Accounting Fundamentals

Accounting FundamentalsAccounting Fundamentals

Dr. Yan XiongDr. Yan XiongDepartment of AccountancyDepartment of Accountancy

CSU SacramentoCSU SacramentoThe lecture notes are primarily based on Reimers The lecture notes are primarily based on Reimers

(2003).(2003). 7/11/037/11/03

Chapter 8: Financing with DebtChapter 8: Financing with Debt

AgendaAgenda Long-term Notes Payable and Long-term Notes Payable and

MortgageMortgage Time Value of MoneyTime Value of Money Bonds PayableBonds Payable

AgendaAgenda Long-term Notes Payable and Long-term Notes Payable and

MortgagesMortgages

Business BackgroundBusiness BackgroundCapital structure is the mix of debt and equity Capital structure is the mix of debt and equity

used to finance a company.used to finance a company.DEBT:LoansLoans from banks, insurance companies, or pension funds are often used when borrowing small amounts of capital.BondsBonds are debt securities issued when borrowing large amounts of money.

Can be issued by either corporations or governmental units.

Notes Payable and MortgagesNotes Payable and MortgagesWhen a company borrows money When a company borrows money

from the bank for longer than a year, from the bank for longer than a year, the obligation is called a long-term the obligation is called a long-term note payable.note payable.

A mortgage is a special kind of “note” A mortgage is a special kind of “note” payable--one issued for property.payable--one issued for property.

These obligations are frequently These obligations are frequently repaid in equal installments, part of repaid in equal installments, part of which are repayment of which are repayment of principalprincipal and and part of which are part of which are interestinterest..

Example: Borrowing To Buy Land Example: Borrowing To Buy Land By Using A MortgageBy Using A MortgageABC Co. signed a $100,000, 3 yr. mortgage ABC Co. signed a $100,000, 3 yr. mortgage

(for a piece of land) which carried an 8% (for a piece of land) which carried an 8% annual interest rate. Payments are to be annual interest rate. Payments are to be made annually on December 31 of each year made annually on December 31 of each year for $38,803.35.for $38,803.35.

How would the mortgage be recorded?How would the mortgage be recorded?What is the amount of the liability (What is the amount of the liability (mortgage mortgage

payablepayable) ) afterafter the first payment is made? the first payment is made?

Recording the MortgageRecording the Mortgage

How would the mortgage be recorded in How would the mortgage be recorded in the journal?the journal?

DateDate TransactionTransaction Debit DebitCreditCredit

Jan 1 Land 100,000

Mortgage payable 100,000

Example continued...Example continued...For Yr.1, the outstanding amount borrowed For Yr.1, the outstanding amount borrowed

is $100,000 (at 8%), so the interest is:is $100,000 (at 8%), so the interest is: $8,000$8,000

Payment is $38,803.35, so the amount that Payment is $38,803.35, so the amount that will reduce the principal is will reduce the principal is $30,803.35$30,803.35

New outstanding principal amount isNew outstanding principal amount is $100,000 - 30,803.35 = $100,000 - 30,803.35 = $69,196.65$69,196.65

Recording The First Payment On A Recording The First Payment On A MortgageMortgage

How would the payment on the mortgage How would the payment on the mortgage be recorded in the journal?be recorded in the journal?


Dec 31 Mortgage payable 30,803.35

Interest expense 8,000.00

Cash 38,803.35

Amortization ScheduleAmortization SchedulePrinciple Balance Payment Interest

Reduction in Principle

100,000.00 38,803.35 38,803.35 38,803.35

8,000.00 30,803.35

69,196.65 5,535.73* 33,267.62

*69,196.65 x .08

35,929.03 2,874.32**

= 2,874.32

35,929.03

**35,929.03 x .08

AgendaAgenda Time Value of MoneyTime Value of Money

Time Value of MoneyTime Value of Money

The example of the mortgage demonstrates The example of the mortgage demonstrates that money has value over time. that money has value over time.

When you borrow $100,000 and pay it back When you borrow $100,000 and pay it back over three years, you have to pay back MORE over three years, you have to pay back MORE than $100,000. than $100,000.

Your repayment includes interest--the cost of Your repayment includes interest--the cost of using someone else’s money.using someone else’s money.

A dollar received today is worth more than a A dollar received today is worth more than a dollar received in the future.dollar received in the future.

The sooner your money can earn interest, the The sooner your money can earn interest, the faster the interest can earn interest.faster the interest can earn interest.

Interest and Compound InterestInterest and Compound Interest InterestInterest is the return you receive for is the return you receive for

investing your money. You are actually investing your money. You are actually “lending” your money, so you are paid “lending” your money, so you are paid for letting someone else use your for letting someone else use your money.money.

Compound interestCompound interest -- is the interest that -- is the interest that your investment earns on the interest your investment earns on the interest that your investment previously earned.that your investment previously earned.

?

Future Value of a Future Value of a Single AmountSingle AmountHow much will today’s dollar be worth in How much will today’s dollar be worth in the future?the future?

