Financial Accounting - Long-term Liabilities - Bonds

- [Instructor] Okay,
let's spend a few minutes

talking about bonds.

So when a company needs money,

there's a few things they can do.

They could issue stock,

they can go to the bank and get a loan,

they can issue bonds, which
is another type of loan.

Now, the difference or
their primary reason

why a bond is more attractive
than say a stock issuance,

is because the interest
that companies pay on bonds,

and/or on a loan is tax deductible.

Now the dividends that they pay

back to stockholders
are not tax deductible.

So, there's a big benefit
for companies to issue bonds.

In addition, then they're not diluting

their stockholders' equity,

and increasing that as well
if they do a stock issuance.

So, a bond might be
preferable to say a bank loan,

because sometimes they can do
them for a lot longer terms,

and they may be able to get
a preferable interest rate

or a better interest
rate issuing the bond.

So, I have an example here.

It's hard to find them anymore

because they're primarily
electronically issued,

but you will see who the
issuer of the bonds are,

it will give you the maturity.

This was due May 1st, 2008,

and interestingly enough,
if you can see it,

it was issued back in 1909.

So, when I say a lot
longer than a bank loan,

truly, this was a hundred year bond

that was issued way back in the 1900s,

and you can see it paid 11.875% interest.

So, that's quite a good interest rate.

You won't find anything
comparable to that these days.

Now the problem with a hundred year bond,

is there's a considerable
risk involved as well.

A lot of opportunity for the
company to go out of business.

So those are some of the things
that you'll find on here.

Also, the par value.

So the face value of the loan was $5,000.

So if you bought one
of these back in 1909,

it would've been for $5,000,

and for every year,

you would've been paid 11.875%
interest on your money.

So, that would've been a
pretty good deal back then.

Alright, so bonds get a little bit tricky,

and I'll tell you why.

Because when the board meets
and decides to issue the bonds,

and at what rate they're gonna issue them,

and the point at which they
might actually be issued,

there's a time lag there.

So, even though the market
say was paying 10% interest,

once it actually gets issued,

the market might be paying
a different interest level.

So that's either gonna make
our bond more attractive

in the marketplace or less attractive.

So, let's say our bond
is paying 10% interest.

If the market is paying 8% interest,

which one would you rather own,

our bond at 10% interest
or the market at 8%?

I'm assuming you'll say our bond,

since it's paying a higher interest rate,

and so, our bond will sell at a premium.

People are willing to
pay more for our bond,

because it's gonna pay
them a higher interest rate

than what the market would pay.

If market and our bond are the same,

it will be issued at par value,

at that face value like
our previous bond, $5,000.

Now, if the market's paying
12% interest on average,

and ours is only paying
10, that's a problem.

Nobody's gonna wanna buy our bond,

so we have to discount it.

We actually have to,
kind of, put it on sale,

to get people to buy it,

because they can go elsewhere
and get 12% interest.

So, that kind of complicates
the accounting for bonds here,

just ever so slightly.

So, let's look at an example of a bond

that's issued a par value.

This is Matrix, Inc.,

and they issued a $1,500,000

par value bonds,

which happened to be 1500 bonds

at a thousand dollars face value.

Stated rate and market rate are the same.

So, that means our bond will
be issued at face value.

Bonds typically pay interest twice a year.

So, the interest rate
that you see stated here,

we will have to divide by two

when we go to do our interest
payment every six months.

Bond's dated January 1st, 2010,

and it matures in five years,

so there's your maturity date.

So upon issuance, when we issue the bond,

we will receive cash,

for, in this case, 1,500,000

and we'll credit our
long-term liability here,

bonds payable for 1,500,000.

So, the way the bond will work is,

we will pay interest every six months,

and then upon maturity,

we will repay that $1,500,

or the face value of that bond,

to the people who purchased our bond.

So, you can see here cash goes up

and our liabilities also
go up upon bond issuance.

And as I said,

that particular bond market
and the stated rate were equal.

