Bonds Payable & Investment
in Bonds
BY RACHELLE AGATHA, CPA, MBA
Slides by Rachelle Agatha, CPA,
with excerpts from Warren, Reeve, Duchac
Objectives:
1. Compute the potential impact of
long-term borrowing on earnings
per share.
2. Describe the characteristics,
terminology, and pricing of bonds
payable.
3. Journalize entries for bonds
payable.
2
Objectives:
4. Describe and illustrate the
payment and redemption of
bonds payable.
5. Journalize entries for the
purchase, interest, discount and
premium amortization, and sale
of bond investments.
6. Prepare a corporation balance
sheet.
3
Objective 1
Compute the
potential impact of
long-term
borrowing on the
earnings per share
of a corporation.
4
Financing Corporations
A bond is simply a form of
an interest-bearing note.
Like a note, a bond requires
periodic interest payments,
and the face amount must
be repaid at the maturity
date.
5
Plan 1
Plan 2
Plan 3
Issued 12% bonds
$4 million $2 million $2 million
Issued 9% preferred
stock, $50 par value
$2 million $1 million
Issued common stock,
$10 par value
$1 million
$4 million $4 million $4 million
6
Effect of Alternative
Financing Plans—
$800,000 Earnings
7
Effect of Alternative
Financing Plans—
$440,000 Earnings
8
8
Gonzales Co., is considering the following alternative
plans for financing their company:
Plan I
Issue 10% Bonds (at face)
Issue $10 Common Stock
Plan II
$2,000,000
$3,000,000 $1,000,000
Income tax is estimated at 40% of income.
Determine the earnings per share of common stock
under the two alternative financing plans, assuming
income before bond interest and income tax is
$750,000.
9
Plan I
Earnings before bond interest
$750,000
and income tax
0
Bond interest
$750,000
Balance
300,000
Income tax ($750,000 x 40%)
$450,000
Net income
0
Dividend on preferred stock
Earnings available for
$450,000
common stock
Number of common shares /300,000
Earnings per share on
$1.50
common stock
Plan II
(2,000,000 x 10%)
($550,000 x 40%)
$750,000
200,000
$550,000
220,000
$330,000
0
$330,000
/100,000
$3.30
10
Objective 2
Describe the
characteristics,
terminology, and
pricing of bonds
payable.
11
Bonds Payable
 A corporation that issues bonds enters into a
contract (called a bond indenture or trust
indenture) with the bondholders.
 Usually, the face value of each bond, called
the principal, is $1,000 or a multiple of
$1,000.
 Interest on bonds may be payable annually,
semiannually, or quarterly. Most pay interest
semiannually.
12
 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.
13
 Bonds that a corporation reserves
the right to redeem before their
maturity are called callable
bonds.
 Bonds issued on the basis of the
general credit of the corporation are
debenture bonds.
14
Pricing of 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.
15
The market or effective rate of interest is
determined by transactions between buyers
and sellers of similar bonds. The market rate
of interest is affected by a variety of factors,
including:
1. investors assessment of current economic
conditions, and
2. future expectations.
16
MARKET RATE = CONTRACT RATE
Selling price of bond = $1,000
$1,000
10% payable
annually
If the contract rate equals the market rate of interest, the
bonds will sell at their face amount.
17
MARKET RATE > CONTRACT RATE
Selling price of bond < $1,000
$1,000
10% payable
annually
–
Discount
If the market rate is higher than the contract rate, the bonds
will sell at a discount.
18
MARKET < CONTRACT RATE
Selling price of bond > $1,000
$1,000
10% payable
annually
+
Premium
If the market rate is lower than the contract rate, the bonds
will sell at a premium.
19
Time Value of Money
The time value of money
concept recognizes that an
amount of cash to be
received today is worth
more than the same amount
of cash to be received in the
future.
20
Present Value of the Face Amount
of Bonds
A $1,000, 10% bond is purchased. It pays interest
annually and will mature in two years.
$1,000
10% payable
annually
Today
End of
Year 1
End of
Year 2
21
Present Value of $1 at Compound
Interest
N = 2 rate =10%
22
Present Value of the Face Amount
of Bonds
A $1,000, 10% bond is purchased. It pays interest
annually and will mature in two years.
$1,000
10% payable
annually
Today
$826.45
End of
Year 1
End of
Year 2
$1,000 x 0.82645
23
Using Exhibit 3 in your test, what is the present value
of $4,000 to be received in 5 years, if the market rate
of interest is 10% compounded annually?
