1. CPA, MBA BY RACHELLE AGATHA, CPA, MBA Bonds Payable & Investment in Bonds Slides by Rachelle Agatha, CPA, with excerpts from Warren, Reeve, Duchac

2. 2 1. Compute the potential impact of long-term borrowing on earnings per share. 2. Describe the characteristics, terminology, and pricing of bonds payable. 3. Journalize entries for bonds payable. Objectives:

3. 3 4. Describe and illustrate the payment and redemption of bonds payable. 5. Journalize entries for the purchase, interest, discount and premium amortization, and sale of bond investments. 6. Prepare a corporation balance sheet. Objectives:

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

5. 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. 6 Plan 1 Plan 2 Plan 3 Issued 12% bonds$4 million$2 million$2 million Issued 9% preferred stock, $50 par value$2 million$1 million Issued common stock, $10 par value$1 million $4 million$4 million$4 million

7. 7 Effect of Alternative Financing Plans— $800,000 Earnings

8. 8 8 Effect of Alternative Financing Plans— $440,000 Earnings

9. 9 Gonzales Co., is considering the following alternative plans for financing their company: Plan I Plan II 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.

10. 10 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 $750,000 200,000 $550,000 220,000 $330,000 0 $330,000 /100,000 Plan II $3.30 (2,000,000 x 10%) ($550,000 x 40%) $750,000 0 $750,000 300,000 $450,000 0 $450,000 /300,000 Plan I $1.50 ($750,000 x 40%)

11. 11 Describe the characteristics, terminology, and pricing of bonds payable. Objective 2

12. 12 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.

13. 13  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.

14. 14  Bonds issued on the basis of the general credit of the corporation are debenture bonds.  Bonds that a corporation reserves the right to redeem before their maturity are called callable bonds.

15. 15 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.

16. 16 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: 1.investors assessment of current economic conditions, and 2.future expectations.

17. 17 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.

18. 18 MARKET RATE > CONTRACT RATE Selling price of bond < $1,000 – Discount $1,000 10% payable annually If the market rate is higher than the contract rate, the bonds will sell at a discount.

19. 19 MARKET < CONTRACT RATE Selling price of bond > $1,000 + Premium $1,000 10% payable annually If the market rate is lower than the contract rate, the bonds will sell at a premium.

20. 20 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.

21. 21 Today End of Year 1 End of Year 2 Present Value of the Face Amount of Bonds $1,000 10% payable annually A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years.

22. Present Value of $1 at Compound Interest 22 N = 2 rate =10%

23. 23 Today End of Year 1 End of Year 2 $1,000 x 0.82645 $826.45 Present Value of the Face Amount of Bonds $1,000 10% payable annually A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years.

24. 24 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.62092* = $2,483.68 *Present value of $1 for 5 periods at 10%

25. 25 Today End of Year 1 End of Year 2 Interest payment $100 Interest payment $100 $90.91$100 x 0.90909 $82.64 $100 x 0.82645 Present Value of the Periodic Bond Interest Payments Present value, at 10%, of $100 interest payments to be received each year for 2 years (rounded) $ 173.55

26. Present Value of Annuity of $1 at Compound Interest 26

27. 27 Present Value of 2-Year, 10% Bond Present value of face value of $1,000 due in 2 years at 10% compounded annually: $1,000 x 0.82645 (Exhibit 3: n = 2, i = 10%)$ 826.45 Present value of 2 annual interest payments of 10% compounded annually: $100 x 1.73554 (Exhibit 4: n = 2, i = 10%) 173.55 Total present value of bond$1,000.00

28. 28 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.

29. 29 Present value of face value of $20,000 due in 5 years at 5% compounded annually: $20,000 x.78353 (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 4.32948 (present value of annuity of $1 for 5 periods at 5%). *Rounded to the nearest dollar 4,329* $20,000

30. 30 Journalize entries for bonds payable. Objective 3

31. 31 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%. Bonds Issued at Face Amount

32. 32 Present value of face amount of $100,000 due in 5 years at 12% compounded annually: $100,000 x 0.55840 (Exhibit 3: n = 10, i = 6%) $ 55,840 Present value of 10 interest payments of $6,000 at 12% compounded semiannually: $6,000 x 7.36009 (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.

33. 33 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%. Issued $100,000 bonds payable at face amount. Bonds Payable 100 000 00 Jan. 1Cash100 000 00 2007

34. 34 On June 30, an interest payment of $6,000 is made ($100,000 x.12 x 6/12). June 30Interest Expense6 000 00 Cash 6 000 00 Paid six months’ interest on bonds.

