Chapter 14 Power Notes

Bonds Payable and Investments in Bonds

Learning Objectives
1. Financing Corporations
2. Characteristics of Bonds Payable
3. The Present-Value Concept and Bonds Payable
4. Accounting for Bonds Payable
5. Bond Sinking Funds
6. Bond Redemption
7. Investments in Bonds C14
8. Corporation Balance Sheet
9. Financial Analysis and Interpretation
Chapter 14 Power Notes
Bonds Payable and Investments in Bonds

Slide # Power Note Topics

3 • Long-Term Financing
9 • Characteristics of Bonds Payable
17 • Time Value of Money
28 • Issuing Bonds Payable
34 • Redemption of Bonds Payable
35 • Investments in Bonds
36 • Number of Times Interest Earned

Note: To select a topic, type the slide # and press Enter.

Two Methods of Long-Term Financing

Resources = Sources

Liabilities

Assets
Stockholders’
Equity
Two Methods of Long-Term Financing

Resources = Sources

Liabilities

Assets
Stockholders’
Equity Financing – Stockholders
Equity
Two Methods of Long-Term Financing

Resources = Sources

Liabilities
Debt Financing – Bondholders

Bondholders
Assets
Stockholders’
Equity Financing – Stockholders
Equity
 Two Methods of Financing

Bondholders Stockholders

Why issue bonds rather than stock?

Bonds (debt) – Interest payments to bondholders

are an expense that reduces taxable income.
Stock (equity) – Dividend payments are made from
after tax net income and retained earnings.
Earnings per share on common stock can often
be increased by issuing bonds rather than
additional stock.
Alternative Financing Plans – $800,000 Earnings
Plan 1 Plan 2 Plan 3
12 % bonds — — $2,000,000
Preferred 9% stock, $50 par — $2,000,000 1,000,000
Common stock, $10 par $4,000,000 2,000,000 1,000,000
Total $4,000,000 $4,000,000 $4,000,000
Earnings before interest
and income tax $ 800,000 $ 800,000 $ 800,000
Deduct interest on bonds — — 240,000
Income before income tax $ 800,000 $ 800,000 $ 560,000
Deduct income tax 320,000 320,000 224,000
Net income $ 480,000 $ 480,000 $ 336,000
Dividends on preferred stock — 180,000 90,000
Available for dividends $ 480,000 $ 300,000 $ 246,000
Shares of common stock 400,000 200,000 100,000
Earnings per share $ 1.20 $ 1.50 $ 2.46
Alternative Financing Plans – $440,000 Earnings
Plan 1 Plan 2 Plan 3
12 % bonds — — $2,000,000
Preferred 9% stock, $50 par — $2,000,000 1,000,000
Common stock, $10 par $4,000,000 2,000,000 1,000,000
Total $4,000,000 $4,000,000 $4,000,000
Earnings before interest
and income tax $ 440,000 $ 440,000 $ 440,000
Deduct interest on bonds — — 240,000
Income before income tax $ 440,000 $ 440,000 $ 200,000
Deduct income tax 176,000 176,000 80,000
Net income $ 264,000 $ 264,000 $ 120,000
Dividends on preferred stock — 180,000 90,000
Available for dividends $ 264,000 $ 84,000 $ 30,000
Shares of common stock 400,000 200,000 100,000
Earnings per share $ 0.66 $ 0.42 $ 0.30
 Characteristics of Bonds Payable

 Long-term debt – repayable 10, 20, or 30 years

after date of issuance.
 Issuedin face (principal) amounts of $1,000, or
multiples of $1,000.
 Contractinterest rate is fixed for term (life) of
the bond.
 Face amount of bond repayable at maturity
date.
 Bond Variables and Constants

1. Constants – fixed by bond contract.

a. Principal (face) amount.
b. Contract rate of interest.
c. Term (life) of the bond.
2. Variables – determined in the bond market.
a. Market price of the bond.
b. Market (effective) interest rate.
 How are Bond Prices Determined
The selling price of bonds are based on two amounts.

