LONG TERM LIABILITIES (continued)

PROFESSOR S CLASS NOTES FOR UNIT 17 COB 241 Sections 13, 14, 15 Class on November 14, 2017 Unit 17 is a continuation of the topics in Chapter 10. Unit 17 picks up where Unit 16 left off. LONG TERM LIABILITIES (continued) Long-Term vs. Short-Term Liabilities A short-term liability is a liabililty which must be paid back in the next 12 months. A long-term liability is one which does not need to be paid back in the next 12 months. A Review of Notes Payable Compounding of Interest A Note Payable is a loan. For most Notes Payable, the loan is taken out from a bank or other lending institution, and a lump sum is paid back at the end of the loan the date called the maturity date or due date. The due date determines whether the Note Payable is considered a short-term or longterm liability. We will primarily consider Long-Term Notes Payable in this unit. The Note Payable document itself is a promissory note. In addition to the due date and the original amount of the loan, the note document specifies an interest rate, and a compounding period. Each accounting period, the specified rate is multiplied by the loan balance at the beginning of the period, to calculate the dollars of interest for that period. As covered in Unit 16, this dollar amount is considered interest expense by the borrower. Typically, on a Note Payable, the borrower adds the interest to the beginning loan balance, rather than paying it to the lender. This increases the loan balance, and thus the next period s beginning balance. As covered in Unit 16, the next period s interest calculation is based on that new period s beginning balance. A compound interest table like the one below illustrates the growth in the loan balance over the long-term period of the Note. 1

Example of a Note Payable Example: A company obtains a 15-year Compound Interest Loan, borrowing $100,000 at a rate of 6% APR. Note how the loan balance grows over the life of the loan: In most Notes Payable, the interest is not paid until the end of the loan period. The interest is compounded, and added to the Note Payable in the borrower s books when it is expensed. Under accrual accounting principles, interest expense must be recognized (recorded) in the period in which it is incurred, not when it is paid. The column labeled Interest in the table above shows the amount to be debited to Interest Expense and credited (added) to the liability account. (Many companies simply add the accrued interest to the Note Payable account as shown above in the column labeled Ending Balance for each period. Other companies establish a second T-account for the Interest Payable. Either way, the company is accruing a growing liability.) From the example above, it is clear that when the ABC Company borrowed $100,000 in Year 1 at an annual rate of 6%, they will end up paying $239,655.92 at the end of the 15 years. This starkly illustrates how compound interest can quickly build. 2

Shortcut to Calculate the Final Liability Balance A shortcut method for determining the final value of the loan can be obtained by using a Future Value Table. Such a table is provided in your textbook on page 733, Table I. To use this table, remember that the loan is 6%, for 15 years. In the 6% column, go down to the 15-period row, and you see the factor is 2.396558. Multiply the $100,000 beginning loan principal by this factor, and it shows you the $239,655 shown as the final loan balance from the table on the previous page. A New Topic: Bonds A Bond is another kind of Long-Term Liability. A bond is simply another kind of long-term Loan. The bond document is a promissory note. The issuer of the bond is the borrower. The borrower sells the bond to the lender. Once the lender has loaned money to the company, the lender is said to be the holder of the bond. Bonds vs. Notes: Bonds Can Be Traded On The Open Market Bonds differ from Notes Payable in that a Note Payable usually is the result of a loan from a bank or other commercial lender. Bonds Payable on the other hand are the result of a loan obtained from the open financial market. Individuals can purchase bonds (and frequently do) as investments, the same way individuals can purchase stock certificates. 3

