15-1 L ONG-TERM F INANCING B ONDS CHAPTER 15 [After listening to the lecture comments for this slide, click anywhere outside the slide to continue.]

15-1

LONG-TERM FINANCING BONDS

CHAPTER 15CHAPTER 15

[After listening to the lecture comments for this slide,

click anywhere outside the slide to continue.]

15-2

Three Ways Corporations Three Ways Corporations Can Raise Cash Can Raise Cash

Sell Stock

Borrow from Bank

Borrow from Investors (i.e., Sell Corporate Bonds)

Forget U. S. Government Savings Bonds. They are very different from corporate bonds.

15-3

SellerCash

Bond Certificate

Nature of Bond TransactionsNature of Bond Transactions

NeverNever lose sight of the nature of a bond transaction!

Is long-term debt for issuing company Is investment for purchasing companies or

individuals

BuyerA/K/A: Issuer Borrower

A/K/A: Investor Lender

15-4

Seller

Nature of Bond TransactionsNature of Bond Transactions

The seller agrees to pay and the buyer expects to get

Periodic interest at specified dates Face value (i.e., principal) of bonds at maturity

BuyerFace Value Payment

at Maturity

Interest Payments Every Six Months

A/K/A: Issuer Borrower

A/K/A: Investor Lender

15-5

Other Types of LoansOther Types of Loans

What is the most familiar loan to you?

Parents

Auto

Home

15-6

Level Periodic Payments

(Includes principal & interest)

Level Periodic Payments

(Includes interest only)

Auto or Home Loan vs.Auto or Home Loan vs.Bond LoanBond Loan

How does the repayment of an auto or home loan differ from the repayment of a bond loan?

How does the repayment of an auto or home loan differ from the repayment of a bond loan?

Last Pmt.

Auto/Home Loan$

Time

Bond Loan$

Time Last Pmt.

Principal Payment(at maturity)

15-7

BONDS STOCK

Bonds vs. StockBonds vs. Stock

15-8

BONDS

Debt

STOCK

Equity

Bonds vs. StockBonds vs. Stock

15-9

BONDS

Debt

Maturity Date

STOCK

Equity

No Maturity

Bonds vs. StockBonds vs. Stock

15-10

BONDS

Debt

Maturity Date

Interest

STOCK

Equity

No Maturity

Dividends

Bonds vs. StockBonds vs. Stock

15-11

Bonds vs. StockBonds vs. StockBONDS

Debt

Maturity Date

Interest

Bond Interest Expense Is Deductible for Taxes

STOCK

Equity

No Maturity

Dividends

Dividends Are Not Deductible for Taxes

15-12

Know advantages of issuing debt (p. 545) Does not dilute control of company Interest is tax deductible Favorable financial leverage

A/K/A Trading on the equity

Know disadvantages of issuing debt (546) Interest must be paid Harder to withstand a major loss Possibility of unfavorable financial

leverage

Bonds vs. StockBonds vs. Stock

15-13

Favorable Financial LeverageFavorable Financial Leverage((Using borrowed funds to increase EPS)Using borrowed funds to increase EPS)

(E.g. borrow at 10%; invest at 20%)

P. 547

15-14

Characteristics of BondsCharacteristics of Bonds(PP. 544 - 545)(PP. 544 - 545)

Secured or Unsecured Bonds Registered or Unregistered Bonds Coupon Bonds Serial Bonds Callable Bonds Convertible Bonds Bonds with Stock Warrants Junk Bonds

