Bonds Accounting

8/14/2019 Bonds Accounting

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Financial Accounting Reporting

Review Chapter 9

Lucile Faurel Review Chapter 9 2

Short-Term vs. Long-Term Liabilities Current (or short-term) liabilities:

Obligations that are to be repaid or performed within one year.

Generally shown in nominal terms, not present value terms.

Examples: accounts payable, accrued expenses payable, taxes payable,unearned revenues, product warranty liabilities, the current portion of

long-term debt, notes payable, and commercial paper.

Noncurrent (or long-term) liabilities:

Obligations that are to be repaid or performed after one year.Most are shown in present value terms (except e.g. deferred income taxes).

Examples: bonds, leases, mortgages, pensions, and postretirementbenefits.


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Current Liabilities Warranties

Sony sells $200,000 of a particular TV model.Estimated warranty cost is 3% of sales.

Journal entry at the time of sale:

Note: Estimated warranty expense = $200,000 * .03 = $6,000.

Dr. Warranties Expense (I/S) 6,000

Cr. Liability for Warranties (B/S) 6,000

A customer brings a TV in for repair under the warranty.

Repairs total $500, including parts and labor.

Journal entry at the time of the repair:

Dr. Liability for Warranties (B/S) 500

Cr. Cash (and/or AP, Wages Payable, etc.) (B/S) 500


Noncurrent Liabilities Bonds Bonds are formal certificates of debt that promise to pay:

A specified amount of interestin cash annually or semi-annually.

A specifiedprincipalat a specific maturity date.

Vocabulary:

Bonds are issued by companies (issuers) that wish to borrowmoney from the general public.

Bonds are issued to multiple lenders / investors (bondholders).

The face value (also calledpar value or maturity value) is theprincipal the company is required to pay at maturity.

The coupon rate (also called nominal interest rate, contractual rate,stated rate) determines the amount of interest the company is requiredto pay every year.

Bonds generally pay interest every 6 months (i.e. semi-annually).


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Valuing Bonds

Because bonds create cash flows in future periods, they are recordedat the present value of those future payments, discounted at themarket interest rate in effect when the liability is created.

When valuing bonds, the present value tables are used to determinethe amount of proceeds that will be received (i.e. the price of thebonds).

Thepresent value of $1 table (Table 9A-2, p.422) is used to determinethe present value of the face amount (principal) of the bonds.

Thepresent value of an annuity of $1 (Table 9A-3, p.423) is used to

determine the present value of the series of interest payments.

The amounts are added together to determine the amount of proceedsand any resulting discount orpremium.


Present Value of $1, Table 9A-2, p.422.


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Present Value of Ordinary Annuity of $1, Table 9A-3, p.423.


Proceeds on Bond Issuance

A. Market Interest Rate = 7% = Coupon Rate

Proceeds = $100,000.

Bond sold at par.

B. Market Interest Rate = 8% > Coupon Rate

Proceeds = $100,000 * 0.7903 + $3,500 * 5.2421 = $97,377.

Bond sold at a discount.

C. Market Interest Rate = 6% < Coupon Rate

Proceeds = $100,000 * 0.8375 + $3,500 * 5.4172 = $102,710.

Bond sold at a premium.

Bond: Face Amount: $100,000

Term: 3 years

Coupon Rate: 7%

Interest Payments: $3,500 paid semi-annually

4%, 6periods, Table 9A-3

($100,000 * .07)/2


3%, 6periods, Table 9A-2 3%, 6periods, Table 9A-3


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Par, Discount & Premium

If the market rate is EQUAL to the coupon rate,the bond will sell at PAR.

If the market rate isABOVE the coupon rate,

the bond will sell at a DISCOUNT.

If the market rate is BELOW the coupon rate,the bond will sell at a PREMIUM.


Coupon Rate vs. Market Rate The coupon (interest) rate is:

The rate of interest stated on the bond.

The interest to be paid in cash every year by the issuing company.

Used to calculate the amount of interest payments (paid in cash).

The market (interest) rate (or effective interest rate, yield to maturity) is:

The rate available on investments in similar bonds at a moment in time.

Used in the present value calculations when determining the

proceeds on issuance.

Used to calculate the amount of interest expense to recognize.

Changes in the market rate after the bonds are issued do NOT affect the interestexpense recognized.


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Effective Interest Amortization

How do we decrease the bond discount or bond premium?Effective interest amortization

The discount or premium is amortized over the life of the debt(but not using a straight-line amortization).

The interest expense is equal to the market interest rate(at the time of issuance) multiplied by the amount of debtoutstanding at the beginning of the given period.

The difference between the interest expense and the cashpaid (for interest payments) represents the amortization ofthe discount or premium.


Discount Amortization

Journal entry upon bond issuance:

Dr. Cash 97,377Cr. Bonds Payable 97,377

Journal entry for interest expense, end of Period 1 (6 months after issuance):

Dr. Interest Expense 3,895Cr. Cash (or Interest Payable) 3,500Cr. Bonds Payable 395

Journal entry at maturity (end of Period 6):

Dr. Bonds Payable 100,000Cr. Cash 100,000

BondsPayable,

End(e=a+d)

Amortization ofDiscount

(d=b-c)

CashPayment

(c)

InterestExpense

(4%)(b=a*4%)

BondsPayable,

Beg.(a)

Period

1 97,377 3,895 3,500 395 97,772

2 97,772 3,911 3,500 411 98,183

3 98,183 3,927 3,500 427 98,610

4 98,610 3,944 3,500 444 99,055

5 99,055 3,962 3,500 462 99,517

6 99,517 3,983 3,500 483 100,000

Coupon rate = 7%, Market Rate = 8%, FV = $100,000, Proceeds = $97,377 (see slide 4, B).


