ch10 Fundamental of Financial Accounting by Edmonds (4th Edition)

Fundamental
Financial Accounting
Concepts
Fourth Edition
by
Edmonds, McNair, Milam, Olds
PowerPoint® presentation by
J. Lawrence Bergin
10- 2
Chapter 10
Accounting for Debt
Transactions
LOANS & BONDS
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

10- 3
Business Background
● Capital structure is the mix of debt and
equity used to finance a company.
● Loans from banks, insurance
companies, or pension funds are often
used when borrowing small amounts
of capital.
● Bonds are debt securities issued when
borrowing large amounts of money.
❐ Can be issued by either corporations or
governmental units.
10- 4
Business Background
● Capital structure is the mix of debt and
equity used to finance a company.
● Loans from banks, insurance
companies, or pension funds are often
used when borrowing small amounts
of capital.
● Bonds are debt securities issued when
borrowing large amounts of money.
❐ Can be issued by either corporations or
governmental units.
10- 5
Financial Analysis
● The debt-to-equity ratio is an
important measure of the state of a
company’s capital structure.
Debt-to-Equity Ratio = Total Liab. ÷Total Equity
● When a company’s debt-to-equity
ratio is excessive, a large amount of
fixed debt payments may cause

problems in tight cash flow periods.
10- 6
Loans: Long-term Notes Payable

● Most long-term notes
require period payments.
● The note is repaid in
equal installments, part of
which are repayment of
principal and part of
which are interest.

10- 7
Example: Borrowing on
Long-term Note Payable
● ABC Co. signed a $100,000, 3 year
Note Payable which carried an 8%
annual interest rate. Payments are to
be made annually on December 31 of
each year for $38,803.35.
● What is the amount of the liability
(Note payable) after the first payment
is made?

10- 8
Example continued...
● For Yr.1, the outstanding amount
borrowed is $100,000 (at 8%), so the
interest is:
❐ $8,000
● Payment is $38,803.35, so the
amount that will reduce the principal
is
❐ $30,803.35 [$38,803.35-$8,000]
● New outstanding principal amount is
❐ $100,000 - 30,803.35 = $69,196.65
10- 9
Amortization schedule
A B C D
Principal Payment Interest Prin. Repaid
Prev. bal. - D Given .08 X A (B - C)
1 100,000.00 38,803.35 8,000.00 30,803.35
2 69,196.65 38,803.35 5,535.73* 33,267.62**
3
35,929.03 38,803.35 2,874.32 35,929.03
0.00
* 69,196.65 x .08
** 38,803.35 - 5,535.73 = 33,267.62
69,196.65 - 33,267.62 = 35,929.03
10- 10
Horizontal Model
BALANCE SHEET INCOME STATEMENT CASHFLOW
ASSET = + EQUITY STATEMENT
Accts Note Com. Ret. Interest Net OA,IA,FA
Event Cash = Payable + Stk. + Earn. Rev. - Exp. = Inc. $ amt
BB 80,000.00 20,000.00 60,000.00 80,000.00 bal.
borrow 100,000.00 100,000.00 100,000.00 FA
1st Pay (38,803.35) (30,803.35) (8,000.00) 8,000.00 (8,000.00) (8,000.00) OA
(30,803.35) FA
end 1 141,196.65 69,196.65 20,000.00 52,000.00 - 8,000.00 (8,000.00) 141,196.65 bal.
beg.2 141,196.65 69,196.65 20,000.00 52,000.00 - closed out - 141,196.65 bal.
2nd Pay (38,803.35) (33,267.62) (5,535.73) 5,535.73 (5,535.73) (5,535.73) OA
(33,267.62) FA
end 2 102,393.30 35,929.03 20,000.00 46,464.27 5,535.73 (5,535.73) 102,393.30 bal.
beg.3 102,393.30 35,929.03 20,000.00 46,464.27 - closed out - 102,393.30 bal.
3rd Pay (38,803.35) (35,929.03) (2,874.32) 2,874.32 (2,874.32) (2,874.32) OA
(35,929.03) FA
EB 63,589.95 = - + 20,000.00 + 43,589.95 - - 2,874.32 = (2,874.32) 63,589.95 bal.

