Ch04 completing the accounting cycle, intro accounting, 21st edition warren reeve fess eng
Chapter 13 Bonds Payable and Investments in Bonds Financial and Managerial Accounting 8th Edition...
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Transcript of Chapter 13 Bonds Payable and Investments in Bonds Financial and Managerial Accounting 8th Edition...
Chapter Chapter 1313Bonds Payable and Bonds Payable and
Investments in BondsInvestments in BondsFinancial and Managerial Accounting
8th Edition
Warren Reeve Fess
PowerPoint Presentation by Douglas CloudProfessor Emeritus of AccountingPepperdine University
© Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved.
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1. Compute the potential impact of long-term borrowing on the earnings per share of a corporation.
2. Describe the characteristics of bonds.3. Compute the present value of bonds
payable.4. Journalize entries for bonds payable.5. Describe bond sinking funds.
ObjectivesObjectivesObjectivesObjectives
After studying this After studying this chapter, you should chapter, you should
be able to:be able to:
After studying this After studying this chapter, you should chapter, you should
be able to:be able to:
6. Journalize entries for bond redemptions.
ObjectivesObjectivesObjectivesObjectives
7. Journalize entries for the purchase, interest, discount, and premium amortization, and sale of bond investments.
8. Prepare a corporation balance sheet.9. Compute and interpret the number of
times interest charges are earned.
Two Methods of Long-Term FinancingTwo Methods of Long-Term FinancingTwo Methods of Long-Term FinancingTwo Methods of Long-Term Financing
Resources = Sources
Stockholders’Equity
Assets
Liabilities
Equity Financing: Stockholders
Debt Financing: Bondholders
Bondholders
Bonds (debt)—Interest payments to bondholders are an expense that reduces taxable income.
Stock (equity))—Dividend payments are made from after tax net income and retained earnings. Earnings per share on common stock can often be increased by issuing bonds rather than additional stock.
Why issue bonds rather than stock?Why issue bonds rather than stock?
Stockholders
Two Methods of Long-Term FinancingTwo Methods of Long-Term FinancingTwo Methods of Long-Term FinancingTwo Methods of Long-Term Financing
Alternative Financing Plans – $800,000 EarningsAlternative Financing Plans – $800,000 EarningsPlan 1 Plan 2 Plan 3
12 % bonds — — $2,000,000Preferred 9% stock, $50 par — $2,000,000 1,000,000Common stock, $10 par $4,000,000 2,000,000 1,000,000Total $4,000,000 $4,000,000 $4,000,000Earnings before interest
and income tax $ 800,000 $ 800,000 $ 800,000Deduct interest on bonds — — 240,000
Income before income tax $ 800,000 $ 800,000 $ 560,000Deduct income tax 320,000 320,000 224,000
Net income $ 480,000 $ 480,000 $ 336,000Dividends on preferred stock — 180,000 90,000Available for dividends $ 480,000 $ 300,000 $ 246,000
Shares of common stock ÷400,000 ÷200,000 ÷100,000
Earnings per share $ 1.20 $ 1.50 $ 2.46
Alternative Financing Plans – $440,000 EarningsAlternative Financing Plans – $440,000 EarningsPlan 1 Plan 2 Plan 3
12 % bonds — — $2,000,000Preferred 9% stock, $50 par — $2,000,000 1,000,000Common stock, $10 par $4,000,000 2,000,000 1,000,000Total $4,000,000 $4,000,000 $4,000,000Earnings before interest
and income tax $ 440,000 $ 440,000 $ 440,000Deduct interest on bonds — — 240,000
Income before income tax $ 440,000 $ 440,000 $ 200,000Deduct income tax 176,000 176,000 80,000
Net income $ 264,000 $ 264,000 $ 120,000Dividends on preferred stock — 180,000 90,000Available for dividends $ 264,000 $ 84,000 $ 30,000
Shares of common stock ÷400,000 ÷200,000 ÷100,000
Earnings per share $ 0.66 $ 0.42 $ 0.30
Characteristics of Bonds PayableCharacteristics of Bonds PayableCharacteristics of Bonds PayableCharacteristics of Bonds PayableA bond contract is called a bond indenture or trust
indenture.
Long-term debt—repayable 10, 20, or 30 years after date of issuance.
Issued in face (principal) amounts of $1,000, or multiples of $1,000.
Contract interest rate is fixed for term (life) of the bond.
