Lesson 9
Bond Basics
Bonds are, in essence, notes payable issued by companies borrowing money
from the general public rather than from some bank or other financial institution.
Most bonds are issued by publicly-held companies and typically involve large
amounts of money borrowed on a long-term basis.
The actual issuance or sale of bonds to investors is usually done through
investment banking companies and is facilitated by dividing up the total face or
par value of the bonds, or, in other words, the total principal amount payable
under the bonds, into smaller bond certificates with denominations that are
typically set at $1,000 each.
Lesson 9
$100,000,000 = 100,000 X $1,000 bonds
Bond Financing
Once issued, investors will sometimes sell their bonds to other investors in a
secondary market.
Registered bonds require any change in ownership to be registered with the
issuer before payments are made to the new investor.
Coupon or "bearer" bonds require no such registration and payments are simply
made to those who have physical possession of the bonds.
The detailed terms and conditions of a bond are documented in a written
agreement referred to as a bond indenture that's held and enforced by a
designated trustee acting on behalf of all bondholders.
1
2
Problem 9-1
Term bonds refer to bonds that provide for payment of the entire principal or face
value of the bonds at a specified date.
Bonds Issued at Face Value
Serial bonds provide for principal payments in installments over time.
On 11/1/X3, Stagg Corporation issued $10,000,000 of 5-year term bonds
at face value. Assuming a 7% stated interest rate, payable semiannually,
prepare journal entries to record the following:
Secured bonds pledge specific assets as collateral in the event of an issuer's default.
Debentures are unsecured bonds.
a. Issuance of bonds on 11/1/X3.
Senior or subordinated bonds specify certain priorities of claims that bondholders
may have against the assets of the issuer relative to the claims of other creditors.
b. 20X3 interest expense given a calendar year-end.
Callable bonds allow an issuer to make payoffs at agreed amounts prior to maturity.
c. Payment of interest on 5/1/X4.
Convertible bonds allow bondholders to convert their bonds to stock after a
specified period of time.
d. Payment of interest on 11/1/X4.
Junk bonds are bonds issued by companies with low credit ratings.
(High-yield bonds)
e. Final payment of interest and principal on 11/1/X8
The interest rate payable on a bond or its stated rate is affected by more than just a
company's credit rating. Generally speaking, shorter-term, convertible, secured
bonds, issued by triple-A rated companies will pay lower rates of interest, than
longer term unsecured bonds.
4
3
Problem 9-1 - Answer
Problem 9-1 - Answer
Bonds Issued at Face Value
a. Issuance of bonds on 11/1/X3.
Cash
d. Payment of interest on 11/1/X4.
10,000,000
Bonds Payable
Interest Expense
Cash
10,000,000
b. 20X3 interest expense given a calendar year-end.
Interest Expense*
Interest Payable
350,000
350,000
e. Final payment of interest and principal on 11/1/X8
116,667
Interest Expense
Bonds Payable
Cash
116,667
* $10,000,000 x 7% x 2/12 months = $116,667
350,000
10,000,000
10,350,000
c. Payment of interest on 5/1/X4.
Interest Payable
116,667
Interest Expense
233,333
Cash*
* $10,000,000 x 7% x 6/12 months = $350,000
350,000
6
5
9-1
Bonds are often issued at a premium or a discount.
Today
- $1,000,000
This happens when a bond's stated rate of interest differs from the
market rate demanded by investors at the time the bonds are issued.
Year 1
Year 2
Year 3
$60,000
$60,000
$60,000
$1,000,000
(investors' return = 6%)
Example: On 12/15/X4, Jordan, Inc. finalizes its bond indenture and
prints certificates for a planned 12/31 issuance of $1,000,000 of 3-year
term bonds bearing interest at a stated rate of 6% payable annually. This
6% rate is based on market rates at the time the indenture is finalized
On the date issuance 16 days later, market interest rates have increased
and investors are now demanding a 7% return on any investment in the
bonds.
Jordan now has $1,000,000 of bonds with no interested investors.
In most cases, companies solve this problem by offering the bonds at a
discount, or, in this case, Jordan would simply offer the bonds at a price
below the $1,000,000 face value to provide investors with an effective
7% return on their investment.
7
Today
- $980,000
Year 1
Year 2
Year 3
$60,000
$60,000
$60,000
$1,000,000
(investors' return = higher than 6%)
8
Today
PV of Annuity @ 7% = $157,459
PV of SCF @ 7% = $816,298
$973,757
Year 1
Year 2
Year 3
$60,000
$60,000
$60,000
$1,000,000
Current Market Value or Price of the Bonds
(97.4 rounded or 97.4% of the $1 million face value of the bonds)
(97.4 rounded or 97.4% of the $1 million face value of the bonds)
The issuance of the bonds at a discount, or an amount less than the face value
of the bonds, is a way to increase an investors' return over and above the
stated 6% rate.