Bonds vs. Notes: Bond Lifetime (Time to Maturity) Another way that bonds differ from Notes Payable is that bonds are issued for ten, twenty, or even up to fifty years. By contrast, Notes Payable rarely exceed five years, with most of them being loans for only one or two years. The date at which the bond loan must be paid back is called the maturity date of the bond. It is printed on the bond document. Bonds vs. Notes: Periodic Payments A third way that bonds differ from Notes Payable is that almost all Notes Payable represent compound interest loan, where the interest is accrued and paid back at the end of the loan, while most bonds require periodic payments during the life of the bond. By contrast, a Bond Payable almost always requires the borrower to actually pay interest every period (either annually, or more rarely, semi-annually). Bond interest is typically not compounded. Bonds vs. Notes: Interest Expense Differs from Interest Paid On a Note Payable, the interest which is expensed is the same amount as the interest which is paid to the lender at the end of the loan term. This is not necessarily the case for Bonds. The periodic payment made from the borrower to the lender on a bond is not necessarily the same as the interest expense the borrower incurs. Hold this thought for a moment we will address it in the next section. Interest Rates on Bonds There are two interest rates associated with bonds. These rates are sometimes the same, but often are very different values. The first is called the nominal interest rate, or stated rate of interest. The second is called the Effective Rate of Interest, or the Market Rate of Interest since it is the market rate as the date the bond is sold. 4

Stated Rate of Interest The stated Interest Rate, sometimes called the Nominal Interest Rate, is the interest rate printed on the bond document itself. This rate, expressed as a percentage of the face value, is nothing more than a contract provision that specifies, in writing, what the periodic payment will be. Effective or Market Rate of Interest The second rate is called the market rate of interest at the time of sale. It is also sometimes called the Effective Rate of Interest. This is the rate, expressed as a percentage of the face value, which will be expensed each period by the borrower. As stated above, the effective rate of interest does not have to be the stated or printed rate of interest found on the document. Remember, the only time the stated or printed rate of interest is used is when determining the periodic cash payment the bond issuer will pay to the holder of the bond. Comparison of Rates The difference use of the two rates can be best understood by following an example. Example: ABC Company issues a 20-year, $100,000 bond, with a printed rate of interest of 5%. This means that every year, ABC company must pay the bond holder $5,000. This $5,000 payment will be made each year for the entire 20 year life of the bond. This payment amount is fixed, and will not change, regardless of who owns the bond, who purchases the bond, or who sells the bond. The Market Rate of Interest, however, is used to calculate the interest expense the borrower must expense each period. To complicate matters, however, you will shortly see that while the market rate of interest may stay the same, the dollar amount of interest expense can (and almost always does) change from period to period over the life of the bond. Example: ABC Company issues a 20-year $100,000 bond. At the time of issue, the market rate of interest is 7%. This value is the rate used to calculate the amount of interest that is expensed each period. 5

Review of the Way Bonds Work Bonds have a face value printed on them. This is the fixed dollar amount which the holder of the bond will receive on the maturity date. The maturity date is printed on the bond. On the maturity date, the original borrower (the company issuing the bond) will pay off the bond by paying the face value to whoever holds the bond on that date. This is called redeeming the bond. And as explained above, a bond also has a stated rate of interest printed on it. As stated above, for almost all bonds issued today, the only thing this stated rate of interest is used for, is to determine the periodic payment the holder will receive each year. Multiplying the face value by the stated rate of interest (both of which are printed on the bond) gives the periodic payment amount. The issuer of the bond must pay this amount every period (usually every year) to whoever holds the bond at the end of that period. Some bonds call for two payments to be made each year, rather than one. The two payments are made, six months apart. These are known as semi-annual payments. The amount of semi-annual payment is determined by multiplying the face value printed on the bond by half of the stated rate of interest printed on the bond. Once the periodic payment amount has been determined, the Stated Rate of Interest printed on the bond can, for all practical purposes, be completely ignored. The proceeds which the borrower receives from issuing the bond (e.g., the original loan amount) is called the issue price of the bond. Once the bond is issued, a lender can decide to sell the promissory note (the bond) to anyone willing to buy it. It is this marketability which drives the bond market, one of the capital markets which make up the free-market environment in capitalistic economies. The dollar price at which the bond is traded between a willing buyer and a willing seller is called the market price of the bond. It must be point out here that the issue price of a bond is simply the market price of the bond on the day of issue. The market price fluctuates based on a number of factors. One of these factors is the overall supply and demand for financial resources across the entire economy. Another is the number and quality of alternative investments available to lenders. A third is the risk associated with an issuer possibly becoming insolvent, going bankrupt, or defaulting on the loan. A number of other factors also affect the price of the bond. 6

