Fundamental Financial Accounting Concepts

Fourth Edition
by Edmonds, McNair, Milam, Olds
PowerPoint® presentation by J. Lawrence Bergin

10- 2

Chapter 10
Accounting for Debt Transactions
LOANS & BONDS

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10- 3

Business Background
q Capital structure is the mix of debt and

equity used to finance a company. q Loans from banks, insurance companies, or pension funds are often used when borrowing small amounts of capital. q Bonds are debt securities issued when borrowing large amounts of money.
Ë

Can be issued by either corporations or governmental units.
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10- 4

Business Background
q Capital structure is the mix of debt and

equity used to finance a company. q Loans from banks, insurance companies, or pension funds are often used when borrowing small amounts of capital. q Bonds are debt securities issued when borrowing large amounts of money.
Ë

Can be issued by either corporations or governmental units.
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10- 5

Financial Analysis
q The debt-to-equity ratio is an

important measure of the state of a company’s capital structure.
Debt-to-Equity Ratio = Total Liab. ÷Total Equity
q When a company’s debt-to-equity

ratio is excessive, a large amount of fixed debt payments may cause problems in tight cash flow periods.

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10- 6

Loans: Long-term Notes Payable
q Most long-term notes

require period payments. q The note is repaid in equal installments, part of which are repayment of principal and part of which are interest.

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10- 7

Example: Borrowing on Long-term Note Payable
q ABC Co. signed a $100,000, 3 year

Note Payable which carried an 8% annual interest rate. Payments are to be made annually on December 31 of each year for $38,803.35. q What is the amount of the liability (Note payable) after the first payment is made?
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10- 8

Example continued...
q For Yr.1, the outstanding amount

borrowed is $100,000 (at 8%), so the interest is:
Ë

$8,000

q Payment is $38,803.35, so the

amount that will reduce the principal is
Ë

$30,803.35

[$38,803.35-$8,000]

q New outstanding principal amount is
Ë

$100,000 - 30,803.35 = $69,196.65
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10- 9

Amortization schedule
A Principal
Prev. bal. - D

B C D Payment Interest Prin. Repaid
Given .08 X A (B - C)

1 100,000.00 38,803.35 8,000.00 30,803.35 2 69,196.65 38,803.35 5,535.73* 33,267.62** 3 35,929.03 38,803.35 2,874.32 35,929.03 0.00 * 69,196.65 x .08 ** 38,803.35 - 5,535.73 = 33,267.62 69,196.65 - 33,267.62 = 35,929.03
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10- 10

Horizontal Model
ASSET
Accts Event

Cash 80,000.00 100,000.00 (38,803.35) 141,196.65 141,196.65 (38,803.35) 102,393.30 102,393.30 (38,803.35)

BALANCE SHEET + EQUITY = Note Com. Ret. Stk. + Earn. = Payable + 20,000.00 100,000.00 (30,803.35) 69,196.65 69,196.65 (33,267.62) 35,929.03 35,929.03 (35,929.03) 20,000.00 20,000.00 20,000.00 20,000.00 (8,000.00) 52,000.00 52,000.00 (5,535.73) 46,464.27 46,464.27 (2,874.32) + 20,000.00 + 43,589.95 60,000.00

INCOME STATEMENT Interest Rev. - Exp. = Net Inc.

CASHFLOW STATEMENT
OA,IA,FA $ amt

BB borrow 1st Pay end 1 beg.2 2nd Pay end 2 beg.3 3rd Pay EB

80,000.00 bal. 100,000.00 FA 8,000.00 8,000.00 closed out 5,535.73 5,535.73 closed out 2,874.32 (8,000.00) (8,000.00) OA (30,803.35) FA (8,000.00) 141,196.65 bal. (5,535.73) 141,196.65 bal. (5,535.73) OA (33,267.62) FA (5,535.73) 102,393.30 bal. (2,874.32) 102,393.30 bal. (2,874.32) OA (35,929.03) FA 63,589.95 bal.

63,589.95 =

- - 2,874.32 = (2,874.32)

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10- 11
Date

Account Titles

Debit

Credit

Jan. 1

Cash Notes Payable
3 Yr., 8%, bank loan

100,000.00 100,000.00

Journal Entries for Note Payable Example

12/31/01 Interest Expense Notes Payable Cash
Year 1 payment of interest & prin.