TODAY FUTURE

If You Deposit $100 In An Account If You Deposit $100 In An Account Earning 6%, How Much Would You Have Earning 6%, How Much Would You Have In The Account After 1 Year?In The Account After 1 Year?

n:n:i% = 6i% = 6 PV = 100 PV = 100 N = 1 N = 1 FV = 100 * 1.06FV = 100 * 1.06

PV = PV = FV =FV =100 106

01

If You Deposit $100 In An Account If You Deposit $100 In An Account Earning 6%, How Much Would You Have Earning 6%, How Much Would You Have In The Account After In The Account After 5 Years5 Years??

Using a future value table Using a future value table

i% = 6i% = 6 PV = 100 PV = 100 n = 5 n = 5 FV = 100 * (FV = 100 * (factor from FV of $1factor from FV of $1

table, where n = 5) table, where n = 5)

00 5 5

PV PV = 100= 100 FV = FV =


n:n:i% = 6i% = 6 PV = 100 PV = 100 N = 1 N = 1 FV = 100 * 1.3382 FV = 100 * 1.3382

00 1 1

PV = PV = 100100 FV = FV =


n:n:i% = 6i% = 6 PV = 100 PV = 100 N = 1 N = 1 FV = 100 * (FV = 100 * (factor from FV of $1factor from FV of $1 table, where n = 5) table, where n = 5)

00 1 1

PV PV = = FV = FV = 133.82133.82 100

The previous example had a single payment. The previous example had a single payment. Sometimes there is a series of payments.Sometimes there is a series of payments.

Annuity: Annuity: a sequence of equal cash flows, a sequence of equal cash flows, occurring at the end of each period. occurring at the end of each period.

When the payments occur at the end of the When the payments occur at the end of the period, the annuity is also known as an period, the annuity is also known as an ordinary ordinary annuityannuity..

When the payments occur at the beginning of When the payments occur at the beginning of the period, the annuity is called an the period, the annuity is called an annuity dueannuity due..

The Value of a Series of PaymentsThe Value of a Series of Payments

What An Annuity Looks LikeWhat An Annuity Looks Like

0 1 2 3 4

If you borrow money to buy a house If you borrow money to buy a house or a car, you will pay a stream of or a car, you will pay a stream of equal payments.equal payments.

That’s an annuity.That’s an annuity.

ExampleExample

If you invest $1,000 at the end of the next If you invest $1,000 at the end of the next 3 years, at 8%, how much would you have 3 years, at 8%, how much would you have after 3 years?after 3 years?

0 1 2 3

n = 3 i = 8% Pmt. = 1,000

1,0001,000 1,0001,000 1,0001,000

Future Value of an AnnuityFuture Value of an Annuity

If you invest $1,000 at the end of the next 3 If you invest $1,000 at the end of the next 3 years, at 8%, how much would you have years, at 8%, how much would you have after 3 years?after 3 years?

0 1 2 3FVA = 1,000 * [value from FVA table, 3yrs. 8%]

FVA = 1,000 * 3.2464 = $3,246.40

1,0001,000 1,0001,000 1,0001,000

Future Value of an AnnuityFuture Value of an Annuity

Future Value of an Ordinary Annuity Future Value of an Ordinary Annuity (Annuity in Arrears)(Annuity in Arrears)

In the previous example, notice that the In the previous example, notice that the last payment is deposited on the last day last payment is deposited on the last day of the last period. That means it doesn’t of the last period. That means it doesn’t have time to earn any interest! This type have time to earn any interest! This type of annuity is called an of annuity is called an ordinary annuityordinary annuity, or , or an an annuity in arrearsannuity in arrears..

Future Value of an Annuity DueFuture Value of an Annuity Due

Often, when the series of payments Often, when the series of payments applies to money saved, an applies to money saved, an annuity dueannuity due is is a better description of what happens.a better description of what happens.

Suppose you decide to save $1,000 each Suppose you decide to save $1,000 each year for three years, starting TODAY!year for three years, starting TODAY!

Future Value of an Annuity DueFuture Value of an Annuity DueIf you invest $1,000 at the If you invest $1,000 at the beginningbeginning of each of each of the next 3 years, at 8%, how much would of the next 3 years, at 8%, how much would you have after 3 years?you have after 3 years?

0 1 2 3FVA = 1,000 * [value from FVADue table, 3yrs. 8%]

FVA = 1,000 * 3.50611 = $3,506.11

1,0001,000 1,0001,0001,0001,000

Today

Futurevalue

How much is $1 received in the future How much is $1 received in the future worth today?worth today? (COMPOUNDING)(COMPOUNDING)

Figuring out how much a future amount is Figuring out how much a future amount is worth TODAY is called DISCOUNTING the worth TODAY is called DISCOUNTING the cash flow.cash flow.

Present Value of a Single AmountPresent Value of a Single Amount

?TODAY FUTURE

ioioi% = 6% i% = 6% N = 1 N = 1 FV = 100 FV = 100 PV = PV = ????

00 1 1

PV = PV = FV = 100 FV = 100

If you will receive $100 one year from now, If you will receive $100 one year from now, what is the PV of that $100 if the relevant what is the PV of that $100 if the relevant interest rate is 6%?interest rate is 6%?

