Introductory Accounting B

1. Introductory Accounting B B11-391 Mark Binder, CA Chapter 17

2. Learning Objectives Compare bond versus share financing Explain the types of bonds and their issuing procedures Prepare entries to record bonds issued at par Determine the price of a bond Prepare entries to record bonds issued at a discount Prepare entries to record bonds issued at a premium Record the retirement of a bond

3. Bonds Most people are familiar with Canada Savings Bonds In Manitoba we have had Manitoba Hydro Bonds and Manitoba Builder Bonds Bonds are a method of financing that businesses use Bonds are a form of debt Bonds are used instead of or to augment bank financing

4. Advantages of Bonds Bonds do not affect shareholder control Interest on bonds is tax deductible Bonds can increase return on equity – leverage If return is higher than interest rate return on equity will increase

5. Disadvantages of a Bond Payments are not discretionary and can be difficult to make when income is low Bonds can decrease return on equity If return is lower than interest rate return on equity will decrease Happens when income is low Has caused financial collapse of companies – Magna Int’l and Olympia and York

6. Types of Bonds Bonds by definition has specific assets pledged against the bond issue If the company defaults on the bond the pledged asset can be sold and the cash distributed to bond holders Debentures are unsecured Sometimes called ‘Junk’ Bonds

7. Term and Serial Bonds Term bonds have a scheduled maturity date when the bond must be repaid Serial Bonds have several maturity dates The maturity dates are in series

8. Bond Issuance Procedures The issuing company develops a document called the bond indenture which acts as the contract between them and the bond holders Each bond holder will receive a bond certificate Usually, issuing companies sell the bonds to an investment firm called an underwriter

9. Bond Issuing Procedures Cont’d The underwriter then resells the bonds to the public When an underwriter sells bonds to a large number of investors the bondholder’s interests are represented by a trustee The trustee ensures the issuer complies with the bond indenture When Manitoba Hydro issued it’s bonds Montreal Trust was the trustee

10. Issuing Bonds Part of the Bond indenture identifies the interest rate on the bond Interest is usually paid semi- annually This rate is called the stated rate, coupon rate or nominal rate The market price for the bonds will be determined by how much investors are willing to pay for the bonds

11. Issuing Bonds Sometimes investors will accept the stated rate of the bond. This is called issuing at par. Sometimes investors will require a higher return than the stated rate on the bonds. This is called issuing a bond at a discount

12. Issuing Bonds Occasionally, the market will require a lower rate of return than the stated rate of the bond. This is called issuing at a premium

13. Issuing at Par XYZ company issues it’s $500,000 6% 5 year bond dated January 1st. The market rate is also 6% The bonds pay interest semi-annually The Journal entry would be: Dr: Cash $500,000 Cr: Bond Payable $500,000

14. Issuing at Par In six months the interest would be recorded as: Dr: Bond Interest Expense $15,000 Cr:Cash $15,000 $500,000 x 6% x ½ =$15,000

15. Issuing at Par – Sale Between Interest Dates Bonds do not have to be sold on their interest date If they are not, standard practice is to include in the issue price of the bond the accrued interest since the day of issuance

16. Issuance at Par – Sale Between Interest Dates XYZ company issues it’s $500,000 6% 5 year bond dated January 1st on March 1st. The market rate is also 6% In this case the bonds were issued (sold) 2 months after their dated date The bonds were sold at par plus two months interest (January and February) What was the issue price?

17. Issuance at Par – Sale Between Interest Dates Since the bonds were sold at par the market interest rate is also 6%. The sale price of the bonds: Face value of bonds $500,000 Accrued interest ($500,000 x 6% x 2/12) 5,000 $505,000

18. Issuance at Par – Sale Between Interest Dates The journal entry to record this would be: Dr: Cash $505,000 Cr: Bond Payable $500,000 Cr: interest payable $5,000 What would the journal entry be for the 1st interest payment?

19. Issuance at Par – Sale Between Interest Dates Dr: Interest expense $10,000 Dr: Interest payable $5,000 Cr: Cash $15,000 Interest expense = $500,000 x 6% x 4/12 = $10,000 or $15,000 ($500,000 x 6% x ½) - $5,000 (interest payable)

20. Bond Maturity When the bonds mature in 5 years the journal entry will be: Dr: Bond Payable $500,000 Cr: Cash $500,000

21. Issuing at a Discount Assume the same scenario except the market rate is 10% Because the market is demanding a 10% return a investor will not pay the face value of the bond. The investor will pay an amount which will yield a 10% return

22. Determining Issue Price Keep in mind that nothing about the bond indenture will change. The cash payments of interest and the face value of the bond are unchangeable. The question we need to ask is what would someone pay for: $15,000 every 6 months for the next 5 years and $500,000 in five years?

23. Determining Issue Price This is a question based purely on mathematics. $15,000 x (P/A, 5%,10) = P/A – the present value of an annuity at 5% for 10 periods (Table IV.3) $15,000 x 7.7217 = $115,825.50 $500,000 x (P/F, 5%, 10) = P/F – the present value of a future cash flow (Table IV.1) $500,000 x 0.6139 = $306,950

24. Determining the Issue Price The issue price is the sum of these two cash flows: Present value of interest payments 115,825.50 Present value of the face value payment 306,950.00 422,775.50 Alternatively you could use your calculator

25. Determining the Issue Price Clear TVM Set the following variables N = 10 FV = -500,000 PMT = -15,000 I/Y = 5 Compute (CPT) PV (Present Value) = 422,782.65 Notice the difference of $422,782.65 - $422,775.50 = $7.15

26. Determining the Issue Price Their will frequently be a difference between the ‘calculator value’ and the ‘table value’ The difference should not be significant but exists because the calculator uses more decimal places then are in the table. For the most part this course will emphasize the table method. You can and should use your calculator as a verification of your calculation.

