Chapter 10
Describe bonds payable

Large companies issue bonds to public to raise
money
◦ Multiple lenders = bondholders
 Each bondholder receives bond certificate that shows
 Amount borrowed (principal)
 Maturity date
 Interest rate

Company pays interest (usually semi-annually) to
bondholders
◦ Bondholders receive interest
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Principal or Maturity value
• Amount borrower must pay back on maturity date
Maturity date
• Date on which borrower must pay principal to the
bondholders
Stated interest rate
• Annual rate of interest borrower pays to
bondholders
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
Term bonds
◦ All mature at same date

Serial bonds
◦ Mature in installments at regular intervals

Secured bonds
◦ Bondholder has right to assets if company fails to pay
principal or interest, e.g. mortgage

Debenture
◦ Unsecured; not backed by company’s assets,
by goodwill only
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Maturity(par) value
Discount
• $1,000 bond issued for
$1,000
• No discount or
premium
• $1,000 bond issued for
$980
• Issued below maturity
value
Premium
• $1,000 bond issued for
$1,015
• Issued above maturity
value
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
Quoted as a percent of maturity value
A $1,000 bond quoted a price of
101.5 would sell for $1,015
A $1,000 bond quoted a price of
89.75 would sell for $897.50


Issue price determines cash company receives
Company must pay maturity value at maturity date
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

Money earns income over time
Investors will pay less than $1,000 now to receive
$1,000 in the future
2009
Present value:
Today’s price
$750
2012
Present value is always
less than future value
Future value:
Maturity value
$1,000
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Stated interest rate


Determines amount of
cash interest borrower
pays each year
Remains constant
Stated
interest
rate
Market interest rate


Rate investors demand
for loaning money
Varies daily
Market
interest
rate
Issue price of bonds payable
9%
=
9%
Maturity value
9%
<
10%
Discount (below maturity value)
9%
>
8%
Premium (above maturity value)
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Review Question 7.
Which of the following types of bonds are
backed by the company’s assets?
A.
B.
C.
D.
Term bonds
Serial bonds
Mortgage bonds
Debentures
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7.
Which of the following types of bonds are
backed by the company’s assets?
A.
B.
C.
D.
Term bonds
Serial bonds
Mortgage bonds
Debentures
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8.
If a company issues a bond at a price
greater than its maturity value, it is said to
be sold at:
A.
B.
C.
D.
a premium.
a discount.
face value.
none of the above.
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8.
If a company issues a bond at a price
greater than its maturity value, it is said to
be sold at:
A.
B.
C.
D.
a premium.
a discount.
face value.
none of the above.
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9.
If the stated interest rate of a bond is
less than the market rate, it will be
issued at:
A.
B.
C.
a premium.
a discount.
maturity value.
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9.
If the stated interest rate of a bond is
less than the market rate, it will be
issued at:
A.
B.
C.
a premium.
a discount.
maturity value.
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Measure interest expense on bonds using the
straight-line amortization method
GENERAL JOURNAL
DATE
Issue
date
DESCRIPTION
DEBIT
Cash
CREDIT
100,000
Bonds payable
100,000
To record issuance of 8% bonds at maturity value
Int.
pmt
dates
Interest expense
$100,000 x 8% x 1/2
4,000
Cash
4,000
To record semi-annual interest payment
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GENERAL JOURNAL
DATE
DESCRIPTION
DEBIT
Maturity Bond payable
date
Cash
CREDIT
100,000
100,000
To record payment of bonds at maturity
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GENERAL JOURNAL
DATE
DESCRIPTION
DEBIT
Issue Cash
date Discount on bonds payable
CREDIT
98,000
2,000
Bonds payable
100,000
To record issuance of $100,000, 10-year, 8% bonds at 98
Contra account to
Bonds payable
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Long-term liabilities
Bonds payable
$100,000
Less: Discount on bonds payable
( $2,000) $98,000
Carrying
value
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$2,000/10
x 6/12
GENERAL JOURNAL
DATE
DESCRIPTION
DEBIT
Int. pmt Interest expense
date
Discount on bonds payable
CREDIT
4,100
100
Cash
4,000
$100,000 x 8% x 6/12
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GENERAL JOURNAL
DATE
DESCRIPTION
DEBIT
Issue Cash
date
Premium on bonds payable
CREDIT
104,000
Bonds payable
4,000
100,000
To record issuance of $100,000, 10-year, 8% bonds at 98
Companion account
to Bonds payable
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Long-term liabilities
Bonds payable
$100,000
Plus: Premium on bonds payable
$4,000 $104,000
Carrying
value
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GENERAL JOURNAL
DATE
DESCRIPTION
Int. pmt Interest expense
date Premium on bonds payable
$4,000/10
x 6/12
DEBIT
CREDIT
3,800
200
Cash
4,000
$100,000 x 8% x 6/12
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Bonds payable
$100,000
Premium
$200
$4,000
$3,800
Carrying value after first
interest payment =
$103,800
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
Interest payments seldom occur at year-end
◦ Interest must be accrued
GENERAL JOURNAL
DATE
12
DESCRIPTION
$2,000/10 x 3/12
DEBIT
31 Interest expense
CREDIT
2,050
Discount on bonds payable
Interest payable
50
2000
(100,000 x 8% x 3/12)
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
The following interest payment entry will take into
account the adjusting entry previously made
GENERAL JOURNAL
DATE
3
DESCRIPTION
x 3/12
DEBIT $2,000/10
CREDIT
31 Interest payable
2,000
Interest expense
2,050
Discount on bonds payable
50
Cash
4,000
(100,000 x 8% x 1/12)
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$100,000 x 8% x 6/12 =
$4,000
Accrued
interest
Cash interest
payment
$2,000
$2,000
(100,000 x 8% x 3/12)
(100,000 x 8% x 3/12)
January 1:
bond date
April 1:
issue date
Interest
expense
June 20:
1st interest
payment
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GENERAL JOURNAL
DATE
4
1
DESCRIPTION
Cash
DEBIT
102,000
Bonds payable
100,000
Interest payable
6
30
CREDIT
2,000
Interest expense
2,000
Interest payable
2,000
Cash
4,000
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Report liabilities on the balance sheet
Any Company
Classified Balance Sheet (partial)
December 30, 2010
Liabilities
Current liabilities:
Accounts payable
7,200
Salaries payable
1,500
Unearned revenue
400
FICA tax payable
100
Employee income tax payable
150
Interest payable
2,100
Current portion of long-term debt
5,000
Total current liabilities
Long-term liabilities:
Note payable
Bonds payable, net of discount
16,450
50,000
98,200
Total long-term liabilities
148,200
Total liabilities
164,650
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Compare issuing bonds to issuing stock
Issuing stock
Issuing bonds



