ACCOUNTING - CLUTCH CH LONG TERM LIABILITIES.
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2 CONCEPT: INTRODUCTION TO BONDS AND BOND CHARACTERISTICS Bonds Payable are groups of debt securities issued to lenders Example: Company wants to raise $1,000,000. The company can sell 1,000 bonds worth $1,000 each. The company will pay on the bonds annually or semi-annually. The company repays the amount of the bonds (i.e. $1,000 per bond) on the maturity date. Repayment Characteristics: Term Bonds bonds with one maturity date; the principal is paid back in a Serial Bonds bonds with multiple maturity dates; the principal is paid back in Collateral Characteristics: Secured Bonds bonds that are collateralized by certain assets (such as a mortgage) risk Debenture Bonds bonds that are backed only by the good faith of the borrower risk Other Characteristics: Callable Bonds bonds that can be repurchased by the issuer at the call price at any time before the maturity date Convertible Bonds bonds that can converted into shares of in the company Interest Rate Characteristics: Stated Rate the rate printed on the face of the bond; also called the coupon rate This determines the amount of cash interest that will be paid (credit to Cash in each interest journal entry) Market Rate the going interest rate for similar bonds on the open market; also called the effective rate This determines the selling price of the bond and the amount of Interest Expense (debit to Interest Expense) Bond Issuance Terminology: Bond prices are quoted at a percentage of their maturity value: A $1,000 bond quoted at 100 is bought or sold for, which is 100% of the face value A $1,000 bond quoted at 103 is bought or sold for, which is 103% of the face value A $1,000 bond quoted at is bought or sold for, which is % of the face value Face Value the principal amount of the bond Discount Price a price face value; this occurs when the stated rate is the market rate Premium Price a price face value; this occurs when the stated rate is the market rate Page 2
3 CONCEPT: FACE VALUE BONDS A bond is issued at face value when the stated interest rate is the market interest rate The selling price of a bond is equal to the present value of the interest payments and principal payments Stated Rate = Market Rate Stated Rate < Market Rate Stated Rate > Market Rate Bonds are initially issued and the respective journal entry is made: on January 1 and July 1. The market interest rate was equal to 9%. January 1, 2018 Journal Entry: Interest is paid in cash on the interest payment dates. A journal entry is made for interest expense: on January 1 and July 1. The market interest rate was equal to 9%. July 1, 2018 Journal Entry: Page 3
4 Interest is paid in cash on the interest payment dates. A journal entry is made for interest expense: on January 1 and July 1. The market interest rate was equal to 9%. December 31, 2018 Journal Entry: On the maturity date, the company repays the principal and removes the bonds payable from the books: on January 1 and July 1. The market interest rate was equal to 9%. January 1, 2023 Journal Entry: Page 4
5 CONCEPT: DISCOUNT ON BONDS A bond is issued at a discount when the stated interest rate is the market interest rate The selling price of a bond is equal to the present value of the interest payments and principal payments Stated Rate = Market Rate Stated Rate < Market Rate Stated Rate > Market Rate Bonds are initially issued and the respective journal entry is made: on January 1 and July 1. The market interest rate was equal to 10%. The bonds were issued at 94. January 1, 2018 Journal Entry: Interest is paid in cash. A journal entry is made for interest expense and discount amortization: on January 1 and July 1. The market interest rate was equal to 10%. The bonds were issued at 94. July 1, 2018 Journal Entry: Page 5