The issuance of the bonds at a discount, or an amount less than the face value
of the bonds, is a way to increase an investors' return over and above the
stated 6% rate.
How much of a discount is required to produce a 7% rate of return?
How much of a discount is required to produce a 7% rate of return?
How much would someone have to invest today earning an annual rate of 7%
to generate the cash flows promised under the 6% bond? What is the present
value of those future cash flows at an interest rate of 7% compounding
annually?
How much would someone have to invest today earning an annual rate of 7%
to generate the cash flows promised under the 6% bond? What is the present
value of those future cash flows at an interest rate of 7% compounding
annually?
10
9
Jordan's accounting for the issuance of these bonds if we assume the
bonds are issued at $973,757 on 12/31/X4:
Cash
Discount on Bonds
Bonds Payable
973,757
26,243
Combined entry at 12/31/X5:
Interest Expense
Discount on Bonds
Cash
1,000,000
Amortization of discount at the end of each period:
Interest Expense
Discount on Bonds
8,163
60,000
$68,748 $973,757 = .071
(Cost of borrowing was about 7%.)
8,748
8,748
True interest cost at an effective 7% rate:
$973,757 x 7% x 1 year = $68,163
Straight-line approach: $26,243 3 years = $8,748/yr.
(This straight-line method is acceptable only if the $8,748 amount doesn't
differ significantly with results that would otherwise be obtained under a more
accurate effective-interest method, which takes into account the time value of
money.)
The process of effective interest amortization begins with the calculation
and recording of total interest expense for the period based on the effective
interest rate times the actual amount borrowed, and then the difference
between that amount and the amount of interest actually paid is the amount
of discount amortization recorded for the period.
Payment of interest on 12/31/X5:
Interest Expense
Cash
68,163
60,000
60,000
Stated interest: 6% x $1,000,000 x 1 year = $60,000
12
11
9-2
Effective Interest Method of Bond Discount Amortization
Annual Bonds
Period Payable
1
2
3
Balance
of Bond
Discount
Effective
Net
Interest
Amount
Rate
Total
Interest
Expense
Interest
Paid
Effective Interest Method of Bond Discount Amortization
Discount
Amort.
Annual Bonds
Period Payable
1,000,000 - 26,243 = 973,757 x 7% = 68,163 - 60,000 = 8,163
1,000,000 - 18,080 = 981,920 x 7% = 68,734 - 60,000 = 8,734
1,000,000 - 9,346 = 990,654 x 7% = 69,346 - 60,000 = 9,346
1
2
3
Jordan, Inc.
Balance Sheet
1/1/X6
Balance
of Bond
Discount
Net
Amount
Effective
Interest
Rate
Total
Interest
Expense
Interest
Paid
Discount
Amort.
1,000,000 - 26,243 = 973,757 x 7% = 68,163 - 60,000 = 8,163
1,000,000 - 18,080 = 981,920 x 7% = 68,734 - 60,000 = 8,734
1,000,000 - 9,346 = 990,654 x 7% = 69,346 - 60,000 = 9,346
Entry at 12/31/X6:
Long-term liabilities:
Bonds payable, less $18,080 discount balance
Interest Expense
Discount on Bonds
Cash
$981,920
Bond carrying value at 1/1/X6:
Amount originally borrowed
Add: First year's discount amortization
$973,757
8,163
$981,920
GAAP: Long-term liabilities should always be reported at the present value of the future cash
flows payable.
PV of the $60,000 annuity for two years $108,481
PV of the $1,000,000 single cash flow
at end of 2nd year
873,439
$981,920
68,734
8,734
60,000
Entry at 12/31/X7:
Interest Expense
Discount on Bonds
Cash
69,346
9,346
60,000
Bonds Payable
Cash
1,000,000
1,000,000
13
14
Problem 9-2
Problem 9-2 - Answer
Accounting for Bonds Issued at a Discount
Accounting for Bonds Issued at a Discount
a. Issuance of bonds on 10/1/X4.
On 10/1/X4, Owens Corporation issued $10,000,000 of bonds at a price of
98. Assuming the bonds have a four-year term and bear interest at a stated
rate of 6% payable semi-annually, prepare journal entries to record the:
Cash
Discount on Bonds
Bonds Payable
a. Issuance of bonds on 10/1/X4.
9,800,000
200,000
10,000,000
b. 12/31/X4 adjustment for 20X4 interest expense. (Use the
straight-line method of bond discount amortization.)
b. 12/31/X4 adjustment for 20X4 interest expense. (Use the
straight-line method of bond discount amortization.)
