Chapter 9 (PART 2): Long Term Liabilities (Bonds)
I. Bonds
A. Bonds - Long-Term debt sold to creditors.
A bond makes (2) promises:
1. Repayment of bond principal at maturity (face value of the bond)
2. Periodic interest payments; based on the bond principal/face value/par value (usually
annually or semi-annually).
Example:
XYZ Co. needs to finance a $200,000 expansion of their current facility. They want to issue
200, $1,000 bonds that mature in 3-years. The bonds pay 10% interest, compounded
semiannually.
B. Terminology
1. Face Value (Par Value) – The denomination of the bond. Bonds are usually sold in
$1,000 denominations. Amount due at maturity.
2. Coupon (Stated, Face) Interest Rate - fixed rate of interest that will be paid each interest
payment. Set by Issuing Company.
3. Market (Effective,Yield) Interest Rate – rate of interest that bondholders
(investors) could obtain by investing in other bonds that are
similar to the issuing firm’s bonds. Set by Bond Market.
4. Term Bond - all bonds mature on same date
5. Serial Bond - bonds retire in installments
6. Debenture Bonds -unsecured. Not backed by collateral. Look at
general credit worthiness of company.
7. Secured Bonds – bonds backed by specific collateral
8. Callable Bonds - corporation reserves right to buy them back
early at a stated price (call price or redemption price)
9. Convertible Bonds - can be exchanged for a stated # shares of
common stock
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10. Bond Indenture – bond contract. Specifies all legal provisions of bond (rates, dates, etc…)
Both the Coupon Rate & and the Market Rate lock in on the date of issuance. The company
receives the cash proceeds and records the liability. They are now legally obligated to make
all interest payments and repay the principal at maturity. While interest rates will continue to
change daily after the bond has been issued, these market changes do NOT affect the
accounting for the bond on the company’s books!! Everything (the amount of debt to be
repaid & the interest rates) lock in on the date of the initial sale!
II. How Bonds are Sold:
THE SELLING PRICE OF BONDS IS AFFECTED BY THE
DIFFERENCE BETWEEN COUPON RATE AND MARKET RATE
Bonds are sold one of three ways:
1. @ face (par) value coupon = market
2. @ a discount coupon < market
3. @ a premium coupon > market
Selling Price of bond is dependent on Time Value of Money. The amount of money a corporation
receives when it sells bonds is the present value of the future cash flows associated with them.
Because a bond is made up of (2) promises of future cash flows, you must find the present value of
BOTH to determine selling price.
Selling Price = PV of Face Amount + PV of Cash Interest Payments
Example: Denver Co. plans to issue a 10%, 3-yr Bond with a face value of $100,000. Interest is paid
semiannually. Determine if the bond will sell for a Premium, Discount, or at Par for each of the following
conditions:
a. The market (yield) rate is 8%: __________________
b. The market (yield) rate is 10%: __________________
c. The market (yield) rate is 12%: __________________
Note: always use MARKET RATE to discount the cash flows to Present Value (PV)
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Computing the Issue Price of Bonds:
Step 1: Find Cash Interest Payments Cash Interest Payment = FV x Coupon %
Step 2: Find PV of Face Amount PV = FV x PV of $1 (% Mkt, n)
Step 3: Find PV of Cash Interest Payments PV = PMT x PVOA (% Mkt, n)
Step 4: Add PV of Face + PV of PMTs Selling Price of Bond
(Cash Proceeds to the Company)
Example: Bonds sell at Face Value: Coupon (Stated) Rate = Market Rate
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Aggie Company plans to issue $100,000, 3- year bonds that pay 10% semi-annual interest.
Market rate is 10%.
Yr 1 Yr 2 Yr3
PV of Face Amount: |__________|__________|____________|
PV of Cash Interest Payments:
Yr 1 Yr 2 Yr3
|__________|__________|____________|
Journal Entries to Record: Selling Price =
Date of Issuance:
Date of Each Cash Interest Payment:
**Carrying Value will not change over the life of a bond issued at Face Value**
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Example: Bonds Sell at a Discount: Coupon (Stated) Rate < Market Rate
Aggie Company plans to issue $100,000, 3-year bonds that pay 10% semi-annual interest.
Market rate is 12%.
