Long-Term Liabilities and Investments
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1 Ch 21 Long-Term Liabilities and Investments Understanding bonds Accounting for issuance of bond Retirement of a bond Bond sinking funds Accounting for investments in stocks and bonds Presentation of bonds and investment 1
2 Bonds Payable 2 A Bond An interest-bearing security that represents debt to the issuing corporation Many publicly traded in the securities market Quoted on the bond market at a percent of face value When a corporation borrows money by issuing a bond, it is obligated to make two types of payments: Interest on the bond during the period of time the bond is outstanding Repayment of the bond s principal amount at the maturity date, the date on which the principal must be repaid
3 Bonds Payable The principal of a bond The amount the corporation must repay when the bond matures Bond certificate includes The principal of a bond The bond s rate of interest The date the bond matures 3
4 Advantages of Bonds The issuing corporation may be able to earn a greater return on the money it receives from the bonds than it must pay out in interest. Leverage The use of funds to earn a greater return than the cost of the borrowed fund Interest paid to bondholders is a tax-deductible business expense, which results in a savings of income taxes. Dividends paid to stockholders are not a tax-deductible business expense. Bondholders do not have voting rights in the corporation. When bonds are issued, funding is obtained but ownership of the corporation remains the same. Issuing bonds does not increase the number of stockholders. If the corporation can increase earnings through leverage, 4 stockholders are in a position to receive more dividends.
5 Disadvantages of Bonds Bondholders receive regular interest payments, even if the issuing corporation is suffering net losses. Defaulting on interest payments can result in legal action and force the corporation into bankruptcy. Bondholders, being creditors, have a prior claim to assets in the event the corporation liquidates. Stockholders claims can only be satisfied when bondholders (and other creditors) have been satisfied in full. At maturity, the principal of the bonds must be repaid to the bondholders, regardless of the profitability of the corporation. 5
6 Classification of Bonds-Time of Payment Term Bonds Bonds that mature at one point in time Serial Bonds Bonds that mature periodically over a number of years Secured Bonds Also called mortgage trust bonds Have a specific asset or assets pledged as collateral for the debt Debenture Bonds Issued on the general credit of the corporation No specific assets pledged as collateral Registered Bonds o Bonds for which the names and addresses of the bondholders are registered with the issuing corporation Coupon Bonds 6 Not registered with the corporation Ownership transferred by delivery of the bonds Interest payments received by presenting an interest coupon to a bank
7 Accounting for the Issuance of Bonds Bond Indenture A contract between the corporation and the bondholders Selling of Bonds Premium Sold for more than face value (M.R. < C.R.) Discount Sold for less than face value (M.R. > C.R.) At Face Value Sold for equal to face value (M.R. = C.R.) Contract Interest Rate The rate of interest stated on the bond certificate Market Interest Rate Also called the effective interest rate The rate prevailing in the bond market at the time the bonds are issued 7
8 Issuing Bonds at Face Value On Jan. 1, 2009, Massey International issued $100,000 of 5%, 10- year debenture bonds at face value, with interest payable semiannually on Jun. 30 and Dec. 31. Massey records the following journal entries for 2009: 2009 Jan. 1 Cash 100,000 Bonds Payable 100,000 Jun. 30 Interest Expense 2,500 Cash 2,500 8 Dec. 31 Interest Expense 2,500 Cash 2,500