Interest Expense
Discount on Bonds**
Interest Payable*
c. Payment of interest on 4/1/X5
d. Payment of interest on 10/1/X5.
162,500
12,500
150,000
* $10,000,000 x 6% x 3/12 months = $150,000
** $200,000 48 months = $4,167/mo. x 3 = $12,500
e. 12/31/X5 adjustment for 20X5 interest expense.
Questions:
c. Payment of interest on 4/1/X5.
1. What is the carrying value of the bonds payable on Owens' 12/31/X4
and 12/31/X5 balance sheets and why does it increase over time?
Interest Payable
Interest Expense
Discount on Bonds**
Cash*
2. Is the effective interest rate on these bonds higher or lower than the
stated 6% rate? What was Owens' total interest expense in 20X5 and
how does it compare with the stated interest actually paid?
150,000
162,500
12,500
300,000
* $10,000,000 x 6% x 6/12 months = $300,000
** $4,167/mo. x 3 = $12,500
16
15
Problem 9-2 - Answer
Problem 9-2 - Answer
d. Payment of interest on 10/1/X5.
Interest Expense
Discount on Bonds**
Cash*
Questions:
325,000
1. What is the carrying value of the bonds payable on Owens' 12/31/X4
and 12/31/X5 balance sheets and why does it increase over time?
25,000
300,000
* $10,000,000 x 6% x 6/12 months = $300,000
** $4,167/mo. x 6 = $25,000
12/31/X4
Bonds payable
Less: Discount on bonds
e. 12/31/X5 adjustment for 20X5 interest expense.
Interest Expense
Discount on Bonds**
Interest Payable*
162,500
12,500
150,000
12/31/X5
$10,000,000
(187,500)
$ 9,812,500
$10,000,000
(137,500)
$ 9,862,500
Discount on Bonds
* $10,000,000 x 6% x 3/12 months = $150,000
** $4,167/mo. x 3 = $12,500
10/1/X4
200,000
12/31/X4
187,500
12/31/X5
12,500
'X4 Adjustment
12,500
4/1/X5
25,000
10/1/X5
12,500
12/31/X5
137,500
18
17
9-3
Problem 9-2 - Answer
Problem 9-2 - Answer
Questions:
2. Is the effective interest rate on these bonds higher or lower than the
stated 6% rate?
Since the carrying value is equal to the face value of the bonds
less the balance of any bond discount, the amortization and
reduction of that discount over time will automatically increase
the bonds' carrying value. In fact, when the bonds finally
mature and the discount is fully amortized, the carrying value
will equal the full face value of the bonds or the amount due at
maturity.
HIGHER
What was Owens' total interest expense in 20X5 and
how does it compare with the stated interest actually paid?
20X5: Total interest expense recorded at 4/1/X5
$162,500
at 10/1/X5
325,000
at 12/31/X5
162,500
$650,000
This carrying value can also be determined by adding the
amount of any unpaid interest expense to the amount originally
borrowed under the bonds. In other words, the bonds' carrying
value is also equal to the amount of discount amortization to date
plus the amount of cash received upon original issuance and
since the total amount of amortized discount increases over time
the carrying value automatically increases as well.
Total stated interest paid
$600,000
The actual (effective) interest cost is higher than the stated
interest paid due to the $50,000 discount amortization.
19
20
Problem 9-3
Problem 9-3 - Answer
Accounting for Bonds Issued at a Discount
Accounting for Bonds Issued at a Discount
For the same Owens Corporation bonds noted in the preceding problem,
a. Issuance of bonds on 10/1/X4.
Cash
Discount on Bonds
Bonds Payable
Face value: $10,000,000
Term: 4 years
Stated interest rate: 6% payable semi-annually
9,656,303*
343,697
10,000,000
* Pricing of bonds to yield 7% compounding semi-annually:
Prepare journal entries for the following assuming issuance at a price to yield
an effective interest rate of 7% compounding semi-annually:
PV of a $300,000 annuity at the end of
every 6-months for 4 years
$ 2,062,187
PV of a $10,000,000 single cash flow
at the end of the 4th year
$ 7,594,116
$ 9,656,303
a. Issuance of bonds on 10/1/X4.
b. The 12/31/X4 adjustment for 20X4 interest expense. (Use the
effective interest method of bond discount amortization)
c. Payment of interest on 4/1/X5.
d. Payment of interest on 10/1/X5.
e. The 12/31/X5 adjustment for 20X5 interest expense.
Questions: Why are bonds sometimes issued at a discount rather than their
face or par value?
22
21
Problem 9-3 - Answer
Problem 9-3 - Answer
Calculations:
Calculations:
PV of a $300,000 annuity at the end of every 6-months for 4 years at
a rate of 7% compounding semi-annually.