10- 11
Date Account Titles Debit Credit
Jan. 1 Cash 100,000.00
Notes Payable 100,000.00
3 Yr., 8%, bank loan
Journal 12/31/01 Interest Expense 8,000.00

Entries Cash 38,803.35
Year 1 payment of interest & prin.
for Note
12/31/02 Interest Expense 5,535.73
Payable Notes Payable 33,267.62
Cash 38,803.35
Example Year 2 payment of interest & prin.
12/31/03 Interest Expense 2,874.32

Cash 38,803.35
Final payment of interest & prin.
10- 12
Loans: Long-term Mortgages

● A mortgage is a special
kind of “note” payable--
one issued for property
(land, buildings).
● It is repaid in equal
installments, part of
which are repayment of
principal and part of
which are interest.

10- 13
How buying an asset using a mortgage

is reflected in the financial statements:
● Journal entry when the
mortgage is issued:
❐ Debit LAND or BLDG.
❐ Credit Mortgage Payable
● Journal entry to make a

City National Bank payment:
❐ Debit Interest expense
❐ Debit Mortgage Payable
❐ Credit Cash.

10- 14
Characteristics of Bonds
Payable
● Bonds usually involve the borrowing
of a large sum of money, called
principal,
principal for a fairly long time period.
● The principal is usually paid back as
a lump sum at the end of the bond
period.
● Individual bonds are often
denominated with a par value,
value or face
value,
value of $1,000.
10- 15
Characteristics of Bonds
Payable
To make them quicker and
easier, all bond illustrations
presented here will have very
short terms and small
principals.

10- 16
Characteristics of Bonds Payable

● Bonds usually carry a stated rate of
interest.
interest
● Interest is normally paid semiannually.
● Interest is computed as:
Interest = Principal × Stated Rate ×

3M
Time
Bond

10- 17
Characteristics of Bonds Payable

● The new bondholder receives a
bond certificate.
certificate
❐ Identifies the par value, the stated
interest rate, the interest dates, and
the maturity date.
● The trustee makes sure the
issuing company fulfills all of
the provisions of the bond
indenture, or agreement.
10- 18
Bond Classifications
● Unsecured bonds (also called
debentures) do not have pledged
assets as a guarantee of repayment
at maturity.
● Secured bonds include a pledge of
specific assets as a guarantee of
repayment at maturity.

10- 19
● Ordinary bonds (also called
single-payment bonds)
❐ The full face amount is paid at
the maturity.
● Serial bonds
❐ The principal is paid in
installments on a series of
specified maturity dates.

10- 20
● Callable bonds
❐ May be retired and repaid (called) at any
time at the option of the issuer.
issuer
● Redeemable bonds
❐ May be turned in at any time for repayment
at the option of the bondholder.
bondholder
● Convertible bonds
❐ May be exchanged for other securities of the
issuer (usually shares of common stock) at
the option of the bondholder.
bondholder
10- 21
● Registered bonds
❐ Payment of interest is made by check
and mailed directly to the bondholder
whose name must be registered.
●Coupon bonds
nd
❐Coupons are attached to the
Bo
bond for each
t
es
ter
N
interest payment.
O
In
UP
CO
❐The bondholder “clips” each
coupon and presents it
for payment on the
interest date.
10- 22
Measuring Bonds Payable

and Interest Expense
The selling price of the bond is
determined by the “market” based on
the time value of money.
Bonds issued
today future
... principal payment

.
dates of interest payments
10- 23
The time value of money...

● Selling price of a
bond =
present value of
future cash flows
promised by the
bonds, discounted
using the market
rate of interest
The Appendix to this chapter shows how to make

Present Value calculations.
10- 24
Measuring Bonds Payable

and Interest Expense
● The interest rate used to compute the
present value is the market interest rate.
rate
❐ Also called yield, effective rate, or true rate.
● Creditors demand a certain rate of
interest to compensate them for the
risks related to bonds.
● The stated rate,
rate or coupon rate,
rate is only
used to compute the periodic cash
interest payments.

10- 25
Determining the Selling

Price
● Bonds sell at:
❐“Par” (100% of face value)
❐ less than par (discount)
❐ more than par (premium)
● Market (or “effective”) rate of interest

vs. bond’s stated rate of interest
determines the selling price (or
market or issue price of the bond).

