1. Listen to the following videos and then complete the assignments using the changed numbers on the guidance report. Place your answers on the guidance report.
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chapter 2 Issues in Accounting for Corporate Debt and Equity istockphoto Learning Objectives Be able to articulate the advantages and disadvantages of preferred stock as an alternative class of equity capital. Be familiar with the accounting for traditional notes payable arrangements. Understand the nature of bond financing. Be able to account for bonds, including use of the straight-line amortization technique for bonds issued at a premium or discount. Be able to apply the unique accounting issues pertaining to bonds issued between interest payment dates and for bonds retired before scheduled maturity. Be aware of accounting issues that relate to leases and other contractual commitments. waL80281_02_c02_035-056.indd 1 9/25/12 1:02 PM CHAPTER 2 Section 2.1 Alternative Types of Capital Stock Chapter Outline 2.1 Alternative Types of Capital Stock Accounting for Preferred Stock 2.2 Long-Term Notes Payable Level Payment Notes Calculating the Amount of a Level Payment 2.3 Bonds Payable Bond Pricing Bond Features Accounting for Bonds Payable Issued at Par Accounting for Bonds Payable Issued at a Premium Accounting for Bonds Payable Issued at a Discount Alternative Approach to Amortization Bonds Issued Between Interest Dates Year-End Interest Accruals Frequency of Interest Accruals Debt Retirements T he financial accounting course acquainted you with the measurement and reporting aspects of common stock and short-term obligations. But, these business financing devices are far from the only tools available to support the capital needs of a business. This chapter exposes you to a vast frontier of other financial instruments that can be used to support the \"credit side\" of the balance sheet. Each financing vehicle has clear advantages and disadvantages. Each has unique contractual aspects. And, each has unique accounting considerations. 2.1 Alternative Types of Capital Stock B roadly speaking, the \"credit side\" of the balance sheet represents the many sources of business financing used by a business. The familiar accounting equation signals that business financing is divided between liabilities and equity (assets 5 liabilities 1 equity). Thus far, you have been advised that equity is based around shares of capital stock and retained earnings. Also, in the financial accounting course, you learned about the accounting for common stock. Recall that common stock may have a designated par value. Common shareholders usually have a right to share in a portion of a corporation's dividends. They may also have an option to buy a proportional part of any additional shares issued by the company (a \"preemptive right\"). Common shareholders also tend to possess voting rights on the selection of corporate directors and a subset of corporate governance matters (e.g., a decision to merge the company with another). If the company ceases to operate, common shareholders have the final residual claim to any corporate assets, following the complete satisfaction of all other liabilities and claims. 36 waL80281_02_c02_035-056.indd 2 9/25/12 1:02 PM CHAPTER 2 Section 2.1 Alternative Types of Capital Stock Sometimes a company may wish to attract additional equity financing, but it is reticent to grant new investors all of the traditional rights associated with common stock. This gives rise to the concept of preferred stock. Preferred stockholders usually do not receive voting rights or unlimited upside associated with escalating earnings, dividends, and corporate growth, but they do receive preference in the event of corporate liquidation (they are repaid before common shareholders but not creditors) and are usually afforded a decent and somewhat guaranteed, dividend stream. Thus the name \"preferred stock.\" Looking closer at selected features of preferred stock: Dividend preferences: Preferred stock is paid a dividend prior to any distribution to common stockholders. Preferred dividends tend to be expressed as a percentage of the preferred stock's \"par value.\" For example, a 4%, $100 par, preferred would ordinarily pay $4 per share per year in dividends. Preferred stock is frequently cumulative, meaning that any unpaid dividends must eventually be paid prior to any further payouts to common stock. Be aware that if you encounter noncumulative preferred, one added risk factor is that any missed dividends are forever forgone. Companies are under no obligation to pay dividends on noncumulative preferred stock. In essence, investors in these securities risk forgoing one of the key benefits (i.e., a reasonable certain dividend stream) of preferred stocks. Fixed liquidation: It is quite normal for preferred stock to be subject to fixed terms relative to the company's ability to call or buy back the shares. Call price is often set at a certain percentage of par. For example, callable at 110 would mean the company has the option to buy back $100 par value preferred at $110. Specific terms can govern the call back time window, and there may even be a mandatory buy back date. In some respects, the dividend and retirement provisions almost make the preferred stock seem more like corporate debt. Indeed, the distinction between debt and equity can become fuzzy. Conversion to common: On occasion, but not frequently, you might encounter convertible preferred stock. This means that the preferred shares may be exchanged for common stock at a set ratio. For example, a 5:1 conversion ratio suggests that each preferred share can be swapped for 5 common shares. Conversion is a positive feature from an investor point of view because the preferred stock gets an opportunity to participate in strong corporate growth and stock price appreciation. However, this benefit usually comes at a price; convertible preferred normally bears a much lower dividend than equivalent shares that are not convertible. Accounting for Preferred Stock The basic journal entry to record the issuance of preferred stock is not any different than the entry that is needed for common stock. The following example should look familiar: 5-15-X1 Cash 1,050,000 Preferred Stock 1,000,000 Paid-in-Capital, In Excess of Par 50,000 To issue 10,000 shares of $100 par value stock at 105 37 waL80281_02_c02_035-056.indd 3 9/25/12 1:02 PM CHAPTER 2 Section 2.1 Alternative Types of Capital Stock If you take careful note of the preceding entry's description, you will see that the stock was issued at 105, or 105% of par value. This means each of the 10,000 shares was sold for $105, generating total proceeds of $1,050,000. Because par value is the basis for calculating periodic dividends on preferred, the assigned amount becomes quite significant. Such was not the case for common stock. Because preferred dividends are expected to be paid as a flat percentage