BOND ACCOUNTING

LECTURE 7 BY HINA SAMDANI

What are bonds?

Bonds are a form of interest bearing notes payable. They are issued by corporations, governmental agencies. When companies need large funds of long-term capital to finance some capital intensive projects they resort to options such as Shares or Bonds also known a bonds payable in the accounting books. Bonds are basically Debt instruments and are used to break up a large loan into small bits.

Cont..

Bonds are issued for a long time period usually 30 -40 years. Bonds are transferable i.e. can be sold to other investors. Bonds are often referred to as the fixed income investments as they pay specific rate of interest coupon rate on the value of investment.

ADVANTAGES OF BOND FINANCING

Stockholders control is not affected.

Bond holders do not have voting rights, so current owners retain full control of the company. Bond tax is deductible for tax purposes. No additional shares of common stock are issued

Tax saving results.

Earning per share may be higher.

Effects on Earning per Share Stocks vs. Bonds

PLAN A Issue stock Income before interest & tax Interest (12%x5000000) Income before tax Tax expense (30%) Net income Outstanding shares Earnings per share $ 1500000 1500000 450000 1050000 300000 $3.50 PLAN B Issue bonds $1500000 600000 900000 270000 630000 100000 $6.30

BOND CHARACTERISTICS

Face Value: Amount of principal the issuer pay at maturity date.

Interest Rate: Referred as Stated Rate is the rate used to determine the amount of cash interest the borrower pays and the investor receives. Paid semiannually. Bond Indenture: The legal document in which the terms of the bond issue are set forth.

CONT..

Call option:

- Can be called back at any time but at a higher price. Convertible Bonds:
Can be converted into a specified number of shares at the option of the bondholder. Bond sinking fund: A fund created to ensure the investor of the ability of the corporation to pay back its loans.

TYPES OF BONDS
1. SECURED & UNSECURED BONDS: SECURED BONDS: Have specific asset of the issuer pledged as collateral for the bonds.

A bond secured by real estate is called a Mortgage Bond. A bond secured by specific assets set aside to retire the bond is called Sinking Fund Bond.

UNSECURED BONDS: Are issued against the general credit of the borrower.

These bonds are called Debenture Bonds.

CONT..
2. TERM & SERIAL BONDS: TERM BONDS: Bonds that mature at a single specified future dare. SERIAL BONDS: Bonds that mature in installments.

3. REGISTERED & BEARER BONDS: REGISTERED BONDS: Bonds that issue in the name of the owner. Interest payments made by checks. BEARER BONDS: Bonds not registered. Holders must send coupons to receive interest payments.

CONT.
4. CONVERTIBLE & CALLABLE BODS: CONVERTIBLE BONDS: Bonds that can be converted

into common stock at the bond holders option. CALLABLE BONDS: Bonds subject to retirement at a stated dollar amount prior to maturity at the option of the issuer.

5. Junk bonds: Bonds issued by companies with a lesser credit rating. Usually pay very high interest.

ISSUING PROCEDURES

State laws grant the power to issue bonds. Approval required by board of directors. BOD must stipulate:

Number of bond to be issued Face value Interest rate.

Bond indenture prepared Bond certificates printed Include:

Name of the issuer Face value Interest rate Maturity date.

Generally sold through investment company specialized in bond selling.

MARKET PRICE OF A BOND

Bond prices are quoted as a percentage of their face value or maturity value. The primary factors which determine the market value of a bond are:

The relationship of the bonds coupon rate to the market interest rate of similar investments (Market rate of interest). The amount to be received. The length of time till the bond matures. The investor confidence in the company.

CONT.

When ever the price of the bond is more than its maturity value (face value) it is said to be selling at Premium. When ever the price of the bond is less than its maturity value (face value) it is said to be selling at Discount.

ACCOUNTING FOR BOND ISSUES

Bonds may be issued at: Face Value Below Face Value (at a discount) Above Face Value (at a premium)

ISSUING BONDS AT FACE VALUE

On January 1 Devor issues 1,000, 10 years, 9%, $1,000 bonds. Entry to record sale: Jan 1 Cash 1,000,000 Bonds payable 1,000,000 To record sale of bonds at value. Reported in long-term liability section of balance sheet.

CONT..
Interest paid semi annually. Entry to record interest payment: July 1 Bond interest expense 45,000 Cash 45,000 To record payment of bond interest. ($1,000,000 x 9% x 6/12)

Adjusting entry on December 31: Dec 31 Bond interest expense 45,000 Bond interest payable To accrue bond interest.

45,000

ISSUING BONDS ON DISCOUNT OR PREMIUM

MARKET INTEREST RATE BONDS SELL AT

BOND INTEREST RATE 10%

8%

PREMIUM

10%
12%

FACE VALUE
DISCOUNT

ISSUING BONDS AT A DISCOUNT

On January 1, 2002, Candlestick Inc. sells $100,000, 5-year, 10% bonds for $92,639. Entry:

Jan 1 Cash 92,639 Discount on bonds payable 7,361 Bonds payable 100,000 To record sale of bonds at a discount.

CONT..

Balance sheet presentation:

Long-term liabilities: Bonds payable $100,000 Less: discount on bonds payable 7,361
COST OF BORROWING: Semiannual interest payments ($100,000 x 10% x = $5,000; $5000x10) Add: Bond discount (100,000-$92,639) Total cost of borrowing

$92,639

$50,000 7,361 $57,361

CONT
COST OF BORROWING:
Principal at maturity Semiannual interest payments( $5000x10) Cash to be paid to be paid to bondholders Cash received from bondholders Total cost of borrowing $100,000 50,000 150,000 92,639 $57,361

ISSUING BONDS AT A PREMIUM

On January 1, 2002, Candlestick Inc. sells $100,000, 5-year, 10% bonds for $108,111. Entry:
108,111
100,000 8,111 Bonds payable Premium on bonds payable

Jan 1 Cash

To record sale of bonds at a premium.

CONT..

Balance sheet presentation:

Long-term liabilities: Bonds payable $100,000 Add: Premium on bonds payable 8,111
COST OF BORROWING: Semiannual interest payments ($100,000 x 10% x = $5,000; $5000x10) Less: Bond premium ($108,111-$100,000) Total cost of borrowing

$108,111

$50,000 8,111 $41,889

CONT
COST OF BORROWING:
Principal at maturity Semiannual interest payments( $5000x10) Cash to be paid to be paid to bondholders Cash received from bondholders Total cost of borrowing $100,000 50,000 150,000 108,111 $41,889

ACCOUNTING FOR BOND RETIREMENT

REDEEMING BONDS AT MATURITY:

On January 1, 2002, Candlestick Inc. sells $100,000, 5-year, 10% bonds at face value.

Bonds payable 100,000 Cash 100,000 To record redemption of bond at maturity.

CONVERTING BONDS INTO COMMON STOCK

Assume that on January 1 Saunders Associates converts $100,000 bonds sold at face value into 2000 shares of $10 par value common stock.
Bonds payable 100,000 Common stock 20,000 Paid in capital in excess of par value 80,000 To record bond conversion.