May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part... May not be scanned, copied or duplicated, or posted to a publicly accessible
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Nature of Bonds Payable
• A bond is a form of interest-bearing note Like a note, a bond requires periodic interest
payments, with the face amount to be repaid at the maturity date.
• As creditors of the corporation, bondholder
claims on the corporation’s assets rank ahead of stockholders.
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Bond Characteristics and Terminology
(slide 1 of 2)
• A bond issue is normally divided into a number of
individual bonds.
• The face amount of each bond, called the principal, is
usually $1,000 or a multiple of $1,000 The principal
must be repaid on the dates the bonds mature.
• The interest on bonds may be payable annually,
semiannually, or quarterly
o Most bonds pay interest semiannually.
• The underlying contract between the company issuing bonds and the bondholders is called a bond indenture
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Bond Characteristics and Terminology
(slide 2 of 2)
• The two most common types of bonds are term bonds and serial bonds.
o When all bonds of an issue mature at the same time, they are
called term bonds.
o If the bonds mature over several dates, they are called serial
bonds.
• There are also a variety of more complicated bond
structures.
o Bonds that may be exchanged for shares of common stock are
called convertible bonds.
o Bonds that may be redeemed by the corporation prior to maturity
are called callable bonds.
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Proceeds from Issuing Bonds
o The interest rate on the bonds.
o The market rate of interest for similar bonds.
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Proceeds from Issuing Bonds
• The market rate of interest , sometimes called the
effective rate of interest , is the rate determined from sales and purchases of similar bonds
o The market rate of interest is affected by a variety of factors, including investors’ expectations of current and future economic conditions.
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Proceeds from Issuing Bonds
(slide 3 of 5)
• By comparing the market and contract rates of interest, it can be determined whether the bonds will sell for more than, less than, or at their face amount.
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Proceeds from Issuing Bonds
(slide 4 of 5)
• If the market rate equals the contract rate, bonds will sell at the face amount
• If the market rate is greater than the contract
rate, the bonds will sell for less than their face
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Proceeds from Issuing Bonds
(slide 5 of 5)
• The price of a bond is quoted as a percentage of the bond’s face value.
o For example, a $1,000 bond quoted at 98 could be
purchased or sold for $980 ($1,000 × 0.98).
o Likewise, bonds quoted at 109 could be purchased or sold for $1,090 ($1,000 × 1.09).
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Accounting for Bonds Payable
• When bonds are issued at less or more than
their face amount, the discount or premium must
be amortized over the life of the bonds At the
maturity date, the face amount must be repaid.
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Bonds Issued at Face Amount
(slide 1 of 3)
• Assume that on January 1, Year 1, Eastern Montana Communications Inc issued the
following bonds:
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Bonds Issued at Face Amount
(slide 2 of 3)
• Since the contract rate of interest and the market rate of interest are the same, the bonds will sell
at their face amount The entry to record the
issuance of the bonds is as follows:
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Bonds Issued at Face Amount
(slide 3 of 3)
• Every six months (on June 30 and December 31) after the bonds are issued, interest of $6,000 ($100,000 × 12% × ½ year) is paid The first interest payment on June 30, Year 1, is recorded as
follows:
• At the maturity date, the payment of the principal of $100,000 is recorded as follows:
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Bonds Issued at a Discount
(slide 1 of 2)
• Assume that on January 1, Year 1, Western Wyoming Distribution Inc issued the following bonds:
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Bonds Issued at a Discount
(slide 2 of 2)
• Because the contract rate of interest is less than the
market rate of interest, the bonds will sell at less than their face amount Assuming the bonds sell for $96,406, the entry to record the issuance of the bonds is as
follows:
Discount on Bonds Payable is a contra account to Bonds Payable and has a normal debit balance It is subtracted from Bonds Payable to determine the carrying amount (or book value) of the bonds payable The carrying amount of bonds payable is the face amount of the bonds less any unamortized discount or plus any unamortized premium Thus, the carrying amount of the bonds payable is $96,406 ($100,000 – $3,594).
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Amortizing a Bond Discount
(slide 1 of 4)
• Every period, a portion of the bond discount
must be reduced and added to interest expense
to reflect the passage of time This process,
called amortization , increases the contract rate
of interest on a bond to the market rate of
interest that existed on the date the bonds were issued.