15-15

Bonds Payable TermsBonds Payable Terms

BOND PAYABLE

15-16

BOND PAYABLE

Face Value $1,000

1. Face Value = Maturity Value

Bonds Payable TermsBonds Payable Terms

15-17

BOND PAYABLE

Face Value $1,000 Interest 10%

1. Face Value = Maturity Value2. Stated Interest Rate

Bonds Payable TermsBonds Payable Terms

15-18

BOND PAYABLE

Face Value $1,000 Interest 10%

6/30 & 12/31

1. Face Value = Maturity Value2. Stated Interest Rate3. Interest Payment Dates

Bonds Payable TermsBonds Payable Terms

15-19

BOND PAYABLE

Face Value $1,000 Interest 10%

6/30 & 12/31

Bond Date 12/31/94

1. Face Value = Maturity Value2. Stated Interest Rate3. Interest Payment Dates4. Bond Date

Bonds Payable TermsBonds Payable Terms

15-20

BOND PAYABLE

Face Value $1,000 Interest 10%

6/30 & 12/31

Maturity Date 12/31/99Bond Date 12/31/94

1. Face Value = Maturity Value2. Stated Interest Rate3. Interest Payment Dates4. Bond Date5. Maturity Date

Bonds Payable TermsBonds Payable Terms

15-21

BOND PAYABLE

Face Value $1,000 Interest 10%

6/30 & 12/31

Maturity Date 12/31/99Bond Date 12/31/94

1. Face Value = Maturity Value2. Stated Interest Rate3. Interest Payment Dates4. Bond Date5. Maturity Date

We also need to know the sale or issue date

of the bond.

Bonds Payable TermsBonds Payable Terms

15-22

Bonds Issued at Face ValueBonds Issued at Face Value on Bond Date - Example on Bond Date - Example

On 12/31/94 Graphics Inc. issues 10 bonds at face value. The market interest rate is

10%. The bonds have the following terms:

Face Value = $1,000

Maturity Date = 12/31/99 (5 years)

Stated Interest Rate = 10%

Interest Dates = 6/30 & 12/31

Bond Date = 12/31/94

15-23

Prepare the journal entry to record the issuance of the bonds on 12/31/94.

Bonds Issued at Face ValueBonds Issued at Face Value on Bond Date on Bond Date

15-24

Prepare the journal entry to record the issuance of the bonds on 12/31/94.

Long-term Liability

Bonds Issued at Face ValueBonds Issued at Face Value on Bond Date on Bond Date

15-25

Prepare the journal entry required every 6/30 and 12/31 to pay interest.

Bonds Issued at Face ValueBonds Issued at Face Value on Bond Date on Bond Date

15-26

Prepare the journal entry required every 6/30 and 12/31 to pay interest.

Bonds Issued at Face ValueBonds Issued at Face Value on Bond Date on Bond Date

15-27

Prepare the journal entry to record the maturity of the bond on 12/31/99.

Bonds Issued at Face ValueBonds Issued at Face Value on Bond Date on Bond Date

15-28

Prepare the journal entry to record the maturity of the bond on 12/31/99.

Bonds Issued at Face ValueBonds Issued at Face Value on Bond Date on Bond Date

15-29

In the previous example, the bonds were sold on the

bond date.

But this is not always the case.

Are you ready to see what happens when we sell

bonds between the bond’s interest dates?

Bonds Issued Between Bonds Issued Between Interest DatesInterest Dates

15-30

When bonds are sold betweenbetween the interest dates, the bond issuer collects

cash for:

The face value of the bonds

AND

The accrued interest since the bonds’ date

Bonds Issued Between Bonds Issued Between Interest DatesInterest Dates

15-31

Then, on the next interest payment date, the bond issuer pays bondholders a

full 6 months of interest.

Bonds Issued Between Bonds Issued Between Interest DatesInterest Dates

15-32

The 6 month interest payment to the bondholders is composed of:

Repayment of the interest received from the bondholders when the bonds were

originally sold

AND Interest earned by the bondholders since

the bonds were sold

Bonds Issued Between Bonds Issued Between Interest DatesInterest Dates

Why is it done this way?

15-33

On 4/1/95 Graphics Inc. issues 1,000 bonds at face value. The bonds have

the following terms:

Face Value = $1,000

Stated Interest Rate = 10%

Interest Dates = 6/30 & 12/31

Bond Date = 12/31/94

Maturity Date = 12/31/99 (5 years)

Bonds Issued Between Bonds Issued Between Interest Dates - ExampleInterest Dates - Example

15-34

How much cash is Graphics Inc. going to receive for the entire issue of the bonds?

Cash Price of Bonds:$1,000 × 1,000 = 1,000,000$

Accrued Interest:$1,000,000 × 10% ×3/12 = 25,000

Total Cash Received 1,025,000$

Bonds Issued Between Bonds Issued Between Interest DatesInterest Dates

15-35

What does the $25,000 in accrued interest represent for Graphics Inc.?

