Ch12 wrd12e instructor_final

c. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part.

Long-Term Long-Term

Liabilities: Liabilities:

Bonds and Bonds and

NotesNotes

Chapter 12Chapter 12Chapter 12Chapter 12

Learning ObjectivesLearning Objectives

1.1. Compute the potential impact of long-term Compute the potential impact of long-term borrowing on earnings per share.borrowing on earnings per share.

2.2. Describe the characteristics and terminology of Describe the characteristics and terminology of bonds payable.bonds payable.

3.3. Journalize entries for bonds payable.Journalize entries for bonds payable.

4.4. Describe and illustrate the accounting for Describe and illustrate the accounting for installment notes.installment notes.

5.5. Describe and illustrate the reporting of long-term Describe and illustrate the reporting of long-term liabilities including bonds and notes payable.liabilities including bonds and notes payable.

6.6. Describe and illustrate how the number of times Describe and illustrate how the number of times interest charges are earned is used to evaluate a interest charges are earned is used to evaluate a company’s financial condition.company’s financial condition.


Learning Learning Objective

ObjectiveCompute the potential impact of

Compute the potential impact of

long-term borrowing on earnings

long-term borrowing on earnings per share.per share.

11


Financing CorporationsFinancing Corporations

o Corporations finance their operations Corporations finance their operations using the following sources:using the following sources: Short-term debt, such as purchasing goods or Short-term debt, such as purchasing goods or

services on account.services on account.

Long-term debt, such as issuing bonds or notes Long-term debt, such as issuing bonds or notes payable.payable.

Equity, such as issuing common or preferred Equity, such as issuing common or preferred stock.stock.



o A A bondbond is a form of an interest-bearing is a form of an interest-bearing note. Like a note, a bond requires periodic note. Like a note, a bond requires periodic interest payments, and the face amount interest payments, and the face amount must be repaid at the maturity date.must be repaid at the maturity date.



Huckadee Corporation is considering the Huckadee Corporation is considering the following plans to issue debt and equity:following plans to issue debt and equity:



o In deciding among financing plans, the In deciding among financing plans, the effect on earnings per share is often effect on earnings per share is often considered.considered.

o Earnings per share (EPS)Earnings per share (EPS) measures the measures the income earned by each share of common income earned by each share of common stock. It is computed as follows:stock. It is computed as follows:

Earnings per Share =Net Income - Preferred Dividends

Number of Common Shares Outstanding


The effect of the preceding financing plans is shown in Exhibit 1 Exhibit 1 (next slide).

The effect of the preceding financing plans is shown in Exhibit 1 Exhibit 1 (next slide).


o Assume the following data for Huckadee Assume the following data for Huckadee Corporation:Corporation: Earnings before interest and income taxes are Earnings before interest and income taxes are

$800,000.$800,000.

The tax rate is 40%.The tax rate is 40%.

All bonds or stocks are issued at their par or All bonds or stocks are issued at their par or face amount.face amount.

Highest EPS

FINANCING FINANCING CORPORATIONSCORPORATIONS

Highest EPS

FINANCING FINANCING CORPORATIONSCORPORATIONS



ObjectiveDescribe the characteristics and

Describe the characteristics and

terminology of bonds payable.

terminology of bonds payable.

22


Bond Characteristics and TerminologyBond Characteristics and Terminology

o The underlying contract between the The underlying contract between the company issuing bonds and the company issuing bonds and the bondholders is called a bondholders is called a bond indenturebond indenture..



o Usually, the face amount of each bond, Usually, the face amount of each bond, called the principal, is $1,000, or a called the principal, is $1,000, or a multiple of $1,000. Interest on bonds may multiple of $1,000. Interest on bonds may be payable annually, semiannually, or be payable annually, semiannually, or quarterly. Most pay interest semiannually.quarterly. Most pay interest semiannually.



o When all bonds of an issue mature at the When all bonds of an issue mature at the same time, they are called same time, they are called term bondsterm bonds..

o If they mature over several dates, they are If they mature over several dates, they are called called serial bondsserial bonds..

o Bonds that may be exchanged for other Bonds that may be exchanged for other securities are called securities are called convertible bondsconvertible bonds..



o Bonds that a corporation reserves the Bonds that a corporation reserves the right to redeem before their maturity are right to redeem before their maturity are called called callable bondscallable bonds..

o Bonds issued on the basis of the general Bonds issued on the basis of the general credit of the corporation are called credit of the corporation are called debenture bondsdebenture bonds..


