Chapter 15

Bonds Payable and

Investments in Bonds
Accounting, 21st Edition
Warren Reeve Fess

© Copyright 2004 South-Western, a division

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Professor Emeritus of Accounting
Pepperdine University
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 Objectives
Objectives
1. Compute the potential impact of long-
After
After studying
term borrowing studying this
this
on the earnings per
chapter, you should
share of a corporation.should
chapter, you
be
be able
able to:
to:
2. Describe the characteristics of bonds.
3. Compute the present value of bonds
payable.
4. Journalize entries for bonds payable.
5. Describe bond sinking funds.
 Objectives
Objectives
6. Journalize entries for bond
redemptions.
7. Journalize entries for the purchase,
interest, discount, and premium
amortization, and sale of bond
investments.
8. Prepare a corporation balance sheet.
9. Compute and interpret the number of
times interest charges are earned.
Two
Two Methods
Methods of
of Long-Term
Long-Term Financing
Financing
Resources = Sources

Liabilities

Debt Financing: Bondholders

Assets
Stockholders’
Equity

Equity Financing: Stockholders

Two
Two Methods
Methods of
of Long-Term
Long-Term Financing
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
Characteristics of
of Bonds
Bonds Payable
Payable
 A bond contract is called a bond indenture or trust
indenture.
 Long-term debt—repayable 10, 20, or 30 years after
date of issuance.
 Issued in face (principal) amounts of $1,000, or
multiples of $1,000.
 Contract interest rate is fixed for term (life) of the bond.
 Face amount of bond repayable at maturity date.
Characteristics
Characteristics of
of Bonds
Bonds Payable
Payable
✔ When all bonds of an issue mature at the
same time, they are called term bonds. If the
maturity dates are spread over several dates,
they are called serial bonds.
✔ Bonds that may be exchanged for other
securities are called convertible bonds.
✔ Bonds that a corporation reserves the right to
redeem before maturity are callable bonds.
✔ Bonds issued on the basis of the general
credit of the corporations are debenture
bonds.
 The
The Present-Value
Present-Value Concept
Concept
and
and Bonds
Bonds Payable
Payable
When a corporation issues bonds, the price
that buyers are willing to pay depends
upon three factors:
1. The face amount of the bonds, which is
the amount due at the maturity date.
2. The periodic interest to be paid on the
bonds. This is called the contract rate
or the coupon rate.
3. The market or effective rate of interest.
The
The Present-Value
Present-Value Concept
Concept
and
and Bonds
Bonds Payable
Payable
MARKET RATE = CONTRACT RATE

Sell price of bond = $1,000

$1,000
10% payable
annually
The
The Present-Value
Present-Value Concept
Concept
and
and Bonds
Bonds Payable
Payable
MARKET RATE > CONTRACT RATE

Sell price of bond < $1,000

$1,000
10% payable
–
annually Discount
The
The Present-Value
Present-Value Concept
Concept
and
and Bonds
Bonds Payable
Payable
MARKET < CONTRACT RATE

Sell price of bond > $1,000

$1,000
10% payable
+
annually Premium
 A $1,000, 10% bond is purchased. It pays
interest annually and will mature in two years.
$100 $100
$1,000
Interest Interest
10%
payment payment
payable
annually

Today End of End of

Year 1 Year 2

$90.91 $100 x 0.90909

$82.65 $100 x 0.82645

$1,000 x 0.82645
$826.45
$1,000.00 (rounded)
 The
The Present-Value
Present-Value Concept
Concept
and
and Bonds
Bonds Payable
Payable
OR
Present value of face value of $1,000 due
in 2 years at 10% compounded annually:
$1,000 x 0.82645 $ 826.45
Present value of 2 annual interest payments
of 10% compounded annually: $100 x
1.73554 (PV of annuity of $1 for 2 years
at 10%) 173.55
Total present value of bonds $1,000.00
 Accounting
Accounting for
for Bonds
Bonds Payable
Payable
Bonds Issued at Face Amount
On January 1, 2005, a corporation issues for cash
$100,000 of 12%, five-year bonds; interest payable
semiannually. The market rate of interest is 12%.
Present value of face amount of $100,000 due in 5
years at 12% compounded annually: $100,000 x
0.55840 $ 55,840
Present value of 10 interest payments of $6,000
compounded semiannually: $6,000 x 7.3609
(PV of annuity of $1 for 10 periods at 6%) 44,160
Total present value of bonds $100,000
 Accounting
Accounting for
for Bonds
Bonds Payable
Payable
Bonds Issued at Face Amount
On January 1, 2005, a corporation issues for cash
$100,000 of 12%, five-year bonds; interest payable
semiannual. The market rate of interest is 12%.
2005
Jan. 1 Cash 100 000 00
Bonds Payable 100 000 00
Issued $100,000 bonds
payable at face amount.
 Accounting
Accounting for
for Bonds
Bonds Payable
Payable
Bonds Issued at Face Amount

