Chapter 15
Bonds Payable and
Investments in Bonds
Accounting, 21st Edition
Warren Reeve Fess
PowerPoint Presentation by Douglas Cloud
Professor Emeritus of Accounting
Pepperdine University
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Objectives
1. Compute the potential impact of longAfter studying
this
term borrowing
on the earnings
per
you should
share of achapter,
corporation.
be able to:
2. Describe the characteristics of bonds.
3. Compute the present value of bonds
payable.
4. Journalize entries for bonds payable.
5. Describe bond sinking funds.
Objectives
6. Journalize entries for bond
redemptions.
7. Journalize entries for the purchase,
interest, discount, and premium
amortization, and sale of bond
investments.
8. Prepare a corporation balance sheet.
9. Compute and interpret the number of
times interest charges are earned.
Two Methods of Long-Term Financing
Resources
=
Sources
Liabilities
Debt Financing: Bondholders
Assets
Stockholders’
Equity
Equity Financing: Stockholders
Two Methods of Long-Term Financing
Bondholders
Stockholders
Why issue bonds rather than stock?
Bonds (debt)—Interest payments to bondholders
are an expense that reduces taxable income.
Stock (equity)—Dividend payments are made
from after tax net income and retained earnings.
Earnings per share on common stock can often
be increased by issuing bonds rather than
additional stock.
Alternative Financing Plans – $800,000 Earnings
12 % bonds
Preferred 9% stock, $50 par
Common stock, $10 par
Total
Earnings before interest
and income tax
Deduct interest on bonds
Income before income tax
Deduct income tax
Net income
Dividends on preferred stock
Available for dividends
Shares of common stock
Earnings per share
Plan 1
—
—
$4,000,000
$4,000,000
Plan 2
—
$2,000,000
2,000,000
$4,000,000
Plan 3
$2,000,000
1,000,000
1,000,000
$4,000,000
$ 800,000
—
$ 800,000
320,000
$ 480,000
—
$ 480,000
÷400,000
$
1.20
$ 800,000
—
$ 800,000
320,000
$ 480,000
180,000
$ 300,000
÷200,000
$
1.50
$ 800,000
240,000
$ 560,000
224,000
$ 336,000
90,000
$ 246,000
÷100,000
$
2.46
Alternative Financing Plans – $440,000 Earnings
12 % bonds
Preferred 9% stock, $50 par
Common stock, $10 par
Total
Earnings before interest
and income tax
Deduct interest on bonds
Income before income tax
Deduct income tax
Net income
Dividends on preferred stock
Available for dividends
Shares of common stock
Earnings per share
Plan 1
—
—
$4,000,000
$4,000,000
Plan 2
—
$2,000,000
2,000,000
$4,000,000
Plan 3
$2,000,000
1,000,000
1,000,000
$4,000,000
$ 440,000
—
$ 440,000
176,000
$ 264,000
—
$ 264,000
÷400,000
$
0.66
$ 440,000
—
$ 440,000
176,000
$ 264,000
180,000
$ 84,000
÷200,000
$
0.42
$ 440,000
240,000
$ 200,000
80,000
$ 120,000
90,000
$ 30,000
÷100,000
$
0.30
Characteristics of Bonds Payable
 A bond contract is called a bond indenture
or trust indenture.
 Long-term debt—repayable 10, 20, or 30
years after date of issuance.
 Issued in face (principal) amounts of
$1,000, or multiples of $1,000.
 Contract interest rate is fixed for term (life)
of the bond.
 Face amount of bond repayable at maturity
date.
Characteristics of Bonds Payable
When all bonds of an issue mature at the
same time, they are called term bonds. If the
maturity dates are spread over several dates,
they are called serial bonds.
Bonds that may be exchanged for other
securities are called convertible bonds.
Bonds that a corporation reserves the right to
redeem before maturity are callable bonds.
Bonds issued on the basis of the general
credit of the corporations are debenture
bonds.
The Present-Value Concept
and Bonds Payable
When a corporation issues bonds, the price
that buyers are willing to pay depends
upon three factors:
1. The face amount of the bonds, which is
the amount due at the maturity date.
2. The periodic interest to be paid on the
bonds. This is called the contract rate
or the coupon rate.
3. The market or effective rate of interest.
The Present-Value Concept
and Bonds Payable
MARKET RATE = CONTRACT RATE
Sell price of bond = $1,000
$1,000
10% payable
annually
The Present-Value Concept
and Bonds Payable
MARKET RATE > CONTRACT RATE
Sell price of bond < $1,000
$1,000
10% payable
annually
–
Discount
The Present-Value Concept
and Bonds Payable
MARKET < CONTRACT RATE
Sell price of bond > $1,000
$1,000
10% payable
annually
+
Premium
A $1,000, 10% bond is purchased. It pays
interest annually and will mature in two years.
