Stockholders' Equity: Classes of Capital Stock

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Course: BUS103: Introduction to Financial Accounting
Book: Stockholders' Equity: Classes of Capital Stock
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Date: Saturday, April 20, 2024, 7:29 PM

Description

Read this chapter, which introduces long-term bonds, their value, how they compare with stock. Some companies expand using stock, while some use debt (bonds). The example exercises refer to Appendix A, which is included here.

Learning objectives

After studying this chapter, you should be able to:

  • Describe the features of bonds and tell how bonds differ from shares of stock
  • List the advantages and disadvantages of financing with long-term debt and prepare examples showing how to employ financial leverage.
  • Prepare journal entries for bonds issued at face value.
  • Explain how interest rates affect bond prices and what causes a bond to sell at a premium or a discount.
  • Apply the concept of present value to compute the price of a bond.
  • Prepare journal entries for bonds issued at a discount or a premium.
  • Prepare journal entries for bond redemptions and bond conversions.
  • Describe the ratings used for bonds.
  • Analyze and use the financial results – times interest earned ratio.
  • Explain future value and present value concepts and make required calculations (Appendix).

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The accountant's role in financial institutions

Companies that require funds to maintain existing operations and expand new operations frequently do not have the necessary cash available within the company. Therefore, these companies are required to obtain long-term financing from banks and other financial institutions. The operations of financial institutions are unique from those of the typical manufacturing or service company. As a result, the accounting measurement and disclosure practices followed by financial institutions can be quite different from those followed in other industries. In addition to the more traditional careers in accounting (auditing, professional services, financial reporting, cost accounting, and taxation), accounting majors with interests in finance may pursue a career in financial institutions.

Accountants in this industry commonly deal with issues related to marketable securities, derivatives, hedging, sale of receivables, foreign currency exchanges, and loan loss provisions and impairments. In addition, accountants in this area are being called upon to play an increasing role in the strategic operations of the financial institution. Not only are accountants needed to account for the institution's transactions, but they are being asked to recommend new opportunities for growth and to advise on financial risk as well. Some of these new areas include issues related to asset/liability management, interest rate risk, present value measurements, capital structure, and key ratio analysis.

Accountants also play a key role in one of the most important decisions of a financial institution - the decision of whether to lend money to a prospective borrower. The decision to lend money hinges on the ability of the prospective borrower to pay interest and repay debt. Since accountants have been trained in financial statement preparation and interpretation, accountants are some of the most sought after professionals for understanding the financial position and risk of a prospective borrower.

In previous chapters, you learned that corporations obtain cash for recurring business operations from stock issuances, profitable operations, and short-term borrowing (current liabilities). However, when situations arise that require large amounts of cash, such as the purchase of a building, corporations also raise cash from long-term borrowing, that is, by issuing bonds. The issuing of bonds results in a Bonds Payable account.

Bonds payable

A bond is a long-term debt, or liability, owed by its issuer. Physical evidence of the debt lies in a negotiable bond certificate. In contrast to long-term notes, which usually mature in 10 years or less, bond maturities often run for 20 years or more.

Generally, a bond issue consists of a large number of USD 1,000 bonds rather than one large bond. For example, a company seeking to borrow USD 100,000 would issue one hundred USD 1,000 bonds rather than one USD 100,000 bond. This practice enables investors with less cash to invest to purchase some of the bonds.

Bonds derive their value primarily from two promises made by the borrower to the lender or bondholder. The borrower promises to pay (1) the face value or principal amount of the bond on a specific maturity date in the future and (2) periodic interest at a specified rate on face value at stated dates, usually semiannually, until the maturity date.

Large companies often have numerous long-term notes and bond issues outstanding at any one time. The various issues generally have different stated interest rates and mature at different points in the future. Companies present this information in the footnotes to their financial statements. Exhibit 41 shows a portion of the long-term borrowings footnote from Dow Chemical Company's 2000 annual report. Promissory notes, debenture bonds, and foreign bonds are shown, with their amounts, maturity dates, and interest rates.

Promissory notes and debentures at 2000 December 31 Millions
2000
1999
6.95%, final maturity 2002 $ 346 $ ---
7.81%, final maturity 2002 ---
7.13%, final maturity 2003
7.00%, final maturity 2005 300 ---
7.70%, final maturity 2006 2,473 2,448
Subtotal $3,267 $3,135
Foreign bonds at 2000 December 31 Millions
2000
1999
4.63%, final maturity 2000, Swiss Fran $--- $ 95
6.38%, final maturity 2001, Japanese Yen 218 244
5.00%, final maturity 2003, Euro 139 151
Subtotal $357 $490

Exhibit 41: Dow chemical company's long-term notes and bonds (in millions)

Comparison with stock

A bond differs from a share of stock in several ways:

  • A bond is a debt or liability of the issuer, while a share of stock is a unit of ownership.
  • A bond has a maturity date when it must be paid. A share of stock does not mature; stock remains outstanding indefinitely unless the company decides to retire it.
  • Most bonds require stated periodic interest payments by the company. In contrast, dividends to stockholders are payable only when declared; even preferred dividends need not be paid in a particular period if the board of directors so decides.
  • Bond interest is deductible by the issuer in computing both net income and taxable income, while dividends are not deductible in either computation.

Selling (issuing) bonds

A company seeking to borrow millions of dollars generally is not able to borrow from a single lender. By selling (issuing) bonds to the public, the company secures the necessary funds.

Usually companies sell their bond issues through an investment company or a banker called an underwriter. The underwriter performs many tasks for the bond issuer, such as advertising, selling, and delivering the bonds to the purchasers. Often the underwriter guarantees the issuer a fixed price for the bonds, expecting to earn a profit by selling the bonds for more than the fixed price.

When a company sells bonds to the public, many purchasers buy the bonds. Rather than deal with each purchaser individually, the issuing company appoints a trustee to represent the bondholders. The trustee usually is a bank or trust company. The main duty of the trustee is to see that the borrower fulfills the provisions of the bond indenture. A bond indenture is the contract or loan agreement under which the bonds are issued. The indenture deals with matters such as the interest rate, maturity date and maturity amount, possible restrictions on dividends, repayment plans, and other provisions relating to the debt. An issuing company that does not adhere to the bond indenture provisions is in default. Then, the trustee takes action to force the issuer to comply with the indenture.

Bonds may differ in some respects; they may be secured or unsecured bonds, registered or unregistered (bearer) bonds, and term or serial bonds. We discuss these differences next.

Certain bond features are matters of legal necessity, such as how a company pays interest and transfers ownership. Such features usually do not affect the issue price of the bonds. Other features, such as convertibility into common stock, are sweeteners designed to make the bonds more attractive to potential purchasers. These sweeteners may increase the issue price of a bond.

Secured bonds: A secured bond is a bond for which a company has pledged specific property to ensure its payment. Mortgage bonds are the most common secured bonds. A mortgage is a legal claim (lien) on specific property that gives the bondholder the right to possess the pledged property if the company fails to make required payments.

Unsecured bonds: An unsecured bond is a debenture bond, or simply a debenture. A debenture is an unsecured bond backed only by the general creditworthiness of the issuer, not by a lien on any specific property. A financially sound company can issue debentures more easily than a company experiencing financial difficulty.

Registered bonds: A registered bond is a bond with the owner's name on the bond certificate and in the register of bond owners kept by the bond issuer or its agent, the registrar. Bonds may be registered as to principal (or face value of the bond) or as to both principal and interest. Most bonds in our economy are registered as to principal only. For a bond registered as to both principal and interest, the issuer pays the bond interest by check. To transfer ownership of registered bonds, the owner endorses the bond and registers it in the new owner's name. Therefore, owners can easily replace lost or stolen registered bonds.

Unregistered (bearer) bonds: An unregistered (bearer) bond is the property of its holder or bearer because the owner's name does not appear on the bond certificate or in a separate record. Physical delivery of the bond transfers ownership.

Coupon bonds: A coupon bond is a bond not registered as to interest. Coupon bonds carry detachable coupons for the interest they pay. At the end of each interest period, the owner clips the coupon for the period and presents it to a stated party, usually a bank, for collection.

Term bonds and serial bonds: A term bond matures on the same date as all other bonds in a given bond issue. Serial bonds in a given bond issue have maturities spread over several dates. For instance, one-fourth of the bonds may mature on 2011 December 31, another one-fourth on 2012 December 31, and so on.