Interest

Payable

Bonds Issued Between Bonds Issued Between Interest DatesInterest Dates

15-36

Prepare the journal entry to record the bond issue on 4/1/95.

Bonds Issued Between Bonds Issued Between Interest DatesInterest Dates

15-37

Prepare the journal entry to record the bond issue on 4/1/95.

Bonds Issued Between Bonds Issued Between Interest DatesInterest Dates

15-38

Prepare the journal entry to record the bond interest payment on 6/30/95.

Bonds Issued Between Bonds Issued Between Interest DatesInterest Dates

15-39

Prepare the journal entry to record the bond interest payment on 6/30/95.

Bond Interest Expense is for the three months April, May, and June.

($1,000,000 × 10% × 3/12 = $25,000)

Bonds Issued Between Bonds Issued Between Interest DatesInterest Dates

15-40

Prepare the journal entry to record the bond interest payment on 6/30/95.

Total Bond Interest Paid is for the six months January through June ($1,000,000 × 10% × 6/12 = $50,000)

Bonds Issued Between Bonds Issued Between Interest DatesInterest Dates

15-41

Prepare the journal entry to record the bond interest payment on 6/30/95.

The debit to Bond Interest Payable is for the accrued interest that was

collected when the bonds were sold.

Bonds Issued Between Bonds Issued Between Interest DatesInterest Dates

15-42

““Interesting” TerminologyInteresting” Terminology

The two sets of interest terms used with bonds are:

Market Rate - A/K/A:Effective Rate

Yield RateAPR

"True" RateCompound Rate

Contract Rate - A/K/A:Stated Rate Coupon Rate

Nominal Rate Face Rate

Simple Rate

15-43

Bond Prices and Interest RatesBond Prices and Interest Rates

Market rate = contract rateBonds sell at face or par value

Market rate > contract rateBonds sell at a discount

(i.e., below face value)

Market rate < contract rateBonds sell at a premium

(i.e., above face value)

15-44

What happens when the market interest rate is different from the bond’s contract interest rate?

For example, the market is earning 12%. Would you want to invest in Graphics Inc.’s 10% bond?

YES!

Market Interest Rate vs.Market Interest Rate vs.Contract Interest RateContract Interest Rate

NO!

15-45

How could Graphics Inc. make their bonds more attractive to you?

They cannot change any terms of the bonds payable.

The only thing they can change is the selling price of the bonds.

Market Interest Rate vs.Market Interest Rate vs.Contract Interest RateContract Interest Rate

15-46

So, if the bond is paying 10% interest and the market is paying 12% interest,

Graphics Inc. would:

Sell the bond below face value(i.e., at a discount)

BUT

Pay interest on the full face value

AND

Repay the full face value at maturity

Market Interest Rate vs.Market Interest Rate vs.Contract Interest RateContract Interest Rate

15-47

This arrangement will increaseincrease the effective interest rate of Graphics Inc.

bonds to the market rate.

Market Interest Rate vs.Market Interest Rate vs.Contract Interest RateContract Interest Rate

Therefore, Graphics Inc.’s 10% bonds would be just as attractive as the market

investments earning 12%.

How can this happen?

(Proof is on next slide)

15-48

Illustration 15.3, P. 550(Slightly modified)

12% 10%

Proof of Concept

Assumptions: Face amount (i.e., loan) = $1,000 Length of loan = 1 yr. Market rate = 12% Contract rate = 10%

Market Interest Rate vs.Market Interest Rate vs.Contract Interest RateContract Interest Rate

15-49

Market Interest Rate vs.Market Interest Rate vs.Contract Interest RateContract Interest Rate

Proof of Concept

Interest = Principal x Rate x Time

100** = P x .12* x 1

P = 833

**1,000 x 10% contract rate

Assumptions: Face amount (i.e., loan) = $1,000 Length of loan = 1 yr. Market rate = 12%* Contract rate = 10%

15-50

On 12/31/94 Graphics Inc. sells 1,000 bonds at 92.6395% of face value. The

market interest rate is 12%. The bonds have the following terms:

Face Value = $1,000

Maturity Date = 12/31/99 (5 years)

Stated Interest Rate = 10%

Interest Dates = 6/30 & 12/31

Bond Date = 12/31/94

Bonds Sold at a DiscountBonds Sold at a Discounton Bond Dateon Bond Date

15-51

How much cash is Graphics Inc. going to receive for the entire bond issue?

