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					Introductory Accounting B
B11-391 Mark Binder, CA Chapter 17

Learning Objectives
• Compare bond versus share financing • Explain the types of bonds and their issuing procedures • Prepare entries to record bonds issued at par • Determine the price of a bond • Prepare entries to record bonds issued at a discount • Prepare entries to record bonds issued at a premium • Record the retirement of a bond

Bonds
• Most people are familiar with Canada Savings Bonds • In Manitoba we have had Manitoba Hydro Bonds and Manitoba Builder Bonds • Bonds are a method of financing that businesses use • Bonds are a form of debt • Bonds are used instead of or to augment bank financing

Advantages of Bonds
• Bonds do not affect shareholder control • Interest on bonds is tax deductible • Bonds can increase return on equity – leverage
– If return is higher than interest rate return on equity will increase

Disadvantages of a Bond
• Payments are not discretionary and can be difficult to make when income is low • Bonds can decrease return on equity
– If return is lower than interest rate return on equity will decrease – Happens when income is low – Has caused financial collapse of companies – Magna Int’l and Olympia and York

Types of Bonds
• Bonds by definition has specific assets pledged against the bond issue
– If the company defaults on the bond the pledged asset can be sold and the cash distributed to bond holders

• Debentures are unsecured
– Sometimes called ‘Junk’ Bonds

Term and Serial Bonds
• Term bonds have a scheduled maturity date when the bond must be repaid • Serial Bonds have several maturity dates
– The maturity dates are in series

Bond Issuance Procedures
• The issuing company develops a document called the bond indenture which acts as the contract between them and the bond holders • Each bond holder will receive a bond certificate • Usually, issuing companies sell the bonds to an investment firm called an underwriter

Bond Issuing Procedures Cont’d
• The underwriter then resells the bonds to the public • When an underwriter sells bonds to a large number of investors the bondholder’s interests are represented by a trustee • The trustee ensures the issuer complies with the bond indenture • When Manitoba Hydro issued it’s bonds Montreal Trust was the trustee

Issuing Bonds
• Part of the Bond indenture identifies the interest rate on the bond • Interest is usually paid semi- annually • This rate is called the stated rate, coupon rate or nominal rate • The market price for the bonds will be determined by how much investors are willing to pay for the bonds

Issuing Bonds
• Sometimes investors will accept the stated rate of the bond. This is called issuing at par. • Sometimes investors will require a higher return than the stated rate on the bonds. • This is called issuing a bond at a discount

Issuing Bonds
• Occasionally, the market will require a lower rate of return than the stated rate of the bond. • This is called issuing at a premium

Issuing at Par
• XYZ company issues it’s $500,000 6% 5 year bond dated January 1st. • The market rate is also 6% • The bonds pay interest semi-annually The Journal entry would be: Dr: Cash $500,000 Cr: Bond Payable $500,000

Issuing at Par
• In six months the interest would be recorded as: Dr: Bond Interest Expense $15,000 Cr:Cash $15,000 $500,000 x 6% x ½ =$15,000

Issuing at Par – Sale Between Interest Dates
• Bonds do not have to be sold on their interest date • If they are not, standard practice is to include in the issue price of the bond the accrued interest since the day of issuance

Issuance at Par – Sale Between Interest Dates
• XYZ company issues it’s $500,000 6% 5 year bond dated January 1st on March 1st. • The market rate is also 6% • In this case the bonds were issued (sold) 2 months after their dated date • The bonds were sold at par plus two months interest (January and February) • What was the issue price?

Issuance at Par – Sale Between Interest Dates
• Since the bonds were sold at par the market interest rate is also 6%. • The sale price of the bonds: • Face value of bonds $500,000 • Accrued interest ($500,000 x 6% x 2/12) 5,000 $505,000

Issuance at Par – Sale Between Interest Dates
• The journal entry to record this would be: Dr: Cash $505,000 Cr: Bond Payable $500,000 Cr: interest payable $5,000 • What would the journal entry be for the 1st interest payment?

Issuance at Par – Sale Between Interest Dates
Dr: Interest expense$10,000 Dr: Interest payable $5,000 Cr: Cash $15,000 Interest expense = $500,000 x 6% x 4/12 = $10,000 or $15,000 ($500,000 x 6% x ½) - $5,000 (interest payable)

Bond Maturity
• When the bonds mature in 5 years the journal entry will be: Dr: Bond Payable Cr: Cash $500,000 $500,000

Issuing at a Discount
• Assume the same scenario except the market rate is 10% • Because the market is demanding a 10% return a investor will not pay the face value of the bond. • The investor will pay an amount which will yield a 10% return

Determining Issue Price
• Keep in mind that nothing about the bond indenture will change. • The cash payments of interest and the face value of the bond are unchangeable. • The question we need to ask is what would someone pay for:
– $15,000 every 6 months for the next 5 years and – $500,000 in five years?

Determining Issue Price
• This is a question based purely on mathematics. • $15,000 x (P/A, 5%,10) = • P/A – the present value of an annuity at 5% for 10 periods (Table IV.3) • $15,000 x 7.7217 = $115,825.50 • $500,000 x (P/F, 5%, 10) = • P/F – the present value of a future cash flow (Table IV.1) • $500,000 x 0.6139 = $306,950

Determining the Issue Price
• The issue price is the sum of these two cash flows:
Present value of interest payments Present value of the face value payment 115,825.50 306,950.00 422,775.50

• Alternatively you could use your calculator

Determining the Issue Price
• Clear TVM • Set the following variables
– – – – N = 10 FV = -500,000 PMT = -15,000 I/Y = 5

• Compute (CPT) PV (Present Value) = 422,782.65 • Notice the difference of $422,782.65 $422,775.50 = $7.15

Determining the Issue Price
• Their will frequently be a difference between the ‘calculator value’ and the ‘table value’ • The difference should not be significant but exists because the calculator uses more decimal places then are in the table. • For the most part this course will emphasize the table method. • You can and should use your calculator as a verification of your calculation.