of preferred stock's par value, and any unpaid dividends on cumulative preferred must be paid ahead of common dividends (unpaid dividends on preferred are known as dividends in arrears), a number of accounting and disclosure issues can arise. A clarifying example will prove helpful. Consider the stockholders' equity section for Preference Corporation shown in Table 2.1. Table 2.1: Stockholder's equity Stockholders' equity Capital stock Preferred stock, $100 par value, 4% cumulative, 100,000 shares authorized, 10,000 shares issued and outstanding Common stock, $1 par value, 500,000 shares authorized, 200,000 shares issued and outstanding $1,000,000 200,000 $1,200,000 Additional paid-in capital Paid-in capital in excess of par 2 preferred stock $50,000 Paid-in capital in excess of par 2 common stock 800,000 Total paid-in capital 850,000 $2,050,000 Retained earnings 950,000 Total stockholders' equity $3,000,000 First, note that the corporation's stockholders' equity section (or related footnotes) includes detailed descriptions about the outstanding stock and its basic features. This includes information about the number of shares authorized (permitted to be issued), actually issued, and outstanding (issued minus any shares reacquired by the company). As it relates to the preferred stock, it is $100 par value, paying a 4% cumulative dividend. As reflected by the $50,000 additional paid-in capital amount, the preferred must have been issued at 105. The 4% dividend rate means that each share will pay $4 per year in dividends, and the cumulative feature requires that any dividends not paid in a given year are to become in arrears for payment in the future. Let us further assume that Preference Corporation has not met its dividend obligation for the past 3 years. Dividends in arrears are $120,000, consisting of $4 per share (10,000 shares 3 $4) for 3 years. If Preference desired to pay $250,000 in dividends during the current year, how much do you suppose would be available to the common shareholders? The answer is only $90,000. Of the $250,000, $160,000 must first be paid to preferred stockholders to satisfy the current and prior year dividends ($40,000 for 4 years). The $90,000 available to common shares would produce a $0.45 per share dividend rate ($90,000/200,000 shares). Because dividends in 38 waL80281_02_c02_035-056.indd 4 9/25/12 1:02 PM CHAPTER 2 Section 2.2 Long-Term Notes Payable arrears can impair the interests of common shareholders, they are to be prominently disclosed in notes to the financial statements. However, they are not accrued as a liability until formally declared by the corporation's board of directors. It certainly pays to read the fine print within financial statements. 2.2 Long-Term Notes Payable T he financial accounting course illustrated the accounting for notes of relatively short duration. Now, let's turn our attention to longer term notes. Borrowers may desire to have a loan that spans 3, 5, 10, or more years. Sometimes, these term loans only require the payment of interest over the life borrowing, with the balance of the note coming due at maturity. Assume that Perez borrowed $50,000 on January 1, 20X5, under a 3-year, 6% term note. Interest is to be paid annually, and the principal will be paid in full on December 31, 20X7. The following entries are necessary to fully account for the note over its duration: 1-1-X5 Cash 50,000 Note Payable 50,000 To record 6% note payable; maturity date on 12-31-X7 12-31-X5 Interest Expense 3,000 Cash 3,000 To record interest payment on Dec. 31 ($50,000 3 6% 5 $3,000) 12-31-X6 Interest Expense 3,000 Cash 3,000 To record interest payment on Dec. 31 ($50,000 3 6% 5 $3,000) 12-31-X7 Interest Expense 3,000 Notes Payable 50,000 Cash 53,000 To record interest and principal payment on Dec. 31 ($50,000 3 6% 5 $3,000) As you can readily observe, the preceding example was relatively simple because the full amount of the note's principal was liquidated with the final payment. But, other notes involve uniform payments over their term, such that each payment involves some amount of interest and principal. The final payment should be sufficient to liquidate the last amount of accrued interest and unpaid principal. You may be familiar with this type of arrangement if you have financed a car or home. These transactions usually involve level payments over the life of the loan. By the way, when you finance real estate, payment of the note is usually secured by the property being financed (if you don't pay, the lender can foreclose on the real estate and take it over). Notes thus secured are called \"mortgage notes.\" 39 waL80281_02_c02_035-056.indd 5 9/25/12 1:02 PM CHAPTER 2 Section 2.2 Long-Term Notes Payable Level Payment Notes Let's revise the terms of the Perez note just illustrated. This time assume that Perez is borrowing $50,000 for 3 years and will be required to make the equal annual payments to liquidate both interest and principal obligations. Because interest is included, the total of the three payments must exceed the $50,000 principal amount. The exact amount of each payment is $18,705.49. You may question how that amount is calculated; it is an excellent question and one you may someday use in your own personal finance. We'll get to that calculation soon. But, for now, take it as a given, and let's see how the accountant would handle the accounting for this note over its entire life. 1-1-X5 Cash 50,000 Note Payable 50,000 To record 6% note payable; to be satisfied by 3 equal annual payments 12-31-X5 Interest Expense 3,000 Notes Payable 15,705.49 Cash 18,705.49 To record $18,705.49 note payment, including interest of $3,000 ($50,000 3 6% 5 $3,000) 12-31-X6 2,057.67 Interest Expense Note Payable 16,647.82 Cash 18,705.49 To record $18,705.49 note payment, including interest of $2,057.67 (($50,000 2 $15,705.49 prior year's loan balance reduction) 3 6% 5 $2,057.67) 12-31-X7 Interest Expense 1,058.80 Notes Payable 17,646.69 Cash 18,705.49 To record $18,705.49 note payment, including interest of $1,058.80 (($50,000 2 $15,705.49 2 $16,647.82 prior years' loan balance reductions) 3 6% 5 $1,058.80) Perhaps the preceding entries appear a bit confusing and require added explanation. The first payment is applied to cover the accrued interest of $3,000, and the additional amount ($18,705.49 2 $3,000 5 $15,705.49) is treated as a reduction of the outstanding loan balance. Perez goes into the next year only owing $34,294.51 ($50,000 2 $15,705.49). Therefore, less interest is accrued during the second year of the loan (and more principal reduction occurs). This iterative process continues over the life of the loan. Frequently, this process is documented via a loan amortization table as shown in Exhibit 2.1. 