Bonds Sold at a DiscountBonds Sold at a Discount

15-52

How much cash is Graphics Inc. going to receive for the entire bond issue?

$1,000 face value × 1,000 bonds sold = $1,000,000 face amount

$1,000,000 × 92.6395% = $926,395 cash proceeds

How much does Graphics Inc. agree to repay at maturity?

Bonds Sold at a DiscountBonds Sold at a Discount

15-53

Graphics Inc. agrees to repay the full face value at maturity.

$1,000 face value × 1,000 bonds sold = $1,000,000

Bonds Sold at a DiscountBonds Sold at a Discount

15-54

The difference between the face value of the bonds and the cash received is the discount.

$1,000,000 - $926,395 = $73,605

The discount causes additional interest expense factor for Graphics Inc but does not

affect interest paid. The discount will be amortized to Bond Interest Expense over the

outstanding life outstanding life of the bonds.

Bonds Sold at a DiscountBonds Sold at a Discount

15-55

Prepare the journal entry to record the issue of the bonds on 12/31/94.

Bonds Sold at a DiscountBonds Sold at a Discount

15-56

Prepare the journal entry to record the issue of the bonds on 12/31/94.

Contra-LiabilityAccount

Bonds Sold at a DiscountBonds Sold at a Discount

15-57

Discount on Bonds Payable

12-31 bal. 73,605

Bonds Sold at a DiscountBonds Sold at a Discount

15-58

Partial Balance Sheet at 12/31/94

Long-term Liabilities: Bonds Payable 1,000,000$ Less: Discount on Bonds Payable 73,605 926,395$

Carrying Value

Face (Maturity) Value

Bonds Sold at a DiscountBonds Sold at a Discount

15-59

Definition of Carrying Value?

Face/Maturity Value

- unamortized discount (current example)

or

+ unamortized premium (later example)

Bonds Sold at a DiscountBonds Sold at a Discount

15-60

Prepare the journal entries required every 6/30 and 12/31. Use straight-line

amortization of the discount.Effective interest method will be

discussed later in the lecture.

Bonds Sold at a DiscountBonds Sold at a Discount

15-61

GENERAL JOURNALPage 1

Date Description PR Debit Credit

6/30 Bond Interest Expense 57,360 Discount on Bonds Payable 7,360 Cash 50,000To record bond interest payment

$1,000,000 × 10% × ½ = $50,000To record discount amortization

$73,605 ÷ 5 yrs. = $14,721 per year $14,721 ÷ 2 = $7,360 rounded

Bonds Sold at a DiscountBonds Sold at a Discount

15-62

Discount on Bonds Payable

12-31 bal. 73,605

Bonds Sold at a DiscountBonds Sold at a Discount

7,360 Amortization on 6-30

6-30 bal. 66,245

15-63

As the discount is amortized, the carrying value of the bonds payable increases toward the maturity value. (i.e. we subtract a smaller

and smaller contra account on the B/S.)

Partial Balance Sheet at 6/30/95

Long-term Liabilities: Bonds Payable 1,000,000$ Less: Discount on Bonds Payable 66,245 933,755$

Bonds Sold at a DiscountBonds Sold at a Discount

15-64

Up from $926,395

Partial Balance Sheet at 6/30/95

Long-term Liabilities: Bonds Payable 1,000,000$ Less: Discount on Bonds Payable 66,245 933,755$

Down from $73,605

Bonds Sold at a DiscountBonds Sold at a Discount

15-65

Compound Interest ConceptsCompound Interest Concepts

Before we go any further, let’s make sure we understand

the compound interest concepts in the

appendix!