$4,000 x .62092* = $2,483.68
*Present value of $1 for 5 periods at 10%
24
Present Value of the Periodic Bond
Interest Payments
$100
Interest
payment
Today
End of
Year 1
$100
Interest
payment
End of
Year 2
$90.91 $100 x 0.90909
$82.64
$173.55
$100 x 0.82645
Present value, at 10%, of $100
interest payments to be received
each year for 2 years (rounded)
25
Present Value of Annuity of $1 at
Compound Interest
26
Present Value of 2-Year, 10% Bond
Present value of face value of $1,000 due in
2 years at 10% compounded annually:
$1,000 x 0.82645 (Exhibit 3: n = 2,
i = 10%)
$ 826.45
Present value of 2 annual interest payments
of 10% compounded annually: $100 x
1.73554 (Exhibit 4: n = 2, i = 10%)
173.55
Total present value of bond
$1,000.00
27
Calculate the present value of a $20,000, 5%,
5-year bond that pays $1,000 ($20,000 x 5%)
interest annually, if the market rate of interest
is 5%. Use Exhibits 3 and 4 for computing
present values.
28
Present value of face value of
$20,000 due in 5 years at 5%
compounded annually: $20,000 x .78353
(present value factor of $1 for 5 periods at
5%)
$15,671*
Present value of 5 annual interest
payments of $1,000 at 5% interest
compounded annually: $1,000 x
4.32948 (present value of annuity of $1 for
5 periods at 5%).
*Rounded to the nearest dollar
4,329*
$20,000
29
Objective 3
Journalize entries
for bonds payable.
30
Bonds Issued at Face Amount
On January 1, 2007, a
corporation issues for cash
$100,000 of 12%, five-year
bonds; interest payable
semiannually. The market
rate of interest is 12%.
31
Present value of face amount of
$100,000 due in 5 years at 12%
compounded annually: $100,000 x
0.55840 (Exhibit 3: n = 10, i = 6%)
Present value of 10 interest payments of
$6,000 at 12% compounded
semiannually: $6,000 x 7.36009 (Exhibit
$ 55,840
44,160*
4: n = 10; i = 6%)
Total present value of bonds
$100,000
*Because the present value tables are rounded to five decimal
places, minor rounding differences may appear in this
illustration.
32
On January 1, 2007, a corporation issues for
cash $100,000 of 12%, five-year bonds;
interest payable semiannual. The market rate
of interest is 12%.
2007
Jan. 1 Cash
100 000 00
Bonds Payable
100 000 00
Issued $100,000 bonds
payable at face amount.
33
On June 30, an interest payment of $6,000 is made
($100,000 x .12 x 6/12).
June 30 Interest Expense
Cash
6 000 00
6 000 00
Paid six months’ interest on
bonds.
34
The bond matured on December 31, 2011.
At this time, the corporation paid the face
amount to the bondholder.
2011
Dec. 31 Bonds Payable
Cash
100 000 00
100 000 00
Paid bond principal at
maturity date.
35
Bonds Issued at a Discount
Assume that the market rate of
interest is 13% on the $100,000
bonds rather than 12%. What
would be the present value of
these bonds?
36
Present value of face amount of
$100,000 due in 5 years at 13%
compounded semiannually: $100,000
x 0.53273
Present value of 10 interest payments
of $6,000, at 13% compounded
semiannually: $6,000 x 7.18883
(present value of annuity of $1 for 10
periods at 6%)
Total present value of bonds
$53,273
43,133
$96,406
37
On January 1, 2007, the firm issued $100,000
bonds for $96,406 (a discount of $3,594).
2007
Jan. 1 Cash
96 406 00
Discount on Bonds Payable
Bonds Payable
3 594 00
100 000 00
Issued $100,000 bonds
at discount.
38
On the first day of the fiscal year, a company
issues a $1,000,000, 6%, 5-year bond that pays
semi-annual interest of $30,000 ($1,000,000
x 6% x ½), receiving cash of $845,562.
Journalize the entry to record the issuance of
the bonds.
Cash
845,562
Discount on Bonds Payable 154,438
Bonds Payable
1,000,000
39
Amortizing a Bond Discount
There are two methods of amortizing a bond
discount:
1) The straight-line method and
2) The effective interest rate method,
often called the interest method.
Both methods amortize the same total
amount of discount over the life of the bonds.
40
Amortizing a Bond Discount
On June 30, 2007, six-months’ interest is paid and the bond discount
is amortized ($3,594 x 1/10) using the straight-line method.
2007
June30 Interest Expense
Discount on Bonds Payable
Cash
6 359 40
359 40
6 000 00
Paid semiannual interest
and amortized 1/10 of
bond discount.
41
Interest Expense
45,444
Discount on Bonds Payable
15,444
Cash
30,000
Paid interest and amortized the
bond discount ($154,438 ÷ 10).
