Chapter 11: Liabilities Bonds Payable Liabilities: Bonds Payable

Bonds Payable

This chapter identifies user information needs, reports financial information, assists and supports decision-making, and measures and records economic events within the accounting cycle (Chs. 1–4) and financial statements (Chs. 5–14).

Introduction to Long-Term Liabilities

• Importance of Long-Term Debt: Companies, like individuals purchasing cars or homes, finance long-term assets and operations using long-term liabilities.

  • Understanding how companies use long-term debt is crucial for analyzing financial condition and related risk for creditors and stockholders.

• PepsiCo Example:

  • PepsiCo, Inc. (PEP) finances over $81\%$ of its total assets with liabilities, with $64\%$ of these being long-term liabilities.

  • Their long-term liabilities include notes and bonds.

  • Example: PepsiCo has $24,652$ million of long-term debt maturing between $2028$ and $2060$ with interest rates of $2.6\%$ and $2.8\%$.

Nature of Bonds Payable (Obj. 1)

• Definition: A bond is a form of interest-bearing note, requiring periodic interest payments and repayment of the face amount at maturity.

  • Example: A $12\%$ bond means the issuing company pays $12\%$ interest on the face amount annually.

  • Bondholders, as creditors, have claims on a corporation's assets that rank ahead of stockholders.

• Characteristics and Terminology:

  • Bonds typically vary in face amount, interest rates, interest payment dates, and maturity dates.

  • Bond Issue: Normally divided into multiple individual bonds.

  • Principal (Face Amount): The amount to be repaid on the maturity date, usually $1,000$ or a multiple thereof.

  • Interest Payments: Can be annual, semiannual, or quarterly; most commonly semiannual.

  • Bond Indenture: The underlying contract between the issuing company and bondholders.

  • Term Bonds: All bonds of an issue mature at the same time.

  • Serial Bonds: Bonds mature over several different dates.

    • Example: $100,000$ of a $1,000,000$ issue matures in year $16$, another $100,000$ in year $17$, and so on.

  • Convertible Bonds: Bonds that may be exchanged for shares of common stock.

  • Callable Bonds: Bonds that may be redeemed by the corporation prior to maturity.

• Proceeds from Issuing Bonds: The amount received for bonds depends on:

  • The face amount of the bonds (amount due at maturity).

  • The interest rate on the bonds (contract rate).

  • The market rate of interest for similar bonds.

  • Contract Rate (Coupon Rate): The interest rate specified in the bond indenture, to be paid on the bond's face amount.

  • Market Rate of Interest (Effective Rate of Interest): The rate determined by sales and purchases of similar bonds, influenced by investor expectations of economic conditions.

  • Comparison of Rates and Selling Price (Exhibit 1):

    • Market Rate = Contract Rate: Bonds sell at their face amount (price of $100$).

    • Market Rate > Contract Rate: Bonds sell for less than their face value (at a discount).

      • Discount: The face amount of the bonds minus the selling price.

      • Reason: Buyers aren't willing to pay full face amount for bonds with a lower contract rate than the market offers.

      • Example: PepsiCo's $2.625\%$ bonds maturing in $2041$ recently sold for less than face value.

    • Market Rate < Contract Rate: Bonds sell for more than their face value (at a premium).

      • Premium: The selling price of the bonds minus the face amount.

      • Reason: Buyers pay more for bonds with a higher contract rate than the market offers.

      • Example: PepsiCo's $5.5\%$ bonds maturing in $2040$ recently sold for more than face value.

  • Bond Price Quoting: Quoted as a percentage of the bond's face value.

    • Example: A $1,000$ bond quoted at $98$ sells for $980 ($1,000 \times 0.98$).

    • Example: Bonds quoted at $109$ sell for $1,090 ($1,000 \times 1.09$).

• Investor Bond Price Risk (Business Insight):

  • Bonds are purchased as investments by individuals and institutions (e.g., pension funds).

  • High-quality bonds are generally less risky than equity due to contracted interest payments and principal return.

