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BOND ACCOUNTING
LECTURE 7
BY
HINA SAMDANI
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What are bonds?
Bonds are a form of interest bearing notes payable.
They are issued by corporations, governmentalagencies.
When companies need large funds of long-termcapital to finance some capital intensive projectsthey resort to options such as Shares or Bonds alsoknown a bonds payable in the accounting books.
Bonds are basically Debt instruments and are usedto break up a large loan into small bits.
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Cont.. Bonds are issued for a long time period
usually 30 -40 years.
Bonds are transferable i.e. can be sold to otherinvestors.
Bonds are often referred to as the fixed
income investments as they pay specific rateof interest coupon rate on the value of
investment.
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ADVANTAGES OF BOND
FINANCING
Stockholders control is not affected.
Bond holders do not have voting rights, so currentowners retain full control of the company.
Tax saving results.
Bond tax is deductible for tax purposes.
Earning per share may be higher.
No additional shares of common stock are issued
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Effects on Earning per Share Stocks vs. Bonds
PLAN A PLAN B
Issue stock Issue bonds
Income before interest
& tax $ 1500000 $1500000
Interest (12%x5000000) - 600000
Income before tax 1500000 900000
Tax expense (30%) 450000 270000
Net income 1050000 630000
Outstanding shares 300000 100000
Earnings per share $3.50 $6.30
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BOND CHARACTERISTICS
Face Value:
Amount of principal the issuer pay at maturity date.
Interest Rate:
Referred as Stated Rate is the rate used to determine theamount of cash interest the borrower pays and theinvestor receives. Paid semiannually.
Bond Indenture:
The legal document in which the terms of the bondissue are set forth.
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CONT..
Call option:
- Can be called back at any time but at a
higher price. Convertible Bonds:
Can be converted into a specified number of
shares at the option of the bondholder.
Bond sinking fund:
A fund created to ensure the investor of the
ability of the corporation to pay back its
loans.
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TYPES OF BONDS
1. SECURED & UNSECURED BONDS:
SECURED BONDS: Have specific asset of the issuer
pledged as collateral for the bonds.
A bond secured by real estate is called a Mortgage
Bond.
A bond secured by specific assets set aside to retire the
bond is called Sinking Fund Bond.UNSECURED BONDS: Are issued against the general
credit of the borrower.
These bonds are called Debenture Bonds.
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CONT..
2. TERM & SERIAL BONDS:
TERM BONDS: Bonds that mature at a single specified futuredare.
SERIAL BONDS: Bonds that mature in installments.
3. REGISTERED & BEARER BONDS:
REGISTERED BONDS: Bonds that issue in the name of theowner.
Interest payments made by checks.
BEARER BONDS: Bonds not registered.
Holders must send coupons to receive interest payments.
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CONT.
4. CONVERTIBLE & CALLABLE BODS:
CONVERTIBLE BONDS: Bonds that can be converted
into common stock at the bond holders option.CALLABLE BONDS: Bonds subject to retirement at a
stated dollar amount prior to maturity at the optionof the issuer.
5. Junk bonds: Bonds issued by companies with a lessercredit rating. Usually pay very high interest.
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ISSUING PROCEDURES
State laws grant the power to issue bonds.
Approval required by board of directors.
BOD must stipulate: Number of bond to be issued
Face value Interest rate.
Bond indenture prepared
Bond certificates printed
Include:
Name of the issuer Face value
Interest rate
Maturity date.
Generally sold through investment company specialized in bond selling.
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MARKET PRICE OF A BOND
Bond prices are quoted as a percentage of their
face value or maturity value.
The primary factors which determine the market
value of a bond are:
The relationship of the bonds coupon rate to the
market interest rate of similar investments (Market
rate of interest). The amount to be received.
The length of time till the bond matures.
The investor confidence in the company.
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CONT.
When ever the price of the bond is more than
its maturity value (face value) it is said to be
selling at Premium. When ever the price of the bond is less than
its maturity value (face value) it is said to be
selling at Discount.
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ACCOUNTING FOR BOND ISSUES
Bonds may be issued at:
Face Value
Below Face Value (at a discount)
Above Face Value (at a premium)
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ISSUING BONDS AT FACE VALUE
On January 1 Devor issues 1,000, 10 years, 9%,$1,000 bonds.
Entry to record sale:
Jan 1 Cash 1,000,000
Bonds payable 1,000,000
To record sale of bonds at value.
Reported in long-term liability section ofbalance sheet.
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CONT..
Interest paid semi annually.
Entry to record interest payment:
July 1 Bond interest expense 45,000
Cash 45,000
To record payment of bond interest.
($1,000,000 x 9% x 6/12)
Adjusting entry on December 31:
Dec 31 Bond interest expense 45,000
Bond interest payable 45,000
To accrue bond interest.
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ISSUING BONDS ON DISCOUNT ORPREMIUM
MARKET BONDS SELL
INTEREST RATE AT
BONDINTEREST
RATE10%
8%
10%
12%
PREMIUM
FACE VALUE
DISCOUNT
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ISSUING BONDS AT A DISCOUNT
On January 1, 2002, Candlestick Inc.sells $100,000, 5-year, 10% bonds for
$92,639. Entry:
Jan 1 Cash 92,639
Discount on bonds payable 7,361Bonds payable 100,000
To record sale of bonds at a discount.
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CONT..
Balance sheet presentation:
Long-term liabilities:
Bonds payable $100,000
Less: discount on bonds payable 7,361 $92,639
COST OF BORROWING:
Semiannual interest payments
($100,000 x 10% x = $5,000; $5000x10) $50,000
Add: Bond discount (100,000-$92,639) 7,361
Total cost of borrowing $57,361
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CONT
COST OF BORROWING:
Principal at maturity $100,000
Semiannual interest payments( $5000x10) 50,000
Cash to be paid to be paid to bondholders 150,000Cash received from bondholders 92,639
Total cost of borrowing $57,361
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ISSUING BONDS AT A PREMIUM
On January 1, 2002, Candlestick Inc. sells
$100,000, 5-year, 10% bonds for $108,111.
Entry:Jan 1 Cash 108,111
Bonds payable 100,000
Premium on bonds payable 8,111To record sale of bonds at a premium.
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CONT..
Balance sheet presentation:
Long-term liabilities:
Bonds payable $100,000
Add: Premium on bonds payable 8,111 $108,111
COST OF BORROWING:
Semiannual interest payments
($100,000 x 10% x = $5,000; $5000x10) $50,000
Less: Bond premium ($108,111-$100,000) 8,111
Total cost of borrowing $41,889
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CONT
COST OF BORROWING:
Principal at maturity $100,000
Semiannual interest payments( $5000x10) 50,000
Cash to be paid to be paid to bondholders 150,000Cash received from bondholders 108,111
Total cost of borrowing $41,889
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ACCOUNTING FOR BOND
RETIREMENT
REDEEMING BONDS AT MATURITY:
On January 1, 2002, Candlestick Inc. sells $100,000,
5-year, 10% bonds at face value.
Bonds payable 100,000
Cash 100,000
To record redemption of bond at maturity.
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CONVERTING BONDS INTO
COMMON STOCK
Assume that on January 1 Saunders Associatesconverts $100,000 bonds sold at face valueinto 2000 shares of $10 par value commonstock.
Bonds payable 100,000
Common stock 20,000Paid in capital in excess of par value 80,000
To record bond conversion.