Face amount of bond repayable at maturity date.
Characteristics of Bonds PayableCharacteristics of Bonds PayableCharacteristics of Bonds PayableCharacteristics of Bonds Payable
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.
Bonds that a corporation reserves the right to redeem before maturity are callable bonds.
Bonds issued on the basis of the general credit of the corporations are debenture bonds.
The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable
The Present-Value Concept The Present-Value Concept and Bonds Payableand 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.
The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable
The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable
MARKET RATE = CONTRACT RATE
Sell price of bond = $1,000
$1,00010% payable
annually
The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable
The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable
MARKET RATE > CONTRACT RATE
Sell price of bond < $1,000
–Discount
$1,00010% payable
annually
The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable
The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable
MARKET < CONTRACT RATE
Sell price of bond > $1,000
+Premium
$1,00010% payable
annually
A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years.
Today End of Year 1
End of Year 2
Interest payment
$100Interest payment
$100
$90.91 $100 x 0.90909
$1,00010%
payable annually
$82.65 $100 x 0.82645
$1,000 x 0.82645$826.45
$1,000.00 (rounded)
The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable
The Present-Value Concept The Present-Value Concept and Bonds Payableand Bonds Payable
OR
Present value of face value of $1,000 due in 2 years at 10% compounded annually:$1,000 x 0.82645 $ 826.45
Present value of 2 annual interest paymentsof 10% compounded annually: $100 x 1.73554 (PV of annuity of $1 for 2 yearsat 10%) 173.55
Total present value of bonds $1,000.00
Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable
Bonds Issued at Face Amount
On January 1, 2005, a corporation issues for cash $100,000 of 12%, five-year bonds; interest payable semiannually. The market rate of interest is 12%.
Present value of face amount of $100,000 due in 5
years at 12% compounded annually: $100,000 x 0.55840$ 55,840
Present value of 10 interest payments of $6,000
compounded semiannually: $6,000 x 7.3609 (PV of annuity of $1 for 10 periods at 6%) 44,160
Total present value of bonds$100,000
Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable
On January 1, 2005, a corporation issues for cash $100,000 of 12%, five-year bonds; interest payable
semiannual. The market rate of interest is 12%.
Jan. 1 Cash 100 000 00
Issued $100,000 bonds
payable at face amount.
Bonds Payable 100 000 00
2005
Bonds Issued at Face Amount
Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable
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
Paid six months’ interest on
bonds.
Cash 6 000 00
Bonds Issued at Face Amount
The bond matured on December 31, 2009. At this time, the corporation paid the face
amount to the bondholder.
Dec. 31 Bonds Payable 100 000 00
Paid bond principal at
maturity date.
Cash 100 000 00
2009
Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable
Bonds Issued at Face Amount
Assume that the market rate of interest is 13% on the $100,000 bond rather than 12%.
Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable
Bonds Issued at a Discount
Present value of face amount 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
Present value of 10 semiannual interest payments
of $6,000 compounded semiannually: $6,000 x 7.18883 (PV of annuity of $1 for 10 periods at 6½%) 43,133
Total present value of bonds$96,406
On January 1, 2005, the firm issued $100,000 bonds for $96,406 (a discount of $3,594).
Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable
Jan. 1 Cash 96 406 00
Discount on Bonds Payable 3 594 00
Issued $100,000 bonds at
discount.
Bonds Payable 100 000 00
2005
Bonds Issued at a Discount
On June 30, 2005, six-months’ interest is paid and the bond discount is amortized using the straight-line method.
June 30 Interest Expense 6 359 40
Paid semiannual interest and
amortized 1/10 of discount.
Discount on Bonds Payable 359 40
Cash 6 000 00
2005
$3,594 ÷ $3,594 ÷ 1010
$3,594 ÷ $3,594 ÷ 1010
Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable
Bonds Issued at a Discount
If the market rate of interest is 11% and the contract rate is 12%, the bond would sell for $103,769.
Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable
Bonds Issued at a PremiumBonds Issued at a Premium
Present value of face amount of $100,000 due in 5
years at 11% compounded annually: $100,000 x 0.58543 (PV of $1 for 10 periods at 5½%)$ 58,543
Present value of 10 semiannual interest payments of
$6,000 at 11%compounded semiannually: $6,000 x 7.53763 (PV of annuity of $1 for 10 periods at 5½%) 45,226
Total present value of bonds$103,769
Sold $100,000 of bonds for $103,769 (a premium of $3,769).