10- 26
Determining the Selling

Price
● Selling price = Present value of
future cash flows promised by the
bonds, using market rate for present-
value calculations. (The Appendix
demonstrates these calculations.)
● Therefore, if
❐ market % > stated %: Discount
❐ market % < stated %: Premium
❐ market % = stated %: Face or par
10- 27
Selling Bonds - Example

On Jan. 2, 2004, CeeDees Corp.
sells $100,000 in bonds having a
stated rate of 7% annually. The
bonds mature in 3 years, and
interest is paid semi-annually. The
market rate is 10% annually.
Determine whether the
bonds sell at par, at a
discount, or at a premium.
10- 28

On Jan. 2, 2004, CeeDees Corp. sells
$100,000 in bonds having a stated rate of
7% annually. The bonds mature in 3
years, and interest is paid semi-annually.
The market rate is 10% annually.
These bonds would sell at a discount.
Investors are “demanding” a 10%
return. These bonds are only paying
7% interest. So, investors won’t buy
them unless the price is reduced; that
is, sold at a DISCOUNT.
10- 29

● Until recently, bond selling prices were
always quoted as a whole number with a
fraction such as: “922/5”. Now decimals
are used instead of fractions. So, the
bond above would be quoted as 92.400 in
the bond market.
What does that mean?
❐ The bonds sold for 92.400% of their face (par)

value.
❐ Proceeds = $92,400 for $100,000 face
bonds. ($100,000 x .924 = $92,400)

10- 30
Recording Bonds Sold at a

Discount
● Prepare the journal entry to record
the sale of the bonds.
Cash $
Discount on Bonds Payable
Bonds Payable $

10- 31

Discount
Cash $
Bonds Payable-face $100,000

10- 32

Discount
Cash $92,400

10- 33

Discount
Cash $92,400
Discount on Bonds Payable 7,600
This is a contra-liability account and appears in

the liability section of the balance sheet
as a SUBTRACTION from the
Bonds Payable-face amount.

10- 34
Measuring and Recording Interest

on Bonds Issued at a Discount
● The discount must be amortized over the
outstanding life of the bonds.
● The discount amortization increases the
periodic interest expense for the issuer.
● Although the “Effective Interest” method is
required by GAAP, the easier “Straight-line”
method will be used for these examples.
❐ The Effective Interest amortization method is

explained in the Appendix)

10- 35
Straight-Line Amortization of
Bond Discount
● Identify the amount of the bond
discount.
● Divide the bond discount by the
number of interest periods.
● Include the discount amortization
amount as part of the periodic
interest expense entry.
● The discount will be reduced to zero
by the maturity date.
10- 36
Straight-Line Amortization of Bond

Discount
● CeeDees Corp. sold their bonds on Jan. 2,
2004 at 92.400. The bonds have a 3-year
maturity and $3,500 interest is paid
semiannually (that is, each six months).
● Why would the bonds sell for 92.400?
❐ The 10% market rate of interest is
greater than the 7% stated rate on the
bond face. So, investors won’t buy
them unless the price is reduced.
● Where did the $3,500 come from?

❐ $100,000 face x .07 x 1/2 yr.
10- 37

Discount
Prepare the journal entry to record the
payment of interest and the discount
amortization for the six months ending
on June 30, 2004.
Interest Expense $
Discount on Bonds Payable $
Cash $

10- 38

Discount
on June 30, 2004.
Interest Expense $
Discount on Bonds Payable $
Cash $3,500
$100,000 Face x .07 stated rate x 1/2 yr. = $3,500 for 6 mos.

10- 39

Discount
on June 30, 2004.
Interest Expense $
Discount on Bonds Payable $1,267
Cash $3,500
$7,600 Disc. : 6 interest periods = $1,267 each 6 months

10- 40

Discount
on June 30, 2004.
Interest Expense $4,767
Cash
Which amount appears on the Income Statement? $3,500
$4767 (the effective interest expense)

Which amount appears on the Cashflow Statement?
$3,500 Operating Activity outflow for cash paid

10- 41

Discount
on June 30, 2004.
Cash $3,500
Note that the existence of a DISCOUNT
causes the Effective Interest EXPENSE to be
GREATER THAN the CASH interest actually
paid to the bondholders.
10- 42

Discount
This exact journal entry will be made
each six months for the three year
term of the bond. At the end, the
balance of the Discount on Bonds
Payable account will be $0.
Cash $3,500

10- 43
Horizontal Model
Record the issue of CeeDee Corp. bonds on 1/1/04.
Record the Interest payments at the end of:
Period 1 = 6/30/04
Period 2 = 12/31/04
Period 3 = 6/30/05
Period 4 = 12/31/05
Period 5 = 6/30/06
Period 6 = 12/31/06
Record the principal repayment at maturity 12/31/06.

