1. Long-Term Liabilities: Bonds and Notes
By Rachelle Agatha, CPA, MBA
Slides by Rachelle Agatha, CPA,
with excerpts from Warren, Reeve, Duchac

2. Objectives:
Overview of Long Term Liabilities
Describe the characteristics, terminology, and pricing of bonds payable.
Accounting for bonds payable.

3. Objectives:
Bonds issued at Discount vs Premium.
Accounting for Premium and Discount.
Installment Notes.
Financial Statement presentation of LTL

4. Objective 1
Compute the potential impact of long-term borrowing on the earnings per share of a corporation.

5. Financing Corporations
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.

6. Effect of Alternative Financing Plans—$800,000 Earnings

7. Effect of Alternative Financing Plans—$440,000 Earnings8

8. Objective 2
Describe the characteristics, terminology, and pricing of bonds payable.

9. Bonds Payable
A corporation that issues bonds enters into a contract (called a bond indenture or trust indenture) with the bondholders.
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.

10. 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.

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

12. 3. The market or effective rate of interest.
Pricing of Bonds Payable
When a corporation issues bonds, the price that buyers are willing to pay depends upon three factors:
1. The face amount of the bonds, which is the amount due at the maturity date.
2. The periodic interest to be paid on the bonds. This is called the contract rate or the coupon rate.
3. The market or effective rate of interest.

13. 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 assessment of current economic conditions, and
future expectations.

14. MARKET RATE = CONTRACT RATE
MARKET RATE = CONTRACT RATE
Selling price of bond = $1,000
$1,000
10% payable
annually
If the contract rate equals the market rate of interest, the bonds will sell at their face amount.

15. MARKET RATE > CONTRACT RATE
MARKET RATE > CONTRACT RATE
Selling price of bond < $1,000
$1,000
10% payable
annually
Discount –
If the market rate is higher than the contract rate, the bonds will sell at a discount.

16. MARKET < CONTRACT RATE
MARKET < CONTRACT RATE
Selling price of bond > $1,000
$1,000
10% payable
annually
Premium +
If the market rate is lower than the contract rate, the bonds will sell at a premium.

17. Time Value of Money
The time value of money concept recognizes that an amount of cash to be received today is worth more than the same amount of cash to be received in the future.

18. Present Value of the Face Amount of Bonds
Present Value of the Face Amount of Bonds
A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years.
$1,000
10% payable
annually
Today
End of Year 1
End of Year 2

19. Present Value of $1 at Compound Interest
N = 2 rate =10%

20. Present Value of the Face Amount of Bonds
Present Value of the Face Amount of Bonds
A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years.
$1,000
10% payable
annually
Today
End of Year 1
End of Year 2
$1,000 x
$826.45

21. *Present value of $1 for 5 periods at 10%
Using Exhibit 3 in your test, what is the present value of $4,000 to be received in 5 years, if the market rate of interest is 10% compounded annually?
$4,000 x * = $2,483.68
*Present value of $1 for 5 periods at 10%

22. $100 $173.55 Present Value of the Periodic Bond Interest Payments
Present Value of the Periodic Bond Interest Payments
Interest payment
$100
Interest payment
$100
Today
End of Year 1
End of Year 2
$82.64
$100 x
$90.91
$100 x
$173.55
Present value, at 10%, of $100 interest payments to be received each year for 2 years (rounded)

23. Present Value of Annuity of $1 at Compound Interest

24. Present value of face value of $1,000 due in
Present Value of 2-Year, 10% Bond
Present value of face value of $1,000 due in
2 years at 10% compounded annually: $1,000 x (Exhibit 3: n = 2,
i = 10%) $
Present value of 2 annual interest payments
of 10% compounded annually: $100 x (Exhibit 4: n = 2, i = 10%)
Total present value of bond $1,000.00

25. Calculate the present value of a $20,000, 5%, 5-year bond that pays $1,000 ($20,000 x 5%) interest annually, if the market rate of interest is 5%. Use Exhibits 3 and 4 for computing present values.

26. Present value of face value of $20,000 due in 5 years at 5% compounded annually: $20,000 x (present value factor of $1 for 5 periods at 5%)
$15,671*
Present value of 5 annual interest payments of $1,000 at 5% interest compounded annually: $1,000 x (present value of annuity of $1 for 5 periods at 5%).
4,329*
$20,000
*Rounded to the nearest dollar

27. Journalize entries for bonds payable.
Objective 3
Journalize entries for bonds payable.

28. Bonds Issued at Face Amount
On January 1, 2007, a corporation issues for cash $100,000 of 12%, five-year bonds; interest payable semiannually. The market rate of interest is 12%.

29. Total present value of bonds $100,000
Present value of face amount of $100,000 due in 5 years at 12% compounded annually: $100,000 x (Exhibit 3: n = 10, i = 6%)
$ 55,840
Present value of 10 interest payments of $6,000 at 12% compounded semiannually: $6,000 x (Exhibit 4: n = 10; i = 6%)
44,160*
Total present value of bonds $100,000
*Because the present value tables are rounded to five decimal places, minor rounding differences may appear in this illustration.

30. On January 1, 2007, a corporation issues for cash $100,000 of 12%, five-year bonds; interest payable semiannual. The market rate of interest is 12%.
Jan. 1 Cash
2007
Bonds Payable
Issued $100,000 bonds payable at face amount.

31. On June 30, an interest payment of $6,000 is made ($100,000 x .12 x 6/12).
June 30 Interest Expense
Cash
Paid six months’ interest on bonds.

