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CHAPTER TWENTY-FOUR

CHAPTER TWENTY-FOUR. CORPORATIONS: BONDS. Def. - a written promise to pay a specific sum of money at a specific future date. It is a debt of the corporation If not paid, creditors can force the company into bankruptcy. Usually issued in denominations of $1,000 each

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CHAPTER TWENTY-FOUR

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  1. CHAPTER TWENTY-FOUR CORPORATIONS: BONDS

  2. Def. - a written promise to pay a specific sum of money at a specific future date. It is a debt of the corporation If not paid, creditors can force the company into bankruptcy. Usually issued in denominations of $1,000 each Enabling corporation to obtain large amounts of money by selling bonds to many investors Bonds can be classified as to: Security Timing of payment of principal Identification of ownership BONDS

  3. SECURITY Bonds are either secured or unsecured • SECURED BONDS • one that is backed by specific corporate assets • Example: Mortgage Bond • UNSECURED BONDS • backed solely by the general credit of the corporation, rather than by specific assets • Also called “Debenture Bonds”

  4. TIMING OF PAYMENT OF PRINCIPAL Principal is to be paid at maturity • TERM BONDS -bonds that all have the same maturity date • SERIAL BONDS - bonds issued in a series so that a specified amount of the bond matures each year • CONVERTIBLE BONDS - bonds that give the holder the option of exchanging the bonds for capital stock of the corporation • CALLABLE BONDS - bonds that give the issuing corporation the option of calling the bonds for redemption before the maturity date

  5. IDENTIFICATION OF OWNERSHIP Principal is to be paid at maturity • REGISTERED BONDS • bonds whose ownership is recorded in the corporate records • name and address of each owner • COUPON BONDS (bearer bonds) • bonds whose ownership generally is not recorded by the corporation • the holder of the bond presents the interest coupons for payment as they come due

  6. DETERMINING SALES PRICE EXAMPLE: Watkin Corp. wants to sell $400,000 of 10%, 10-year bonds. Two factors affecting price: 1. Stated or Coupon rate of interest on the bond 2. Current Market rate of interest on similar investments What if the market rate is 11%?

  7. DETERMINING SALES PRICE EXAMPLE: Watkin Corp. wants to sell $400,000 of 10%, 10-year bonds. Two factors affecting price: 1. Stated or Coupon rate of interest on the bond 2. Current Market rate of interest on similar investments If our bonds offer only 10% and other bonds are offering 11%, investors will not want our bonds.

  8. DETERMINING SALES PRICE EXAMPLE: Watkin Corp. wants to sell $400,000 of 10%, 10-year bonds. Two factors affecting price: 1. Stated or Coupon rate of interest on the bond Sell at a DISCOUNT 2. Current Market rate of interest on similar investments

  9. DETERMINING SALES PRICE EXAMPLE: Watkin Corp. wants to sell $400,000 of 10%, 10-year bonds. Two factors affecting price: 1. Stated or Coupon rate of interest on the bond 2. Current Market rate of interest on similar investments If the market rate is only 9%…. bonds will sell at a PREMIUM.

  10. DETERMINING SALES PRICE EXAMPLE: Watkin Corp. wants to sell $400,000 of 10%, 10-year bonds. When... the Selling Price…. Stated Rate Market Rate, = Face Value = Stated Rate > > Face Value Market Rate, (Premium) Stated Rate Market Rate, < Face Value < (Discount)

  11. ISSUING BONDS AT FACE VALUE EXAMPLE: On April 1, 20-1 the stated rate of 10% is the same as the current market rate. Watkin Corp. will sell the $400,000, 10-year bonds at face value. Let’s look at the issuance journal entry.

  12. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Apr. 1 Cash 400,000 1 2 Bonds Payable 400,000 3 Issued bonds at face value 4 5 Bonds Payable is reported as a long-term liability on the balance sheet. 6 7 8 9 10 11

  13. ISSUING BONDS AT FACE VALUE EXAMPLE: On April 1, 20-1 the stated rate of 10% is the same as the current market rate. Watkin Corp. will sell the $400,000, 10-year bonds at face value. Interest Payment: Face Value x Stated Interest rate Since interest payments are paid every 6 months, 1/2 of the yearly interest is paid in each payment. $400,000 10% x $40,000/year

  14. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Bond Interest Expense Oct. 1 20,000 1 Cash 2 20,000 3 Paid semiannual interest 4 on bonds 5 Since the next interest payment will be after the year end, we must stop at year end and record the accrued interest. 6 7 8 9 10 11

  15. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Dec. 31 10,000 Bond Interest Expense 1 2 3 4 5 October 1 - December 31 = 3 months $400,000 x 10% = $40,000/year $40,000 x 1/4 year(3 months) = $10,000 6 7 8 9 10 11

  16. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Dec. 31 10,000 Bond Interest Expense 1 Bond Interest Payable 10,000 2 3 4 5 6 7 8 9 10 11

  17. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Jan. 1 Bond Interest Payable 10,000 1 Bond Interest Expense 10,000 2 3 4 The adjustment is reversed on January 1. 5 6 7 8 9 10 11