PV (1 + 0.06) = 100 (which is the FV)PV (1 + 0.06) = 100 (which is the FV)PV = 100 / (1.06)PV = 100 / (1.06)1 1 = = $94.34$94.34ORORPV = FV (PV factor PV = FV (PV factor i, ni, n ) )PV = 100 (0.9434 ) (from PV of $1 table)PV = 100 (0.9434 ) (from PV of $1 table)PV = $94.34PV = $94.34

00 1 1PV = PV = 94.94.3434 FV = 100 FV = 100

If you will receive $100 one year from now, If you will receive $100 one year from now, what is the PV of that $100 if the relevant what is the PV of that $100 if the relevant interest rate is 6%?interest rate is 6%?

The previous example had a single payment. The previous example had a single payment. Sometimes there is a series of payments.Sometimes there is a series of payments.

Annuity: Annuity: a sequence of equal cash flows, a sequence of equal cash flows, occurring at the end of each period. occurring at the end of each period.

When the payments occur at the end of the When the payments occur at the end of the period, the annuity is also known as an period, the annuity is also known as an ordinary ordinary annuityannuity..

The Value of a Series of PaymentsThe Value of a Series of Payments

Finding the present value of a series of Finding the present value of a series of cash flows is called cash flows is called discounting the cash discounting the cash flowsflows..

What is the series of future payments worth What is the series of future payments worth todaytoday??

0 1 2 3 4

Present Value of an AnnuityPresent Value of an Annuity

i% = 8i% = 8 N = 3N = 3 PMT = 1,000 PV = PMT = 1,000 PV = ????

0 1 2 3

10001000 10001000 1000 1000

What is the PV of $1,000 at the end of What is the PV of $1,000 at the end of each of the next 3 years, if the interest each of the next 3 years, if the interest rate is 8%?rate is 8%?

PVPVAA = 1,000 = 1,000 (3 yrs., 8% factor from the PVA table)(3 yrs., 8% factor from the PVA table)

PVPVAA = 1,000 * (2.5771) = 1,000 * (2.5771)PVPVAA = $2,577.10 = $2,577.10

0 1 2 3

10001000 10001000 1000 1000

What is the PV of $1,000 at the end of each of What is the PV of $1,000 at the end of each of the next 3 years, if the interest rate is 8%?the next 3 years, if the interest rate is 8%?

PresentValue

AgendaAgenda

Bonds PayableBonds Payable

Characteristics of Bonds PayableCharacteristics of Bonds Payable

Bonds usually involve the borrowing of Bonds usually involve the borrowing of a large sum of money, called a large sum of money, called principalprincipal..

The principal is usually paid back as a The principal is usually paid back as a lump sumlump sum at the end of the bond period. at the end of the bond period.

Individual bonds are often denominated Individual bonds are often denominated with a with a par valuepar value, or , or face valueface value, of $1,000., of $1,000.

Bonds usually carry a Bonds usually carry a stated rate of stated rate of interestinterest..

Interest is normally paid semiannually.Interest is normally paid semiannually.Interest is computed as:Interest is computed as:

Interest = Principal × Stated Rate × Time Interest = Principal × Stated Rate × Time

Characteristics of Bonds PayableCharacteristics of Bonds Payable

Measuring Bonds Payable and Interest ExpenseMeasuring Bonds Payable and Interest Expense

The selling price of the bond is determined by The selling price of the bond is determined by the market based on the time value of money.the market based on the time value of money.

dates of interest payments

. . . principal payment

Today Future

Who Would Buy My Bond?Who Would Buy My Bond?$1,000, 6% stated rate.$1,000, 6% stated rate.The market rate of interest is 8%.The market rate of interest is 8%.Who would buy my bond?Who would buy my bond?Nobody---so I’ll have to sell (issue) it at a Nobody---so I’ll have to sell (issue) it at a discount.discount.e.g., bondholders would give me something less for the bond.e.g., bondholders would give me something less for the bond.

Who Would Buy My Bond?Who Would Buy My Bond?$1,000, 6% stated rate.$1,000, 6% stated rate.The market rate of interest is 4%.The market rate of interest is 4%.Who would buy these bonds?Who would buy these bonds?EVERYONE! EVERYONE! So the market will bid up the price of the So the market will bid up the price of the

bond; e.g., I’ll get a littlebond; e.g., I’ll get a little premiumpremium for it since for it since it has such good cash flows.it has such good cash flows.

Bondholders will pay more than the face.Bondholders will pay more than the face.

Determining the Selling PriceDetermining the Selling PriceBonds sell at:Bonds sell at:

““Par” (100% of face value)Par” (100% of face value) less than par (discount)less than par (discount) more than par (premium)more than par (premium)

Market rate of interest vs. bond’s stated rate of interest determines the selling price (market price of the bond)Market rate of interest vs. bond’s stated rate of interest determines the selling price (market price of the bond)Therefore, ifTherefore, if

market % > stated %: market % > stated %: DiscountDiscount market % < stated %: market % < stated %: PremiumPremium

The time value of money...The time value of money...Selling price of a bond = Selling price of a bond = present valuepresent value of future of future cash flows promised by the cash flows promised by the bonds, discounted using bonds, discounted using the market rate of interestthe market rate of interest

Finding The Proceeds Of A Bond IssueFinding The Proceeds Of A Bond Issue

To calculate the issue price of a bond, you To calculate the issue price of a bond, you must find the present value of the cash must find the present value of the cash flows associated with the bond.flows associated with the bond.

