Chapter 9
Interest is treated separately from the bond itself. Amount of interest paid is driven by the _____.
Bond document: contractual rate of rate x face x time (if it's semi-annual, then time is 1/2)
Interest of Net Income taxes equations
(1-tax rate) x interest rate
Other ratios focus a company's ability to make interest payments: (2)
- Times Interest Earned (Accrual Basis) - Times Interest Earned (Cash Basis)
Effective Interest Method of Bond Amortization
- a method of interest amortization that is based on compound interest calculations. - actual payments of bond interest are driven by the bond document - interest expense will be based on the market or effective rate of interest - cv (market) x rate x time when you have a discount: cv= bp- discount premium: cv = bp+ premium steps to calculate interest payment: - calculate interest payment - calculate bond interest expense - result is the amortization amount Interest expense recognized and amortization amount will change each payment date
Bonds issued at a premium (effective interest method): On December 31, 2017, Mathews Company sold 10 year 7% bonds with a face value of $600,000 for a price of $647,461 when the market rate of interest was 6%. The bonds pay semiannual interest each June 30 and Dec 31. Record the first bond interest payment on June 30 2018.
- market rate lower than our bonds - step 1- bond interest payment: face x rate x time: 600,000 *.07*1/2= $21,000 - step 2- bond interest expense: cv*market rate*time = 647,461*.06*(1/2)= $19,424 Debit: Bond interest expense: 19,424 Premium on bonds payable: 1576 Credit: 21000 Impact on basic accounting equation: Bond interest expense goes up by 19,424 which makes retained earnings go down by that amount. assets (cash) goes down by 21,000. under liabilities, carrying value of the bonds goes down by 1576
Bonds issued at a premium (effective interest method): On December 31, 2017, Mathews Company sold 10 year 7% bonds with a face value of $600,000 for a price of $647,461 when the market rate of interest was 6%. The bonds pay semiannual interest each June 30 and Dec 31. Record the second bond interest payment on Dec 31 2018.
- step 1- bond interest payment: face x rate x time: 600,000 *.07*1/2= $21,000 always the same but bond interest changes because carrying value changes. Old premium on bonds payable is 47461 (647,461-600,000) and then the amortization of 1576 makes the account now 45,445. new cv: 600,000+45,885= 645,885 step 2- bond interest expense: cv*market rate*time = 645,885*.06*1/2= 19377 Debit: Bond Interest Expense: 19377 Premium on Bonds payable: 1623 Credit: Cash: 21,000 premium account now: 45,445-1623=44,262
When would we need to make a transaction related to a bonds payable?
- when we issue the bond itself (will trigger an obligation getting recognized) - bond retirement (when we get rid of the bonds whether we are redeeming them at the end of their maturity or if we are getting rid of them early) - sometimes bonds are sold with a conversion privilege for the bond holder to convert that bond into common stock (but we won't get into this in our class) - record bond interest payments (use contractual/ standard rate) - considering what do we get in exchange for our bonds? Issue price is determined based on present value of future cash flows. that will be driven by the market rate and they will be looking at the present value of a single sum and this will at the maturity (face amount) and they will be looking at all those interest payments and figuring out the pv (present value) of those annuity payments are She says "and the sum of those two things are going to determine the issue price of bonds." figure out what those two things mean.
Example: bonds issued at face: On December 31, 2017, Callahan sold a 5 year, 8% bonds with a face value of $600,000 for a price of $600,000. The bonds pay semiannual interest each June 30 and December 31. we are dealing only with issuance so we are going to record only what is happening on 12/31/17
. bonds payable are dealt with at their face value and we know that face value is 600,000. Debit: Cash: 600,000 Credit: Bonds Payable: 600,000
Example: (sold at par, no discount or premium) On January 1, 2020, Vampatella Co. issued $100,000 of 8% bonds at par. These bonds are due in 5 years with interest payable annually on December 31. 1. The interest payment on December 31 of each year will be: 2. Prepare the journal entries necessary to recognize (a) the interest expense on December 31, 2020-2024, and (b) the repayment of the loan principal on December 31, 2024.
