Principles of Financial Accounting

Chapter 9 Bond Accounting

(p. 390-404)

Introduction to Bonds
Bonds are formal certificates of debt that promise to pay: A specified amount of interest in cash annually or semi-annually. A specified principal at a specific maturity date. Convertible bonds refer to

Vocabulary:

bonds that can be exchanged, at the holders option, for other securities.

Bonds are issued by companies (issuers) that wish to borrow money from the general public. Bonds are issued to multiple lenders / investors (bondholders). The face value (also called par value or maturity value) is the principal the company is required to pay at maturity. The coupon rate (also called nominal interest rate, contractual rate, stated rate) determines the amount of interest the company is required to pay every year.

Bonds generally pay interest every 6 months (i.e. semi-annually).

Professor Lucile Faurel Principles of Financial Accounting Chapter 9 Bond Accounting 2

Valuing Bonds
Because bonds create cash flows in future periods, they are recorded at the present value of those future payments, discounted at the market interest rate in effect when the liability is created. When valuing bonds, the present value tables are used to determine the amount of proceeds that will be received (i.e. the price of the bonds).
The present value of $1 table (Table 9A-2, p.422) is used to determine the present value of the face amount (principal) of the bonds. The present value of an annuity of $1 (Table 9A-3, p.423) is used to determine the present value of the series of interest payments. The amounts are added together to determine the amount of proceeds and any resulting discount or premium.
Professor Lucile Faurel Principles of Financial Accounting Chapter 9 Bond Accounting 3

Proceeds on Bond Issuance

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

A. Market Interest Rate = 7% = Coupon Rate

Proceeds = $100,000. Bond sold at par.

B. Market Interest Rate = 8% > Coupon Rate

Proceeds = $100,000 * 0.7903 + $3,500 * 5.2421 = $97,377. Bond sold at a discount.
4%, 6 periods, Table 9A-2 4%, 6 periods, Table 9A-3

C. Market Interest Rate = 6% < Coupon Rate

Proceeds = $100,000 * 0.8375 + $3,500 * 5.4172 = $102,710. Bond sold at a premium.
3%, 6 periods, Table 9A-2
Professor Lucile Faurel Principles of Financial Accounting Chapter 9 Bond Accounting

3%, 6 periods, Table 9A-3

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Par, Discount & Premium

If the market rate is EQUAL to the coupon rate, the bond will sell at PAR. If the market rate is ABOVE the coupon rate, the bond will sell at a DISCOUNT. If the market rate is BELOW the coupon rate, the bond will sell at a PREMIUM.

Professor Lucile Faurel Principles of Financial Accounting Chapter 9 Bond Accounting

Coupon Rate vs. Market Rate

The coupon (interest) rate is:
The rate of interest stated on the bond. The interest to be paid in cash every year by the issuing company.

Used to calculate the amount of interest payments (paid in cash).

The market (interest) rate (or effective interest rate, yield to maturity) is:
The rate available on investments in similar bonds at a moment in time.

Used in the present value calculations when determining the proceeds on issuance. Used to calculate the amount of interest expense to recognize.
Changes in the market rate after the bonds are issued do NOT affect the interest expense recognized.
Professor Lucile Faurel Principles of Financial Accounting Chapter 9 Bond Accounting 6

Effective Interest Amortization

How do we decrease the bond discount or bond premium?
Straight-line amortization (not GAAP)
The discount or premium is amortized in equal amounts each period.

Effective interest amortization The discount or premium is amortized over the life of the debt. The interest expense is equal to the market interest rate (at the time of issuance) multiplied by the amount of debt outstanding at the beginning of the given period. The difference between the interest expense and the cash paid (for interest payments) represents the amortization of the discount or premium.

Professor Lucile Faurel Principles of Financial Accounting Chapter 9 Bond Accounting

Coupon rate = 7%, Market Rate = 8%, FV = $100,000, Proceeds = $97,377 (see slide 4, B).
Period Bonds Payable, Beg. (a) 97,377 97,772 98,183 98,610 99,055 99,517 Interest Expense (4%) (b=a*4%) 3,895 3,911 3,927 3,944 3,962 3,983 Cash Payment (c) 3,500 3,500 3,500 3,500 3,500 3,500 Amortization of Discount (d=b-c) 395 411 427 444 462 483 Bonds Payable, End (e=a+d) 97,772 98,183 98,610 99,055 99,517 100,000

Discount Amortization

1 2 3 4 5 6

Journal entry upon bond issuance: Dr. Cash 97,377 Cr. Bonds Payable 97,377 Journal entry for interest expense, end of Period 1 (6 months after issuance): Dr. Interest Expense 3,895 Cr. Cash (or Interest Payable) 3,500 Cr. Bonds Payable 395 Journal entry at maturity (end of Period 6): Dr. Bonds Payable 100,000 Professor Lucile Faurel Principles of Financial Accounting Cr. Cash 100,000 Chapter 9 Bond Accounting