Callable bonds: A callable bond contains a provision that gives the issuer the right to call (buy back) the bond before its maturity date. The provision is similar to the call provision of some preferred stocks. A company is likely to exercise this call right when its outstanding bonds bear interest at a much higher rate than the company would have to pay if it issued new but similar bonds. The exercise of the call provision normally requires the company to pay the bondholder a call premium of about USD 30 to USD 70 per USD 1,000 bond. A call premium is the price paid in excess of face value that the issuer of bonds must pay to redeem (call) bonds before their maturity date.

Convertible bonds: A convertible bond is a bond that may be exchanged for shares of stock of the issuing corporation at the bondholder's option. A convertible bond has a stipulated conversion rate of some number of shares for each USD 1,000 bond. Although any type of bond may be convertible, issuers add this feature to make risky debenture bonds more attractive to investors.

Bonds with stock warrants: A stock warrant allows the bondholder to purchase shares of common stock at a fixed price for a stated period. Warrants issued with long-term debt may be nondetachable or detachable. A bond with nondetachable warrants is virtually the same as a convertible bond; the holder must surrender the bond to acquire the common stock. Detachable warrants allow bondholders to keep their bonds and still purchase shares of stock through exercise of the warrants.

Junk bonds: Junk bonds are high-interest rate, high-risk bonds. Many junk bonds issued in the 1980s financed corporate restructurings. These restructurings took the form of management buyouts (called leveraged buyouts or LBOs), hostile takeovers of companies by outside parties, or friendly takeovers of companies by outside parties. In the early 1990s, junk bonds lost favor because many issuers defaulted on their interest payments. Some issuers declared bankruptcy or sought relief from the bondholders by negotiating new debt terms.

Several advantages come from raising cash by issuing bonds rather than stock. First, the current stockholders do not have to dilute or surrender their control of the company when funds are obtained by borrowing rather than issuing more shares of stock. Second, it may be less expensive to issue debt rather than additional stock because the interest payments made to bondholders are tax deductible while dividends are not. Finally, probably the most important reason to issue bonds is that the use of debt may increase the earnings of stockholders through favorable financial leverage.

Favorable financial leverage: A company has favorable financial leverage when it uses borrowed funds to increase earnings per share (EPS) of common stock. An increase in EPS usually results from earning a higher rate of return than the rate of interest paid for the borrowed money. For example, suppose a company borrowed money at 10 percent and earned a 15 percent rate of return. The 5 percent difference increases earnings.

Exhibit 42 provides a more comprehensive example of favorable financial leverage. The two companies in the illustration are identical in every respect except in the way they are financed. Company A issued only capital stock, while Company B issued equal amounts of 10 percent bonds and capital stock. Both companies have USD 20,000,000 of assets, and both earned USD 4,000,000 of income from operations. If we divide income from operations by assets (USD 4,000,000/USD 20,000,000), we see that both companies earned 20 percent on assets employed. Yet B's stockholders fared far better than A's. The ratio of net income to stockholders' equity is 18 percent for B, while it is only 12 percent for A.

Assume that both companies issued their stock at the beginning of 2010 at USD 10 per share. B's USD 1.80 EPS are 50 percent greater than A's USD 1.20 EPS. This EPS difference probably would cause B's shares to sell at a substantially higher market price than A's shares. B's larger EPS would also allow a larger dividend on B's shares.

Company B in Exhibit 42 is employing financial leverage, or trading on the equity. The company is using its stockholders' equity as a basis for securing funds on which it pays a fixed return. Company B expects to earn more from the use of such funds than their fixed after-tax cost. As a result, Company B increases its rate of return on stockholders' equity and EPS.

Companies A and B
Condensed Statements Balance Sheets
2010 December 31

Company A Company B
Total assets $20,000,000 $20,000,000
Bonds payable, 10% $10,000,000
Stockholders' equity (capital stock) $20,000,000 10,000,000
Total equities $20,000,000 $20,000,000
Income statements
For the year ended 2010 December 31
Income from operations $4,000,000 $4,000,000
Interest expense 1,000,000
Income before federal income taxes $4,000,000 $3,000,000
       Deduct: Federal income taxes (40%) 1,600,000 1,200,000
Net income $2,400,000 $1,800,000
Number of common shares outstanding 2,000,000 1,000,000
Earnings per share (EPS) (Net income/Number of common shares outstanding) $1.20 $1.80
Rate of return on assets employed (Income from Operations/Total assets; both companies $4,000,000/$20,000,000) 20% 20%
Rate of return on stockholders' equity (Net income/Stockholders' equity):
       Company A ($2,400,000/$20,000,000) 12%
       Company B ($1,800,000/$10,000,000) 18%

Exhibit 42: Favorable financial leverage

Several disadvantages accompany the use of debt financing. First, the borrower has a fixed interest payment that must be met each period to avoid default. Second, use of debt also reduces a company's ability to withstand a major loss. For example, assume that instead of having net income, both Company A and Company B in Exhibit 42 sustain a net loss in 2010 of USD 11,000,000. At the end of 2010, Company A will still have USD 9,000,000 of stockholders' equity and can continue operations with a chance of recovery. Company B, on the other hand, would have negative stockholders' equity of USD 1,000,000 and the bondholders could force the company to liquidate if B could not make interest payments as they came due. The result of sustaining the loss by the two companies is as follows:

Companies A and B
Condensed Statements Balance Sheets
2010 December 31


Company A Company B
Stockholders' equity:    
Paid-in capital:
 
Common stock
$20,000,000 $10,000,000
Retained earnings
(11,000,000)
 (11,000,000)
Total  stockholders' equity $0,000,000 $(1,000,000)

A third disadvantage of debt financing is that it also causes a company to experience unfavorable financial leverage when income from operations falls below a certain level. Unfavorable financial leverage results when the cost of borrowed funds exceeds the revenue they generate; it is the reverse of favorable financial leverage. In the previous example, if income from operations fell to USD 1,000,000, the rates of return on stockholders' equity would be 3 percent for A and zero for B, as shown in this schedule:

Companies A and B
Partial Balance Sheets
2010 December 31

Company A Company B
Income from operations $1,000,000 $1,000,000
Interest expense 1,000,000
Income before federal income taxes $1,000,000 $ -0-
      Deduct: Federal income taxes (40%) 400,000 -0-
Net income 600,000 $ -0-
Rate of return on stockholders' equity:
      Company A ($600,000/$20,000,000) 3%
      Company B ($0/$10,000,000) 0%


The fourth disadvantage of issuing debt is that loan agreements often require maintaining a certain amount of working capital (Current assets - Current liabilities) and place limitations on dividends and additional borrowings.

When a company issues bonds, it incurs a long-term liability on which periodic interest payments must be made, usually twice a year. If interest dates fall on other than balance sheet dates, the company must accrue interest in the proper periods. The following examples illustrate the accounting for bonds issued at face value on an interest date and issued at face value between interest dates.

Bonds issued at face value on an interest date Valley Company's accounting year ends on December 31. On 2010 December 31, Valley issued 10-year, 12 percent bonds with a USD 100,000 face value, for USD 100,000. The bonds are dated 2010 December 31, call for semiannual interest payments on June 30 and December 31, and mature on 2020 December 31. Valley made the required interest and principal payments when due. The entries for the 10 years are as follows:

On 2010 December 31, the date of issuance, the entry is:

2010 Dec. 31 Cash (+A) 100,000
Bonds payable (+L) 100,000
To record bonds issued at face value.


On each June 30 and December 31 for 10 years, beginning 2010 June 30 (ending 2020 June 30), the entry would be:

Each year June 30 And Dec.31 Bond Interest Expense ($100,000 x 0.12 x ½) (-SE) 100,000
Cash (-A) 6,000
To record periodic interest payment.


On 2020 December 31, the maturity date, the entry would be:

2020 Dec. 31 Bond interest expense (-SE) 6,000
Bonds payable (-L) 100,000
Cash (-A) 106,000
To record final interest and bond redemption payment.


Note that Valley does not need adjusting entries because the interest payment date falls on the last day of the accounting period. The income statement for each of the 10 years 2010-2018 would show Bond Interest Expense of USD 12,000 (USD 6,000 X 2); the balance sheet at the end of each of the years 2010-2018 would report bonds payable of USD 100,000 in long-term liabilities. At the end of 2019, Valley would reclassify the bonds as a current liability because they will be paid within the next year.

