Accounting Chapter 10 | 10.3 Accounting for Bond Transactions

Although Discount on Bonds Payable has a debit balance, it is not an asset. Rather it is a ________ __________. This account is deducted from ________ ___________ on the balance sheet, as shown in Illustration 10.9. ILLUSTRATION 10.9 Statement presentation of discount on bonds payable The $98,000 represents the ___________ (or ____) _____ of the bonds (see Helpful Hint). Carrying value (book value) of bonds issued at a discount is determined by? On the date of issue, this amount equals the market price of the bonds.

contra account. bonds payable ILLUSTRATION 10.9 Statement presentation of discount on bonds payable carrying book value subtracting the balance of the discount account from the balance of the Bonds Payable account.

Recall that the _________ ______ _____ is the rate applied to the face (par) value to arrive at the interest paid in a year. When the contractual interest rate and the market interest rate are the same, bonds sell at _____ _____ (___ _____).

contractual interest rate face value (par value)

However, market interest rates change ______. The type of bond issued, the state of the economy, current industry conditions, and the company's performance all affect ________ _________ _____. As a result, contractual and market interest rates often ______. To make bonds salable when the two rates differ, bonds _____ _____ or ________ face value. To illustrate, suppose that a company issues 10% bonds at a time when other bonds of similar risk are paying 12%. Investors will not be interested in buying the 10% bonds, so their value will fall below their face value. When a bond is sold for less than its face value, the difference between the face value of a bond and its selling price is called a ___________. As a result of the decline in the bonds' selling price, the actual interest rate incurred by the company increases to the level of the current market interest rate.

daily market interest rates. differ sell below above discount.

Amortization of the discount ___________ the amount of interest expense reported each period. That is, after the company amortizes the discount, the amount of interest expense it reports in a period will exceed the?

increases contractual amount.

Bonds may be issued at face value, below face value (discount), or above face value (premium). Recall that bond prices for both new issues and existing bonds are quoted as a _____________ of the face value of the bond, and that face value is usually $1,000. Thus, a $1,000 bond with a quoted price of 97 means that the selling price of the bond is 97% of face value, or $970.

percentage

Conversely, if the market rate of interest is lower than the contractual interest rate, investors will have to pay more than face value for the bonds. That is, if the market rate of interest is 8% but the contractual interest rate on the bonds is 10%, the price of the bonds will be bid up. When a bond is sold for more than its face value, the difference between its selling price and the face value is called a ____________. Illustration 10.8 shows these relationships. ILLUSTRATION 10.8 Interest rates and bond prices Issuance of bonds at an amount different from face value is quite common. By the time a company completes the necessary paperwork and markets the bonds, it will be a coincidence if the market rate and the contractual rate are the same. Thus, the issuance of bonds at a discount does not mean that the issuer's financial strength is suspect. Conversely, the sale of bonds at a premium does not indicate that the financial strength of the issuer is exceptional.

premium. ILLUSTRATION 10.8 Interest rates and bond prices

As indicated earlier, a corporation records bond transactions when it issues (_____) or redeems (____ ___) bonds and when bondholders convert bonds into common stock. If bondholders sell their bond investments to other investors, the issuing company receives no further money on the transaction, nor does the issuing company journalize the transaction (although it does keep records of the names of bondholders in some cases).

sells buys back

The previous example assumed that the contractual (_______) interest rate and the market (__________) interest rate paid on the bonds were the same.

(stated) (effective)

What is the learning objective 3?

Explain how to account for bond transactions.

To illustrate the issuance of bonds at a premium, we now assume the Candlestick Inc. bonds described above sell for $102,000 (102% of face value) rather than for $98,000. The entry to record the sale is as follows. Candlestick adds the premium on bonds payable to the bonds payable amount on the balance sheet, as shown in Illustration 10.13. The sale of bonds above face value causes the total cost of borrowing to be less than the ____ ___________ ____. The reason: The borrower is not required to pay the bond premium at the maturity date of the bonds. Thus, the bond premium is considered to be a reduction in the cost of borrowing that reduces bond interest over the life of the bonds. The total cost of borrowing $102,000 for Candlestick is shown in Illustration 10.14 (see Helpful Hint). ILLUSTRATION 10.14 Total cost of borrowing—bonds issued at a premium Alternatively, we can compute the cost of borrowing as shown in Illustration 10.15. ILLUSTRATION 10.15 Alternative computation of total cost of borrowing—bonds issued at a premium

bond interest paid

To illustrate the accounting for bonds issued at face value, assume that on January 1, 2022, Candlestick Inc. issues $100,000, five-year, 10% bonds at 100 (100% of face value). The entry to record the sale is as follows. Candlestick reports bonds payable in the long-term liabilities section of the balance sheet because the maturity date is January 1, 2027 (more than one year away). Over the term (life) of the bonds, companies make entries to record ____ __________. Interest on bonds payable is computed in the same manner as interest on ____ ________.

bond interest. notes payable.

Assume that interest is payable annually on January 1 on the Candlestick bonds. In that case, Candlestick accrues interest of $10,000 ($100,000 × 10%) on December 31. At December 31, Candlestick recognizes the $10,000 of interest expense incurred with the following entry. The company classifies interest payable as a current ________ because it is scheduled for payment within the next year. When Candlestick pays the interest on January 1, 2023, it debits (______________) Interest Payable and credits (_________________) Cash for $10,000. Candlestick records the payment on January 1 as follows.

liability decreases decreases

The issuance of bonds below face value—at a discount—causes the total cost of borrowing to differ from the bond interest paid. That is, the issuing corporation must pay not only the contractual interest rate over the term of the bonds but also the face value (rather than the issuance price) at ____________. Therefore, the difference between the issuance price and face value of the bonds—the discount—is an additional cost of ___________. The company records this additional cost as ________ _________ over the life of the bonds. The total cost of borrowing $98,000 for Candlestick is therefore $52,000, computed as shown in Illustration 10.10. ILLUSTRATION 10.10 Total cost of borrowing—bonds issued at a discount Alternatively, we can compute the total cost of borrowing as shown in Illustration 10.11. ILLUSTRATION 10.11 Alternative computation of total cost of borrowing—bonds issued at discount To follow the expense recognition principle, companies allocate bond discount to ___________ in each period in which the bonds are outstanding. This is referred to as? As shown in Illustration 10.10, for the bonds issued by Candlestick, total interest expense will exceed the contractual interest by $2,000 over the life of the bonds. As the discount is amortized, its balance? As a consequence, the carrying value of the bonds will increase, until at maturity the carrying value of the bonds equals their face amount. This is shown in Illustration 10.12. Appendices 10A and 10B at the end of this chapter discuss procedures for amortizing bond discount.

maturity. borrowing interest expense expense amortizing the discount. declines.

Similar to bond discount, companies allocate bond premium to expense in each period in which the bonds are outstanding (see Helpful Hint). Helpful Hint>> Both a discount and a premium account are? A _______________ _____________ is one that is needed to value properly the item to which it relates.

valuation accounts. valuation account