8,000.00 30,803.35 38,803.35

12/31/02 Interest Expense Notes Payable Cash
Year 2 payment of interest & prin.

5,535.73 33,267.62 38,803.35

12/31/03 Interest Expense Notes Payable Cash
Final payment of interest & prin.
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2,874.32 35,929.03 38,803.35
© The McGraw-Hill Companies, Inc., 2003

10- 12

Loans: Long-term Mortgages
q A mortgage is a special

kind of “note” payable-one issued for property (land, buildings). q It is repaid in equal installments, part of which are repayment of principal and part of which are interest.
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10- 13

How buying an asset using a mortgage is reflected in the financial statements:
q Journal entry when the

mortgage is issued:
Ë Ë

Debit LAND or BLDG. Credit Mortgage Payable

City National Bank

q Journal entry to make a

payment:
Ë Ë Ë

Debit Interest expense Debit Mortgage Payable Credit Cash.

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10- 14

Characteristics of Bonds Payable
q Bonds usually involve the borrowing

of a large sum of money, called principal, for a fairly long time period. principal q The principal is usually paid back as a lump sum at the end of the bond period. q Individual bonds are often denominated with a par value, or face value value, of $1,000. value
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10- 15

Characteristics of Bonds Payable
To make them quicker and easier, all bond illustrations presented here will have very short terms and small principals.

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10- 16

Characteristics of Bonds Payable
q Bonds usually carry a stated rate of

interest. interest q Interest is normally paid semiannually. q Interest is computed as: Interest = Principal × Stated Rate × Time 3M
Bond

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10- 17

Characteristics of Bonds Payable
q The new bondholder receives a

bond certificate. certificate
Ë

Identifies the par value, the stated interest rate, the interest dates, and the maturity date.

q The trustee makes sure the

issuing company fulfills all of the provisions of the bond indenture, or agreement.
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10- 18

Bond Classifications
q Unsecured bonds (also called

debentures) do not have pledged assets as a guarantee of repayment at maturity. q Secured bonds include a pledge of specific assets as a guarantee of repayment at maturity.

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10- 19

Bond Classifications
q Ordinary bonds (also called

single-payment bonds)
Ë

The full face amount is paid at the maturity. The principal is paid in installments on a series of specified maturity dates.
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q Serial bonds
Ë

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10- 20

Bond Classifications
q Callable bonds
Ë

May be retired and repaid (called) at any time at the option of the issuer. issuer May be turned in at any time for repayment at the option of the bondholder. bondholder May be exchanged for other securities of the issuer (usually shares of common stock) at the option of the bondholder. bondholder
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q Redeemable bonds
Ë

q Convertible bonds
Ë

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10- 21

Bond Classifications
q Registered bonds
Ë

Payment of interest is made by check and mailed directly to the bondholder whose name must be registered.
Bo nd
ter In
CO

qCoupon bonds
ËCoupons

are attached to the bond for each interest payment.
ËThe

bondholder “clips” each coupon and presents it for payment on the interest date. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

UP

O N

es

t

10- 22

Measuring Bonds Payable and Interest Expense
The selling price of the bond is determined by the “market” based on the time value of money.
Bonds issued

today

future

...
dates of interest payments
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principal payment
.

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10- 23

The time value of money...
q Selling price of a

bond = present value of future cash flows promised by the bonds, discounted using the market rate of interest
The Appendix to this chapter shows how to make Present Value calculations.
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10- 24

Measuring Bonds Payable and Interest Expense
q The interest rate used to compute the
Ë

present value is the market interest rate. rate
Also called yield, effective rate, or true rate.

q Creditors demand a certain rate of

interest to compensate them for the risks related to bonds. q The stated rate, or coupon rate, is only rate rate used to compute the periodic cash interest payments.
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10- 25

Determining the Selling Price
q Bonds sell at:

“Par” (100% of face value) Ë less than par (discount) Ë more than par (premium)
Ë

q Market (or “effective”) rate of interest

vs. bond’s stated rate of interest determines the selling price (or market or issue price of the bond).
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10- 26