The real world is more complicated. For example, assume the Valley bonds were dated 2010 October 31, issued on that same date, and pay interest each April 30 and October 31. Valley must make an adjusting entry on December 31 to accrue interest for November and December. That entry would be:

2010 Dec. 31 Bond interest expense ($100,000 x 0.12 x 2/12) (-SE) 2,000
Bond interest payable (+L) 2,000
To accrue two month's interest expense.


The 2011 April 30, entry would be:

2011 Apr. 30 Bond interest expense ($100,000 x 0.12 x (4/12)) (-SE) 4,000
Bond interest payable (-L) 2,000
Cash (-A) 6,000
To record semiannual interest payment.


The 2011 October 31, entry would be:

2011 Oct. 31 Bond interest expense (-SE) 6,000
Cash (-A) 6,000
To record semiannual interest payment.


Each year Valley would make similar entries for the semiannual payments and the year-end accrued interest. The firm would report the USD 2,000 Bond Interest Payable as a current liability on the December 31 balance sheet for each year.

Bonds issued at face value between interest dates Companies do not always issue bonds on the date they start to bear interest. Regardless of when the bonds are physically issued, interest starts to accrue from the most recent interest date. Firms report bonds to be selling at a stated price "plus accrued interest". The issuer must pay holders of the bonds a full six months' interest at each interest date. Thus, investors purchasing bonds after the bonds begin to accrue interest must pay the seller for the unearned interest accrued since the preceding interest date. The bondholders are reimbursed for this accrued interest when they receive their first six months' interest check.

Using the facts for the Valley bonds dated 2010 December 31, suppose Valley issued its bonds on 2011 May 31, instead of on 2010 December 31. The entry required is:

2011 May 31 Cash (+A) 105,000
Bonds payable (+L) 100,000
Bond interest payable ($100,000 x 0.12 x (5/12)) (+L) 5,000
To record bonds issued at face value plus accrued interest.


This entry records the USD 5,000 received for the accrued interest as a debit to Cash and a credit to Bond Interest Payable.

The entry required on 2011 June 30, when the full six months' interest is paid, is:

2011 June 30 Bond Interest Expense ($100,000 x 0.12 x (1/12)) (-SE) 1,000
Bond interest payable (-L) 5,000
Cash (-A) 6,000
To record bond interest payment


This entry records USD 1,000 interest expense on the USD 100,000 of bonds that were outstanding for one month. Valley collected USD 5,000 from the bondholders on May 31 as accrued interest and is now returning it to them.

Bond prices and interest rates

The price of a bond issue often differs from its face value. The amount a bond sells for above face value is a premium. The amount a bond sells for below face value is a discount. A difference between face value and issue price exists whenever the market rate of interest for similar bonds differs from the contract rate of interest on the bonds. The effective interest rate (also called the yield) is the minimum rate of interest that investors accept on bonds of a particular risk category. The higher the risk category, the higher the minimum rate of interest that investors accept. The contract rate of interest is also called the stated, coupon, or nominal rate. Firms state this rate in the bond indenture, print it on the face of each bond, and use it to determine the amount of cash paid each interest period. The market rate fluctuates from day to day, responding to factors such as the interest rate the Federal Reserve Board charges banks to borrow from it; government actions to finance the national debt; and the supply of, and demand for, money.

Market and contract rates of interest are likely to differ. Issuers must set the contract rate before the bonds are actually sold to allow time for such activities as printing the bonds. Assume, for instance, that the contract rate for a bond issue is set at 12 percent. If the market rate is equal to the contract rate, the bonds will sell at their face value. However, by the time the bonds are sold, the market rate could be higher or lower than the contract rate. As shown in Exhibit 43, if the market rate is lower than the contract rate, the bonds will sell for more than their face value. Thus, if the market rate is 10 percent and the contract rate is 12 percent, the bonds will sell at a premium as the result of investors bidding up their price. However, if the market rate is higher than the contract rate, the bonds will sell for less than their face value. Thus, if the market rate is 14 percent and the contract rate is 12 percent, the bonds will sell at a discount. Investors are not interested in bonds bearing a contract rate less than the market rate unless the price is reduced. Selling bonds at a premium or a discount allows the purchasers of the bonds to earn the market rate of interest on their investment.

Computing long-term bond prices involves finding present values using compound interest. The appendix to this chapter explains the concepts of future value and present value. If you do not understand the present value concept, read the appendix before continuing with this section.

Buyers and sellers negotiate a price that yields the going rate of interest for bonds of a particular risk class. The price investors pay for a given bond issue is equal to the present value of the bonds. To compute present value, we discount the promised cash flows from the bonds – principal and interest using the market, or effective, rate. We use the market rate because the bonds must yield at least this rate or investors are attracted to alternative investments. The life of the bonds is stated in interest (compounding) periods. The interest rate is the effective rate per interest period, which is found by dividing the annual rate by the number of times interest is paid per year. For example, if the annual rate is 12 percent, the semiannual rate would be 6 percent.

Issuers usually quote bond prices as percentages of face value – 100 means 100 percent of face value, 97 means 97 percent of face value, and 103 means 103 percent of face value. For example, one hundred USD 1,000 face value bonds issued at 103 have a price of USD 103,000. Regardless of the issue price, at maturity the issuer of the bonds must pay the investor(s) the face value of the bonds.

Market Rate
Contract Rate
Bonds sell at a premium if market rate < contract rate 10% 12%
Bonds sell at a face value if market rate = contract rate 12% 12%
Bonds sell at a discount if market rate > contract rate
14% 12%



Exhibit 43: Bond premiums and discounts

Bonds issued at face value The following example illustrates the specific steps in computing the price of bonds. Assume Carr Company issues 12 percent bonds with a USD 100,000 face value to yield 12 percent. Dated and issued on 2010 June 30, the bonds call for semiannual interest payments on June 30 and December 31 and mature on 2013 June 30. The bonds would sell at face value because they offer 12 percent and investors seek 12 percent. Potential purchasers have no reason to offer a premium or demand a discount. One way to prove the bonds would be sold at face value is by showing that their present value is USD 100,000:

Cash Flow x Present value Factor = Present value
Principal of $100,000 due in six interest periods multiplied by present value factor for 6% from Table A.3 of the Appendix (end of text) $100,000 X 0.70496 =$70,496
Interest of $6,000 due at the end of six interest periods multiplied by present value factor for 6% from Table A.4 of the Appendix (end of text) 6,000 X 4.91732 =29,504
Total price (present value) $100,000


According to this schedule, investors who seek an effective rate of 6 percent per six-month period should pay USD 100,000 for these bonds. Notice that the same number of interest periods and semiannual interest rates occur in discounting both the principal and interest payments to their present values. The entry to record the sale of these bonds on 2010 June 30, debits Cash and credits Bonds Payable for USD 100,000.


An accounting perspective:

Business insight

Some persons estimate that Social Security will be broke by the year 2025 unless changes are made. Therefore, you may want to set aside funds during your working career to provide for retirement.

Over the last 60 years, the inflation rate has averaged about 3 percent per year, treasury bills have averaged a little under 4 percent per year, corporate bonds have averaged about a little over 5 percent per year, and stocks have averaged a little over 10 percent per year. Using the tables at the end of the text we can determine how much you would have at age 65 if you invested USD 2,000 each year for 45 years in treasury bills, corporate bonds, or stocks, beginning at age 20.

To do this calculation for treasury bills, for instance, we would first use Table A.2 to determine the future value of an annuity of USD 2,000 for 30 periods at 4 percent (USD 2,000 X 56.08494 = USD 112,170). (We would have used 45 periods, but the table only went up to 30 periods.) Then we would use Table A.1 to find the value of this lump sum of USD 112,170 for another 15 years at 4 percent (USD 112,170 X 1.80094 = USD 202,011). Then we cannot forget that we have another 15 years of USD 2,000 annuity to consider. Thus, we go back to Table A.2 and calculate the future value of an annuity of USD 2,000 for 15 periods at 4 percent (USD 2,000 X 20.02359 = USD 40,047). Then we add the USD 202,011 and the USD 40,047 to get the total future value of USD 242,058. (You would have invested USD 2,000 X 45 years = USD 90,000.) Would you be pleased? Not when you see what you could have had at age 65 if you invested in stocks.

If you had invested in corporate bonds at 5 percent, you would have USD 319,401. However, if you had invested in stocks at 10 percent, you would have USD 1,437,810 at age 65. Can you use the tables in the back of the text to verify these amounts?


