acct 201 acct 201 acct 201 1 reporting and analyzing long-term liabilities uaa – acct 201...

Reporting and Analyzing Long-Term Liabilities

UAA – ACCT 201 Principles of Financial

Accounting Dr. Fred Barbee

Topic LO Read HW

Basics of BondsA1, C1

422-425

Bond IssuancesP1, P2, P3

425-436

E1,2,3, 4,5,6;

Present Value of Bonds and Notes

C3, C4

445-448

Chapter 10 - Day 1 - Agenda

No Homework Due Today!

Basics of Bonds

Bond Issue Date

Bond Certificateat Par Value

Bond Selling Price

Company Investors

ACCT 201 ACCT 201 ACCT 201

Basics of Bonds

Bond Issue Date

Company Investors

Basics of Bonds

Bond Interest Payments

Interest Payment = Bond Par Value x

Stated Interest Rate

Bond Interest Payments

Bond Issue Date

Company Investors

Basics of Bonds

Bond Par Value at maturity

Bond Maturity

Advantages of Bonds

Bonds do not affect

owner control.

Interest on bonds is

tax deductible.

Bonds can increase

Disadvantages of Bonds

Bonds require periodic

payment of interest.

Bonds require payment of principal at maturity.

Bonds can decrease ROE.

Types of

Secured and

Unsecured

Registered and

Bearer

Term and Serial

Convertible and Callable

Bond market values are expressed as a percent of their par

value.

Bond Trading

Bond Issuances

A trustee monitors the bond issue.

An investment firm called an underwriter.

A company sells the bonds to. . .

. . . investors

Bond Issuing Procedures

The underwriter The underwriter sells the bonds to . sells the bonds to . . .. .

Interest Rates and the Issue Price

The Market Rate . . .

The rate of interest currently being demanded in the market, i.e., the rate that investors expect to earn on their investment.

The market rate is often referred to by other terms . . .

The Effective Rate

The Yield

The rate used to compute the present values of the two components of the price of a bond:

The Present Value of the interest payments; and

The Present Value of the face value at maturity.

The Contract Rate . . .

The interest rate specified on the face of the bond and in the bond indenture.

The contract rate is often referred to by other names:

The Stated Rate

The Nominal Rate

The Coupon Rate

The contract rate is used only to calculate the amount of interest to be paid to the bondholders at each interest period.

Interest Rates and the Issue Price

What Determines the Market Rate?

In most cases the market price of bonds is influenced by . . .

The riskiness of the bonds; and

The interest rate at which the bonds are issued.

Riskiness of the Bonds

The risk factor is a combination of:

The general economic conditions; and

The financial status of the company selling the bonds,

Moody’s, or

Standard and Poors

Interest Rate on the Bonds

The interest rate on the bonds is primarily determined by the riskiness of the bonds . . .

The higher the risk,

The higher the interest rate.

Issuing Bonds Payable

What Determines the Issue Price?

When issuing bonds payable, there are three possibilities. Bonds may be issued . . .

At face value (par);

At a discount (less than par); or

At a premium (greater than par).

Bonds Issued at Face Value

If the market rate is equal to the contract rate, the bonds will sell at face value (i.e., at par).

EffectiveMarketYield

CouponContractNominal

Bonds will sell at

Market Rate = Contract Rate

Bonds Issued at a Discount

If the market rate is higher than the contract rate, the bonds will sell bonds will sell at a at a discountdiscount (less than face value).

Market Rate > Contract Rate

Bonds will sell at a

Bonds Issued at a Premium

If the market rate is lower than the contract rate, the bonds will sell bonds will sell at a at a premiumpremium (more than face value)

Bonds will sell at

Market Rate < Contract Rate

Example #1

Bonds Issued At Par Value

Issuing Bonds at Par

Par Value = $1,000,000

Stated Interest Rate = 10%

Market Interest Rate = 10%

Interest Dates = 6/30 & 12/31

Bond Date = Jan. 1, 2002

Maturity Date = Dec. 31, 2021 (20 years)

Bonds Issued at Face Value

If the market rate is equal to the contract rate, the bonds will sell bonds will sell at at face valueface value (i.e., at par).

GENERAL JOURNAL Page 34Date Description PR Debit Credit

Jan. 1 Cash 1,000,000

Bonds Payable 1,000,000

The journal entry to record the issuance of bonds at par.

Jun. 30 Bond Interest Expense 50,000

Cash 50,000

$1,000,000 10%1/2

This entry will be made every six months until the bonds mature.

The journal entry to record the six-month interest payment on June 30.

Dec. 31 Bonds Payable 1,000,000

Cash 1,000,000

On Dec. 31, 202, when the bonds mature, the following entry would be

Example #2

Bonds Issued at A Discount

Issuing Bonds at a Discount

Par Value = $1,000,000, 5 YearsIssue Price = 92.6405% of par valueStated Interest Rate = 10%Market Interest Rate = 12%Interest Dates = 6/30 & 12/31Bond Date = Jan. 1, 2002Maturity Date = Dec. 31, 2006

Bonds Issued at a Discount

If the market rate is higher than the contract rate, the bonds will sell bonds will sell at a at a discount (less than face value).

