13. Why might a company choose to issue bonds over issuing stock? A. Earnings per share will decrease. B. It can create financial leverage. C. Interest payments are optional. D. All of the above are true. Copyright ©2009 Prentice Hall. All rights reserved.45

13.Why might a company choose to issue bonds over issuing stock? A.Earnings per share will decrease. B.It can create financial leverage. C.Interest payments are optional. D.All of the above are true. Copyright ©2009 Prentice Hall. All rights reserved.46