6 Interest is paid in cash. A journal entry is made for interest expense and discount amortization: on January 1 and July 1. The market interest rate was equal to 10%. The bonds were issued at 94. December 31, 2018 Journal Entry: On the maturity date, the company repays the principal and removes the bonds payable from the books: on January 1 and July 1. The market interest rate was equal to 10%. The bonds were issued at 94. January 1, 2023 Journal Entry: PRACTICE: In 2014, ABC Company issued $100,000, 10%, bonds while the market interest rate was 12%. The bonds mature in the current year. The amount of principal that ABC Company will repay in the current year is equal to: a) $0 b) An amount greater than $0 but less than $100,000 c) $100,000 d) Some amount greater than $100,000 Page 6
7 CONCEPT: PREMIUM ON BONDS A bond is issued at a premium when the stated interest rate is the market interest rate The selling price of a bond is equal to the present value of the interest payments and principal payments Stated Rate = Market Rate Stated Rate < Market Rate Stated Rate > Market Rate Bonds are initially issued and the respective journal entry is made: on January 1 and July 1. The market interest rate was equal to 8%. The bonds were issued at 108. January 1, 2018 Journal Entry: Interest is paid in cash. A journal entry is made for interest expense and premium amortization: on January 1 and July 1. The market interest rate was equal to 8%. The bonds were issued at 108. July 1, 2018 Journal Entry: Page 7
8 Interest is paid in cash. A journal entry is made for interest expense and premium amortization: on January 1 and July 1. The market interest rate was equal to 8%. The bonds were issued at 108. December 31, 2018 Journal Entry: On the maturity date, the company repays the principal and removes the bonds payable from the books: on January 1 and July 1. The market interest rate was equal to 8%. The bonds were issued at 108. January 1, 2023 Journal Entry: PRACTICE: The carrying value (i.e. book value) of Bonds Payable is equal to: a) Bonds Payable + Accrued Interest b) Bonds Payable Premium on Bonds Payable c) Bonds Payable Amortization of Premium on Bonds Payable d) Bonds Payable Discount on Bonds Payable Page 8
9 CONCEPT: ZERO COUPON BONDS A zero coupon bond has no payments. The stated rate on these bonds is. The selling price of a bond is equal to the present value of the interest payments and principal payments Stated Rate = Market Rate Stated Rate < Market Rate Stated Rate > Market Rate Bonds are initially issued and the respective journal entry is made: On January 1, 2018, ABC Company issues $50,000 of zero coupon bonds maturing in five years. The market interest rate was equal to 8%. The bonds were issued at 85. January 1, 2018 Journal Entry: There is no cash interest. However, a journal entry is made for interest expense and discount amortization: On January 1, 2018, ABC Company issues $50,000 of zero coupon bonds maturing in five years. The market interest rate was equal to 8%. The bonds were issued at 85. December 31, 2018 Journal Entry: Page 9
10 On the maturity date, the company repays the principal and removes the bonds payable from the books: On January 1, 2018, ABC Company issues $50,000 of zero coupon bonds maturing in five years. The market interest rate was equal to 8%. The bonds were issued at 85. January 1, 2023 Journal Entry: PRACTICE: On January 1, ABC Company issues $1,000,000 of zero coupon bonds at 75. The bonds mature in five years. Assuming that ABC uses the straight-line method for amortization of bond premiums and discounts, the journal entry at the end of the first year would include: a) A credit to Cash of $50,000 b) A credit to Interest Payable of $50,000 c) A credit to Discounts on Bonds Payable of $50,000 d) A credit to Bonds Payable of $50,000 e) None of the above Page 10
11 CONCEPT: STRAIGHT LINE AMORTIZATION OF BOND PREMIUM OR DISCOUNT Stated Rate = Market Rate Stated Rate < Market Rate Stated Rate > Market Rate Premium Bonds are initially issued and the respective journal entry is made: on January 1 and July 1. The market interest rate was equal to 8%. The bonds were issued at 108. January 1, 2018 Journal Entry: Amortization Amount = Total Bond Premium or Discount Total Number of Interest Periods Interest is paid in cash. A journal entry is made for interest expense and premium amortization: on January 1 and July 1. The market interest rate was equal to 8%. The bonds were issued at 108. July 1, 2018 Journal Entry: Page 11