Jan. 1 Cash 103 769 00
Issued $100,000 bonds at a
premium.
Bonds Payable100 000 00
Premium on Bonds Payable3 769 00
2005
Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable
Bonds Issued at a PremiumBonds Issued at a Premium
On June 30, paid the semiannual interest and amortized the premium.
June 30 Interest Expense 5 623 10
Premium on Bonds Payable 376 90
Paid semiannual interest and
amortized 1/10 of bond premium.
Cash 6 000 00
2005
$3,769 x 1/10$3,769 x 1/10$3,769 x 1/10$3,769 x 1/10
Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable
Bonds Issued at a PremiumBonds Issued at a Premium
Zero-Coupon BondsZero-Coupon Bonds
Zero-coupon bonds do not provide for interest payments. Only the face amount is paid at maturity.
Assume market rate is 13% at date of issue.
Zero-coupon bonds do not provide for interest payments. Only the face amount is paid at maturity.
Assume market rate is 13% at date of issue.
Present value of $100,000 due in 5 years at 13% compounded semi annually: $100,000 x 0.53273(PV of $1 for 10 periods at 6½%)$53,273
Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable
On January 1, 2005, Issue 5-year, $100,000 zero-coupon bonds when the
market rate of interest is 13%.
On January 1, 2005, Issue 5-year, $100,000 zero-coupon bonds when the
market rate of interest is 13%.
Jan. 1 Cash 53 273 00
Discount on Bonds Payable 46 727 00
Issued $100,000 zero-
coupon bonds.
Bonds Payable100 000 00
2005
Accounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds PayableAccounting for Bonds Payable
Zero-Coupon BondsZero-Coupon Bonds
The bond indenture may require that a fund for the payments of the face value
of the bonds at maturity be set aside over the life of the bonds. This special fund
is called a bond sinking fund.
The bond indenture may require that a fund for the payments of the face value
of the bonds at maturity be set aside over the life of the bonds. This special fund
is called a bond sinking fund.
Bond RedemptionBond RedemptionBond RedemptionBond Redemption
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.
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.
June 30 Bonds Payable 25 000 00
Premium on Bonds Payable 1 000 00
Retired bonds for $24,000.
Cash 24 000 00
Gain on redemption of Bonds2 000 00
2005
Bond RedemptionBond RedemptionBond RedemptionBond Redemption
Instead, assume that the firm reacquired all of the bonds, paying $105,000.
Instead, assume that the firm reacquired all of the bonds, paying $105,000.
June 30 Bonds Payable 100 000 00
Premium on Bonds Payable 4 000 00
Loss on Redemption of Bonds 1 000 00
Retired bonds for $105,000.
Cash105 000 00
2005
Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds
Bonds are purchased directly from the issuing corporation or through an organized bond exchange. Bond prices are quoted as a
percentage of the face amount.
A premium or discount on a bond investment is recorded in a single
investment account and is amortized over the remaining life of the bonds.
A premium or discount on a bond investment is recorded in a single
investment account and is amortized over the remaining life of the bonds.
On April 2, 2005, Purchased a $1,000 Lewis Company bond at 102 plus a brokerage fee of
$5.30 and accrued interest of $10.20.
On April 2, 2005, Purchased a $1,000 Lewis Company bond at 102 plus a brokerage fee of
$5.30 and accrued interest of $10.20.
Apr. 2 Investment in Lewis Co. Bonds. 1 025 30
Invested in a Lewis
Company bond.
Cash1 035 50
2005
Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds
Interest Revenue 10 20
Note that the brokerage fee is added to the cost of the investment.
Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds
To assist your understanding, let’s look at an extended illustration for
Crenshaw, Inc.
To assist your understanding, let’s look at an extended illustration for
Crenshaw, Inc.
On July 1, 2005, Crenshaw Inc. purchases $50,000 of 8% bonds of Deitz Corporation due
in 8 3/4 years. The effective interest rate is 11%. The purchase price is $41,706 plus
interest of $1,000 accrued from April 1, 2005.
On July 1, 2005, Crenshaw Inc. purchases $50,000 of 8% bonds of Deitz Corporation due
in 8 3/4 years. The effective interest rate is 11%. The purchase price is $41,706 plus
interest of $1,000 accrued from April 1, 2005.
