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					        Principles of Financial Accounting


                                                                  Chapter 9
                                                               Bond Accounting
                                                                  (p. 390-404)




                                     Introduction to Bonds
          Bonds are formal certificates of debt that promise to pay:
               A specified amount of interest in cash annually or semi-annually.
               A specified principal at a specific maturity date.   “Convertible” bonds refer to
                                                                                 bonds that can be exchanged, at the
          Vocabulary:                                                            holders’ option, for other securities.
                Bonds are “issued” by companies (“issuers”) that wish to borrow
                money from the general public.
                Bonds are issued to multiple lenders / investors (“bondholders”).
                The face value (also called par value or maturity value) is the
                principal the company is required to pay at maturity.
                 The coupon rate (also called nominal interest rate, contractual rate,
                stated rate) determines the amount of interest the company is required
                to pay every year.
                Bonds generally pay interest every 6 months (i.e. semi-annually).
Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                                           2




                                                                                                                          1
                                                   Valuing Bonds
        Because bonds create cash flows in future periods, they are recorded
        at the present value of those future payments, discounted at the
        market interest rate in effect when the liability is created.

        When valuing bonds, the present value tables are used to determine
        the amount of proceeds that will be received (i.e. the “price” of the
        bonds).
              The present value of $1 table (Table 9A-2, p.422) is used to determine
              the present value of the face amount (principal) of the bonds.
              The present value of an annuity of $1 (Table 9A-3, p.423) is used to
              determine the present value of the series of interest payments.
              The amounts are added together to determine the amount of proceeds
              and any resulting discount or premium.

Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                                         3




                           Proceeds on Bond Issuance
                       Bond:           Face Amount:            $100,000
                                       Term:                   3 years
                                                                             ($100,000 * .07)/2
                                       Coupon Rate:            7%
                                       Interest Payments:      $3,500 paid semi-annually

    A. Market Interest Rate = 7% = Coupon Rate
                       Proceeds = $100,000.
                       Bond sold at par.
    B. Market Interest Rate = 8% > Coupon Rate
                       Proceeds = $100,000 * 0.7903 + $3,500 * 5.2421 = $97,377.
                       Bond sold at a discount.
                                                                                        4%, 6 periods, Table 9A-3
                          4%, 6 periods, Table 9A-2
    C. Market Interest Rate = 6% < Coupon Rate
                       Proceeds = $100,000 * 0.8375 + $3,500 * 5.4172 = $102,710.
                       Bond sold at a premium.
                         3%, 6 periods, Table 9A-2                                      3%, 6 periods, Table 9A-3

Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                                         4




                                                                                                                        2
                              Par, Discount & Premium
                         If the market rate is EQUAL to the coupon rate,
                         the bond will sell at PAR.

                         If the market rate is ABOVE the coupon rate,
                         the bond will sell at a DISCOUNT.

                         If the market rate is BELOW the coupon rate,
                         the bond will sell at a PREMIUM.




Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                        5




                        Coupon Rate vs. Market Rate
          The coupon (interest) rate is:
                The rate of interest stated on the bond.
                The interest to be paid in cash every year by the issuing company.
                Used to calculate the amount of interest payments (paid in cash).

          The market (interest) rate (or effective interest rate, yield to maturity) is:
                The rate available on investments in similar bonds at a moment in time.
                Used in the present value calculations when determining the
                proceeds on issuance.
                Used to calculate the amount of interest expense to recognize.
                Changes in the market rate after the bonds are issued do NOT affect the interest
                expense recognized.
Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                        6




                                                                                                       3
                     Effective Interest Amortization
          How do we decrease the bond discount or bond premium?
                Straight-line amortization (not GAAP)
                      The discount or premium is amortized in equal amounts each period.
                Effective interest amortization
                   The discount or premium is amortized over the life of the debt.
                      The interest expense is equal to the market interest rate
                      (at the time of issuance) multiplied by the amount of debt
                      outstanding at the beginning of the given period.
                      The difference between the interest expense and the cash
                      paid (for interest payments) represents the amortization of
                      the discount or premium.


Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                                 7




                                    Discount Amortization
     Coupon rate = 7%, Market Rate = 8%, FV = $100,000, Proceeds = $97,377 (see slide 4, B).
                  Period            Bonds              Interest    Cash     Amortization of    Bonds
                                   Payable,            Expense    Payment     Discount        Payable,
                                     Beg.               (4%)                                    End
                                      (a)             (b=a*4%)      (c)        (d=b-c)        (e=a+d)
                      1             97,377               3,895     3,500         395           97,772
                      2             97,772               3,911     3,500         411           98,183
                      3             98,183               3,927     3,500         427           98,610
                      4             98,610               3,944     3,500         444           99,055
                      5             99,055               3,962     3,500         462           99,517
                      6             99,517               3,983     3,500         483          100,000
                           Journal entry upon bond issuance:
                                                 Dr. Cash                   97,377
                                                             Cr. Bonds Payable               97,377
                           Journal entry for interest expense, end of Period 1 (6 months after issuance):
                                                 Dr. Interest Expense         3,895
                                                             Cr. Cash (or Interest Payable)    3,500
                                                             Cr. Bonds Payable                   395
                           Journal entry at maturity (end of Period 6):
                                                 Dr. Bonds Payable         100,000
Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting
                                                             Cr. Cash                       100,000         8




                                                                                                                4
                                    Premium Amortization
     Coupon rate = 7%, Market Rate = 6%, FV = $100,000, Proceeds = $102,710 (see slide 4, C).
                  Period            Bonds              Interest     Cash     Amortization of    Bonds
                                   Payable,            Expense     Payment     Premium         Payable,
                                     Beg.               (3%)                                     End
                                      (a)             (b=a*3%)       (c)        (d=b-c)        (e=a+d)
                      1            102,710                3,081     3,500         -419         102,291
                      2            102,291                3,069     3,500         -431         101,860
                      3            101,860                3,056     3,500         -444         101,416
                      4            101,416                3,042     3,500         -458         100,958
                      5            100,958                3,029     3,500         -471         100,487
                      6            100,487                3,013     3,500         -487         100,000
                           Journal entry upon bond issuance:
                                                 Dr. Cash                 102,710
                                                             Cr. Bonds Payable              102,710
                           Journal entry for interest expense, end of Period 4 (2 years after issuance):
                                                 Dr. Interest Expense        3,042
                                                 Dr. Bonds Payable             458
                                                             Cr. Cash (or Interest Payable)   3,500
                           Journal entry at maturity (end of Period 6):
                                                 Dr. Bonds Payable         100,000
Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting
                                                             Cr. Cash                       100,000        9




                                           Bond Issued at Par
     Coupon rate = 7%, Market Rate = 7%, FV = $100,000, Proceeds = $100,000 (see slide 4, A).
                  Period            Bonds              Interest     Cash     Amortization of    Bonds
                                   Payable,           Expense      Payment    Discount /       Payable,
                                     Beg.               (3.5%)                 Premium           End
                                      (a)            (b=a*3.5%)      (c)        (d=b-c)        (e=a+d)
                      1             100,000                3,500     3,500         -            100,000
                      2             100,000                3,500     3,500         -            100,000
                      3             100,000                3,500     3,500         -            100,000
                      4             100,000                3,500     3,500         -            100,000
                      5             100,000                3,500     3,500         -            100,000
                      6             100,000                3,500     3,500          -           100,000
                          Journal entry upon bond issuance:
                                       Dr. Cash                    100,000
                                                   Cr. Bonds Payable                 100,000
                          Journal entry for interest expense at the end of each period:
                                       Dr. Interest Expense          3,500
                                                   Cr. Cash (or Interest Payable)       3,500
                          Journal entry at maturity (end of Period 6):
                                       Dr. Bonds Payable          100,000
                                                   Cr. Cash                         100,000
Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                                10




                                                                                                                5
                                           Practice Problem A
          A company issues a 2-year bond with a face value of $20,000 and a
          coupon rate of 10%.
             Interest is paid and compounded semi-annually on June 30 and
             December 31 of each year.
             At the time of issuance, the market rate is 12%.
          1. What is the amount of the proceeds from the issuance of this bond?
                      Proceeds = $20,000 * 0.7921 + $1,000 * 3.4651 = $19,307.
                      Bond sold at a discount.
                                                                                               6%, 4 periods, Table 9A-3
                                                       6%, 4 periods, Table 9A-2