15-66

Compound Interest ConceptsCompound Interest ConceptsExample #1Example #1

Future Value (Worth) of $1Future Value (Worth) of $1

Today

Year 1 Year 2

+ $1 - ?- $1.2544

(From Table A.1)

+ $1,000 - X

1 = 1.2544

1,000 X X = 1,254.40

Example is related to Illustration 15-6

Interest Rate = 12% No. Periods = 2 years

15-67

Future Value of an Annuity of $1Future Value of an Annuity of $1

Compound Interest ConceptsCompound Interest ConceptsExample #2Example #2

Today

Pd. 1 Pd. 2 Pd. 3

+ $1 + $1 + $1 - ?- $3.1836

(From Table A.2)

+ $100 + $100 + $100 - X

1 = 3.1836

100 X X = 318.36

Example is related to Illustration 15-7

Interest Rate = 6% No. Periods = 3

15-68

Present Value (Worth) of $1Present Value (Worth) of $1

Compound Interest ConceptsCompound Interest ConceptsExample #3Example #3

Two Perspectives:TextRice

Today

Year 1 Year 2

Text

Today

Year 1 Year 2

Rice

15-69

Present Value (Worth) of $1Present Value (Worth) of $1

Compound Interest ConceptsCompound Interest ConceptsExample #3Example #3

Today

Year 1 Year 2

Rice+ ? - $1+ $.7972

(From Table A.3)

+ X - $1,000

.7972 = 1 .

X 1,000 X = 797.20

Example is related to Illustration 15-8

Interest Rate = 12% No. Periods = 2 years

15-70

Present Value of an Annuity of $1Present Value of an Annuity of $1

Compound Interest ConceptsCompound Interest ConceptsExample #4Example #4

Today

Pd. 1 Pd. 2 Pd. 3

+ ? - $1 - $1 - $1+ $2.673

(From Table A.4)

+ X - $100 - $100 - $100

2.673 = 1 .

X 100 X = 267.30

Example is related to Illustration 15-9

Interest Rate = 6%No. Periods = 3

15-71

So, What Does All of This So, What Does All of This Have to do With Bonds?Have to do With Bonds?

The bond investor is buying the right to receive two things:

X - The present value of the maturity amount of the bonds (i.e., the face amount)

Y - The present value of the periodic bond interest payments

15-72

Z = Total Present Value of Bonds (i.e., Total Market Price)

+ X - 100,000+ 70,496

A/K/A, the cost to the investor and the proceeds to the issuer.

So, What Does All of This So, What Does All of This Have to do With Bonds?Have to do With Bonds?

Example below uses data from bottom p. 550 Facts: Interest Rate = 6% No. Periods = 6

Maturity/Face Amount = $100,000

Issue Date

Pd. 1 Pd. 2 Pd. 3 Pd. 4 Pd. 5 Pd. 6

Maturity Date

+ Y - 6,000 - 6,000 - 6,000 - 6,000 - 6,000 - 6,000

6-30 12-31 6-30 12-31 6-30 12-31 6-301999 2000 2001 2002

+ 29,504

100,000

QUESTION: This bond was sold at a (click one):

Premium Discount Face Amount

15-73

Let’s apply what we just learned.

Bonds Sold at a DiscountBonds Sold at a Discount

15-74

Calculate how Graphics, Inc.

would determine the selling price of

its bonds.

Bonds Sold at a DiscountBonds Sold at a Discount

NOTE: The $926,395 selling price of the bonds on the next slide was previously

calculated on slide #52 as a simple percentage of face amount. The current calculation is a conceptual one which

builds on the present value concepts in the appendix and on the last few slides. A calculation of bond selling price will

be on the next test.

NOTE: The $926,395 selling price of the bonds on the next slide was previously

calculated on slide #52 as a simple percentage of face amount. The current calculation is a conceptual one which

builds on the present value concepts in the appendix and on the last few slides. A calculation of bond selling price will

be on the next test.

15-75

Face Value 1,000,000$ Stated Interest Rate 10%Number of Periods (5 yrs. × 2) 10

Market Interest Rate 12%

Selling Price of Bonds 926,395$

Facts

Interest Payments 50,000$ PV Ann. $1, 10 periods, 6% × 7.36009 PV of Interest Payments (rounded) 368,005

Present Value of Bonds on Issuance Date: Principal 1,000,000$ PV $1, 10 periods, 6% × .55839 PV of Principal 558,390$

Bonds Sold at a DiscountBonds Sold at a Discount

15-76

Now, what happens when the market interest rates are lower than the

bond’s contract interest rate?

For example, the market is earning 8%. Would you want to invest in Graphics Inc.’s

10% bond?

