Bonds and Long-Term Notes

BONDS Long-term debt is comprised of those obligations that will become due in more than one year or the operating cycle whichever is longer. The two types of long-term debt discussed in this chapter are bonds and long-term notes. Long-term debt typically has covenants or restrictions imposed on the borrower to protect the lender. Bonds Bonds are long-term obligations issued by publicly traded companies that segment the obligation into multiple instruments so that it can be sold to a large number of investors. The bonds are normally denominated in $1,000 increments so that if the company issues $10 million in bonds it is actually issuing 10,000, $1,000 bonds. The contract is called a bond indenture, which is the promise to pay a sum certain (Face Amount), plus periodic interest (Stated Interest) based on the face amount of the bond. Valuation of Bonds The time lag between the authorization and issuance of bonds is rather long. The bonds are issued at a stated, coupon or nominal rate of interest which is set long before the bonds are actually issued. During this time lag market interest rates may have increased or decreased relative to the stated rate. The interest paid on a bond is the stated rate based on the face amount (par value, principal amount, or maturity value). At the date of issue the bonds will be sold to the investment community based on market interest rates. The investment community values the bonds at the present value of their future cash flow, which includes the principal payment at the maturity date and the periodic interest payments. Both these cash flows are discounted at the market rate of interest on the date of issue. If the stated rate and the market rate are different the bonds will be sold at a premium (the market rate is less than the stated rate) or at a discount (the market rate is greater than the stated rate). Example: Bonds Issued at Par Spencer Company issued 100, $1,000, 10-year bonds that pay interest semiannually on April 1 and October 1 at 10% per year. The bonds are issued at par on April 1, 2006. The following is the analysis of the bond issue price:

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Bonds and Long-Term Notes

Face value PV of 1, n=20, i=5% PV of face value Face value Stated interest rate Annual interest Payments per year Semi-annual interest payments PVOA, n=20, i=5% PV of annuity Issue price of the bonds Issue Price of the Bonds $100,000 0.37689 $37,689 100,000 10% 10,000 2 5,000 12.46221 62,311 $100,000

On April 1, 2006 the bonds will be issued at par. Because the stated interest rate and the market interest rate are identical the bonds will be sold at the face amount.
Date 4/1/06 Account Debit Credit Cash $100,000 Bonds payable $100,000 To record the issuance of 100, $1,000, 10-year bonds at par with an annual interest rate of 10%

On October 1, 2006 the first semiannual interest payment will be made to the bond holders. The journal entry to record this payment is as follows:
Date 10/1/06 Account Debit Credit Bond interest expense $5,000 Cash $5,000 To record the payment of interest on the bonds payable at October 1, 2006 Analysis of interest expense: Face value Stated interest rate Annual interest Payments per year Semi-annual interest payments

$100,000 10% 10,000 2 $5,000

If we assume the Spencer Company is a calendar year corporation then the company will need to record a year-end accrual for the interest payable on the bonds in order to prepare the December 31, 2006 financial statements. The journal entry for the accrual of the short-period interest is as follows:

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Bonds and Long-Term Notes

Date Account Debit 12/31/06 Bond interest expense $2,500 Bond interest payable To record bond interest payable on December 31, 2006 Analysis of interest expense: Face value Stated interest rate Annual interest Months left in 2006 Bond interest payable Credit $2,500

$100,000 10% 10,000 3/12 $2,500

Amortization of Premium or Discount on Bonds Payable If the market rate of interest is different than the stated rate on the bonds, they will be sold at a premium or discount. There are two methods of amortizing the premium or discount: the straight-line method and the effective interest method. GAAP requires the use of the effective interest method. All of the examples in this lesson will focus on the effective interest method. The purpose of the effective interest method is to reflect the effective interest on the bonds in each accounting period with corresponds to the market rate of interest on the date of issue. The following are the formulas for amortization of a discount and amortization of a premium. Amortization of Discount INTEREST PAID Period Stated X Interest Face Amount of Rate Bonds AMORTIZATION = Amortization of Discount

INTEREST EXPENSE Period Carrying value Effective of bonds at Less X Interest beginning of Rate period

Amortization of a Premium INTEREST PAID X INTEREST EXPENSE AMORTIZATION Amortization of Premium

Face Amount of Bonds

Carrying value of Period Period Stated Less bonds at = X Effective Interest beginning of Interest Rate Rate period

Example: Bonds Issued at a Discount Spencer Company issued 100, $1,000, 10-year bonds that pay interest semiannually on April 1 and October 1 at 10% per year. The market rate of interest on the April 1, 2006, the date the bonds were sold was 12%. The issue price of the bonds would be calculated as follows:

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Bonds and Long-Term Notes

Face value PV of 1, n=20, i=6% PV of face value Face value Stated interest rate Annual interest Payments per year Semi-annual interest payments PVOA, n=20, i=6% PV of annuity Issue price of the bonds

Issue Price of the Bonds $100,000 0.31180 $31,180 100,000 10% 10,000 2 5,000 11.46992 57,350 $88,530

The journal entry to record the issuance of the bonds would be as follows:
Date 4/1/06 Account Debit Credit Cash $88,530 Discount on bonds payable 11,470 Bonds payable $100,000 To record the issuance of 100, $1,000, 10-year bonds at 10% interest per annum with an effective yield of 12%

At this point it is helpful to prepare a schedule of amortization of bond discount. The following schedule reflects the payment of the semiannual interest payments and the amortization of the discount for the life of the bond issue. Please note that the interest expense is 6% of the carrying amount of the bond.