                                                                                           Interest payment =
                                                                                           ($20,000 * 10%)/2 =
                                                                                          $20,000 * 5% = $1,000

Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                                                11




                                           Practice Problem A
          A company issues a 2-year bond with a face value of $20,000 and a
          coupon rate of 10%. At the time of issuance, the market rate was 12%.
          2. Write out ALL journal entries related to this bond (i.e. from issuance
             until maturity).
    Issuance, beg of period 1:                                             End of period 3:
    Dr. Cash                                            19,307             Dr. Interest Expense (19,633*.06) 1,178
              Cr. Bonds Payable                              19,307                  Cr. Cash                     1,000
                                                                                     Cr. Bonds Payable              178
    End of period 1:
    Dr. Interest Expense (19,307*.06) 1,158                                End of period 4:
              Cr. Cash                     1,000                           Dr. Interest Expense (19,811*.06) 1,189
              Cr. Bonds Payable              158                                     Cr. Cash                     1,000
                                                                                     Cr. Bonds Payable              189
    End of period 2:              19,307+158
    Dr. Interest Expense (19,465*.06) 1,168                                Maturity, end of period 4:
              Cr. Cash                    1,000                            Dr. Bonds Payable               20,000
              Cr. Bonds Payable             168                                       Cr. Cash                  20,000
Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                                                12




                                                                                                                                6
                                          Practice Problem B
          A company issues a 2-year bond with a face value of $20,000 and a
          coupon rate of 10%.
             Interest is paid and compounded semi-annually on June 30 and
             December 31 of each year.
             At the time of issuance, the market rate is 8%.
          1. What is the amount of the proceeds from the issuance of this bond?
                      Proceeds = $20,000 * 0.8548 + $1,000 * 3.6299 = $20,726.
                      Bond sold at a premium.
                                                                                               4%, 4 periods, Table 9A-3
                                                       4%, 4 periods, Table 9A-2



                                                                                           Interest payment =
                                                                                           ($20,000 * 10%)/2 =
                                                                                          $20,000 * 5% = $1,000

Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                                                13




                                          Practice Problem B
          A company issues a 2-year bond with a face value of $20,000 and a
          coupon rate of 10%. At the time of issuance, the market rate was 8%.
          2. Write out ALL journal entries related to this bond (i.e. from issuance
             until maturity).
    Issuance, beg of period 1:                                             End of period 3:
    Dr. Cash                                            20,726             Dr. Interest Expense (20,377*.04) 815
              Cr. Bonds Payable                              20,726        Dr. Bonds Payable                 185
                                                                                     Cr. Cash                    1,000
    End of period 1:
    Dr. Interest Expense (20,726*.04) 829                                  End of period 4:
    Dr. Bonds Payable                 171                                  Dr. Interest Expense (20,192*.04) 808
              Cr. Cash                    1,000                            Dr. Bonds Payable                 192
                                                                                     Cr. Cash                    1,000
    End of period 2:              20,726-171
    Dr. Interest Expense (20,555*.04) 822                                  Maturity, end of period 4:
    Dr. Bonds Payable                  178                                 Dr. Bonds Payable               20,000
              Cr. Cash                    1,000                                       Cr. Cash                  20,000
Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                                                14




                                                                                                                                7
                   Early Extinguishment of Bonds
        Firms that issue bonds do not always hold the bonds to maturity.
                    They can repurchase bonds on the open market, or
                    They can call back bonds at a pre-specified price (if the bonds are issued
                    with a “call” provision).

        Early extinguishments of debt usually result in a gain or loss.
              Gain (loss) on early extinguishment = Book value of debt – price
              paid for debt (i.e. market value).
                    Book value of bond = face value – unamortized discount or premium
                    = balance of Bonds Payable account at the time of the early extinguishment.

              Since 2002, gains and losses from early extinguishment of debt are
              usually classified as “other income” on the income statement.
                    Special item “above the line,” i.e. not included in operating income.

Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                           15




                    CASELLA WASTE SYSTEMS, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                                                                     Fiscal Year Ended April 30,
                                                   (in thousands)    2002       2003      2004

                      Revenues                                      $ 421,235 $ 420,863 $ 439,686
                      Operating expenses:
                        Cost of operations                           276,693    278,347    287,309
                        General and administration                    54,456     55,772     58,198
                        Depreciation and amortization                 50,712     47,930     59,673
                        Impairment charge                                 —       4,864      1,663
                        Restructuring charge                            (438)        —          —
                                                                     381,423    386,913    406,843
                      Operating income                                39,812     33,950     32,843
                      Other expense/(income), net:
                         Interest income                                (904)      (318)      (251)
                         Interest expense                             31,451     26,572     25,648
                         Income from equity method investments        (1,899)    (2,073)    (2,261)
                         Loss on debt extinguishment                      —       3,649         —
                         Minority interest                              (154)      (152)        —
                         Other expense/(income)                       (4,480)    (1,599)     5,948
                      Other expense, net                              24,014     26,079     29,084
                      Income from continuing operations               15,798      7,871      3,759
Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                           16




                                                                                                           8
                   Early Extinguishment of Bonds
                                                        Journal Entry
        Consider the discount bond examined in slide 8. The company decides
        to repurchase this bond on the first day of Year 3.
              At the end of Year 2 (i.e. Period 4), the book value is $99,055.
              Assume the company repurchases the bond for $90,000:
                     Gain (Loss) = $99,055 – $90,000 = $9,055 of GAIN.
                     Dr. Bonds Payable                      99,055
                            Cr. Cash                                                     90,000
                            Cr. Gain on Early Extinguishment                              9,055
              Now, assume the company repurchases the bond for $110,000:
                     Gain (Loss) = $99,055 – $110,000 = $(10,945) of LOSS.
                     Dr. Bonds Payable                                  99,055
                     Dr. Loss on Early Extinguishment                   10,945
                            Cr. Cash                                                    110,000
Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                         17




                           Noninterest-Bearing Bonds
          Noninterest-bearing bonds (also called zero coupon bonds):
                Pay no interest (i.e. the coupon rate is 0%) during their life and thus
                are issued at very deep discounts.

          Example:
                Consider a 4-year zero coupon bond with a face value of $1,000.
                The market rate at the time of issue is 10% (compounded semi-annually).
                Journal entry to record the issuance:
                      Proceeds = 1,000 * 0.6768 = $677.                 5%, 8 periods, Table 9A-2

                      Journal entry:
                     Dr. Cash                                            677
                            Cr. Bonds Payable                                           677

Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                         18




                                                                                                         9
                           Noninterest-Bearing Bonds
        Example (cont’d):
              Amortization schedule:
                  Period            Bonds              Interest           Cash       Amortization of    Bonds
                                   Payable,            Expense           Payment       Discount        Payable,
                                     Beg.               (5%)                                             End
                                      (a)             (b=a*4%)             (c)           (d=b-c)       (e=a+d)
                      1                677                     34           –             34             711
                      2                711                     36           –             36             747
                      3                747                     37           –             37             784
                      4                784                     39           –             39             823
                      5                823                     41           –             41             864
                      6                864                     43           –             43             907
                      7                907                     45           –             45             952
                      8                952                     48           –             48           1,000




Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                                                 19




                           Noninterest-Bearing Bonds
        Example (cont’d):
              Journal entries to record accrued interest:
                                                           677 * .05
      At end of period 1:                                                        At end of period 5:
      Dr. Interest Expense                               34                      Dr. Interest Expense          41
                Cr. Bonds Payable                                   34                     Cr. Bonds Payable           41
                                                           (677+34) * .05
     At end of period 2:                                                         At end of period 6:
     Dr. Interest Expense                                36                      Dr. Interest Expense          43
               Cr. Bonds Payable                                    36                     Cr. Bonds Payable           43

      At end of period 3:                                                        At end of period 7:
      Dr. Interest Expense                                37                     Dr. Interest Expense             45
                Cr. Bonds Payable                                   37                     Cr. Bonds Payable           45

      At end of period 4:                                                        At end of period 8:
      Dr. Interest Expense                                39                     Dr. Interest Expense          48
                Cr. Bonds Payable                                   39                     Cr. Bonds Payable           48

Professor Lucile Faurel – Principles of Financial Accounting
Chapter 9 – Bond Accounting                                                                                                 20




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