Determining the Selling Price
q Selling price = Present value of

future cash flows promised by the bonds, using market rate for presentvalue calculations. (The Appendix demonstrates these calculations.) q Therefore, if
market % > stated %: Discount Ë market % < stated %: Premium Ë market % = stated %: Face or par
Ë
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10- 27

Selling Bonds - Example
On Jan. 2, 2004, CeeDees Corp. sells $100,000 in bonds having a stated rate of 7% annually. The bonds mature in 3 years, and interest is paid semi-annually. The market rate is 10% annually. Determine whether the bonds sell at par, at a discount, or at a premium.
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10- 28

Selling Bonds - Example
On Jan. 2, 2004, CeeDees Corp. sells $100,000 in bonds having a stated rate of 7% annually. The bonds mature in 3 years, and interest is paid semi-annually. The market rate is 10% annually.

These bonds would sell at a discount. Investors are “demanding” a 10% return. These bonds are only paying 7% interest. So, investors won’t buy them unless the price is reduced; that is, sold at a DISCOUNT.
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10- 29

Selling Bonds - Example
q Until recently, bond selling prices were always quoted as a whole number with a fraction such as: “922/5”. Now decimals are used instead of fractions. So, the bond above would be quoted as 92.400 in the bond market. What does that mean?
Ë

The bonds sold for 92.400% of their face (par) value. Proceeds = $92,400 for $100,000 face bonds. ($100,000 x .924 = $92,400)
© The McGraw-Hill Companies, Inc., 2003

Ë

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10- 30

Recording Bonds Sold at a Discount
q Prepare the journal entry to record

the sale of the bonds.
Cash $ Discount on Bonds Payable Bonds Payable

$

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10- 31

Recording Bonds Sold at a Discount
q Prepare the journal entry to record

the sale of the bonds.
Cash $ Discount on Bonds Payable Bonds Payable-face

$100,000

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10- 32

Recording Bonds Sold at a Discount
q Prepare the journal entry to record

the sale of the bonds.
Cash $92,400 Discount on Bonds Payable Bonds Payable-face $100,000

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10- 33

Recording Bonds Sold at a Discount
q Prepare the journal entry to record

the sale of the bonds.
Cash $92,400 Discount on Bonds Payable 7,600 Bonds Payable-face $100,000
This is a contra-liability account and appears in the liability section of the balance sheet as a SUBTRACTION from the Bonds Payable-face amount.
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10- 34

Measuring and Recording Interest on Bonds Issued at a Discount
q The discount must be amortized over the

outstanding life of the bonds. q The discount amortization increases the periodic interest expense for the issuer. q Although the “Effective Interest” method is required by GAAP, the easier “Straight-line” method will be used for these examples.
Ë

The Effective Interest amortization method is explained in the Appendix)
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10- 35

Straight-Line Amortization of Bond Discount
q Identify the amount of the bond

discount. q Divide the bond discount by the number of interest periods. q Include the discount amortization amount as part of the periodic interest expense entry. q The discount will be reduced to zero by the maturity date.
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10- 36

q CeeDees Corp. sold their bonds on Jan. 2,

Straight-Line Amortization of Bond Discount

2004 at 92.400. The bonds have a 3-year maturity and $3,500 interest is paid semiannually (that is, each six months). q Why would the bonds sell for 92.400? Ë The 10% market rate of interest is greater than the 7% stated rate on the bond face. So, investors won’t buy them unless the price is reduced.
q Where did the $3,500 come from?
Ë
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$100,000 face x .07 x 1/2 yr.
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10- 37

Straight-Line Amortization of Bond Discount Prepare the journal entry to record the payment of interest and the discount amortization for the six months ending on June 30, 2004.
Interest Expense $ Discount on Bonds Payable Cash $ $

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10- 38

Straight-Line Amortization of Bond Discount Prepare the journal entry to record the payment of interest and the discount amortization for the six months ending on June 30, 2004.
Interest Expense $ Discount on Bonds Payable Cash $ $3,500

$100,000 Face x .07 stated rate x 1/2 yr. = $3,500 for 6 mos.