Market Interest Rate vs.Market Interest Rate vs.Contract Interest Rate (again)Contract Interest Rate (again)

YES! NO!

15-77

So, if the bond is paying 10% interest and the market is paying 8% interest, Graphics

Inc. would:

Sell the bond above face value (i.e., at a premium)

BUT

Pay interest on only the face value

AND

Repay only the face value at maturity

Market Interest Rate vs.Market Interest Rate vs.Contract Interest RateContract Interest Rate

15-78

Based on the logic explained earlier, this arrangement will decreasedecrease the effective

interest rate of Graphics Inc. bonds to the market rate.

Therefore, Graphics Inc.’s 10% bonds would provide a return to the investor/lender equal to

the market’s 8%.

Market Interest Rate vs.Market Interest Rate vs.Contract Interest RateContract Interest Rate

15-79

On 12/31/94 Graphics Inc. sells 1,000 bonds at 108.1105% of face value. The market interest rate is 8%. The bonds

have the following terms:

Face Value = $1,000

Maturity Date = 12/31/99 (5 years)

Stated Interest Rate = 10%

Interest Dates = 6/30 & 12/31

Bond Date = 12/31/94

Bonds Sold at a PremiumBonds Sold at a Premium

15-80

How much cash is Graphics Inc. going to receive for the entire bond issue?

Bonds Sold at a PremiumBonds Sold at a Premium

15-81

How much cash is Graphics Inc. going to receive for the entire bond issue?

$1,000 face value × 1,000 sold = $1,000,000 face amount

$1,000,000 × 108.1105% = $1,081,105 cash proceeds

Bonds Sold at a PremiumBonds Sold at a Premium

15-82

How much does Graphics Inc. agree to repay at maturity?

$1,000 face value × 1,000 sold = $1,000,000

How much cash interest does Graphics Inc. agree to pay at each interest date?

$1,000,000 × 10% contract rate × 6/12 = $50,000

Bonds Sold at a PremiumBonds Sold at a Premium

This is the cash amount which will be This is the cash amount which will be paidpaid regardless of whether the bonds were issued regardless of whether the bonds were issued

at face, a discount or a premium!at face, a discount or a premium!

15-83

In this case, the difference between the face value of the bonds and the cash

received is the premium.

$1,081,105 - $1,000,000 = $81,105

The premium causes a reductionreduction in the interest expense for Graphics but not in the interest paid. The premium will be

amortized to bond interest expense over the life of the bonds.

Bonds Sold at a PremiumBonds Sold at a Premium

15-84

Prepare the journal entry to record the issue of the bonds on 12/31/94.

Bonds Sold at a PremiumBonds Sold at a Premium

15-85

Prepare the journal entry to record the issue of the bonds on 12/31/94.

Adjunct-LiabilityAccount

Bonds Sold at a PremiumBonds Sold at a Premium

15-86

Premium on Bonds Payable

81,105 Bal. 12-31

Bonds Sold at a PremiumBonds Sold at a Premium

15-87

Carrying Value

Partial Balance Sheet at 12/31/94

Long-term Liabilities: Bonds Payable 1,000,000$ Add: Premium on Bonds Payable 81,105 1,081,105$

Maturity Value

Bonds Sold at a PremiumBonds Sold at a Premium

15-88

Prepare the journal entries required every 6/30 and 12/31. Use straight-line

amortization of the premium.

Bonds Sold at a PremiumBonds Sold at a Premium

Again, effective interest method

will be discussed later in lecture.

15-89

GENERAL JOURNALPage 1

Date Description PR Debit Credit

6/30 Bond Interest Expense 41,889 Premium on Bonds Payable 8,111

Cash 50,000To record bond interest payment

$1,000,000 × 10% × ½ = $50,000To record premium amortization

$81,105 ÷ 5 yrs. = $16,221 per year $16,221 ÷ 2 = $8,111 rounded

Bonds Sold at a PremiumBonds Sold at a Premium

15-90

Premium on Bonds Payable

81,105 Bal. 12-31

6-30 amort. 8,111

72,994 Bal. 6-30

Bonds Sold at a PremiumBonds Sold at a Premium

15-91

Partial Balance Sheet at 6/30/95

Long-term Liabilities: Bonds Payable 1,000,000$ Add: Premium on Bonds Payable 72,994 1,072,994$

Carrying Value

Adjunct-liability account

Bonds Sold at a PremiumBonds Sold at a Premium

Down from $81,105

Down from $1,081,105

15-92

As the premium is amortized, the carrying value of the bonds payable decreases toward the maturity value. (i.e. we add a smaller and

smaller adjunct account on the B/S.)