42
Bonds Issued at a Premium
If the market rate of interest is
11% and the contract rate is
12%, on the five year, $100,000
bonds, the bonds will sell for
$103,769.
43
Present value of face amount of
$100,000 due in 5 years at 11%
compounded semiannually: $100,000
$ 58,543
x 0.58543 (Exhibit 3: n =10, i = 5½%)
Present value of 10 interest payments
of $6,000, at 11% compounded
semiannually: $6,000 x 7.53763
(Exhibit 4: n = 10, i = 5½%)
Total present value of bonds
45,226
$103,769
44
Issued $100,000 of bonds for $103,769 (a
premium of $3,769). The entry to record
this information is as follows:
2007
Jan. 1 Cash
103 769 00
Bonds Payable
Premium on Bonds Payable
100 000 00
3 769 00
Issued $100,000 bonds
at a premium.
45
A company issues a $2,000,000, 12%, 5-year
bond that pays semiannual interest of
$120,000 ($2,000,000 x 12% x ½), receiving
cash of $2,154,435. Journalize the bond
issuance.
Cash
2,154,435
Premium on Bonds Payable
154,438
Bonds Payable
2,000,000
46
Amortizing a Bond Premium
On June 30, 2007, paid the semiannual
interest and amortized the premium. The
firm uses straight-line amortization.
2007
June 30 Interest Expense
Premium on Bonds Payable
5 623 10
376 90
Cash
6 000 00
Paid semiannual interest and
amortized 1/10 of bond prem.
$3,769 x
1/10
47
Using the bond from previous example,
journalize the first interest payment and the
amortization of the related bond premium.
Interest Expense
104,556
Premium on Bonds Payable
15,444
Bonds Payable
120,000
Paid interest and amortize the
bond premium ($154,435/10).
48
Zero-Coupon Bonds
Zero-coupon bonds do not provide for interest payments.
Only the face amount is paid at maturity. Assume that the
market rate is 13% at date of issue.
Present value of $100,000 due in 5 years at
13% compounded semiannually: $100,000
x 0.53273 (PV of $1 for 10 periods at 6½%)
= $53,273
49
On January 1, 2007, issue 5-year,
$100,000 zero-coupon bonds when the
market rate of interest is 13%.
2007
Jan. 1 Cash
53 273 00
Discount on Bonds Payable
Bonds Payable
46 727 00
100 000 00
Issued $100,000 zerocoupon bonds.
50
Objective 4
Describe and
illustrate the
payment and
redemption of
bonds payable.
51
Since the payment of bonds
normally involves a large
amount of cash, a bond
indenture may require that cash
be periodically transferred into
a special cash fund, called a
sinking fund, over the life of
the bond issue.
52
Bond Redemption
A corporation may call or
redeem bonds before they
mature. Callable bonds can
be redeemed by the issuing
corporation within the period of
time and the price stated in the
bond indenture. Normally, the
call price is above the face value.
53
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.
2007
June 30Bonds Payable
Premium on Bonds Payable
Cash
Gain on Redemption of Bonds
25 000 00
1 000 00
24 000 00
2 000 00
Retired bonds for
$24,000.
54
Instead, assume that on June 30 the corporation calls
all of the bonds, paying $105,000.
2007
June 30Bonds Payable
100 000 00
Premium on Bonds Payable
4 000 00
Loss on Redemption of Bonds
1 000 00
Cash
105 000 00
Redeemed $100,000
bonds for $105,000.
55
A $500,000 bond issue on which there is an
unamortized discount of $40,000 is redeemed
for $475,000. Journalize the redemption of
the bonds.
Bonds Payable
500,000
Loss on Redemption of Bonds
15,000
Discount on Bonds Payable
40,000
Cash
475,000
56
Objective 5
Journalize entries
for the purchase,
interest, discount,
and premium
amortization, and
sale of bond
investments.
57
Accounting for Bond Investments
Bonds may be purchased either
directly from the issuing
corporation or through an
organized bond exchange.
Prices for bonds are quoted as a
percentage of the face
amount.
58
On April 2, 2007, an investor purchases a $1,000
Lewis Company bond at 102 plus a brokerage fee of
$5.30 and accrued interest of $10.20.
2007
Apr. 2 Investment in Lewis Co. Bonds
Interest Revenue
Cash
1 025 30
10 20
1 035 50
Invested in a Lewis
Company bond.
59
On April 2, 2007, an investor purchases a $1,000
Lewis Company bond at 102 plus a brokerage fee of
$5.30 and accrued interest of $10.20.
2007
Apr. 2 Investment in Lewis Co. Bonds
Interest Revenue
1 025 30
10 20
Cash
1 035 50
Invested in a Lewis
Company bond.
Note that the brokerage fee is added to
the cost of the investment.