First, find the present value of the interest First, find the present value of the interest payments using the market rate of payments using the market rate of interest. Do this by finding the PV of an interest. Do this by finding the PV of an annuity.annuity.

Then, find the present value of the Then, find the present value of the principal payment at the end of the life of principal payment at the end of the life of the bonds. Do this by finding the PV of a the bonds. Do this by finding the PV of a single amount.single amount.

Selling Bonds -- ExampleSelling Bonds -- ExampleOn May 1, 1991, Clock Corp. sells $1,000,000 in On May 1, 1991, Clock Corp. sells $1,000,000 in bonds having a stated rate of 6% annually. The bonds having a stated rate of 6% annually. The bonds mature in 10 years, and interest is paid bonds mature in 10 years, and interest is paid semiannually. The market rate is 8% annually.semiannually. The market rate is 8% annually.

Determine the proceeds Determine the proceeds from this bond issue.from this bond issue.

First, what are the cash flows First, what are the cash flows associated with this bond?associated with this bond?

Interest payments of $60,000 (that’s 6% Interest payments of $60,000 (that’s 6% of the $1 million face value) each year of the $1 million face value) each year for 10 years.for 10 years.

ANDAND A lump sum payment of $1,000,000 (the A lump sum payment of $1,000,000 (the

face amount of the bonds) in 10 years.face amount of the bonds) in 10 years.

The PV of the future cash flows = The PV of the future cash flows = issue price of the bondsissue price of the bonds

The present value of these cash flows The present value of these cash flows will be the issue price of the bonds.will be the issue price of the bonds.

That is the amount of cash the That is the amount of cash the bondholders are willing to give TODAY bondholders are willing to give TODAY to receive these cash flows in the future.to receive these cash flows in the future.

Two parts to the cash flows:Two parts to the cash flows:INTEREST PAYMENTSINTEREST PAYMENTSPV of an ordinary annuity of PV of an ordinary annuity of $60,000 for 10 periods at an $60,000 for 10 periods at an interest rate of 8%:interest rate of 8%:Use a calculator or a PV of Use a calculator or a PV of an annuity table:an annuity table:

60,000 (PV60,000 (PVA,A,,,8%, 108%, 10)=)=60,000 (6.7101) =60,000 (6.7101) = 402,606402,606

PRINCIPAL PAYMENTPRINCIPAL PAYMENTPV of a single amount of $1 PV of a single amount of $1 million ten years in the million ten years in the future at 8%:future at 8%:Use a calculator or a PV of Use a calculator or a PV of a single amount table:a single amount table:

1,000,000 (PV,1,000,000 (PV,,,8%, 10) 8%, 10) ==1,000,000 (.46319)=1,000,000 (.46319)=463,190463,190

Selling Bonds -- ExampleSelling Bonds -- ExampleThe sum of the PV of the two cash flows is The sum of the PV of the two cash flows is

$865,796. $865,796. The bonds would be described as one that The bonds would be described as one that

sold for “sold for “8787.” We’ll round to a whole number .” We’ll round to a whole number just to make the example easier to follow.just to make the example easier to follow.

What does that mean?What does that mean?It means the bonds sold for 87% of their par or It means the bonds sold for 87% of their par or face value. face value.

Selling Bonds -- ExampleSelling Bonds -- Example

If the bonds sold for 87% of their face If the bonds sold for 87% of their face value, the proceeds would be value, the proceeds would be approximately $870,000 (rounded) for approximately $870,000 (rounded) for $1,000,000-face bonds.$1,000,000-face bonds.

Recording Bonds Sold at a DiscountRecording Bonds Sold at a Discount

The balance sheet would show the The balance sheet would show the bonds at their face amount minus any bonds at their face amount minus any discount.discount.

The discount on bonds payable is called The discount on bonds payable is called a contra-liability, because it is deducted a contra-liability, because it is deducted from the liability.from the liability.

Cash would be recorded for the Cash would be recorded for the difference, that is, the proceeds.difference, that is, the proceeds.

Recording Bonds Sold at a DiscountRecording Bonds Sold at a Discount

How would the issuance of the bonds at a How would the issuance of the bonds at a discount be recorded in the journal?discount be recorded in the journal?


May 1 Cash 870,000

Discount on bond payable 130,000

Bonds payable 1,000,000

Selling Bonds -- ExampleSelling Bonds -- Example

On May 1, 1991, Magic Inc. sells $1,000,000 On May 1, 1991, Magic Inc. sells $1,000,000 in bonds having a stated rate of 9%in bonds having a stated rate of 9% annually. The bonds mature in 10 years annually. The bonds mature in 10 years and interest is paid semiannually. The and interest is paid semiannually. The market rate is 8% annually.market rate is 8% annually.

Determine the issue price of these Determine the issue price of these bonds.bonds.

Selling Bonds -- ExampleSelling Bonds -- ExampleTo figure out the proceeds from the sale, you either have to To figure out the proceeds from the sale, you either have to calculate the present value of the cash flows (using the market calculate the present value of the cash flows (using the market rate of interest)rate of interest)

ORORBe told that the bonds sold at X, a percentage of par (e.g., 104).Be told that the bonds sold at X, a percentage of par (e.g., 104).