  • Price Risk: Bond prices move opposite to changes in market interest rates:

    • Market Rate Increase $\rightarrow$ Market Price Decrease

    • Market Rate Decrease $\rightarrow$ Market Price Increase

  • Maturity Impact on Price Fluctuation: The longer the bond's term, the greater the magnitude of price fluctuation in response to market interest rate changes.

    • Short-term bond prices fluctuate minimally.

    • Long-term bond prices fluctuate more significantly.

    • This explains why long-term bonds often have higher coupon rates than short-term bonds, compensating for higher price risk.

Accounting for Bonds Payable (Obj. 2)

• Bonds can be issued at face amount, a discount, or a premium.

• Discounts or premiums must be amortized over the life of the bonds.

• At maturity, the face amount must be repaid.

• Corporations may redeem bonds before maturity.

Bonds Issued at Face Amount

• Occurs when the market rate of interest equals the contract rate of interest.

• Illustration (Eastern Montana Communications Inc.):

  • Face amount: $100,000$

  • Contract rate: $12\%$ (semiannual interest on June 30 and December 31)

  • Term: $5$ years

  • Market rate: $12\%$

• Journal Entry - Issuance (Jan. 1, 20Y5):

  • Cash $100,000$

  • Bonds Payable $100,000$

    • (Issued $100,000$ bonds payable at face amount)

• Journal Entry - First Semiannual Interest Payment (June 30, 20Y5):

  • Interest Expense $6,000$

  • Cash $6,000$

    • (Paid six months’ interest: $100,000 \times 12\% \times 1/2$ year)

• Journal Entry - Payment of Principal at Maturity (Dec. 31, 20Y9):

  • Bonds Payable $100,000$

  • Cash $100,000$

    • (Paid bond principal at maturity date)

Bonds Issued at a Discount

• Occurs when the market rate of interest is greater than the contract rate of interest.

  • Investors are unwilling to pay the full face amount for bonds with a lower contract rate.

  • Bond Discount: The difference between the face amount and the selling price.

    • This discount adjusts the contract rate to the higher market rate.

• Illustration (Western Wyoming Distribution Inc.):

  • Face amount: $100,000$

  • Contract rate: $12\%$ (semiannual interest on June 30 and December 31)

  • Term: $5$ years

  • Market rate: $13\%$

  • Selling price: $96,406$

• Journal Entry - Issuance (Jan. 1, 20Y1):

  • Cash $96,406$

  • Discount on Bonds Payable $3,594$

  • Bonds Payable $100,000$

    • (Issued $100,000$ bonds at discount)

  • Discount on Bonds Payable: A contra-liability account with a normal debit balance, subtracted from Bonds Payable.

  • Carrying Amount (Book Value): Face amount less any unamortized discount.

    • Initial carrying amount: $96,406 ($100,000 - 3,594$).

• Amortizing a Bond Discount:

  • Amortization: The process of reducing the bond discount and adding it to interest expense over the bond's life.

  • This increases the bond's contract interest rate towards the market rate at issuance.

  • General Amortization Entry:

    • Interest Expense XXX

    • Discount on Bonds Payable XXX

  • Combined Amortization and Interest Payment Entry:

    • Interest Expense XXX

    • Discount on Bonds Payable XXX

    • Cash (semiannual interest) XXX

  • Methods of Amortization:

    • Straight-line method: Provides equal amounts of discount (or premium) write-off each period. Used in this chapter if results are not significantly different from effective interest rate method.

    • Effective interest rate method: Required by GAAP, described in Appendix 2.

• Straight-Line Method Illustration (Western Wyoming Distribution Inc.):

  • Discount on bonds payable: $3,594$

  • Term: $5$ years ($10$ semiannual periods)

  • Semiannual amortization: $359.40 ($3,594 \div 10$ periods)

• Combined Journal Entry - First Interest Payment and Amortization (June 30, 20Y1):

  • Interest Expense $6,359.40$

  • Discount on Bonds Payable $359.40$

  • Cash $6,000.00$

    • (Paid semiannual interest: $100,000 \times 12\% \times 1/2 = 6,000$)

    • (Amortized $1/10$ of bond discount)

  • The semiannual interest expense remains constant at $6,359.40. This effectively increases the stated $12\%$ contract rate to approximate the $13\%$ market rate.