$100
Today
Interest
payment
Interest
10%
payable
payment
annually
End of
Year 1
End of
Year 2
$90.91
$100 x 0.90909
$82.65
$100 x 0.82645
$826.45
$1,000 x 0.82645
$1,000.00 (rounded)
$100
$1,000
The Present-Value Concept
and Bonds Payable
OR
Present value of face value of $1,000 due
in 2 years at 10% compounded annually:
$1,000 x 0.82645
$ 826.45
Present value of 2 annual interest payments
of 10% compounded annually: $100 x
1.73554 (PV of annuity of $1 for 2 years
at 10%)
173.55
Total present value of bonds
$1,000.00
Accounting for Bonds Payable
Bonds Issued at Face Amount
On January 1, 2005, a corporation issues for cash
$100,000 of 12%, five-year bonds; interest payable
semiannually. The market rate of interest is 12%.
Present value of face amount of $100,000 due in 5
years at 12% compounded annually: $100,000 x
0.55840
Present value of 10 interest payments of $6,000
compounded semiannually: $6,000 x 7.3609
(PV of annuity of $1 for 10 periods at 6%)
Total present value of bonds
$ 55,840
44,160
$100,000
Accounting for Bonds Payable
Bonds Issued at Face Amount
On January 1, 2005, a corporation issues for cash
$100,000 of 12%, five-year bonds; interest payable
semiannual. The market rate of interest is 12%.
2005
Jan. 1 Cash
100 000 00
Bonds Payable
Issued $100,000 bonds
payable at face amount.
100 000 00
Accounting for Bonds Payable
Bonds Issued at Face Amount
On June 30, an interest payment of $6,000
is made ($100,000 x .12 x 6/12).
June 30 Interest Expense
Cash
Paid six months’ interest on
bonds.
6 000 00
6 000 00
Accounting for Bonds Payable
Bonds Issued at Face Amount
The bond matured on December 31, 2009.
At this time, the corporation paid the face
amount to the bondholder.
2009
Dec. 31 Bonds Payable
Cash
100 000 00
100 000 00
Paid bond principal at
maturity date.
Accounting for Bonds Payable
Bonds Issued at a Discount
Assume that the market rate of interest is 13%
on the $100,000 bond rather than 12%.
Present value of face amount of $100,000 due in 5
years at 13% compounded semiannually: $100,000
x 0.53273 (PV of $1 for 10 periods at 6½%)
Present value of 10 semiannual interest payments
of $6,000 compounded semiannually: $6,000 x
7.18883 (PV of annuity of $1 for 10 periods at 6½%)
Total present value of bonds
$53,273
43,133
$96,406
Accounting for Bonds Payable
Bonds Issued at a Discount
On January 1, 2005, the firm issued $100,000
bonds for $96,406 (a discount of $3,594).
2005
Jan. 1 Cash
96 406 00
Discount on Bonds Payable
Bonds Payable
Issued $100,000 bonds at
discount.
3 594 00
100 000 00
Accounting for Bonds Payable
Bonds Issued at a Discount
On June 30, 2005, six-months’ interest is paid and the bond
discount is amortized using the straight-line method.
2005
June 30 Interest Expense
Discount on Bonds Payable
Cash
6 359 40
359 40
6 000 00
Paid semiannual interest and
amortized 1/10 of discount.
$3,594 ÷
10
Accounting for Bonds Payable
Bonds Issued at a Premium
If the market rate of interest is 11% and the contract
rate is 12%, the bond would sell for $103,769.
Present value of face amount of $100,000 due in 5
years at 11% compounded annually: $100,000 x
0.58543 (PV of $1 for 10 periods at 5½%)
$ 58,543
Present value of 10 semiannual interest payments of
$6,000 at 11%compounded semiannually: $6,000 x
7.53763 (PV of annuity of $1 for 10 periods at 5½%)
45,226
Total present value of bonds
$103,769
Accounting for Bonds Payable
Bonds Issued at a Premium
Sold $100,000 of bonds for
$103,769 (a premium of $3,769).
2005
Jan. 1 Cash
103 769 00
Bonds Payable
Premium on Bonds Payable
Issued $100,000 bonds at a
premium.
100 000 00
3 769 00
Accounting for Bonds Payable
Bonds Issued at a Premium
On June 30, paid the semiannual
interest and amortized the premium.
2005
June 30 Interest Expense
Premium on Bonds Payable
5 623 10
376 90
Cash
Paid semiannual interest and
amortized 1/10 of bond premium.
6 000 00
$3,769 x 1/10
Accounting for Bonds Payable
Zero-Coupon Bonds
Zero-coupon bonds do not provide for interest
payments. Only the face amount is paid at maturity.
Assume market rate is 13% at date of issue.
Present value of $100,000 due in 5 years at 13%
compounded semi annually: $100,000 x 0.53273
(PV of $1 for 10 periods at 6½%)
$53,273
Accounting for Bonds Payable
Zero-Coupon Bonds
On January 1, 2005, Issue 5-year,
$100,000 zero-coupon bonds when the
market rate of interest is 13%.
2005
Jan. 1 Cash
53 273 00
Discount on Bonds Payable
Bonds Payable
Issued $100,000 zerocoupon bonds.
46 727 00
100 000 00
The bond indenture may require that a
fund for the payments of the face value of
the bonds at maturity be set aside over the
life of the bonds. This special fund is
called a bond sinking fund.