Pricing of Bonds The bond price at any given point in time is always calculated by adding two values together. The two values are: a. The Present Value of the bond s face value, and b. The Present Value of the future periodic payments. Present Value of the Bond s Face Value The face value of a bond is the amount that the issuer will pay the bond holder on the bond s maturity date. To find the Present Value of this future cash payment, we multiply the face value by the factor found in a Present Value of $1 Table. An example of a Present Value Table can be found in your textbook on page 733, Table II: To use this table, you must know the market rate of interest as of the date the bond will be issued (or traded). In practice, these rates are determined by factors discussed above: the economy, alternative investments, and risk. In this course, the market rate will be provided to you. The market rate is often different from the rate printed on the bond. Example: Continuing our example above: ABC company issues a 15-year bond, carrying a stated rate of interest of 5%. At the time of issue, the market rate of interest is 7%. To find the present value of the face value, we go down the 7% column, to the 15-year row, and discover the factor is 0.362446. The present value of the $100,000 payment that will be made 15 years from now, we multiply $100,000 times 0.362446 = $36,244.60. This is the present value of the redemption amount. Note: it is only part of the price of the bond. Continue reading. 7

Present Value of the Bond s Face Value The other part of the bond s price is the present value of the stream of periodic payments the issuer will make to the bond holder(s) over the life of the bond. Remember: the face value of the bond is multiplied by the stated rate of interest printed on the bond to find the amount of each periodic payment. Example: Continuing our example from above: ABC Company issues a 15-year bond, carrying a stated rate of interest of 5%. This means that the ABC Company will issue a cash payment to the bond holder every year of $5,000. A stream of payments is called an Annuity. To find the present value of this future stream of periodic payments, we use a Present Value of an Annuity Table. Such a table can be found in your textbook on page 734, Table IV. Example: Continuing our example above: ABC company issues a 15-year bond, carrying a stated rate of interest of 5%. This means the annual payment will be 5% of $100,000, or $5,000. At the time of issue, the market rate of interest is 7%. To find the present value of the 15 years of annual $5000 payments, we go down the 7% column, to the 15-year row, and discover the factor is 9.107914. The present value of the periodic payments is $5000 times 9.107914 = $45,539.57. This is the present value of the payments. To get the price of the bond, we must add the present value of the payments to the present value of the redemption payment (e.g., the present value of the face value of the bond). 8

Price of the Bond The price of the 15-year 5% $100,000 bond on its issue date, when the market rate of interest is 7%, is the sum of the two present values: The present value of the redemption amount: $36,244.60, plus The present value of the stream of $5000 payments: $45,539.57 Thus the price of our example bond on its issue date is $81,784.17. Use the Market Rate of Interest NOT the Stated Rate It is critically important to note that when using the Tables, the column is determined by the current Market Rate of Interest, not the rate of interest printed on the bond! Bond Discount In our example, ABC Company s bond carried a face-value of $100,000 and a stated rate of interest of 5%. But at the time of the sale, the market rate of interest was 7%. Because investors (lenders) could obtain 7% interest income from other investment opportunities, they are not willing to pay full price for the bond. When the market rate of interest is higher than the stated rate of interest on the bond, the bond will sell at a discount. The difference between the actual issue price and the face value of the bond is known as the amount of Bond Discount. We ll talk more about bond discount in a later section. Bond Premium In contrast, if the market rate of interest is lower than the stated rate of interest on the bond, then investors will prefer to buy ABC s bond over other alternative investments. Remember, the stated rate of interest determines the cash flow (the annual periodic payments). Investors will be so eager to own a bond with a stated rate higher than the market rate, they will be willing to pay more than the face value for the bond. If the market rate of interest is lower than the stated rate of interest on the bond, the bond will sell at a premium. The difference between face value and issue price is known as Bond Premium. 9

