Long-Term Liabilities: Bonds and Notes

1. Long-Term Liabilities: Bonds and Notes Chapter 14

2. Learning Objectives • Compute the potential impact of long-term borrowing on earnings per share. • Describe the characteristics and terminology of bonds payable. • Journalize entries for bonds payable. • Describe and illustrate the accounting for installment notes. • Describe and illustrate the reporting of long-term liabilities including bonds and notes payable. • Describe and illustrate how the number of times interest charges are earned is used to evaluate a company’s financial condition.

3. Learning Objective 1 Compute the potential impact of long-term borrowing on earnings per share.

4. Financing Corporations • Corporations finance their operations using the following sources: • Short-term debt, such as purchasing goods or services on account. • Long-term debt, such as issuing bonds or notes payable. • Equity, such as issuing common or preferred stock.

5. Financing Corporations • A bond is a form of an interest-bearing note. Like a note, a bond requires periodic interest payments, and the face amount must be repaid at the maturity date.

6. Financing Corporations Huckadee Corporation is considering the following plans to issue debt and equity:

7. Net Income - Preferred Dividends Number of Common Shares Outstanding Earnings per Share = Financing Corporations • In deciding among financing plans, the effect on earnings per share is often considered. • Earnings per share (EPS) measures the income earned by each share of common stock. It is computed as follows:

8. Financing Corporations • Assume the following data for Huckadee Corporation: • Earnings before interest and income taxes are $800,000. • The tax rate is 40%. • All bonds or stocks are issued at their par or face amount. The effect of the preceding financing plans is shown in Exhibit 1 (next slide).

9. Financing Corporations Highest EPS

10. Financing Corporations Highest EPS

11. Learning Objective 2 Describe the characteristics and terminology of bonds payable.

12. Bond Characteristics and Terminology • The underlying contract between the company issuing bonds and the bondholders is called a bond indenture.

13. Bond Characteristics and Terminology • Usually, the face amount of each bond, called the principal, is $1,000, or a multiple of $1,000. Interest on bonds may be payable annually, semiannually, or quarterly. Most pay interest semiannually.

14. Bond Characteristics and Terminology • When all bonds of an issue mature at the same time, they are called term bonds. • If they mature over several dates, they are called serial bonds. • Bonds that may be exchanged for other securities are called convertible bonds.

15. Bond Characteristics and Terminology • Bonds that a corporation reserves the right to redeem before their maturity are called callable bonds. • Bonds issued on the basis of the general credit of the corporation are called debenture bonds.

16. Proceeds from Issuing Bonds • When a corporation issues bonds, the proceeds received for the bonds depend on: • The face amount of the bonds, which is the amount due at the maturity date. • The interest rate on the bonds. • The market rate of interest for similar bonds.

17. Proceeds from Issuing Bonds • 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.

18. Proceeds from Issuing Bonds • The market rate of interest, or effective rate of interest, is determined by transactions between buyers and sellers of similar bonds. • The market rate of interest is affected by a variety of factors, including investors’ expectations of current and future economic conditions.

19. Proceeds from Issuing Bonds

20. Proceeds from Issuing Bonds

21. Proceeds from Issuing Bonds

22. Proceeds from Issuing Bonds • Summary • If the market rate equals the contract rate, bonds will sell at the face amount. • If the selling price of the bonds is less than the face amount, the bonds are selling at a discount. • If the selling price of the bonds is more than the face amount, the bonds are selling at a premium.

23. Proceeds from Issuing Bonds • The price of a bond is quoted as a percentage of the bond’s face value. • A $1,000 bond quoted at 98 could be purchased or sold for $980 ($1,000 x 0.98). • A $1,000 bond quoted at 109 could be purchased or sold for $1,090 ($1,000 x 1.09).

24. Learning Objective 3 Journalize entries for bonds payable.

25. Bonds Issued at Face Amount • On January 1, 2013, Eastern Montana Communications Inc. issued the following bonds:

26. Bonds Issued at Face Amount • Since the contract rate of interest and the market rate of interest are the same, the bonds will sell at their face amount.