Yr 1 Yr 2 Yr3
PV of Face Amount: |__________|__________|____________|
PV of Cash Interest Payments:
Yr 1 Yr 2 Yr3
|__________|__________|____________|
Journal Entries to Record: Selling Price =
Date of Issuance:
Balance Sheet:
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Reporting Interest Expense and How the Carrying Value Changes as it Matures
To determine Interest Expense using Effective Interest Method:
RULES: 1. Use Market Rate % to find Int. Expense – the true cost of
borrowing is the market rate
2. Use Coupon or Stated Rate % to find cash interest payment only.
AMORTIZATION TABLE
Interest Cash Discount Carrying
Date Expense Payment Amortization Value
Journal Entry: 1st Cash Interest Payment 2nd Cash Interest Payment
Balance Sheet Presentation at end of 1st year:
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Effect of a Discount
1. Increases the cost of borrowing (received less today, but must pay back face value
at maturity)
2. Amortization of Discount increases Interest Expense because int. exp. is
calculated based on carrying value & true cost of borrowing.
3. Carrying value increases over life of bond until it reaches its face value at
maturity
How to find Total Cost to Borrow (Interest Expense) – 2 ways to find:
1. Cash Outflow vs. Cash Inflow
2. Add Discount to Cash Interest Payments
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Example: Bonds Sell at a Premium: Coupon (Stated) Rate > Market Rate
Aggie Company plans to issue $100,000, 3-year bonds that pay 10% semi-annual interest.
Market rate is 8%.
Yr 1 Yr 2 Yr3
PV of Face Amount: |__________|__________|____________|
PV of Cash Interest Payments:
Yr 1 Yr 2 Yr3
|__________|__________|____________|
Journal Entries to Record: Selling Price =
Date of Issuance:
Balance Sheet:
AMORTIZATION TABLE
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Interest Cash Premium Carrying
Date Expense Payment Amortization Value
Journal Entry: 1st Cash Interest Payment 2nd Cash Interest Payment
Balance Sheet Presentation at end of 1st year:
Effect of a Premium
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1. Premium reduces the cost of borrowing (received more up front and must pay
back only face value at maturity).
2. Amortization of premium reduces interest expense
(Market rate--the actual cost of borrowing--is less than the coupon rate.)
3. Carrying value of bond is reduced over its life until it reaches face value at
maturity
How to find Total Cost to Borrow (Interest Expense) – 2 ways to find:
1. Cash Outflow vs. Cash Inflow
2. Subtract Premium from Cash Interest Payments
Example Problem:
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Joyce Company issued $10,000 of bonds payable on January 1, 2021
with an 8 percent coupon interest rate payable annually on December 31.
The bonds mature in five years. Market rate of interest is 7%.
Required:
1. Determine the selling price of the bonds.
2. Prepare a schedule showing the premium to be amortized each year for the life
of the bonds, assuming the effective interest method of amortization.
3. Give the journal entry to record the interest payment on
December 31, 2021.
1. Selling Price:
2. AMORTIZATION TABLE
Interest Cash Int. Premium Carrying
Date Expense Payment Amortization Value
Issue
12/31/21
12/31/22
12/31/23
12/31/24
12/31/25________________________________________________________
III. Bond Prices and Market Interest Rates:
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There is an inverse relationship between market interest rates and bond prices.
If market interest rates increase, bond prices decrease.
If market interest rates decrease, bond prices increase.
At issue:
Ex: If our bonds originally sold at a premium (c > m) and are now selling on the
market at a discount (c < m), then market rates have
____________________.
IV. RETIREMENT OF BONDS
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A. If you retire at maturity (when face value = carrying value), then:
B. If you Retire Early:
1. Callable Bonds - corp. buys bonds back at call price
2. Repurchase through market - pay prevailing market rate.
C. Gain/loss on Retirement:
1. Repurchase price < carrying value = gain (credit)
2. Repurchase price > carrying value = loss (debit)
Example 1:
Terry, Inc., has outstanding a $100,000, 8%, 10-year bond issue which was sold on
January 1, 2017, at a price of $110,000. The following liability appeared on the balance sheet dated
December 31, 2021.
LONG-TERM DEBT:
Bonds payable....……. $100,000
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Premium...................... 5,000 $105,000
Make the entry necessary to record the retirement of the bonds if the firm calls the bonds
at 106 on January 1, 2022.
Example 2:
Because of changing market conditions, a corporation decided to redeem one half of its
$300,000 bonds prior to maturity. The bonds had been issued at a discount and the
balance in the discount account at the time of redemption was $15,000. The bonds are
selling on the open market at 94.
Make the entry necessary to record the retirement of the bonds if the firm buys them
on the open market.
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