First, what are the cash flows First, what are the cash flows associated with this bond?associated with this bond?

Interest payments of $90,000 (that’s 9% Interest payments of $90,000 (that’s 9% of the $1 million face value) each year of the $1 million face value) each year for 10 years.for 10 years.

ANDAND A lump sum payment of $1,000,000 (the A lump sum payment of $1,000,000 (the

face amount of the bonds) in 10 years.face amount of the bonds) in 10 years.

The PV of the future cash flows = The PV of the future cash flows = issue price of the bondsissue price of the bonds

The present value of these cash flows The present value of these cash flows will be the issue price of the bonds.will be the issue price of the bonds.

That is the amount of cash the That is the amount of cash the bondholders are willing to give TODAY bondholders are willing to give TODAY to receive these cash flows in the future.to receive these cash flows in the future.

Two Parts To The Cash FlowsTwo Parts To The Cash Flows

INTEREST PAYMENTSINTEREST PAYMENTSPV of an ordinary annuity of PV of an ordinary annuity of $90,000 for 10 periods at an $90,000 for 10 periods at an interest rate of 8%:interest rate of 8%:Use a calculator or a PV of Use a calculator or a PV of an annuity table:an annuity table:

90,000 (PV90,000 (PVA,,A,,8%, 108%, 10)=)=90,000 (6.7101) =90,000 (6.7101) =$ 603,909$ 603,909

PRINCIPAL PAYMENTPRINCIPAL PAYMENTPV of a single amount of $1 PV of a single amount of $1 million ten years in the million ten years in the future at 8%:future at 8%:Use a calculator or a PV of Use a calculator or a PV of a single amount table:a single amount table:

1,000,000 (PV,1,000,000 (PV,,,8%, 10) 8%, 10) ==1,000,000 (.46319) =1,000,000 (.46319) = $ 463,190$ 463,190

Bonds Issued At A PremiumBonds Issued At A Premium The total PV of the two cash flows is The total PV of the two cash flows is

$1,067,099. This is more than the face, so $1,067,099. This is more than the face, so these bonds are being issued at a premium.these bonds are being issued at a premium.

Again, we’ll round the number to make the Again, we’ll round the number to make the example easier to follow. Let’s say these example easier to follow. Let’s say these bonds were issued at 107, or 107% of par.bonds were issued at 107, or 107% of par.

That would make the proceeds $1,070,000 That would make the proceeds $1,070,000 (rounded).(rounded).

Recording Bonds Sold at a Recording Bonds Sold at a PremiumPremium

How would the issuance of the bonds at a How would the issuance of the bonds at a premium be recorded in the journal?premium be recorded in the journal?


May 1 Cash 1,070,000

Premium on bond payable 70,000

Bonds payable 1,000,000

Measuring and Recording Interest on Measuring and Recording Interest on Bonds Issued at a DiscountBonds Issued at a DiscountThe discount must be The discount must be amortizedamortized over over

the outstanding life of the bonds.the outstanding life of the bonds.The discount amortization increases the The discount amortization increases the

periodic periodic interest expenseinterest expense for the issuer. for the issuer.Two methods are commonly used:Two methods are commonly used:

Effective-interest amortizationEffective-interest amortization Straight-line amortizationStraight-line amortization

Clock corp. Sold their bonds on May 1, 1991 Clock corp. Sold their bonds on May 1, 1991 at 87. The bonds have a 10-year maturity at 87. The bonds have a 10-year maturity and $30,000 interest is paid semiannually.and $30,000 interest is paid semiannually.

Why would the bonds sell for Why would the bonds sell for 8787?? The market rate of interest was The market rate of interest was

greatergreater than the rate on the face on than the rate on the face on the date of issue.the date of issue.

So clock corp. Had to offer the bonds at a So clock corp. Had to offer the bonds at a “discount” to get buyers.“discount” to get buyers.

Recall the Facts of the ProblemRecall the Facts of the Problem

Clock Corp. sold their bonds on May 1, 1991 Clock Corp. sold their bonds on May 1, 1991 at 87. The bonds have a 10-year maturity and at 87. The bonds have a 10-year maturity and $30,000 interest is paid semiannually.$30,000 interest is paid semiannually.

Where did the Where did the $30,000$30,000 come from? come from? 1,000,000 x .06 x 1/2 1,000,000 x .06 x 1/2 The interest payments are always The interest payments are always

calculated by the terms and calculated by the terms and amounts stated on the face of the amounts stated on the face of the bonds.bonds.

Problem, ContinuedProblem, Continued

Effective Interest Method For Effective Interest Method For Amortizing A Bond DiscountAmortizing A Bond Discount

If we prepared a balance sheet on the date If we prepared a balance sheet on the date of issue, the bond would be reported of issue, the bond would be reported like this:like this:

Bonds PayableBonds Payable $ 1,000,000 $ 1,000,000 less Discount on B/P (130,000)less Discount on B/P (130,000) Net Bonds PayableNet Bonds Payable 870,000 870,000


The discount is a contra-liability (and is The discount is a contra-liability (and is deducted from the face value of the bond to deducted from the face value of the bond to give the “book value.”)give the “book value.”)