1. Present Value of Face Amount

The present value of the face amount (constant) of
the bond at its maturity date, based on the current
market interest rate (variable).
2. Present Value of Interest Payments
The present value of the periodic interest payments
(constant) for the term of the bonds, based on the
current market interest rate (variable).
 Market and Contract Interest Rates
Differences in market and bond contract interest
rates result in Discounts and Premiums.

When Bonds sell at

Market rate = Contract rate Face value
Market rate > Contract rate Discount
Market rate < Contract rate Premium
 Cash Flow of Bonds Payable
On January 1, $100,000 of 12%, five-year bonds, with
interest of $6,000 payable semiannually are issued.
Market rate is 13% at date of issue.

Cash Outflows: Present Values

Interest payments $ 60,000 = $ 43,133
(10 periods at $6,000)
Face amount 100,000 = 53,273
(at end of 5 years)
$160,000 = $96,403
Cash Inflows:
Selling proceeds $ 96,406 = $96,406
 Cash Flow of Bonds Payable
On January 1, $100,000 of 12%, five-year bonds, with
interest of $6,000 payable semiannually are issued.
Market rate is 13% at date of issue.

Cash Outflows: Present Values

Interest payments $ 60,000 = $ 43,133
(10 periods at $6,000)
Face amount 100,000 = 43,133
Present value of an annuity of $6,000 for
(at end of 5 years)
10 periods at a market rate of 6.5% per
$160,000 = $96,403
period is $43,133.
Cash Inflows:
Payment x Factor
Selling proceeds = Present
$ 96,403 = Value
$96,403
$6,000 x 7.1888 = $43,133
 Cash Flow of Bonds Payable
On January 1, $100,000 of 12%, five-year bonds, with
interest of $6,000 payable semiannually are issued.
Market rate is 13% at date of issue.

Cash Outflows: Present Values

Interest payments $ 60,000 = $ 43,133
(10 periods at $6,000)
Face amount 100,000 = 53,273
(at end of 5 years)
$160,000 = $96,403
Present value of $100,000 paid at the end
Cash Inflows:
of 10 six-month periods at a market rate of
Selling proceeds $ 96,403 = $96,403
6.5% per period is $53,273.
Payment x Factor = Present Value
$100,000 x .53273 = $53,273
 Cash Flow of Bonds Payable
On January 1, $100,000 of 12%, five-year bonds, with
interest of $6,000 payable semiannually are issued.
Market rate is 13% at date of issue.

Cash Outflows: Present Values

Interest payments $ 60,000 = $ 43,133
(10 periods at $6,000)
Face amount 100,000 = 53,273
(at end of 5 years)
$160,000 = $96,406
Cash Inflows:
Selling price $96,406
The Time Value of Money – Future Value
The time value of money concept is used in many
business decisions. This concept is an important
consideration in accounting for bonds payable.

Present
Value $1,000

What is the future value of $1,000 invested

today (present value) at 8% per year?

Future
$ ????
Value
The Time Value of Money – Future Value
The time value of money concept is used in many
business decisions. This concept is an important
consideration in accounting for bonds payable.

Present
Value $1,000

What is the future value of $1,000 invested

today (present value) at 8% per year?

Future = $1,000 + ($1,000 x 8%)

$1,080 = $1,000 x 108% or 1.08
Value
The Time Value of Money – Present Value
The time value of money concept is used in many
business decisions. This concept is an important
consideration in accounting for bonds payable.

Present
Value $ ????

What is the present value of $1,000 to be

received one year from today at 8% per year?

Future
$1,000
Value
The Time Value of Money – Present Value
The time value of money concept is used in many
business decisions. This concept is an important
consideration in accounting for bonds payable.

Present
Value $ 925.93 = $1,000 / 108% or 1.08

What is the present value of $1,000 to be

received one year from today at 8% per year?

Future
$1,000
Value
 Calculating Present Values
Present values can be determined using present value
tables, mathematical formulas, calculators or computers.

Present value of $1 with Compound Interest

PV Table
Period 6% Calculator
1 .9434 = $1.0000 / 1.06

One dollar at the end of one

period at 6% per period is equal
to $.9434 today (present value).
 Calculating Present Values
Present values can be determined using present value
tables, mathematical formulas, calculators or computers.