40 waL80281_02_c02_035-056.indd 6 9/25/12 1:02 PM CHAPTER 2 Section 2.2 Long-Term Notes Payable Exhibit 2.1 A B C D E F Year Beginning of Year Loan Balance Interest on Beginning Balance Amount of Payment Reduction in Principal End of Year Loan Balance (6% of Column C) (Given Level Payment) (Column D minus Column C) (Column B minus Column E) 1 $ 50,000.00 $ 3,000.00 $ 18,705.49 $ 15,705.49 $ 34,294.51 2 $ 34,294.51 $ 2,057.67 $ 18,705.49 $ 16,647.82 $ 17,646.69 3 $ 17,646.69 $ 1,058.80 $ 18,705.49 $ 17,646.69 $ 0.00 Calculating the Amount of a Level Payment Most students tend to perk up when the subject of level payment notes is covered. The reason is that many students have borrowed money on such terms. Cars and homes are typically financed via these types of financial instruments. You have already seen how to account for such a loan, provided you know the amount of the payment. But, you may be wondering how to determine the payment amount. It can seem a bit mysterious, and many people simply rely on financial calculators, tables, or built-in spreadsheet functions. Let's try to demystify this process. Begin by considering that the funding received by the borrower ($50,000 in the Perez example) is deemed to be worth the same as the future repayments. In other words, Perez was willing to trade three installments of $18,705.49 in exchange for an immediate cash receipt of $50,000; they are of equal value at the time the loan is initiated. Accountants would say that the three payments of $18,705.49 have a present value of $50,000. Obviously, they total more than $50,000 (($18,705.49 3 3) . $50,000), but the excess represents the interest component. This requires a deeper examination of the concept of present value. Present value calculations are associated with many accounting issues. Present value reveals how much money to be received in the future is worth today. There are several ways to calculate present value amounts, and this topic will be dealt with extensively in a future chapter. For now, be aware that one useful tool is a present value table. Refer to the present value table (Appendix C), and note the following factors for the 6% annual interest rate column: Present value of $1 to be received in 1 year 5 0.9434 Present value of $1 to be received in 2 years 5 0.8900 Present value of $1 to be received in 3 years 5 0.83962 What these factors mean is that, assuming a 6% interest rate environment, a person would just as soon have $0.9434 today compared to receiving $1 in 1 year. Similarly, the person would just as soon have $0.89 today as $1 in 2 years. This logic can be extended to any number of periods and at any interest rate per period. Using this logic and a 6% rate, what do you suppose the present value of $18,705.49 per year for 3 years calculates to be? Examine Table 2.2, and verify that the present value of the payments is indeed $50,000. 41 waL80281_02_c02_035-056.indd 7 9/25/12 1:02 PM CHAPTER 2 Section 2.2 Long-Term Notes Payable Table 2.2: Present value of payments Payment Present value factor Payment times present value factor Year 1 $18,705.49 0.9434 $17,646.75 Year 2 $18,705.49 0.8900 16,647.88 Year 3 $18,705.49 0.83962 15,705.50 2.67302 $50,000.00* *Adjusted for rounding differences. A quick shortcut is to sum the present value factors (2.67302 as shown) and multiply the total by the $18,705.49. By summing the individual factors, an annuity factor is deter-mined. There are annuity tables that already contain the summed values and that can be used to determine the present value of all payments together. (An annuity is a stream of equal payments occurring on a regular interval.) Once you have this logic in hand, you have the basis for calculating the payment amount for any level payment note. The payments on a loan represent a series of level payments that cover both the principal and interest. The present value of those payments is the amount you borrowed. Thus, Loan Amount 5 Payments 3 Summation of Present Value Factors Using some algebra, if you know the amount of your loan and the interest rate, you can also solve for the payment amount. You merely need to find the summation of the present value factors related to the loan's duration and interest rate. To practice, assume a $100,000, 5-year loan at 8% per annum. Refer to the 8% column of a present value table and find the following factors: Present value of $1 to be received in 1 year 5 0.9259 Present value of $1 to be received in 2 years 5 0.8573 Present value of $1 to be received in 3 years 5 0.7938 Present value of $1 to be received in 4 years 5 0.7350 Present value of $1 to be received in 5 years 5 0.6806 Summing these individual factors totals 3.9927 (with rounding adjustments). Thus, the following formula applies: $100,000 5 Payment 3 3.9927 Or Payment 5 $100,000/3.9927 Thus Payment 5 $25,045.71 42 waL80281_02_c02_035-056.indd 8 9/25/12 1:02 PM CHAPTER 2 Section 2.3 Bonds Payable You can safely conclude that five payments of $25,045.71 will exactly pay off the $100,000 loan and all interest. Bear in mind that these calculations must always use the \"interest rate period.\" This means that a 5-year, 12% annual interest rate loan, with monthly pay-ments, would really be a 60-period, 1% loan (i.e., 5 years contain 60 months). Giving careful consideration to the preceding mathematics also points out an important planning issue you should keep in mind. Specifically, proportionate frequent payments (e.g., monthly) have more impact on debt reduction than an annual payment. For example, by making payments of $1,000 per month rather than $12,000 per year, you will achieve an accelerated principal reduction and incur less overall interest cost. 2.3 Bonds Payable L arge corporations sometimes have credit needs that exceed the capacity of a single lender. A single bank or other lender may not be able to prudently lend hundreds of millions, or billions, of dollars to one company. This requires the borrower to split its credit needs into smaller units, or bonds payable. A bond payable is a financial instrument whereby the issuing company receives an upfront cash payment in exchange for a promise to make periodic interest payments and repay the face amount of the bond at a fixed maturity date. Banks, retirement funds, individual investors, and others can buy these bonds, effectively making a loan to the issuing company. Each bond will typically display a face or par value ($1,000 per bond is quite common). This is the amount that must be repaid at maturity. The bond will also carry a stated rate of interest. If a $1,000 bond has a 5% stated rate (also known as the annual rate or coupon rate), then it would pay annual interest of $50 (often, the payment of bond interest occurs on a semian-nual or other periodic basis). Bond Pricing Sometimes bonds are issued at par value to investors. At other times, investors might be willing to pay more or less than face value for a bond. A company that is in dire financial difficulty may not be able to repay its debts. Investors would clearly not pay face value to buy such bonds; they are too risky, and they would only trade at a deep discount to face value. Bonds would also sell