In order to get the book value to equal the In order to get the book value to equal the face value at maturity, we’ll have to get rid of face value at maturity, we’ll have to get rid of the balance in the discount account.the balance in the discount account.

Each time we pay interest to our Each time we pay interest to our bondholders, we’ll amortize a little of the bondholders, we’ll amortize a little of the discount.discount.


Each time we pay interest to our bondholders, we’ll Each time we pay interest to our bondholders, we’ll amortize a little of the discount--how much?amortize a little of the discount--how much?

On the first interest date, the amount we’ve actually On the first interest date, the amount we’ve actually “borrowed” from the bondholders is $870,000. “borrowed” from the bondholders is $870,000.

The market rate at the time we borrowed--the rate The market rate at the time we borrowed--the rate we we hadhad to pay to get the bondholders to buy our to pay to get the bondholders to buy our bonds--was 8%.bonds--was 8%.

870,000 x .08 x 1/2 = 870,000 x .08 x 1/2 = 34,800 (This will be the interest 34,800 (This will be the interest expense for the first 6 months.)expense for the first 6 months.)

Effective Interest Amortization of Effective Interest Amortization of Bond DiscountBond Discount

We know the cash payment to the We know the cash payment to the bondholders is $30,000:bondholders is $30,000:

1,000,000 x .06 x 1/21,000,000 x .06 x 1/2 par value interest 6-month par value interest 6-month

periodperiodraterate


The difference between the interest The difference between the interest expense of $34,800 and the cash payment expense of $34,800 and the cash payment to the bondholders of $30,000 is the to the bondholders of $30,000 is the amount of discount amortization.amount of discount amortization.

$34,800$34,800- 30,000- 30,000 $ 4,800 This amount will be deducted$ 4,800 This amount will be deducted from the discount.from the discount.

Recording the First Interest Payment Recording the First Interest Payment on Bonds Sold at a Discounton Bonds Sold at a Discount

How would the first interest payment be How would the first interest payment be recorded in the journal?recorded in the journal?


Nov 1 Interest expense 34,800


Cash 30,000

Next Time --Next Time -- When we calculate the amount of When we calculate the amount of

interest expense for the second interest interest expense for the second interest payment, our principal balance has payment, our principal balance has changed.changed.

Instead of 870,000, we now have a Instead of 870,000, we now have a principal balance of principal balance of 874,800874,800. Why?. Why?

874,800 x .08 x 1/2 = $34,992874,800 x .08 x 1/2 = $34,992 This is the interest expense for the This is the interest expense for the

second six-month period.second six-month period.


interest expenseinterest expense $34,992$34,992 cash paymentcash payment 30,00030,000

discount amortizationdiscount amortization 4,992 4,992

After this payment, the new book value of the bonds will be 874,800 + 4,992 = $879,792.

Recording the Second Interest Payment on Recording the Second Interest Payment on Bonds Sold at a DiscountBonds Sold at a Discount

How would the second interest payment be How would the second interest payment be recorded in the journal?recorded in the journal?


May 1 Interest expense 34,992


Cash 30,000


Carrying value of bonds is defined as the par Carrying value of bonds is defined as the par or face value of the bonds minus any or face value of the bonds minus any unamortized discount (or plus any unamortized discount (or plus any unamortized premium).unamortized premium).

In this example, the discount has now been In this example, the discount has now been reduced from 130,000 to 120,208. The reduced from 130,000 to 120,208. The carrying value of the bonds is the face carrying value of the bonds is the face ($1,000,000) minus the unamortized discount ($1,000,000) minus the unamortized discount ($120,208) = $879,792.($120,208) = $879,792.

The book value of the bonds is increasing.The book value of the bonds is increasing.

What’s Happening?What’s Happening? Each time we pay the bondholders $30,000, Each time we pay the bondholders $30,000,

we are we are notnot paying the full amount of the true paying the full amount of the true interest expense for the $870,000 loan.interest expense for the $870,000 loan.

The amount we The amount we don’tdon’t pay gets added to the pay gets added to the carrying value of the bond. (Reducing the carrying value of the bond. (Reducing the discount increases the carrying value of the discount increases the carrying value of the bond.)bond.)

So, the bond’s carrying value is increasing So, the bond’s carrying value is increasing from $870,000 to the face value of $1,000,000 from $870,000 to the face value of $1,000,000 over the life of the bond.over the life of the bond.

Straight-Line Amortization of Bond Straight-Line Amortization of Bond DiscountDiscountThe other method is not as accurate, but the The other method is not as accurate, but the

calculations are easier.calculations are easier. Identify the amount of the bond discount.Identify the amount of the bond discount.Divide the bond discount by the number of Divide the bond discount by the number of

interest periods.interest periods. Include the discount amortization amount as Include the discount amortization amount as

part of the periodic interest expense entry.part of the periodic interest expense entry.The discount will be reduced to zero by the The discount will be reduced to zero by the

maturity date.maturity date.

Here’s a review of the facts of the problem:Here’s a review of the facts of the problem: Clock Corp. sold their bonds on May 1, 1991 at 87. Clock Corp. sold their bonds on May 1, 1991 at 87.

The bonds have a 10-year maturity and $30,000 The bonds have a 10-year maturity and $30,000 interest is paid semiannually.interest is paid semiannually.

