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Chapter 16 - Lecture Notes

# Chapter 16 - Lecture Notes

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09/22/2012

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Chapter 16 – Bonds Payable.Bonds
- Is an example of debt financing.-The face (principle) amount of the bond will be repaid to the bondholders upon the bond’s maturity date.-A method of raising large sums of capital-Is classified as a long term liability on the balance sheet-Form of interest bearing note-Any bond interest will be calculated using the bond coupon rate and will be paid outsemiannually-Bondholders are deemed to be creditors of the company. They have a priority claim over the stockholders. This is illustrated in the expression of the Accounting Equation asfollows: Assets – Liabilities = Stockholders Equity-There is a legal obligation to pay the bond interest. If the company defaults on thisobligation the bondholders can sue them. Note: Under equity financing a corporation isnot legally obligated to issue dividends on stock. Dividends are a distribution of netincome to the stockholders and a company cannot guarantee that it will generate a profit.-Corporations sell bonds to an investment firm called and underwriter. This underwriter will sell the bonds to the public.-Bonds are issued in denominations of \$1000. Bonds are usually expressed as a percentage of the face value at issuance.(1)If Bond Is Issued at 100% - It is issued at par (face amount).(2)If Bond Is Issued Above 100% - It is issued at a premium. Amortization of the premium will occur over the life of the bond.- As amortization occurs bond interest income is recorded- As amortization occurs the bond carrying value decreases- At maturity the carrying value of the bond equals the face amount(3)If Bond Is Issued Below 100% - It is issued at a discount.- Amortization of the discount will occur over the life of the bond- As amortization occurs bond interest expense is recorded- As amortization occurs the bond carrying value increases- At maturity the carrying value of the bond will equal the face amount1

Relationship Between the Bond Coupon Rate and The Prevailing Market Rate(Effective Interest Rate)
(1) Bond coupon rate = Market Rate(Bond is issued at PAR)(2) Bond coupon rate > Market Rate(Bond is issued at premium)(3) Bond coupon rate < Market rate(Bond is issued at discount)If the bond is issued between interest payment dates, the bondholder will pay the amount of the bond and accrued interest.Any accrued interest received by the issuing corporation will be recorded as a current liability.This amount will be repaid to the bondholders along with the first payment (semi-annually) thatis made. The payment made is allocated between accrued interest payable and bond interestexpense.
Example 1:
Bond issued with a face amount of \$100,000 for 10 years. Bond is issued at 88%. This bond isissued at a discount because it is less than 100%.
Each bond issued
1,000 * 88% = 880(1)Record entry for the issuance of the bond:Cash (100,000 * 88%)88,000Discount on Bonds12,000Bonds Payable (Face Amount)1000,000Discount on Bonds-A contra-liability account Normal Balance is a debit.To increase the account it is debited.To decrease the account it is credited.The total interest expense to be repaid over the life of the bonds is initially recorded in thediscount on bonds account. As the bonds remain outstanding, interest expense must be recordedthrough the amortization of bond discount.2

(2)Record AmortizationInterest Expense1200Discount on Bonds1200AT END OF YEAR 1Straight Line Amortization of Discount= Total Amount of Discount / Total Months in Bond Issue= 12,000 / 120 months (10 yrs. * 12 months)= 100 / monthAnnual bond amortization 100 / month * 12 months = \$1,200Carrying Value (For bonds issued at discount)At Issue End of Yr.1 At MaturityBonds Payable 100,000100,000100,000Unamortized Discount 12,000 10,800 0Carrying Value88,00089,200100,000-At issuance the carrying value will equal the proceeds received.-At maturity, the carrying value will equal the face amount of the bond.Record the Amortized Bond Discount= Total Bond Discount / Number of Years= 12,000 / 10= 1,200 / year 3