12 Discount Bonds are initially issued and the respective journal entry is made: on January 1 and July 1. The market interest rate was equal to 10%. The bonds were issued at 94. January 1, 2018 Journal Entry: Amortization Amount = Total Bond Premium or Discount Total Number of Interest Periods Interest is paid in cash. A journal entry is made for interest expense and discount amortization: on January 1 and July 1. The market interest rate was equal to 10%. The bonds were issued at 94. July 1, 2018 Journal Entry: PRACTICE: Jayster Company issued bonds at a discount. The semi-annual journal entry for interest expense will include: a) A debit to Discount on Bonds Payable b) A debit to Premium on Bonds Payable c) A credit to Discount on Bonds Payable d) A credit to Premium on Bonds Payable Page 12
13 CONCEPT: EFFECTIVE INTEREST AMORTIZATION OF BOND PREMIUM OR DISCOUNT Stated Rate = Market Rate Stated Rate < Market Rate Stated Rate > Market Rate The selling price of a bond is equal to the present value of the interest payments and principal payments: On January 1, 2018, ABC Company issues $100,000 of 9% bonds payable maturing in five years. Interest is payable semiannually on January 1 and July 1. The market interest rate was equal to 10%. January 1, 2018 Journal Entry: Bond Carrying Value = Bonds Payable Account Discount on Bonds Payable (or + Premium on Bonds Payable) Interest Expense = Bond Carrying Value Market Interest Rate Cash Interest Payment = Principal Amount of Bonds Stated Interest Rate Amortization of Discount or Premium = Interest Expense Cash Interest Payment Interest Expense JE for Discount Bond Interest Expense JE for Premium Bond Page 13
14 On January 1, 2018, ABC Company issues $100,000 of 9% bonds payable maturing in five years. Interest is payable semiannually on January 1 and July 1. The market interest rate was equal to 10%. Semi-annual Interest Date 1/1/2018 Beginning Bond Carrying Value Interest Payment (Credit to Cash) Interest Expense (Debit to Int. Exp) Discount Amort. (Credit to Discount on BP) Discount Account Balance Ending Bond Carrying Value 7/1/2018 1/1/2019 7/1/2019 1/1/2020 7/1/2020 1/1/2021 7/1/2021 1/1/2022 7/1/2022 1/1/2023 Interest is paid in cash. A journal entry is made for interest expense and discount amortization: On January 1, 2018, ABC Company issues $100,000 of 9% bonds payable maturing in five years. Interest is payable semiannually on January 1 and July 1. The market interest rate was equal to 10%. July 1, 2018 Journal Entry: December 31, 2018 Journal Entry: January 1, 2019 Journal Entry: Page 14
15 Page 15
16 CONCEPT: REDEEMING BONDS BEFORE MATURITY A company may decide to redeem (i.e. repurchase) their bonds before maturity: No longer require the loan and desire to stop paying interest Interest rates have fallen; could save money on interest by repurchasing old bonds and issuing new bonds The company will repurchase the bonds at a different price than the current of the bonds The difference between the repurchase price and the carrying value will result in a or Gain or Loss on Retirement = Repurchase Price Carrying Value of Bonds On January 1, 2012, RX Enterprises issued $100,000 of 7% bonds maturing in ten years when other bonds of similar risk were paying 8%. The bonds were issued at 94 and paid semi-annual interest on January 1 and July 1. During 2012, the market rate of interest dropped to 6%. On January 1, 2013, RX decided to repurchase the bonds when the market price was $106,000. Repurchase Price: Carrying Value of Bonds: January 1, 2013 Journal Entry: On January 1, 2012, RX Enterprises issued $100,000 of 7% bonds maturing in ten years when other bonds of similar risk were paying 8%. The bonds were issued at 94 and paid semi-annual interest on January 1 and July 1. During 2012, the market rate of interest increased to 10%. On January 1, 2013, RX decided to repurchase the bonds when the market price was $88,000. Repurchase Price: Carrying Value of Bonds: January 1, 2013 Journal Entry: Page 16
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