PV of a $300,000 annuity at the end of every 6-months for 4 years at
a rate of 7% compounding semi-annually.
HP10bii:
TI BAII Plus:
C ALL
8
-300,000
0
7
2
N
PMT
: Clear memory.
C/CE
: Number of compounding periods
8
-300,000
0
7
P/Y
2 ENTER
: Annuity payment.
FV
: Future value.
I/YR
: Interest rate.
P/YR
: Reset compounding periods per year.
PV
2nd
: Present value.
2nd
CLR TVM
CPT
2,062,187
N
PMT
: Clear all Time-Value-of-Money values.
: Number of compounding periods.
: Annuity payment.
FV
: Future value.
I/Y
: Interest rate.
C/CE
PV
: Reset compounding periods per year.
: Present value.
2,062,187
24
23
9-4
Problem 9-3 - Answer
Problem 9-3 - Answer
Calculations:
Calculations:
PV of a $10,000,000 single cash flow at the end of the 4th year at 7%
compounding semi-annually.
PV of a $10,000,000 single cash flow at the end of the 4th year at 7%
compounding semi-annually.
HP10bii:
TI BAII Plus:
C ALL
8
0
-10,000,000
7
2
N
PMT
C/CE
: Number of compounding periods
8
0
-10,000,000
7
P/Y
2 ENTER
: Annuity payment.
FV
: Future value.
I/YR
: Interest rate.
P/YR
: Reset compounding periods per year.
PV
CLR TVM
: Clear memory.
2nd
: Present value.
2nd
: Clear all Time-Value-of-Money values.
: Number of compounding periods.
N
PMT
: Annuity payment.
FV
: Future value.
I/Y
: Interest rate.
C/CE
CPT
7,594,116
PV
: Reset compounding periods per year.
: Present value.
7,594,116
25
26
Problem 9-3 - Answer
Problem 9-3 - Answer
b. The 12/31/X4 adjustment for 20X4 interest expense. (Use the
effective interest method of bond discount amortization)
Interest Expense
Discount on Bonds**
Interest Payable*
d. Payment of interest on 10/1/X5.
Interest Expense
Discount on Bonds**
Cash*
168,986
18,986
150,000
1
Bonds
Payable
Balance
of Bond
Discount
Carrying
Value
Effect.
Rate
Total
Interest
Expense
39,300
300,000
* $10,000,000 x 6% x 6/12 months = $300,000
** Effective Interest Amortization:
* $10,000,000 x 6% x 3/12 months = $150,000
** Effective Interest Amortization:
6-Month
Period
339,300
Stated
Interest
Discount
Amort.
6-Month
Period
1,000,000 - 343,697 = 9,656,303 x 3.5% = 337,971 - 300,000 = 37,971
1
2
Discount amortization for the three months of October - December of 'X4:
$37,971 x 3/6 months. = $18,986
Bonds
Payable
Balance
of Bond
Discount
Net
Amount
Effect.
Rate
Total
Interest
Expense
Stated
Interest
Discount
Amort.
10,000,000 - 343,697 = 9,656,303 x 3.5% = 337,971 - 300,000 = 37,971
10,000,000 - 305,726 = 9,694,274 x 3.5% = 339,300 - 300,000 = 39,300
c. Payment of interest on 4/1/X5.
Interest Payable
Interest Expense
Discount on Bonds**
Cash*
150,000
168,985
18,985
300,000
* $10,000,000 x 6% x 6/12 months = $300,000
** $37,971 x 3/6 mos. = $18,985
28
27
Problem 9-3 - Answer
Problem 9-3 - Answer
Questions: Why are bonds sometimes issued at a discount rather than their
face or par value?
e. The 12/31/X5 adjustment for 20X5 interest expense.
Interest Expense
Discount on Bonds**
Interest Payable*
170,338
20,338
150,000
Answer: If market interest rates increase above a bond's stated
rate prior to the bond's actual issuance, investors will not buy the
bonds unless they're offered at a discount sufficient to yield the
current market rate of interest. If market rates are equal to the
stated interest, then the bonds will be issued at their face or par
value.
* $10,000,000 x 6% x 3/12 months = $150,000
** Effective Interest Amortization:
6-Month
Period
1
2
3
Bonds
Payable
Balance
of Bond
Discount
Net
Amount
Effect.
Rate
Total
Interest
Expense
Stated
Interest
Discount
Amort.