Present value of $1 with Compound Interest

PV Table
Period 6% Calculator
1 .9434 = $1.0000 / 1.06
2 .8900 = $ .9434 / 1.06
One dollar at the end of two
periods at 6% per period is equal
to $.8900 today (present value).
To use the value from the prior
period as the starting point, don’t
clear your calculator.
 Calculating Present Values
Present values can be determined using present value
tables, mathematical formulas, calculators, or computers.

Present value of $1 with Compound Interest

PV Table
Period 6% Calculator
1 .9434 = $1.0000 / 1.06
2 .8900 = $ .9434 / 1.06
3 .8396 = $ .8900 / 1.06

One dollar at the end of three

periods at 6% per period is equal
to $.8396 today (present value).
 Calculating Present Values
Present values can be determined using present value
tables, mathematical formulas, calculators or computers.

Present value of $1 with Compound Interest

PV Table
Period 6% Calculator
1 .9434 = $1.0000 / 1.06
2 .8900 = $ .9434 / 1.06
3 .8396 = $ .8900 / 1.06
4 .7921 = $ .8396 / 1.06
5
When using .7432 = $learn
a calculator, .7921to /use
1.06constant division.
You will
6 then.7050
enter $1 =
and
$ 1.06
.7432the first time, pressing
/ 1.06
only the equal (=) key for each successive answer.
 Calculating Present Values of Annuities
Annuities represent a series of equal amounts to be
paid or received in the future over equal periods.

Present value of $1 — Annuity of $1

PV Table Annuity Calculation
Period 6% 6% Sum of Periods
1 .9434 .9434 = Period 1
2 .8900 1.8334 = Periods 1–2
3 The PV
.8396 2.6730 of $1
of an annuity = Periods
to be 1–3
4 received
.7921each 3.4651 = Periods
year for two years is1–4
5 $1.8334. This is
.7432 the sum =ofPeriods
4.2124 the PV 1–5
of
the two amounts for periods 1 and 2.
4.2124
 Calculating Present Values of Annuities
Annuities represent a series of equal amounts to be
paid or received in the future over equal periods.

Present value of $1 — Annuity of 1$

PV Table Annuity Calculation
Period 6% 6% Sum of Periods
1 .9434 .9434 = Period 1
2 .8900 1.8334 = Periods 1–2
3 .8396 2.6730 = Periods 1–3
4 The PV
.7921 3.4651 of $1
of an annuity = Periods
to be 1–4
5 received
.7432each 4.2124 = Periods
year for three years 1–5
is
$2.6730. This is the sum of the PV of
4.2124
the three amounts for periods 1–3.
 Calculating Present Values of Annuities
Annuities represent a series of equal amounts to be
paid or received in the future over equal periods.

Present value of $1 — Annuity of 1$

PV Table Annuity Calculation
Period 6% 6% Sum of Periods
1 .9434 .9434 = Period 1
2 .8900 1.8334 = Periods 1–2
3 .8396 2.6730 = Periods 1–3
4 .7921 3.4651 = Periods 1–4
5 .7473 4.2124 = Periods 1–5
Total 4.2124
 Bonds Issued at Face Amount
On January 1, $100,000 of 12%, five-year bonds, with
interest of $6,000 payable semiannually are issued.
Market rate is 12% at date of issue.
Date Description Debit Credit
Jan. 1 Cash 100,000
Bonds Payable 100,000
Issued 12%, five-year bonds at face.

