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Accounting II | © |
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© 1989 John Petroff
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.
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