July 1 Investment in Deitz Corp. Bonds. 41 706 00
Interest Revenue 1 000 00
Purchased investment in
bonds, plus accrued interest.
Cash42 706 00
2005
Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds
$50,000 x 8% x 3/12$50,000 x 8% x 3/12
Received semiannual interest for April 1 to October 1 ($50,000 x 8% x 6/12).
Received semiannual interest for April 1 to October 1 ($50,000 x 8% x 6/12).
Oct. 1 Cash 2 000 00
Received semiannual
interest for April 1 to
October 1.
Interest Revenue2 000 00
Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds
Adjusting entry for interest accrued from October 1 to December 31
($50,000 x 8% x 3/12).
Adjusting entry for interest accrued from October 1 to December 31
($50,000 x 8% x 3/12).
Dec. 31 Interest Receivable 1 000 00
Adjusting entry for interest
accrued from October 1 to
December 31.
Interest Revenue1 000 00
Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds
Adjusting entry for amortization of discount for July 1 to December 31: ($50,000 –$41,706)/105 x 6 months.
Adjusting entry for amortization of discount for July 1 to December 31: ($50,000 –$41,706)/105 x 6 months.
Dec. 31 Investment in Deitz Corp. Bonds 474 00
Adjusting entry for
amortization of discount
from July 1 to December 31.
Interest Revenue474 00
Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds
Rounded to Rounded to nearest dollar nearest dollar ($79 a month)($79 a month)
Investment RevenueOct. 1 2,000Dec. 31 1,000
31 4743,474
July 1 1,000
Bal. 2,474
Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds
The Deitz bonds are sold on June 30, 2012 for $47,350 plus accrued interest. It has
been six months since the last amortization entry, so amortization for the current year
must be recorded (6 months).
The Deitz bonds are sold on June 30, 2012 for $47,350 plus accrued interest. It has
been six months since the last amortization entry, so amortization for the current year
must be recorded (6 months).
June 30 Investment in Deitz Corp. Bonds 474 00
Amortized discount for
current year.
Interest Revenue474 00
2012
Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds
$79 x 6$79 x 6
Investment in Deitz Corporation Bonds
July 1 41,706Dec. 31 474Dec. 31 948Dec. 31 948Dec. 31 948Dec. 31 948Dec. 31 948Dec. 31 948June 30 474
48,342
2005
2006
2007
2008
2009
2010
2011
2012
The investment account after all
amortization entries have been made,
including the June 30, 2012
adjusting entry.
Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds
$79 x 6$79 x 6$79 x 12$79 x 12
This investment was sold on June 30, 2009 for $47,350 plus accrued interest. It has
been six months since the last amortization entry, so amortization for the current year
must be recorded (6 months).
This investment was sold on June 30, 2009 for $47,350 plus accrued interest. It has
been six months since the last amortization entry, so amortization for the current year
must be recorded (6 months).
June 30 Cash 48 350 00
Loss on Sale of Investment 992 00
Interest Revenue1 000 00
Investment in Deitz Corp. Bonds48 342 00
2012
Investments in BondsInvestments in BondsInvestments in BondsInvestments in Bonds
$50,000 $50,000 x 8% x x 8% x
3/123/12
Number of Times Interest Charges Earned
Number of Times Interest Charges Earned
Financial Financial Analysis and Analysis and InterpretationInterpretation
Solvency MeasuresSolvency Measures——The Long-Term CreditorThe Long-Term Creditor
Number of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges Earned
2006 2005
Income before income tax $ 900,000 $ 800,000Add interest expense 300,000 250,000Amount available for interest $1,200,000 $1,050,000
Income before income tax + Interest expenseInterest Expense
$800,000 + $250,000$250,000
2005200520052005 = 4.2 times
Solvency MeasuresSolvency Measures——The Long-Term CreditorThe Long-Term Creditor
Number of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges Earned
2006 2005
Income before income tax $ 900,000 $ 800,000Add interest expense 300,000 250,000Amount available for interest $1,200,000 $1,050,000
Income before income tax + Interest expenseInterest Expense
$900,000 + $300,000$300,000
2006200620062006 = 4.0 times
The purpose of the ratio is to assess the risk to debtholders in
terms of number of times interest charges were earned.
The purpose of the ratio is to assess the risk to debtholders in
terms of number of times interest charges were earned.
The EndThe End
Chapter 13Chapter 13