Partial Balance Sheet at 6/30/95

Long-term Liabilities: Bonds Payable 1,000,000$ Add: Premium on Bonds Payable 72,994 1,072,994$

Bonds Sold at a PremiumBonds Sold at a Premium

15-93

Again, let’s calculate how Graphics, Inc.

would determine the selling price of

the bonds.

Bonds Sold at a PremiumBonds Sold at a Premium

The $1,081,105 selling price of the bonds on the following slide was

previously calculated on slide #81 as a simple percentage of face amount. As before, the following calculation is a

conceptual one which builds on present value concepts in the appendix.

The $1,081,105 selling price of the bonds on the following slide was

previously calculated on slide #81 as a simple percentage of face amount. As before, the following calculation is a

conceptual one which builds on present value concepts in the appendix.

15-94

Face Value 1,000,000$ Stated Interest Rate 10%Number of Periods (5 yrs. × 2) 10

Market Interest Rate 8%

Selling Price of Bonds 1,081,105$

Facts

Interest Payments 50,000$ PV Ann. $1, 10 periods, 4% × 8.11090 PV of Interest Payments (rounded) 405,545

Present Value of Bonds on Issuance Date: Principal 1,000,000$ PV $1, 10 periods, 4% × . 67556 PV of Principal 675,560$

Bonds Sold at a PremiumBonds Sold at a Premium

15-95

Examples of Simple Sales EntriesExamples of Simple Sales EntriesSold at Face

Cash 1,000 Bonds Payable 1,000

Sold at Discount Cash 900 Discount on Bonds Payable 100 Bonds Payable 1,000

Sold at Premium Cash 1,100 Premium on Bonds Payable 100 Bonds Payable 1,000

15-96

Methods of AmortizationMethods of AmortizationStraight-Line vs. Effective InterestStraight-Line vs. Effective Interest

Which is preferred for GAAP?Effective interest method

So, when can straight-line be used? When the results are not materially

different from the effective interest method.

How do the two methods differ?

15-97

Conceptual difference given a discount situation.

$

Time

$

Time

Straight-line Effective Interest

?

?

Methods of AmortizationMethods of AmortizationStraight-Line vs. Effective InterestStraight-Line vs. Effective Interest

15-98

$

Time

$

Time

Straight-line

Int .Exp.

Conceptual difference given a discount situation.

Methods of AmortizationMethods of AmortizationStraight-Line vs. Effective InterestStraight-Line vs. Effective Interest

Effective Interest

Interest expense: constant amount

Interest expense: constant rate

CV

15-99

Effective Interest MethodEffective Interest Method(For Either Premium (For Either Premium oror Discount) Discount)

Calculate bond interest expense at the date of each semiannual interest payment as follows Bond interest expense = Carrying value of

bond at beginningbeginning of period X Market/effective/yield rate of interest X 6/12

The amortization amount, then, is simply the difference between the interest expense and the cash interest payment.

15-100

From an earlier example, Graphics Inc. sold 10% bonds with a face value of $1,000,000 for

$926,395. Market rate = 12%. Amortization entry 6 months later

Bond Interest Expense *55,584

Cash ($1,000,000 x .10 x 6/12) 50,000

Discount on Bonds Payable 5,584

*($926,395 x .12 X 6/12)

To do the next amortization entry, one ideally needs what?