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10- 39

Straight-Line Amortization of Bond Discount Prepare the journal entry to record the payment of interest and the discount amortization for the six months ending on June 30, 2004.
Interest Expense $ Discount on Bonds Payable
$7,600 Disc.

$1,267 $3,500

Cash

:

6 interest periods = $1,267 each 6 months

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10- 40

Straight-Line Amortization of Bond Discount Prepare the journal entry to record the payment of interest and the discount amortization for the six months ending on June 30, 2004.
Interest Expense $4,767 Discount on Bonds Payable $1,267 Cashamount appears on the Income Statement? $3,500 Which
$4767 (the effective interest expense)
Which amount appears on the Cashflow Statement?

$3,500 Operating Activity outflow for cash paid
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10- 41

Straight-Line Amortization of Bond Discount Prepare the journal entry to record the payment of interest and the discount amortization for the six months ending on June 30, 2004.
Interest Expense $4,767 Discount on Bonds Payable $1,267 Cash $3,500 Note that the existence of a DISCOUNT causes the Effective Interest EXPENSE to be GREATER THAN the CASH interest actually paid to the bondholders.
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10- 42

Straight-Line Amortization of Bond Discount

This exact journal entry will be made each six months for the three year term of the bond. At the end, the balance of the Discount on Bonds Payable account will be $0.
Interest Expense $4,767 Discount on Bonds Payable $1,267 Cash $3,500

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10- 43

Horizontal Model
Record the issue of CeeDee Corp. bonds on 1/1/04. Record the Interest payments at the end of: Period 1 = 6/30/04 Period 2 = 12/31/04 Period 3 = 6/30/05 Period 4 = 12/31/05 Period 5 = 6/30/06 Period 6 = 12/31/06 Record the principal repayment at maturity 12/31/06.
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10- 44

Record issuance of CeeDees bonds, all interest payments, and final repayment of the bonds at maturity.
Balance Sheet Income Statement Assets= Cashflow Liab. + Equity Statement Cash = Bond - Bond+ Bond + C.C.+ R.E. Rev./- Exp./ Pay-par Disc. Prem. Gain- Loss = N.I. OA,IA,FA

Horizontal Model Transaction Analysis

P e r

0 1 2
bal

C Income Statement accounts closed to $0. 3 4
bal

0

0

0

C Income Statement accounts closed to $0. 5 6
end

0

0

0

bal

10- 45

Horizontal Model Transaction Analysis
Record the Issue of the CeeDee Corp. bonds on 1/1/04. Record Interest expense for the first 2 periods.
Balance Sheet Income Statement Assets= Cashflow Liab. + Equity Statement P Cash = Bond - Bond+ Bond + C.C.+ R.E. Rev./ - Exp./ e r Pay-par Disc. Prem. Gain - Loss = N.I. OA,IA,FA 0 92400 100000 7600 92400 FA 1 (3500) (1267) (4767) 4767 (4767) (3500)OA 2 (3500) (1267) (4767) 4767 (4767) (3500)OA
bal

85400 100000 5066

(9534)

9534 (9534) 85400 bal

How much Interest Expense is on the 2004 Inc. Statement? $9,534 ($4,767 + $4,767) How much interest will be on the 2004 Cashflow Statement? $7,000 ($3,500 + $3,500) What is the bond Carrying Value on the 12/31/04 Bal. Sheet? First, let’s discuss what Bond Carrying Value means.

10- 46

Carrying value of BONDS PAYABLE
q While the specific long-term

liability, Bonds Payable, is always recorded (and kept) at face value, the remaining balance (called the Unamortized balance) of the Discount or Premium will be either subtracted (if discount) or added (if premium) to the B/P-face amount to get the carrying value [also called “book” value] of the bonds at any given date.
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10- 47

Carrying value of BONDS PAYABLE
The December 31, 2004 CeeDees Corp. Balance Sheet will report the bonds at their Carrying Value:
Long-term Liability section: Bonds Payable-face Less: Unamortized Discount $100,000 ( 5,066)

Total Bond Liability (Carrying V.) $ 94,934

Let’s return to the horizontal model.
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10- 48