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Premium Amortization



Journal entry for interest expense, end of Period 4 (2 years after issuance):

Dr. Interest Expense 3,042Dr. Bonds Payable 458

Cr. Cash (or Interest Payable) 3,500



BondsPayable,

End(e=a+d)

Amortization ofPremium

(d=b-c)

CashPayment

(c)

InterestExpense

(3%)(b=a*3%)

BondsPayable,

Beg.(a)

Period

1 102,710 3,081 3,500 -419 102,291

2 102,291 3,069 3,500 -431 101,860

3 101,860 3,056 3,500 -444 101,416

4 101,416 3,042 3,500 -458 100,958

5 100,958 3,029 3,500 -471 100,487

6 100,487 3,013 3,500 -487 100,000

Coupon rate = 7%, Market Rate = 6%, FV = $100,000, Proceeds = $102,710 (see slide 4, C).




Journal entry for interest expense at the end of each period:

Dr. Interest Expense 3,500Cr. Cash (or Interest Payable) 3,500



BondsPayable,

End(e=a+d)

Amortization ofDiscount /Premium(d=b-c)

CashPayment

(c)

InterestExpense(3.5%)

(b=a*3.5%)

BondsPayable,

Beg.(a)

Period

6 100,000 3,500 3,500 - 100,000

4 100,000 3,500 3,500 - 100,000

5 100,000 3,500 3,500 - 100,000

2 100,000 3,500 3,500 - 100,000

Bond Issued at Par

1 100,000 3,500 3,500 - 100,000

3 100,000 3,500 3,500 - 100,000

Coupon rate = 7%, Market Rate = 7%, FV = $100,000, Proceeds = $100,000 (see slide 4, A).


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Early Extinguishment of Bonds

Early extinguishments of debt usually result in a gain or loss.Gain (loss) on early extinguishment = Book value of debt price

paid for debt (i.e. market value).

Book value of bond = face value unamortized discount or premium

= balance of Bonds Payable account at the time of the early extinguishment.

Since 2002, gains and losses from early extinguishment of debt areusually classified as other income on the income statement.

Special item above the line, i.e. not included in operating income.

Prior to 2002, such gains and losses were reported as Extraordinary Items,

i.e. below the line.


Fiscal Year Ended April 30,2002 2003 2004

Revenues $ 421,235 $ 420,863 $ 439,686

Operating expenses:Cost of operations 276,693 278,347 287,309General and administration 54,456 55,772 58,198Depreciation and amortization 50,712 47,930 59,673Impairment charge 4,864 1,663Restructuring charge (438)

381,423 386,913 406,843

Operating income 39,812 33,950 32,843

Other expense/(income), net:Interest income (904) (318) (251 )

Interest expense 31,451 26,572 25,648Income from equity method investments (1,899) (2,073) (2,261)Loss on debt extinguishment 3,649 Minority interest (154) (152) Other expense/(income) (4,480) (1,599) 5,948

Other expense, net 24,014 26,079 29,084

Income from continuing operations 15,798 7,871 3,759

CASELLA WASTE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands)


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Early Extinguishment of BondsJournal Entry

Consider the discount bond examined in slide 8. The company decidesto repurchase this bond on the first day of Year 3.

At the end of Year 2 (i.e. Period 4), the book value is $99,055.

Assume the company repurchases the bond for $90,000:

Gain (Loss) = $99,055 $90,000 = $9,055 of GAIN.

Dr. Bonds Payable 99,055

Cr. Cash 90,000

Cr. Gain on Early Extinguishment 9,055

Now, assume the company repurchases the bond for $110,000:

Gain (Loss) = $99,055 $110,000 = $(10,945) of LOSS.Dr. Bonds Payable 99,055

Dr. Loss on Early Extinguishment 10,945

Cr. Cash 110,000


Zero Coupon Bonds Zero coupon bonds (also called noninterest-bearing bonds):

Pay no interest (i.e. the coupon rate is 0%) during their life and thusare issued at very deep discounts.

Example:

Consider a 4-year zero coupon bond with a face value of $1,000.The market rate at the time of issue is 10% (compounded semi-annually).

Journal entry to record the issuance:

Proceeds = 1,000 * 0.6768 = $677.

Journal entry:

Dr. Cash 677

Cr. Bonds Payable 677



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BondsPayable,

End(e=a+d)

Amortization ofDiscount

(d=b-c)

CashPayment

(c)

InterestExpense

(5%)(b=a*5%)

BondsPayable,

Beg.(a)

Period

1 677 34 34 711

2 711 36 36 747

3 747 37 37 784

4 784 39 39 823

5 823 41 41 864

6 864 43 43 907

Zero Coupon Bonds Example (contd):

Amortization schedule:

7 907 45 45 952

8 952 48 48 1,000


Zero Coupon Bonds Example (contd):Journal entries to record accrued interest:

At end of period 1:

Dr. Interest Expense 34Cr. Bonds Payable 34

At end of period 2:


At end of period 3:


At end of period 4:Dr. Interest Expense 39

Cr. Bonds Payable 39

At end of period 5:


At end of period 6:


At end of period 7:


At end of period 8:


677 * .05

(677+34) * .05

Bonds Accounting

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