at a discount if they offered very poor/low interest rates relative to other investment opportunities. Conversely, bonds can sell at a premium to face value. How could this be the case? Suppose that the going rate of interest is approximately 5%, and you have the choice of buying a bond with a stated rate of 5% versus another one with a 10% rate of interest (and both companies are fully expected to make all of their scheduled payments). Obviously, you would opt for the time 10% bond. Indeed, you would probably pay a premium to obtain the superior cash flow associated with the higher interest rates. Although beyond the scope of this course, you may be wondering exactly how you would calculate the price to pay for a bond that carries an interest rate above or below the going rate. Consider that a bond payable is a promise to make future payments related to both interest and principal. Thus, the amount an investor should pay for a bond is the present value of these payments, as determined by reference to present value factors associated with going market rate of interest on the date the investor decides to purchase the bonds. Generalizing, when the market rate of interest is greater than the stated rate of interest, 43 waL80281_02_c02_035-056.indd 9 9/25/12 1:02 PM CHAPTER 2 Section 2.3 Bonds Payable the discounted present value of the cash flow will be below the face value of the bond (thus this bond would be priced at a discount, and vice versa (stated rate . market rate so would be priced at a premium)). The present value methods are precise mathematical tools that allow sophisticated investors to determine the right valuations for bonds. Exhibit 2.2 includes examples of bond pricing assuming alternative terms and should easily allow you to see the general relationships. Exhibit 2.2 BOND TERMS* PAR VALUE LIFE 5 years 10 years 30 years MARKET RATE ISSUE PRICE STATED RATE $ 100,000 6% 6% $ 100,000 $ 100,000 6% 10% $ 84,557 $ 100,000 6% 4% $ 108,983 $ 100,000 6% 6% $ 100,000 $ 100,000 6% 10% $ 75,076 $ 100,000 6% 4% $ 116,351 $ 100,000 6% 6% $ 100,000 $ 100,000 6% 10% $ 62,141 $ 100,000 6% 4% $ 134,761 *Each bond is assumed to pay interest on a semiannual basis The specific terms of a bond issue are specified in a bond indenture. This indenture is a written document defining the terms of the bond issue. In addition to making representations about the interest payments and life of the bond, numerous other factors must be addressed. Bond Features Before discussing the specifics of bond accounting, it is best to consider some of the differentiating features that may (or may not) be present in a particular bond issue. As you think about your own investment strategies in years to come, you will likely give thought to buying some bonds. Knowing these finer points about bonds will likely help you avoid some unexpected outcomes. First, it is important to note whether a particular bond is secured. A secured bond has specific assets that are pledged as collateral to insure payment. In the event of default, the bond holders may claim particular designated assets in an attempt to reclaim value for their investments. Many bonds are only secured by the general faith and credit of the issuer. These instruments are termed debenture bonds. Another way in which investors attempt to achieve security for their bond investments is by requiring the company to set up a sinking fund. In essence, a sinking fund is a required escrow account into which monies are periodically transferred to insure that funds will be available at maturity to satisfy the obligation. 44 waL80281_02_c02_035-056.indd 10 9/25/12 1:02 PM CHAPTER 2 Section 2.3 Bonds Payable Occasionally, a bond may be convertible. The holder receives the right to exchange the bond for a set number of shares of common stock. This is a great feature if a company's stock value climbs significantly. It is sort of like \"having your cake and eating it too.\" The investor not only has the benefit of receiving interest over the life of the bond but also might be able to turn it in for a far more valuable financial instrument. The downside is that investors usually accept lower interest rates than must be paid on bonds that are not convertibledrawing on another old saying, \"there is no free lunch.\" You should be aware that some bonds are callable. These bonds afford the issuing company with an option to buy back the debt at a fixed price and well before scheduled maturity. In a declining interest rate environment, the company may want to retire the older higher rate debt, and the call provision gives them the right to do so. If you are thinking of buying high-rate bonds to lock in a great long-term return, be aware of whether the call feature is present. So, be careful not to pay too high of a premium for callable bonds. The call price is usually stated as a percentage of face value (e.g., a $1,000 bond callable at 103 can be repurchased for $1,030), and one would be taking a chance to pay more than the call price when investing in bonds. Accounting for Bonds Payable Issued at Par When a bond is issued at its face or par value, the accounting is quite straightforward, much like the accounting for a term loan that matures on a fixed date. Assume that Clark Corporation issued 1,000 of its $1,000 face value bonds at par on January 1, 20X1. These 4-year, 7% bonds pay interest twice per year and have a 5-year life. The following entries are necessary to record the initial bond issuance, the subsequent interest payments, and repayment of the bonds at maturity. Please pay close attention to the details as presented in the journal entry description below each entry. 1-1-X1 Cash 1,000,000 Bonds Payable 1,000,000 To record issuance of 1,000, 7%, 4-year bonds at par (1,000 3 $1,000 each) Each interest date Interest Expense 35,000 Cash 35,000 To record interest payments (this entry occurs on every interest payment date at 6-month intervals$1,000,000 3 7% 3 6/12), beginning on June 30, 20X1, and continuing through December 31, 20X4 12-31-X5 Bonds Payable 1,000,000 Cash 1,000,000 To record repayment at maturity 45 waL80281_02_c02_035-056.indd 11 9/25/12 1:02 PM CHAPTER 2 Section 2.3 Bonds Payable Accounting for Bonds Payable Issued at a Premium To revise the preceding example, assume that the market rate of interest was below 7% at the time that Clark Corporation issued the above bonds. The stated rate of the bond remained at 7%, however. Thus, the Clark bonds were quite attractive to investors so they paid a premium. For our illustration, assume the bonds were issued at 108% of face. This means that Clark will get $1,080,000 when the bonds are issued but only have to repay $1,000,000 at maturity. This may seem quite a bargain, but consider that Clark is also agreeing to pay a stated rate of interest of 7%, when the market conditions were less. In a way, the $80,000 premium over face value stands to reduce the overall cost of the borrowing, and that is how accountants treat such amounts. Accountants amortize the original issue premium as a reduction of interest expense. One method of amortization is the straight-line amortization approach. With this technique, an equal amount of premium is amortized each period, as a reduction of the overall interest expense. The following entries demonstrate this approach. Again, a careful reading of the journal entry descriptions is necessary. 