Why would the bonds sell for Why would the bonds sell for 8787?? The market rate of interest is The market rate of interest is greatergreater than the rate than the rate

on the face.on the face. Where did the Where did the $30,000$30,000 come from? come from?

1,000,000 x .06 x 1/2 1,000,000 x .06 x 1/2

Straight-Line Amortization of Bond Straight-Line Amortization of Bond DiscountDiscount

The discount of $130,000 is divided by 20. The discount of $130,000 is divided by 20. (10-year bonds with interest paid twice each year)(10-year bonds with interest paid twice each year)

$6,500 will be amortized from the discount $6,500 will be amortized from the discount every time the interest payment is made.every time the interest payment is made.

So, interest expense will be $36,500 every So, interest expense will be $36,500 every time the $30,000 payment is made.time the $30,000 payment is made.

Straight-Line Amortization of Straight-Line Amortization of Bond DiscountBond Discount

Straight-Line Amortization of Straight-Line Amortization of Bond DiscountBond Discount

How would the interest payments be How would the interest payments be recorded in the journal?recorded in the journal?


All Interest expense 36,500


Cash 30,000

Measuring and Recording Interest on Measuring and Recording Interest on Bonds Issued at a PremiumBonds Issued at a Premium

The premium must be The premium must be amortizedamortized over the over the term of the bonds.term of the bonds.

The premium amortization decreases the The premium amortization decreases the periodic periodic interest expenseinterest expense for the issuer. for the issuer.

Two methods are commonly used:Two methods are commonly used: Effective-interest amortizationEffective-interest amortization Straight-line amortizationStraight-line amortization

Magic Inc. sold their bonds on May 1, 1991 at Magic Inc. sold their bonds on May 1, 1991 at 107. There were $1,000,000 worth of bonds 107. There were $1,000,000 worth of bonds with a stated rate of 9%with a stated rate of 9% annually. The bonds annually. The bonds mature in 10 years and $45,000 interest is paid mature in 10 years and $45,000 interest is paid semiannually. The market rate is 8% annually.semiannually. The market rate is 8% annually.

Why would the bonds sell for Why would the bonds sell for 107107?? The market rate of interest is The market rate of interest is lessless than than

the rate on the face.the rate on the face. Where did the Where did the $45,000$45,000 come from? come from?

$1,000,000 x 9% x 1/2 = 45,000$1,000,000 x 9% x 1/2 = 45,000

Recall the Facts of the ProblemRecall the Facts of the Problem

Effective Interest Method For Effective Interest Method For Amortizing A Bond PremiumAmortizing A Bond Premium

If we prepared a balance sheet on the date of If we prepared a balance sheet on the date of issue, the bond would be reported like this:issue, the bond would be reported like this:

Bonds PayableBonds Payable $ 1,000,000 $ 1,000,000 plus Premium on B/P 70,000plus Premium on B/P 70,000

Net Bonds PayableNet Bonds Payable $1,070,000 $1,070,000


The premium carries a credit balance (and is The premium carries a credit balance (and is added to the face value of the bond to give added to the face value of the bond to give the “book value.”)the “book value.”)

In order to get the book value to equal the In order to get the book value to equal the face value at maturity, we’ll have to get rid of face value at maturity, we’ll have to get rid of the balance in the premium account.the balance in the premium account.

Each time we pay interest to our Each time we pay interest to our bondholders, we’ll amortize a little of the bondholders, we’ll amortize a little of the premium.premium.


Each time we pay interest to our bondholders, we’ll Each time we pay interest to our bondholders, we’ll amortize a little of the premium--how much?amortize a little of the premium--how much?

On the first interest date, the amount we’ve actually On the first interest date, the amount we’ve actually “borrowed” from the bondholders is $1,070,000. “borrowed” from the bondholders is $1,070,000.

The market rate at the time we borrowed--the rate The market rate at the time we borrowed--the rate we we hadhad to pay to get the bondholders to buy our to pay to get the bondholders to buy our bonds--was 8%. The face rate is 9%bonds--was 8%. The face rate is 9%

1,070,000 x .08 x 1/21,070,000 x .08 x 1/2 = = 42,800 (This will be the interest 42,800 (This will be the interest expense for the first 6 months.)expense for the first 6 months.)

If we pay the bondholders $45,000 cash If we pay the bondholders $45,000 cash and the interest expense is $42,800*, the and the interest expense is $42,800*, the difference will be the amount of the difference will be the amount of the premium amortization. premium amortization.

Notice that the interest expense is LESS Notice that the interest expense is LESS than the payment to the bondholders when than the payment to the bondholders when bonds are issued at a premium. (It is just bonds are issued at a premium. (It is just the opposite when bonds are issued at a the opposite when bonds are issued at a discount.)discount.)

*1,070,000 x .08 x 1/2=42,800*1,070,000 x .08 x 1/2=42,800


Recording the First Interest Payment Recording the First Interest Payment on Bonds Sold at a Premiumon Bonds Sold at a Premium



Nov 1 Interest expense 42,800


Cash 45,000

Next Time --Next Time -- When we calculate the amount of interest When we calculate the amount of interest

expense for the second interest payment, our expense for the second interest payment, our principal balance has changed.principal balance has changed.