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Bonds and Long-Term Notes

Schedule of Amortization of Bond Discount Interest Interest Discount Carrying Payment Expense Amortization Amount $88,530 $5,000 $5,312 $312 88,842 5,000 5,331 331 89,173 5,000 5,350 350 89,523 5,000 5,371 371 89,894 5,000 5,394 394 90,288 5,000 5,417 417 90,705 5,000 5,442 442 91,147 5,000 5,469 469 91,616 5,000 5,497 497 92,113 5,000 5,527 527 92,640 5,000 5,558 558 93,198 5,000 5,592 592 93,790 5,000 5,627 627 94,417 5,000 5,665 665 95,082 5,000 5,705 705 95,787 5,000 5,747 747 96,534 5,000 5,792 792 97,326 5,000 5,840 840 98,166 5,000 5,890 890 99,056 5,000 5,943 944 100,000 $100,000 $111,469 $11,470

Date 4/1/06 10/1/06 4/1/07 10/1/07 4/1/08 10/1/08 4/1/09 10/1/09 4/1/10 10/1/10 4/1/11 10/1/11 4/1/12 10/1/12 4/1/13 10/1/13 4/1/14 10/1/14 4/1/15 10/1/15 4/1/16

To record the first interest payment we need to calculate the market interest on the carrying amount. This is the interest expense. The difference between the actual interest payment and the interest expense is amortization of the discount. The discount is added to the carrying value to derive the new carrying value. On the maturity date the carrying value will be the face amount of $100,000. The following journal entry is prepared to record the first interest payment on October 1, 2006.

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Bonds and Long-Term Notes

Date 10/1/06 Account Debit Credit Bond interest expense $5,312 Discount on bonds payable $312 Cash 5,000 To record the payment, interest expense and amortization of discount on bonds payable for October 1, 2006 Analysis of amortization of discount: Carrying value of bonds Effective interest rate Interest expense Interest payment Amortization of discount

$88,530 6% 5,312 5,000 $312

If we again assume the Spencer Company is a calendar year corporation then the company will need to do a year-end accrual of the interest expense and interest payable on the bonds in order to prepare the December 31, 2006 financial statements. The journal entry for the accrual of the short-period interest is as follows:
Date Account 12/31/06 Bond interest expense Discount on bonds payable Interest payable Debit $2,665 Credit $165 2,500

To record interest expense, amortization of discount and interest payable on December 31, 2006 Analysis of amortization of discount: Carrying value of bonds Effective interest rate Interest expense Months left in 2002 Interest expense Interest payment Months left in 2002 Interest payable Amortization of discount

$88,842 6% 5,331 3/6 $2,665 5,000 3/6 2,500 $165

Example: Bonds Issued at a Premium Spencer Company issued 500, $1,000, 5-year bonds that pay interest annually on September 1 at 10% per year. The market rate of interest on the September 1, 2006, the date the bonds were sold is 8%. The issue price of the bonds would be calculated as follows:

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Bonds and Long-Term Notes

Face value PV of 1, n=5, i=8% PV of face value Face value Stated interest rate Annual interest PVOA, n=5, i=8% PV of annuity Issue price of the bonds Issue Price of the Bonds $500,000 0.68058 $340,290 500,000 10% 50,000 3.99271 199,636 $539,926

The journal entry to record the sale of the bonds would be as follows:
Date 9/1/06 Account Debit 539,926 Credit

Cash Premium on bonds payable 39,926 Bonds payable 500,000 To record the issuance of 500, $1,000, 5-year bonds at 10% interest per annum with an effective yield of 8%

The following is a schedule of amortization of bond premium.

Schedule of Amortization of Bond Premium Date 9/1/06 9/1/07 9/1/08 9/1/09 9/1/10 9/1/11 Interest Payment $50,000 50,000 50,000 50,000 50,000 $250,000 Interest Expense $43,194 42,650 42,062 41,427 40,741 $210,074 Premium Amortization $6,806 7,350 7,938 8,573 9,259 $39,926 Carrying Amount $539,926 533,120 525,770 517,832 509,259 500,000

Using the above schedule, the journal entry to record the accrual of interest expense, amortization of premium and interest payable on December 31, 2006 would be as follows:

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Bonds and Long-Term Notes

Date Account 12/31/06 Bond interest expense Premium on bonds payable Interest payable Debit $14,398 2,269 Credit