Bonds issued at a discount Assume the USD 100,000, 12 percent Carr bonds are sold to yield a current market rate of 14% annual interest, or 7 percent per semiannual period. Carr computes the present value (selling price) of the bonds as follows:

Cash Flow x Present value Factor = Present value
Principal of $100,000 due in six interest periods multiplied by present value factor for 7% from Table A.3 of the Appendix (end of text) $100,00 0 X0.66630 =$66,634
Interest of $6,000 due at the end of six interest periods multiplied by present value factor for 7% from Table A.4 of the Appendix (end of text) 6,000 X4.76654 =28,559
Total price (present value) $95,233


Note that in computing the present value of the bonds, Carr uses the actual USD 6,000 cash interest payment that will be made each period. The amount of cash the company pays as interest does not depend on the market interest rate. However, the market rate per semiannual period – 7 percent – does change, and Carr uses this new rate to find interest factors in the tables.

The journal entry to record issuance of the bonds is:

2010 June 30 Cash (+A) 95,233
Discount on bonds payable (-L; Contra-account) 4,767
Bonds payable (+L) 100,000
To record bonds issued at a discount.


In recording the bond issue, Carr credits Bonds Payable for the face value of the debt. The company debits the difference between face value and price received to Discount on Bonds Payable, a contra account to Bonds Payable. Carr reports the bonds payable and discount on bonds payable in the balance sheet as follows:

Long-term liabilities:
Bonds payable, 12%, due 2009 June 30 $100,000
Less: Discount on bonds payable 4,767 $95,233


The USD 95,233 is the carrying value, or net liability, of the bonds. Carrying value is the face value of the bonds minus any unamortized discount or plus any unamortized premium. The next section discusses unamortized premium on bonds payable.

Bonds issued at a premium Assume that Carr issued the USD 100,000 face value of 12 percent bonds to yield a current market rate of 10 percent. The bonds would sell at a premium calculated as follows:

Cash Flow x Present value Factor = Present value
Principal of $100,000 due in six interest periods multiplied by present value factor for 5% from Table A.3 of the Appendix (end of text) $100,00 0 X 0.74622
=$74,622
Interest of $6,000 due at the end of six interest periods multiplied by present value factor for 5% from Table A.4 of the Appendix (end of text)
6,000 X 5.07569
=30,454
Total price (present value)
$105,076


The journal entry to record the issuance of the bonds is:

2010 June 30 Cash (+A) 105,076
Bonds payable (+L) 100,000
Premium on bonds payable (+L) 5,076
To record bonds issued at a premium.


The carrying value of these bonds at issuance is USD 105,076, consisting of the face value of USD 100,000 and the premium of USD 5,076. The premium is an adjunct account shown on the balance sheet as an addition to bonds payable as follows:

Long-term liabilities:
Bonds payable, 12%, due 2009 June 30 $100,000
Add: Premium on bonds payable 5,076 $105,076


When a company issues bonds at a premium or discount, the amount of bond interest expense recorded each period differs from bond interest payments. A discount increases and a premium decreases the amount of interest expense. For example, if Carr issues bonds with a face value of USD 100,000 for USD 95,233, the total interest cost of borrowing would be USD 40,767: USD 36,000 (which is six payments of USD 6,000) plus the discount of USD 4,767. If the bonds had been issued at USD 105,076, the total interest cost of borrowing would be USD 30,924: USD 36,000 less the premium of USD 5,076. The USD 4,767 discount or USD 5,076 premium must be allocated or charged to the six periods that benefit from the use of borrowed money. Two methods are available for amortizing a discount or premium on bonds – the straight-line method and the effective interest rate method.

The straight-line method records interest expense at a constant amount; the effective interest rate method records interest expense at a constant rate. APB Opinion No. 21 states that the straight-line method may be used only when it does not differ materially from the effective interest rate method. In many cases, the differences are not material.


An accounting perspective:

Business insight

US government bonds have traditionally offered a fixed rate of interest. In early 1997, the US Treasury began offering inflation indexed bonds. The amount of interest on these bonds is tied to the officially reported rate of inflation. The bonds pay interest every six months, and the interest is based on the inflation-adjusted value of the principal. These bonds are designed to protect purchasers against purchasing power loss due to inflation. At that time, there was some concern by investors that the government had been considering calculating the official rate of inflation differently than in the past in such a way that it would lower the annual increase as compared to the then present method of calculation. This change in calculation, if adopted, would lower the amount of interest earned on these bonds. However, there were some assurances that for this purpose the official rate of inflation would be calculated the "old way".


The straight-line method The straight-line method of amortization allocates an equal amount of discount or premium to each month the bonds are outstanding. The issuer calculates the amount by dividing the discount or premium by the total number of months from the date of issuance to the maturity date. For example, if it sells USD 100,000 face value bonds for USD 95,233, Carr would charge the USD 4,767 discount to interest expense at a rate of USD 132.42 per month (equal to USD 4,767/36). Total discount amortization for six months would be USD 794.52, computed as follows: USD 132.42 X 6. Interest expense for each six-month period then would be USD 6,794.52, calculated as follows: USD 6,000 + (USD 132.42 X 6). The entry to record the expense on 2010 December 31, would be:

2010 Dec. 31 Bond interest expense (-SE) 6,794.52
Cash (-A) 6,000.00
Discount on bonds payable ($132.42 x 6) (+L) 794.52
To record interest payment and discount amortization.


By the maturity date, all of the discount would have been amortized.

To illustrate the straight-line method applied to a premium, recall that earlier Carr sold its USD 100,000 face value bonds for USD 105,076. Carr would amortize the USD 5,076 premium on these bonds at a rate of USD 141 per month, equal to USD 5,076/36. The entry for the first period's semiannual interest expense on bonds sold at a premium is:

2010 Dec. 31 Bond interest expense (-SE) 5,154
Premium on bonds payable ($141 x 6) (-L) 846
Cash (-A) 6,000
To record interest payable and premium amortization.


By the maturity date, all of the premium would have been amortized.

The effective interest rate method APB Opinion No. 21 recommends an amortization procedure called the effective interest rate method, or simply the interest method. Under the interest method, interest expense for any interest period is equal to the effective (market) rate of interest on the date of issuance times the carrying value of the bonds at the beginning of that interest period. Using the Carr example of 12 percent bonds with a face value of USD 100,000 sold to yield 14 percent, the carrying value at the beginning of the first interest period is the selling price of USD 95,233. Carr would record the interest expense for the first semiannual period as follows:

2010 Dec. 31 Bond interest expense ($95,233 x 0.14 x ½) (- SE) 6,666
Cash ($100,000 x 0.12 x ½) (-A) 6,000
Discount on bonds payable (+L) 666
To record discount amortization and interest payment.


Note that interest expense is the carrying value times the effective interest rate. The cash payment is the face value times the contract rate. The discount amortized for the period is the difference between the two amounts.

After the preceding entry, the carrying value of the bonds is USD 95,899, or USD 95,233 + USD 666. Carr reduced the balance in the Discount on Bonds Payable account by USD 666 to USD 4,101, or USD 4,767 - USD 666. Assuming the accounting year ends on December 31, the entry to record the payment of interest for the second semiannual period on 2011 June 30 is:

2011 June 30 Bond interest expense ($95,899 x 0.14 x ½) (-SE) 6,713
Cash ($100,000 x 0.12 x ½) (-A) 6,000
Discount on bonds payable (+L) 713
To record discount amortization and interest payment.


Carr can also apply the effective interest rate method to premium amortization. If the Carr bonds had been issued at USD 105,076 to yield 10 percent, the premium would be USD 5,076. The firm calculates interest expense in the same manner as for bonds sold at a discount. However, the entry would differ somewhat, showing a debit to the premium account. The entry for the first interest period is:

2010 Dec. 31 Bond Interest Expense ($105,076 x 0.10 x ½) (-SE) 5,254
Premium on bonds payable (-L) 746
Cash ($100,000 x 0.12 x ½) (-A) 6,000
To record interest payment and premium amortization.