On June 30, an interest payment of $6,000

is made ($100,000 x .12 x 6/12).

June 30 Interest Expense 6 000 00

Cash 6 000 00
Paid six months’ interest on
bonds.
 Accounting
Accounting for
for Bonds
Bonds Payable
Payable
Bonds Issued at Face Amount
The bond matured on December 31, 2009.
At this time, the corporation paid the face
amount to the bondholder.
2009
Dec. 31 Bonds Payable 100 000 00
Cash 100 000 00
Paid bond principal at
maturity date.
 Accounting
Accounting for
for Bonds
Bonds Payable
Payable
Bonds Issued at a Discount

Assume that the market rate of interest is 13%

on the $100,000 bond rather than 12%.
Present value of face amount of $100,000 due in 5
years at 13% compounded semiannually: $100,000
x 0.53273 (PV of $1 for 10 periods at 6½%) $53,273
Present value of 10 semiannual interest payments
of $6,000 compounded semiannually: $6,000 x
7.18883 (PV of annuity of $1 for 10 periods at 6½%) 43,133
Total present value of bonds $96,406
 Accounting
Accounting for
for Bonds
Bonds Payable
Payable
Bonds Issued at a Discount
On January 1, 2005, the firm issued $100,000
bonds for $96,406 (a discount of $3,594).
2005
Jan. 1 Cash 96 406 00
Discount on Bonds Payable 3 594 00
Bonds Payable 100 000 00
Issued $100,000 bonds at
discount.
 Accounting
Accounting for
for Bonds
Bonds Payable
Payable
Bonds Issued at a Discount
On June 30, 2005, six-months’ interest is paid and the bond
discount is amortized using the straight-line method.
2005
June 30 Interest Expense 6 359 40
Discount on Bonds Payable 359 40
Cash 6 000 00
Paid semiannual interest and $3,594
$3,594÷÷
amortized 1/10 of discount. 10
10
 Accounting
Accounting for
for Bonds
Bonds Payable
Payable
Bonds Issued at a Premium
If the market rate of interest is 11% and the contract
rate is 12%, the bond would sell for $103,769.
Present value of face amount of $100,000 due in 5
years at 11% compounded annually: $100,000 x
0.58543 (PV of $1 for 10 periods at 5½%) $ 58,543
Present value of 10 semiannual interest payments of
$6,000 at 11%compounded semiannually: $6,000 x
7.53763 (PV of annuity of $1 for 10 periods at 5½%) 45,226
Total present value of bonds $103,769
 Accounting
Accounting for
for Bonds
Bonds Payable
Payable
Bonds Issued at a Premium

Sold $100,000 of bonds for

$103,769 (a premium of $3,769).
2005
Jan. 1 Cash 103 769 00
Bonds Payable 100 000 00
Premium on Bonds Payable 3 769 00
Issued $100,000 bonds at a
premium.
 Accounting
Accounting for
for Bonds
Bonds Payable
Payable
Bonds Issued at a Premium

On June 30, paid the semiannual

interest and amortized the premium.
2005
June 30 Interest Expense 5 623 10
Premium on Bonds Payable 376 90
Cash 6 000 00
Paid semiannual interest and
$3,769
$3,769xx1/10
1/10
amortized 1/10 of bond premium.
 Accounting
Accounting for
for Bonds
Bonds Payable
Payable
Zero-Coupon Bonds

