2. If the market rate is 9%, the bonds will issue at a discount. The only change we make is that
now I = 4.5% rather than 4%.
Calculator Input
Bond
characteristics Key Amount
1. Face amount FV $500,000
2. Interest payment each period PMT $20,000 = $500,000 x 8% x ½ year
3. Market interest rate each period I 4.5% = 9% / 2 semi-annual periods
4. Periods to maturity N 20 = 10 years x 2 periods each year
Calculator Output
Issue price PV $467,480
Present value of principal = $500,000 x 0.41464* $207,321
Present value of interest payments = $20,0001 x 13.00794** 260,159
Issue price of the bonds $467,480
1 $500,000 x 8% x ½ year = $20,000
* Table 2, i = 4.5% , n = 20
**Table 4, i = 4.5% , n = 20
3. If the market rate is 7%, the bonds will issue at a premium. The only change we make is that
now I = 3.5%.
Calculator Input
Bond
characteristics Key Amount
1. Face amount FV $500,000
2. Interest payment each period PMT $20,000 = $500,000 x 8% x ½ year
3. Market interest rate each period I 3.5% = 7% / 2 semi-annual periods
4. Periods to maturity N 20 = 10 years x 2 periods each year
Calculator Output
Issue price PV $535,531
Present value of principal = $500,000 x 0.50257* $251,285
Present value of interest payments = $20,0001 x 14.21240** 284,248
Issue price of the bonds $535,533***
1 $500,000 x 8% x ½ year = $20,000
* Table 2, i = 3.5% , n = 20
**Table 4, i = 3.5% , n = 20
*** $2 difference due to rounding
Problem #2
Assume that on January 1, 2015, Adventure Island issues $500,000 of 8% bonds, due in ten
years, with interest payable semi-annually on June 30 and December 31 each year.
Required:
1. If the market rate is 8%, the bonds will issue at $500,000. Record the bond issue on January
1, 2015, and the first two semi-annual interest payments on June 30, 2015, and December 31,
2015.
2. If the market rate is 9%, the bonds will issue at $467,480. Record the bond issue on January
1, 2015, and the first two semi-annual interest payments on June 30, 2015, and December 31,
2015.
3. If the market rate is 7%, the bonds will issue at $535,531. Record the bond issue on January
1, 2015, and the first two semi-annual interest payments on June 30, 2015, and December 31,
2015.
Solution:
1.
January 1, 2015 Debit Credit
Cash 500,000
Bonds Payable 500,000
(Bond issue at face amount)
June 30, 2015
Interest Expense 20,000
Cash ($500,000 x 5% x ½) 20,000
(Semi-annual interest payment)
December 31, 2015
Interest Expense 20,000
Cash ($500,000 x 8% x ½) 20,000
(Semi-annual interest payment)
2.
January 1, 2015 Debit Credit
Cash 467,480
Bonds Payable 467,480
(Bond issue at a discount)
June 30, 2015
Interest Expense ($467,480 x 9% x ½) 21,037
Bonds Payable (difference) 1,037
Cash ($500,000 x 8% x ½) 20,000
(Semi-annual interest payment)
December 31, 2015
Interest Expense ([$467,480 + 1,037] x 9% x ½) 21,083
Bonds Payable (difference) 1,083
Cash ($500,000 x 8% x ½) 20,000
(Semi-annual interest payment)
3.
January 1, 2015 Debit Credit
Cash 535,531
Bonds Payable 535,531
(Bond issue at a premium)
June 30, 2015
Interest Expense ($535,531 x 7% x ½) 18,744
Bonds Payable (difference) 1,256
Cash ($500,000 x 8% x ½) 20,000
(Semi-annual interest payment)
December 31, 2015
Interest Expense ([$535,531 – 1,256] x 7% x ½) 18,700
Bonds Payable (difference) 1,300
Cash ($500,000 x 8% x ½) 20,000
(Semi-annual interest payment)
Key Points by Learning Objective
LO9-1 Explain financing alternatives.
Companies obtain external funds through debt financing (liabilities) and equity financing
(stockholders’ equity). One advantage of debt financing is that interest on borrowed funds is tax
deductible.
LO9-2 Identify the characteristics of bonds.
The distinguishing characteristics of bonds include whether they are backed by collateral
(secured or unsecured), become due at a single specified date or over a series of years (term or
serial), can be redeemed prior to maturity (callable), or can be converted to common stock
(convertible).
LO9-3 Determine the price of a bond issue.
The price of a bond is equal to the present value of the face amount (principal) payable at
maturity, plus the present value of the periodic interest payments. Bonds can be issued at face
amount, below face amount (at a discount), or above face amount (at a premium).
LO9-4 Account for the issuance of bonds.
When bonds issue at face amount, the carrying value and the corresponding interest expense
remain constant over time. When bonds issue at a discount (below face amount), the carrying
value and the corresponding interest expense increase over time. When bonds issue at a premium
(above face amount), the carrying value and the corresponding interest expense decrease over
time.
LO9-5 Record the retirement of bonds.
No gain or loss is recorded on bonds retired at maturity. For bonds retired before maturity, we
record a gain or loss on early extinguishment equal to the difference between the price paid to
repurchase the bonds and the bonds’ carrying value.
