Chapter 11 Liabilities: Bonds Payable Corporate Financial Accounting 14e Warren Reeve Duchac â 2017 Cengage Learningđ May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Nature of Bonds Payable • A bond is a form of interest-bearing note Like a note, a bond requires periodic interest payments, with the face amount to be repaid at the maturity date • As creditors of the corporation, bondholder claims on the corporation’s assets rank ahead of stockholders â 2017 Cengage Learningđ May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Bond Characteristics and Terminology (slide of 2) • A bond issue is normally divided into a number of individual bonds • The face amount of each bond, called the principal, is usually $1,000 or a multiple of $1,000 The principal must be repaid on the dates the bonds mature • The interest on bonds may be payable annually, semiannually, or quarterly o • Most bonds pay interest semiannually The underlying contract between the company issuing bonds and the bondholders is called a bond indenture â 2017 Cengage Learningđ May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Bond Characteristics and Terminology (slide of 2) • • The two most common types of bonds are term bonds and serial bonds o When all bonds of an issue mature at the same time, they are called term bonds o If the bonds mature over several dates, they are called serial bonds There are also a variety of more complicated bond structures o Bonds that may be exchanged for shares of common stock are called convertible bonds o Bonds that may be redeemed by the corporation prior to maturity are called callable bonds â 2017 Cengage Learningđ May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Proceeds from Issuing Bonds (slide of 5) • When a corporation issues bonds, the proceeds received for the bonds depend on: o The face amount of the bonds, which is the amount due at the maturity date o The interest rate on the bonds o The market rate of interest for similar bonds © 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Proceeds from Issuing Bonds (slide of 5) • The face amount and the interest rate on the bonds are identified in the bond indenture • The interest rate to be paid on the face amount of the bond is called the contract rate or coupon rate • The market rate of interest, sometimes called the effective rate of interest, is the rate determined from sales and purchases of similar bonds o The market rate of interest is affected by a variety of factors, including investors’ expectations of current and future economic conditions © 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Proceeds from Issuing Bonds (slide of 5) • By comparing the market and contract rates of interest, it can be determined whether the bonds will sell for more than, less than, or at their face amount © 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Proceeds from Issuing Bonds (slide of 5) • If the market rate equals the contract rate, bonds will sell at the face amount • If the market rate is greater than the contract rate, the bonds will sell for less than their face value o • The face amount of the bonds less the selling price is called a discount If the market rate is less than the contract rate, the bonds will sell for more than their face value o The selling price of the bonds less the face amount is called a premium © 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Proceeds from Issuing Bonds (slide of 5) • The price of a bond is quoted as a percentage of the bond’s face value o For example, a $1,000 bond quoted at 98 could be purchased or sold for $980 ($1,000 × 0.98) o Likewise, bonds quoted at 109 could be purchased or sold for $1,090 ($1,000 × 1.09) â 2017 Cengage Learningđ May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Accounting for Bonds Payable • When bonds are issued at less or more than their face amount, the discount or premium must be amortized over the life of the bonds At the maturity date, the face amount must be repaid â 2017 Cengage Learningđ May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Amortizing a Bond Premium (slide of 2) • The entry to amortize a bond premium is as follows: • The preceding entry may be made annually as an adjusting entry, or it may be combined with the semiannual interest payment o In the latter case, the entry would be as follows: â 2017 Cengage Learningđ May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Bond Redemption (slide of 2) • • A corporation may redeem or call bonds before they mature o This is often done when the market rate of interest declines below the contract rate of interest o In such cases, the corporation may issue new bonds at a lower interest rate and use the proceeds to redeem the original bond issue Callable bonds can be redeemed by the issuing corporation within the period of time and at the price stated in the bond indenture o Normally, the call price is above the face value © 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Bond Redemption (slide of 2) • A corporation usually redeems its bonds at a price different from the carrying amount (or book value) of the bonds • A gain or loss may be realized on a bond redemption as follows: • o A gain is recorded if the price paid for redemption is below the bond carrying amount o A loss is recorded if the price paid for the redemption is above the carrying amount Gains and losses on the redemption of bonds are reported in the Other income (loss) section of the income statement © 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Reporting Bonds Payable (slide of 2) • Bonds payable are reported as liabilities on the balance