After the first entry, the carrying value of the bonds is USD 104,330, or USD 105,076 - USD 746. The premium account now carries a balance of USD 4,330, or USD 5,076 - USD 746. The entry for the second interest period is:

2011 June 30 Bond interest expense ($104,330 x 0.10 x ½) (-SE) 5,216*
Premium on bonds payable (-L) 784
Cash ($100,000 x 0.12 x ½) (-A) 6,000
To record interest payment and premium amortization

*rounded down


An accounting perspective:

Business Insight The difference between the single-line method and effective interest method for amortizing a bond discount can be seen in the following graphic. The carrying values (CV) start at the same point and end at the same point under both methods.The total interest expense is the same under both methods. However, the interest expense and amortization of bond discount are at a constant amount each period under the straight-line method,and they are at a concentrate under the effective interest rate matched.

Discount and premium amortization schedules A discount amortization schedule (Exhibit 44) and a premium amortization schedule (Exhibit 45) aid in preparing entries for interest expense. Usually, companies prepare such schedules when they first issue bonds, often using computer programs designed for this purpose. The companies then refer to the schedules whenever they make journal entries to record interest. Note that in each period the amount of interest expense changes; interest expense gets larger when a discount is involved and smaller when a premium is involved. This fluctuation occurs because the carrying value to which a constant interest rate is applied changes each interest payment date. With a discount, carrying value increases; with a premium, it decreases. However, the actual cash paid as interest is always a constant amount determined by multiplying the bond's face value by the contract rate.

Recall that the issue price was USD 95,233 for the discount situation and USD 105,076 for the premium situation. The total interest expense of USD 40,767 for the discount situation in Exhibit 44 is equal to USD 36,000 (which is six USD 6,000 payments) plus the USD 4,767 discount. This amount agrees with the earlier computation of total interest expense. In Exhibit 45, total interest expense in the premium situation is USD 30,924, or USD 36,000 (which is six USD 6,000 payments) less the USD 5,076 premium. In both illustrations, at the maturity date the carrying value of the bonds is equal to the face value because the discount or premium has been fully amortized.

Adjusting entry for partial period Exhibit 44 and Exhibit 45 also would be helpful if Carr must accrue interest for a partial period. Instead of a calendar-year accounting period, assume the fiscal year of the bond issuer ends on August 31. Using the information provided in the premium amortization schedule (Exhibit 45), the adjusting entry needed on 2010 August 31 is:

2010 Aug. 31 Bond interest expense ($5,254 x (2/6)) 1,751
Premium on bonds payable ($746 x (2/6)) 249
Bond interest payable ($6,000 x (2/6)) 2,000
To record two months' accrued interest.


(A)
Interest Payment Date
(B)
Bond Interest Expense Debit
(E x 0.14 x ½)
(C)
Cash credit
($100,000 x 0.12 x ½)
(D)
Discount on Bonds Payable
Credit (B-C)
(E)
Carrying value of Bonds Payable
(previous balance in E+D)
Issued Price $ 95,233
2010/12/31 $6,666 $6,000 $666 95,899
2011/6/30 6,713 6,000 713 96,612
2011/12/31 6,763 6,000 763 97,375
2012/6/30 6,816 6,000 816 98,191
2012/12/31 6,873 6,000 873 99,064
2013/6/30 6,936* 6,000 936 100,000
$40,767 $36,000 $4,767


Exhibit 44: Discount amortization schedule for bonds payable

This entry records interest for two months, July and August, of the six-month interest period ending on 2010 December 31. The first line of Exhibit 45 shows the interest expense and premium amortization for the six months. Thus, the previous entry records two-sixths (or one-third) of the amounts for this six-month period. Carr would record the remaining four months' interest when making the first payment on 2010 December 31. That entry reads:

2010 Dec. 31 Bond interest payable (-L) 2,000
Bond interest expense ($5,254 x (4/6)) (-SE) 3,503
Premium on bonds payable ($746 x 4/6) (-L) 497
Cash (-A) 6,000
To record four months' interest expense and semiannual interest payment.


During the remaining life of the bonds, Carr would make similar entries for August 31 and December 31. The amounts would differ, however, because Carr uses the interest method of accounting for bond interest. The entry for each June 30 would be as indicated in Exhibit 45.

Redeeming bonds payable

Bonds may be (1) paid at maturity, (2) called, or (3) purchased in the market and retired. Bonds may also be retired by being converted into stock. Each action is either a redemption of bonds or the extinguishment of debt. A company that pays its bonds at maturity would have already amortized any related discount or premium and paid the last interest payment. The only entry required at maturity would debit Bonds Payable and credit Cash for the face amount of the bonds as follows:

2013 June 30 Bond payable (-L) 100,000
Cash (-A) 100,000
To pay bonds on maturity date.


(A)
Interest Payment Date
(B)
Bond Interest Expense Debit
(E x 0.14 x ½)
(C)
Cash credit
($100,000 x 0.12 x ½)
(D)
Discount on Bonds Payable
Credit (B-C)
(E)
Carrying value of Bonds Payable
(previous balance in E+D)
Issued Price $105,076
2010/12/31 $ 5,254 $6,000 $ 746 104,330
2011/6/30 5,216* 6,000 784 103,546
2011/12/31 5,177 6,000 823 102,723
2012/6/30 5,136 6,000 864 101,859
2012/12/31 5,093 6,000 907 100,952
2013/6/30 5,048 6,000 952 100,000
$30,924 $36,000 $5,076

*Rounded down.

Exhibit 45: Premium amortization schedule for bonds payable

An issuer may redeem some or all of its outstanding bonds before maturity by calling them. The issuer may also purchase bonds in the market and retire them. In either case, the accounting is the same. Assume that on 2012 January 1, Carr calls bonds totaling USD 10,000 of the USD 100,000 face value bonds in Exhibit 45 at 103, or USD 10,300. Even though accrued interest would be added to the price, assume that the interest due on this date has been paid. A look at the last column on the line dated 2011/12/31 in Exhibit 45 reveals that the carrying value of the bonds is USD 102,723, which consists of Bonds Payable of USD 100,000 and Premium on Bonds Payable of USD 2,723. Since 10 percent of the bond issue is being redeemed, Carr must remove 10 percent from each of these two accounts. The firm incurs a loss for the excess of the price paid for the bonds, USD 10,300, over their carrying value, USD 10,272. The required entry is:

2012 Jan. 1
Bond payable (-L) 10,000
Premium on bonds payable ($2,723/10) (-L) 272
Loss on bond redemption 9$10,272 - $10,300) (-SE) 28
Cash (-A)
10,300
To record bonds redeemed.
28


According to FASB Statement No. 4, gains and losses from voluntary early retirement of bonds are extraordinary items, if material. We report such gains and losses in the income statement, net of their tax effects, as described in Chapter 13. The FASB is currently reconsidering the reporting of these gains and losses as extraordinary items.

To avoid the burden of redeeming an entire bond issue at one time, companies sometimes issue serial bonds that mature over several dates. Assume that on 2002 June 30, Jasper Company issued USD 100,000 face value, 12 percent serial bonds at 100. Interest is payable each year on June 30 and December 31. A total of USD 20,000 of the bonds mature each year starting on 2010 June 30. Jasper has a calendar-year accounting period. Entries required for 2010 for interest expense and maturing debt are:

2010 June 30
Bond interest expense ($100,000 x 0.12 x ½) (-SE) 6,000
Cash (-A) 6,000
To record interest payment.
30 Serial bonds payable (-L) 20,000
Cash (-A) 20,000
To record retirement of serial debt
Dec. 31 Bond interest expense ($80,000 x 0.12 x ½) (-SE) 4,800
Cash (-A) 4,800
To record payment of semiannual interest expense.


Note that Jasper calculates the interest expense for the last six months of 2010 only on the remaining outstanding debt (USD 100,000 original issue less the USD 20,000 that matured on 2010 June 30). Each year after the bonds maturing that year are retired, interest expense decreases proportionately. Jasper reports the USD 20,000 amount maturing the next year as a current liability on each year-end balance sheet. The remaining debt is a long-term liability.

Naturally, bond investors are concerned about the safety of their investments. They fear the company may default on paying the entire principal at the maturity date. This concern has led to provisions in some bond indentures that require companies to make periodic payments to a bond redemption fund, often called a sinking fund. The fund trustee uses these payments to redeem a stated amount of bonds annually and pay the accrued bond interest. The trustee determines which bonds to call and uses the cash deposited in the fund only to redeem these bonds and pay their accrued interest.

To illustrate, assume Hand Company has 12 percent coupon bonds outstanding that pay interest on March 31 and September 30 and were issued at face value. The bond indenture requires that Hand pay a trustee USD 53,000 each September 30. The entry for the payment to the trustee is:

Sept. 30 Sinking fund (+A) 53,000
Cash (-A) 53,000
To record payment to trustee of required deposit.