1-1-X1 Cash 1,080,000 Premium on Bonds Payable 80,000 Bonds Payable 1,000,000 To record issuance of 1,000, 7%, 4-year bonds at an $80,000 premium (1,000 3 $1,000 3 108%) Each interest date Interest Expense 25,000 Premium on Bonds Payable 10,000 Cash 35,000 To record interest payments (this entry occurs on every interest payment date at 6-month intervals) and related amortization of bond premium ($80,000 premium amortized over 8 semiannual periods) 12-31-X5 Bonds Payable 1,000,000 Cash 1,000,000 To record repayment at maturity Bonds payable is reported on the balance sheet as a liability, along with the unamortized premium appended thereto (known as an \"adjunct\" account). A balance sheet prepared immediately following the bond issuance would reveal the following: Bonds payable $1,000,000 Plus: Premium on bonds payable 80,000 $1,080,000 The income statement for each year will reveal total interest expense of $50,000 ($25,000 for each 6-month period), reflecting the difference between the interest paid and the reduction of the premium. An amortization table is helpful to shed light on this process (Exhibit 2.3). 46 waL80281_02_c02_035-056.indd 12 9/25/12 1:02 PM CHAPTER 2 Section 2.3 Bonds Payable Exhibit 2.3 PERIOD ENDING BONDS PAYABLE $ 1,000,000 UNAMORTIZED PREMIUM $ 80,000 NET BOOK VALUE OF DEBT (Bonds Payable plus Premium) $ INTEREST EXPENSE (Cash paid less premium amortization) 1,080,000 6/30/X1 1,000,000 70,000 1,070,000 12/31/X1 1,000,000 60,000 1,060,000 $ 25,000 25,000 6/30/X2 1,000,000 50,000 1,050,000 25,000 12/31/X2 1,000,000 40,000 1,040,000 25,000 6/30/X3 1,000,000 30,000 1,030,000 25,000 12/31/X3 1,000,000 20,000 1,020,000 25,000 6/30/X4 1,000,000 10,000 1,010,000 25,000 12/31/X4 1,000,000 - 1,000,000 25,000 Another very simple way to consider this accounting issue is to think only about cash effects. The company borrowed $1,080,000 and repaid $1,280,000 ($35,000 3 8 semiannual periods 1 $1,000,000 maturity value), for a difference of $200,000. The accounting expense of $25,000 on eight separate dates also equals the same $200,000! Thus, the company expenses the excess of the cash repaid over what was borrowed, following the systematic and rational process evident in the journal entries. Accounting for Bonds Payable Issued at a Discount To further revise the Clark Corporation example, this time assume that the market rate of interest was above 7% when the bonds were originally issued. The stated rate of the bond remained at 7%, leaving the Clark bonds as not so attractive. Informed investors would only purchase the bonds at a discount. Assume the bonds were issued at 96% of face. This means that Clark will get $960,000 when the bonds are issued but will still have to repay $1,000,000 at maturity. The $40,000 discount from face value must be repaid and will increase the overall interest cost. Using the straight-line approach, an equal amount of discount is to be amortized each period. The following entries demonstrate how discount amortization results in an increase in each period's interest expense: 1-1-X1 Cash 960,000 Discount on Bonds Payable 40,000 Bonds Payable 1,000,000 To record issuance of 1,000, 7%, 4-year bonds at a $40,000 discount (1,000 3 $1,000 3 96%) Each interest date Interest Expense 40,000 Discount on Bonds Payable 5,000 Cash 35,000 To record interest payments (this entry occurs on every interest payment date at 6-month intervals) and related amortization of bond discount ($40,000 discount amortized over 8 semiannual periods) 47 waL80281_02_c02_035-056.indd 13 9/25/12 1:02 PM CHAPTER 2 Section 2.3 Bonds Payable 12-31-X5 Bonds Payable 1,000,000 Cash 1,000,000 To record repayment at maturity Now, bonds payable is reported on the balance sheet as a liability, less the unamortized discount (another example of a contra account). A balance sheet prepared immediately following the bond issuance would reveal the following: Bonds payable $1,000,000 40,000 Less: Discount on bonds payable $960,000 The income statement for each year will reveal total interest expense of $80,000 ($40,000 for each 6-month period), reflecting the cash paid for interest, plus the extra amount for discount amortization. The appropriate amortization process is reflected in Exhibit 2.4. Exhibit 2.4 PERIOD ENDING BONDS PAYABLE $ 1,000,000 UNAMORTIZED DISCOUNT $ 40,000 NET BOOK VALUE OF DEBT (Bonds Payable less Discount) $ INTEREST EXPENSE (Cash paid plus discount amortization) 960,000 6/30/X1 1,000,000 35,000 965,000 12/31/X1 1,000,000 30,000 970,000 $ 40,000 40,000 6/30/X2 1,000,000 25,000 975,000 40,000 12/31/X2 1,000,000 20,000 980,000 40,000 6/30/X3 1,000,000 15,000 985,000 40,000 12/31/X3 1,000,000 10,000 990,000 40,000 6/30/X4 1,000,000 5,000 995,000 40,000 12/31/X4 1,000,000 - 1,000,000 40,000 Thinking about cash flow impacts, consider that the company borrowed $960,000 and repaid $1,280,000 ($35,000 3 8 semiannual periods 1 $1,000,000 maturity value), for a difference of $320,000. The accounting expense of $40,000 on eight separate dates also equals the same $320,000! Again, we can see that the company will expense the difference in the total amount of cash borrowed and repaid. Alternative Approach to Amortization If you study more advanced accounting courses, you will learn about many alternative accounting approaches. In the case of bond accounting, there is a more complex, but theoretically preferable, approach to recording premium and discount amortization. It is the 48 waL80281_02_c02_035-056.indd 14 9/25/12 1:02 PM CHAPTER 2 Section 2.3 Bonds Payable effective-interest method. This approach recognizes interest expense each period as a constant percentage of a bond's balance sheet carrying value. The theoretical support for this alternative calculation is based on a belief that the interest calculation aligns with the basis on which the bond was priced. In other words, interest expense is calculated to match the effective-interest rate by which investors presumably priced the bond initially. Importantly, the approach produces the same total interest cost but assigns it in a different pattern to each of the individual accounting periods. Bonds Issued Between Interest Dates Bonds usually require a specific interest payment on designated interest payment dates. This payment is to occur regardless of the length of time the bonds are outstanding. Thus, if a bond is actually issued later than its initial issue date, some interest will have already accrued. The issuer will then collect the amount of accrued interest when the bonds are issued and simply return that amount among the full interest payment on the next interest payment date. In other words, interest is paid for the full amount regardless of when the bonds were actually issued. The net effect is that the purchaser of the bond does not receive interest for periods during which the bond was not owned. Assume Sloval Corporation planned to issue $250,000 of 8% bonds, dated April 1, 20X2. The actual issuance was delayed until June 1. The first interest payment of $10,000 ($250,000 3 8% 3 6/12) is due on September 30. At the date of issuance, June 1, interest for April and May has already accrued ($250,000 3 8% 3 2/12 5 $3,333). Thus, the bond issue transaction will capture the issue price of the bond plus the accrued interest. This event, along with the subsequent payment of interest on September 30, is shown below. Note that the interest payment entry only expenses interest for the 4 months the bonds were outstanding. 