Financial accounting IFRS 4 kieoso ch11 PPT

• Board of directors must stipulate number of bonds to be authorized, total face value, and contractual interest rate • Terms of bond are set forth in a legal document called a bond ind

Chapter Outline

Learning Objectives

LO 1 Describe the major characteristics of bonds

LO 2 Explain how to account for bond transactions

LO 3 Explain how to account for other non-current

liabilities

LO 2 Discuss how non-current liabilities are reported

and analyzed

Learning Objective 1

Describe the Major Characteristics of

Bonds

Overview of Bonds

Bonds are a form of interest-bearing notes payable

issued by corporations, universities, and governmental

agencies

Sold in small denominations (usually $1,000 or multiples

of $1,000)

When a company issues bonds, it is borrowing money

The person who buys the bonds (the bondholder) is

investing in bonds

Types of Bonds (1 of 2)

Secured and Unsecured Bonds

• Secured bonds have specific assets of issuer pledged

as collateral for bonds

• Unsecured bonds are issued against general credit

of borrower

Types of Bonds (2 of 2)

Convertible and Callable Bonds

• Convertible bonds can be

converted into ordinary shares at

bondholder’s option

• Callable bonds can be redeemed

(bought back), by issuing company,

at a stated dollar amount prior to

maturity

• Board of directors must stipulate number of bonds to

be authorized, total face value, and contractual

interest rate

• Terms of bond are set forth in a legal document called

a bond indenture

Issuing Procedures (2 of 3)

• Bond certificate

 Issued to investor

 Provides name of the issuer, face value,

contractual interest rate, and maturity date

• Face value - principal due at maturity

• Maturity date - date final payment is due

• Contractual interest rate – annual rate used to

determine cash interest paid, also referred to as the

stated rate

Issuing Procedures (3 of 3)

Bond Trading

• Bondholders can sell their bonds at any time on

national securities exchanges

• Bonds prices are quoted as a percentage of face value

• Corporation makes journal entries only when it issues

or buys back bonds, or when bondholders convert

bonds into common stock

• Market information for bonds:

Issuer Maturity Close Yield Est Volume (000)

Boeing Co 5.125 Feb 15, 2020 96.595 5.747 33,965

Determining the Market Price of a

Bond

Current market price (present value) of a bond is a

function of three factors:

1 dollar amounts to be received,

2 length of time until amounts are received, and

3 market rate of interest

The process of finding the present value is referred to as discounting the future amounts

Illustration: Assume that Acropolis SA on January 1, 2020,

issues €100,000 of 9% bonds, due in five years, with interest payable annually at year-end.

Present value of €100,000 received in 5 years € 64,993 Present value of €9,000 received annually for 5 years 35,007

Determining the Price of a Bond

Do It! 1: Bond Terminology

State whether each of the following statements is true or false.

1 Mortgage bonds and sinking fund bonds are both

2 Unsecured bonds are also known as debenture

3 The stated interest rate is the rate investors demand for

4 The face value is the amount of principal the issuing

company must pay at the maturity date. True

5 The bond issuer must make journal entries to record

transfers of its bonds among investors. False

Learning Objective 2

Explain How to Account for Bond

Transactions

Accounting for Bond Transactions

• A company records bond transactions when

 it issues (sells) or redeems (buys back) bonds

 bondholders convert bonds into ordinary shares

• Bonds may be issued at

 face value

 below face value (discount)

 above face value (premium)

• Bond prices are quoted as a percentage of face value

Issuing Bonds (1 of 2)

Review Question

The market interest rate:

a is the contractual interest rate used to

determine the amount of cash interest paid by the borrower

b is listed in the bond indenture

c is the rate investors demand for loaning funds

d more than one of the above is true

Issuing Bonds (2 of 2)

Review Question

The market interest rate:

a is the contractual interest rate used to

determine the amount of cash interest paid by the borrower

b is listed in the bond indenture

c is the rate investors demand for loaning funds

d more than one of the above is true

Issuing Bonds at Face Value (1 of 2)

Illustration: On January 1, 2020, Candlestick AG issues

€100,000, five-year, 10% bonds at 100 (100% of face value) The entry to record the sale is:

Prepare the entry Candlestick would make to accrue interest

Issuing Bonds at Face Value (2 of 2)

Prepare the entry Candlestick would make to pay the interest

on Jan 1, 2021.

Jan 1 Interest Payable 10,000

Discount or Premium on Bonds (1 of 3)

Interest Rates and Bond Prices

Discount or Premium on Bonds (2 of 3)

Review Question

Karson Ltd issues 10-year bonds with a maturity value of £200,000

If the bonds are issued at a premium, this indicates that:

a the contractual interest rate exceeds the market interest

rate.

b the market interest rate exceeds the contractual interest

rate

c the contractual interest rate and the market interest rate

are the same.

d no relationship exists between the two rates.