Par Value

Cash Proceeds Discount

1,000,000$ - 926,405$ = 73,595$

Amortizing the discount increases Interest Expense over

the outstanding life of the bond.

$1,000,000 92.6405%$1,000,000 92.6405%

Jan. 1 Cash 926,405

Discount on Bonds Payable 73,595

Contra-LiabilityAccount

On Jan. 1, 2002, the bond issue would be recorded as follows.

Partial Balance Sheet as of Jan. 1, 2002

Long-term Liabilities: Bonds Payable 1,000,000$ Less: Discount on Bonds Payable 73,595 926,405$

Maturity Value

Carrying Value

Using the straight-line method, the discount amortization will be $7,360 every six months.

$73,595 ÷ 10 periods = $7,360 (rounded)

Using the straight-line method, the discount amortization will be $7,360 every six months.

$73,595 ÷ 10 periods = $7,360 (rounded)

Long-term Liabilities: Bonds Payable 1,000,000$ Less: Discount on Bonds Payable 73,595 926,405$

$73,595 ÷ 10 periods = $7,360 (rounded)

$1,000,000 × 10% × ½ = $50,000

Jun. 30 Interest Expense 57,360

Discount on Bonds Payable 7,360

Cash 50,000

This entry will be made every six months to record the interest payment and the

amortization of the discount.

This entry will be made every six months to record the interest payment and the

amortization of the discount.

Straight-Line Amortization TableA B C D E

Interest Interest Discount Unamortized CarryingDate Payment Expense Amortization* Discount Value

1/1/2002 73,595$ 926,405$ 6/30/2002 50,000$ 57,360$ 7,360$ 66,235 933,765

12/31/2002 50,000 57,360 7,360 58,875 941,125

$1,000,000 x 10% x

1/2$50,000 +

$7,360

$73,595/10 = $7,360 (rounded)

$66,235 - $7,360

$1,000,000 - $58,875

Interest Interest Discount Unamortized CarryingDate Payment Expense Amortization* Discount Value

1/1/2002 73,595$ 926,405$ 6/30/2002 50,000$ 57,360$ 7,360$ 66,235 933,765

12/31/2002 50,000 57,360 7,360 58,875 941,125 6/30/2003 50,000 57,360 7,360 51,515 948,485

12/31/2003 50,000 57,360 7,360 44,155 955,845 6/30/2004 50,000 57,360 7,360 36,795 963,205

12/31/2004 50,000 57,360 7,360 29,435 970,565 6/30/2005 50,000 57,360 7,360 22,075 977,925

12/31/2005 50,000 57,360 7,360 14,715 985,285 6/30/2006 50,000 57,360 7,360 7,355 992,645

12/31/2006 50,000 57,355 7,355 0 1,000,000 500,000$ 573,595$ 73,595$

What if the company used the effective interest method to

amortize the discount?

Effective Interest Method

The effective interest method allocates bond interest expense over the life of the bonds in a way that yields a constant rate of interest.

Effective Interest Amortization TableA B C D E

Interest Interest Discount Unamortized PresentDate Payment Expense* Amortization* Discount Value1/1/2002 73,595$ 926,405$

6/30/2002 50,000$ 55,584$ 5,584$ 68,011 931,989 12/31/2002 50,000 55,919 5,919 62,092 937,908

$1,000,000 x 10% x

$931,989 x 12% x 1/2

$55,919 - $50,000

$1,000,000 - $62,092; or $931,989 + $5,919

$68,011 - $5,919

Effective Interest Amortization TableA B C D E

Interest Interest Discount Unamortized PresentDate Payment Expense* Amortization* Discount Value1/1/2002 73,595$ 926,405$

6/30/2002 50,000$ 55,584$ 5,584$ 68,011 931,989 12/31/2002 50,000 55,919 5,919 62,092 937,908 6/30/2003 50,000 56,274 6,274 55,818 944,182

12/31/2003 50,000 56,651 6,651 49,167 950,833 6/30/2004 50,000 57,050 7,050 42,117 957,883

12/31/2004 50,000 57,473 7,473 34,644 965,356 6/30/2005 50,000 57,921 7,921 26,723 973,277

12/31/2005 50,000 58,396 8,397 18,326 981,674 6/30/2006 50,000 59,426 8,900 9,426 990,574

12/31/2006 50,000 59,430 9,426 0 1,000,000 500,000$ 573,595$ 73,595$

* Rounded.

Comparing Straight-Line and Effective Interest Methods

$53,000

$54,000

$55,000

$56,000

$57,000

$58,000

$59,000

$60,000

Straight-Line Method

Effective InterestMethod

Both methods report the same amount of interest expense over the life of the bond.