Subsequent Sales Price Bond Discount and Bond Premium only apply to the issue price of the bond. If the investor (the lender who originally bought the bond) decides to later sell the promissory note, the bond will sell at a price determined by the market rate of interest on the date of that sale. Example: Continuing our example from above: ABC company issues a 15-year $100,000 bond on July 1, 2012. The stated rate of interest on the bond is 5%, meaning that the annual payment amount is $5000. The bond was issued on July 1, 2012, and on that date, the market rate of interest was 7%. The bond sold at a discount, for a price of $81,784.17. At the time of issue, the buyer of that bond, a Mr. Smith, paid ABC company $81,784.17 for the bond. On June 30 of each year thereafter, Mr. Smith receives a payment of $5000 from ABC company. After receiving the June 30, 2018 payment (the end of the sixth year), Mr. Smith decides to sell his bond to Ms. Wayland on July 1, 2018. The market rate of interest on July 1 2018 is 5%. The selling price of the bond on July 1 2018 will be composed of the two parts: 1. The present value (as of July 1, 2018) of the $100,000 face value, plus 2. The present value (as of July 1, 2018) of the remaining $5000 annual payments. There are 9 remaining annual payments until the maturity date of the bond. Using the present value Table II, we go down the 5% column to the 9 th row and find the factor for the face value to be 0.644609. So the present value of the redemption payment is $100,000 x 0.644609 = $64,460.90. The present value of the nine remaining annual payments of $5000 each is found using the Present Value of an Annuity Table IV. If we go down the 5% column to the 9 th row, we find the factor is 7.107822. So the present value of the remaining annual payments is $5,000 x 7.107822 = $35,539.11. The price of the bond Ms. Wayland will pay Mr. Smith is $64,460.90+$35,539.11, or $100,000.00 Explanation Notice in our example that the price of bond on July 1, 2018 is the face value of the bond! This is not sheer coincidence. Look closely at the market rate of interest on July 1, 2018, and compare it with the stated rate of interest printed on the bond. Whenever the market rate of interest is the same as the stated rate of interest printed on the bond, the bond will always sell at its face value. This holds true for any date on which the bond is sold, including its issue date. Had the market rate of interest on the issue date (July 1 2012) been 5%, ABC would have issued the bond at a price of $100,000, and there would have been no bond discount. 10

Accounting for Bond Discount Let s go back to ABC Company and look again at our original example. Example: ABC Company issues a 15-year, $100,000 bond, carrying a stated rate of interest of 5%, meaning the annual cash payment will be $5,000. On the issue date, July 1, 2012, the market rate of interest was 7%, so the bond sold at a discount, at a price of $81,784.17. The journal entry to record this issue is: DATE DEBIT CREDIT 1-Jul-2012 Cash $ 81,784.17 Bond Payable $ 100,000.00 Bond Discount $ 18,215.83 ABC sold the bond at a price of $81,784.17, so ABC debits cash to show their cash inflow. ABC gave a piece of paper to Mr. Smith that said ABC would pay $100,000 in 15 years. Thus, ABC must credit a long-term liability for $100,000, and describe this liability in the disclosure notes which will accompany the financial statements. But ABC doesn t actually owe the full $100,000 until June 30, 2027. Actually, as of July 1, 2012, ABC s liability is only to refund Mr. Smith s money, or $81,784.17. To bring ABC s liabilities down to the correct accurate liability figure, ABC will debit a Contra-Liability account, a sister account to the Bond Payable liability account. The name of the Contra-Liability account is Bond Discount. These two accounts together (the Bond Payable account credit balance of $100,000 and the Bond Discount account debit balance of $18,215.83) will net together to show the net Long Term Liability (as of July 1, 2012) of what ABC actually owes on July 1, 2012: $81,784.17. To repeat, on ABC s Balance Sheet, in the Long-Term Liability section, ABC will show a Bond Payable due 2027 of $100,000, reduced by a Bond Discount of $18,215.83, to show a net liability of $81,784.17. This $81,784.17 is known as the Carrying Value of the Bond. So far, so good. But we have one other consideration to think about: On June 30 of each year for the next 15 year, ABC company must make a cash payment to the bond holder of $5,000. 11