Discount or Premium on Bonds (3 of 3)

Review Question

Karson Ltd issues 10-year bonds with a maturity value of £200,000

If the bonds are issued at a premium, this indicates that:

a the contractual interest rate exceeds the market interest

rate.

b the market interest rate exceeds the contractual interest

rate

c the contractual interest rate and the market interest rate

are the same.

d no relationship exists between the two rates.

Issuing Bonds at a Discount (1 of 2)

Illustration: Assume that on January 1, 2020, Candlestick

AG sells €100,000, five-year, 10% bonds for €98,000 (98% of face value) Interest is payable annually on January 1 The entry to record the issuance is as follows.

Bonds Payable 98,000

Issuing Bonds at a Discount (2 of 2)

Statement Presentation

Candlestick AG Statement of Financial Position (partial)

The issuing company must pay not only the contractual interest

rate over the term of the bonds but also the face value (rather

than the issuance price) at maturity

Non-current liabilities

Total Cost of Borrowing (1 of 2)

Bonds Issued at a Discount

Annual interest payments

(€100,000 × 10% = €10,000; €10,000 × 5) €50,000 Add: Bond discount (€100,000 − €98,000) 2,000

Bonds Issued at a Discount

Principal at maturity €100,000 Annual interest payments (€10,000 × 5) 50,000 Cash to be paid to bondholders 150,000 Less: Cash received from bondholders 98,000

Issuing Bonds at a Discount

Amortization of bond discount:

• Allocated to expense in each period

• Increases amount of interest expense reported each

period

• Amount of interest expense reported each period will

exceed contractual amount paid

• As discount is amortized, its balance declines

• Carrying value of bonds will increase, until at maturity

carrying value of bonds equals their face amount

Issuing Bonds at a Premium (1 of 2)

Illustration: Assume that the Candlestick AG bonds

previously described sell for €102,000 (102% of face value) rather than for €98,000 The entry to record the sale is as

follows:

Bonds Payable 102,000

Issuing Bonds at a Premium (2 of 2)

Statement Presentation

The borrower is not required to pay the bond premium at the

maturity date of the bonds Thus, the bond premium is considered

to be a reduction in the cost of borrowing.

Candlestick AG Statement of Financial Position (partial)

Non-current liabilities

Total Cost of Borrowing (2 of 2)

Bonds Issued at a Premium

Annual interest payments Blank

(€100,000 × 10% = €10,000; €10,000 × 5) €50,000 Add: Bond discount (€102,000 − €100,000) 2,000

Bonds Issued at a Premium

Principal at maturity €100,000 Annual interest payments (€10,000 × 5) 50,000 Cash to be paid to bondholders 150,000 Less: Cash received from bondholders 102,000

Total cost of borrowing € 48,000

Issuing Bonds at a Premium

Amortization of bond premium:

• Allocated to expense in each period

• Decreases amount of interest expense reported each

period

• Amount of interest expense reported each period will be

less than contractual amount paid

• As premium is amortized, its balance declines

• Carrying value of bonds will decrease, until at maturity

carrying value of bonds equals their face amount

Do It! 2a: Bond Issuance

Giant Ltd issues ¥200,000,000 of bonds for ¥189,000,000 (a) Prepare the journal entry to record the issuance of the

bonds, and (b) show how the bonds would be reported on the statement of financial position at the date of issuance

b Non-current liabilities

Bonds payable ¥189,000,000

Redeeming Bonds at Maturity

Candlestick AG records the redemption of its bonds at

maturity as follows:

Jan 1 Bonds Payable 100,000

Redeeming Bonds before Maturity (1 of 2)

When a company retires bonds before maturity, it is

necessary to:

1 eliminate carrying value of bonds at redemption date

2 record cash paid

3 recognize gain or loss on redemption

The carrying value of the bonds is the face value of the

bonds less unamortized bond discount or plus

unamortized bond premium at the redemption date

Redeeming Bonds before Maturity (2 of 2)

Illustration: Assume at the end of the fourth period, Candlestick

AG having sold its bonds at a premium, retires the bonds at 103 after paying the annual interest Assume that the carrying value

of the bonds at the redemption date is €100,476 Candlestick

records the redemption at the end of the fourth interest period (January 1, 2024) as follows:

Jan 1 Bonds Payable 100,476

Loss on Bond Redemption 2,524

Do It! 2b: Bond Redemption

R & B Ltd issued £500,000, 10-year bonds at a discount Prior

to maturity, when the carrying value of the bonds is £496,000, the company redeems the bonds at 98 (£500,000 × 98% =

£490,000) Prepare the entry to record the redemption of the

bonds.