Proceeds from Issuing BondsProceeds from Issuing Bonds

o When a corporation issues bonds, the When a corporation issues bonds, the proceeds received for the bonds depend proceeds received for the bonds depend on:on: The face amount of the bonds, which is the The face amount of the bonds, which is the

amount due at the maturity date.amount due at the maturity date.

The interest rate on the bonds.The interest rate on the bonds.

The market rate of interest for similar bonds.The market rate of interest for similar bonds.



o The face amount and the interest rate on The face amount and the interest rate on the bonds are identified in the bond the bonds are identified in the bond indenture.indenture.

o The interest rate to be paid on the face The interest rate to be paid on the face amount of the bond is called the amount of the bond is called the contract contract rate rate or or coupon ratecoupon rate..



o The The market rate of interestmarket rate of interest, or , or effective effective rate of interestrate of interest, is determined by , is determined by transactions between buyers and sellers of transactions between buyers and sellers of similar bonds. similar bonds.

o The market rate of interest is affected by a The market rate of interest is affected by a variety of factors, including investors’ variety of factors, including investors’ expectations of current and future expectations of current and future economic conditions.economic conditions.

PROCEEDS PROCEEDS FROM ISSUING FROM ISSUING

BONDSBONDS


BONDSBONDS


BONDSBONDS



o SummarySummary If the market rate equals the contract rate, If the market rate equals the contract rate,

bonds will sell at the bonds will sell at the face amountface amount..

If the selling price of the bonds is less than the If the selling price of the bonds is less than the face amount, the bonds are selling at a face amount, the bonds are selling at a discountdiscount..

If the selling price of the bonds is more than If the selling price of the bonds is more than the face amount, the bonds are selling at a the face amount, the bonds are selling at a premiumpremium..



o The price of a bond is quoted as a The price of a bond is quoted as a percentage of the bond’s face value.percentage of the bond’s face value. A $1,000 bond quoted at 98 could be A $1,000 bond quoted at 98 could be

purchased or sold for $980 ($1,000 x 0.98).purchased or sold for $980 ($1,000 x 0.98).

A $1,000 bond quoted at 109 could be A $1,000 bond quoted at 109 could be purchased or sold for $1,090 ($1,000 x 1.09).purchased or sold for $1,090 ($1,000 x 1.09).



ObjectiveJournalize entries for bonds

Journalize entries for bonds payable.payable.

33


Bonds Issued at Face AmountBonds Issued at Face Amount

o On January 1, 2013, Eastern Montana On January 1, 2013, Eastern Montana Communications Inc. issued the following Communications Inc. issued the following bonds:bonds:



o Since the contract rate of interest and the Since the contract rate of interest and the market rate of interest are the same, the market rate of interest are the same, the bonds will sell at their face amount.bonds will sell at their face amount.



o Every six months (on June 30 and Every six months (on June 30 and December 31) after the bonds are issued, December 31) after the bonds are issued, interest of $6,000 ($100,000 × 0.12 × interest of $6,000 ($100,000 × 0.12 × 6/12) is paid.6/12) is paid.



o The bond matures on December 31, 2017. The bond matures on December 31, 2017. At this time, the corporation pays the face At this time, the corporation pays the face amount to the bondholders.amount to the bondholders.


Bonds Issued at a DiscountBonds Issued at a Discount

o On January 1, 2013, Western Wyoming On January 1, 2013, Western Wyoming Distribution Inc. issued $100,000, 12%, Distribution Inc. issued $100,000, 12%, five-year bonds when the market rate was five-year bonds when the market rate was 13%. (Interest will be paid semiannually 13%. (Interest will be paid semiannually on June 30 and December 31.) on June 30 and December 31.)