$16,667

To record bond interest expense, amortization of premium and accrued bond interest payable at December 31, 2006 Analysis of amortization of premium: Bond interest on September 1, 2007 Number of months in 2006 Bond interest expense for 2006 Interest payment on September 1, 2007 Number of months in 2006 Bond interest payable at Dember 31, 2006 Amortization of premium for 2006

$43,194 4/12 $14,398 50,000 4/12 16,667 $2,269

The journal entry to record the payment of interest, interest expense and amortization of the premium on September 1, 2003 would be as follows:
Date 9/1/07 Account Debit Credit Bond interest expense $28,796 Premium on bonds payable 4,537 Bond interest payable 16,667 Cash $50,000 To record interest expense, interest payment and amortization of premium on bonds payable at September 1, 2007 Analysis of amortization of premium: Bond interest on September 1, 2003 Accrued in 2002 Bond interest expense for 2003 Interest payment on September 1, 2003 Accrued in 2002 Portion allocated to 2003 Amortization of premium for 2003

$43,194 14,398 $28,796 50,000 16,667 33,333 $4,537

Bonds Issued between Interest Dates The stated interest is paid to the bond holder on the interest payment date. If the bonds are sold at some date other than the interest payment date the amount of accrued interest up to the date of the transaction is accrued and paid to the seller. The buyer is reimbursing the seller up front for the interest that will be paid to the buyer on the next interest payment date.

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Bonds and Long-Term Notes

Example: Spencer Company issued 100, $1,000, 10% bonds on April 1, 2006. The bonds were dated January 1, 2006 and mature on January 1, 2007, with interest payable on July 1, and January 1. The bonds were issued to yield 8% per annum plus accrued interest. The calculation of the issue price is as follows:
Issue Price of the Bonds $100,000 0.67556 $67,556 100,000 10% 10,000 2 5,000 8.11090 40,555 $108,111

Face value PV of 1, n=10, i=4% PV of face value Face value Stated interest rate Annual interest Payments per year Semi-annual interest payments PVOA, n=10, i=4% PV of annuity Issue price of the bonds

The journal entry to record the sale of the bonds would be as follows:
Date 4/1/06 Account Debit Credit Cash $110,611 Premium on bonds payable $8,111 Bonds payable 100,000 Interest expense 2,500 To record the issuance of 100, $1,000, 10% bonds including accrued interest on April 1, 2006 Analysis of cash received: Issue price of bonds Semi-annual interest payment, July 1 Months from 1/1 to 4/1 Accrued interest Cash received

$108,111 $5,000 3/6 2,500 $110,611

The schedule of amortization of bonds premium is as follows:

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Bonds and Long-Term Notes

Schedule of Amortization of Bond Premium Interest Interest Premium Carrying Payment Expense Amortization Amount $108,111 $5,000 $4,324 $676 107,435 5,000 4,297 703 106,732 5,000 4,269 731 106,001 5,000 4,240 760 105,241 5,000 4,210 790 104,451 5,000 4,178 822 103,629 5,000 4,145 855 102,774 5,000 4,111 889 101,885 5,000 4,075 925 100,960 5,000 4,040 960 100,000 $50,000 $41,889 $8,111

Date 1/1/06 7/1/06 1/1/07 7/1/07 1/1/08 7/1/08 1/1/09 7/1/09 1/1/10 7/1/10 1/1/11

The following journal entry records the payment of interest and amortization of premium on July 1, 2006.
Date 7/1/06 Account Debit $4,324 676 Credit

Interest expense Premium on bonds payable Cash $5,000 To record the interest payment, interest expense and the amortization of the premium on the July 1, 2006 payment.

The following journal entry records interest expense, amortization of premium and accrual of interest payable at December 31, 2006.
Date Account 12/31/06 Bond interest expense Premium on bonds payable Interest payable Debit $4,297 703 Credit

$5,000

To record bond interest expense, amortization of premium and accrued bond interest payable at December 31, 2006

Costs of Issuing Bonds The costs involved in issuing bonds should be capitalized as a deferred charge and amortized over the life of the bonds. Although the effective interest method would be GAAP the amounts are not material so most entities use the straight-line method. Example: Spencer Company issued 500, $1,000 5-year bonds at par on July 1, 2006. The costs associated with this bond issue were $20,000. The company uses the straight-line method of

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Bonds and Long-Term Notes

amortizing bond issue costs. The journal entry to record the bond issue on July 1, 2006 would be as follows:

Date 7/1/06

Account

Cash Unamortized bond issue costs Bonds payable $500,000 To record the issuance of 500, $1,000 5-year bonds on July 1, 2006

Debit $480,000 20,000

Credit

The journal entry to record the amortization of bond issue cost on December 31, 2006 would be as follows:
Date Account Debit Credit 12/31/06 Bond issue expense $2,000 Unamortized bond issue costs $2,000 To amortize the bond issue costs for the six months ended December 31, 2006 Analysis of bond issue expense: Unamortized bond issue costs Year of straight-line amortization Annual depreciation Number of months in 2006 Amortization for 2006

$20,000 5 4,000 6/12 $2,000

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