35. 35 The bond matured on December 31, 2011. At this time, the corporation paid the face amount to the bondholder. Cash 100 000 00 Paid bond principal at maturity date. Dec. 31Bonds Payable100 000 00 2011

36. 36 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? Bonds Issued at a Discount

37. 37 Present value of face amount of $100,000 due in 5 years at 13% compounded semiannually: $100,000 x 0.53273 $53,273 Present value of 10 interest payments of $6,000, at 13% compounded semiannually: $6,000 x 7.18883 (present value of annuity of $1 for 10 periods at 6%) 43,133 Total present value of bonds $96,406

38. 38 On January 1, 2007, the firm issued $100,000 bonds for $96,406 (a discount of $3,594). Issued $100,000 bonds at discount. Bonds Payable 100 000 00 Jan.1Cash96 406 00 2007 Discount on Bonds Payable3 594 00

39. 39 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. Cash845,562 Discount on Bonds Payable154,438 Bonds Payable1,000,000

40. 40 Amortizing a Bond Discount There are two methods of amortizing a bond discount: 1)The straight-line method and 2)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.

41. 41 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. Discount on Bonds Payable 359 40 June30Interest Expense6 359 40 2007 Amortizing a Bond Discount Cash 6 000 00 Paid semiannual interest and amortized 1/10 of bond discount.

42. 42 Interest Expense45,444 Discount on Bonds Payable15,444 Cash30,000 Paid interest and amortized the bond discount ($154,438 ÷ 10).

43. 43 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. Bonds Issued at a Premium

44. 44 Present value of face amount of $100,000 due in 5 years at 11% compounded semiannually: $100,000 x 0.58543 (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 7.53763 (Exhibit 4: n = 10, i = 5½%) 45,226

45. 45 Issued $100,000 of bonds for $103,769 (a premium of $3,769). The entry to record this information is as follows: Issued $100,000 bonds at a premium. Bonds Payable100 000 00 Premium on Bonds Payable3 769 00 Jan.1Cash103 769 00 2007

46. 46 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. Cash2,154,435 Premium on Bonds Payable154,438 Bonds Payable2,000,000

47. 47 On June 30, 2007, paid the semiannual interest and amortized the premium. The firm uses straight-line amortization. Paid semiannual interest and amortized 1/10 of bond prem. Cash6 000 00 June 30Interest Expense5 623 10 2007 $3,769 x 1/10 Amortizing a Bond Premium Premium on Bonds Payable376 90

48. 48 Using the bond from previous example, journalize the first interest payment and the amortization of the related bond premium. Interest Expense104,556 Premium on Bonds Payable15,444 Bonds Payable120,000 Paid interest and amortize the bond premium ($154,435/10).

49. 49 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. Zero-Coupon Bonds Present value of $100,000 due in 5 years at 13% compounded semiannually: $100,000 x 0.53273 (PV of $1 for 10 periods at 6½%) = $53,273

50. 50 On January 1, 2007, issue 5-year, $100,000 zero-coupon bonds when the market rate of interest is 13%. Issued $100,000 zero- coupon bonds. Bonds Payable100 000 00 Jan.1Cash53 273 00 2007 Discount on Bonds Payable46 727 00

51. 51 Describe and illustrate the payment and redemption of bonds payable. Objective 4

52. 52 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.

53. 53 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.

54. 54 Retired bonds for $24,000. Cash24 000 00 Gain on Redemption of Bonds2 000 00 June 30Bonds Payable25 000 00 2007 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. Premium on Bonds Payable 1 000 00

55. 55 Cash105 000 00 June 30Bonds Payable100 000 00 2007 Premium on Bonds Payable 4 000 00Loss on Redemption of Bonds 1 000 00 Redeemed $100,000 bonds for $105,000. Instead, assume that on June 30 the corporation calls all of the bonds, paying $105,000.

56. 56 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 Payable500,000 Loss on Redemption of Bonds15,000 Discount on Bonds Payable40,000 Cash475,000

57. 57 Journalize entries for the purchase, interest, discount, and premium amortization, and sale of bond investments. Objective 5

58. 58 Bonds may be purchased either directly from the issuing corporation or through an organized bond exchange. Prices for bonds are quoted as a percentage of the face amount. Accounting for Bond Investments

59. 59 On April 2, 2007, an investor purchases a $1,000 Lewis Company bond at 102 plus a brokerage fee of $5.30 and accrued interest of $10.20. Cash1 035 50 Apr.2Investment in Lewis Co. Bonds1 025 30 2007 Interest Revenue10 20 Invested in a Lewis Company bond.

60. 60 Cash 1 035 50 Apr.2Investment in Lewis Co. Bonds1 025 30 2007 Interest Revenue10 20 Invested in a Lewis Company bond. On April 2, 2007, an investor purchases a $1,000 Lewis Company bond at 102 plus a brokerage fee of $5.30 and accrued interest of $10.20. Note that the brokerage fee is added to the cost of the investment.