10- 44
Horizontal Model Transaction Analysis

Record issuance of CeeDees bonds, all interest payments,
and final repayment of the bonds at maturity.
Balance Sheet Income Statement
Assets= Cashflow
Liab. + Equity Statement
P Cash = Bond - Bond+ Bond + C.C.+ R.E. Rev./- Exp./
e
r Pay-par Disc. Prem. Gain- Loss = N.I. OA,IA,FA
0
1
2
bal
C Income Statement accounts closed to $0. 0 0 0
3
4
bal
5
6
end
bal
10- 45

Record the Issue of the CeeDee Corp. bonds on 1/1/04.
Record Interest expense for the first 2 periods.
Assets= CashflowLiab. + Equity Statement
P Cash = Bond - Bond+ Bond + C.C.+ R.E. Rev./ - Exp./
e
r Pay-par Disc. Prem. Gain - Loss = N.I. OA,IA,FA
0 92400 100000 7600 92400 FA
1 (3500) (1267) (4767) 4767 (4767) (3500)OA
2 (3500) (1267) (4767) 4767 (4767) (3500)OA
bal 85400 100000 5066 (9534) 9534 (9534) 85400 bal
How much Interest Expense is on the 2004 Inc. Statement?
$9,534 ($4,767 + $4,767)
How much interest will be on the 2004 Cashflow Statement?
$7,000 ($3,500 + $3,500)
What is the bond Carrying Value on the 12/31/04 Bal. Sheet?
First, let’s discuss what Bond Carrying Value means.
10- 46
Carrying value of BONDS

PAYABLE
● While the specific long-term
liability, Bonds Payable, is always
recorded (and kept) at face value,
the remaining balance (called the
Unamortized balance) of the
Discount or Premium will be
either subtracted (if discount) or
added (if premium) to the B/P-face
amount to get the carrying value
[also called “book” value] of the
bonds at any given date.
10- 47
Carrying value of BONDS

PAYABLE
The December 31, 2004 CeeDees Corp.
Balance Sheet will report the bonds at
their Carrying Value:
Long-term Liability section:
Less: Unamortized Discount ( 5,066)
Total Bond Liability (Carrying V.) $ 94,934
Let’s return to the
horizontal model.
10- 48

Recording Year 1 transactions for CeeDee Corp. bonds
Assets= Cashflow Liab. + Equity Statement
P Cash = BondO - Bond+ Bond + C.C.+ R.E. Rev./ - Exp./
e
0 92400 100000 7600 92400 FA
1 (3500) (1267) (4767) 4767 (4767) (3500)OA
2 (3500) (1267) (4767) 4767 (4767) (3500)OA
bal 85400 100000 5066 (9534) 9534 (9534) 85400 bal
Bond Liability:
Bond Payable-face $100,000
Less: Unamortized Discount 5,066
Bond Carrying Value $ 94,934
10- 49

Assuming the 2004 closing entries were made,
record the two 2005 interest expense transactions.
P Cash = Bond - Bond+ Bond + C.C.+ R.E. Rev./- Exp./
e
0 92400 100000 7600 92400 FA
1 (3500) (1267) (4767) 4767 (4767) (3500)OA
2 (3500) (1267) (4767) 4767 (4767) (3500)OA
bal 85400 100000 5066 (9534) 9534 (9534) 85400 bal
3 (3500) (1267) (4767) 4767 (4767) (3500)OA
4 (3500) (1267) (4767) 4767 (4767) (3500)OA
bal 78400 100000 2532 (19,068) 9534 (9534) 78,400bal
10- 50

Record the two 2006 interest expense transactions, and
Record the repayment of principal on Dec. 31, 1906.
e
0 92400 100000 7600 92400 FA
1 (3500) (1267) (4767) 4767 (4767) (3500)OA
2 (3500) (1267) (4767) 4767 (4767) (3500)OA
bal 85400 100000 5066 (9534) 9534 (9534) 85400 bal
3 (3500) (1267) (4767) 4767 (4767) (3500)OA
4 (3500) (1267) (4767) 4767 (4767) (3500)OA
bal 78400 100000 2532 (19068) 9534 (9534) 78400 bal
5 (3500) (1267) (4767) 4767 (4767) (3500)OA
6 (3500) (1265) ($2 less-rounding) (4765) 4765 (4765) (3500)OA
end(100000)(100000) (100000)FA
bal (28600) 0 0 (28600) 9532 (9532) (28600)
10- 51

On Jan. 2, 2004, Blimp, Inc. sells
$100,000 in bonds having a stated rate
of 10% annually. The bonds mature in 3
years and interest is paid semiannually.
The market (effective, or yield) rate is
8% annually.
Determine whether the bonds sell at par,
at a discount, or at a premium.

