chapter twenty-four corporations: bonds. bonds 4def. - a written promise to pay a specific sum of...

CHAPTER TWENTY-FOUR

CORPORATIONS: BONDS

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• Enabling corporation to obtain large amounts of

money by selling bonds to many investorsBonds can be classified as to:

• Security• Timing of payment of principal• Identification of ownership

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”

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

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

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%?





If our bonds offer only 10% andother bonds are offering 11%,

investors will not want our bonds.





Sell at aDISCOUNT





If the market rate is only 9%….bonds will sell at a

PREMIUM.


EXAMPLE: Watkin Corp. wants to sell $400,000 of 10%, 10-year bonds.

Stated Rate = Market Rate, = Face Valuethe Selling Price….When...

Stated Rate > Market Rate, > Face Value(Premium)

Stated Rate < Market Rate, < Face Value(Discount)

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 theissuance journal entry.

GENERAL JOURNALDATE DESCRIPTION PR DEBIT CREDIT

Cash1234

567

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Bonds Payable is reported as along-term liability on the balance sheet.

400,000

Bonds Payable 400,000Issued bonds at face value

Apr. 1

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

$400,000 x 10%

$40,000/year

Since interest paymentsare paid every 6 months,1/2 of the yearly interestis paid in each payment.


Bond Interest Expense1234

567

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Since the next interest payment will beafter the year end, we must stop

at year end and record the accrued interest.

20,000Cash 20,000

Paid semiannual intereston bonds

Oct. 1



567

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10,000Dec. 31

October 1 - December 31 = 3 months$400,000 x 10% = $40,000/year

$40,000 x 1/4 year(3 months) = $10,000



567

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10,000Dec. 31Bond Interest Payable 10,000



567

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10,000Jan. 1 Bond Interest Payable10,000

The adjustment isreversed on January 1.

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 106%

Bonds will sell for $424,000


Cash1234

567

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424,000

Bonds Payable 400,000Apr. 1

Bonds Payable is recorded atthe FACE VALUE of the bonds.


Cash1234

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424,000

Bonds Payable 400,000Apr. 1

Premium on Bonds Payable is an adjunct-liability account.

24,000Premium on Bonds Pay.

Balance Sheet (Partial)Long-term liabilities:

Bonds Payable $400,000Premium on Bonds Payable 24,000 $424,000

Bonds Payable + Premium =Carrying Value



$400,000 x 10% x 1/2 = $20,000 Interest payment

Selling at a premium doesnot affect the amount of the

interest payments.




But this is not the Interest Expense recognized every 6 months.




$24,000 Premium received reduces the amount of interest expense

Premium is amortizedover the life of the bond.

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

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:

PremiumLife of Bonds x 1/2 Year

$24,00010 Years x 1/2 Year = $1,200



567

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18,800Oct. 1

Interest Payment - Amortization of Premium$20,000 - $1,200



567

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18,800Premium on Bonds Pay. 1,200

Paid semiannual interest

Oct. 1

Cash 20,000

and amortized premium



567

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9,400Dec. 31

Bond Interest Payable 10,000

At year end, 3 months ofaccrued Interest Expense

and Premium Amortizationare recognized.

Premium on Bonds Pay. 600



567

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9,400Dec. 31

Bond Interest Payable 10,000

This entry will bereversed January 1.

Premium on Bonds Pay. 600

PREMIUM AMORTIZATION

Date

Interest Expense

Debit

Premium on Bonds Payable

Cash Credit

Bonds Payable Balance


Balance

Carrying Value of Bonds

4/1/-1 $400,000 $24,000 $424,000

When the bonds are issuedthe Carrying Value is $424,000.

$400,000 face value + $24,000 premium


Date

Interest Expense

Debit


Cash Credit



Balance


4/1/-1$18,800 $1,200

$400,000 $24,000 $424,00010/1/-1

$1,200 of the Premium isamortized every six months.


Date

Interest Expense

Debit


Cash Credit



Balance


4/1/-1$18,800 $1,200 $20,000

$400,000 $24,000 $424,000400,00010/1/-1 22,800 422,800

The carrying value is reducedby $1,200 every six months.


Date

Interest Expense

Debit


Cash Credit



Balance


4/1/-1$18,800 $1,200 $20,000

$400,000 $24,000 $424,000400,00010/1/-1 22,800 422,800

4/1/-2 18,800 1,200 20,000 400,000 21,600 421,60010/1/-2 18,800 1,200 20,000 400,000 20,400 420,400

4/1/10 18,800 1,200 20,000 400,000 2,400 402,40010/1/10 18,800 1,200 20,000 400,000 1,200 401,200

4/1/11 18,800 1,200 20,000 400,000 0 400,000

By the maturity date of the bond,the premium is gone and the

carrying value has reached theface value of the bond.

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.

$400,000 x 96%

Bonds will sell for $384,000


Cash1234

567

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384,000

Bonds Payable 400,000

Apr. 1

Discount on Bonds Payableis a contra-liability account.

Discount on Bonds Pay. 16,000

Balance Sheet (Partial)Long-term liabilities:

Bonds Payable $400,000Discount on Bonds Payable 16,000 $384,000

Bonds Payable - Discount =Carrying Value


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.