61. 61 On July 1, 2007, Crenshaw Inc. purchases $50,000 of 8% bonds of Deitz Corporation due in 8 3/4 years. The effective interest rate is 11%. The purchase price is $41,706 plus interest of $1,000 accrued from April 1, 2007 ($50,000 x 8% x 3/12). Extended Illustration for Crenshaw, Inc.

62. 62 Interest Revenue1 000 00 Cash42 706 00 Purchased investment in bonds, plus accrued interest. July1Investment in Deitz Corp. Bonds41 706 00 2007 The entry to record the investment is as follows:

63. 63 Crenshaw, Inc. received semiannual interest for April 1 to October 1 ($50,000 x 8% x 6/12). Interest Revenue2 000 00 Received semiannual interest for April 1 to October 1. Oct.1Cash2 000 00

64. 64 Adjusting entry for interest accrued from October 1 to December 31 ($50,000 x 8% x 3/12). Interest Revenue1 000 00 Dec.31Interest Receivable1 000 00 Adjusting entry for interest accrued from October 1 to December 31.

65. 65 Adjusting entry for amortization of discount for July 1 to December 31: ($50,000 –$41,706)/105 = $79 (rounded) x 6 months. Interest Revenue474 00 31Investment in Deitz Corp. Bonds474 00 Adjusting entry for amortization of discount for July 1 to December 31.

66. 66 Interest Revenue Oct.12,000 Dec. 31 Adj.1,000 31 Adj. 474 2,474 July 11,000 Adj. Bal. The effect of these entries on Interest Revenue is as follows:

67. 67 The Deitz bonds are sold for $47,350 plus accrued interest on June 30, 2014. The carrying amount of the bond as of January 1, 2014 is $47,868 [$41,706 + ($79 per month x 78 months)]. Accounting for Bond Investments—Sale

68. 68 It has been six months since the last amortization entry, so amortization for this period is recorded (6 months). Interest Revenue474 00 June30Investment in Deitz Corp. Bonds474 00 2014 Amortized discount for current year.

69. 69 The next slide shows the Investment in Dietz Corp. Bonds account after all amortization entries have been made, including the June 30, 2014 adjusting entry.

70. 70 Investment in Deitz Corp. Bonds July 141,706 Dec. 31474 Dec. 31948 June 30 474 48,342 2007 2008 2009 2010 2011 2012 2013 2014

71. 71 This investment is sold on June 30, 2014 for $47,350 plus accrued interest of $1,000 ($50,000 x 8% x 3/12). 30Cash48 350 00 Loss on Sale of Investments992 00 Interest Revenue1 000 00 Investment in Deitz Co. Bonds48 342 00 Received interest and proceeds from sale of bonds.

72. 72 On October 1, 2008 Viewtec Corporation purchases $10,000 of 6% bonds of Watson Corporation due in 9¼ years. The bonds were purchased at a price of $8,341 plus interest of $150 ($10,000 x 6% x 3/12) accrued from July 1, 2008, the date of the last semiannual interest payment. a.Journalize the purchase of the bonds plus accrued interest. b.Journalize the entry to record the amortization of the discount on December 31.

73. 73 Investment in Watson Corp. Bonds 8,341 Interest Revenue 150 Cash 8,491 Oct. 1 2008 a. Investment in Watson Corp. Bonds42* Interest Revenue42 Dec. 1 2008 b. *[($10,000 – $8,341)/111 months] x 3 months

74. 74 Prepare a corporation balance sheet. Objective 6

75. 75 Balance Sheet of a Corporation (Continued)

76. 76 Balance Sheet of a Corporation (Concluded)

77. 77 Held-to-Maturity Securities Investments in bonds or other debt securities that management intends to hold to their maturity are called held-to-maturity securities.

78. 78  Such securities are classified as long-term investments under the caption Investments.  These investments are reported at their cost less any amortized premium or plus any amortized discount.  The market (fair) value of the bond investment should be disclosed, either on the face of the balance sheet or in an accompanying note. Balance Sheet Presentation of Bond Investments

79. 79 Some corporations have a high ratio of debt to stockholders’ equity. For such corporations, analysts often assess the relative risk of the debtholders in terms of the number of times the interest charges are earned during the year. Financial Analysis and Interpretation

80. 80 To illustrate, assume the following data: Interest expense$ 36,883,000 Income before income tax174,315,000 Income before income tax + Interest expense Interest expense $174,315,000 + $36,883,000 $36,883,000 Number of Times the Interest Charges Earned (Continued)

81. 81 The number of times interest charges are earned is 5.73. This ratio indicates that the debtholders have adequate protection against a potential drop in earnings jeopardizing their receipt of interest payments. A full analysis should involve a comparison with industry averages.

82. Summary  Financing Corporations  Bond terms & Characteristics  Time Value of Money  Accounting for Bonds  Investment in Bonds  Financial Statement Presentation