  • As the discount is amortized, the carrying amount of the bonds increases until it equals the face amount at maturity.

• Pandemic Bonds (Business Insight):

  • In $2017$, the World Bank issued bonds to support its Pandemic Emergency Financing Facility (PEF), providing funds to developing countries during pandemics.

  • Class A bonds: $6.9\%$ annual return; Class B bonds: $11.5\%$ annual return. Raised $225$ million (Class A) and $95$ million (Class B).

  • Investors (endowments, pension funds) effectively bet against natural disasters or infectious diseases.

  • COVID-19 triggered the first payout of $195.84$ million to $64$ countries.

  • PEF closed in April $2021$ due to concerns about slow payouts and financing methods.

Bonds Issued at a Premium

• Occurs when the market rate of interest is less than the contract rate of interest.

  • Investors are willing to pay more for bonds with a higher contract rate.

  • Bond Premium: The selling price of the bonds minus the face amount.

    • This premium adjusts the contract rate to the lower market rate.

• Illustration (Northern Idaho Transportation Inc.):

  • Face amount: $100,000$

  • Contract rate: $12\%$ (semiannual interest on June 30 and December 31)

  • Term: $5$ years

  • Market rate: $11\%$

  • Selling price: $103,769$

• Journal Entry - Issuance (Jan. 1, 20Y3):

  • Cash $103,769$

  • Bonds Payable $100,000$

  • Premium on Bonds Payable $3,769$

    • (Issued $100,000$ bonds at a premium)

  • Premium on Bonds Payable: A liability account with a normal credit balance, added to Bonds Payable.

  • Carrying Amount (Book Value): Face amount plus any unamortized premium.

    • Initial carrying amount: $103,769 ($100,000 + 3,769$).

• Amortizing a Bond Premium:

  • Amortization decreases the contract rate of interest to the market rate at issuance.

  • General Amortization Entry:

    • Premium on Bonds Payable XXX

    • Interest Expense XXX

  • Combined Amortization and Interest Payment Entry:

    • Interest Expense XXX

    • Premium on Bonds Payable XXX

    • Cash (semiannual interest) XXX

• Straight-Line Method Illustration (Northern Idaho Transportation Inc.):

  • Premium on bonds payable: $3,769$

  • Term: $5$ years ($10$ semiannual periods)

  • Semiannual amortization: $376.90 ($3,769 \div 10$ periods)

• Combined Journal Entry - First Interest Payment and Amortization (June 30, 20Y3):

  • Interest Expense $5,623.10$

  • Premium on Bonds Payable $376.90$

  • Cash $6,000.00$

    • (Paid semiannual interest: $100,000 \times 12\% \times 1/2 = 6,000$)

    • (Amortized $1/10$ of bond premium)

  • The semiannual interest expense remains constant at $5,623.10. This effectively decreases the stated $12\%$ contract rate to approximate the $11\%$ market rate.

  • As the premium is amortized, the carrying amount of the bonds decreases until it equals the face amount at maturity.

• Bond Ratings (Business Insight):

  • Investors assess the likelihood of default (issuer not repaying principal/interest).

  • Independent rating agencies (e.g., Standard & Poor’s - S&P) review and grade financial condition of bond issuers (scale: D to AAA).

  • Investment Grade (IG) Bonds: Rated BBB– or higher; issued by companies unlikely to default.

  • Noninvestment Grade (High-Yield/HY) Bonds: Rated below BBB–; issued by companies in weaker financial condition, reflecting higher potential for default.

    • These bonds have a higher yield to compensate investors for increased risk.

Bond Redemption

• Corporations may redeem or