Horizontal Model Transaction Analysis
Recording Year 1 transactions for CeeDee Corp. bonds
Balance Sheet Income Statement Assets= Cashflow Liab. + Equity Statement P Cash = BondOBond+ Bond + C.C.+ R.E. Rev./ - Exp./ e r Pay-par Disc. Prem. Gain - Loss = N.I. OA,IA,FA 0 92400 100000 7600 92400 FA 1 (3500) (1267) (4767) 4767 (4767) (3500)OA 2 (3500) (1267) (4767) 4767 (4767) (3500)OA
bal

85400 100000 5066

(9534)

9534 (9534) 85400 bal

Bond Liability: Bond Payable-face $100,000 Less: Unamortized Discount 5,066 Bond Carrying Value $ 94,934

10- 49

Horizontal Model Transaction Analysis
Assuming the 2004 closing entries were made, record the two 2005 interest expense transactions.
Balance Sheet Income Statement Assets= Cashflow Liab. + Equity Statement P Cash = Bond - Bond+ Bond + C.C.+ R.E. Rev./- Exp./ e r Pay-par Disc. Prem. Gain - Loss = N.I. OA,IA,FA 0 92400 100000 7600 92400 FA 1 (3500) (1267) (4767) 4767 (4767) (3500)OA 2 (3500) (1267) (4767) 4767 (4767) (3500)OA bal 85400 100000 5066 (9534) 9534 (9534) 85400 bal C Income Statement accounts closed to $0. 0 0 0 3 (3500) (1267) (4767) 4767 (4767) (3500)OA 4 (3500) (1267) (4767) 4767 (4767) (3500)OA bal 78400 100000 2532 (19,068) 9534 (9534) 78,400bal C Income Statement accounts closed to $0. 0 0 0

10- 50

Record the two 2006 interest expense transactions, and Record the repayment of principal on Dec. 31, 1906.
Balance Sheet Income Statement Assets= Cashflow Liab. + Equity Statement P Cash = Bond - Bond+ Bond + C.C.+ R.E. Rev./ - Exp./ e r Pay-par Disc. Prem. Gain - Loss = N.I. OA,IA,FA 0 92400 100000 7600 92400 FA 1 (3500) (1267) (4767) 4767 (4767) (3500)OA 2 (3500) (1267) (4767) 4767 (4767) (3500)OA bal 85400 100000 5066 (9534) 9534 (9534) 85400 bal C Income Statement accounts closed to $0. 0 0 0 3 (3500) (1267) (4767) 4767 (4767) (3500)OA 4 (3500) (1267) (4767) 4767 (4767) (3500)OA bal 78400 100000 2532 (19068) 9534 (9534) 78400 bal C Income Statement accounts closed to $0. 0 0 0 5 (3500) (1267) (4767) 4767 (4767) (3500)OA 6 (3500) (1265) ($2 less-rounding) (4765) 4765 (4765) (3500)OA
end(100000)(100000)

Horizontal Model Transaction Analysis

bal (28600)

0

0

(28600)

9532 (9532) (28600)

(100000)FA

10- 51

Selling Bonds - Example
On Jan. 2, 2004, Blimp, Inc. sells $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 3 years and interest is paid semiannually. The market (effective, or yield) rate is 8% annually. Determine whether the bonds sell at par, at a discount, or at a premium.

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10- 52

Selling Bonds - Example
To figure out the proceeds from the sale, you either have to calculate the present value of the payments (using the market rate of interest) OR Be told that the bonds sold at “105.250”

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10- 53

Recording Bonds Sold at a Premium
Ë Prepare the journal entry to record

the issuance of the bonds.
Cash Bonds Payable - face Premium on Bonds Pay.

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10- 54

Recording Bonds Sold at a Premium
Ë Prepare the journal entry to record

the issuance of the bonds.
Cash Bonds Payable - face Premium on Bonds Pay. $100,000

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10- 55

Recording Bonds Sold at a Premium
Ë Prepare the journal entry to record

the issuance of the bonds.
Cash $105,250 Bonds Payable - face Premium on Bonds Pay. $100,000

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10- 56

Recording Bonds Sold at a Premium
Ë Prepare the journal entry to record

the issuance of the bonds.
Cash $105,250 Bonds Payable - face Premium on Bonds Pay.
This is called an adjunct account and appears in the liability section as an addition to the Bond Payable-face liability.
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$100,000 5,250

10- 57

Measuring and Recording Interest on Bonds Issued at a Premium
q The premium must be amortized over

the term of the bonds.