Amortization of the Bond Discount. The first cash payment after issuing the bond comes due on June 30, 2013. The journal entry to record the annual cash payment on this bond is: DATE DEBIT CREDIT 30-Jun-2013 Interest Expense (7% of $81,784.17) $ 5,724.89 Cash $ 5,000.00 Bond Discount $ 724.89 Take a close look at this journal entry. First, ABC must recognize interest expense. Interest expense is calculated using the Market Rate of Interest as of the date the bond was issued. This rate will not change. Repeat: interest expense is calculated using the market rate of interest on the date the bond is issued. The bond was issued July 1, 2012 when the market rate was 7%. The interest expense is calculated using the Carrying Value of the Bond as of the date interest expense is calculated. This amount will change from period to period if the bond sold at a premium or a discount. Repeat; interest expense is calculated on the Carrying Value of the bond on the date the interest is calculated. As of June 30, 2013, the carrying value of the bond is still its issue price: $81,784.17. Thus in our example bond, the interest expense is 7% of $81,784.17., or $5,724.89 Next, ABC must make a cash payment to the bond holder, Mr. Smith, for $5,000. Finally, since debits don t equal credits yet, the difference must be credited to the Bond Discount account. That will bring ABC s journal entry into balance. You may ask: why do we credit the Bond Discount account? First, remember that as of July 1, 2013, ABC s net liability was only $81,784.17. This is made up of a Bond Payable account of $100,000, less Bond Discount balance of $18,215.83. But by the year 2027, we have to show an actual liability of $100,000. 12

By amortizing (reducing) the Contra-Liability account, ABC is increasing the Carrying Value of the bond. (Remember that the Bond Discount T-account is a sister account to the Long-Term Liability account, and as such, it is a Liability account even though it contains a debit balance. And notice that ABC is crediting the Bond Discount account. By crediting a liability account, ABC is increasing total liabilities.) The net result of this journal entry is to increase ABC s total liabilities by $724.89. Subsequent journal entries will further increase the total liabilities, until finally, in 2027, the entire debit balance of the Bond Discount account will have been eliminated, making ABC s liability in 2027 equal to $100,000 the amount ABC will actually have to pay in 2027. Table Showing Amortization of Bond Discount 30-Jun Beginning Interest Annual Discount Ending Year Carrying Value Expense Payment Amortization Carrying Value 2013 $81,784.17 $5,724.89 $5,000.00 $724.89 $82,509.06 2014 $82,509.06 $5,775.63 $5,000.00 $775.63 $83,284.70 2015 $83,284.70 $5,829.93 $5,000.00 $829.93 $84,114.62 2016 $84,114.62 $5,888.02 $5,000.00 $888.02 $85,002.65 2017 $85,002.65 $5,950.19 $5,000.00 $950.19 $85,952.83 2018 $85,952.83 $6,016.70 $5,000.00 $1,016.70 $86,969.53 2019 $86,969.53 $6,087.87 $5,000.00 $1,087.87 $88,057.40 2020 $88,057.40 $6,164.02 $5,000.00 $1,164.02 $89,221.42 2021 $89,221.42 $6,245.50 $5,000.00 $1,245.50 $90,466.92 2022 $90,466.92 $6,332.68 $5,000.00 $1,332.68 $91,799.60 2023 $91,799.60 $6,425.97 $5,000.00 $1,425.97 $93,225.57 2024 $93,225.57 $6,525.79 $5,000.00 $1,525.79 $94,751.36 2025 $94,751.36 $6,632.60 $5,000.00 $1,632.60 $96,383.96 2026 $96,383.96 $6,746.88 $5,000.00 $1,746.88 $98,130.84 2027 $98,130.84 $6,869.16 $5,000.00 $1,869.16 $99,999.99 $18,215.82 Notice in the table above, at the end of 2013, ABC recorded interest expense of $5724.89, the cash payment of $5000, and the amortization of the Bond Discount of $724.89. This brings the carrying value up to $82,509.06. 13