60
Extended Illustration for
Crenshaw, Inc.
On July 1, 2007, 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, 2007
($50,000 x 8% x 3/12).
61
The entry to record the investment is as follows:
2007
July 1 Investment in Deitz Corp. Bonds
Interest Revenue
Cash
Purchased
41 706 00
1 000 00
42 706 00
investment in bonds,
plus accrued interest.
62
Crenshaw, Inc. received semiannual interest for April
1 to October 1 ($50,000 x 8% x 6/12).
Oct. 1 Cash
Interest Revenue
2 000 00
2 000 00
Received semiannual
interest for April 1 to
October 1.
63
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
64
Adjusting entry for amortization of discount for
July 1 to December 31: ($50,000 –$41,706)/105
= $79 (rounded) x 6 months.
31 Investment in Deitz Corp. Bonds
Interest Revenue
Adjusting entry for
amortization of discount
for July 1 to December
31.
474 00
474 00
65
The effect of these entries on Interest Revenue
is as follows:
Interest Revenue
July 1
1,000
Oct.
1
Dec. 31 Adj.
31
Adj.
Adj. Bal.
2,000
1,000
474
2,474
66
Accounting for Bond Investments—Sale
The Deitz bonds are sold for
$47,350 plus accrued interest on
June 30, 2014. The carrying
amount of the bond as of
January 1, 2014 is $47,868
[$41,706 + ($79 per month x 78
months)].
67
It has been six months since the last
amortization entry, so amortization for this
period is recorded (6 months).
2014
June30 Investment in Deitz Corp. Bonds
Interest Revenue
474 00
474 00
Amortized discount for
current year.
68
The next slide shows
the Investment in
Dietz Corp. Bonds
account after all
amortization entries
have been made,
including the June 30,
2014 adjusting entry.
69
Investment in Deitz Corp. Bonds
2007
July 1 41,706
Dec. 31
474
2008
Dec. 31
948
2009
Dec. 31
948
2010
Dec. 31
948
2011
Dec. 31
948
2012
Dec. 31
948
2013
Dec. 31
948
2014
June 30
474
48,342
70
This investment is sold on June 30, 2014 for
$47,350 plus accrued interest of $1,000 ($50,000 x
8% x 3/12) .
30 Cash
Loss on Sale of Investments
Interest Revenue
Investment in Deitz Co. Bonds
Received interest and
48 350 00
992 00
1 000 00
48 342 00
proceeds from sale of
bonds.
71
On October 1, 2008 Viewtec Corporation
purchases $10,000 of 6% bonds of Watson
Corporation due in 9¼ years. The bonds were
purchased at a price of $8,341 plus interest of
$150 ($10,000 x 6% x 3/12) accrued from July 1,
2008, the date of the last semiannual interest
payment.
a. Journalize the purchase of the bonds plus
accrued interest.
b. Journalize the entry to record the
amortization of the discount on December
31.
72
2008
a. Oct.Investment
in Watson Corp. Bonds 8,341
1
Interest Revenue
150
Cash
8,491
2008
b. Dec. 1 Investment in Watson Corp. Bonds 42*
Interest Revenue
42
*[($10,000 – $8,341)/111 months] x 3
months
73
Objective 6
Prepare a
corporation
balance sheet.
74
Balance Sheet of a
Corporation
(Continued)
75
Balance Sheet of a
Corporation
(Concluded)
76
Held-to-Maturity Securities
Investments in bonds or other
debt securities that management
intends to hold to their maturity
are called held-to-maturity
securities.
77
Balance Sheet Presentation of Bond
Investments
 Such securities are classified as long-term
investments under the caption Investments.
 These investments are reported at their cost less
any amortized premium or plus any amortized
discount.
 The market (fair) value of the bond investment
should be disclosed, either on the face of the
balance sheet or in an accompanying note.
78
Financial Analysis and Interpretation
Some corporations have a high ratio of debt
to stockholders’ equity. For such
corporations, analysts often assess the
relative risk of the debtholders in terms of
the number of times the interest
charges are earned during the year.
79
Number of Times the Interest Charges
Earned
To illustrate, assume the following data:
Interest expense
$ 36,883,000
Income before income tax 174,315,000
Income before income tax + Interest expense
Interest expense
$174,315,000 + $36,883,000
$36,883,000
(Continued)
80
The number of times interest
charges are earned is 5.73.
This ratio indicates that the debtholders have
adequate protection against a potential drop in
earnings jeopardizing their receipt of interest
payments. A full analysis should involve a
comparison with industry averages.
81
Summary
 Financing Corporations
 Bond terms & Characteristics
 Time Value of Money
 Accounting for Bonds
 Investment in Bonds
 Financial Statement Presentation