27. Bonds Issued at Face Amount • Every six months (on June 30 and December 31) after the bonds are issued, interest of $6,000 ($100,000 × 0.12 × 6/12) is paid.

28. Bonds Issued at Face Amount • The bond matures on December 31, 2017. At this time, the corporation pays the face amount to the bondholders.

29. Reminder: Bonds Issued at a Discount • On January 1, 2013, Western Wyoming Distribution Inc. issued $100,000, 12%, five-year bonds when the market rate was 13%. (Interest will be paid semiannually on June 30 and December 31.)

30. The discount may be viewed as the amount required by investors to accept a bond rate of interest below the market rate. Bonds Issued at a Discount The firm issued the $100,000 bonds for $96,406 (a discount of $3,594).

31. Amortizing a Bond Discount • The two methods of computing the amortization of a bond discount are: • Straight-line method • Effective interest rate method, sometimes called the interest method • Both methods amortize the same total amount of discount over the life of the bonds.

32. Amortizing a Bond Discount • The effective interest rate method is required by generally accepted accounting principles. • However, the straight-line method may be used if the results do not differ significantly from the interest method.

33. Amortizing a Bond Discount • On June 30, 2013, Western Wyoming Distribution Inc. pays six-months’ interest on the five-year bond issued earlier, and the bond discount is amortized ($3,594 × 1/10). The interest payment and amortization entries can be combined as follows: *$100,000 × 12% × 6/12

34. Reminder: Bonds Issued at a Premium • On January 1, 2013, Northern Idaho Transportation Inc. issued $100,000, 12%, five-year bonds for $103,769. The market rate of interest is 11%.

35. Amortizing a Bond Premium • The entry to record the first interest payment and the amortization of the premium on the $100,000, 12%, five-year bonds issued on January 1, 2013, is made on June 30, 2013. The combined entry is as follows:

36. Bond Redemption • A corporation may call, or redeem, bonds before they mature. Callable bonds can be redeemed by the issuing corporation within the period of time and at the price stated in the bond indenture. Normally, the call price is above the face value.

37. Bond Redemption • The carrying amount of bonds payable is the face amount of the bonds less any unamortized discount or plus any unamortized premium.

38. Bond Redemption • A gain or loss may be realized on a bond redemption as follows: • A gain is recorded if the price paid for the redemption is below the bond carrying amount. • A loss is recorded if the price paid for the redemption is above the carrying amount.

39. Gains on the redemption of bonds are reported in the Other Income section of the income statement. Bond Redemption • On June 30, 2013, a corporation has a bond issue of $100,000 outstanding, on which there is an unamortized premium of $4,000. The corporation redeems one-fourth of the bonds for $24,000.

40. Losses on the redemption of bonds are reported in the Other Loss section of the income statement. Bond Redemption • The corporation calls the remaining $75,000 of outstanding bonds, which are held by a private investor, for $79,500 on July 1, 2013.

41. Learning Objective 4 Describe and illustrate the accounting for installment notes.

42. Installment Notes • An installment note is a debt that requires the borrower to make equal periodic payments to the lender for the term of the note. Unlike bonds, a note payment includes the following: • Payment of a portion of the amount initially borrowed, called the principal • Payment of interest on the outstanding balance

43. Installment Notes • Installment notes are often used to purchase specific assets, such as equipment, and are often secured by the purchased asset. • When a note is secured by an asset, it is called a mortgage note. • If the borrower fails to pay a mortgage note, the lender has the right to take possession of the pledged asset.

44. Issuing an Installment Note • Lewis Company issues a $24,000, 6%, five-year note to City National Bank on January 1, 2013. The annual payment is $5,698.

45. Annual Payments $24,000 x 0.06

46. Annual Payments – $1,440 $5,698

47. Annual Payments – $4,258 $24,000

48. Annual Payments • The entry to record the first payment on December 31, 2013, is as follows:

49. Annual Payments • The entry to record the second payment on December 31, 2014, is as follows:

50. Annual Payments • The entry to record the final payment on December 31, 2017, is as follows: • After the entry is posted, the balance in Notes Payable related to this note is zero.