(Again, GAAP requires the Effective Interest method, but we’ll use the Straight-line method here.)
q The premium amortization decreases

the periodic interest expense for the issuer.

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10- 58

Straight-Line Amortization of Bond Premium
q Identify the amount of the bond

premium. q Divide the bond premium by the number of interest periods. q Include the premium amortization amount as part of the periodic interest expense entry. q The premium will be reduced to zero by the maturity date.
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10- 59

Straight-Line Amortization of Bond Premium
Prepare the journal entry to record the payment of interest and the premium amortization for the six months ending on June 30, 2004.
Interest Expense Premium on Bonds Payable Cash $ $

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10- 60

Straight-Line Amortization of Bond Premium
Prepare the journal entry to record the payment of interest and the premium amortization for the six months ending on June 30, 2004.
Interest Expense Premium on Bonds Payable Cash $ $5,000

$100,000 x .10 x 1/2 = $5,000

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10- 61

Straight-Line Amortization of Bond Premium
Prepare the journal entry to record the payment of interest and the premium amortization for the six months ending on June 30, 2004.
Interest Expense Premium on Bonds Payable Cash $ 875 $5,000

$5,250 : 6 periods = $875 each six months.

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10- 62

Straight-Line Amortization of Bond Premium
Prepare the journal entry to record the payment of interest and the premium amortization for the six months ending on June 30, 2004.
Interest Expense Premium on Bonds Payable Cash $4,125 875 $5,000

The existence of a Premium causes the EFFECTIVE interest expense ($4,125) to be lower than the CASH interest paid ($5,000).
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10- 63

Straight-Line Amortization of Bond Premium
Prepare the journal entry to record the payment of interest and the premium amortization for the six months ending on June 30, 2004.
Interest Expense Premium on Bonds Payable Cash $4,125 875 $5,000

This exact same entry will be made at the end of each six months throughout the three year term of the bond.
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10- 64

Horizontal Model Transaction Analysis
Balance Sheet Income Statement Assets= Cashflow Liab. + Equity P Cash = Bond - Bond+ Bond + C.C.+ R.E. Rev./ - Exp./ e r Pay-par Disc. Prem. Gain - Loss = N.I. 0 105250 100000 5250 1 (5000) (875) (4125) 4125 (4125) 2 (5000) (875) (4125) 4125 (4125)
bal bal

Record the issue of the Blimp Corp. bonds on 1/1/04, and the Interest expense for the first 2 periods.
Statement

OA,IA,FA 105250FA (5000) OA (5000) OA

95250 100000

3500

(8250)

8250 (8250) 95250

How much Interest Expense is on the 2004 Inc. Statement? $8,250 ($4,125 + $4,125) How much interest will be on the 2004 Cashflow Statement? $10,000 ($5,000 + $5,000) What is the bond Carrying Value on the 12/31/04 Bal. Sheet?

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Horizontal Model Transaction Analysis
Record the issue of the Blimp Corp. bonds on 1/1/04, and the Interest expense for the first 2 periods. Balance Sheet Long-term Liabilities: Income Statement

+ Equity Statement P Bond R.E. Rev./ - Exp./ $100,000 Cash = Bond - Bond + Bond + C.C.+Payable-face e r Pay-par Disc. Prem. Gain - Loss = N.I. OA,IA,FA Plus: Unamortized Prem. 3,500 0 105250 100000 5250 105250FA Value $103,500 1 (5000) (875) Bond Carrying 4125 (4125) (5000) OA (4125) 2 (5000) (875) (4125) 4125 (4125) (5000) OA

Assets= Cashflow Liab.