9 Issuing Bonds at a Premium On Jan. 1, 2009, Massey International issued $100,000 of 5%, 10- year debenture bonds at 104, with interest payable semiannually on Jun. 30 and Dec. 31. Massey records the following journal entry on Jan. 1, 2009: 2009 Jan. 1 Cash 104,000 Bonds Payable 100,000 Premium on Bonds Payable 4,000 Premium on Bonds Payable Account An adjunct to the Bonds Payable account Its balance is added to the balance of the Bonds Payable account to show the carrying value of the bonds 9
10 Amortization of Bond Premium 2009 Jan. 1 Cash 104,000 Bonds Payable 100,000 Premium on Bonds Payable 4,000 Jun. 30 Interest Expense 2,500 Cash 2,500 Jun. 30 Premium on Bonds Payable 200 Interest Expense 200 Dec. 31 Interest Expense 2,500 Cash 2, Dec. 31 Premium on Bonds Payable 200 Interest Expense 200
11 Discount on Bonds Payable Account A contra liability account Its balance is subtracted from the balance of the Bonds Payable account to show the carrying value of the bonds Example: On Jan. 1, 2009, Massey International issued $100,000 of 5%, 10-year debenture bonds at 97, with interest payable semiannually on Jun. 30 and Dec. 31. Massey records the following journal entry on Jan. 1, 2009: 2009 Jan. 1 Cash 97,000 Discount on Bonds Payable 3,000 Bonds Payable 100,000 11
12 Amortization of Bond Discount 2009 Jan. 1 Cash 97,000 Discount on Bonds Payable 3,000 Bonds Payable 100,000 Jun. 30 Interest Expense 2,500 Cash 2,500 Jun. 30 Interest Expense 150 Discount on Bonds Payable 150 Dec. 31 Interest Expense 2,500 Cash 2,500 Dec. 31 Interest Expense Discount on Bonds Payable 150
13 Retirement of Bonds at Maturity On Jan. 1, 2019, Massey International retired its $100,000, 10- year issue that was dated Jan. 1, Massey records the following journal entry on Jan. 1, 2019: 2019 Jan. 1 Bonds Payable 100,000 Cash 100,000 Issuing Bonds Between Interest Dates Assume Massey s $100,000, 5% bonds are dated Jan. 1, Assume the bonds were sold at face value on Mar. 31, three months into the interest period. The interest accrued from the bond date (Jan. 1) until the date of sale (Mar. 31) is $1,250 ($100, /12). In addition to the market value of the bonds, the bondholders must pay Massey the $1,250 accrued interest. 13
14 Issuing Bonds Between Interest Dates Massey records the following journal entry on Mar. 31, 2009: 2009 Mar. 31 Cash 101,250 Bonds Payable 100,000 Interest Payable 1,250 On Jun. 30, 2009, Massey records its first interest payable to bondholders: 2009 Jun. 30 Interest Expense 1,250 Interest Payable 1,250 Cash 2,500 14
15 Adjusting Entry for Accrued Interest Expense Assume on Apr. 1, 20X4, F. J. Ingrum Company issued $50,000 of 6%, 10-year bonds at face value. The bonds pay interest semiannually on Apr. 1 and Oct. 1. On Oct. 1, 20X4, Ingrum made the regular semiannual interest payable of $1,500 ($50,000 X.06 X 6/12). The next semiannual interest payment will be made on Apr. 1, 20X5. An adjusting entry for accrued interest must be made on Dec. 31, 20X4. The adjusting entry is prepared for $750 ($50,000 X.06 X 3/12): 20X4 Dec. 31 Interest Expense 750 Interest Payable
16 Adjusting Entry for Accrued Interest Expense On Apr. 1, 20X5, the following entry is made to pay interest expense for the current year and the accrued interest from 20X4: 20X5 Apr. 1 Interest Expense 750 Interest Payable 750 Cash 1,500 16
17 Bond Sinking Fund Like a savings account The balance is used to repay the bond principal when it becomes due. As a measure of security for bondholders, the bond agreement may specify that the issuing corporation make annual deposits into a bond sinking fund. Accounting for a Bond Sinking Fund Sinking Fund Cash account 17 An asset Debit when cash is deposited in a bond sinking fund Credit Cash account
18 Accounting for a Bond Sinking Fund Sinking Fund Investments account An asset Debit when investments are purchased from the fund Credit Sinking Fund Cash account Sinking Fund Income account Credit when earnings are received from the investments Debit Sinking Fund Cash account 18