Zero-coupon
Zero-coupon bonds
bonds do do notnot provide
provide for
for interest
interest
payments.
payments. Only
Only the
the face
face amount
amount isis paid
paid at
at maturity.
maturity.
Assume
Assume market
market rate
rate isis 13%
13% atat date
date of
of issue.
issue.
Present value of $100,000 due in 5 years at 13%
compounded semi annually: $100,000 x 0.53273
(PV of $1 for 10 periods at 6½%)
$53,273
 Accounting
Accounting for
for Bonds
Bonds Payable
Payable
Zero-Coupon Bonds
On
On January
January 1,
1, 2005,
2005, Issue
Issue 5-year,
5-year,
$100,000
$100,000 zero-coupon
zero-coupon bonds
bonds when when the
the
market
market rate
rate of
of interest
interest isis 13%.
13%.
2005
Jan. 1 Cash 53 273 00
Discount on Bonds Payable 46 727 00
Bonds Payable 100 000 00
Issued $100,000 zero-
coupon bonds.
 The
The bond
bond indenture
indenture may
may require
require that
that aa
fund
fund forfor the
the payments
payments of of the
the face
face value
value
of
of the
the bonds
bonds atat maturity
maturity be
be set
set aside
aside over
over
the
the life
life of
of the
the bonds.
bonds. This
This special
special fund
fund
isis called
called aa bond
bond sinking
sinking fund.
fund.
 Bond
Bond Redemption
Redemption
On
On June
June 30,
30, aa corporation
corporation has
has aa bond
bond issue
issue ofof
$100,000
$100,000 outstanding
outstanding on
on which
which there
there isis an
an
unamortized
unamortized premium
premium of of $4,000.
$4,000. TheThe corporation
corporation
purchases
purchases one-fourth
one-fourth of
of the
the bonds
bonds for
for $24,000.
$24,000.
2005
June 30 Bonds Payable 25 000 00
Premium on Bonds Payable 1 000 00
Cash 24 000 00
Gain on redemption of Bonds 2 000 00
Retired bonds for $24,000.
 Bond
Bond Redemption
Redemption
Instead,
Instead, assume
assume that
that the
the firm
firm reacquired
reacquired
all
all of
of the
the bonds,
bonds, paying
paying $105,000.
$105,000.
2005
June 30 Bonds Payable 100 000 00
Premium on Bonds Payable 4 000 00
Loss on Redemption of Bonds 1 000 00
Cash 105 000 00
Retired bonds for $105,000.
 Investments
Investments in
in Bonds
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.
AA premium
premium or or discount
discount on on aa bond
bond
investment
investment isis recorded
recorded in in aa single
single
investment
investment account
account andand isis amortized
amortized overover
the
the remaining
remaining life
life of
of the
the bonds.
bonds.
 Investments
Investments in
in Bonds
Bonds
On
On April
April 2,
2, 2005,
2005, Purchased
Purchased aa $1,000
$1,000 Lewis
Lewis
Company
Company bond
bond at
at 102
102 plus
plus aa brokerage
brokerage fee
fee of
of
$5.30
$5.30 and
and accrued
accrued interest
interest of
of $10.20.
$10.20.
2005
Apr. 2 Investment in Lewis Co. Bonds. 1 025 30
Interest Revenue 10 20
Cash 1 035 50
Invested in a Lewis
Company bond.
Note that the brokerage fee is added
to the cost of the investment.
Investments
Investments in
in Bonds
Bonds
To
To assist
assist your
your
understanding,
understanding, let’s
let’s look
look at
at
an
an extended
extended illustration
illustration for
for
Crenshaw,
Crenshaw, Inc.
Inc.
 Investments
Investments in
in Bonds
Bonds
On
On July
July 1,
1, 2005,
2005, Crenshaw
Crenshaw Inc. Inc. purchases
purchases
$50,000
$50,000 of of 8%
8% bonds
bonds of
of Deitz
Deitz Corporation
Corporation due due
in
in 88 3/4
3/4 years.
years. The
The effective
effective interest
interest rate
rate isis
11%.
11%. The Thepurchase
purchase price
price isis $41,706
$41,706 plus
plus
interest
interest ofof $1,000
$1,000 accrued
accrued from
from April
April 1,
1, 2005.
2005.
2005
July 1 Investment in Deitz Corp. Bonds. 41 706 00
Interest Revenue 1 000 00
Cash 42 706 00
Purchased investment in $50,000 x 8% x 3/12
bonds, plus accrued interest.
 Investments
Investments in
in Bonds
Bonds
Received
Received semiannual
semiannual interest
interest for
for April
April 11 to
to
October
October 11 ($50,000
($50,000 xx 8%
8% xx 6/12).
6/12).