10,000,000 - 343,697 = 9,656,303 x 3.5% = 337,971 - 300,000 = 37,971
10,000,000 - 305,726 = 9,694,274 x 3.5% = 339,300 - 300,000 = 39,300
10,000,000 - 266,426 = 9,733,574 x 3.5% = 340,675 - 300,000 = 40,675
Amortization for first 3 months of the 3rd semi-annual period:
$40,675 x 3/6 months. = $20,338
30
29
9-5
If market interest rates decrease prior to funding, the bonds will be issued at a premium.
This means the price of the bonds, or in other words, the amount of cash received from
investors upon issuance, will be greater than the face or maturity value of the bonds.
Effective Interest Method of Bond Premium Amortization
Effective
Total
Interest Interest
Rate
Expense
Interest
Paid
Premium
Amort.
Entry to record interest expense for the year ended 12/31/X5:
Interest Expense
Premium on Bonds
Cash
Present Value at 5%
$163,395
51,362
8,638
60,000
Jordan, Inc.
Balance Sheet
1/1/X5
863,838
$1,027,233
Long-term liabilities:
Bonds payable, including $18,595 premium balance
Accounting for the issuance of these bonds at a price of $1,027,233 on 1/1/X5:
Cash
Carrying
Value
1,000,000 + 27,233 = 1,027,233 x 5% = 51,362 - 60,000 = 8,638
1,000,000 + 18,595 = 1,018,595 x 5% = 50,930 - 60,000 = 9,070
1,000,000 + 9,525 = 1,009,525 x 5% = 50,475 - 60,000 = 9,525
1
2
3
PV of the bonds future cash flows at an interest rate of 5% compounding annually:
- Annuity of $60,000 or 6% stated interest
payable at the end of each year for three years
- $1,000,000 single cash flow at the end
of three years
Balance
of Bond
Premium
Bonds
Period Payable
Assume Jordan, Inc. finalizes its documentation for the issuance of 3-year term bonds
with a total face value of $1,000,000, bearing interest at a stated rate of 6%, payable
annually. If market interest rates decrease to 5% prior to actual issuance, Jordan will
want to adjust the bonds' interest rate down before the bonds are issued. In actual
practice, rather than change the stated interest rate of the bonds, issuance at a price
above the face value of the bonds will create the same economic effect.
$1,018,595
1,027,233
Premium on Bonds
Bonds Payable
27,233
1,000,000
In essence, any premium balance is an unearned offset against future interest
costs, which is substantially the same as unearned revenue.
31
32
Problem 9-4
Effective Interest Method of Bond Premium Amortization
Balance
of Bond
Premium
Bonds
Period Payable
1
2
3
Carrying
Value
Effective
Total
Interest Interest
Rate
Expense
Interest
Paid
Determining a Bond's Price at Issuance
On May 1, 20X5, Harrison Corp. issued 2-year term bonds with a total face
value of $10,000,000 bearing interest at 8%, compounding semiannually.
The bond indenture provides for interest payments to be made on 11/1 and
5/1 of each year through maturity on May 1, 20X7.
Premium
Amort.
1,000,000 + 27,233 = 1,027,233 x 5% = 51,362 - 60,000 = 8,638
1,000,000 + 18,595 = 1,018,595 x 5% = 50,930 - 60,000 = 9,070
1,000,000 + 9,525 = 1,009,525 x 5% = 50,475 - 60,000 = 9,525
Calculate the issuing price of the bonds if they are priced to generate an
effective interest rate to investors of:
Entry to record interest expense for the year ended 12/31/X6:
Interest Expense
Premium on Bonds
Cash
50,930
9,070
A. 7.5% compounding semiannually
60,000
B. 8.0% compounding semiannually
Entries at 12/31/X6:
Interest Expense
Premium on Bonds
Cash
C. 8.5% compounding semiannually
50,475
9,525
Bonds Payable
Cash
60,000
1,000,000
1,000,000
34
33
Problem 9-4 - Answer
Problem 9-4 - Answer
Determining a Bond's Price at Issuance
Determining a Bond's Price at Issuance
A. Price of bonds to yield 7.5% effective interest rate compounding
semiannually = $10,091,285
A. Price of bonds to yield 7.5% effective interest rate compounding
semiannually = $10,091,285
The sum of:
The sum of:
PV of a $400,000 annuity at the end of every 6-months for 2 years at
a rate of 7.5% compounding semi-annually.
PV of a $400,000 annuity at the end of every 6-months for 2 years at
a rate of 7.5% compounding semi-annually.
HP10bii:
TI BAII Plus:
C ALL
4
-400,000
0
7.5
2
Press
N
PMT
: Clear memory.
C/CE
: Number of compounding periods
4
-400,000
0
7.5
P/Y
2 ENTER
: Annuity payment.
FV
: Future value.
I/YR
: Interest rate.
P/YR
: Reset compounding periods per year.
