Chapter 17 Part 1 Bonds Payable

1
Chapter 17Part 1 Bonds Payable

• Introduction to Bonds
• Bond Discounts

2
Bond Basics

• A written promise to pay an amount identified as
  the par value of the bond along with interest at
  the stated rate.
• A bond is a liability to the issuing corporation
  and a receivable to the bond owner.

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Bond Basics

• Par value (or face value or face amount) is paid
  at a specified future date, or maturity date.
• The interest is paid each year based on the
  stated rate of interest.
• The stated rate is quoted at an annual rate.

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Advantages of Bonds

• Bonds do not affect shareholder control, whereas
  the issuance of shares does.
• Interest on bonds is tax deductible for the
  corporation issuing the payments.
• Bonds can increase return on equity. How? By
  providing a return on equity greater than the
  rate of interest paid on the bonds.

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Advantages of Bonds

• Example
• Net income for XYZ Corporation is 500,000.
  Currently, equity is 2,000,000.
• By investing 750,000, Net income will increase
  by 250,000 before paying any interest.
• The company can issue shares, or issue bonds
  paying 10 interest.
• The decision to invest depends on the return on
  equity for the shareholders.

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Advantages of Bonds
Return on Equity

• In this case, it is advantageous to issue bonds
  as the return on equity is greater than that of a
  share issuance.

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Disadvantages of Bonds

• Bonds require payment of both annual interest and
  the par value at maturity.
• Bond payments can be a burden on the company if
  income is low.
• Bonds can decrease return on equity. How? By
  providing a return on equity lower than the rate
  of interest paid on the bonds.

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Advantages of Bonds

• Example
• Net income for XYZ Corporation is 500,000.
  Currently, equity is 2,000,000.
• By investing 750,000, Net income will increase
  by 250,000 before paying any interest.
• The company can issue shares, or issue bonds
  paying 30 interest.
• The decision to invest depends on the return on
  equity for the shareholders.

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Advantages of Bonds
Return on Equity

• In this case, it is not advantageous to issue
  bonds as the return on equity is less than that
  of a share issuance.

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Types of Bonds

• Secured and Unsecured Bonds
• Secured bonds have specific company assets
  pledged (or mortgaged) as collateral.
• Unsecured bonds, also called debentures, are
  backed by the issuers general credit standing.

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Types of Bonds

• Term and Serial Bonds
• Terms bonds are scheduled for payment at a single
  specified date.
• Many terms bonds are sinking funds which require
  the issuing corporation to make deposits to a
  sinking fund, from which the bondholders are paid
  at maturity.
• Serial bonds mature at several different dates
  (repaid over a number of periods).

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Types of Bonds

• Registered and Bearer Bonds
• Registered bonds are issued in the names of their
  owners.
• Bond payments are sent directly to these
  registered owners.
• Bearer (unregistered) bonds are made payable to
  whomever holds them.

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Types of Bonds

• Convertible and Callable Bonds
• Convertible bonds can be exchanged by bondholders
  for a fixed number of shares of the issuing
  companys common shares.
• Callable bonds have an option exercisable by the
  issuer to retire them at a stated dollar amount
  prior to maturity.

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Issuing Bonds

• Bonds Issued at Par
• Accounts used
• Bonds Payable
• Bond Interest Expense
• Cash
• Interest Payable only if issued between
  interest dates

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Issuing Bonds

• Example
• Barnes Company issues 800,000 of 9, 20 year
  bonds dated January 1, 2002 and due in 20 years.
• Show entries for issuance, interest payment,
  and bond maturity.

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Issuing Bonds

• Entries

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Issuing Bonds between Interest Dates

• The bond issuer collects interest upon the sale.
• Interest is repaid to the purchaser on the first
  interest date.
• Administration is simplified because every
  bondholder is paid the same amount of interest on
  the interest date.

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Issuing Bonds

• Example
• Canadian Tire issues 100,000 of bonds on
  January 1. The bonds are sold on March 1.
• Show entries for issuance of bond and first
  interest payment.

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Issuing Bonds

• Entries

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Accruing Bond Interest

• Bond interest may need to be accrued if the
  fiscal year period ends between interest dates.
• Example
• Canadian Tires year end is July 31. Therefore,
  one month of interest is accrued since the last
  interest payment on June 30

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Issuing Bonds at a Discount

• Discounts on Bonds Payable is an account used
  when bonds are issued at a value less than 100
  of par.
• It is a contra liability account which is
  deducted from the par value of the bonds to
  produce the carrying (or book) value of the bonds.

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Issuing Bonds at a Discount

• Both the face value of the bond and the discount
  are shown on the balance sheet presentation.
• The book value of the bonds at the date of issue
  is always equal to the cash price of the bonds.

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Issuing Bonds at a Discount

• Interest payments are calculated on the face
  value of the bond, not the cash received for
  them.
• Example
• On January 1, 2003, XYZ Corporation issues
  100,000 par value bonds for cash of 91,890,
  bearing interest of 6 for the bond term of five
  years. Interest is paid semi-annually.

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Issuing Bonds at a Discount

• Entry

Balance Sheet Presentation
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Amortizing Bond Discounts

• The bond discount calculated must be amortized
  over the life of the bond.
• Dont forget accrual if the interest period and
  accounting period do not coincide.
• Also accrue the amortization of the bond discount.

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Amortizing Bond Discounts

• There are two methods to amortize the discount
• Straight-Line Method
• Effective Interest Method

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Straight-Line Method

• The interest expense for each period is the same
  for each payment made throughout the life of the
  bond.
• The amortization of the discount is therefore the
  same.

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Straight-Line Method

• The total interest expense over the life of the
  bond needs to be determined in order to calculate
  the expense and amortization for each period.
• Interest expense from prior example is

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Straight-Line Method Amortization Table
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Effective Interest Method

• Interest expense increases as the bond matures
  because it is based on the carrying value of the
  bond.
• The carrying value of the bond increases as the
  discount is amortized.

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Effective Interest Method

• The amortization of the discount increases with
  the carrying life of the bond.
• The interest rate used to calculate the interest
  expense is the market rate at the issue date.
  This rate will be constant throughout all
  subsequent calculations, regardless of any change
  in the market rates over the life of the bond.

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Effective Interest Method Amortization Table

• (Assumed market interest rate of 4
  semi-annually)

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Introduction to BondsBond Discounts

• Questions??

34
Assignment Hints

• Problems
• 17-2A
• Bond Interest Expense 4,599
• 17-3A
• Ending Balance Dec. 31/06 48,142
• Ending Discount Balance Dec. 31/06 1,858
• 17-4A
• May 1/07 Carrying Value 241,567

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Assignment Hints

• Problems
• 17-5A
• CR Interest Payable 4,083
• DR Bond Interest Expense 2,205
• 17-6A
• June 1/07 Carrying Value 178,362
• 17-7A
• DR Bond Interest Expense 3,819
• CR Discount on Bonds Payable 438