Oct. 1 Cash 2 000 00

Interest Revenue 2 000 00
Received semiannual
interest for April 1 to
October 1.
 Investments
Investments in
in Bonds
Bonds
Adjusting
Adjusting entry
entry for
for interest
interest accrued
accrued
from
from October
October 11 to
to December
December 31 31
($50,000
($50,000 xx 8%
8% xx 3/12).
3/12).
Dec. 31 Interest Receivable 1 000 00
Interest Revenue 1 000 00
Adjusting entry for interest
accrued from October 1 to
December 31.
 Investments
Investments in
in Bonds
Bonds
Adjusting
Adjusting entry
entry for
for amortization
amortization of
of
discount
discount for
for July
July 11 to
to December
December 31:
31:
($50,000
($50,000 –$41,706)/105
–$41,706)/105 xx 66 months.
months.

Dec. 31 Investment in Deitz Corp. Bonds 474 00

Interest Revenue 474 00
Adjusting entry for Rounded to
amortization of discount nearest dollar
from July 1 to December 31. ($79 a month)
 Investments
Investments in
in Bonds
Bonds

Investment Revenue
July 1 1,000 Oct. 1 2,000
Dec. 31 1,000
31 474
3,474
Bal. 2,474
 Investments
Investments in
in Bonds
Bonds
The
The Deitz
Deitz bonds
bonds are
are sold
sold onon June
June 30,
30, 2012
2012
for
for $47,350
$47,350 plus
plus accrued
accrued interest.
interest. ItIt has
has
been
been sixsix months
months since
since the
the last
last amortization
amortization
entry,
entry, soso amortization
amortization forfor the
the current
current year
year
must
must be
be recorded
recorded (6 (6 months).
months).
2012
June 30 Investment in Deitz Corp. Bonds 474 00
Interest Revenue 474 00
Amortized discount for $79 x 6
current year.
 Investments
Investments in
in Bonds
Bonds
Investment in Deitz Corporation Bonds
2005
July 1 41,706
The investment
Dec. 31
2006
474 $79 x 6
account after all
Dec. 31 948 $79 x 12
2007
Dec. 31 948 amortization
2008
Dec. 31 948 entries have
2009
Dec. 31 948 been made,
2010
Dec. 31 948 including the
2011
Dec. 31 948 June 30, 2012
2012
June 30 474 adjusting entry.
48,342
 Investments
Investments in
in Bonds
Bonds
This
This investment
investment was
was sold
sold onon June
June 30,
30, 2009
2009
for
for $47,350
$47,350 plus
plus accrued
accrued interest.
interest. ItIt has
has
been
been sixsix months
months since
since the
the last
last amortization
amortization
entry,
entry, soso amortization
amortization forfor the
the current
current year
year
$50,000
must
must be
be recorded
recorded (6 (6 months).
months). x 8% x
2012 3/12
June 30 Cash 48 350 00
Loss on Sale of Investment 992 00
Interest Revenue 1 000 00
Investment in Deitz Corp. Bonds 48 342 00
 Financial
Analysis and
Interpretation
Number
Number of
of Times
Times Interest
Interest
Charges
Charges Earned
Earned
 Solvency Measures—The Long-Term Creditor

Number
Number of
of Times
Times Interest
Interest Charges
Charges Earned
Earned
2006 2005
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
Income before income tax + Interest expense
Interest Expense
2005 $800,000 + $250,000
2005 = 4.2 times
$250,000
 Solvency Measures—The Long-Term Creditor

Number
Number of
of Times
Times Interest
Interest Charges
Charges Earned
Earned
2006 2005
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
Income before income tax + Interest expense
Interest Expense
2006 $900,000 + $300,000
2006 = 4.0 times
$300,000
 The
The purpose
purpose of of the
the ratio
ratio isis to
to
assess
assess the
the risk
risk to
to debtholders
debtholders in in
terms
terms of
of number
number of of times
times interest
interest
charges
charges were
were earned.
earned.
Chapter 15

The
The End
End