PV
2nd
: Present value.
2nd
CLR TVM
CPT
1,460,554
N
PMT
: Clear all Time-Value-of-Money values
: Number of compounding periods
: Annuity payment.
FV
: Future value.
I/Y
: Interest rate.
C/CE
PV
: Reset compounding periods per year.
: Present value.
1,460,554
36
35
9-6
Problem 9-4 - Answer
Problem 9-4 - Answer
PV of a $10,000,000 single cash flow at the end of 2 years at 7.5%,
compounding semiannually = $8,630,731 (rounded)
PV of a $10,000,000 single cash flow at the end of 2 years at 7.5%,
compounding semiannually = $8,630,731 (rounded)
HP10bii:
TI BAII Plus:
C ALL
4
0
-10,000,000
7.5
2
Press
N
PMT
C/CE
: Number of compounding periods
4
0
-10,000,000
7.5
P/Y
2 ENTER
: Annuity payment.
FV
: Future value.
I/YR
: Interest rate.
P/YR
: Reset compounding periods per year.
PV
CLR TVM
: Clear memory.
2nd
2nd
: Present value.
CPT
N
PMT
: Clear all Time-Value-of-Money values.
: Number of compounding periods.
: Annuity payment.
FV
: Future value.
I/Y
: Interest rate.
C/CE
PV
8,630,731
: Reset compounding periods per year.
: Present value.
8,630,731
37
38
Problem 9-4 - Answer
Problem 9-4 - Answer
Determining a Bond's Price at Issuance
Determining a Bond's Price at Issuance
B. Price of bonds to yield 8.0 % effective interest rate
compounding semiannually = $10,000,000.
B. Price of bonds to yield 8.0 % effective interest rate
compounding semiannually = $10,000,000.
The sum of:
The sum of:
PV of an annuity of $400,000 at the end of 4 6-month periods at a
rate of 8.0% compounding semiannually = $1,451,958 (rounded)
PV of an annuity of $400,000 at the end of 4 6-month periods at a
rate of 8.0% compounding semiannually = $1,451,958 (rounded)
HP10bii:
TI BAII Plus:
C ALL
4
-400,000
0
8
2
Press
N
PMT
: Clear memory.
C/CE
: Number of compounding periods
4
-400,000
0
8
P/Y
2 ENTER
: Annuity payment.
FV
: Future value.
I/YR
: Interest rate.
P/YR
: Reset compounding periods per year.
PV
2nd
CLR TVM
2nd
: Present value.
CPT
N
PMT
: Clear all Time-Value-of-Money values
: Number of compounding periods
: Annuity payment.
FV
: Future value.
I/Y
: Interest rate.
C/CE
PV
1,451,958
: Reset compounding periods per year.
: Present value.
1,451,958
40
39
Problem 9-4 - Answer
Problem 9-4 - Answer
PV of a $10,000,000 single cash flow at the end of 2 years at 8.0%,
compounding semiannually = $8,548,042 (rounded)
PV of a $10,000,000 single cash flow at the end of 2 years at 8.0%,
compounding semiannually = $8,548,042 (rounded)
HP10bii:
TI BAII Plus:
C ALL
4
0
-10,000,000
8
2
Press
N
PMT
: Clear memory.
C/CE
: Number of compounding periods
4
0
-10,000,000
8
P/Y
2 ENTER
: Annuity payment.
FV
: Future value.
I/YR
: Interest rate.
P/YR
: Reset compounding periods per year.
PV
2nd
: Present value.
2nd
CLR TVM
CPT
8,548,042
N
PMT
: Clear all Time-Value-of-Money values.
: Number of compounding periods.
: Annuity payment.
FV
: Future value.
I/Y
: Interest rate.
C/CE
PV
: Reset compounding periods per year.
: Present value.
8,548,042
42
41
9-7
Problem 9-4 - Answer
Problem 9-4 - Answer
Determining a Bond's Price at Issuance
Determining a Bond's Price at Issuance
C. Price of bonds to yield 8.5% effective interest rate
compounding semiannually = $9,909,785
C. Price of bonds to yield 8.5% effective interest rate
compounding semiannually = $9,909,785
The sum of:
The sum of:
PV of an annuity of $400,000 at the end of 4 6-month periods at a rate
of 8.5% compounding semiannually = $1,443,444 (rounded)
PV of an annuity of $400,000 at the end of 4 6-month periods at a rate
of 8.5% compounding semiannually = $1,443,444 (rounded)
HP10bii:
TI BAII Plus:
C ALL
4
-400,000
0
8.5
2
Press
N
PMT
: Clear memory.
C/CE
: Number of compounding periods
4
-400,000
0
8.5
P/Y
2 ENTER
: Annuity payment.
