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Bonds Payable and Other Long Term Liabilities

 1) Key Things To Know 5) Medium Practice Test 2) Self Test 6) Hard Practice Test 3) Practice as You Learn 7) On Your Test 4) Easy Practice Test 8) Quick Study Sheet

Key Things to Know

Bonds Payable–  borrow from investors who invest in the bond to earn a return of
interest income

The bond is a contract with the investor that loaned the money.
Every bond is a contract which has the following:

Maturity Value:                     Amount that must be repaid (usually in \$1,000s)
Maturity Date:                       Date the maturity value amount must be repaid
Stated Interest Rate:            “Coupon” – amount paid as interest, periodically-
monthly, semi-annually or annually

Market Yield/Effective interest rate:  The interest the company really incurs,
and the investor really earns

Simplified Example:           \$1,000 Maturity Value (MV) due to be paid in 10 years
10% Stated interest (annual coupon)

The bond will pay \$100 interest (\$1,000 MV * 10% stated) – the amount of
interest paid is in the bond contract and does not change

The investor varies the rate of return they earn by what they are willing to pay.
Whatever percent the investor earns is the same percent the company really
incurs in interest expense.   The real rate of return is the market/effective rate.

If pay \$1,000, actually earn 10%               \$100/\$1000 = 10%

If pay \$900, actually earn 11.1%               \$100/\$900  = 11.1%

If pay \$1,100, actually earn 9.1%              \$100/\$1100 = 9.1%

In most cases, the cash exchanged will not be equal to the maturity value because the market rate does not equal the stated (coupon) rate.  This creates a:

Discount:    Cash exchanged is less than face value

Premium:    Cash exchanged is more than face value

Regardless of what is paid at the beginning, the face value must be paid on the
maturity date.

The actual bond market the bonds trade on determine the acceptable market rate that
investors are willing to invest to earn.   The market / effective rate changes every day.
The stated coupon rate does not change.

Determining the price of the bond:

Bonds trade on the open market at a percent of maturity value.

A bond that trades at 98 means:  98% (.98) x the maturity value is paid

For a \$300,000 maturity value bond priced at 98, the investor pays
\$294,000  (\$300,000 x .98)

For a \$200,000 maturity value bond priced at 125.75, the investor pays
\$251,500  (\$200,000 x 1.2575, move the decimal point over 2 places)

Note:  Most Financial Accounting professors will not have you calculate the price of
the bond and the bond price will be given to you as a number % or total amount.

If the bond price is not stated, it can be calculated using the effective interest rate,
the number of periods until maturity, and the coupon rate.

Total periodic coupon payment**   x   present value factor of an annuity
+
Maturity value   x     present value factor of a single amount

= Amount paid now to get the effective interest rate return on your money

** Periodic coupon payment = Maturity Value x coupon % / number of payments
per year

Use the PV tables to get the factor for the total number of cash payments the
bond will make (years to maturity x payments each year) and the
effective / market interest rate.

Journal Entries related to the bond payable:

The amount received is the cash that is exchanged between the investor and the company.   This is often called “issuing a bond”, which means borrowing money.

Issue Bonds – Premium:                          Issue Bonds – Discount:

Issue:

Cash                                                                          Cash
Bond Payable (MV)                                                 Bond Payable (MV)

Interest paid:

Interest Expense                                                      Interest Expense
Cash                                                                         Cash

Amortization Table:

Use an “Amortization Table” to determine how much of the cash payment is interest expense and how much is a discount or premium.  The interest expense uses the effective/market yield rate and the cash paid is from the coupon rate.  These two rates are most likely different.
______________________________________________________________________

Effective             Coupon                                 Discount or                    Amount owed-
Interest Exp.   -   Interest     =   Difference        Premium       + / -        “Carrying value”

“Yield %”         “Stated %” or                                                              Begin with the price

“Market %”       “coupon %”                                                         of the bond The                                                                                                              cash exchanged
x the last                 x MV                                                                         (not the MV)
amount owed    (same for
all periods)

Interest                   Cash              Discount or                                 End with the

Long – Term Installment Loans / Notes Payable / Mortgage Payable:

Borrow money from bank
Repay in equal payments.

The payments must cover interest expense and repayment of principle

You must determine how much of the payment is for interest expense and how much
is for repayment of loan.               We use and amortization schedule for this:

Example:  You borrowed \$800,000 at 10% and your annual payment is \$89,750.

 Payment Interest 10% Difference: to repay principle Amount Owed (Carrying Value) \$800,000 1) \$89,750 \$80,000 \$9,750 \$790,250 2) \$89,750 \$79,025 \$10,725 \$779,525

Journal entries:

Borrow:

Cash                          \$800,000
Note Payable              \$800,000

Interest – 1st year payment

Interest Expense      \$80,000
Note Payable            \$  9,750
Cash                          \$89,750

Interest – 2nd year payment

Interest Expense      \$79,025
Note Payable            \$10,725
Cash                          \$89,750

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