Bond Redemption
On June 30, a corporation has a bond issue of
$100,000 outstanding on which there is an
unamortized premium of $4,000. The corporation
purchases one-fourth of the bonds for $24,000.
2005
June 30 Bonds Payable
Premium on Bonds Payable
Cash
Gain on redemption of Bonds
Retired bonds for $24,000.
25 000 00
1 000 00
24 000 00
2 000 00
Bond Redemption
Instead, assume that the firm reacquired
all of the bonds, paying $105,000.
2005
June 30 Bonds Payable
100 000 00
Premium on Bonds Payable
4 000 00
Loss on Redemption of Bonds
1 000 00
Cash
Retired bonds for $105,000.
105 000 00
Investments in Bonds
Bonds are purchased directly from the
issuing corporation or through an organized
bond exchange. Bond prices are quoted as a
percentage of the face amount.
A premium or discount on a bond
investment is recorded in a single
investment account and is amortized over
the remaining life of the bonds.
Investments in Bonds
On April 2, 2005, Purchased a $1,000 Lewis
Company bond at 102 plus a brokerage fee of
$5.30 and accrued interest of $10.20.
2005
Apr. 2 Investment in Lewis Co. Bonds.
Interest Revenue
Cash
1 025 30
10 20
1 035 50
Invested in a Lewis
Company bond.
Note that the brokerage fee is added
to the cost of the investment.
Investments in Bonds
To assist your understanding,
let’s look at an extended
illustration for Crenshaw, Inc.
Investments in Bonds
On July 1, 2005, Crenshaw Inc. purchases
$50,000 of 8% bonds of Deitz Corporation due
in 8 3/4 years. The effective interest rate is 11%.
The purchase price is $41,706 plus interest of
$1,000 accrued from April 1, 2005.
2005
July 1 Investment in Deitz Corp. Bonds.
Interest Revenue
Cash
Purchased investment in
bonds, plus accrued interest.
41 706 00
1 000 00
42 706 00
$50,000 x 8% x 3/12
Investments in Bonds
Received semiannual interest for April 1 to
October 1 ($50,000 x 8% x 6/12).
Oct. 1 Cash
2 000 00
Interest Revenue
Received semiannual
interest for April 1 to
October 1.
2 000 00
Investments in Bonds
Adjusting entry for interest accrued
from October 1 to December 31
($50,000 x 8% x 3/12).
Dec. 31 Interest Receivable
Interest Revenue
Adjusting entry for interest
accrued from October 1 to
December 31.
1 000 00
1 000 00
Investments in Bonds
Adjusting entry for amortization of
discount for July 1 to December 31:
($50,000 –$41,706)/105 x 6 months.
Dec. 31 Investment in Deitz Corp. Bonds
Interest Revenue
Adjusting entry for
amortization of discount
from July 1 to December 31.
474 00
474 00
Rounded to
nearest dollar
($79 a month)
Investments in Bonds
Investment Revenue
July 1
1,000
Oct. 1
Dec. 31
31
Bal. 2,474
2,000
1,000
474
3,474
Investments in Bonds
The Deitz bonds are sold on June 30, 2012
for $47,350 plus accrued interest. It has
been six months since the last amortization
entry, so amortization for the current year
must be recorded (6 months).
2012
June 30 Investment in Deitz Corp. Bonds
474 00
Interest Revenue
Amortized discount for
current year.
474 00
$79 x 6
Investments in Bonds
Investment in Deitz Corporation Bonds
2005
July 1
Dec. 31
2006
Dec. 31
2007
Dec. 31
2008
Dec. 31
2009
Dec. 31
2010
Dec. 31
2011
Dec. 31
2012
June 30
41,706
474
948
948
948
948
948
948
474
48,342
The investment
$79
x
6
account after all
$79
x 12
amortization
entries have
been made,
including the
June 30, 2012
adjusting entry.
Investments in Bonds
This investment was sold on June 30, 2009
for $47,350 plus accrued interest. It has
been six months since the last amortization
entry, so amortization for the current year
$50,000
must be recorded (6 months).
x 8% x
3/12
2012
June 30 Cash
Loss on Sale of Investment
Interest Revenue
Investment in Deitz Corp. Bonds
48 350 00
992 00
1 000 00
48 342 00
Financial
Analysis and
Interpretation
Number of Times Interest
Charges Earned
Solvency Measures—The Long-Term Creditor
Number of Times Interest Charges Earned
Income before income tax
Add interest expense
Amount available for interest
2006
2005
$ 900,000 $ 800,000
300,000
250,000
$1,200,000 $1,050,000
Income before income tax + Interest expense
Interest Expense
2005 $800,000 + $250,000 = 4.2 times
$250,000
Solvency Measures—The Long-Term Creditor
Number of Times Interest Charges Earned
Income before income tax
Add interest expense
Amount available for interest
2006
2005
$ 900,000 $ 800,000
300,000
250,000
$1,200,000 $1,050,000
Income before income tax + Interest expense
Interest Expense
2006 $900,000 + $300,000 = 4.0 times
$300,000
The purpose of the ratio is to
assess the risk to debtholders in
terms of number of times interest
charges were earned.
Chapter 15
The End