sheet o Any portion of the bonds that is due within one year is reported as a current liability o Any remaining bonds are reported as a long-term liability © 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Reporting Bonds Payable (slide of 2) • Any unamortized premium is reported as an addition to the face amount of the bonds • Any unamortized discount is reported as a deduction from the face amount of the bonds • A description of the bonds should also be reported either on the face of the financial statements or in the accompanying notes â 2017 Cengage Learningđ May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Analysis for Decision Making: Times Interest Earned • Analysts assess the risk that bondholders will not receive their interest payments by computing the times interest earned ratio during the year as follows: Times Interest Earned = Income Before Income Tax + Interest Expense Income Expense • This ratio computes the number of times interest payments could be paid out of current-period earnings • High values of this ratio are considered favorable, whereas low values are considered unfavorable o Values of this ratio less than 1.0 suggest that the firm is unable to cover interest payments from current-period income before tax © 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 1: Present Value Concepts and Pricing Bonds Payable (slide of 2) • When a corporation issues bonds, the price that investors are willing to pay for the bonds depends on the following: o The face amount of the bonds, which is the amount due at the maturity date o The periodic interest to be paid on the bonds o The market rate of interest © 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 1: Present Value Concepts and Pricing Bonds Payable (slide of 2) • An investor determines how much to pay for the bonds by computing the present value of the bond’s future cash receipts, using the market rate of interest o A bond’s future cash receipts include its face value at maturity and the periodic interest payments â 2017 Cengage Learningđ May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 1: Present Value Concepts • The concept of present value is based on the time value of money o The time value of money concept recognizes that cash received today is worth more than the same amount of cash to be received in the future • Present value is the current worth of a future sum of money or stream of cash flows given a specified rate of return • The amount to be received in the future if you make a deposit now is the future value © 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 1: Present Value of an Amount • The present value of an amount to be received in the future can be determined by a series of divisions or by using a table of present values o The present value of $1 table is used to find the present value factor of $1 to be received after a number of periods in the future The amount to be received is then multiplied by this factor to determine its present value â 2017 Cengage Learningđ May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 1: Present Value of an Annuity (slide of 2) • A series of equal cash receipts spaced equally in time is called an annuity • The present value of an annuity is the sum of the present values of each cash receipt â 2017 Cengage Learningđ May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 1: Present Value of an Annuity (slide of 2) • A present value of an annuity of $1 table can be used to find the present value of an annuity o The present value of an annuity is calculated by multiplying the equal cash payment times the appropriate present value of an annuity of $1 â 2017 Cengage Learningđ May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 1: Pricing Bonds • • The selling price of a bond is the sum of the present values of: o The face amount of the bonds due at the maturity date o The periodic interest to be paid on the bonds The market rate of interest is used to compute the present value of both the face amount and the periodic interest © 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 2: Effective Interest Rate Method of Amortization (slide of 2) • The effective interest rate method of amortization provides for a constant rate of interest over the life of the bonds o This is in contrast to the straight-line method, which provides for a constant amount of interest expense each period © 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Appendix 2: Effective Interest Rate Method of Amortization (slide of 2) • The interest rate used in the effective interest method of amortization, sometimes called the interest method, is the market rate on the date the bonds are issued • The carrying amount of the bonds is multiplied by this interest rate to determine the interest expense for the period • The difference between the interest expense and the interest payment is the amount of discount or premium to be amortized for the period â 2017 Cengage Learningđ May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part ... Amortizing a Bond Discount (slide of 4) • The effective interest rate method is required by generally accepted accounting principles • However, the straight-line method may be used if the results... determined from sales and purchases of similar bonds o The market rate of interest is affected by a variety of factors, including investors’ expectations of current and future economic conditions... a publicly accessible website, in whole or in part Proceeds from Issuing Bonds (slide of 5) • By comparing the market and contract rates of interest, it can be determined whether the bonds will