Stockholders' Equity: Classes of Capital Stock

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.

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.

Interest Payment Date
Bond Interest Expense Debit
(E x 0.14 x ½)
Cash credit
($100,000 x 0.12 x ½)
Discount on Bonds Payable
Credit (B-C)
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)
To record bonds redeemed.

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
Medium to speculative Baa Baa
Ba Ba
Poor to lowest quality Caa Caa
Ca Ca
In default, value is questionable DDD

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.