32. The bond matured on December 31, At this time, the corporation paid the face amount to the bondholder.
Dec. 31 Bonds Payable
2011
Cash
Paid bond principal at maturity date.

33. Bonds Issued at a Discount
Assume that the market rate of interest is 13% on the $100,000 bonds rather than 12%. What would be the present value of these bonds?

34. Present value of face amount of $100,000 due in 5 years at 13% compounded semiannually: $100,000 x
$53,273
Present value of 10 interest payments of $6,000, at 13% compounded semiannually: $6,000 x (present value of annuity of $1 for 10 periods at 6%)
43,133
Total present value of bonds $96,406

35. On January 1, 2007, the firm issued $100,000 bonds for $96,406 (a discount of $3,594).
Jan. 1 Cash
2007
Discount on Bonds Payable
Bonds Payable
Issued $100,000 bonds at discount.

36. 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 x 6% x ½), receiving cash of $845,562. Journalize the entry to record the issuance of the bonds.
Cash 845,562
Discount on Bonds Payable 154,438
Bonds Payable 1,000,000

37. There are two methods of amortizing a bond discount:
Amortizing a Bond Discount
There are two methods of amortizing a bond discount:
The straight-line method and
The effective interest rate method, often called the interest method.
Both methods amortize the same total amount of discount over the life of the bonds.

38. Amortizing a Bond Discount
Amortizing a Bond Discount
On June 30, 2007, six-months’ interest is paid and the bond discount is amortized ($3,594 x 1/10) using the straight-line method.
June 30 Interest Expense
2007
Discount on Bonds Payable
Cash
Paid semiannual interest and amortized 1/10 of bond discount.

39. Interest Expense 45,444
Discount on Bonds Payable 15,444
Cash 30,000
Paid interest and amortized the bond discount ($154,438 ÷ 10).

40. Bonds Issued at a Premium
If the market rate of interest is 11% and the contract rate is 12%, on the five year, $100,000 bonds, the bonds will sell for $103,769.

41. Present value of face amount of $100,000 due in 5 years at 11% compounded semiannually: $100,000 x (Exhibit 3: n =10, i = 5½%)
$ 58,543
Total present value of bonds $103,769
Present value of 10 interest payments of $6,000, at 11% compounded semiannually: $6,000 x (Exhibit 4: n = 10, i = 5½%)
45,226

42. Issued $100,000 of bonds for $103,769 (a premium of $3,769). The entry to record this information is as follows:
Jan. 1 Cash
2007
Bonds Payable
Premium on Bonds Payable
Issued $100,000 bonds at a premium.

43. A company issues a $2,000,000, 12%, 5-year bond that pays semiannual interest of $120,000 ($2,000,000 x 12% x ½), receiving cash of $2,154,435. Journalize the bond issuance.
Cash 2,154,435
Premium on Bonds Payable 154,438
Bonds Payable 2,000,000

44. Amortizing a Bond Premium
On June 30, 2007, paid the semiannual interest and amortized the premium. The firm uses straight-line amortization.
June 30 Interest Expense
2007
Premium on Bonds Payable
Cash
Paid semiannual interest and amortized 1/10 of bond prem.
$3,769 x 1/10

45. Using the bond from previous example, journalize the first interest payment and the amortization of the related bond premium.
Interest Expense 104,556
Premium on Bonds Payable 15, Bonds Payable 120,000
Paid interest and amortize the
bond premium ($154,435/10).

46. Zero-Coupon Bonds
Zero-coupon bonds do not provide for interest payments. Only the face amount is paid at maturity. Assume that the market rate is 13% at date of issue.
Present value of $100,000 due in 5 years at 13% compounded semiannually: $100,000 x (PV of $1 for 10 periods at 6½%) = $53,273

47. On January 1, 2007, issue 5-year, $100,000 zero-coupon bonds when the market rate of interest is 13%.
Jan. 1 Cash
2007
Discount on Bonds Payable
Bonds Payable
Issued $100,000 zero- coupon bonds.

48. Describe and illustrate the payment and redemption of bonds payable.
Objective 4
Describe and illustrate the payment and redemption of bonds payable.

49. Since the payment of bonds normally involves a large amount of cash, a bond indenture may require that cash be periodically transferred into a special cash fund, called a sinking fund, over the life of the bond issue.

50. 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.

51. 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.
June 30 Bonds Payable
2007
Premium on Bonds Payable
Cash
Gain on Redemption of Bonds
Retired bonds for $24,000.

52. Instead, assume that on June 30 the corporation calls all of the bonds, paying $105,000.
June 30 Bonds Payable
2007
Premium on Bonds Payable
Loss on Redemption of Bonds
Cash
Redeemed $100,000 bonds for $105,000.

53. 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.
Bonds Payable 500,000
Loss on Redemption of Bonds 15,000
Discount on Bonds Payable 40,000
Cash 475,000

54. Objective 5
Installment Notes

55. 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.

56. Issuing an Installment Note4
Issuing an Installment Note
Lewis Company issues a $24,000, 6%, five-year note to City National Bank on January 1, The annual payment is $5,698.

57. 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)

58. 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)

59. 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.

61. Financial Statement Presentation
Objective 6
Financial Statement Presentation

62. 5

63. Income Before Income Tax + Interest Expense Interest Expense 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 =

64. Summary Financing Corporations Bond terms & Characteristics
Time Value of Money
Accounting for Bonds
Accounting for Notes Payable
Financial Statement Presentation