The trustee calls USD 50,000 of bonds, pays for the bonds and accrued interest, and notifies Hand. The trustee also bills Hand for its fee and expenses incurred of USD 325. Assuming no interest has been recorded on these bonds for the period ended September 30, the entries are:

Sept. 30 Bonds Payable (-L) 50,000
Bond interest expense (-SE) 3,000
Sinking fund (-A) 53,000
To record bond redemption and interest paid by trustee.
30 Sinking fund expense (-SE) 325
Cash (-A) 325
To record trustee fee and expenses.


If a balance exists in the Sinking Fund account at year-end, Hand includes it in a category labeled Investments or Other Assets on the balance sheet. Hand would describe the USD 50,000 of bonds that must be retired during the coming year as "Current maturity of long-term debt" and report it as a current liability on the balance sheet.

The existence of a sinking fund does not necessarily mean that the company has created a retained earnings appropriation entitled "Appropriation for Bonded Indebtedness". A sinking fund usually is contractual (required by the bond indenture), and an appropriation of retained earnings is simply an announcement by the board of directors that dividend payments will be limited over the term of the bonds. The former requires cash to be paid in to a trustee, and the latter restricts retained earnings available for dividends to stockholders. Also, even if the indenture does not require a sinking fund, the corporation may decide to (1) pay into a sinking fund and not appropriate retained earnings, (2) appropriate retained earnings and not pay into a sinking fund, (3) do neither, or (4) do both.

A company may add to the attractiveness of its bonds by giving the bondholders the option to convert the bonds to shares of the issuer's common stock. In accounting for the conversions of convertible bonds, a company treats the carrying value of bonds surrendered as the capital contributed for shares issued.

Suppose a company has USD 10,000 face value of bonds outstanding. Each USD 1,000 bond is convertible into 50 shares of the issuer's USD 10 par value common stock. On May 1, when the carrying value of the bonds was USD 9,800, investors presented all of the bonds for conversion. The entry required is:

May 1 Bond payable (-L) 10,000
Discount bonds payable (+L) 200
Common stock ($10,000/$1,000 = 10 bonds; 10 bonds x 50 share x $10 par) (+SE) 5,000
Paid-in capital in excess of par value – common (+SE) 4,800

To record bonds converted to common stock


The entry eliminates the USD 9,800 book value of the bonds from the accounts by debiting Bonds Payable for USD 10,000 and crediting Discount on Bonds Payable for USD 200. It credits Common Stock for the par value of the 500 shares issued (500 shares X USD 10 par). The excess amount (USD 4,800) is credited to Paid-In Capital in Excess of Par Value – Common.


An accounting perspective:

Business insight

The Securities and Exchange Commission took action to protect the public against abusive telemarketing calls from sellers of municipal bonds. The residence of any person can only be called between 8 am and 9 pm, without their prior consent. Callers must clearly disclose the purpose of the call. Also, a centralized "Do-not-call" list of people who do not wish to receive solicitations must be maintained and honored.


The two leading bond rating services are Moody's Investors Service and Standard & Poor's Corporation. The bonds are rated as to their riskiness. The ratings used by these services are:

Moody's Standard & Poor's
Highest quality to upper medium Aaa Aaa
Aa Aa
A A
Medium to speculative Baa Baa
Ba Ba
B B
Poor to lowest quality Caa Caa
Ca Ca
C C
In default, value is questionable DDD
DD
D


Normally, Moody's rates junk bonds at Ba or below and Standard & Poor's at BB or below. As a company's prospects change over time, the ratings of its outstanding bonds change because of the higher or lower probability that the company can pay the interest and principal on the bonds when due. A severe recession may cause many companies' bond ratings to decline.

Bond prices appear regularly in certain newspapers. For instance, The Wall Street Journal quoted IBM's bonds as follows:

Issue Coupon Maturity Yield Price Change
IBM 2013 6.6 113 -2


The bonds carry a coupon rate of 7° percent. The bonds mature in 2013. The current price is USD 113 per hundred, or USD 1,130.00 for a USD 1,000 bond. The price the preceding day was USD 115, since the change was -2. The current price yields a return to investors of 6.6 percent. As the market rate of interest changes from day to day, the market price of the bonds varies inversely. Thus, if the market rate of interest increases, the market price of bonds decreases, and vice versa.


An accounting perspective:

Business insight

Companies sometimes invest in the bonds of other companies. According to FASB Statement No. 115 (covered in Chapter 14), investments in these bonds fall into three categories – trading securities, available-for-sale securities, or held-to-maturity securities. The bonds would be classified as trading securities if they were acquired principally for the purpose of selling them in the near future. If the bonds were to be held for a longer period of time, but not until maturity, they would be classified as available-for-sale securities. Bonds that will be held to maturity are classified as held-to-maturity securities. All trading securities are current assets. Available-for-sale securities are either current assets or long-term assets, depending on how long management intends to hold them. Discounts and premiums on bonds classified as trading and available-for-sale securities are not amortized because management does not know how long they will be held. Held-to-maturity securities are long-term assets. Discounts and premiums on bonds classified as held-to maturity securities are amortized by the holder of the bonds in the same manner as for the issuer of the bonds. Further discussion of investments in bonds is reserved for an intermediate accounting course.

Analyzing and using the financial results – Times interest earned ratio

The times interest earned ratio (or interest coverage ratio) indicates the ability of a company to meet required interest payments when due. We calculate the ratio as follows:

\text { Time interest earned ratio }=\frac{\text { Income before interest also taxes }(\text { IBIT })}{\text { Interest expense }}

Income before interest and taxes (IBIT), also called "earnings before interest and taxes (EBIT)", is the numerator because there would be no income taxes if interest expense is equal to or greater than IBIT. To find IBIT when the income statement is not complex, take net income and add back interest expense and taxes. However, in complex situations, when there are discontinued operations, changes in accounting principle, extraordinary items, interest revenue, and/or other similar items, analysts often use "operating income" to represent IBIT. The higher the ratio, the more comfortable creditors feel about receiving interest payments in the future.


An ethical perspective:
Rawlings furniture company

The Rawlings brothers inherited 300,000 shares (30 percent) of the common stock of the Rawlings Furniture Company from their father, who had founded the company 55 years earlier. One brother served as president of the company, and the other two brothers served as vice presidents. The company, which produced a line of fine furniture sold nationwide, earned an average of USD 4 million per year. Located in Jamesville, New York, USA, the company had provided steady employment for approximately 10 percent of the city's population. The city had benefited from the revenues the company attracted to the area and from the generous gifts provided by the father.

The remainder of the common stock was widely held and was traded in the over-the-counter market. No other stockholder held more than 4 percent of the stock. The stock had recently traded at USD 30 per share. The company has USD 10 million of 10 percent bonds outstanding, which mature in 15 years.

The brothers enjoyed the money they received from the company, but did not enjoy the work. They also were frustrated by the fact that they did not own a controlling interest (more than 50 percent) of the company. If they had a controlling interest, they could make important decisions without obtaining the agreement of the other stockholders

With the assistance of a New York City brokerage house, the brothers decided to pursue a plan that could increase their wealth. The company would offer to buy back shares of common stock at USD 40 per share. These shares would then be canceled, and the Rawlings brothers would have a controlling interest. The stock buy-back would be financed by issuing 10-year, 14 percent, high-interest junk bonds. The brokerage house had located some financial institutions willing to buy the bonds. The interest payments on the junk bonds would be USD 3 million per year. The brothers thought the company could make these payments unless the country entered a recession. If need be, wage increases could be severely restricted or eliminated and the company's pension plan could be terminated. If the junk bonds could be paid at maturity, the brothers would own a controlling interest in what could be an extremely valuable company. If the interest payments could not be met or if the junk bonds were defaulted at maturity, the company could eventually be forced to liquidate. The risks are high, but so are the potential rewards. If another buyer entered the picture at this point and bid an even higher amount for the stock, the brothers could sell their shares and exit the company. Two of the brothers hoped that another buyer might bid as much as USD 50 per share so they could sell their shares and pursue other interests. The changes a new buyer might make are unpredictable at this point.