6-1-X2 Cash 253,333 Interest Payable 3,333 Bonds Payable 250,000 To record issuance of bonds at par, plus accrued interest 9-30-X2 Interest Expense 6,667 Interest Payable 3,333 Cash 10,000 To record interest payment (includes return of accrued interest payable from original issue on June 1) You should also be aware that these same concepts apply when bond investors trade bonds between interest dates. If you buy a bond, you will pay for the accrued interest up to the date of your purchase. On the next regular interest date, you will get these funds back, along with any additionally earned accruing interest. This pricing mechanism is intended to simplify the bond issuer's accounting such that the issuer only needs to make one interest payment to the current holder of a bond rather than having to provide pro-rata payments to the various investors who may have held the bonds throughout the period. 49 waL80281_02_c02_035-056.indd 15 9/25/12 1:02 PM CHAPTER 2 Section 2.3 Bonds Payable Year-End Interest Accruals Another facet of bond accounting that should not be overlooked is the year-end adjusting entry. If a company's year ends on a date other than an interest payment date, it is necessary to accrue all accumulated interest. Continuing with Sloval Corporation, assume a December 31 year end. Because interest was last paid on September 30, the following adjusting entry is needed to reflect the accrual of interest for October, November, and December: 12-31-X2 Interest Expense 5,000 Interest Payable 5,000 Year-end accrual for 3 months ($250,000 3 8% 3 3/12) On March 31 of the following year, the $10,000 regular interest payment will be split between coverage of interest payable ($5,000) and interest expense ($5,000). The interest expense relates to January, February, and March's interest cost. If the bonds were subject to any premium or discount, year-end adjusting entries should also reflect an appropriate amount of amortization relating to elapsed time periods. Frequency of Interest Accruals Most of the end-of-period adjusting entries illustrated in this chapter assumed that accrued interest was being recorded through the end of the year. However, as emphasized in the financial accounting course, adjusting entries are to be recorded whenever financial statements are to be prepared. Companies frequently prepare monthly and/or quarterly reports. As such, interest accruals related to notes and bonds may need to be recorded more frequently. For example, if Sloval Corporation prepared a monthly income statement, the following adjusting entry would be a recurring monthly accrual: Interest Expense 1,667 Interest Payable 1,667 Year-end accrual for 3 months ($250,000 3 8% 3 1/12) Debt Retirements Debt may be paid off early. A company may have generated excess cash and desires to avoid future interest cost via early retirement of debt. If interest rates decline, a company might want to take advantage of more favorable rates and refinance existing debt with a new loan on better terms. Perhaps you have engaged in such a transaction by \"refinancing\" a home loan. Whether a loan is extinguished or refinanced does not matter to the accountant. In either case, the old debt is removed from the books, and the new loan is simply accounted for as a new loan. 50 waL80281_02_c02_035-056.indd 16 9/25/12 1:02 PM CHAPTER 2 Concept Check Normally, you would think of paying off debt at its recorded amount, and the appropriate journal entry would involve a simple debit to the debt and credit to cash. However, it is also possible that the cash payment to satisfy the debt may differ from the book value of the debt. This can occur if there is a fixed call price or prepayment penalty for early retirement of an obligation. The accounting sequence for recording a debt retirement contemplates bringing all interest accruals current and then recording the final liquidation of the obligation. To illustrate, assume the Moreno Corporation is retiring a $250,000 term loan that bears interest at 6%. The last interest payment occurred on May 1, 20X5, and the debt is being retired on July 1, 20X5. The loan was originally scheduled to mature at the end of 20X8. The borrowing agreement requires Moreno to pay a $7,500 penalty if the loan is paid off before 20X8. The first step to account for this debt retirement is to bring the accounting for interest up to date: 7-1-X5 Interest Expense 2,500 Interest Payable 2,500 To record interest accrual ($250,000 3 6% 3 2/12 months 5 $2,500) Then, the actual bond retirement can be recorded, with the difference between the carrying value and the funds utilized being recorded as a loss (debit) or gain (credit). 7-1-X5 Note Payable 250,000 Interest Payable 2,500 Loss on Debt Retirement 7,500 Cash 260,000 Concept Check The five questions that follow relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The correct answers can be found at the end of your text.) 1.\t\u0007When the interest payment dates of a bond are June 1 and December 1, and a bond issue is sold on August 1, the amount of cash received by the issuer upon sale will be a.\tincreased by the accrued interest from August 1 to December 1. b.\tincreased by the accrued interest from June 1 to August 1. c.\tdecreased by the accrued interest from August 1 to December 1. d.\tdecreased by the accrued interest from June 1 to August 1. 2. Bonds payable are sold at 98 when there is a difference between the a.\tissue date and maturity date. b.\tcontract interest rate and effective interest rate. c.\tcarrying value and maturity value. d.\tface value and maturity value. 51 waL80281_02_c02_035-056.indd 17 9/25/12 1:02 PM CHAPTER 2 Key Terms 3. Bonds payable sold at 104 should be disclosed on the balance sheet at their face value a.\tplus any unamortized discount. b.\tplus any unamortized premium. c.\tminus any unamortized discount. d.\tminus any unamortized premium. 4.\t\u0007Jim Hoover and his accountant recently met to discuss various business and accounting matters related to incorporation of Hoover Oil and Gas. Which of the following statements would not have been made by the accountant? a.