Reminder:


Bonds Issued at a DiscountBonds Issued at a Discount

The firm issued the $100,000 bonds for The firm issued the $100,000 bonds for $96,406 (a discount of $3,594).$96,406 (a discount of $3,594).

The discount may be viewed as the amount required by investors to accept a bond rate of interest below the

market rate.


Amortizing a Bond DiscountAmortizing a Bond Discount

o The two methods of computing the The two methods of computing the amortization of a bond discount are:amortization of a bond discount are: Straight-line methodStraight-line method

Effective interest rate methodEffective interest rate method, , sometimes called the sometimes called the interest methodinterest method

o Both methods amortize the same total Both methods amortize the same total amount of discount over the life of the amount of discount over the life of the bonds.bonds.



o The The effective interest rate methodeffective interest rate method is is required by generally accepted accounting required by generally accepted accounting principles.principles.

o However, the straight-line method may be However, the straight-line method may be used if the results do not differ used if the results do not differ significantly from the interest method.significantly from the interest method.



o On June 30, 2013, Western Wyoming On June 30, 2013, Western Wyoming Distribution Inc. pays six-months’ interest Distribution Inc. pays six-months’ interest on the five-year bond issued earlier, and on the five-year bond issued earlier, and the bond discount is amortized ($3,594 × the bond discount is amortized ($3,594 × 1/10). The interest payment and 1/10). The interest payment and amortization entries can be combined as amortization entries can be combined as follows:follows:

*$100,000 × 12% × 6/12


Bonds Issued at a PremiumBonds Issued at a Premium

o On January 1, 2013, Northern Idaho On January 1, 2013, Northern Idaho Transportation Inc. issued $100,000, 12%, Transportation Inc. issued $100,000, 12%, five-year bonds for $103,769. The market five-year bonds for $103,769. The market rate of interest is 11%.rate of interest is 11%.

Reminder:Reminder:


Amortizing a Bond PremiumAmortizing a Bond Premium

o The entry to record the first interest The entry to record the first interest payment and the amortization of the payment and the amortization of the premium on the $100,000, 12%, five-year premium on the $100,000, 12%, five-year bonds issued on January 1, 2013, is made bonds issued on January 1, 2013, is made on June 30, 2013. The combined entry is on June 30, 2013. The combined entry is as follows:as follows:


Bond RedemptionBond Redemption

o A corporation may call, or redeem, bonds A corporation may call, or redeem, bonds before they mature. before they mature. Callable bondsCallable bonds can be can be redeemed by the issuing corporation redeemed by the issuing corporation within the period of time and at the price within the period of time and at the price stated in the bond indenture. Normally, stated in the bond indenture. Normally, the call price is above the face value.the call price is above the face value.



o The The carrying amountcarrying amount of bonds payable is of bonds payable is the face amount of the bonds less any the face amount of the bonds less any unamortized discount or plus any unamortized discount or plus any unamortized premium.unamortized premium.



o A gain or loss may be realized on a bond A gain or loss may be realized on a bond redemption as follows:redemption as follows: A A gaingain is recorded if the price paid for the is recorded if the price paid for the

redemption is below the bond carrying amount.redemption is below the bond carrying amount.

A A lossloss is recorded if the price paid for the is recorded if the price paid for the redemption is above the carrying amount.redemption is above the carrying amount.



o On June 30, 2013, a corporation has a bond issue On June 30, 2013, a corporation has a bond issue of $100,000 outstanding, on which there is an of $100,000 outstanding, on which there is an unamortized premium of $4,000. The corporation unamortized premium of $4,000. The corporation redeems one-fourth of the bonds for $24,000.redeems one-fourth of the bonds for $24,000.