On June 30, 2014, notice that ABC will again record interest expense, but this time it will be calculated as 7% of $82,509.06! Each year s interest is calculated as 7% (the market rate on the date of issue) times that year s beginning Carrying Value of the Bond. The table above can be compared to the table created for a Negative Amortization Mortgage discussed in Unit 16. In a negative amortization mortgage, the payment made by the borrower was less than the interest charged on the mortgage. Thus, the difference was added to the loan balance, increasing the amount the borrower owed. The amortization of a bond discount does the same thing: The fact that the bond was issued at a discount is a result of the market rate of interest being higher than the rate used to calculated the annual cash payment. Thus, the cash payment is not sufficient to completely cover the annual interest expense (which is at the higher market rate). Hence, the total liability (carrying value of the bond) increases. 30-Jun Beginning Interest Annual Discount Ending Year Carrying Value Expense Payment Amortization Carrying Value Debited to Interest expense Credited to Cash Credited to Bond Discount Compare the journal entry made on June 30, 2013, with the above columns on the table for this bond. Bond Premium What if a bond was issued, and on the issue date, the market rate of interest was lower than the stated rate of interest on the bond? In this case, the bond would sell at a premium. Investors (lenders) would rather have the higher yielding bond than a lower current investment, so they will bid up the price of the bond above its face value. Example: PDQ Corporation issues a 15-year $100,000 bond carrying a face value of 5%. On the date of issue, the market rate of interest is 4%. In this case, the bond will sell at more than $100,000. It is left to the student to determine the price that this bond will sell for. The price of the bond is composed of two figures: The present value of the bond s redemption payment ($100,000) and the present value of the annual payments (in this case, 5% of the 4100,000, or $5,000). What is the price the bond will sell for? 14

Accounting for Bond Premium The student should calculate the two components of the bond price. As a check-figure, the bond should sell for $111,118.44. Example: PDQ Company issues a 15-year, $100,000 bond, carrying a stated rate of interest of 5%, meaning the annual cash payment will be $5,000. On the issue date the market rate of interest was 4%, so the bond sold at a premium, at a price of $111.118.44. The journal entry to record this issue is: DATE DEBIT CREDIT Issue date Cash $ 111,118.44 Bond Payable $ 100,000.00 Bond Premium $ 11,118.44 PDQ sold the bond at a price of $111,118.44, so PDQ debits cash to show their cash inflow. PDQ gave a piece of paper to the bond buyer that said PDQ would pay $100,000 in 15 years. Thus, PDQ must credit a long-term liability for $100,000, and describe this liability in the disclosure notes which will accompany the financial statements. But the day after issue, PDQ s liability is $111,118.44 (they would refund the price paid by the bond buyer).. To bring PDQ s liabilities up to the correct accurate liability figure, PDQ will credit a sister liability account, The name of the additional liability account is Bond Premium. These two accounts together (the Bond Payable account credit balance of $100,000 and the Bond Premium account credit balance of $11,118.44) will net together to show the net Long Term Liability of what PDQ actually owes. To repeat, on PDQ s Balance Sheet, in the Long-Term Liability section, PDQ will show a Bond Payable of $100,000, increased by a Bond Premium of $11,118.44, to show a net liability of $111,118.44 This $111,118.44 is known as the Carrying Value of the Bond. Next, let s look at what happens after the first year of PDQ s bond issue: PDQ Corporation must make a cash payment to the bond holder of $5,000. 15

Amortization of the Bond Premium. The first cash payment after issuing the bond comes due a year after the issue date. At the end of this first year, PDQ makes the following journal entry: DATE DEBIT CREDIT Issue date Interest Expense (4% of $111,118.44) $ 4,444.74 Cash $ 5,000.00 Bond Premium $ 555.26 Take a close look at this journal entry. First, PDQ must recognize interest expense. Interest expense is calculated using the Market Rate of Interest as of the date the bond was issued. This rate will not change. Repeat: interest expense is calculated using the market rate of interest on the date the bond is issued. The bond was issued when the market rate was 4%. The interest expense is calculated using the Carrying Value of the Bond as of the date interest expense is calculated. This amount will change from period to period if the bond sold at a premium or a discount. Repeat; Interest expense is calculated on the Carrying Value of the bond on the date the interest is calculated. Thus in PDQ s example bond, PDQ s interest expense is 4% of $111,118.44., or $4,444.74. Next, PDQ must make a cash payment to the bond holder of $5,000. This credits cash. Finally, since debits don t equal credits yet, the difference must be debited to the Bond Premium account. That will bring PDQ s journal entry into balance. You may ask: why do we debit the Bond Premium account? Remember that Bond Premium is an additional liability account, which brought the $100,000 Bond Payable liability up to its accurate carrying value on the date of issue: $111,118.44. 16