O

bal bal

95250 100000

3500

(8250)

8250 (8250) 95250

How much Interest Expense is on the 2004 Inc. Statement? $8,250 ($4,125 + $4,125) How much interest will be on the 2004 Cashflow Statement? $10,000 ($5,000 + $5,000) What is the bond Carrying Value on the 12/31/04 Bal. Sheet? $103,500

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Understanding Notes to Financial Statements
q Effective-interest method of

amortization is required by GAAP. (This method is in the Appendix.) q Straight-line amortization may be used if it is not materially different from effective interest amortization. q Most companies do not disclose the method used for bond interest amortization.
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Early Retirement of Debt
q When a bondholder (the

investor) sells a bond that is already “on the market”, there is no effect on the books of the issuing company. q Occasionally, the issuing company will call (repay early) some or all of its bonds.
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Calling a bond...
q If the bond is callable, the issuer

may decided to call the bond (retire it before maturity). q The liability and any remaining premium or discount would be removed from the books. q The difference between cash paid and Carrying value on that date is recorded as an income statement Gain (cash paid < CV) or Loss (cash paid > CV).
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Early Retirement of Debt
q Bonds can be retired by exercising a

call provision on the bond, or by purchasing the bond on the open market. q Any gains or losses incurred as a result of retiring the bonds should be reported as an extraordinary item in the lower portion of the income statement.
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Ex: Early Retirement of Debt
What if the Blimp Corp. called their bonds at the end of year 1? The bonds had a “Call Provision” requiring the company to pay 104 to call the bonds. Bonds Payable - face + Unamortized Premium Carrying Value on 12/31/04 Cash paid to Call bonds Loss on Bond Retirement $100,000 3,500 $103,500 104,000 $ 500

The $500 loss is reported as an Extraordinary item on Inc. Statement.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

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Horizontal Model Transaction Analysis
Record the CALL of the Blimp Corp. bonds on 12/31/04.
Balance Sheet Income Statement Assets= Cashflow Liab. + Equity Statement P Cash = Bond - Bond+ Bond + C.C.+ R.E. Rev./ - Exp./ e r Pay-par Disc. Prem. Gain - Loss = N.I. OA,IA,FA 0 105250 100000 5250 105250FA 1 (5000) (875) (4125) 4125 (4125) (5000) OA 2 (5000) (875) (4125) 4125 (4125) (5000) OA
B

95250 100000

3500 (3500)

(8250) (500)

8250 (8250) 95250 bal 500 (500) (104000)FA

C (104000) (100000)

.

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Bond Sinking Funds
q A special fund to be used to retire

bonds at maturity. q Normally, periodic cash contributions are made to the fund. q Usually reported on the balance sheet as a non-current (investment) asset.

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Ratio Analysis
Times-interest-earned Ratio Indicates the borrower’s ability to meet fixed interest payments

Times Interest Earned =

EBIT* Interest Expense

*EBIT = Earnings Before Interest and Taxes

Higher ratio is better; indicates less risk of default.
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Ratio Analysis
Times-interest-earned Ratio
Example: $100 ( 70) 30 (10) 20 (6) $ 14
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Sales Operating Expenses Earnings before Interest and Taxes Interest Expense Income before Taxes Income taxes Net Earnings
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EBIT Interest Expense $30 = 3 times Your $10
financial future is cloudy!

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Debt vs. Equity Financing

Financing with debt
Interest payments are tax deductible.

Financing with Equity (additional
owners’ capital investment) Distributions to owners (Dividends) are NOT tax deductible.
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Debt vs. Equity Financing

Financing with debt
Interest payments MUST BE PAID even if the company is losing money.

Financing with Equity (additional
owners’ capital investment) Distributions to owners (Dividends) could be reduced or eliminated in “bad times.”
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Debt vs. Equity Financing

Matt’s of Milton, Inc. must raise $1,000,000 to finance an expansion project. Two options are being considered. Option #1: Issue 10 year, 5% annual rate bonds at 100. Option #2: Attract new ownership investors by issuing 20,000 new ownership shares at $50 each. Current owners, holding 10,000 shares, will expect to continue receiving their $2.50 per share annual cash dividend distribution.
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Debt vs. Equity Financing
Use Equity Use Debt $1,000,000 (800,000) $ 200,000 (50,000) $ 150,000 60,000) $ 90,000 (25,000) $ 65,000