Gains on the redemption of bonds are reported in the Other Income section of the income statement.



o The corporation calls the remaining The corporation calls the remaining $75,000 of outstanding bonds, which are $75,000 of outstanding bonds, which are held by a private investor, for $79,500 on held by a private investor, for $79,500 on July 1, 2013.July 1, 2013.

Losses on the redemption of bonds are reported in the Other Loss section of the income statement.



ObjectiveDescribe and illustrate the

Describe and illustrate the

accounting for installment notes.

accounting for installment notes.

44


Installment NotesInstallment Notes

o An An installment noteinstallment note is a debt that requires is a debt that requires the borrower to make equal periodic the borrower to make equal periodic payments to the lender for the term of the payments to the lender for the term of the note. Unlike bonds, a note payment note. Unlike bonds, a note payment includes the following:includes the following: Payment of a portion of the amount initially Payment of a portion of the amount initially

borrowed, called the borrowed, called the principalprincipal

Payment of interest on the outstanding balancePayment of interest on the outstanding balance


Installment NotesInstallment Notes

o Installment notes are often used to Installment notes are often used to purchase specific assets, such as purchase specific assets, such as equipment, and are often secured by the equipment, and are often secured by the purchased asset.purchased asset.

o When a note is secured by an asset, it is When a note is secured by an asset, it is called a called a mortgage notemortgage note..

o If the borrower fails to pay a mortgage If the borrower fails to pay a mortgage note, the lender has the right to take note, the lender has the right to take possession of the pledged asset.possession of the pledged asset.


Issuing an Installment NoteIssuing an Installment Note

o Lewis Company issues a $24,000, 6%, Lewis Company issues a $24,000, 6%, five-year note to City National Bank on five-year note to City National Bank on January 1, 2013. The annual payment is January 1, 2013. The annual payment is $5,698.$5,698.

$24,000 x 0.06

ANNUAL ANNUAL PAYMENTSPAYMENTS

$5,698 – $1,440


$24,000 – $4,258



Annual PaymentsAnnual Payments

o The entry to record the first payment on The entry to record the first payment on December 31, 2013, is as follows:December 31, 2013, is as follows:



o The entry to record the second payment The entry to record the second payment on December 31, 2014, is as follows:on December 31, 2014, is as follows:



o The entry to record the final payment on The entry to record the final payment on December 31, 2017, is as follows:December 31, 2017, is as follows:

o After the entry is posted, the balance in After the entry is posted, the balance in Notes Payable related to this note is zero.Notes Payable related to this note is zero.



ObjectiveDescribe and illustrate the

Describe and illustrate the

reporting of long-term liabilities

reporting of long-term liabilities

including bonds and notes

including bonds and notes payable.payable.

55

REPORTING REPORTING LONG-TERM LONG-TERM LIABILITIESLIABILITIES



ObjectiveDescribe and illustrate how the

Describe and illustrate how the

number of times interest charges

number of times interest charges

are earned is used to evaluate a

are earned is used to evaluate a

company’s financial condition.

company’s financial condition.

66


Number of Times Interest Charges are Number of Times Interest Charges are EarnedEarned

o Analysts assess the risk that bondholders Analysts assess the risk that bondholders will not receive their interest payments by will not receive their interest payments by computing the computing the number of times interest number of times interest charges are earned charges are earned during the year as during the year as follows:follows:

Number of Times Interest

Charges are Earned

=

Income Before Income Tax + Interest Expense

Interest Expense


Appendix 1:Appendix 1:

Present Value Concepts


and Pricing Bonds

and Pricing Bonds

PayablePayable



and Pricing Bonds

and Pricing Bonds

PayablePayable


Present Value Concept/Pricing Bonds PayablePresent Value Concept/Pricing Bonds Payable

o When a corporation issues bonds, the When a corporation issues bonds, the price that investors are willing to pay for price that investors are willing to pay for the bonds depends on the following:the bonds depends on the following: The face amount of the bonds, which is the The face amount of the bonds, which is the

amount due at the maturity date.amount due at the maturity date.

The periodic interest to be paid on the bonds. The periodic interest to be paid on the bonds.