10- 52

To figure out the proceeds from the
sale, you either have to calculate the
present value of the payments (using
the market rate of interest)
OR
Be told that the bonds sold at
“105.250”

10- 53

Premium
❐ Prepare the journal entry to record
the issuance of the bonds.
Cash
Bonds Payable - face
Premium on Bonds Pay.

10- 54

Premium
Cash
Bonds Payable - face $100,000

10- 55

Premium
Cash $105,250

10- 56

Premium
Cash $105,250
Premium on Bonds Pay. 5,250
This is called an adjunct account
and appears in the liability section
as an addition to the
Bond Payable-face liability.
10- 57
Measuring and Recording Interest

on Bonds Issued at a Premium
● The premium must be amortized over

the term of the bonds.
(Again, GAAP requires the Effective
Interest method, but we’ll use the
Straight-line method here.)
● The premium amortization decreases

the periodic interest expense for the
issuer.
10- 58
Straight-Line Amortization of
Bond Premium
● Identify the amount of the bond
premium.
● Divide the bond premium by the
number of interest periods.
● Include the premium amortization
amount as part of the periodic
interest expense entry.
● The premium will be reduced to zero
by the maturity date.
10- 59
Straight-Line Amortization
of Bond Premium
payment of interest and the premium
on June 30, 2004.
Interest Expense $
Premium on Bonds Payable
Cash $

10- 60
of Bond Premium
on June 30, 2004.
Interest Expense $
Premium on Bonds Payable
Cash $5,000
$100,000 x .10 x 1/2 = $5,000

10- 61
of Bond Premium
on June 30, 2004.
Interest Expense $
Premium on Bonds Payable 875
Cash $5,000
$5,250 : 6 periods = $875 each six months.

10- 62
of Bond Premium
on June 30, 2004.
Cash $5,000
The existence of a Premium causes the
EFFECTIVE interest expense ($4,125) to be
lower than the CASH interest paid ($5,000).
10- 63
of Bond Premium
on June 30, 2004.
Cash $5,000
This exact same entry will be made at the end
of each six months throughout the three year
term of the bond.
10- 64

Record the issue of the Blimp Corp. bonds on 1/1/04,
and the Interest expense for the first 2 periods.
Assets= Cashflow
e
0 105250 100000 5250 105250FA
1 (5000) (875) (4125) 4125 (4125) (5000) OA
2 (5000) (875) (4125) 4125 (4125) (5000) OA
bal 95250 100000 3500 (8250) 8250 (8250) 95250
bal
$8,250 ($4,125 + $4,125)
$10,000 ($5,000 + $5,000)
10- 65

Record the issue of the Blimp Corp. bonds on 1/1/04,
and the Interest expense for the first 2 periods.
Balance Sheet Long-term Liabilities:
Income Statement
Assets= Cashflow
P
e
O
Cash = Bond - Bond + Bond +Bond
C.C.+Payable-face
R.E. Rev./ - Exp./ $100,000
Plus: Unamortized Prem. 3,500
0 105250 100000 5250 105250FA
1 (5000) (875) Bond Carrying 4125
(4125) Value(4125)$103,500
(5000) OA
2 (5000) (875) (4125) 4125 (4125) (5000) OA
bal 95250 100000 3500 (8250) 8250 (8250) 95250
bal
$8,250 ($4,125 + $4,125)
$10,000 ($5,000 + $5,000)
$103,500
10- 66
Understanding Notes to
Financial Statements
● Effective-interest method of
amortization is required by GAAP.
(This method is in the Appendix.)
● Straight-line amortization may be
used if it is not materially different
from effective interest amortization.
● Most companies do not disclose the
method used for bond interest
amortization.
10- 67
Early Retirement of Debt

● When a bondholder (the
investor) sells a bond that is
already “on the market”, there
is no effect on the books of
the issuing company.
● Occasionally, the issuing
company will call (repay
early) some or all of its
bonds.
10- 68
Calling a bond...
● If the bond is callable, the issuer
may decided to call the bond
(retire it before maturity).
● The liability and any remaining
premium or discount would be
removed from the books.
● The difference between cash
paid and Carrying value on that
date is recorded as an income
statement Gain (cash paid < CV)
or Loss (cash paid > CV).
10- 69
Early Retirement of Debt

● Bonds can be retired by exercising a
call provision on the bond, or by
purchasing the bond on the open
market.
● Any gains or losses incurred as a
result of retiring the bonds should be
reported as an extraordinary item in
the lower portion of the income
statement.