Issuing at a Discount
• Whenever the stated rate is below market it is called issuing at a discount • The journal entry to record issuing a bond at a discount is:
Dr: Cash $422,776 (rounded) Dr: Discount on Bonds Payable $ 77,224 Cr: Bonds Payable $500,000 The discount is computed effectively as a plug $500,000 - $422,776 = $77,224.

Issuing a Bond at a discount
• Another alternative method of describing the past situation is to say the bonds were sold at 84.5 • This means the cash collected was 84.5% of the face value of the bond • The 84.5% is rounded result.

Discounts
Our bonds will be disclosed on the financial statements as follows:
Bond Payable 6%, due December 31, 2006 $500,000 Less: discount on bonds payable 77,224 422,776

Discounts
• The discount posses a specific problem • As time passes and the bond approaches maturity the discount must be slowly eliminated • By the time the maturity date arrives, the value of the bond on the financial statements should represent the amount that must be paid, the face value of the bond. • Therefore, once a discount is recorded it must be amortized over the life of the bond • We will use two methods:
– Straight Line – Effective Interest

Straight Line Method
• As was the case in straight line amortization the amount of the discount is amortized on a straight line basis. • Recall that our bond is a 5 year bond • Discount is $77,224 • Interest payments are semi annual.

Straight Line Method
• Straight line amortization would be: $77,224/10 periods = $7,722.4 or $7,722 each period. • The Journal entry to record the first interest payment is: Dr: Bond interest expense 22,722 Cr: Discount on bond 7,722 Cr: Cash 15,000

Straight Line amortization
• Each period 7,722 will be reduced from the total of the discount on issuing • The amortization of the discount must create a credit against the discount
– Remember the discount has a debit balance so to eliminate it, a credit must be posted.

• The offsetting debit is added to interest expense.

Effective Interest Method
• Under the straight line method the interest expense is constant – does not differ from one period to the next. • When dividing the interest expense by the carrying a variable interest rate is created. • This creates the impression of a floating interest rate.

Effective Interest Method
• Under the effective interest method interest expense divided by carrying value will yield a constant rate of interest. • The constant rate of interest is the market rate of interest at issue date.

Effective Interest Method
• The key to calculating interest under the effective interest method is to focus on the ‘carrying value’ of the bond • The carrying value is the value of the bond less the discount (plus the premium) • In our continuing example after issuance our balance appears as follows:

Effective Interest Method
Bond Payable 6%, due December 31, 2006 $500,000 Less: discount on bonds payable 77,224 422,776 • Under the effective interest method the interest we compute is the market rate of interest x the carrying value of the bond • In this case it is 422,776 x 5% (market rate of interest) = $21,139 (rounded)

Effective Interest Method
• The journal entry to record interest is: Dr: Interest expense $21,139 Cr: Cash $15,000 Cr: Discount on Bond $6,139 • Notice how this differs from the straight line method • In both cases the credit to cash, which is established in the bond indenture, remains the same

Effective Interest Method
• In the straight line method the amortization of the discount was determined and interest expense was ‘plugged’ • In the effective interest method the interest expense is computed and the amortization of the discount is ‘plugged’ • What would be the journal entry for the second interest payment?

Effective Interest Method
• To determine the interest expense we first have to determine the carrying value of the bond • Discount value $77,724 – amortization from first journal entry $6,139 = $71,085 Bond Payable 6%, due December 31, 2006 $500,000 Less: discount on bonds payable 71,085 428,915

Effective Interest Method
• Interest expense is then $428,915 x 5% = $21,446 • The journal entry to record this would be: Dr: Interest expense $21,446 Cr: Cash $15,000 Cr: Discount on Bond $6,446

Issuing at a Premium
• If the market rate is less than the stated rate on the bonds, the bonds are said to be issued at a premium • If in our prior example the bonds were sold at 103 the journal entry would be:

Journal entry – Bond Premium
Dr: Cash $515,000 Cr: Premium on bond payable $15,000 Cr: Bond Payable $500,000 • Amortization of a premium works identically to amortizing a discount on the straight line method • $15,000 / 10 = $1,500 per period • What would be the journal entry to record the first interest payment?

Journal entry bond premium
• The journal entry to record the first interest payment would be: Dr: Interest expense $13,500 Dr: Bond premium $1,500 Cr: Cash $15,000

Effective Interest Method – Bond Premium
• Alternatively, the Bond premium could be amortized using the effective interest method • Assume XYZ Corporation issues it’s bond at 103 and amortizes the premium using the effective interest method. • What would the journal entry be to record the first interest payment • Assume the market rate of interest is 5.31% (This is approximately true)

Effective Interest Method
• The carrying value of the bond is: • Face value of Bond $500,000 • Plus the premium 15,000 $515,000 5.31% /2 = 2.655% x 2.655% $13,673.25

Effective Interest Method
Dr: Bond Interest Expense $13,673.25 Dr: Premium on Bond $1,326.75 Cr: Cash $15,000


				
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