So, it was issued at
what's called par value

or face amount.

Let's say, now here,

we're gonna issue it a discount,

and how I know that it says
the issue price is 92.6405%

of par value.

That is below a hundred.

That means our bond was
issued at a discount,

and you can see why.

The stated rate of our bond was 10%,

and the market rate was 12%.

So, our bond is less attractive

to others in the marketplace,

so we have to issue it at a discount.

We will not get a million dollars

when we go to issue that particular bond,

we are only going to get,

926,405.

That's the face value, times that,

92.6405%.

And we're gonna learn how to
calculate that amount here,

a little bit later to figure out

what the value of the bond will be.

So, that bond is issued
at a $73,595 discount.

So, now when we issue the bond,

we don't get a million dollars.

We're only gonna get $926,405.

We still have to credit our bonds payable

for the full million.

That's how much we'll pay back

at the end of the due date
and the maturity date.

And then we will debit this account

called discount on bonds payable.

It's a contra-liability
account to our bonds payable.

So, it will reduce the
carrying value of our bond

by the amount of the discount.

And that's probably
better illustrated here.

So, you can see our balance sheet,

which show the liability bonds
payable at a million dollars,

and then minus that
discount on bonds payable,

73,595.

And our carrying value
of that bond will be

926,405.

So, every interest payment,

we are gonna amortize this
discount on bonds payable.

So, we're gonna reduce it,

kind of like we were doing
with our depreciation.

We wanna reduce it

to get our carrying value
back up to a million dollars.

That also will increase
our interest expense

with every interest payment.

To amortize that we just use
the straight line method.

So, we will take that bond discount

and divide it by the number
of interest payments.

So, with every interest payment,

$7,360 will be added to
our interest expense.

So, here's an example.

To make our

interest payment every six months,

we need to credit cash for $50,000.

That's the amount of the interest,

which is a million dollars times 10%,

times 6 over 12,

6 months out of 12, or half of the year.

$50,000 is our interest payment.

That's a credit to cash.

That's what we will pay our
bond holders every six months.

And then, we had to amortize
that discount on bonds payable.

So again, we take the discount
divided by 10 periods.

So, every interest payment,

we will credit discount on
bonds payable by $7,360.

Those two added together now

become our bond interest expense.

So, had this bond been issued
at market, or at par value,

bond interest expense would be 50,000,

cash would be credited for 50,000.

Now let's look at a bond
issuance at a premium.

In this case,

our bond is paying 10%,
the market's only paying 8.

Now our bond is more attractive

to everyone in the marketplace.

They're willing to pay us
a premium to buy our bond.

And you can also tell that

because here it's issued
over a hundred percent.

So they are paying us 108% of face value,

to buy that bond.

So, it looks a little bit
different than the discount.

So the cash we will receive,

is the 1 million,

times the 108.1145%.

So, $1,081,145,

we will receive in cash
from the bond holders.

Credit, bonds payable a million dollars.

That's what we'll pay back upon maturity.

And we credit premium on bonds payable,

which is an adjunct liability account.

So, it gets added to our
bonds payable account.

And interesting thing here,

the premium now will decrease

the amount of bond interest
expense that we have.

So, now we have bonds payable

and we add to it the
premium on bonds payable.

So our carrying value is actually

over and above the $1 million face value.

We will amortize that just
like we did the bond discount.

Take the premium amount,

81,145 divided by the
10 interest payments,

five years, two payments per year.

That's $8,155.

So, that will be reducing
our interest expense

by that much every six months.

So again, credit to cash,

when we make an interest
payment for $50,000,

we already went through that calculation.

Now we debit premium
on bonds payable 8,115.

So, you can see that our
bond interest expense

is now reduced to $41,885.

So, let's figure out how they calculated

that 92 whatever percent,

to figure out the present
value of the bond.

Okay, so let's look at how we calculated

the present value of that particular bond.

So again, sorry,

our stated rate is 10%,

the market rate is 12%.

So, what does that tell us?