The market rate of interest.The market rate of interest.


Present Value ConceptPresent Value Concept

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

o Present valuePresent value is the current worth of a future is the current worth of a future sum of money or stream of cash flows given sum of money or stream of cash flows given a specified rate of return.a specified rate of return.

o The amount to be received in the future if The amount to be received in the future if you make a deposit now is the you make a deposit now is the future valuefuture value..


TodayOne Year

from TODAY

$1,00010%

payable annually

Present value of $1,000 to be received one year from today


Present Value of an AmountPresent Value of an Amount

o A $1,000, 10% bond is purchased. It pays A $1,000, 10% bond is purchased. It pays interest annually and will mature in one interest annually and will mature in one year. year.

PRESENT PRESENT VALUE OF AN VALUE OF AN

AMOUNTAMOUNT

Today

One Year from TODAY

$1,00010%

payable annually



$1,000 X .90909 = $909.09

$909.09



Today End of Year 1

End of Year 2

$1,00010%

payable annually


o A $1,000, 10% bond is purchased. It pays A $1,000, 10% bond is purchased. It pays interest annually and will mature in two interest annually and will mature in two years.years.

Present value of $1,000 to be received two years from today


PRESENT PRESENT VALUE OF AN VALUE OF AN

AMOUNTAMOUNT

Today End of Year 1

End of Year 2

$1,00010%

payable annually



$1,000 X .82645 = $826.45

$826.45



Present Value of the Periodic ReceiptsPresent Value of the Periodic Receipts

o A series of equal cash receipts spaced A series of equal cash receipts spaced equally in time is called an equally in time is called an annuityannuity..

o The The present value of an annuity present value of an annuity is the sum is the sum of the present values of each cash receipt.of the present values of each cash receipt.


Present Value of the Periodic ReceiptsPresent Value of the Periodic Receipts

o Assume that $100 is to be received Assume that $100 is to be received annually for two years and that the market annually for two years and that the market rate of interest is 10%.rate of interest is 10%.

o The next slide illustrates that the present The next slide illustrates that the present value of the amount ($100) at 10% for one value of the amount ($100) at 10% for one year and the present value of the amount year and the present value of the amount ($100) at 10% for two years is summed to ($100) at 10% for two years is summed to arrive at the present value of the annuity.arrive at the present value of the annuity.

Today End of Year 1

End of Year 2

Interest payment

$100Interest payment

$100

$90.91 $100 × 0.90909

$82.64 $100 × 0.82645

Present value, at 10%, of $100 interest payments to be received each year for 2 years (rounded)

$173.55

Present Value of the Periodic Present Value of the Periodic ReceiptsReceipts


Present Value of the Periodic Present Value of the Periodic ReceiptsReceiptso When the present value of an annuity (a When the present value of an annuity (a

series of equal cash receipts at fixed series of equal cash receipts at fixed intervals) is involved, the present value of intervals) is involved, the present value of an annuity of $1 at compound interest an annuity of $1 at compound interest ((Exhibit 5Exhibit 5) can be used.) can be used.

$100 x 1.73554 = $173.55

The same amount as derived earlier

PRESENT PRESENT VALUE OF THE VALUE OF THE

PERIODIC PERIODIC RECEIPTSRECEIPTS


Pricing BondsPricing Bonds

o Southern Utah Communications Inc. issued Southern Utah Communications Inc. issued $100,000, 12%, five-year bonds on $100,000, 12%, five-year bonds on January 1, 2013. The bonds pay interest January 1, 2013. The bonds pay interest semiannually on June 30 and December semiannually on June 30 and December 31.31.


Market Rate of Interest at 12%Market Rate of Interest at 12%

o Present value of face amount of $100,000 Present value of face amount of $100,000 due in 5 years = $ ?due in 5 years = $ ?