27. Issuing at a Discount Whenever the stated rate is below market it is called issuing at a discount The journal entry to record issuing a bond at a discount is: Dr: Cash $422,776 (rounded) Dr: Discount on Bonds Payable $ 77,224 Cr: Bonds Payable $500,000 The discount is computed effectively as a plug $500,000 - $422,776 = $77,224.

28. Issuing a Bond at a discount Another alternative method of describing the past situation is to say the bonds were sold at 84.5 This means the cash collected was 84.5% of the face value of the bond The 84.5% is rounded result.

29. Discounts Our bonds will be disclosed on the financial statements as follows: Bond Payable 6%, due December 31, 2006 $500,000 Less: discount on bonds payable 77,224 422,776

30. Discounts The discount posses a specific problem As time passes and the bond approaches maturity the discount must be slowly eliminated By the time the maturity date arrives, the value of the bond on the financial statements should represent the amount that must be paid, the face value of the bond. Therefore, once a discount is recorded it must be amortized over the life of the bond We will use two methods: Straight Line Effective Interest

31. Straight Line Method As was the case in straight line amortization the amount of the discount is amortized on a straight line basis. Recall that our bond is a 5 year bond Discount is $77,224 Interest payments are semi annual.

32. Straight Line Method Straight line amortization would be: $77,224/10 periods = $7,722.4 or $7,722 each period. The Journal entry to record the first interest payment is: Dr: Bond interest expense 22,722 Cr: Discount on bond 7,722 Cr: Cash 15,000

33. Straight Line amortization Each period 7,722 will be reduced from the total of the discount on issuing The amortization of the discount must create a credit against the discount Remember the discount has a debit balance so to eliminate it, a credit must be posted. The offsetting debit is added to interest expense.

34. Effective Interest Method Under the straight line method the interest expense is constant – does not differ from one period to the next. When dividing the interest expense by the carrying a variable interest rate is created. This creates the impression of a floating interest rate.

35. Effective Interest Method Under the effective interest method interest expense divided by carrying value will yield a constant rate of interest. The constant rate of interest is the market rate of interest at issue date.

36. Effective Interest Method The key to calculating interest under the effective interest method is to focus on the ‘carrying value’ of the bond The carrying value is the value of the bond less the discount (plus the premium) In our continuing example after issuance our balance appears as follows:

37. Effective Interest Method Bond Payable 6%, due December 31, 2006 $500,000 Less: discount on bonds payable 77,224 422,776 Under the effective interest method the interest we compute is the market rate of interest x the carrying value of the bond In this case it is 422,776 x 5% (market rate of interest) = $21,139 (rounded)

38. Effective Interest Method The journal entry to record interest is: Dr: Interest expense $21,139 Cr: Cash $15,000 Cr: Discount on Bond $6,139 Notice how this differs from the straight line method In both cases the credit to cash, which is established in the bond indenture, remains the same

39. Effective Interest Method In the straight line method the amortization of the discount was determined and interest expense was ‘plugged’ In the effective interest method the interest expense is computed and the amortization of the discount is ‘plugged’ What would be the journal entry for the second interest payment?

40. Effective Interest Method To determine the interest expense we first have to determine the carrying value of the bond Discount value $77,724 – amortization from first journal entry $6,139 = $71,085 Bond Payable 6%, due December 31, 2006 $500,000 Less: discount on bonds payable 71,085 428,915

41. Effective Interest Method Interest expense is then $428,915 x 5% = $21,446 The journal entry to record this would be: Dr: Interest expense $21,446 Cr: Cash $15,000 Cr: Discount on Bond $6,446

42. Issuing at a Premium If the market rate is less than the stated rate on the bonds, the bonds are said to be issued at a premium If in our prior example the bonds were sold at 103 the journal entry would be:

43. Journal entry – Bond Premium Dr: Cash $515,000 Cr: Premium on bond payable $15,000 Cr: Bond Payable $500,000 Amortization of a premium works identically to amortizing a discount on the straight line method $15,000 / 10 = $1,500 per period What would be the journal entry to record the first interest payment?

44. Journal entry bond premium The journal entry to record the first interest payment would be: Dr: Interest expense $13,500 Dr: Bond premium $1,500 Cr: Cash $15,000

45. Effective Interest Method – Bond Premium Alternatively, the Bond premium could be amortized using the effective interest method Assume XYZ Corporation issues it’s bond at 103 and amortizes the premium using the effective interest method. What would the journal entry be to record the first interest payment Assume the market rate of interest is 5.31% (This is approximately true)

46. Effective Interest Method The carrying value of the bond is: Face value of Bond $500,000 Plus the premium 15,000 $515,000 5.31% /2 = 2.655% x 2.655% $13,673.25

47. Effective Interest Method Dr: Bond Interest Expense $13,673.25 Dr: Premium on Bond $1,326.75 Cr: Cash $15,000