$400,000 x 10%

Interest Payments $20,000 every 6 months

x 1/2

Selling bonds at a discount,does not affect the amount

of interest paid.


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.

$16,00010 years

x 1/2 $800=



567

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20,800Discount on Bonds Pay. 800

Paid semiannual interest

Oct. 1

Cash 20,000

and amortized discount

Discount amortizationincreases the interest expense.



567

89

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At year end, 3 months ofaccrued Interest Expense

and Discount Amortizationare recognized.

400Discount on Bond Pay.



567

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This entry will bereversed January 1.

400Discount on Bond Pay.

DISCOUNT AMORTIZATION

Date

Interest Expense

Debit

Discount on Bonds Payable

Cash Credit



Balance


4/1/-1$20,800 $800 $20,000

$400,000 $16,000 $384,000400,00010/1/-1 15,200 384,800

Every 6 months, the discount isreduced by $800, causing the

Carrying Value to rise by $800.

DISCOUNT AMORTIZATION

Date

Interest Expense

Debit


Cash Credit



Balance


4/1/-1$20,800 $800 $20,000

$400,000 $16,000 $384,000400,00010/1/-1 15,200 384,800

4/1/-2 20,800 800 20,000 400,000 14,400 385,60010/1/-2 20,800 800 20,000 400,000 13,600 386,400

4/1/10 20,800 800 20,000 400,000 1,600 398,40010/1/10 20,800 800 20,000 400,000 800 399,200

4/1/11 20,800 800 20,000 400,000 0 400,000

At the maturity date of the bond, the discount is gone and the carrying value is now equal

to the face value.

BOND REDEMPTION

Corporations may redeem bonds:At maturity date

• By paying the face value of the noteBefore 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

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.

$40,000 x =103 $41,200

Watkin will pay $41,200 to redeem $40,000 of bonds….

$1,200 LOSS


Bonds Payable1234

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40,000Loss on Bonds Redeemed 1,200

What if these bonds had originally been sold at a 106 (Premium)?

41,200Cash

BOND REDEMPTIONTo 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.

Face Value + Unamortized PremiumCarrying Value =

$40,000 +

We must determine how much of the premium remains unamortized

at the date of redemption (8 years later).

UNAMORTIZED PREMIUM

$42,400Bonds were

originally sold at

$40,000 x 106

UNAMORTIZED PREMIUM

$42,400Bonds were

originally sold at Face Value 40,000

Premium $ 2,400Amortized over 10 years

$ 240 per year8

÷

x years$ 1,920Amortized so far

$2,400 premium - $1,920 amortized so far= $480 remaining unamortized


Face Value + Unamortized PremiumCarrying Value =

$40,000 +

Carrying Value of $40,480; butcash paid to redeem the bonds is

$41,200 ($40,000 x 103)….$720 LOSS

$480


Bonds Payable1234

567

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40,000

Loss on Bonds Redeemed480

41,200Cash

Premium on Bonds Pay.720

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 97.

$40,000 x =97 $38,800

Watkin will pay $38,800 to redeem $40,000 of bonds….

$1,200 GAIN


Bonds Payable1234

567

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40,000Gain on Bonds Redeem. 1,200

What if these bonds had originally been sold at 96 (Discount)?

38,800Cash


Face Value - Unamortized DiscountCarrying Value =

$40,000 -

We need to determine how muchof the discount remains unamortized

at the time of redemption.

UNAMORTIZED DISCOUNT

$38,400Bonds were

originally sold at

$40,000 x 96

UNAMORTIZED DISCOUNT

$38,400Bonds were

originally sold at Face Value 40,000

Discount $ 1,600Amortized over 10 years

$ 160 per year6

÷

x years$ 960Amortized so far

$1,600 discount - $960 amortized so far= $640 remaining unamortized


Face Value - Unamortized DiscountCarrying Value =

$40,000 -

Carrying Value is $39,360; butcash paid to redeem the bonds is

$38,800 ($40,000 x 97)….$560 GAIN

$640


Bonds Payable1234

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40,000

Gain on Bonds Redeem.640

38,800Cash

Discount on Bonds Pay.560

BOND SINKING FUNDS

Required by the Bond Indenturewritten agreement for

issuing bonds Issuer must

accumulate and invest funds over a period of years

To provide the amount at maturity

BOND SINKING FUNDS

EXAMPLE: Watkin Corp. is required to make deposits of $30,000 to a trustee each year.

Let’s look that the journal entry.


Bonds Sinking Fund1234

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30,000Cash 30,000

Watkin’s trustee reportsearnings of $2,800 for the year.



567

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30,000Cash 30,000

Bonds Sinking Fund 2,800Sinking Fund Earnings 2,800

Watkin bonds are redeemedat maturity by the trustee….



567

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30,000Cash 30,000


Bonds Payable 400,000Bond Sinking Fund 400,000

$960 is remaining in the sinking fundafter the bonds are redeemed.



567

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30,000Cash 30,000


Bonds Payable 400,000Bond Sinking Fund 400,000

Bond Sinking FundCash 960

960

chapter twenty-four corporations: bonds. bonds 4def. - a written promise to pay a specific sum of...

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