  18. ISSUING BONDS AT A PREMIUM EXAMPLE: On April 1, 20-1 the stated rate of 10% is GREATER than the current market rate, so Watkin Corp. will sell the $400,000, 10-year bonds at 106. x $400,000 106% $424,000 Bonds will sell for

  19. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Apr. 1 Cash 424,000 1 2 Bonds Payable 400,000 3 4 Bonds Payable is recorded at the FACE VALUE of the bonds. 5 6 7 8 9 10 11

  20. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Apr. 1 Cash 424,000 1 2 Bonds Payable 400,000 3 Premium on Bonds Pay. 24,000 4 5 Premium on Bonds Payable is an adjunct-liability account. 6 7 8 9 10 11

  21. Balance Sheet (Partial) Long-term liabilities: Bonds Payable $400,000 Premium on Bonds Payable 24,000 $424,000 Bonds Payable + Premium = Carrying Value

  22. ISSUING BONDS AT A PREMIUM EXAMPLE: On April 1, 20-1 the stated rate of 10% is GREATER than the current market rate, so Watkin Corp. will sell the $400,000, 10-year bonds at 106. $400,000 x 10% x 1/2 = $20,000 Interest payment Selling at a premium does not affect the amount of the interest payments.

  23. ISSUING BONDS AT A PREMIUM EXAMPLE: On April 1, 20-1 the stated rate of 10% is GREATER than the current market rate, so Watkin Corp. will sell the $400,000, 10-year bonds at 106. $400,000 x 10% x 1/2 = $20,000 Interest payment But this is not the Interest Expense recognized every 6 months.

  24. ISSUING BONDS AT A PREMIUM EXAMPLE: On April 1, 20-1 the stated rate of 10% is GREATER than the current market rate, so Watkin Corp. will sell the $400,000, 10-year bonds at 106. $400,000 x 10% x 1/2 = $20,000 Interest payment $24,000 Premium received reduces the amount of interest expense Premium is amortized over the life of the bond.

  25. AMORTIZING BOND PREMIUM • Two methods of amortizing premiums or discounts: • EFFECTIVE INTEREST • recommended method • covered in the appendix • STRAIGHT-LINE • simple to apply • generally provides acceptable results

  26. AMORTIZING BOND PREMIUM EXAMPLE: On April 1, 20-1 the stated rate of 10% is GREATER than the current market rate, so Watkin Corp. will sell the $400,000, 10-year bonds at 106. FORMULA: Premium x 1/2 Year Life of Bonds $24,000 $1,200 x 1/2 Year = 10 Years

  27. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Bond Interest Expense Oct. 1 18,800 1 2 Interest Payment - Amortization of Premium $20,000 - $1,200 3 4 5 6 7 8 9 10 11

  28. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Bond Interest Expense Oct. 1 18,800 1 Premium on Bonds Pay. 2 1,200 3 Cash 20,000 4 Paid semiannual interest 5 and amortized premium 6 7 8 9 10 11

  29. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Dec. 31 9,400 Bond Interest Expense 1 Premium on Bonds Pay. 600 2 3 Bond Interest Payable 10,000 4 5 At year end, 3 months of accrued Interest Expense and Premium Amortization are recognized. 6 7 8 9 10 11

  30. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Dec. 31 9,400 Bond Interest Expense 1 Premium on Bonds Pay. 600 2 3 Bond Interest Payable 10,000 4 5 This entry will be reversed January 1. 6 7 8 9 10 11

  31. PREMIUM AMORTIZATION Interest Expense Debit Premium on Bonds Payable Bonds Payable Balance Premium on Bonds Payable Balance Carrying Value of Bonds Cash Credit Date 4/1/-1 $400,000 $24,000 $424,000 When the bonds are issued the Carrying Value is $424,000. $400,000 face value + $24,000 premium

  32. PREMIUM AMORTIZATION Interest Expense Debit Premium on Bonds Payable Bonds Payable Balance Premium on Bonds Payable Balance Carrying Value of Bonds Cash Credit Date 4/1/-1 $400,000 $24,000 $424,000 10/1/-1 $18,800 $1,200 $1,200 of the Premium is amortized every six months.

  33. PREMIUM AMORTIZATION Interest Expense Debit Premium on Bonds Payable Bonds Payable Balance Premium on Bonds Payable Balance Carrying Value of Bonds Cash Credit Date 4/1/-1 $400,000 $24,000 $424,000 10/1/-1 $18,800 $1,200 $20,000 400,000 22,800 422,800 The carrying value is reduced by $1,200 every six months.