1. 100,000*.08= 8,000 2. a. December 31, 2020-2024 Debit: interest expense: 8,000 cash: 8,000 b. Dec, 31 2024 Debit: bonds payable: 100,000 Credit: cash: 100,000
Steps to record interest payments under straight-line method of bond amortization:
1. calculate interest payment (go back to contractual/stated rate in face x rate x time= interest payed 2. Calculate amortization amount: (total premium or discount)/ (# of payments) 3. result is bond interest expense
Example: Bond interest payment straight-line method premium: On December 31, 2017, Callahan sold a 5 year, 8% bonds with a face value of $600,000 for a price of $619,000. The bonds pay semiannual interest each June 30 and December 31. Record the first semi-annual bond interest payment.
1. face x rate x time = 600,000 x .08 x .5 = 24,000--> amount paid 2. 19,000/ 10 = 1,900 Debit: Bond Interest Expense: 22,100 premium account: 1,900 Credit: 24,000
3 parts of retirement of bonds
1. record cash paid 2. remove carrying value 3. record gain or loss
Example: Bond interest payment straight-line method discount: On December 31, 2017, Callahan sold a 5 year, 8% bonds with a face value of $600,000 for a price of $586,000. The bonds pay semiannual interest each June 30 and December 31. Record the first semi-annual bond interest payment.
1. step 1: face x rate x time = 600,000 x .08 x .5 = 24,000 <-- amount paid Step 2: So we know we have a 14,000 discount 14,000 / 10 # of payments =1,400 Debit: Bonds Interest expense: 25,400 Credit: Discount on bonds payable: 1,400 Cash: 24000
example: bonds issued at a discount: On December 31, 2017, Callahan sold a 5 year, 8% bonds with a face value of $600,000 for a price of $586,000. The bonds pay semiannual interest each June 30 and December 31.
12/31/ 17 Debit: cash: 586,000 Credit: bonds payable: 600,000 Discount on bons payable: 14,000
example: Bonds issued at a premium: On December 31, 2017, Callahan sold a 5 year, 8% bonds with a face value of $600,000 for a price of $619,000. The bonds pay semiannual interest each June 30 and December 31.
12/31/17 debit: cash: 619,000 credit: bonds payable: 600,000 premium on bonds payable account: 19,000
callable bonds
Bonds that give the issuer the option to retire them at a stated amount prior to maturity.
how does issuing a bond at premium impact the basic accounting equation?
Cash goes up under assets and bonds payable goes up under liability. since asset is greater than bonds payable you add an adjunct account (increases the amount of obligations) called premium on bonds payable to make liabilities same as asset. and no impact on Stockholder's equity. premium on bonds payable increases and decreases the way that bonds payable does.
The payment schedule for debts are flexible. T/F
F
Example: Bonds issued a face: On December 31, 2017, Callahan sold a 5 year, 8% bonds with a face value of $600,000 for a price of $600,000. The bonds pay semiannual interest each June 30 and December 31. Record the first semi-annual bond interest payment.
Face x rate x time= 600,000 x .08 x .5 = 24,000 In this case, 24,000 represents the amount of bond interest expense that we record as well as the amount of interest that we pay. (bond interest expense= bond interest paid) 6/30/18 debit: bond interest expense: 24,000 credit: 24,000 we arnt doing anything to the bond payable account
When me make a bond retirement we need to compare what 2 things?
carrying value to call price
Give an example of a secured bond
For example, mortgage bonds are secured by real estate. In this case, should the borrower fail to make the payments required by the bond, the lender can take possession of (repossess) the real estate that secures the bond. The real estate provides "security" for the lender in case the debt is not paid.
bonds issued at a discount impact on basic accounting equation
Interest expense goes up so retained earrings go down. and cash under assets goes down. and the amortization of the discount goes down when credited which makes carrying value go up which makes liabilities go up
What happens to interest when bonds are issued at a premium?
Interest expense recognized will be less than interest paid. What will happen every time that bonds are issued as a premium, is that that premium is going to serve to reduce the sum of our interest payments in order to get to our interest expense. So over the life of the life of the bonds we will recognize less interest expense than what we actually pay. And that will be handled through the amortization process (for both discount and premium)
What happens to interest when bonds are issued at a discount?
Interest expense recognized will be more than interest paid. This is because whatever shortfall we experience when we issued those bonds, is going to be considered over time as an increase over and above what we payed in interest to get to interest expense. In short, bonds will be issued at a discount and we will recognize more expense than what we are actually paying.
How does the issuance of the bond impact the basic account equation?
