Long-term Debt: BondsINTERMEDIATE ACCOUNTING II

CHAPTER 14 – PART 1

Long-term DebtSource of external financing for company operations. Signifies creditors’ interest in a company’s assets.Requires the future payment of cash in specified (or

estimated) amounts, at specified (or projected) dates.Common debt instruments are bonds and long-term

notes.

Transference of KnowledgeThis chapter focuses on accounting for long-term liabilities from the perspective of the issuer. An opposite transaction is recorded by the investor. For example, the issuer will record a bond or note payable [liability] and the investor (lender) will record an investment (bond) or note receivable [asset]. The same is true for interest: The issuer will record interest expense while the investor records interest income.

Bonds Divide a large liability into many smaller liabilities (usually $1,000

per bond). Obligate a company to repay a stated amount at a specified

maturity date and periodic interest between the issue date and maturity.

Require periodic interest (usually semiannually) as a stated percentage of the face amount.

Make specific promises to bondholders described in a document called a bond indenture.

Represent a liability to the corporation that issues the bonds and an asset to a company that buys the bonds as an investment.

Bond Pricing Supply and demand cause a bond to be priced to yield the market rate of

interest for securities of similar risk and maturity. Bonds may be sold

• At par (face value)• At a discount (less than face value)• At a premium (more than face value)

The bond price can be calculated as the present value of all the cash flows (principal and interest) using the market interest rate.

Bond prices are typically stated in terms of a percentage of face value. • A bond price of 97 means a $1,000 bond will sell for $970• A bond price of 102 means a $1,000 bond will sell for $1,020.

Other things being equal, the lower the perceived riskiness of the corporation issuing bonds, the higher the price those bonds will command.

On January 1, 2013, Masterwear Industries issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%. The entire bond issue was purchased by United Intergroup, Inc. 

Present value (price) of the bonds:Present Values

Interest * $42,000 x 4.76654 ** = $200,195Principal $700,000 x 0.66634 *** = 466,438Present value (price) of the bonds $666,633

Determining the Bond Selling Price Bond prices are determined as the sum of the present value of all future cash flows

using the market interest rate.• Interest is disbursed in payments throughout the bond indenture and is therefore

an annuity – use the PVA table.• Face value is repaid at the end of the bond indenture – use the PV table.• Use the market interest rate. Since bond interest is generally paid semiannually,

double the period and halve the interest rate.Illustration

* Interest: $700,000 X .12 X 6/12 = $42,000** present value of an ordinary annuity of $1: n=6, i=7% ***present value of $1: n=6, i=7% Note:Because interest is paid semiannually, the present value calculations use: (a) the semiannual market rate (7%), and (b) 6 (3 x 2) semi-annual periods.

Brief Exercise 14–2, page 836 Interest: $80,000,000 X .05 X 6/12* Present value of an ordinary annuity of $1: n = 40, i = 3%. (Table 4)** Present value of $1: n = 40, i = 3%. (Table 2)

Interest $ 2,000,000 x 23.11477* = $46,229,540Principal $ 80,000,000 x 0.30656** = 24,524,800Present value (price) of the bonds $70,754,340

Brief Exercise 14–3, page 837When the stated rate and the market rate are equal, the bonds will sell at face value, $75 million in this instance.

Brief Exercise 14–4, page 837Interest $ 2,500,000 x 27.35548* = $68,388,700Principal $100,000,000 x 0.45289** = 45,289,000Present value (price) of the bonds $113,677,700

Interest: $100,000,000 X .05 X 6/12* Present value of an ordinary annuity of $1: n = 40, i = 2%. (Table 4)** Present value of $1: n = 40, i = 2%. (Table 2)

Brief Exercise 14–3, page 837 – Additional Requirement1) Journalize the issuance of the bonds at par (face) value.

Assume the bonds were issued Jan 1.2) Journalize the first interest payment. Assume the bonds pay

interest semiannually Jun 30 and Dec 31.

Interest: $75,000,000 X .06 X 6/12

Date Account Debit CreditJan 1 Cash 75,000,000

Bonds Payable 20,000,000

Dec 31 Interest Expense 2,250,000

Cash 2,250,000

Date Account Debit CreditJan 1 Investment in Bonds 75,000,000

Cash 20,000,000

Dec 31 Cash 2,250,000

Interest Revenue 2,250,000

ISSUER INVESTOR

Brief Exercise 14–2, page 836 – Additional Requirement1) Journalize the issuance of the bonds at a discount. Assume the bonds were issued Jan 1.

Interest $ 2,000,000 x 23.11477 = $46,229,540Principal $ 80,000,000 x 0.30656 = 24,524,800Present value (price) of the bonds $70,754,340

Discount: Difference Between Par Value and Issue Price of Bonds $80,000,000 – $70,754,340 = $9,245,660

Date Account Debit CreditJan 1 Cash 70,754,340

Discount on Bonds Payable 9,245,660

Bonds Payable 80,000,000

ISSUER

Brief Exercise 14–4, page 837 – Additional Requirement1) Journalize the issuance of the bonds at a discount. Assume the bonds were issued Jan 1.

Premium: Difference Between Par Value and Issue Price of Bonds $100,000,000 – $113,677,700 = $13,677,700

Date Account Debit CreditJan 1 Cash 113,677,700

Premium on Bonds Payable 13,677,700

Bonds Payable 100,000,000

ISSUER

Interest $ 2,500,000 x 27.35548 = $68,388,700Principal $100,000,000 x 0.45289 = 45,289,000Present value (price) of the bonds $113,677,700

Effective Interest Method When bonds are sold at a discount or premium, that amount must

be amortized over the bond indenture Interest expense will be adjusted relative to the cash payment for

interest based on the amount amortized• Discounts increase interest expense• Premiums decrease interest expense

Two methods Make specific promises to bondholders described in a document

called a bond indenture. Represent a liability to the corporation that issues the bonds and

an asset to a company that buys the bonds as an investment.

Discount/Premium Amortization When bonds are sold at a discount or premium, that amount must be

amortized to expense over the life of the bond. Interest expense will be adjusted (relative to the cash payment) based

on the amount amortized• Discounts increase interest expense• Premiums decrease interest expense

Two methods exist for amortizing the disount/premium• Effective Interest Method• Straight-line Method

At the end of the bond indenture, the balance in the discount or premium will be fully amortized and the account balance will be -0-.

To be continued…

Long-term Debt: BondsINTERMEDIATE ACCOUNTING II - CHAPTER 14, PART 1

TO BE CONTINUED