Chapter 14: Bonds and Long-Term Notes Part 1 - Bonds Intermediate Accounting II Dr. Chula King Student Learning Outcomes Account for bonds at face value, at a discount, or at a premium using the effective interest method On issuance Interest payment Adjusting entry At maturity Before maturity Prepare and use an amortization table for bonds issued at a discount or premium Back to Chapter 12 Investment in bonds Purchase of right to receive Periodic interest based on stated rate Amount due at maturity Market yield or effective interest used to determine present value of interest and present value of amount due at maturity Premium: Stated rate > Effective or Market rate Discount: Stated rate < Effective or Market rate Par: Stated rate = Effective or Market rate 1
Back to Chapter 12 (continued) Investor purchases bond: Held-to-Maturity, Available for Sale, Trading Accounting Issues Recording the Purchase Recording receipt of interest and discount/premium amortization Recording adjusting entry related to interest accrual and discount/premium amortization Recording disposition of investment Recognizing fair value (if available for sale or trading) Issuing Bonds Bond indenture bond contract Promise to pay Sum of money at designated maturity date Periodic interest at specified rate on maturity amount Paper certificate, typically $1,000 face value Interest usually paid semiannually Used when amount of capital needed is too large for one lender to supply Valuation of Bonds Payable Selling price set by Supply and demand of buyers and sellers Relative risk Market conditions State of the economy Valued at present value of expected cash flows Periodic cash interest, plus Cash amount payable at maturity Discounted at market or effective interest rate 2
Interest Stated, coupon or nominal rate: Interest rate printed on the bond used to determine cash interest Bond issuer sets the rate Stated as a percentage of the bond face value (par) Market rate or effective yield: Rate that provides acceptable return on investment given issuer s risk and market conditions used to determine present value For Example On January 1, 20X1, Apex, Inc., issued $ face value, 10% bonds that pay interest semiannually on June 30 and December 31. The bonds mature in 3 years on December 31, 20X3. 1/1/X1 6/30/X1 12/31/X1 6/30/X2 12/31/X2 6/30/X3 12/31/X3 5,000 5,000 5,000 5,000 5,000 5,000 #4, 6 payments @? Issue Price #2, 6 periods @? Market Rate (effective) = 10%: Par 1/1/X1 6/30/X1 12/31/X1 6/30/X2 12/31/X2 6/30/X3 12/31/X3 5,000 5,000 5,000 5,000 5,000 5,000 #4, 6 payments @ 5% 25,378 = 5.07569 x 5,000 #2, 6 periods @ 5% 74,622 =.74622 x Cash Bonds Payable 3
Market Rate (effective) = 8%: Premium 1/1/X1 6/30/X1 12/31/X1 6/30/X2 12/31/X2 6/30/X3 12/31/X3 5,000 5,000 5,000 5,000 5,000 5,000 #4, 6 payments @ 4% 26,211 211 = 5.24214 x 5,000 105,242 #2, 6 periods @ 4% 79,031 =.79031 x Cash 105,242 Premium on B/P 5,242 Bonds Payable Market Rate (effective) = 12%: Discount 1/1/X1 6/30/X1 12/31/X1 6/30/X2 12/31/X2 6/30/X3 12/31/X3 5,000 5,000 5,000 5,000 5,000 5,000 #4, 6 payments @ 6% 24,587 = 4.91732 x 5,000 95,083 #2, 6 periods @ 6% 70,496 =.70496 x Cash 95,083 Discount on B/P 4,917 Bonds Payable Effective Interest Method Produces periodic interest expense based on a constant percentage (effective rate) applied to the carrying value of the bonds Interest Expense = Effective Interest Rate x Carrying Value of Bonds at beginning of period Interest Paid = Stated Interest Rate x Face Amount of Bonds Amortization = Interest Expense Interest Paid Change in Carrying Value = Beginning of period value ± Amortization 4