Example #3

Bonds Issued at A Premium

Issuing Bonds at a Premium

Par Value = $1,000,000

Issue Price = 108.1145% of par value

Stated Interest Rate = 10%

Market Interest Rate = 8%

Interest Dates = 6/30 & 12/31

Bond Date = Jan. 1, 2002

Maturity Date = Dec. 31, 2006 (5 years)

Bonds Issued at a Premium

If the market rate is lower than the contract rate, the bonds will sell at a premium (more than face value)

Cash Proceeds Par Value Premium

1,081,145$ - 1,000,000$ = 81,145$

Amortizing the premium decreases Interest Expense

over the outstanding life of the bond.

$1,000,000 108.1145%$1,000,000

108.1145%

Jan. 1 Cash 1,081,145

Premium on Bonds Payable 81,145

Adjunct-LiabilityAccount

On Jan. 1, 2002, the company would record the bond issue as follows.

Using the straight-line method, the premium amortization will be $8,115 every six months.

$81,145 ÷ 10 periods = $8,115 (rounded)

Using the straight-line method, the premium amortization will be $8,115 every six months.

$81,145 ÷ 10 periods = $8,115 (rounded)

Long-term Liabilities: Bonds Payable 1,000,000$ Add: Premium on Bonds Payable 81,145 1,081,145$

$81,145 ÷ 10 periods = $8,115 (rounded)

$1,000,000 × 10% × ½ = $50,000

Jun. 30 Interest Expense 41,885

Premium on Bonds Payable 8,115

Cash 50,000

The semiannual interest payment over the life of the bonds.

Interest Interest Premium Unamortized CarryingDate Payment Expense Amortization* Premium Value

01/01/2002 81,145$ 1,081,145$ 06/30/2002 50,000$ 41,885$ 8,115$ 73,030 1,073,030 12/31/2002 50,000 41,885 8,115 64,915 1,064,915 06/30/2003 50,000 41,885 8,115 56,800 1,056,800 12/31/2003 50,000 41,885 8,115 48,685 1,048,685 06/30/2004 50,000 41,885 8,115 40,570 1,040,570 12/31/2004 50,000 41,885 8,115 32,455 1,032,455 06/30/2005 50,000 41,885 8,115 24,340 1,024,340 12/31/2005 50,000 41,885 8,115 16,225 1,016,225 06/30/2006 50,000 41,885 8,115 8,110 1,008,110 12/31/2006 50,000 41,890 8,110 0 1,000,000

500,000$ 418,855$ 81,145$

* Rounded.

Let’s look at the effective interest

method amortization table

for this bond.

Effective Interest Method Amortization TableA B C D E

Interest Interest Premium Unamortized PresentDate Payment Expense* Amortization* Premium Value

01/01/2002 81,145$ 1,081,145$ 06/30/2002 50,000$ 43,246$ 6,754$ 74,391 1,074,391 12/31/2002 50,000 42,976 7,024 67,367 1,067,367 06/30/2003 50,000 42,695 7,305 60,062 1,060,062 12/31/2003 50,000 42,402 7,598 52,464 1,052,464 06/30/2004 50,000 42,099 7,901 44,563 1,044,563 12/31/2004 50,000 41,783 8,217 36,346 1,036,346 06/30/2005 50,000 41,454 8,546 27,800 1,027,800 12/31/2005 50,000 41,112 8,888 18,912 1,018,912 06/30/2006 50,000 40,756 9,244 9,668 1,009,668 12/31/2006 50,000 40,332 9,668 0 1,000,000

500,000$ 418,855$ 81,145$

* Rounded.

Accrued interest Earned interest

Investor pays bond purchase

price plus accrued interest.

Investor receives 6 months’ interest.

Jan. 1, 2002 Bond Date

Bond Issue Date

First Interest Payment

Apr. 1, 2002 June 30, 2002

Issuing Bonds Between Interest Dates

Par Value = $1,000,000Stated Interest Rate = 10%Market Interest Rate = 10%Interest Dates = 6/30 & 12/31Bond Date = Jan. 1, 2002Maturity Date = Dec. 31, 2006 (5 years)

How much cash will the company receive for the entire issue of the bonds?

What does the $25,000 in accrued interest represent for the company?

Prepare the journal entry to

record the bond issue on April 1, 2002.

Prepare the journal entry to

record the bond issue on April 1, 2002.

Here is the journal entry to record the bond issue on April 1, 2002.

Apr. 1 Cash 1,025,000

Interest Payable 25,000

Now, prepare the entry for June 30, 2002.

Here is the entry to record the interest payment on June 30, 2002.

Jun. 30 Interest Payable 25,000

Interest Expense 25,000

Cash 50,000

$1,000,000 × 10% × ½ = $50,000$1,000,000 × 10% × ½ = $50,000

Jan. 1 Apr. 1 Dec. 31

End of accounting

periodOct. 1

Interest Payment Dates

At year-end, an adjusting entry is necessary to recognize bond interest

expense accrued since the most recent interest payment.

At year-end, an adjusting entry is necessary to recognize bond interest

expense accrued since the most recent interest payment.

3 months’ accrued interest

Accruing Bond Interest Expense

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