The times interest earned ratios in a recent year for several companies (described in footnotes to the table) were as follows:

Company Earnings beforeInterest and Taxes (millions) Interest Expense (Millions) Times Interest Earned Ratio
Ford Mother Companya $19,136 $10,902 1.76
Proctor & Gamble Companyb 6,258 722 8.67
AMR Corporationc 1,754 467 3.76
Dell Computer Corporationd 3,241 47 68.96
Hewlett-Packard Companye 4,882 257 19.00

a Ford Motor Company is the world's largest producer of trucks and the second largest producer of cars and trucks combined.
b Proctor and Gamble markets more than 300 brands to nearly five billion customers in over 140 countries.
c AMR's principal subsidiary is America Airlines.
d Dell is the world's largest direct computer systems company.
e Hewlett-Packard Company designs, manufactures, and services products and systems for measurement, computation, and communications.


You can see from these data that a great deal of variability exists in the times interest earned ratios for real companies. To judge the ability of companies to pay bond interest when due, bondholders would carefully examine other financial data as well.

Some companies that issued high-interest junk bonds in the 1980s defaulted on their interest payments and had to declare Chapter 11 bankruptcy or renegotiate payment terms with bondholders in the 1990s. Other companies with high-interest bonds issued new low-interest bonds and used the proceeds to retire the highinterest bonds.

Chapter 16 discusses the fourth major financial statement – the statement of cash flows, which we mentioned in Chapter 1. This statement shows the cash inflows and outflows from operating, investing, and financing activities.

Understanding the learning objectives

  • A bond is a liability (with a maturity date) that bears interest that is deductible in computing both net income and taxable income.
  • A stock is a unit of ownership on which a dividend is paid only if declared, and dividends are not deductible in determining net income or taxable income.
  • Bonds may be secured or unsecured, registered or unregistered, callable, and/or convertible.
  • Advantages include stockholders retaining control of the company, tax deductibility of interest, and possible creation of favorable financial leverage.
  • Disadvantages include having to make a fixed interest payment each period, reduction in a company's ability to withstand a major loss, possible limitations on dividends and future borrowings, and possible reduction in earnings per share caused by unfavorable financial leverage.
  • If bonds are issued at face value on an interest date, no accrued interest is recorded.
  • If bonds are issued between interest dates, accrued interest must be recorded.
  • If the market rate is lower than the contract rate, bonds sell for more than their face value, and a premium is recorded.
  • If the market rate is higher than the contract rate, bonds sell for less than their face value, and a discount is recorded.
  • The present value of the principal plus the present value of the interest payments is equal to the price of the bond.
  • The contract rate of interest is used to determine the amount of future cash interest payments.
  • The effective rate of interest is used to discount the future payment of principal and of interest back to the present value.
  • When bonds are issued, Cash is debited, and Bonds Payable is credited. For bonds issued at a discount, Discount on Bonds Payable is also debited. For bonds issued at a premium, Premium on Bonds Payable is also credited. For bonds issued between interest dates, Bond Interest Payable is also credited.
  • Any premium or discount must be amortized over the period the bonds are outstanding.
  • Under the effective interest rate method, interest expense for any period is equal to the effective (market) rate of interest at date of issuance times the carrying value of the bond at the beginning of that interest period.
  • Under the straight-line method of amortization, an equal amount of discount or premium is allocated to each month the bonds are outstanding.
  • When bonds are redeemed before they mature, a loss or gain (an extraordinary item, if material) on bond redemption may occur.
  • A bond sinking fund might be required in the bond indenture.
  • Bonds may be convertible into shares of stock. The carrying value of the bonds is the capital contributed for shares of stock issued. • Bonds are rated as to their riskiness.
  • The two leading bond rating services are Moody's Investors Services and Standard & Poor's Corporation.
  • Each of these services has its own rating scale. For instance, the highest rating is Aaa (Moody's) and AAA (Standard & Poor's).
  • The times interest earned ratio indicates a company's ability to meet interest payments when due.
  • The ratio is equal to income before interest and taxes (IBIT) divided by interest expense.
  • The future value of an investment is the amount to which a sum of money invested today will grow in a stated time period at a specified interest rate.&
  • Present value is the current worth of a future cash receipt and is the reciprocal of future value. To discount future receipts is to bring them back to their present values.

Appendix: Future value and present value

Managers apply the concepts of interest, future value, and present value in making business decisions. Therefore, accountants need to understand these concepts to properly record certain business transactions.

The time value of money

The concept of the time value of money stems from the logical reference for a dollar today rather than a dollar at any future date. Most individuals prefer having a dollar today rather than at some future date because (1) the risk exists that the future dollar will never be received; and (2) if the dollar is on hand now, it can be invested, resulting in an increase in total dollars possessed at that future date.

Most business decisions involve a comparison of cash flows in and out of the company. To be useful in decision making, such comparisons must be in dollars of the same point in time. That is, the dollars held now must be accumulated or rolled forward, or future dollars must be discounted or brought back to the present dollar value, before comparisons are valid. Such comparisons involve future value and present value concepts.

Future value

The future value or worth of any investment is the amount to which a sum of money invested today grows during a stated period of time at a specified interest rate. The interest involved may be simple interest or compound interest. Simple interest is interest on principal only. For example, USD 1,000 invested today for two years at 12 percent simple interest grows to USD 1,240 since interest is USD 120 per year. The principal of USD 1,000, plus 2 X USD 120, is equal to USD 1,240. Compound interest is interest on principal and on interest of prior periods. For example, USD 1,000 invested for two years at 12 percent compounded annually grows to USD 1,254.40 as follows:

Principal or present value $1,000.00
Interest, year 1 = $1,000 x 0.12 = 120.00
Value at end of year 1 $1,120.00
Interest, year 2 = $1,120 x 0.12 = 134.40
Value at end of year 2 (future value) $1,254.40

In Exhibit 46, we graphically portray these computations of future worth and show how USD 1,000 grows to USD 1,254.40 with a 12 percent interest rate compounded annually. The effect of compounding is USD 14.40 –  the interest in the second year that was based on the interest computed for the first year, or USD 120 X 0.12 = USD 14.40

Interest tables ease the task of computing the future worth to which any invested amount will grow at a given rate for a stated period. An example is Table A.1 in the Appendix at the end of this text. To use the Appendix tables, first determine the number of compounding periods involved. A compounding period may be any length of time, such as a day, a month, a quarter, a half-year, or a year, but normally not more than a year. The number of compounding periods is equal to the number of years in the life of the investment times the number of compoundings per year. Five years compounded annually is five periods, five years compounded quarterly is 20 periods, and so on.

Second, determine the interest rate per compounding period. Interest rates are usually quoted in annual terms; in fact, federal law requires statement of the interest rate in annual terms in some situations. Divide the annual rate by the number of compounding periods per year to get the proper rate per period. Only with an annual compounding period will the annual rate be the rate per period. All other cases involve a lower rate. For example, if the annual rate is 12 percent and interest is compounded monthly, the rate per period (one month) will be 1 percent.

To use the tables, find the number of periods involved in the Period column. Move across the table to the right, stopping in the column headed by the Interest Rate per Period, which yields a number called a factor. The factor shows the amount to which an investment of USD 1 will grow for the periods and the rate involved. To compute the future worth of the investment, multiply the number of dollars in the given situation by this factor. For example, suppose your parents tell you that they will invest USD 8,000 at 12 percent for four years and give you the amount to which this investment grows if you graduate from college in four years. How much will you receive at the end of four years if the interest rate is 12 percent compounded annually? How much will you receive if the interest rate is 12 percent compounded quarterly?

To calculate these amounts, look at the end-of-text Appendix, Table A.1. In the intersection of the 4 period row and the 12 percent column, you find the factor 1.57352. Multiplying this factor by USD 8,000 yields USD 12,588.16, the answer to the first question. To answer the second question, look at the intersection of the 16 period row and the 3 percent column. The factor is 1.60471, and the value of your investment is USD 12,837.68. The more frequent compounding would add USD 12,837.68 - USD 12,588.16 = USD 249.52 to the value of your investment. The reason for this difference in amounts is that 12 percent compounded quarterly is a higher rate than 12 percent compounded annually.