10- 70
Ex: Early Retirement of Debt

What if the Blimp Corp. called their bonds at the
end of year 1? The bonds had a “Call Provision”
requiring the company to pay 104 to call the bonds.

+ Unamortized Premium 3,500
Carrying Value on 12/31/04 $103,500
Cash paid to Call bonds 104,000
Loss on Bond Retirement $ 500
The $500 loss is reported as an Extraordinary item on Inc. Statement.
10- 71

Record the CALL of the Blimp Corp. bonds on 12/31/04.
e
0 105250 100000 5250 105250FA
1 (5000) (875) (4125) 4125 (4125) (5000) OA
2 (5000) (875) (4125) 4125 (4125) (5000) OA
B 95250 100000 3500 (8250) 8250 (8250) 95250 bal
C (104000) (100000) (3500) (500) 500 (500) (104000)FA
.
10- 72
Bond Sinking Funds

● A special fund to be used to retire
bonds at maturity.
● Normally, periodic cash
contributions are made to the fund.
● Usually reported on the balance
sheet as a non-current (investment)
asset.

10- 73
Ratio
Analysis
Times-interest-earned Ratio
Indicates the borrower’s ability to
meet fixed interest payments
EBIT*
Times Interest Earned =
Interest Expense
*EBIT = Earnings Before Interest and Taxes
Higher ratio is better; indicates less risk of

default.
10- 74
Ratio
Analysis
Times-interest-earned Ratio
Example: EBIT
Sales $100 Interest Expense
Operating Expenses ( 70)
$30 = 3 times
Earnings before Interest
$10 Your
and Taxes 30 financial future
is cloudy!
Interest Expense (10)
Income before Taxes 20
Income taxes (6)
Net Earnings $ 14

10- 75
Debt vs. Equity
Financing
Financing with debt
Interest payments are tax deductible.
Financing with Equity (additional
owners’ capital investment)
Distributions to owners (Dividends)
are NOT tax deductible.
10- 76
Debt vs. Equity
Financing
Financing with debt
Interest payments MUST BE PAID
even if the company is losing money.
Financing with Equity (additional
owners’ capital investment)
Distributions to owners (Dividends)
could be reduced
or eliminated in “bad times.”
10- 77
Debt vs. Equity
Financing
Matt’s of Milton, Inc. must raise $1,000,000 to
finance an expansion project. Two options are
being considered.
Option #1:
Issue 10 year, 5% annual rate bonds at 100.
Option #2:
Attract new ownership investors by issuing
20,000 new ownership shares at $50 each.
Current owners, holding 10,000 shares, will
expect to continue receiving their $2.50 per
share annual cash dividend distribution.
10- 78
Debt vs. Equity
Financing
Use Equity Use Debt
Sales Revenue (forecasted) $1,000,000 $1,000,000
Operating Exp (80% x sales) (800,000) (800,000)
Earnings before Interest & Taxes $ 200,000 $ 200,000
Interest Exp. ($1,000,000 x .05) - (50,000)
Income before taxes $ 150,000
Income taxes (40%) $ 200,000 60,000)
Net Income (80,000) $ 90,000
$2.50 Dividend on Orig. 10,000 sh. $ 120,000 (25,000)
$2.50 Dividend on Extra 20,000 sh. (25,000) -
Addition to Retained Earnings (50,000) $ 65,000
$ 45,000

10- 79
Debt vs. Equity
Financing
Use Equity Use Debt
Although interest is $50,000
more,
Sales Net Income is only
Revenue $1,000,000 $1,000,000
$30,000 less
Operating Expbecause $20,000
(80% x sales) (800,000) (800,000)
less before
Earnings TAXESInterest
were paid.
& Taxes $ 200,000 $ 200,000
Interest Exp. ($1,000,000 x .05) - (50,000)
Income taxes (40%) $ 200,000 60,000)
Net Income (80,000) $ 90,000
$ 45,000

