Chapter 14: Financing Liabilities: Bonds and

Long-Term Notes Payable

14-1 Why do Companies issue Long-Term Financing Liabilities?
Why does debt financing typically have a lower cost of capital than equity financing?

- Historically, because debt has a lesser investment risk than stock, investors in debt securities
typically expect a lower rate of return than investors in equity securities.

Why does issuing debt result in an income tax advantage compared to issuing equity?

- Interest payments to debt holders are deductible as interest expense by a corporation for
income tax purposes, whereas dividend payments on equity securities are not.

14-2 What are the Characteristics of Bonds Payable?

What is a bond? Define face value, maturity date, contract rate, bond certificate, and bond indenture.

- Bond: a debt instrument in which a company agrees to pay the holder the face value at the
maturity date and usually to pay periodic interest on the face value at a specified rate.
- Face (Par) Value: The amount of money that the issuer agrees to pay at maturity; same concept
as the principal of a note
- Maturity Date: The date on which the issuer of the bond agrees to pay the bondholder the face
value (plus any final amount of interest owed).
- Contract (stated, face, or nominal) rate: The interest rate the issuer of the bond agrees to pay
each period until maturity
- Bond Certificate: A legal document that provides evidence of ownership and specifies the face
value, the annual interest rate, the maturity date, and other characteristics of the bond issue.
- Bond indenture: A document (contract) that defines the rights of the bondholders and the
obligations of the issuer.

What is the difference between a mortgage bond and a debenture bond?

- Debenture bonds: Bonds not secured by specific property whose marketability is based on the
general credit rating of the company; A company must have a long history of profitability and
positive cash flows as well as expectations of future positive earnings and cash flows, to sell
debenture bonds.
- Mortgage bonds: Bonds secured by a lien against specific property of the company; if the
company becomes bankrupt and is liquidated, the holders of these bonds have first claim
against the proceeds of the sale of the assets that secure their debt.

What are callable bonds? Convertible bonds?

- Callable bonds: Bonds that the company has the option to repay (call) at a predetermined price
(usually at a premium above the face value) for a specified period.
- Convertible bonds: Bonds that give bondholders the option to convert the bonds into a
predetermined number of common equity shares of the issuing company
Why do stated (contract) rate and the effective rate (yield) of interest on bonds frequently differ?

- The difference may result from a difference of opinion between the underwriter and the
company about the correct yield; it may also result from a change of economic conditions
between the date the company set the terms of the bond issue and the date it was issued.

14-3 How is the Issue Price of Bonds Payable Computed?

Why do bond discounts and bond premiums arise at the time of sale?

- The difference between the price paid and the face value essentially adjusts the yield to the
issuer and the purchaser.
o when bonds are sold at a discount the yield is higher than the contract rate and the
discount between the lower purchase price and the face value at maturity, along with
the contract interest received by the purchaser each period result in a yield that is
greater than the contract rate
o When bonds are sold at a premium, the yield is lower than the contract rate and the
premium between the higher selling price and the face value, along with the contract
interest received by the purchaser each period, results in a yield lower than the contract
rate.

How is the amount of proceeds from a bond issue determined once the market (yield) rate of interest
is specified?

- To determine the selling price the effective rate is applied to both the future principal and the
periodic interest payments.
- If a company decides to sell $100,000 of a 5-year bond that pays a semiannual interest rate with
a contract of 12%:
o The computation for the interest period is: 12%/ 2 periods = 6% semiannual rate
o The computation for maturity is: 5 (year bonds) x 2 (periods) = 10 semiannual periods
o The selling price is computed as the sum of:
 PV of principal:100,000 x .0558395= 55,839.50
 0.558395= table 3 (value of 1), n=10 periods, i=0.06 (6%)
 PV of interest payments: 6000 x 7.360087=44,160.50
 6000= 100,000 x 0.12 x ½
 7.360087 = table 4 (ordinary annuity), n=10 periods, i=0.06
- If the same company decides to sell the $100,000 of 5-year bonds at a discount when the
effective interest rate 14% the discount is computed using the semiannual 7% (this is from using
½ of the 14% effective rate as follows:
o Finding the sum of the selling price, which is:
 PV of principal: 100,000 x .508349 =50,834.90 (from using ½ of the 14 %)
 PV of interest payments: 6000 x 7.023582 = 42,141.49 (from using ½ of the 14%)
 50,834.90+42141.49= 92,976.39
o And subtracting it from the face value:
 100,000-92,976.39= a discount of $7,023.61
- If the same company decides to sell the bonds at a premium of 10% the premium is computed
using the semiannual 5% ( from using ½ of the 10% effective rate)
o Finding the sum of the selling price which is
 (PV of principal + PV of interest) – Face Value= premium
 (61,391.30 + 46,330.41)- 100,000= 7721.71
14-4 How is the issuance of bonds recorded?
Distinguish between bond premiums or discounts and bond issue costs.

- If bonds are issued at a premium, the issuer will record the premium in a separate account titled
premium on bonds payable; Premium on bonds payable account is an adjunct account and is
added to the bonds payable account in the long term liability section of the balance sheet; the
book value of the bond issue is the face value plus the unamortized premium
o DR Cash for 107,721.71, CR Bonds Payable 100,000 and Premium on Bonds Payable for
7,721.71
- If bonds are issued at a discount the issuer will record the discount in a separate account titled
discounts on bonds payable; Discount on bonds payable is a contra account and is subtracted
from the Bonds Payable account on the balance sheet. The book value of the bond issue is the
face value minus any unamortized discount
o DR Cash for 92,976.39 and Discount on Bonds Payable for 7,023.61, CR Bonds Payable
for 100,000

Why does the recorded amount of interest expense for the first interest payment differ from the
expense recorded for other interest payments when bonds are issued between interest payment
dates?

- Since bonds are often sold after their authorization date and between interest payment dates.
In these cases the issuing company may pay interest only for the period of time the bonds are
outstanding, which is from the sale date to the next interest payment date. This procedure
reduces the record keeping for the first interest payment and is typically credited to interest
expense. It is calculated by:
o Multiplying the face value by the stated interest for the fraction of the year from the
interest payment date prior to the sale date.
o A company issues $800,000 of 10-year bonds dated Jan. 1 2016 at par. The bonds have a
contract interest rate of 12% and pay semiannualy on Jan 1 and Jul 1. On March 1,
because 2 months have elapsed since the interest payment date prior to the sale the
company would collect 16,000 which is (800,000x.12x [2/12]) in addition to the face
value; The company would then record the first semiannual interest payment as:
 DR Interest Expense ($800,000 x .12 x 6/12) and CR Cash for that same amount
o The company could also record the entry as
 DR Cash 816,000, CR Interest Payable 16,000 and Bonds Payable 800,000

14-5
What two methods may a company use to amortize a premium or discount over the life of a bond
issue? Briefly describe each method.

- The effective interest method: is where the amortized portion of the discount or premium is the
difference between the amount of interest revenue and the cash interest payment
- The straight line method: for fixed assets, a method of depreciation that allocates an equal
amount of an asset’s cost to depreciation expense for each period of the asset’s service life. For
bonds or notes payable, a method of amortizing discounts and premiums where the amortized
portion of the discounts and premiums where the amortized portion of the discount or premium
is an equal amount each period during the life of the payable.

How is the amount of interest expense a company records each period affected by the amortization of
a bond discount using the straight line method