Well, the markets-

People are gonna prefer
the market to our bond,

so our bond's gonna be
issued at a discount.

The question is how much of a discount?

So, we can calculate that.

If you go to the tables in your book,

I think the time value of money tables,

I think they were at
the end of chapter six.

Table 6-4,

is the factor for calculating
the present value of a dollar.

So, that would apply to our bond payment.

So, we would multiply

the factor times the
face value of the bond.

So, this bond happened
to be $1,500,000 bond.

So, how do we determine the
factor here, this 0.5584?

Well, we go to that present
value of a dollar table,

and we are going to go
down the number of periods.

Well, this was a five year bond,

that's gonna pay interest twice a year.

What we see here,

five year bond pays interest twice a year.

So, our N will be 10.

So, we'll go down to the
number of periods, equals 10,

and then we're gonna go
across until we get to 6%.

Well, the market rate was 12%

and we would divide that by two,

because we'll make two
interest payments per year.

So, that would be 6%.

So we'll go across the number of periods

to where we get to the 6% column,

and you should see the
factor table there at 0.5584.

Then we're gonna do the
exact same calculation

using the present value of an annuity.

So, this will give us the value-

that would be the value of our bond.

We wanna determine its
value in today's dollars.

So, that bond, if we were-

In today's dollars, the
equivalent would be $837,600.

And then, assuming an interest rate,

again of 12% compounded every six months,

that would a accumulate to
1,500,000 in five years.

So, the interest component of this

that we're paying interest on
that bond every six months,

we use the present value of
an annuity of a dollar table.

Still go down to 10,

and over to 6%,

and that will give us 7.3601,

multiply that times the amount
of the interest payment.

In this case, it was a $1,500,000 bond,

times 10%, times half a year.

So, 75,000.

So, those interest
payments in today's dollars

worth $552,008,

add that up,

this is what people are
willing to pay us for the bond,

$1,389,608.

That's how we determine the
issue price of the bond.

And then when we actually
would go and issue it,

we would debit cash for that present value

of the interest payments,

and of the actual face value of the note.

Credit, short term debt or notes payable,

for the 1,500,000,

that we'll have to pay back upon maturity.

Now the difference between the two becomes

our discount on bonds
payable, which is debited.

So, our liabilities
increase for bonds payable,

discount on bonds payable

actually decreases our bonds payable,

and then, because it's
an adjunct liability,

and then we,

cash is debited for the proceeds
on that particular sale.

Okay, one last topic
will be bond retirement.

So, what do we do upon
conclusion of the bond?

Well we have to pay back
the face value of the note.

So, we debit bonds payable
for face value, credit, cash,

all the discount and premium

should have been fully amortized out.

So, this is what we would be left with.

Now, what if we retire
the bond before maturity,

and we can do that with a callable bond.

If the carrying value is greater
than the retirement price,

we have a gain.

If it's less than the retirement
price, we have a loss.

So, here's what I typically
tend to tell students,

put in what we know,

and what we don't know will
become our gain or loss.

So, we have to get rid of the
carrying value of the bonds,

which is the bonds payable,

and the discount or
premium on bonds payable.

Record any cash paid,

and then we'll recognize the gain or loss.

So, for example here,

we had a $1,500,000 bond issued,

and then we're going to retire,

a million dollar face amount
of bonds paying bond holders,

a 1,020,000.

Often when a company
calls the bond in early,

they have to pay a little bit extra.

And then it had an unamortized
discount of $62,000.

So, we need to get rid of
the face amount of the bond.

So, we debit bonds payable
for the million dollars.

We have this discount

that we need to get rid
of on our books as well.

It normally would carry a debit balance,

so we have to credit discount
on bonds payable, 62,000.

Then we credit cash for
the amount paid 1,020,000.

Now look at your debits and your credits.

Your debits would be a million,

your credits would be 1,082,000.

So, that's a difference of 82,000,

that becomes our loss on bonds payable.

Hope that gives you a little
bit of a background on bonds.

Thank you.