PV of face due in 5 years ($100,000 x 0.55840) = $55,840

PV of $1 for 10 periods at 6%
PV of 10 interest payments ($6,000 x 7.36009) = 44,160
PV of annuity of $1 for 10 periods at 6%
Total selling price = $100,000
 Bonds Issued at a Discount
On January 1, $100,000 of 12%, five-year bonds, with
interest of $6,000 payable semiannually are issued.
Market rate is 13% at date of issue.
Date Description Debit Credit
Jan. 1 Cash 96,406
Discount on Bonds Payable 3,594
Bonds Payable 100,000
Issued 12%, five-year bonds at a discount.
PV of face due in 5 years ($100,000 x 0.53273) = $53,273
(PV of $1 for 10 periods at 6.5%)
PV of 10 interest payments ($6,000 x 7.18883) = $43,133
(PV of annuity of $1 for 10 periods at 6.5%)
Total selling price = $96,406
 Amortization of a Bond Discount
The straight-line method amortizes bond discount in
equal periodic amounts.
Date Description Debit Credit
Jan. 1 Cash 96,406
Discount on Bonds Payable 3,594
Bonds Payable 100,000
Issued 12%, five-year bonds at a discount.
Jun. 30 Interest Expense 6,359.70
Discount on Bonds Payable 359.70
Cash 6,000.00
Payment of semiannual interest and
amortization of 1/10 of bond discount.
 Bonds Issued at a Premium
On January 1, $100,000 of 12%, five-year bonds, with
interest of $6,000 payable semiannually are issued.
Market rate is 11% at date of issue.
Date Description Debit Credit
Jan. 1 Cash 103,769
Bonds Payable 100,000
Premium on Bonds Payable 3,769
Issued 12%, five-year bonds at a premium.
PV of face due in 5 years ($100,000 x 0.58543) = $ 58,543
(PV of $1 for 10 periods at 5.5%)
PV of 10 interest payments ($6,000 x 7.53763) = 45,226
(PV of annuity of $1 for 10 periods at 5.5%)
Total PV (selling price) = $103,769
 Amortization of a Bond Premium
The straight-line method amortizes bond premium in
equal periodic amounts.
Date Description Debit Credit
Jan. 1 Cash 103,769
Bonds Payable 100,000
Premium on Bonds Payable 3,769
Issued 12%, five-year bonds at a premium.
Jun. 30 Interest Expense 5,623.10
Premium on Bonds Payable 376.90
Cash 6,000.00
Payment of semiannual interest and
amortization of 1/10 of bond premium.
 Zero-Coupon Bonds
Zero-coupon bonds do not provide for interest
payments. Only the face amount is paid at maturity.
Assume market rate is 13% at date of issue.
Date Description Debit Credit
Jan. 1 Cash 53,273
Discount on Bonds Payable 46,727
Bonds Payable 100,000
Issued $100,000 five-year zero-coupon bonds.
PV of face due in 5 years ($100,000 x 0.53273) = $53,273
(PV of $1 for 10 periods at 6.5%)
An investment of $53,273 today would yield $100,000 in
five years compounded semiannually at 6.5%.
 Bond Redemption
A corporation may call or redeem its bonds before
they mature. Assume a bond issue of $100,000 and
an unamortized premium of $4,000. Carrying value is
$96,000 and one-fourth of the bonds are purchased.

Date Description Debit Credit

Jun. 30 Bonds Payable 25,000
Premium on Bonds Payable 1,000
Gain on Redemption of Bonds 2,000
Cash 24,000
Redeemed one-fourth of the total bonds.
 Investments in Bonds
Bonds are purchased directly from the issuing corporation
or through an organized bond exchange. Bond prices are
quoted as a percentage of the face amount.
Date Description Debit Credit
Apr. 2 Investment in Bonds 1,025.30
Interest Revenue 10.20
Cash 1,035.50
Purchased a $1,000 bond at 102 plus a brokerage
fee of $5.30 and accrued interest of $10.20
Investors do not usually record premium (or
discount) in separate accounts because bonds
are not often held until maturity.
 Solvency Measures — The Long-Term Creditor

Number of Times Interest Charges Earned

2003 2002
Income before income tax $ 900,000 $ 800,000
Add interest expense 300,000 250,000
Amount available for interest $1,200,000 $1,050,000
 Solvency Measures — The Long-Term Creditor

Number of Times Interest Charges Earned

2003 2002
Income before income tax $ 900,000 $ 800,000
Add interest expense 300,000 250,000
Amount available for interest $1,200,000 $1,050,000
Number of times earned 4.0 times 4.2 times

Use: To assess the risk to debtholders in terms

of number of times interest charges were
earned.
Chapter 14 Power Notes
Bonds Payable and Investments in Bonds

This is the last slide in Chapter 14.

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