Coupon rate = 7%, Market Rate = 6%, FV = $100,000, Proceeds = $102,710 (see slide 4, C).
Period Bonds Payable, Beg. (a) 102,710 102,291 101,860 101,416 100,958 100,487 Interest Expense (3%) (b=a*3%) 3,081 3,069 3,056 3,042 3,029 3,013 Cash Payment (c) 3,500 3,500 3,500 3,500 3,500 3,500 Amortization of Premium (d=b-c) -419 -431 -444 -458 -471 -487 Bonds Payable, End (e=a+d) 102,291 101,860 101,416 100,958 100,487 100,000

Premium Amortization

1 2 3 4 5 6

Journal entry upon bond issuance: Dr. Cash 102,710 Cr. Bonds Payable 102,710 Journal entry for interest expense, end of Period 4 (2 years after issuance): Dr. Interest Expense 3,042 Dr. Bonds Payable 458 Cr. Cash (or Interest Payable) 3,500 Journal entry at maturity (end of Period 6): Dr. Bonds Payable 100,000 Professor Lucile Faurel Principles of Financial Accounting Cr. Cash 100,000 Chapter 9 Bond Accounting

Coupon rate = 7%, Market Rate = 7%, FV = $100,000, Proceeds = $100,000 (see slide 4, A).
Period Bonds Payable, Beg. (a) 100,000 100,000 100,000 100,000 100,000 100,000 Interest Expense (3.5%) (b=a*3.5%) 3,500 3,500 3,500 3,500 3,500 3,500 Cash Payment (c) 3,500 3,500 3,500 3,500 3,500 3,500 Amortization of Discount / Premium (d=b-c) Bonds Payable, End (e=a+d) 100,000 100,000 100,000 100,000 100,000 100,000

Bond Issued at Par

1 2 3 4 5 6

Journal entry upon bond issuance: Dr. Cash 100,000 Cr. Bonds Payable 100,000 Journal entry for interest expense at the end of each period: Dr. Interest Expense 3,500 Cr. Cash (or Interest Payable) 3,500 Journal entry at maturity (end of Period 6): Dr. Bonds Payable 100,000 Cr. Cash 100,000
Professor Lucile Faurel Principles of Financial Accounting Chapter 9 Bond Accounting 10

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

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

Professor Lucile Faurel Principles of Financial Accounting Chapter 9 Bond Accounting

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

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

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

Professor Lucile Faurel Principles of Financial Accounting Chapter 9 Bond Accounting

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

Early Extinguishment of Bonds

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

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

Since 2002, gains and losses from early extinguishment of debt are usually classified as other income on the income statement.
Special item above the line, i.e. not included in operating income.
Professor Lucile Faurel Principles of Financial Accounting Chapter 9 Bond Accounting 15

CASELLA WASTE SYSTEMS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands)
Revenues Operating expenses: Cost of operations General and administration Depreciation and amortization Impairment charge Restructuring charge Operating income Other expense/(income), net: Interest income Interest expense Income from equity method investments Loss on debt extinguishment Minority interest Other expense/(income) Other expense, net Income from continuing operations
Professor Lucile Faurel Principles of Financial Accounting Chapter 9 Bond Accounting

Fiscal Year Ended April 30, 2002 2003 2004 $ 421,235 $ 420,863 $ 439,686 276,693 54,456 50,712 (438) 381,423 39,812 (904) 31,451 (1,899) (154) (4,480) 24,014 15,798 278,347 55,772 47,930 4,864 386,913 33,950 (318) 26,572 (2,073) 3,649 (152) (1,599) 26,079 7,871 287,309 58,198 59,673 1,663 406,843 32,843 (251) 25,648 (2,261) 5,948 29,084 3,759
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Early Extinguishment of Bonds

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

90,000 9,055

Now, assume the company repurchases the bond for $110,000:

99,055 10,945 110,000
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Noninterest-Bearing Bonds
Noninterest-bearing bonds (also called zero coupon bonds):
Pay no interest (i.e. the coupon rate is 0%) during their life and thus are issued at very deep discounts.

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

Dr. Cash Cr. Bonds Payable

Professor Lucile Faurel Principles of Financial Accounting Chapter 9 Bond Accounting

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

1 2 3 4 5 6 7 8

Professor Lucile Faurel Principles of Financial Accounting Chapter 9 Bond Accounting

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Noninterest-Bearing Bonds
Example (contd):
Journal entries to record accrued interest:
At end of period 1: Dr. Interest Expense Cr. Bonds Payable At end of period 2: Dr. Interest Expense Cr. Bonds Payable At end of period 3: Dr. Interest Expense Cr. Bonds Payable At end of period 4: Dr. Interest Expense Cr. Bonds Payable
677 * .05

34 34
(677+34) * .05

At end of period 5: Dr. Interest Expense Cr. Bonds Payable At end of period 6: Dr. Interest Expense Cr. Bonds Payable At end of period 7: Dr. Interest Expense Cr. Bonds Payable At end of period 8: Dr. Interest Expense Cr. Bonds Payable

41 41

36 36

43 43

37 37

45 45

39 39

48 48
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Professor Lucile Faurel Principles of Financial Accounting Chapter 9 Bond Accounting

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