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Amortizing a Bond Discount
(slide 2 of 4)
• The entry to amortize a bond discount is as follows:
• The preceding entry may be made annually as an adjusting entry, or it may be combined with the
semiannual interest payment.
o In the latter case, the entry would be as follows:
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Amortizing a Bond Discount
(slide 3 of 4)
• The two methods of computing the amortization
of a bond discount are:
o Straight-line method
o Effective interest rate method, sometimes called the interest method
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Amortizing a Bond Discount
(slide 4 of 4)
• 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
effective interest method
• The straight-line method of amortization
provides equal amounts of discount (or
premium) to be written off to interest expense
each period.
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Bonds Issued at a Premium
(slide 1 of 2)
• Assume that on January 1, Year 1, Northern Idaho Transportation Inc issued the following bonds:
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Bonds Issued at a Premium
(slide 2 of 2)
• Because the contract rate of interest is more than the
market rate of interest, the bonds will sell for more than their face amount Assuming the bonds sell for $103,769, the entry to record the issuance of the bonds is as
follows:
Premium on Bonds Payable has a normal credit balance It is added to Bonds Payable
to determine the carrying amount (or book value) of the bonds payable Thus, the
carrying amount of the bonds payable is $103,769 ($100,000 + $3,769).
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Amortizing a Bond Premium
bonds were issued.
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Amortizing a Bond Premium
(slide 2 of 2)
• The entry to amortize a bond premium is as follows:
• The preceding entry may be made annually as an adjusting entry, or it may be combined with the
semiannual interest payment.
o In the latter case, the entry would be as follows:
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o In such cases, the corporation may issue new bonds
at a lower interest rate and use the proceeds to
redeem the original bond issue.
• Callable bonds can be redeemed by the issuing
corporation within the period of time and at the price stated in the bond indenture
o Normally, the call price is above the face value
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Bond Redemption
(slide 2 of 2)
• A corporation usually redeems its bonds at a price
different from the carrying amount (or book value) of the bonds
• A gain or loss may be realized on a bond redemption as follows:
o A gain is recorded if the price paid for redemption is below the
bond carrying amount.
o A loss is recorded if the price paid for the redemption is above
the carrying amount
• Gains and losses on the redemption of bonds are
reported in the Other income (loss) section of the income
statement.
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Reporting Bonds Payable
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Reporting Bonds Payable
• A description of the bonds should also be
reported either on the face of the financial
statements or in the accompanying notes.
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Analysis for Decision Making:
Times Interest Earned
• Analysts assess the risk that bondholders will not receive their interest payments by computing the times interest earned ratio during the year as follows:
Income Expense
• This ratio computes the number of times interest
payments could be paid out of current-period earnings.
• High values of this ratio are considered favorable,
whereas low values are considered unfavorable.
o Values of this ratio less than 1.0 suggest that the firm is unable
to cover interest payments from current-period income before tax.
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Appendix 1: Present Value Concepts
and Pricing Bonds Payable
(slide 1 of 2)
• When a corporation issues bonds, the price that investors are willing to pay for the bonds
depends on the following:
o The face amount of the bonds, which is the amount due at the maturity date.
o The periodic interest to be paid on the bonds
o The market rate of interest.
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Appendix 1: Present Value Concepts
and Pricing Bonds Payable
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Appendix 1: Present Value Concepts
• The concept of present value is based on the time value of money.
o The time value of money concept recognizes that
cash received today is worth more than the same amount of cash to be received in the future.
• Present value is the current worth of a future sum of money or stream of cash flows given a specified rate of return.
• The amount to be received in the future if you make a deposit now is the future value
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Appendix 1: Present Value of an Amount
• The present value of an amount to be received
in the future can be determined by a series of divisions or by using a table of present values.
o The present value of $1 table is used to find the
present value factor of $1 to be received after a
number of periods in the future The amount to be received is then multiplied by this factor to determine its present value.
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Appendix 1: Present Value of an Annuity
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Appendix 1: Present Value of an Annuity
(slide 2 of 2)
• A present value of an annuity of $1 table can be
used to find the present value of an annuity.
o The present value of an annuity is calculated by
multiplying the equal cash payment times the
appropriate present value of an annuity of $1.
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Appendix 1: Pricing Bonds
• The selling price of a bond is the sum of the present values of:
o The face amount of the bonds due at the maturity date
o The periodic interest to be paid on the bonds
• The market rate of interest is used to compute the present value of both the face amount and the periodic interest.
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Appendix 2: Effective Interest
Rate Method of Amortization
(slide 1 of 2)
• The effective interest rate method of
amortization provides for a constant rate of
interest over the life of the bonds.
o This is in contrast to the straight-line method, which
provides for a constant amount of interest expense
each period.