  34. PREMIUM AMORTIZATION Interest Expense Debit Premium on Bonds Payable Bonds Payable Balance Premium on Bonds Payable Balance Carrying Value of Bonds Cash Credit Date By the maturity date of the bond, the premium is gone and the carrying value has reached the face value of the bond. 4/1/-1 $400,000 $24,000 $424,000 10/1/-1 $18,800 $1,200 $20,000 400,000 22,800 422,800 4/1/-2 18,800 1,200 20,000 400,000 21,600 421,600 10/1/-2 18,800 1,200 20,000 400,000 20,400 420,400 4/1/10 18,800 1,200 20,000 400,000 2,400 402,400 10/1/10 18,800 1,200 20,000 400,000 1,200 401,200 400,000 4/1/11 18,800 1,200 20,000 400,000 0

  35. ISSUING BONDS AT A DISCOUNT EXAMPLE: On April 1, 20-1 the stated rate of 10% is LESS than the current market rate, so Watkin Corp. will sell the $400,000, 10-year bonds at 96. x $400,000 96% $384,000 Bonds will sell for

  36. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Apr. 1 Cash 384,000 1 2 Discount on Bonds Pay. 16,000 3 Bonds Payable 400,000 4 5 Discount on Bonds Payable is a contra-liability account. 6 7 8 9 10 11

  37. Balance Sheet (Partial) Long-term liabilities: Bonds Payable $400,000 Discount on Bonds Payable 16,000 $384,000 Bonds Payable - Discount = Carrying Value

  38. ISSUING BONDS AT A DISCOUNT EXAMPLE: On April 1, 20-1 the stated rate of 10% is LESS than the current market rate, so Watkin Corp. will sell the $400,000, 10-year bonds at 96. x x $400,000 10% 1/2 $20,000 every 6 months Interest Payments Selling bonds at a discount, does not affect the amount of interest paid.

  39. ISSUING BONDS AT A DISCOUNT EXAMPLE: On April 1, 20-1 the stated rate of 10% is LESS than the current market rate, so Watkin Corp. will sell the $400,000, 10-year bonds at 96. $16,000 Discount will be amortized over the life of the bond. $16,000 $800 x = 1/2 10 years

  40. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Bond Interest Expense Oct. 1 20,800 1 Discount on Bonds Pay. 2 800 3 Cash 20,000 4 Paid semiannual interest 5 and amortized discount 6 Discount amortization increases the interest expense. 7 8 9 10 11

  41. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Dec. 31 10,400 Bond Interest Expense 1 Bond Interest Payable 10,000 2 3 400 Discount on Bond Pay. 4 5 At year end, 3 months of accrued Interest Expense and Discount Amortization are recognized. 6 7 8 9 10 11

  42. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT Dec. 31 10,400 Bond Interest Expense 1 Bond Interest Payable 10,000 2 3 400 Discount on Bond Pay. 4 5 This entry will be reversed January 1. 6 7 8 9 10 11

  43. DISCOUNT AMORTIZATION Interest Expense Debit Discount on Bonds Payable Bonds Payable Balance Discount on Bonds Payable Balance Carrying Value of Bonds Cash Credit Date 4/1/-1 $400,000 $16,000 $384,000 10/1/-1 $20,800 $800 $20,000 400,000 15,200 384,800 Every 6 months, the discount is reduced by $800, causing the Carrying Value to rise by $800.

  44. DISCOUNT AMORTIZATION Interest Expense Debit Discount on Bonds Payable Bonds Payable Balance Discount on Bonds Payable Balance Carrying Value of Bonds Cash Credit Date 4/1/-1 $400,000 $16,000 $384,000 At the maturity date of the bond, the discount is gone and the carrying value is now equal to the face value. 10/1/-1 $20,800 $800 $20,000 400,000 15,200 384,800 4/1/-2 20,800 800 20,000 400,000 14,400 385,600 10/1/-2 20,800 800 20,000 400,000 13,600 386,400 4/1/10 20,800 800 20,000 400,000 1,600 398,400 10/1/10 20,800 800 20,000 400,000 800 399,200 400,000 4/1/11 20,800 800 20,000 400,000 0

  45. BOND REDEMPTION • Corporations may redeem bonds: • At maturity date • By paying the face value of the note • Before maturity • By paying the call price if “callable” • Or market price if not callable • Usually results in a gain or a loss • Difference between the amount paid to redeem the bonds and the carrying value of the bonds

  46. BOND REDEMPTION EXAMPLE: Watkin Corp. redeems $40,000 of the $400,000 of bonds that were sold at face value. The $40,000 of bonds were redeemed at 103. $41,200 $40,000 x 103 = Watkin will pay $41,200 to redeem $40,000 of bonds…. $1,200 LOSS

  47. GENERAL JOURNAL DATE DESCRIPTION DEBIT PR CREDIT 40,000 Bonds Payable 1 Loss on Bonds Redeemed 1,200 2 3 41,200 Cash 4 5 What if these bonds had originally been sold at a 106 (Premium)? 6 7 8 9 10 11

  48. BOND REDEMPTION To determine if there is a gain or loss, we must compare the Carrying Value at the time of redemption with the amount paid to redeem the bonds. Carrying Value = + Unamortized Premium Face Value $40,000 + We must determine how much of the premium remains unamortized at the date of redemption (8 years later).

  49. UNAMORTIZED PREMIUM Bonds were originally sold at $42,400 $40,000 x 106

  50. UNAMORTIZED PREMIUM Bonds were originally sold at $42,400 40,000 Face Value $ 2,400 Premium Amortized over 10 years ÷ $ 240 per year x 8 years $ 1,920 Amortized so far $2,400 premium - $1,920 amortized so far = $480 remaining unamortized

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