FV
: Future value.
I/YR
: Interest rate.
P/YR
: Reset compounding periods per year.
PV
2nd
CLR TVM
2nd
: Present value.
PMT
: Annuity payment.
FV
: Future value.
I/Y
: Interest rate.
C/CE
CPT
: Clear all Time-Value-of-Money values
: Number of compounding periods
N
PV
: Reset compounding periods per year.
: Present value.
1,443,444
1,443,444
43
44
Problem 9-4 - Answer
Problem 9-4 - Answer
PV of a $10,000,000 single cash flow at the end of 2 years at 8.5%,
compounding semiannually = $8,466,341 (rounded)
PV of a $10,000,000 single cash flow at the end of 2 years at 8.5%,
compounding semiannually = $8,466,341 (rounded)
HP10bii:
TI BAII Plus:
C ALL
4
0
-10,000,000
8.5
2
Press
N
PMT
: Clear memory.
C/CE
: Number of compounding periods
4
0
-10,000,000
8.5
P/Y
2 ENTER
: Annuity payment.
FV
: Future value.
I/YR
: Interest rate.
P/YR
: Reset compounding periods per year.
PV
2nd
2nd
: Present value.
CLR TVM
PMT
: Annuity payment.
FV
: Future value.
I/Y
: Interest rate.
C/CE
CPT
: Clear all Time-Value-of-Money values.
: Number of compounding periods.
N
PV
: Reset compounding periods per year.
: Present value.
8,466,341
8,466,341
46
45
Problem 9-5
Problem 9-5 - Answer
Accounting for Bonds Issued at a Premium
Accounting for Bonds Issued at a Premium
For the Harrison Corp. bonds described in the previous problem,
a. Issuance of bonds on 5/1/X5.
"On May 1, 20X5, Harrison Corp. issued 2-year term bonds with a total face
value of $10,000,000 bearing interest at 8%. The bond indenture provides for
interest payments to be made on 11/1 and 5/1 of each year through maturity
on May 1, 20X7."
Cash
10,091,285
Premium on Bonds
Bonds Payable
91,285
10,000,000
b. Payment of interest on 11/1/X5.
Assume the bonds are issued at a price of $10,091,285 to yield an effective
interest rate of 7.5% compounding semi-annually and prepare the required
journal entries for:
Interest Expense
Premium on Bonds
Cash*
a. Issuance of the bonds on 5/1/X5.
378,423
21,577
400,000
* $10,000,000 x 8% x 6/12 months = $400,000
** Effective Interest Amortization:
b. Payment of interest on 11/1/X5. (Use the effective interest
method of bond premium amortization)
c. The 12/31/X5 adjustment for 20X5 interest expense.
6-Month Bonds
Period Payable
Determine the carrying value of bonds payable on Harrison's 12/31/X5
balance sheet.
1
Balance
of Bond
Premium
Carrying
Value
Effect.
Rate
Total
Interest
Expense
Stated
Interest
Premium
Amort.
10,000,000 - 91,285 = 10,091,285 x 3.75% = 378,423 - 400,000 = 21,577
Prepare the journal entries to be made with Harrison's final payment of
interest and the payment of principal on 5/1/X7.
48
47
9-8
Problem 9-5 - Answer
Problem 9-5 - Answer
c. The 12/31/X5 adjustment for 20X5 interest expense.
Interest Expense
Premium on Bonds**
Interest Payable*
Determine the carrying value of bonds payable on Harrison's
12/31/X5 balance sheet.
125,871
7,462
12/31/X4
133,333
Bonds payable
Less: Premium on bonds
* $10,000,000 x 8% x 2/12 months = $133,333
** Effective Interest Amortization:
6-Month Bonds
Period Payable
1
2
Balance
of Bond
Premium
Carrying
Value
Effect.
Rate
Total
Interest
Expense
Stated
Interest
x
10,000,000 - 91,285 = 10,091,285 3.75% = 378,423 - 400,000 =
10,000,000 - 69,708 = 10,069,708 x 3.75% = 377,614 - 400,000 =
Premium
Amort.
$10,000,000
62,246
$10,062,246
Premium on Bonds
21,577
22,386
11/1/X5
12/31/X5
Premium amortization for two months (Nov. - Dec.):
91,285
5/1/X5
62,246
12/31/X5
21,577
7,462
$22,386 x 2/6 months. = $7,462
49
50
Problem 9-5 - Answer
Prepare the journal entries to be made with Harrison's final payment of interest and the
payment of principal on 5/1/X7.
Payment of interest:
Interest Payable*
Interest Expense***
Premium on Bonds**
Cash
The payoff and early retirement of bonds is generally
prohibited, except in the case of callable bonds.