LO9-6 Identify other major long-term liabilities.
Most notes payable require periodic installment payments. Each installment payment includes an
amount that represents interest expense and an amount that represents a reduction of the
outstanding loan balance.
An operating lease is recorded just like a rental. In a capital lease, the lessee essentially “buys”
the asset and borrows the money to pay for it.
Analysis
LO9-7 Make financial decisions using long-term liability ratios.
The debt to equity ratio is a measure of financial leverage. Assuming more debt (higher leverage)
can be good or bad depending on whether the company earns a return in excess of the cost of
borrowed funds. The times interest earned ratio measures a company’s ability to meet interest
payments as they become due.
Common Mistakes
Common Mistake
The interest rate we use to calculate the bond issue price is always the market rate, never the
stated rate. Some students get confused and incorrectly use the stated rate to calculate present
value. Use the stated rate to calculate the interest payment each period, but use the market rate to
calculate the present value of the cash flows.
Common Mistake
Students sometimes incorrectly record interest expense using the stated rate rather than the
market rate. Remember that interest expense is the carrying value times the market rate, while
the cash paid for interest is the face amount times the stated rate.
Decision Points
Question Accounting Information Analysis & Decision
How do you
determine a
company’s capital
structure?
Balance Sheet An equity capital structure
would have fewer liabilities
than stockholders’ equity. A
debt capital structure would
have a higher portion of
liabilities relative to
stockholders’ equity.
Question Accounting Information Analysis & Decision
Does the
company have
significant
obligations
related to
operating leases?
Disclosure of lease
commitments in the notes
to the financial
statements
Operating lease commitments
are not reported as liabilities on
the balance sheet, but are
disclosed in the notes to the
financial statements. They
need to be considered when
calculating important debt
ratios such as the debt to equity
ratio.
Question Accounting Information Analysis & Decision
Which company
has higher
leverage?
Debt to equity ratio Debt to equity is a measure of
financial leverage. Companies
with more debt will have a
higher debt to equity ratio and
higher leverage.
Question Accounting Information Analysis & Decision
How does
leverage affect a
company’s return
on equity?
Debt to equity ratio;
return on equity ratio
Leverage increases risk.
In good times, higher
leverage results in
higher return on equity.
In down times, higher
leverage results in lower
return on equity.
Question Accounting Information Analysis & Decision
Can a company
meet its interest
obligations?
Times interest earned
ratio
A high times interest earned
ratio indicates the ability to
meet its interest obligations.
Career Corner
Career Corner
Financing alternatives, capital structure, bonds, notes, and leases are topics covered in both
accounting and finance. How do you decide whether to major in accounting or finance? Some
students choose finance because they consider accounting more of a “desk job” and finance more
“people oriented.” This just isn’t true! Both accounting and finance positions require strong
communication skills. Some students choose finance because they consider it easier to obtain a
degree in finance than a degree in accounting. While there may be some truth to this, remember
Nike’s famous slogan, “No pain, no gain.” Accounting majors can apply for almost any
entry-level finance position, while finance majors do not have the accounting coursework to
apply for many entry-level accounting positions. The extra work for an accounting degree is
likely to pay additional dividends in the future.
Ethical Dilemma
Ethical Dilemma
On January 1, 2015, Dinaco Oil issued $50 million of 8% bonds maturing in 10 years. The
market interest rate on the issue date was 9%, which resulted in the bonds being issued at a
discount. In December 2016, Tex Winters, the company CFO, notes that over the past two years
since the bonds were issued, interest rates have fallen almost 3%. Tex suggests that Dinaco might
consider repurchasing the 8% bonds and reissuing new bonds at the lower current interest rates.
Another executive, Will Bright, asks, “Won’t the repurchase result in a large loss to our
financial statements?” Tex agrees with Will, indicating that Dinaco is likely to just meet earnings
targets for 2016. It would probably not meet them with a multimillion-dollar loss on bond
repurchase. However, 2017 looks to be a record-breaking year. They decide that maybe they
should wait until 2017 to repurchase the bonds.
How could the repurchase of debt cause a loss to be reported in net income? Explain how the
repurchase of debt might be timed to manage reported earnings. Is it ethical to time the
repurchase of bonds to help meet earnings targets?
Key issues
Is it ethical to time the repurchase of bonds to help meet earnings targets?
More broadly, when is it acceptable and when is it not acceptable to time accounting
practices to meet earnings targets?
Option 1: Repurchase the bonds and reissue new bonds at the lower interest rates in 2016
Interest rates have fallen almost 3% in 2016. Interest rates may go back up if they wait
until next year.
Besides, waiting until 2017 will prolong the cost to the company in the payment of higher
interest costs.
Management should be more concerned with real cash flow savings for the company than
meeting reported earnings targets.
Option 2: Wait until 2017 to repurchase the bonds
By waiting until 2017, the company can meet earnings targets in 2016. Missing an
earnings target is likely to result in Dinaco stock becoming less attractive to investors.
Since 2017 is expected to be a record-breaking year, Dinaco will be in a better position to
report the loss on repurchase of bonds in 2017.
Timing the repurchase of bonds is not in violation of generally accepted accounting
principles.