Must pay interest
and principal to
bondholders
Reduces net income
◦ Interest expense
Can increase
earnings per share
◦ Leverage
Does not have to
be “paid off”
 Does not affect
net income
 Increases number
of shares
outstanding

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


Suppose that Granite Corp., with net income of
$300,000 and with 100,000 shares of common
stock outstanding, needs $500,000 for expansion.
Money can be borrowed at 10% interest.
The income tax rate is 40%.
34



50,000 shares of common stock can be issued for
$500,000.
Management believes that the new cash can be
invested in operations to earn income of $200,000
before interest and taxes.
Should the company borrow the money or issue
additional common stock?
35
Borrow $500,000
Expected net income on the new project
Interest expense
Project income before taxes
Income tax expense
Project net income
Net income before expansion
Total income
$200,000
– 50,000
$150,000
– 60,000
$ 90,000
$300,000
$390,000
36
Issue 50,000 shares of common stock at $10 per share
Expected net income on the new project
Income tax expense
Project net income
Net income before expansion
Total income
$200,000
– 80,000
$120,000
$300,000
$420,000
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Expected Income
Issue Bonds
Issue Com.Stk
$
$
200,000
200,000
Interest, 10%
(50,000)
Project Income BT
150,000
200,000
Income Tax, 40%
(60,000)
(80,000)
Project Net Income
90,000
120,000
300,000
300,000
NI before new project
NI w/ New Project
$
# of Shares-C. Stk.
EPS
390,000
-
$
100,000
$
3.90
420,000
150,000
$
2.80
38
Review Question 10.
Which depreciation method produces a
constant expense amount over the asset’s
life?
A.
B.
C.
Straight-line
Units-of-production
Double-declining-balance
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10. Which depreciation method produces a
constant expense amount over the
asset’s life?
A.
Straight-line
B.
C.
Units-of-production
Double-declining-balance
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11. Discount on bonds payable is a:
A.
B.
C.
D.
long-term liability.
contra-account to Bonds payable.
companion account to Bonds payable.
current liability.
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11. Discount on bonds payable is a:
A.
B.
C.
D.
long-term liability.
contra-account to Bonds payable.
companion account to Bonds payable.
current liability.
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12. Which of the following statements is
true regarding a bond issued at a
premium?
A.
B.
C.
Interest expense is greater than the
cash interest payment.
Interest expense is less than the cash
interest payment.
Interest expense is equal to the cash
interest payment.
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43
12. Which of the following statements is
true regarding a bond issued at a
premium?
A.
B.
C.
Interest expense is greater than the
cash interest payment.
Interest expense is less than the cash
interest payment.
Interest expense is equal to the cash
interest payment.
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13. Why might a company choose to issue
bonds over issuing stock?
A.
B.
C.
D.
Earnings per share will decrease.
It can create financial leverage.
Interest payments are optional.
All of the above are true.
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45
13. Why might a company choose to issue
bonds over issuing stock?
A.
B.
C.
D.
Earnings per share will decrease.
It can create financial leverage.
Interest payments are optional.
All of the above are true.
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46