Liabilities increase because our obligations for bonds payable is going to go up. Assets go up because we are getting cash. And there is no impact under equity.
Bonds issued at a discount effective interest method: On December 31 2017, Ferguson sold 15 year, 7% bonds with a face value of $900,000 for a price of $828,415 when the market rate of interest is 8%. The bonds pay semiannual interest every June 30. Record the second bond interest payment of Dec 31, 2018.
Our new carrying value coming into this interest period is now 900,000- (71,585-1637)= 830,052 - step 1- bond interest payment: face x rate x time= 900,000*.07*1/2= $31,500 - step 2- bond interest expense: cv*market rate*time= 830,052*.08*1/2= $33,202 Debit: Bond interest expense: 33,202 Credit: cash: 31,500 Discount on bonds payable: 1,702
Steps for the effective interest method of bond amortization
Step 1: Actual payments of bond interest are driven by bond document payment of bond interest: Face x rterm-45ate x time (the rate is the contractual rate and will be used in the formula to figure out how much gets paid) Step 2: calculate bond interest expense. Interest expense will be based on the market or effective rate of interest. face becomes--> carrying value of the bonds rate---> this time market rate or effective rate cv x rate x time
Less cash is needed to purchase an asset than sign a lease T/F
T
leases create an obligation to make the lease payments regardless of whether or not you use the asset T/F
T
unsecured bondholders are the last lenders to be paid in bankruptcy T/F
T
Why do people purchase bonds at premiums?
The market is willing to pay more in advance for this promise to pay a lesser amount later. The answer is that the rates in the marketplace are lower than what this bond is providing, which increases the demand for this bond. By that token, if the market is not willing to give you face value, you have to sell at a discount.
Debt to equity ratio
Total Liabilites/Total Equity
ebt to equity and debt to total asset ratios measure the relative size of ____ in the accounting equation.
Total Liabilities
secured bond
a term used for a bond that has some collateral pledged against the corporation's ability to pay
unsecured/debenture bonds
a term used for bonds in which the lender is relying on the general credit of the borrowing corporation rather than on collateral.
bond
a type of note that requires the issuing entity to pay the face value of the bond to the holder when it matures and, usually, periodic interest at a specified rate
lease
an agreement that enables a company to use property without legally owning it
straight-line method
an interest amortization method that amortizes equal amounts of premium or discount to interest expense each period
impact of of bond interest payment discount for straight-line method on accounting equation:
asset (cash) goes down and discount balance under liabilites goes down by the amortization amount and the reaction to this is the carrying value (which is also under liabilities) goes up. bonds interest expense goes up by the amount paid plus amortization of the discount which makes retained earnings go down by this amount which makes stockholders equity goes down by this amount (show deddy this vid and ask question about it)****
how does recording an interest payment at face value?
bond interest expense brings down retained earnings so stockholder's equity goes down and cash goes down and nothing happens to liabilities
Underwriter
bonds are frequently sold to the public through an underwriter. Underwriters generate a profit either by offering a price that is slightly less than the expected market price (thereby producing a profit on resale) or by charging the borrower a fee
how to calculate carrying value when you have bonds payable that are issued at premium
bonds payable + premium
carrying value for bonds sold at a premium
bonds payable + premium on bp
retirement of bond (loss) example: Right after a semi-annual interest payment is made, Goldberg Company retired bonds with a face value of $600,000 and a carrying value of 583,000 for a price of $595,000. Record the bond retirement.
bonds payable face value is 600,000. Discount on bonds payable is 17,000 (600,000-583,000) compare cv. call price and see that call price is bigger (583,000<595,000) so we have a loss of 12,000. Impact on accounting equation: a loss of 12,000 on income statement bring retained earnings down by 12,000. Cash (assets go down by 595,000) and liabilities go down (carrying value of bonds) by 583,000. Debit: loss on retirement of bonds: 12,000 bonds payable: 600,000 Credit: Discount on bonds payable: 17,000 cash: 595,000 when you credit the discount on bonds payable account, the account goes to zero
how to calculate carrying value when you have a discount
bonds payable- whatever is in the discount account
carrying value for bonds sold at a discount
bonds payable-discount on bp
convertible bonds
bonds that allow the bondholder to convert the bond into another security—typically common stock.
retirement of bond (gain) example: Right after a semi-annual interest payment is made, Goldberg Company retired bonds with a face value of $600,000 and a carrying value of 583,000 for a price of $577,000. Record the bond retirement.
