Long-Term Financing: Bonds

Learning objectives

• 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).

Source: Roger H. Hermanson, James Don Edwards, and Michael W. Maher, http://solr.bccampus.ca:8001/bcc/file/fa667d22-26c7-487e-8d75-0e57ef8eece7/1/Accounting%20Principles%20A%20Business%20Perspective.pdf
This work is licensed under a Creative Commons Attribution 3.0 IGO License.

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 117 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.

Exhibit 117: Dow chemical company's long-term notes and bonds (in millions)

Comparison with stock

• 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 to principal (or face value of the bond) or to both principal and interest. Most bonds in our economy are registered as principal only. For a bond registered 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 118 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 118 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.

Exhibit 118: 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 118 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: 

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:

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:

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

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

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:

The 2011 April 30, entry would be:

The 2011 October 31, entry would be:

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:

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:

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 119, 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.

Exhibit 119: 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 30.49 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:

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

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:

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:

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:

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:

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

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:

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

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:

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:

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:

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:

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:

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:

Discount and premium amortization schedules A discount amortization schedule (Exhibit 120) and a premium amortization schedule (Exhibit 121) 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 120 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 121, 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 120 and Exhibit 121 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 121), the adjusting entry needed on 2010 August 31 is:

Exhibit 120: 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 121 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:

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:

Exhibit 121: 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 121 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 121 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:

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:

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 proportionally. 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:

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:

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:

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 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:

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:

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

Analyzing and using the financial results—Times interest earned ratio

An ethical perspective: Rawlings furniture company

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

1. Ford Motor Company is the world's largest producer of trucks and the second largest producer of cars and trucks combined.
2. Procter and Gamble markets more than 300 brands to nearly five billion customers in over 140 countries.
3. AMR's principal subsidiary is America Airlines.
4. Dell is the world's largest direct computer systems company.
5. 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 high-interest 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

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:

In Exhibit 122, 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 122: Compound interest and future value

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 123, 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 124).

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 123: Future value of an annuity

Exhibit 124: 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:

Exhibit 125: 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 125, 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.

Demonstration problem

Jackson Company issued USD 100,000 face value of 15 per cent, 20-year junk bonds on 2010 April 30. The bonds are dated 2010 April 30, call for semiannual interest payments on April 30 and October 31, and are issued to yield 16 per cent (8 per cent per period).

Solution to demonstration problem

a.

b.

Key terms

Annuity

Bearer bond

Bond

Bond indenture

Bond redemption (or sinking) fund

Callable bond

Call premium

Carrying value (of bonds)

Compound interest

Contract rate of interest

Convertible bond

Coupon bond

Debenture bond

Discount (on bonds)

Effective interest rate method (interest method)

Face value

Favorable financial leverage

Future value or worth

Interest method

Junk bonds

Market interest rate

Mortgage

Premium (on bonds)

Present value

Registered bond

Secured bond

Serial bonds

Simple interest

Sinking fund

Stock warrant

Straight-line method of amortization

Term bond

Times interest earned ratio

Trading on the equity

Trustee

Underwriter

Unfavorable financial leverage

Unregistered (bearer) bond

Unsecured bond