Bonds Payable 496,000

Gain on Bond Redemption 6,000

Learning Objective 3

Explain How to Account for Other Current Liabilities

Non-Long-Term Notes Payable

• May be secured by a mortgage that pledges title to

specific assets as security for a loan

• Typically terms require borrower to make

installment payments over term of loan Each

payment consists of

1 interest on unpaid balance of loan

2 a reduction of loan principal

• Companies initially record mortgage notes payable

at face value

Accounting for Non-Current Liabilities (1 of 2)

Long-Term Notes Payable (1 of 2)

Illustration: Mongkok Technology Ltd issues a HK$500,000,

8%, 20-year mortgage note on December 31, 2020 The terms provide for annual installment payments of HK$50,926

Interest

Period

(A) Cash Payment

(B) Interest Expense (D) × 8%

(C) Reduction

of Principal (A) − (B)

(D) Principal Balance (D) − (C)

Long-Term Notes Payable (2 of 2)

Illustration: Mongkok records the mortgage loan and first

installment payment as follows:

Lease Liabilities

A lease is a contractual agreement between a lessor

(owner of a property) and a lessee (renter of the

property)

• Gives lessee the right to use specific property for a

specified period of time

• Lessee makes rental payments over the lease term

to the lessor

Accounting for Non-Current Liabilities (2 of 2)

Lease Liabilities (1 of 2)

Accounting for Lease Arrangements

A lessee recognizes a lease liability and a right-of-use asset for all leases with a term greater than one year

Illustration: Assume that Gonzalez Construction decides to

lease new equipment The lease term is four years The

present value of the lease payments is €190,000 Gonzalez

records the transaction as follows.

Right-of-Use Asset 190,000

Lease Liability 190,000

Lease Liabilities (2 of 2)

Accounting for Lease Arrangements

• Right-of-use asset is reported on the statement of

financial position under non-current assets

• Lease liability is reported on the statement of financial

position as a liability

• Portion of lease liability expected to be paid in the

next year is a current liability with the remainder

classified as a non-current liability

Do It! 3: Long-Term Notes

Cole Research issues a ₩250,000,000, 6%, 20-year mortgage note to obtain needed financing for a new lab The terms call for annual payments of ₩21,796,000 each Prepare the entries

to record the mortgage loan and the first installment payment.

Learning Objective 4

Discuss How Non-Current Liabilities are Reported and Analyzed

• Companies report non-current liabilities in a separate

section of the statement of financial position

immediately before current liabilities

• Alternatively, companies may present summary data

in the statement of financial position, with detailed

data (interest rates, maturity dates, conversion

privileges, and assets pledged as collateral) shown in a supporting schedule

Reporting and Analyzing Non-Current

Liabilities (2 of 2)

Mortgage payable, 11%, due in 2028 and

Analysis (1 of 2)

Two ratios that provide information about debt-paying

ability and long-run solvency are:

• Debt to Total Assets Ratio

• Times Interest Earned Ratio

Analysis (2 of 2)

To illustrate these ratios, we will use data from an LG (KOR)

annual report The company had total liabilities of W22,839 billion, total assets of W35,528 billion, interest expense of

W827 billion, income taxes of W354 billion, and net income of W223 billion

Total Liabilities ÷ Total Assets = Debt to Assets Ratio

Net Income + Interest Expense

+ Income Tax Expense ÷ Expense Interest = Times Interest Earned

₩223 + ₩827 + ₩354 ÷ ₩827 = 1.70 times

Debt and Equity Financing (1 of 3)

1 Shareholder control is not affected.

Bondholders do not have voting rights, so current owners (shareholders) retain full control of the company.

2 Tax savings result.

Bond interest is deductible for tax purposes; dividends on stock are not.

3 Return per share (EPS) may be higher.

Although bond interest expense reduces net income, earnings per share is higher under bond financing because no additional shares are issued.

Debt and Equity Financing (2 of 3)

Illustration: Microsystems is considering two plans for

financing the construction of a new €5 million plant Plan A

involves issuance of 200,000 ordinary shares at the current

market price of €25 per share Plan B involves issuance of €5 million, 8% bonds at face value Income before interest and

taxes on the new plant will be €1.5 million Income taxes are expected to be 30% Microsystems currently has 100,000

ordinary shares outstanding

The alternative effects on the return on common stockholders’ equity are shown in the next Illustration.

Debt and Equity Financing (3 of 3)

Plan A:

Issue Shares Plan B: Issue Bonds

Income before interest and taxes €1,500,000 €1,500,000 Interest (8% × €5,000,000) 0 400,000 Income before income taxes 1,500,000 1,100,000 Income tax expense (30%) 450,000 330,000 Net income €1,050,000 € 770,000 Outstanding shares 300,000 100,000

Earnings per share €3.50 €7.70

Do It! 4: Analyzing Non-Current

Compute and discuss the debt to assets ratio at year-end.

The debt to assets ratio = €1,200,000 ÷ €2,000,000 = 60%

This means 60% of its assets were provided by creditors The

higher the percentage of debt to assets, the greater the risk that the company may be unable to meet its maturing obligations.