Interest: Issued at Par 6/30/X1 Interest Expense 5,000 (10% x x 6/12) 12/31/X1 Interest Expense 5,000 Interest: Issued at Premium Date Cash Interest @ 5% Effective Interest @ 4% Premium Carrying Value/ Amortization Balance 1/1/X1 105,242 6/30/X1 5,000 4,210 790 104,452 12/31/X1 5,000 4,178 822 103,630 6/30/X2 5,000 4,145 855 102,775 12/31/X2 5,000 4,111 889 101,886 6/30/X3 5,000 4,075 925 100,961 12/31/X3 5,000 4,038 962 6/30/X1 Interest Expense 4,210 Premium on B/P 790 12/31/X1 Interest Expense 4,178 Premium on B/P 822 Interest: Issued at Discount Date Cash Interest @ 5% Effective Interest @ 6% Discount Carrying Value/ Amortization Balance 1/1/X1 95,083 6/30/X1 5,000 5,705 705 95,788 12/31/X1 5,000 5,747 747 96,535 6/30/X2 5,000 5,792 792 97,327 12/31/X2 5,000 5,840 840 98,167 6/30/X3 5,000 5,890 890 99,057 12/31/X3 5,000 5,943 943 6/30/X1 Interest Expense 5,705 Discount on B/P 705 12/31/X1 Interest Expense 5,747 Discount on B/P 747 5
Interest Payment Is Not at Year End On August 1, 20X1, Apex, Inc., issued $ face value, 10% bonds that pay interest semiannually on January 31 and July 31. The bonds mature in 3 years on July 31, 20X4. Effective Rate = 10%: Issue price = $ Effective Rate = 8%: Issue price = $105,242 Effective Rate = 12%: Issue price = $95,083 Interest: Issued at Par 12/31/X1 Interest Expense 4,167 Interest Payable 4,167 (10% x x 5/12) 1/31/X2 Interest Expense * 833 Interest Payable 4,167 *(10% x x 1/12) Interest: Issued at Premium Date Cash Interest @ 5% Effective Interest @ 4% Premium Amortization Carrying Value/ Balance 8/1/X1 105,242 1/31/X2 5,000 4,210 790 104,452 7/31/X2 5,000 4,178 822 103,630 1/31/X3 5,000 4,145 855 102,775 7/31/X3 5,000 4,111 889 101,886 1/31/X4 5,000 4,075 925 100,961 7/31/X4 5,000 4,038 962 12/31/X1 Interest Expense (4,210 x 5/6) 3,508 Premium on B/P (790 x 5/6) 658 Interest Payable (5,000 x 5/6) 4,166 1/31/X2 Interest Expense (4,210 x 1/6) 702 Interest Payable 4,166 Premium on B/P (790 x 1/6) 132 6
Interest: Issued at Discount Date Cash Interest @ 5% Effective Interest @ 6% Discount Amortization Carrying Value/ Balance 8/1/X1 95,083 1/31/X2 5,000 5,705 705 95,788 7/31/X2 5,000 5,747 747 96,535 1/31/X3 5,000 5,792 792 97,327 7/31/X3 5,000 5,840 840 98,167 1/31/X4 5,000 5,890 890 99,057 7/31/X4 5,000 5,943 943 12/31/X1 Interest Expense (5,705 x 5/6) 4,754 Discount on B/P (705 x 5/6) 588 Interest Payable (5,000 x 5/6) 4,166 1/31/X2 Interest Expense (5,705 x 1/6) 951 Interest Payable 4,166 Discount on B/P (705 x 1/6) 117 Extinguishment of Debt at Maturity Effective Interest Method Premium amortization reduces interest expense and reduces Carrying value, ultimately to par Discount amortization increases interest expense and increases Carrying value, ultimately to par. Therefore, at maturity, no gain or loss results Bonds Payable Cash Early Extinguishment of Debt Gain or loss is the difference between the cash paid to retire the bonds and the carrying value of the debt. 7
For Example On January 1, 2013, Apex, Inc., called its $, 10% bonds for $102,000 when their carrying amount was $97,358. The bonds were issued previously at a price to yield 12%, and pay interest semiannually on June 30 & December 31. Bonds Payable Loss on early retirement of bonds 4,462 Discount on B/P ( 97,538) 2,462 Cash 102,000 The Next Step Part 2 Long-term Notes 8