Instead of 1,070,000, we now have a principal Instead of 1,070,000, we now have a principal balance of 1,067,800. Why?balance of 1,067,800. Why?

Because we amortized $2,200 of the premium. Because we amortized $2,200 of the premium. Now it’s only $67,800.Now it’s only $67,800.

1,067,800 x .08 x 1/2 = $42,712 1,067,800 x .08 x 1/2 = $42,712 This is the interest expense for the second six-This is the interest expense for the second six-

month period.month period.

The payment to the bondholders is the same The payment to the bondholders is the same each time a payment is made-- $45,000.each time a payment is made-- $45,000.

Interest expense for the second payment is Interest expense for the second payment is $42,712$42,712

The difference between the payment and the The difference between the payment and the expense is the amount of amortization of the expense is the amount of amortization of the premium--$2,288.premium--$2,288.

The new carrying value is $1,067,800 - 2,288 The new carrying value is $1,067,800 - 2,288 = $1,065,512.= $1,065,512.


Recording the Second Interest Recording the Second Interest Payment on Bonds Sold at a PremiumPayment on Bonds Sold at a Premium



May 1 Interest expense 42,712


Cash 45,000

Carrying value is defined as the face value plus Carrying value is defined as the face value plus any unamortized premium.any unamortized premium.

In this case, the premium started at 70,000 and In this case, the premium started at 70,000 and has been reduced by 2,200 and by 2,288, for a has been reduced by 2,200 and by 2,288, for a balance of 65,512.balance of 65,512.

The face of $1,000,000 plus the unamortized The face of $1,000,000 plus the unamortized premium of 65,512 gives a carrying value of premium of 65,512 gives a carrying value of $1,065,512 after the second interest payment.$1,065,512 after the second interest payment.


What’s Happening?What’s Happening? Each time we pay the bondholders $45,000, we are Each time we pay the bondholders $45,000, we are

paying the full amount of the true interest expense paying the full amount of the true interest expense for the $1,070,000 loan, plus some of the principal.for the $1,070,000 loan, plus some of the principal.

The amount we pay in excess of the interest The amount we pay in excess of the interest expense gets deducted from the carrying value of expense gets deducted from the carrying value of the bond. (Reducing the premium decreases the the bond. (Reducing the premium decreases the carrying value of the bond.)carrying value of the bond.)

So, the bond’s carrying value is decreasing from So, the bond’s carrying value is decreasing from $1,070,000 to the face value of $1,000,000 over the $1,070,000 to the face value of $1,000,000 over the life of the bond.life of the bond.

Straight-Line Amortization of Bond Straight-Line Amortization of Bond PremiumPremium

Identify the amount of the bond premium.Identify the amount of the bond premium.Divide the bond premium by the number of interest periods.Divide the bond premium by the number of interest periods. Include the premium amortization amount as part of the Include the premium amortization amount as part of the

periodic interest expense entry.periodic interest expense entry.The premium will be reduced to zero by the maturity date.The premium will be reduced to zero by the maturity date.

Straight-Line Amortization of Straight-Line Amortization of Bond PremiumBond PremiumInterest payment is always $45,000.Interest payment is always $45,000.

Premium amortization is Premium amortization is 70,00070,000 = 3,500. = 3,500. 20 20

That means that the premium will be amortized That means that the premium will be amortized by 3,500 every time a payment is made.by 3,500 every time a payment is made.

Interest expense will be $41,500 each time a Interest expense will be $41,500 each time a payment is made.payment is made.

Straight-Line Amortization of Bond Straight-Line Amortization of Bond PremiumPremium

How would the interest payments be How would the interest payments be recorded in the journal?recorded in the journal?


All Interest expense 41,500


Cash 45,000

Carrying Value Of BONDS Carrying Value Of BONDS PAYABLEPAYABLE

While the specific long-term While the specific long-term liability liability Bonds PayableBonds Payable is is always recorded (and kept) at always recorded (and kept) at face value, the face value, the DiscountDiscount or or PremiumPremium ( (on Bonds Payableon Bonds Payable)) will be either subtracted will be either subtracted (discount) or added (premium) (discount) or added (premium) to the BP amount to get the to the BP amount to get the carrying valuecarrying value of the bond at of the bond at any given date.any given date.

Understanding Notes to Understanding Notes to Financial StatementsFinancial StatementsEffective-interest method of amortization is preferred by GAAP.Effective-interest method of amortization is preferred by GAAP.Straight-line amortization may be used if it is not materially Straight-line amortization may be used if it is not materially

different from effective interest amortization.different from effective interest amortization.Most companies do not disclose the method used for bond Most companies do not disclose the method used for bond

interest amortization.interest amortization.

Financial AnalysisFinancial Analysis

The The debt-equity ratiodebt-equity ratio is an important measure of the state of a is an important measure of the state of a company’s capital structure.company’s capital structure.

When a company’s debt-equity ratio is excessive, a large amount of When a company’s debt-equity ratio is excessive, a large amount of fixed debt payments may cause problems in fixed debt payments may cause problems in tight cash flowtight cash flow periods. periods.

Debt-Equity Ratio = Total Debt ÷ Total Equity

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Accounting Fundamentals