BY R A C H E L L E A G AT H A , C PA , M B A

Long-Term Liabilities: Bonds and Notes

Slides by Rachelle Agatha, CPA, with excerpts from Warren, Reeve, Duchac

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1. Overview of Long Term Liabilities

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

3. Accounting for bonds payable.

Objectives:

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4. Bonds issued at Discount vs Premium.

5. Accounting for Premium and Discount.

6. Installment Notes.7. Financial Statement

presentation of LTL

Objectives:

4

Compute the potential impact

of long-term borrowing on the

earnings per share of a

corporation.

Objective 1

Objective 1

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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.

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Effect of Alternative Financing Plans—$800,000 Earnings

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Effect of Alternative Financing Plans—$440,000 Earnings

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Describe the characteristics,

terminology, and pricing of bonds

payable.

Objective 2

Objective 2

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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.

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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.

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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.

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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.

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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.

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MARKET RATE = CONTRACT RATE

Selling price of bond = $1,000

$1,00010% payable

annually

If the contract rate equals the market rate of interest, the bonds will sell at their face amount.

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MARKET RATE > CONTRACT RATE

Selling price of bond < $1,000

–Discount

$1,00010% payable

annually

If the market rate is higher than the contract rate, the bonds will sell at a discount.

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MARKET < CONTRACT RATE

Selling price of bond > $1,000

+Premium

$1,00010% payable

annually

If the market rate is lower than the contract rate, the bonds will sell at a premium.

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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.

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Today End of Year 1

End of Year 2

Present Value of the Face Amount of Bonds

$1,00010% payable annually

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

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Present Value of $1 at Compound Interest

N = 2 rate =10%

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Today End of Year 1

End of Year 2

$1,000 x 0.82645$826.4

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Present Value of the Face Amount of Bonds

$1,00010% payable annually

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

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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%

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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

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Present Value of Annuity of $1 at Compound Interest

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Present Value of 2-Year, 10% Bond

Present value of face value of $1,000 due in2 years at 10% compounded annually:$1,000 x 0.82645 (Exhibit 3: n = 2, i = 10%) $ 826.45

Present value of 2 annual interest paymentsof 10% compounded annually: $100 x 1.73554 (Exhibit 4: n = 2, i = 10%)

173.55Total present value of bond $1,000.00

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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.

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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

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Journalize entries for bonds

payable.

Objective 3

Objective 3

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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

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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.

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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. 1 Cash 100 000 002007

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On June 30, an interest payment of $6,000 is made ($100,000 x .12 x 6/12).

June 30 Interest Expense 6 000 00

Cash 6 000 00

Paid six months’ interest

on bonds.

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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. 31 Bonds Payable100 000 00

2011

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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

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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

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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.1 Cash 96 406 002007

Discount on Bonds Payable3 594 00

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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 845,562Discount on Bonds Payable154,438 Bonds Payable 1,000,000

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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.

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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 Expense 6 359 402007

Amortizing a Bond Discount

Cash 6 000 00

Paid semiannual

interest and

amortized 1/10 of

bond discount.

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Interest Expense 45,444Discount on Bonds Payable 15,444

Cash 30,000Paid interest and amortized the bond discount ($154,438 ÷ 10).

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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

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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

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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. 1 Cash 103 769 002007

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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 2,154,435Premium on Bonds Payable 154,438

Bonds Payable2,000,000

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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 30 Interest Expense 5 623 102007

$3,769 x 1/10

$3,769 x 1/10

Amortizing a Bond Premium

Premium on Bonds Payable

376 90

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Using the bond from previous example, journalize the first interest payment and the amortization of the related bond premium.

Interest Expense 104,556Premium on Bonds Payable 15,444

Bonds Payable 120,000Paid interest and amortize thebond premium ($154,435/10).

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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

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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. 1 Cash 53 273 002007

Discount on Bonds Payable 46 727 00

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Describe and illustrate the payment and

redemption of bonds payable.

Objective 4

Objective 4

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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.

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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.

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Retired bonds for $24,000.

Cash24 000 00

Gain on Redemption of Bonds2 000 00

June 30 Bonds Payable 25 000 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

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Cash105 000 00

June 30 Bonds Payable 100 000 00

2007

Premium on Bonds Payable 4 000 00

Loss 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.

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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 500,000Loss on Redemption of Bonds15,000 Discount on Bonds Payable

40,000Cash 475,000

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Installment Notes

Objective 5

Objective 5

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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.

Issuing an Installment Note

Lewis Company issues a $24,000, 6%, five-year note to City National Bank on January

1, 2008. The annual payment is $5,698.

4

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The entry to record the first payment on December 31, 2008, is as follows:

(Column C of Exhibit 3)(Column D of Exhibit 3)

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The entry to record the second payment on December 31, 2009, is as follows:

(Column C of Exhibit 3)(Column D of Exhibit 3)

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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.

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Financial Statement

Presentation

Objective 6

Objective 6

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Number of Times Interest Charges are Earned

Number of Times Interest Charges are

Earned

=

Income Before Income Tax + Interest Expense

Interest Expense

Number of Times Interest Charges are

Earned

=$152,366,000 + $42,091,000$42,091,000

Number of Times Interest Charges are

Earned

= 4.62

Briggs and Stratton Corporation

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Summary Financing Corporations

Bond terms & Characteristics

Time Value of Money

Accounting for Bonds

Accounting for Notes Payable

Financial Statement

Presentation