Financial and Managerial Accounting
8th Edition
Warren Reeve Fess

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1.
Compute the potential impact of longterm borrowing on the earnings per share of a corporation.
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.

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.

Resources = Sources
Liabilities
Debt Financing: Bondholders
Assets
Stockholders’
Equity
Equity Financing: Stockholders

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
Plan 1
—
Plan 2
—
Plan 3
$2,000,000
—
$2,000,000 1,000,000
$4,000,000
$4,000,000
2,000,000
$4,000,000
1,000,000
$4,000,000
$ 800,000 $ 800,000 $ 800,000
— —
240,000
Income before income tax $ 800,000 $ 800,000 $ 560,000
Deduct income tax 320,000 320,000 224,000
Net income
Dividends on preferred stock
Available for dividends
$ 480,000 $ 480,000 $ 336,000
— 180,000 90,000
$ 480,000 $ 300,000 $ 246,000
Shares of common stock
÷400,000 ÷200,000 ÷100,000
Earnings per share $ 1.20
$ 1.50
$ 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
Plan 1
—
Plan 2
—
Plan 3
$2,000,000
—
$2,000,000 1,000,000
$4,000,000
$4,000,000
2,000,000
$4,000,000
1,000,000
$4,000,000
$ 440,000 $ 440,000 $ 440,000
— —
240,000
Income before income tax $ 440,000 $ 440,000 $ 200,000
Deduct income tax 176,000 176,000 80,000
Net income
Dividends on preferred stock
Available for dividends
$ 264,000 $ 264,000 $ 120,000
— 180,000 90,000
$ 264,000 $ 84,000 $ 30,000
Shares of common stock
÷400,000 ÷200,000 ÷100,000
Earnings per share $ 0.66
$ 0.42
$ 0.30


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.


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

$1,000
A $1,000, 10% bond is purchased. It pays interest annually and will mature in two years.
10% payable annually
$100
Interest payment
$100
Interest payment
Today
End of
Year 1
End of
Year 2
$90.91
$100 x 0.90909
$82.65
$100 x 0.82645
$1,000 x 0.82645
$826.45
$1,000.00 (rounded)

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%)
Total present value of bonds
173.55
$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
Bonds Payable
Issued $100,000 bonds payable at face amount.
100 000 00
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
Paid bond principal at maturity date.
100 000 00
100 000 00

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
$53,273 of $6,000 compounded semiannually: $6,000 x
7.18883 (PV of annuity of $1 for 10 periods at 6½%)
43,133
Total present value of bonds $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
Discount on Bonds Payable
Bonds Payable
Issued $100,000 bonds at discount.
96 406 00
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
Paid semiannual interest and amortized 1/10 of discount.
6 359 40
359 40
6 000 00
$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%)
Present value of 10 semiannual interest payments of
$ 58,543
$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
Bonds Payable
Premium on Bonds Payable
Issued $100,000 bonds at a premium.
103 769 00
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
Cash
Paid semiannual interest and amortized 1/10 of bond premium.
5 623 10
376 90
$3,769 x 1/10
6 000 00

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
Discount on Bonds Payable
Bonds Payable
Issued $100,000 zerocoupon bonds.
53 273 00
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
Premium on Bonds Payable
Loss on Redemption of Bonds
Cash
Retired bonds for $105,000.
100 000 00
4 000 00
1 000 00
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
Invested in a Lewis
1 025 30
10 20
1 035 50
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
41 706 00
1 000 00
42 706 00
Purchased investment in bonds, plus accrued interest.
$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
Interest Revenue
Received semiannual interest for April 1 to
October 1.
2 000 00
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
Rounded to nearest dollar
($79 a month)
474 00

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
Interest Revenue
Amortized discount for current year.
474 00
$79 x 6
474 00

Investments in Bonds
Investment in Deitz Corporation Bonds
2005
July 1 41,706
The investment
Dec. 31
2006
Dec. 31
2007
Dec. 31
2008
Dec. 31
2009
Dec. 31
2010
Dec. 31
2011
Dec. 31
2012
June 30
474
948
948
948
948
948
948
474
48,342
$79 x 6
$79 x 12 account after all 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
2012
June 30 Cash must be recorded (6 months).
48 350 00
$50,000 x 8% x
3/12
992 00 Loss on Sale of Investment
Interest Revenue
Investment in Deitz Corp. Bonds
1 000 00
48 342 00

Number of Times Interest
Charges Earned

Solvency Measures—The Long-Term Creditor
Number of Times Interest Charges Earned
2006 2005
Income before income tax
Add interest expense
$ 900,000 $ 800,000
300,000 250,000
Amount available for interest $1,200,000 $1,050,000
Income before income tax + Interest expense
Interest Expense
2005
$800,000 + $250,000
$250,000
= 4.2 times

Solvency Measures—The Long-Term Creditor
Number of Times Interest Charges Earned
2006 2005
Income before income tax
Add interest expense
$ 900,000 $ 800,000
300,000 250,000
Amount available for interest $1,200,000 $1,050,000
Income before income tax + Interest expense
Interest Expense
2006
$900,000 + $300,000
$300,000
= 4.0 times

The purpose of the ratio is to assess the risk to debtholders in terms of number of times interest charges were earned.