Sales Revenue (forecasted) $1,000,000 Operating Exp (80% x sales) (800,000) Earnings before Interest & Taxes $ 200,000 Interest Exp. ($1,000,000 x .05) Income before taxes Income taxes (40%) $ 200,000 Net Income (80,000) $2.50 Dividend on Orig. 10,000 sh. $ 120,000 $2.50 Dividend on Extra 20,000 sh. (25,000) Addition to Retained Earnings (50,000) $ 45,000
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Debt vs. Equity Financing
Use Debt $1,000,000 (800,000) $ 200,000 (50,000) $ 150,000 60,000) $ 90,000 (25,000) $ 65,000

Use Equity Although interest is $50,000 more, Net Income is only Sales Revenue $1,000,000 $30,000 Exp (80% x sales) Operatingless because $20,000 (800,000) less TAXES were paid. Earnings before Interest & Taxes $ 200,000 Interest Exp. ($1,000,000 x .05) Income before taxes Income taxes (40%) $ 200,000 Net Income (80,000) $2.50 Dividend on Orig. 10,000 sh. $ 120,000 $2.50 Dividend on Extra 20,000 sh. (25,000) Addition to Retained Earnings (50,000) $ 45,000
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Debt vs. Equity Financing
Use Debt $1,000,000 (800,000) $ 200,000 (50,000) $ 150,000 60,000) $ 90,000 (25,000) $ 65,000

There is NO tax savings on the Use Equity additional $50,000 in cash Sales Revenue $1,000,000 dividends paid on sales) Operating Exp (80% xthe new (800,000) shares of stock issued & Taxes Earnings before Interestto raise $ 200,000 the ($1,000,000 Interest Exp.$1,000,000. x .05) Income before taxes Income taxes (40%) $ 200,000 Net Income (80,000) $2.50 Dividend on Orig. 10,000 sh. $ 120,000 $2.50 Dividend on Extra 20,000 sh. (25,000) Addition to Retained Earnings (50,000) $ 45,000
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Debt vs. Equity Financing
Use Debt $1,000,000 (800,000) $ 200,000 (50,000) $ 150,000 60,000) $ 90,000 (25,000) $ 65,000

Use Equity Although $50,000 is paid annually to obtain the $1,000,000 $1,000,000 Sales Revenue financing, the debt sales) Operating Exp (80% xfinancing (800,000) increases Retained Earnings by Earnings before Interest & Taxes $ 200,000 an extra $20,000. Because the Interest Exp. ($1,000,000 x .05) interest is tax deductible the Income before taxes $20,000 tax (40%) Income taxessavings ($50,000 x $ 200,000 40%) stays Net Income in the company to (80,000) the benefit on Orig. 10,000 $2.50 Dividend of the owners. sh. $ 120,000 $2.50 Dividend on Extra 20,000 sh. (25,000) Addition to Retained Earnings (50,000) $ 45,000
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Debt vs. Equity Financing

Use Equity Use Debt Equity transactions and Earnings per share (EPS) are the $1,000,000 $1,000,000 Sales Revenue In this case the use of subject of the (80% x sales) Operating Exp next chapter. But debt is an effective (800,000) (800,000) notice before Interest & Taxes $use of “leverage.” It Earnings here that if the equity 200,000 $ 200,000 option Exp. ($1,000,000 x more improves- the return to Interestis chosen there are .05) (50,000) owners with taxes Income beforewhom the current the owners $ 150,000 as shown owners will have Income taxes (40%) to share all $by the higher EPS for 200,000 60,000) future profits. That reduces the the debt financing Net Income (80,000) $ 90,000 Earnings (profit) per share of $2.50 Dividend on Orig. 10,000 sh. $option. 120,000 (25,000) ownership. $2.50 Dividend on Extra 20,000 sh. (25,000) Addition to Retained Earnings (50,000) $ 65,000 45,000 Earnings per share = N. Inc./# sh. $ $4.00 $9.00
$120,000/30,000sh=$4 & $90,000/10,000sh=$9
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Chapter 10. There is a Ready Shows Appendix that covers the following topics:

qIntroduction

to Present Value and Future Value - Basic Principles - Using P.V. to calculate loan payments - Using F.V. to calculate Bond Sinking Fund payments - Using P.V. to calculate a Bond’s selling price qThe Effective Interest Method of Premium and Discount Amortization qBonds sold with Accrued Interest.
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Chapter 10

The Appendix follows.
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