\t\u0007For control purposes, outside investors will likely buy shares of the new entity's preferred stock. b.\t\u0007It will be necessary to obtain a charter to create the corporation. c.\t\u0007The company's executive officers will be accountable to the board of directors. d.\t\u0007It would probably be advantageous for the company if any preferred stock issuances are callable. 5. Rights of common stockholders generally include which of the following? a.\tA return of par value in the event of corporate liquidation or bankruptcy b.\tThe right to vote on important matters c.\tThe right to convert the common shares into preferred stock or notes d.\tThe right to dividends in every profitable year Key Terms annuity A stream of equal payments occurring on a regular interval. cumulative Aspect of preferred stock that dictates that any unpaid dividends must be paid prior to any further payouts to common stock. bonds payable Financial instruments whereby the issuing company receives an upfront cash payment in exchange for a promise to make periodic interest payments and repay the face amount of the bond at a fixed maturity date. debenture bond A bond that is only secured by the general faith and credit of the issuer. dividends in arrears Unpaid dividends on preferred stock. callable bond A bond that affords the issuing company with an option to buy back the debt at a fixed price and well before scheduled maturity. effective-interest method An approach to amortization that recognizes interest expense each period as a constant percentage of a bond's balance sheet carrying value. convertible A type of preferred stock where preferred shares may be exchanged for common stock at a set ratio. face value Displayed value of a bond that must be repaid at maturity. convertible bond A bond in which the holder receives the right to exchange the bond for a set number of shares of common stock. preferred stock Stock that gives its holders preference over common stockholders in dividend distributions and distributions of assets upon liquidation. 52 waL80281_02_c02_035-056.indd 18 9/25/12 1:02 PM CHAPTER 2 Exercises present value The amount an investor is willing to pay to secure a specified cash flow on a future date at a given rate of return. sinking fund An escrow account that a bond investor may require into which monies are periodically transferred to insure that funds will be available at maturity to satisfy the obligation. secured bond A bond that has specific assets that are pledged as collateral to insure payment. stated rate A bond interest rate. straight-line amortization An approach to amortization in which an equal amount of premium is amortized each period as a reduction of the overall interest expense. Critical Thinking Questions 1. What is a corporation? Discuss the advantages of the corporate form of organization. 2. Briefly explain the disadvantages of the corporate form of organization. 3.\t\u0007Discuss the duties and responsibilities of the directors of a corporation. How do directors gain their authority? 4. Describe a typical corporation's leadership structure. 5. Distinguish between authorized stock and outstanding stock. 6. List the rights typically possessed by common stockholders. 7. Briefly explain the dividend preference associated with preferred stock. 8. How does cumulative preferred stock differ from noncumulative preferred stock? 9. Are dividends in arrears on cumulative preferred stock a liability? Explain. 10. What is \"callable preferred stock\"? Why do corporations issue such stock? Exercises 1. Issuance of stock Prepare journal entries to record the issuance of 100,000 shares of common stock at $20 per share for each of the following independent cases: a.\tJackson Corporation has common stock with a par value of $1 per share. b.\tRoyal Corporation has no-par common with a stated value of $5 per share. c.\tFrench Corporation has no-par common; no stated value has been assigned. 2. Stock subscriptions: Journal entries Investors recently subscribed to 5,000 shares of B&J Travel's $1 par-value common stock at $10 per share. During the year, the company received 80% of the balances due, which resulted in the issuance of 4,000 shares of stock. a.\tPrepare journal entries to record 1) the subscriptions to investors. 2) the receipt of cash from subscribers. 3) the issuance of shares. 53 waL80281_02_c02_035-056.indd 19 9/25/12 1:02 PM CHAPTER 2 Exercises b.\tDetermine the year-end balance in the Common Stock Subscribed account. c.\t\u0007Determine the year-end balance in the Common Stock Subscriptions Receivable account. 3. Analysis of stockholders' equity Star Corporation issued both common and preferred stock during 20X6. The stockholders' equity sections of the company's balance sheets at the end of 20X6 and 20X5 follow: 20X6 Preferred stock, $100 par value, 10% Common stock, $10 par value $ 580,000 20X5 $ 500,000 2,350,000 1,750,000 Preferred 24,000 Common 4,620,000 3,600,000 Retained earnings 8,470,000 6,920,000 $16,044,000 $12,770,000 Paid-in capital in excess of par value Total stockholders' equity a.\tCompute the number of preferred shares that were issued during 20X6. b.\tCalculate the average issue price of the common stock sold in 20X6. c.\tBy what amount did the company's paid-in capital increase during 20X6? d.\tDid Star's total legal capital increase or decrease during 20X6? By what amount? 4. Preparation of stockholders' equity section The following data relate to LeMaster Corporation as of December 31, 20XX, the close of the current accounting period: \u0007 referred stockThe company has 1,000 shares of $50 par-value cumulative pre P ferred stock authorized. The stock pays a 10% dividend; to date, 400 shares have been issued at $55 per share. \u0007 ommon stockA total of 25,000 shares of $1 stated-value common stock is autho C rized. To date, 10,000 shares have been issued at $10 per share, and an additional 3,000 shares have been subscribed to at $15 per share. Assuming a retained earnings balance of $177,000, prepare the stockholders' equity section of LeMaster's December 31, 20XX, balance sheet. 5. Bond premium: Straight-line amortization Castillo Company issued $200,000 of 10%, 4-year bonds on January 1, 20X1, for $216,000. The bonds pay interest semiannually on June 30 and December 31. 54 waL80281_02_c02_035-056.indd 20 9/25/12 1:02 PM CHAPTER 2 Problems a.\tPrepare the required journal entry to record the bond issuance on January 1, 20X1. b.\t\u0007Prepare entries to record the interest payment and premium amortization on June 30 and December 31, 20X1. Castillo uses the straight-line method of amortization. c.\tCompute 20X1 bond interest expense. d.