call price is less than the carrying value: 583,000-577,000= 6,000 gain Impact on accounting equation: gain of 6,000 on I/S increases retained earnings by 6,000. Liabilities go down by 583,000 (carrying value). Assets go down by 577,000 (cash) Debit: Bonds payable: 600,000 Credit: Discount on bonds payable: 17,000 Cash: 577,000 Gain on bonds payable: 6000
when carrying value > call price
carrying value is the obligation. so we have a gain if we get to pay less than than the obligation
A significant advantage of financing with debt rather than stock is the fact that the interest expense on debt is...
deductible for income tax purposes
Straight-line method of bond amortization: Remember that the actual payments of bond interest are driven by the bond document. The contractual/stated rate is what we are using to calculate face x rate x time. Interest expense recorded will be affected by the...
discount or premium amortization
how does recording bond interest expense for premium affect basic accounting equation?
expense goes up so income goes down and so retained earning go down and cash goes down so assets go down and then liabilities goes down: premium on bonds payable and cv of bonds goes down
interest formula
face value * annual interest rate * fraction of the year
Bonds issued at a discount effective interest method: On December 31 2017, Ferguson sold 15 year, 7% bonds with a face value of $900,000 for a price of $828,415 when the market rate of interest is 8%. The bonds pay semiannual interest every June 30. Record the first bond interest payment of June 30, 2018.
face value of these bonds will be the amount in bonds payable and will be $900,000. Discount on bonds payable is 71,585 (because 900,000-71,585 gives us a carrying value of 828,415). step 1- bond interest payment: face x rate x time= 900,000*.07*1/2= $31,500 step 2- bond interest expense: cv*market rate*time= 828,415*.08*1/2= $33,137 step 3- determine the amount of amortization of discount Debit: bond interest expense: 33,137 Credit: cash: 31,500 Discount on bonds payable: 1637 (33,137- 31,500)
what is the impact on the accounting equation when you issue a bond at a discount?
get a bonds payable liabilities go up, and assets go up because you are getting cash, but since the cash is less than the bonds payable, you have another liability that is called "discount on bonds payable" that is the difference between the bonds payable and cash. It is a contra account and it works against bonds payable and as it goes up, it brings liabilities down. and no impact on stockholder's equity.
when discount balance goes downs what happens to carrying value?
goes up
Another potential advantage of debt is that it fixes the amount of compensation to the ____
lender
Long-Term Debt to equity ratio
long term debt/total equity
when carrying value < call price
loss
when carrying value= call price
no gain or loss
lease contracts provide protection against...
obsolescence and flexibility
A third advantage of financing with debt is that in periods of inflation, debt permits the borrower to...
repay the lender in dollars that have declined in purchasing power. For instance, based on changes in the consumer price index (CPI), $1,000,000 borrowed in 1986 and repaid in 2016 provided the lender with approximately 46% of the purchasing power of the amount loaned in 1986.
lease contract can provide lower cost financing through
tax advantages
face value (aka par value or principle)
the amount of money that a borrower must repay at maturity
maturity
the date on which a borrower agrees to pay the creditor the face
market rate
the market rate of interest demanded by creditors
Borrowing, through the use of notes or bonds, is attractive to businesses as a source of money because
the relative cost of issuing debt (the interest payments) is often lower than the cost of issuing equity (giving up ownership shares)
call price
the retirement amount (amount being paid in order to get out of that obligation)
leverage
the use of borrowed capital to produce more income than needed to pay the interest on a debt
Debt to Total assets ratio
total liabilities/total assets
junk bonds
unsecured bonds where the risk of the borrower failing to make the payments is relatively high
What happens if we retire a bond not on the interest payment date?
we will have to make a transaction to recognize the bond interest expense
discount
when a bond sells at a price below face value, due to the yield being greater than the stated rate of interest
premium
when a bond's selling price is above face value.
When do you made a journal entry for a lease?
when you sign it for more than 1 year
does the carrying value change as you record payments?
yes steps to record interest payments: - calculate interest payment - calculate bond interest expense which is based on a moving number because cv is moving and changes - so the difference between those two things is the amortization amount. Interest expense recognized and amortization amount will change each payment due (interest payment the same every time and interest expense will be different since carrying value changes and so amount of amortization will be influenced by that change)