10- 80
Debt vs. Equity
Financing
There is NO tax savings on the Use Equity Use Debt
additional
Sales Revenue $50,000 in cash $1,000,000 $1,000,000
dividends
Operating Exppaid
(80%onxthe new
sales) (800,000) (800,000)
shares ofbefore
Earnings stock Interest
issued to& raise
Taxes $ 200,000 $ 200,000
the $1,000,000.
Interest Exp. ($1,000,000 x .05) - (50,000)
Income taxes (40%) $ 200,000 60,000)
Net Income (80,000) $ 90,000
$ 45,000

10- 81
Debt vs. Equity
Financing
Although $50,000 is paid Use Equity Use Debt
annually
Sales to obtain the $1,000,000 $1,000,000
Revenue $1,000,000
financing,
Operating the(80%
Exp debtxfinancing
sales) (800,000) (800,000)
increasesbefore
Earnings Retained Earnings
Interest by $ 200,000
& Taxes $ 200,000
an extra
Interest $20,000.
Exp. Because
($1,000,000 the
x .05) - (50,000)
interest
Income is taxtaxes
before deductible the $ 150,000
$20,000taxes
Income tax savings
(40%) ($50,000 x $ 200,000 60,000)
40%)
Net stays in the company to
Income (80,000) $ 90,000
$2.50theDividend
benefit of onthe owners.
Orig. 10,000 sh. $ 120,000 (25,000)
$ 45,000

10- 82
Debt vs. Equity
Financing
Equity transactions and Use Equity Use Debt
Earnings
Sales per share (EPS) are the $1,000,000
Revenue In this case $1,000,000
the use of
subject of Exp
Operating the next
(80%chapter.
x sales) But debt (800,000)
is an effective
(800,000)
notice here
Earnings that
before if the equity
Interest & Taxes $use 200,000
of “leverage.”
$ 200,000It
option is
Interest chosen
Exp. there are
($1,000,000 more improves- the return
x .05) (50,000)
to
ownersbefore
Income with whom
taxes the current the owners $as 150,000
shown
owners
Income will (40%)
taxes have to share all $by200,000
the higher EPS60,000)
for
future
Net profits. That reduces the the(80,000)
Income debt financing
$ 90,000
Earnings
$2.50 (profit)
Dividend per share
on Orig. ofsh. $option.
10,000 120,000 (25,000)
ownership.
Earnings per share = N. Inc./# sh. $ $4.00 45,000 $9.00
$120,000/30,000sh=$4 & $90,000/10,000sh=$9
10- 83 Chapter 10.
There is a Ready Shows
Appendix that covers the
following topics:
●Introduction to Present Value and Future Value
- Basic Principles
- Using P.V. to calculate loan payments
- Using F.V. to calculate Bond Sinking Fund
payments
- Using P.V. to calculate a Bond’s selling
price
●The Effective Interest Method of Premium and
Discount Amortization
●Bonds sold with Accrued Interest.
10- 84
Chapter 10
The Appendix follows.


ch10 Fundamental of Financial Accounting by Edmonds (4th Edition)

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Fundamental

LOANS & BONDS

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

fixed debt payments may cause

Loans: Long-term Notes Payable

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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Journal 12/31/01 Interest Expense 8,000.00

12/31/03 Interest Expense 2,874.32

Loans: Long-term Mortgages

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

How buying an asset using a mortgage

● Journal entry to make a

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Characteristics of Bonds Payable

Interest = Principal × Stated Rate ×

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Characteristics of Bonds Payable

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Measuring Bonds Payable

... principal payment

The time value of money...

The Appendix to this chapter shows how to make

Measuring Bonds Payable

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Determining the Selling

● Market (or “effective”) rate of interest

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Determining the Selling

Selling Bonds - Example

Selling Bonds - Example

Selling Bonds - Example

❐ The bonds sold for 92.400% of their face (par)

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Recording Bonds Sold at a

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Recording Bonds Sold at a

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Recording Bonds Sold at a

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Recording Bonds Sold at a

This is a contra-liability account and appears in

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Measuring and Recording Interest

❐ The Effective Interest amortization method is

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003

Straight-Line Amortization of Bond

● Where did the $3,500 come from?

Straight-Line Amortization of Bond

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Straight-Line Amortization of Bond

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Straight-Line Amortization of Bond

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Straight-Line Amortization of Bond

$4767 (the effective interest expense)

$3,500 Operating Activity outflow for cash paid

Straight-Line Amortization of Bond

Straight-Line Amortization of Bond