\t\u0007Present the proper disclosure of the bond issue on Castillo's December 31, 20X1, balance sheet. Problems 1. Bond computations: Straight-line amortization Southlake Corporation issued $900,000 of 8% bonds on March 1, 20X1. The bonds pay interest on March 1 and September 1 and mature in 10 years. Assume the independent cases that follow: Case AThe bonds are issued at 100. Case BThe bonds are issued at 96. Case CThe bonds are issued at 105. Southlake uses the straight-line method of amortization. Instructions Complete the following table: Case A Case B Case C a. Cash inflow on the issuance date b. Total cash outflow through maturity \u0007 otal borrowing cost over the life c. T of the bond issue d. I\u0007 nterest expense for the year ended December 31, 20X1 \u0007 mortization for the year ended e. A December 31, 20X1 \u0007 namortized premium or f. U unamoratized discount as of December 31, 20X1 if any g. B \u0007 ond carrying value as of December 31, 20X1 55 waL80281_02_c02_035-056.indd 21 9/25/12 1:02 PM CHAPTER 2 Problems 2. Bonds: Journal entries, issuance through retirement On May 1, 20X1, American Housing Corporation issued $300,000 of 12%, 5-year bonds for $294,200 plus accrued interest. The bonds are dated March 1, 20X1, and pay semiannual interest on March 1 and September 1. American uses the straightline method of amortization and will amortize the discount over the 58 months that the bonds are expected to be outstanding. Instructions a.\t\u0007Prepare journal entries to record (1) the bond issuance on May 1, 20X1; (2) the semiannual interest payment and discount amortization on September 1, 20X1; and (3) accrued interest and discount amortization on December 31, 20X1. b.\t\u0007Compute total bond interest expense for 20X1. c.\t\u0007Present the proper disclosure of the bond issue on American's December 31, 20X1, balance sheet. d.\t\u0007Prepare journal entries to record the semiannual interest payment and discount amortization on March 1, 20X2. e.\t\u0007Assume that the entire bond issue was called at 101, plus accrued interest, on July 1, 20X2. Prepare journal entries to record the bond retirement. Hint: Examine when amortization was last recorded. 3. Issuance of stock Ventures Inc. was formed on January 1 to invest in artwork. The company is authorized to issue 10,000 shares of $1 par-value common stock and 1,000 shares of 10%, $50 par-value cumulative preferred stock. The following selected transactions occurred during the first quarter of operation: Jan. 3 19 Sold 5,000 shares of common stock to the corporation's founders at $30 per share. Sold 600 shares of preferred stock at $58 per share. Feb. 4 Issued 100 common shares to an attorney for $3,300 of legal work related to corporate start-up and formation. 11 Issued 2,000 shares of common stock to Pierre LaTour in exchange for a painting appraised at $75,000. The art originally cost LaTour $30,000. Instructions a.\tPrepare journal entries to record the company's transactions. b.\t\u0007Prepare the stockholders' equity section of the firm's March 31 balance sheet. The Retained Earnings balance on this date totals $41,000. c.\t\u0007The president of Ventures believes that organization costs should be expensed immediately. Briefly explain why the president's view is incorrect. 56 waL80281_02_c02_035-056.indd 22 9/25/12 1:02 PM Ashf LISTEN TO AUDIO/VIDEO EXPLAINING THE GUIDANCE REPORT Exercise/ Problem Account to be changed Shares Share price $ Original Amount 100000 20 Ch 2 Ex 1 Questions YOUR ANSWERS BASED UPON COURSE START DATE A. Cash Common stock Paid-in-capital B. Cash Common stock Paid-in-capital C. Cash Common stock Ch 2 EX 3 Account to be changed Preferred stock, $100 par value, 10% Common par Original Amount 580000 10 YOUR ANSWERS BASED UPON COURSE START DATE A. Preferred shares issued B. Shares issued of common B. Average issued price of common C. Paid-in-capital increase D. Legal capital increase Ch 2 Pb 3 Account to be changed Jan 3, Common Shares sold Share price Attoney cost Original Amount 5000 58 3300 YOUR ANSWERS BASED UPON COURSE START DATE 3-Jan Cash Common stock Paid-in-capital in excess of par common stock Jan. 19 Cash Preferred stock Paid-in-capital in excess of par- Preferred stock 4-Feb Organization costs Common stock Paid-in-capital in excess of par common stock Investment in art work Common stock Paid-in-capital in excess of par common stock Stockholders Equity Common stock, $1 par-value, authorized 10,000 shares, shares issued and outstanding Preferred stock,10%, $50 par, authorized 1000 shares shares issued and outstanding Total Capital Stock Paid-in-Capital in excess of par: Common stock Preferred stock Total Paid-in-Capital Retained earnings Total Shareholders Equity Ch3 Ex 4 Account to be changed Original Amount 549000 759200 Manufacturing costs Sales YOUR ANSWERS BASED UPON COUR Cost of goods manufactured Beginning work in process Manufacturing costs Ending work in process Cost of goods manufactured Cost of goods sold Beginning finished goods Cost of goods manufactured Ending finished goods Cost of goods sold Net income Sales Cost of goods sold Operating expenses Net income Ch 3 Pb 2 Account to be changed Original Amount 628000 56700 23500 231500 Sales Work in process, Jan. 1 Advertising expense Direct material purchases YOUR ANSWERS BASED UPON COURSE START DATE a. Prepare a schedule of cost of goods manufactured in good form. Direct materials used Beginning raw materials inventory Net purchases Direct materials available Less: Ending raw materials inventory Direct materials used Direct labor Factory overhead Indirect materials used Indirect labor Utilities Taxes Insurance Depreciation Total manufacturing costs Add: Beginning work in process inventory Less: Ending work in process inventory Costs of goods manufactured Sales Cost of goods sold Beginning finished goods inv. Cost of goods manufactured Goods available for sale Less: Ending finished goods inv. Cost of goods sold Gross profit Operating expenses: Selling expenses: Advertising Sales staff salaries Utilities Taxes Insurance Depreciation Total selling expenses Administrative expenses: Utilities Taxes Insurance Depreciation Total administrative exp. Total operating expenses Net income Ashford University ACC206 Guidance Report Week Two YELLOW INDICATES ACCOUNT AMOUNTS CHANGED Change Account to: Based Upon Course Start Date Jan-Feb $ 500000 20X6 600,000 11 Mar-Apr 11000 21 20X5 500,000 $ 20X6 620,000 12 May-Jun 12000 22 20X5 500,000 20X6 640,000 13 5,200 62 3,600 5,400 66 3,900 5,600 70 4,200 12/31/X3 551,000 761,600 12/31/X2 12/31/X3 553,000 764,000 12/31/X2 12/31/X3 555,000 766,400 NSWERS BASED UPON COURSE START DATE 629000 57700 24500 232500 630000 58700 25500 233500 631000 59700 26500 234500 May-Jun $ Jul-Aug 13000 23 20X5 500,000 $ 20X6 660,000 14 Sept-Oct 14000 24 20X5 500,000 $ 20X6 680,000 15 Nov-Dec 15000 25 20X5 500,000 $ 100000 26 20X6 20X5 $ 700,000 $ 500,000 $ 16 5,800 74 4,500 6,000 78 4,800 6,200 82 5,100 12/31/X2 12/31/X3 557,000 768,800 632000 60700 27500 235500 12/31/X2 12/31/X3 559,000 771,200 633000 61700 28500 236500 12/31/X2 12/31/X3 561,000 773,600 634000 62700 29500 237500 12/31/X2