Effective Interest MethodEffective Interest MethodDiscount ExampleDiscount Example

15-101

Effective Interest Method Effective Interest Method Discount Amortization TableDiscount Amortization Table

A: $1,000,000 × 10% × ½ = $50,000B: $931,979 × 6% = $55,919C: $55,919 - $50,000 = $5,919D: $68,021 - $5,919 = $62,102E: $1,000,000 - $62,102 = $937,898

(A) (B) (C) (D) (E)Interest Interest Discount Unamortized Carrying

Date Payment Expense Amortization Discount Value1/1/95 73,605$ 926,395$

6/30/95 50,000$ 55,584$ 5,584$ 68,021 931,979 12/31/95 50,000 55,919 5,919 62,102 937,898

15-102

Effective Interest MethodEffective Interest MethodDiscount Amortization TableDiscount Amortization Table

(A) (B) (C) (D) (E)Interest Interest Discount Unamortized Carrying

Date Payment Expense Amortization Discount Value1/1/95 73,605$ 926,395$

6/30/95 50,000$ 55,584$ 5,584$ 68,021 931,979 12/31/95 50,000 55,919 5,919 62,102 937,898

6/30/96 50,000 56,274 6,274 55,828 944,172 12/31/96 50,000 56,650 6,650 49,178 950,822

6/30/97 50,000 57,049 7,049 42,129 957,871 12/31/97 50,000 57,472 7,472 34,657 965,343

6/30/98 50,000 57,921 7,921 26,736 973,264 12/31/98 50,000 58,396 8,396 18,340 981,660

6/30/99 50,000 58,900 8,900 9,440 990,560 12/31/99 50,000 59,434 9,440 0 1,000,000 *

* Adjusted.

15-103

From an earlier example, Graphics Inc. sold 10% bonds with a face value of $1,000,000 for

$1,081,105. Market rate = 8%. Amortization entry 6 months later

Bond Interest Expense *43,244

Premium on Bonds Payable 6,756

Cash ($1,000,000 x .10 x 6/12) 50,000

*($1,081,105 x .08 X 6/12)

Effective Interest MethodEffective Interest MethodPremium ExamplePremium Example

And now, the amortization table...

15-104

(A) (B) (C) (D) (E)Interest Interest Premium Unamortized Carrying

Date Payment Expense Amortization Premium Value

A: $1,000,000 × 10% × ½ = $50,000B: $1,074,349 × 4% = $42,974C: $50,000 - $42,974 = $7,026D: $74,349 - $7,026 = $67,323E: $1,000,000 + $67,323 = $1,067,323

1/1/95 81,105$ 1,081,105$ 6/30/95 50,000$ 43,244$ 6,756$ 74,349 1,074,349

12/31/95 50,000 42,974 7,026 67,323 1,067,323

Effective Interest Method Effective Interest Method Premium Amortization TablePremium Amortization Table

15-105

Interest Interest Premium Unamortized CarryingDate Payment Expense Amortization Premium Value1/1/95 81,105$ 1,081,105$

6/30/95 50,000$ 43,244$ 6,756$ 74,349 1,074,349 12/31/95 50,000 42,974 7,026 67,323 1,067,323

6/30/96 50,000 42,693 7,307 60,016 1,060,016 12/31/96 50,000 42,401 7,599 52,417 1,052,417

6/30/97 50,000 42,097 7,903 44,514 1,044,514 12/31/97 50,000 41,781 8,219 36,295 1,036,295

6/30/98 50,000 41,452 8,548 27,747 1,027,747 12/31/98 50,000 41,110 8,890 18,857 1,018,857

6/30/99 50,000 40,754 9,246 9,611 1,009,611 12/31/99 50,000 40,389 9,611 0 1,000,000 *

* Rounded

(A) (B) (C) (D) (E)

Effective Interest Method Effective Interest Method Premium Amortization TablePremium Amortization Table

15-106

When they mature, make the simple entryBonds Payable (DEBIT) Cash (CREDIT)

If paid before maturity Compare carrying value of the bonds with the

cash paid to retire the bondsIf retirement price < carrying value, have gainIf retirement price > carrying value, have loss

Is a loss a debit or credit?

Redeeming (Paying Off)Redeeming (Paying Off)Bonds PayableBonds Payable

Gain or loss reported where?Early extinguishment (retirement) of debt (Chap.13)

Debit Credit

15-107

Bond Redemption Sinking FundBond Redemption Sinking Fund

May be required by bond indenture

i.e., contract

Fund is used to redeem bonds and

pay interest

Classified as “Investments” or “Other Assets”

Sinking Fund

Sinking Fund

15-108

Kmbekibek;

Have we bitten off more Have we bitten off more than we can chew?than we can chew?

Rice’s Students OnlyClick the keypad to answer required

virtual keypad questions.