An annuity is a series of equal cash flows (often called rents) spaced equally in time. The semiannual interest payments received on a bond investment are a common example of an annuity. Assume that USD 100 will be received at the end of each of the next three semiannual periods. The interest rate is 6 percent per semiannual period. Using Table A.1 in the Appendix, we find the future value of each of the USD 100 receipts as follows:


Exhibit 46: Compound interest and future value


Future value (after three periods) of $100 received at the end of the -
First period: 1.12360 x $100 = $112.36
Second period: 1.06000 x 100 = 106.00
Third period: 1.00000 x 100 = 100.00
Total future value $318.36


Such a procedure would become quite tedious if the annuity consisted of many receipts. Fortunately, tables are available to calculate the total future value directly. See the Appendix, Table A.2. For the annuity just described, you can identify one single factor by looking at the 3 period row and 6 percent column. The factor is 3.18360 (the sum of the three factors shown above), and when multiplied by USD 100, yields USD 318.36, which is the same answer. In Exhibit 47, we graphically present the future value of an annuity.

Present value

Present value is the current worth of a future cash receipt and is the reciprocal of future value. In future value, we calculate the future value of a sum of money possessed now. In present value, we calculate the current worth of rights to future cash receipts possessed now. We discount future receipts by bringing them back to their present values.

Assume that you have the right to receive USD 1,000 in one year. If the appropriate interest rate is 12 percent compounded annually, what is the present value of this USD 1,000 future cash receipt? You know that the present value is less than USD 1,000 because USD 1,000 due in one year is not worth USD 1,000 today You also know that the USD 1,000 due in one year is equal to some amount, P, plus interest on P at 12 percent for one year. Thus, P + 0.12P = USD 1,000, or 1.12P = USD 1,000. Dividing USD 1,000 by 1.12, you get USD 892.86; this amount is the present value of your future USD 1,000. If the USD 1,000 was due in two years, you would find its present value by dividing USD 892.86 by 1.12, which equals USD 797.20. Portrayed graphically, present value looks similar to future value, except for the direction of the arrows (Exhibit 48).

Table A.3 (end-of-text Appendix) contains present value factors for combinations of a number of periods and interest rates. We use Table A.3 in the same manner as Table A.1. For example, the present value of USD 1,000 due in four years at 16 percent compounded annually is USD 552.29, computed as USD 1,000 X 0.55229. The 0.55229 is the present value factor found in the intersection of the 4 period row and the 16 percent column.

Exhibit 47: Future value of an annuity

Exhibit 48: Compound interest and present value

As another example, suppose that you wish to have USD 4,000 in three years to pay for a vacation in Europe. If your investment increases at a 20 percent rate compounded quarterly, how much should you invest now? To find the amount, you would use the present value factor found in Table A.3, 12 period row, 5 percent column. This factor is 0.55684, which means that an investment of about 55 cents today would grow to USD 1 in 12 periods at 5 percent per period. To have USD 4,000 at the end of three years, you must invest 4,000 times this factor (0.55684), or USD 2,227.36.

The semiannual interest payments on a bond are a common example of an annuity. As an example of calculating the present value of an annuity, assume that USD 100 is received at the end of each of the next three semiannual periods. The interest rate is 6 percent per semiannual period. By using Table A.3 (Appendix), you can find the present value of each of the three USD 100 payments as follows:

Present value of $100 due in:
1 period: 094340 x $100 = $94.34
2 period: 0.89000 x 100 = 89.00
3 period: 0.83962 x 100 = 83.96
Total present value $267.30


Exhibit 49: Present value of an annuity

Such a procedure could become quite tedious if the annuity consisted of a large number of payments. Fortunately, tables are also available showing the present values of an annuity of USD 1 per period for varying interest rates and periods. See the end-of-text Appendix, Table A.4. For the annuity just described, you can obtain a single factor from the table to represent the present value of an annuity of USD 1 per period for three (semiannual) periods at 6 percent per (semiannual) period. This factor is 2.67301; it is equal to the sum of the present value factors for USD 1 due in one period, USD 1 in two periods, and USD 1 in three periods found in the Appendix, Table A.3. When this factor is multiplied by USD 100, the number of dollars in each payment, it yields the present value of the annuity, USD 267.30. In Exhibit 49, we graphically present the present value of this annuity and show how to find the present value of the three USD 100 cash flows by multiplying the USD 100 by a present value of an annuity factor, 2.67301.

Suppose you won a lottery that awarded you a choice of receiving USD 10,000 at the end of each of the next five years or USD 35,000 cash today. You believe you can earn interest on invested cash at 15 percent per year. Which option should you choose? To answer the question, compute the present value of an annuity of USD 10,000 per period for five years at 15 percent. The present value is USD 33,521.60, or USD 10,000 X 3.35216. You should accept the immediate payment of USD 35,000 since it has the larger present value.

Key terms

Annuity A series of equal cash flows spaced in time.

Bearer bond See unregistered bond.

Bond A long-term debt, or liability, owed by its issuer. A bond certificate, a negotiable instrument, is the formal, physical evidence of the debt owed.

Bond indenture The contract or loan agreement under which bonds are issued.

Bond redemption (or sinking) fund A fund used to bring about the gradual redemption of a bond issue.

Callable bond A bond that gives the issuer the right to call (buy back) the bond before its maturity date.

Call premium The price paid in excess of face value that the issuer of bonds must pay to redeem (call) bonds before their maturity date.

Carrying value (of bonds) The face value of bonds minus any unamortized discount or plus any unamortized premium. Sometimes referred to as net liability on the bonds.

Compound interest Interest calculated on the principal and on interest of prior periods.

Contract rate of interest The interest rate printed on the bond certificates and specified on the bond indenture; also called the stated, coupon, or nominal rate.

Convertible bond A bond that may be exchanged for shares of stock of the issuing corporation at the bondholders' option.

Coupon bond A bond not registered as to interest; it carries detachable coupons that are to be clipped and presented for payment of interest due.

Debenture bond An unsecured bond backed only by the general creditworthiness of its issuer.

Discount (on bonds) Amount a bond sells for below its face value.

Effective interest rate method (interest method) A procedure for calculating periodic interest expense (or revenue) in which the first period's interest is computed by multiplying the carrying value of bonds payable (bond investments) by the market rate of interest at the issue date. The difference between computed interest expense (revenue) and the interest paid (received), based on the contract rate times face value, is the discount or premium amortized for the period. Computations for subsequent periods are based on the carrying value at the beginning of the period.

Face value Principal amount of a bond.

Favorable financial leverage An increase in EPS and the rate of return on stockholders' equity resulting from earning a higher rate of return on borrowed funds than the fixed cost of such funds. Unfavorable financial leverage results when the cost of borrowed funds exceeds the income they generate, resulting in decreased income to stockholders.

Future value or worth The amount to which a sum of money invested today will grow during a stated period of time at a specified interest rate.

Interest method See effective interest rate method.

Junk bonds High-interest rate, high-risk bonds; many were issued in the 1980s to finance corporate restructurings.

Market interest rate The minimum rate of interest investors will accept on bonds of a particular risk category. Also called effective rate or yield.

Mortgage A legal claim (lien) on specific property that gives the bondholder the right to possess the pledged property if the company fails to make required payments. A bond secured by a mortgage is called a mortgage bond.

Premium (on bonds) Amount a bond sells for above its face value.

Present value The current worth of a future cash receipt(s); computed by discounting future receipts at a stipulated interest rate.

Registered bond A bond with the owner's name on the bond certificate and in the register of bond owners kept by the bond issuer or its agent, the registrar.

Secured bond A bond for which a company has pledged specific property to ensure its payment.

Serial bonds Bonds in a given bond issue with maturities spread over several dates.

Simple interest Interest on principal only.

Sinking fund See Bond redemption fund.

Stock warrant A right that allows the bondholder to purchase shares of common stock at a fixed price for a stated period of time. Warrants issued with long-term debt may be detachable or nondetachable.

Straight-line method of amortization A procedure that, when applied to bond discount or premium, allocates an equal amount of discount or premium to each period in the life of a bond.

Term bond A bond that matures on the same date as all other bonds in a given bond issue.

Times interest earned ratio Income before interest and taxes (IBIT) divided by interest expense. In complex situations, "operating income" is often used to represent IBIT.

Trading on the equity A company using its stockholders' equity as a basis for securing funds on which it pays a fixed return.

Trustee Usually a bank or trust company appointed to represent the bondholders and to enforce the provisions of the bond indenture against the issuer.

Underwriter An investment company or a banker that performs many tasks for the bond issuer in issuing. bonds; may also guarantee the issuer a fixed price for the bonds.

Unfavorable financial leverage Results when the cost of borrowed funds exceeds the revenue they generate; it is the reverse of favorable financial leverage.

Unregistered (bearer) bond Ownership transfers by physical delivery.

Unsecured bond A debenture bond, or simply a debenture.