6% used because the bonds are semiannual


10 semiannual periods in 5 years


o Present value of face amount of $100,000 Present value of face amount of $100,000 due in 5 years = $ ?due in 5 years = $ ?



o Present value of face amount of $100,000 Present value of face amount of $100,000 due in 5 years ($100,000 × 0.55840) = due in 5 years ($100,000 × 0.55840) = $55,840. $55,840.

o This amount gives us one part of the total This amount gives us one part of the total present value of the bonds.present value of the bonds.



o Next, we need to determine the present Next, we need to determine the present value of 10 semiannual interest payments value of 10 semiannual interest payments of $6,000 at 12% compounded of $6,000 at 12% compounded semiannually.semiannually.



o Present value of 10 semiannual interest Present value of 10 semiannual interest payments of $6,000 at 12% compounded payments of $6,000 at 12% compounded semiannually ($6,000 x 7.36009) = $ semiannually ($6,000 x 7.36009) = $ 44,16044,160

When the face interest rate is the same as the market rate of interest, the total present value of the bonds will equal the total face value.

When the face interest rate is the same as the market rate of interest, the total present value of the bonds will equal the total face value.


Present value of face amount of Present value of face amount of $100,000 due in 5 years $100,000 due in 5 years ($100,000 × 0.55840) = ($100,000 × 0.55840) =

$ 55,840 $ 55,840

Present value of 10 semiannual Present value of 10 semiannual interest payments of $6,000 interest payments of $6,000 at 12% compounded semiannually at 12% compounded semiannually ($6,000 × 7.36009) = ($6,000 × 7.36009) =

44,160 44,160

Total present value of bondsTotal present value of bonds

$100,000$100,000



o Present value of face amount of $100,000 Present value of face amount of $100,000 due in 5 years ($100,000 × 0.58543) = due in 5 years ($100,000 × 0.58543) = $58,543.$58,543.


Present value of face amount Present value of face amount of $100,000 due in 5 years of $100,000 due in 5 years ($100,000 × 0.58543) = ($100,000 × 0.58543) = $ $ 58,54358,543

Present value of 10 semiannual Present value of 10 semiannual interest payments of $6,000 at interest payments of $6,000 at 11% compounded semiannually 11% compounded semiannually ($6,000 × 7.53763) =($6,000 × 7.53763) = 45,22645,226


Present value of face amount Present value of face amount of $100,000 due in 5 years of $100,000 due in 5 years ($100,000 × 0.58543) = ($100,000 × 0.58543) = $ 58,543$ 58,543

Present value of 10 semiannual Present value of 10 semiannual interest payments of $6,000 at interest payments of $6,000 at 11% compounded semiannually 11% compounded semiannually ($6,000 × 7.53763) =($6,000 × 7.53763) = 45,226 45,226

Total present value of bondsTotal present value of bonds $103,769 $103,769


Appendix 2:Appendix 2:

Effective Interest Rate


Method of Method of

AmortizationAmortization



Method of Method of

AmortizationAmortization


Effective Interest Rate MethodEffective Interest Rate Method

o The The effective interest rate methodeffective interest rate method of of amortization, sometimes called the amortization, sometimes called the interest methodinterest method, provides for a constant , provides for a constant raterate of interest over the life of the bonds. of interest over the life of the bonds.

AMORTIZATION AMORTIZATION OF DISCOUNTOF DISCOUNT


Amortization of DiscountAmortization of Discount

o The entry to record the first interest The entry to record the first interest payment on June 30, 2013, and the related payment on June 30, 2013, and the related discount amortization is as follows:discount amortization is as follows:

AMORTIZATION AMORTIZATION OF PREMIUMOF PREMIUM


Amortization of PremiumAmortization of Premium

o The entry to record the first interest The entry to record the first interest payment on June 30, 2013, and the related payment on June 30, 2013, and the related premium amortization is as follows:premium amortization is as follows:


Long-Term Long-Term

Liabilities: Liabilities:

Bonds and Bonds and

NotesNotes

The EndThe EndThe EndThe End

Ch12 wrd12e instructor_final

Education

terminologyo bonds

cengage learning

accessible website

term bonds

debenture bonds

serial bonds

convertible bonds

callable bonds