19 Journal Entries for a Bond Sinking Fund Assume Marsh Electronics Corporation issued $100,000 worth of 10-year bonds dated Jan. 1, 20X0. The bond agreement calls for equal annual deposits in a sinking fund. Marsh estimates that money deposited in the sinking fund can be invested in securities that will provide an annual yield of about 5%. The amount to be deposited in the fund annually is $7,975. The entry to record the annual deposit of cash in the bond sinking fund is as follows: 19 20X0 Jan. 1 Sinking Fund Cash 7,975 Cash 7,975
20 Journal Entries for a Bond Sinking Fund The entry to record the purchase of investments for $6,000 from the fund is as follows: 20X0 Jan. 1 Sinking Fund Investments 6,000 Sinking Fund Cash 6,000 The entry to record the receipt of $310 income from investments on Dec. 31, 20X0 is as follows: 20X0 Dec. 31 Sinking Fund Cash 310 Sinking Fund Income 310 Assume at the end of the 10 th year the cost of the investments was $84,100. The company was able to sell the investments for $86, X9 31 Sinking Fund Cash 86,400 Dec. 20 Sinking Fund Investments 84,100 Gain on Sale of Investments 2,300
21 Financial Statement Presentation of Sinking Fund Accounts Sinking Fund Cash/Sinking Fund Investments are presented on the balance sheet as Investments, a section appearing after Current Assets. Sinking Fund Income is presented on the income statement as Other Income. 21
22 Investments in Stocks and Bonds Equity Securities Investments in stocks issued by corporations Debt Securities Investments in debt instruments (bonds and notes) issued by a corporation or a governmental unit Equity Securities On Mar. 23, 20X1, Tampa Development Company purchased 500 shares of Neil Corporation s common stock for $15 per share, plus a broker s commission of $300. On Dec. 15, 20X1, Neil pays a $1 dividend per share. The journal entries prepared by Tampa during 20X1 are as follows: 22 20X1 Mar. 23 Investment in Neil Corporation Stock 7,800 Cash 7,800 Dec. 15 Cash 500 Dividend Income 500
23 More on Equity Securities Assume on Mar. 10, 20X2, Tampa sold 100 shares of the Neil stock for $21 per share, paying a commission of $80 to the broker who arranged the sale. The cost basis per share of the investment is $7, shares = $15.60 The total cost basis of the shares sold = $ = $1,560 The proceeds from the sale of the stock = ($21 100) $80 = $2,020 The entry to sell the 100 shares of stock is as follows: 23 20X2 Mar. 10 Cash 2,020 Investment in Neil Corporation Stock 1,560 Gain on Sale of Investments 460
24 Debt Securities On Jan. 1, 20X5, Bagley Chemical Company purchased $50,000 worth of Box Corporation s 6% bonds, with interest payable on Jan. 1 and Jul. 1. The bonds were purchased at 98, and a $300 commission was paid. On Jul. 1, 20X5, Bagley received a semiannual interest check for $1,500 from the Box bonds. Bagley prepared the following entries in 20X5: 20X5 Jan. 1 Investment in Box Corporation Bonds 49,300 Cash 49, Jul. 1 Cash 1,500 Interest Income 1,500
25 Purchasing Bonds Between Interest Dates Assume that Bagley purchased the Box bonds on Feb. 1, 20X5, one month after the issue of the bonds. Bagley will pay Box interest that has accrued for one month. Bagley s entry to record the purchase is as follows: 20X5 Feb. 1 Investment in Box Corporation Bonds 49,300 Interest Receivable 250 Cash 49,550 On Jul. 1, 20X5, Bagley records receipt of the first interest check as follows: 25 20X5 Jul. 1 Cash 1,500 Interest Income 1,250 Interest Receivable 250
26 Financial Statement Presentation of Investment Accounts Temporary Investment Liquid Management intends to convert it to cash within one year Long-Term Investment Management intends to hold longer than one year 26
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