133,333
250,603
16,064
Successful issuance of callable bonds usually requires payment of a higher rate
of interest and a call or redemption price that's greater than the face value of the
bonds due at maturity. As a result, callable bonds are rarely issued unless a
company truly believes future refinancing will be available at a lower rate of
interest.
400,000
* Reflects the payment of 2 months of stated interest payable for November and December of
20X6 that would have been previously recorded at 12/31/X6.
** Amortization schedule:
Balance
Total
6-Month
Period
Bonds
Payable
1
2
3
4
10,000,000
10,000,000
10,000,000
10,000,000
Carrying
Value
of Bond
Premium
-
91,285
69,708
47,321
24,096
=
=
=
=
10,091,285
10,069,708
10,047,321
10,024,096
Premium amortization for 4 months (Jan. - April):
Effect.
Rate
x
x
x
x
3.75%
3.75%
3.75%
3.75%
Stated
Interest
Interest
Expense
=
=
=
=
378,423
377,614
376,775
375,904
-
400,000
400,000
400,000
400,000
Premium
Amort.
=
=
=
=
Example: Jordan, Inc issues at face value, $10,000,000 of 8% interest bearing,
5-year term bonds, callable at a price of 103 or $10,300,000. Two years after
issuance, interest rates fall from 8% to 5% and Jordan decides to refinance or
payoff the old bonds by issuing $10,000,000 of new bonds at the current 5%
rate.
21,577
22,386
23,225
24,096
$24,096 x 4/6 months. = $16,064
*** Interest expense: 4 months of stated interest at 8% $266,667
Less: Premium amortization.
Payment of principal:
Bonds Payable
Cash
Journal entry to record the bond retirement:
(16,064)
$250,603
10,000,000
Bonds Payable
Loss on Bond Retirement
Cash
10,000,000
10,000,000
300,000
10,300,000
52
51
Problem 9-6
Assume that Jordan's 8% bonds were originally issued on April 1, 20X4 at a
$100,000 discount. Assuming interest is payable annually and the discount is
amortized on a straight-line basis, what entries would be required upon early
retirement of the bonds on 7/1/X6?
Early Retirement of Bonds
On 12/31/X5, Cook Corporation purchased and retired $1,000,000 of its
previously issued bonds for $970,000 cash, including $10,000 of interest
payable at the time of retirement. Assuming Cook's premium on bonds
account has a remaining balance of $20,000, prepare Cook's journal entry to
record the purchase of the bonds.
Update the bond interest expense through the date of retirement:
Interest Expense
Discount on Bonds**
Interest Payable*
205,000
5,000
200,000
Questions:
* $10,000,000 x 8% x 3/12 months = $200,000
** $100,000 x 3/60 mos. = $5,000
- Why would the current purchase price of the bonds be lower
than their face value when the bonds were originally issued
at a premium?
Payoff of the bonds:
Interest Payable
Bonds Payable
Loss on Bond Retirement
Discount on Bonds**
Cash*
200,000
10,000,000
355,000
- How does this early retirement of bonds improve Cook's
financial position?
55,000
10,500,000
* $10,300,000 + $200,000 = $10,500,000
** $100,000 - (100,000 x 27/60 mos.) = $55,000
54
53
9-9
Problem 9-6 - Answer
Problem 9-6 - Answer
Early Retirement of Bonds
Questions:
- How does this early retirement of bonds improve Cook's financial
position?
Entry to record the purchase of bonds:
Interest Payable *
10,000
Bonds Payable
1,000,000
Premium on Bonds
20,000
Gain on Bond Retirement
60,000
Cash
970,000
* Assumes the expense was previously recorded
Questions:
- Why would the current purchase price of the bonds be lower than their
face value when the bonds were originally issued at a premium?
Answer: Payoffs of debt lower a company's debt ratio or the
amount of total debt to total assets. Generally speaking
companies that have lower levels of debt relative to their total
assets have greater financial flexibility in the future. In addition,
lower debts can improve a company's profits if the interest costs
saved through debt reduction are greater than the earnings that
could have alternatively been achieved through investment of the
surplus cash.
Answer: Bond prices are a reflection of market values and a bonds' market value
fluctuates over time with changes in the effective interest rates demanded by investors.
Those effective rates are influenced by a number of things including the overall state
of the economy and a company's changing prospects and perceived risk.
In this case the declining market value of Cook's bonds over time means effective
interest rates demanded by investors have increased since the bonds original issuance.
In fact, the effective rate at the date of purchase has apparently increased above the
bond's stated interest rate if the bonds are now worth less than their face value. That
could be the result of higher interest rates in the overall economy or greater perceived
risk in Cook Corporation.
55
9-10
56