By amortizing (reducing) the Bond Premium account, PDQ is decreasing the Carrying Value of the bond. (By debinting a liability account, PDQ is decreasing total liabilities.) The net result of this journal entry is to decrease PDQ s total liabilities by $555.26. Subsequent journal entries will further decrease PDQ s total liabilities, until finally, in 15 years, the entire credit balance of the Bond Premiium account will have been eliminated, making PDQ s liability equal to $100,000 the amount PDQ will actually have to pay in 2027. Table Showing Amortization of Bond Premium End of Beginning Interest Annual Premium Ending YEAR Carrying Value Expense Payment Amortization Carrying Value 2013 $111,118.44 $4,444.74 $5,000.00 -$555.26 $110,563.18 2014 $110,563.18 $4,422.53 $5,000.00 -$577.47 $109,985.70 2015 $109,985.70 $4,399.43 $5,000.00 -$600.57 $109,385.13 2016 $109,385.13 $4,375.41 $5,000.00 -$624.59 $108,760.54 2017 $108,760.54 $4,350.42 $5,000.00 -$649.58 $108,110.96 2018 $108,110.96 $4,324.44 $5,000.00 -$675.56 $107,435.40 2019 $107,435.40 $4,297.42 $5,000.00 -$702.58 $106,732.81 2020 $106,732.81 $4,269.31 $5,000.00 -$730.69 $106,002.13 2021 $106,002.13 $4,240.09 $5,000.00 -$759.91 $105,242.21 2022 $105,242.21 $4,209.69 $5,000.00 -$790.31 $104,451.90 2023 $104,451.90 $4,178.08 $5,000.00 -$821.92 $103,629.98 2024 $103,629.98 $4,145.20 $5,000.00 -$854.80 $102,775.18 2025 $102,775.18 $4,111.01 $5,000.00 -$888.99 $101,886.18 2026 $101,886.18 $4,075.45 $5,000.00 -$924.55 $100,961.63 2027 $100,961.63 $4,038.47 $5,000.00 -$961.53 $100,000.09 -$11,118.35 Notice in the table above, at the end of year 1, PDQ recorded interest expense of $4444.74, the cash payment of $5000, and the amortization of the Bond Premium of $555.26. This brings the carrying value down to $110,563.18. In year 2, notice that PDQ will again record interest expense, but this time it will be calculated as 4% of $110,563.18! Each year s interest is calculated as 4% (the market rate on the date of issue) times that year s beginning Carrying Value of the Bond. The table above can be compared to the table created for a standard mortgage or installment loan discussed in Unit 16. In a standard mortgage or installment loan, the 17

payment made by the borrower was more than the interest charged on the loan. Thus, the difference was subtracted to the loan balance, decreasing the amount the borrower owed. The amortization of a bond premium does the same thing: The fact that the bond was issued at a premium is a result of the market rate of interest being lower than the rate used to calculate the annual cash payment. Thus, the cash payment is more than enough to cover the annual interest expense (which is at the lower market rate). Hence, the total liability (carrying value of the bond) decreases. 30-Jun Beginning Interest Annual Discount Ending Year Carrying Value Expense Payment Amortization Carrying Value Debited to Interest expense Credited to Cash Debited to Bond Premium Suggested Practice It is strongly suggested that students review this lengthy description of Bonds several times, working homework problems, and practicing the following: Calculation of Bond Prices Journal Entries for Bonds sold at face value (market rate = stated rate) Journal Entries for Bonds sold at a Discount (market rate > stated rate) Journal Entries for Bonds sold at a Premium (market rate < stated rate) The journal entries must include: Entry made at the time the bond is issued Entry made each year (although only the first three or four years will be on the exam) Entry made at the redemption (maturity date) of the bond 18