LIABILITIES
LIABILITIES
CORPORATE FINANCING OPTIONS
Corporations can raise funds by
issuing common stock, preferred stock, long-term bonds or notes. The board of
directors is responsible for choosing financing options. A great number of
factors influence financing options such as the ability to raise funds,
interest rates, tax considerations, and investor income return expectations.
The type and mix of securities issued have an important effect on net income
and earnings per share.
INTRODUCTION TO BONDS
Each time a corporation issues a
bond, a contract, known as the bond or trust indenture, is executed. The
principal or face value of the bond, when interest payments are due and the
interest rate are stated in the bond indenture. Bonds differ by the following
characteristics: transferability of ownership, issuance and maturity dates,
conversion provisions, redemption rights, and whether they are secured or not.
USING PRESENT VALUE
Present value is used for both
financial analysis and to make business decisions. The concept of present value
indicates that the value of a dollar today is not the same as the value of a
dollar in the future. When a bond is issued two obligations arise: 1) periodic
interest payments and 2) paying the the face amount of the bond at maturity.
The selling price of a bond is determined by the present value of the
combination of these two obligations.
BONDS & INTEREST RATES
The interest rate of a bond is
stated in the bond indenture. That interest rate, known as contract or coupon
rate, is often different from the prevailing market interest rates on the day
the bond is issued. When the market or effective rate is higher than the coupon
rate of the bond, the bond will be sold at a discount. When the market or
effective rate is lower than the coupon rate, the bond will be sold at a
premium. Bonds are rarely sold at their face value due to interest rate
changes.
RECORDING BOND ISSUES
Bonds can be issued at face value,
at a discount, or at a premium. When bonds are issued at face value, cash is
debited and bonds payable credited. When bonds are issued at a discount, the
discount on bonds payable account is debited for the amount of the discount.
When bonds are issued at a premium, the premium on bonds payable account is
credited for the amount of the premium. The present value of a bond is
determined by adding the present value of the face value of the bond and the
present value of its interest payments. The present value can be calculated
using formulas, present value charts, financial calculators or computer
programs.
AMORTIZATION OF DISCOUNTS &
PREMIUMS
The bond premium or discount is
amortized to interest expense until the bond is redeemed or matures. There are
two amortization methods: the straight-line method and the interest method. The
straight-line method amortizes identical interest expenses to each period. The
interest method uses a constant rate of interest. The amortization of premiums
decreases interest expense, while the amortization of discounts increases
interest expense.
BOND SINKING FUNDS
Bond sinking funds are designed
for the purpose of being able to meet debt obligations when they mature. Cash
in these funds is invested in income producing securities. The income earned
from investments and cash deposits are managed so that it will equal the amount
due at maturity. A company has the option to manage its own bond sinking fund
or appoint a trustee.
APPROPRIATION FOR BONDED
INDEBTEDNESS
Appropriations for bonded
indebtedness restrict a company's ability to pay dividends to shareholders. It
requires that part of retained earnings be set aside for the repayment of
bonds. Appropriations do not have a direct relationship to the bond sinking
fund. Whenever an appropriation is made, Retained Earnings is debited and
Appropriation for Bonded Indebtedness credited.
BOND REDEMPTION
Bonds are redeemed most commonly
when the market rate of interest declines after they have been issued. A
company can usually realize a saving by redeeming its bonds and issuing new
bonds with lower interest rates. Only callable bonds have the feature which
allows the company to redeem them at a stated price within a specific time
period. All other bonds can be purchased on the open market. It is very
unlikely, however, that an entire issue can be purchased in this manner.
BOND REDEMPTIONS
When a company is able to redeem
bonds at a price above the carrying amount, a loss is incurred. This requires
an entry that debits Bonds Payable and a Loss on Redemption of Bonds, and
credits Cash. If any unamortized premium remains, this amount must also be
debited. Unamortized premiums increase the cash payment required for bond
redemptions. If a bond is redeemed at a price below the carrying amount, a gain
has been realized. The Gain on Redemption of Bonds account is credited in such
circumstances.
BONDS PAYABLE & THE BALANCE
SHEET
Bonds payable are shown as
long-term balance sheet liabilities, unless they mature in a year or less. If
current assets are expected to be used to retire the bonds, a Bonds Payable
account should be listed in the current liability section. If the bonds are to
be retired and new ones issued, they should remain as a long-term liability.
All bond discounts and premiums also appear on the balance sheet.
BONDS PAYABLE & THE BALANCE
SHEET
Different bond issues should be
maintained in separate accounts. When a Bonds Payable account is present on the
balance sheet, it can be broken down into different issues or consolidated into
a single balance. In the latter case, a schedule or note should disclose the details
of the bond issues. It is also customary to provide a description of bonds
issued in financial statements. The effective interest rate, maturity date,
terms, and sinking fund requirements are commonly indicated in accompanying
notes to financial statements.
BOND INVESTMENTS
Investments in bonds or notes
should be listed under investments in the balance sheet. They should be kept
separate from marketable securities. Businesses commonly invest in bonds
because they have idle funds available. Corporate bonds can be purchased
through a broker or directly from the issuing company. Purchasing from a
company is cheaper because commission fees are absent.
BOND INVESTMENTS
Information on bonds can be
obtained from the financial section of most major newspapers. Bond interest
rates, volume of sales, closing price, the low and high price of the day, and
the maturity date can all be found. Prices of bonds are quoted as a percentage
of a bond's face value. The cost method is recommended when recording the
purchase of a bond. All transaction fees and commissions should be included in
the price of the purchase.
BOND INVESTMENTS
When bonds are purchased between
interest payments, it is customary to pay the accrued interest to the seller.
This accrued interest paid to the seller is debited to the Interest Income
account when bonds are initially acquired. As interest payments are received,
the Interest Income account is credited. At the end of a fiscal year, an
adjusting entry is made for any accrued interest.
SELLING INVESTMENTS IN BONDS
When the investing company sell a
bond, it records a selling price net of all transaction costs and commissions.
The seller also records any accrued interest. The first step in recording the
sale of a bond requires one to determine the appropriate amount of the
amortization of a discount or a premium. This is necessary to calculate the
amount of gain or loss realized from the sale of the investment.
SELLING INVESTMENTS IN BONDS
If a discount has been amortized
in the current year, it is subtracted from the carrying value of the bond. A
premium is added to the carrying amount of the bond. When the proceeds of a
sale are greater than the ending carrying amount of the bond, a gain has been
realized. A loss is realized when the proceeds of a sale are less than the
ending carrying amount.