ACCTG 101 Lecture Notes - Lecture 12: Income Statement, Issued Shares, Effective Interest Rate

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23 Oct 2020

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Bond details (loan from investor to company) The bond indenture is a legal document that specifies all of the details of the bond issuance. The par value (also called face value) is the stated amount that the corporation will pay back to the bondholder at the end of the term. Most corporate bonds have a par value of ,000. The effective interest rate is determined by the bond market. If the bond price goes up, the effective interest rate goes down, and vice versa. For example, if a bond is paying interest per year and its price is the effective interest rate is 6. 67% (60/900). If the bond price increases to the effective interest rate decreases to 6. 32% (60/950). However, once you buy a bond, you have locked-in that effective rate of interest for as long as you hold the bond.

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Can you please help solve the formula portions and show theformulas used?

PROBLEM DATA

The University Club recently issued $1,500,000 of 10-year, 9%bonds at an effective interest rate of 10%. Bond interest ispayable annually.

REQUIREMENTS

1. You have been asked to calculate the issuance price of thebonds and prepare amortization schedules for any discount orpremium. The worksheet BONDS has been provided to assist you. Notethat the worksheet contains a scratch pad at the bottom that hasbeen preprogrammed to automatically compute and display therelevant cash flows needed for bond pricing.

2. The bond pricing formula will utilize the NPV (Net PresentValue) function on your spreadsheet program. The NPV function willautomatically compute the net present value of annual future cashflows discounted at a specific interest rate. The interest rateshould be expressed as a cell address.


BONDS
Bond Pricing andAmortization

Data Section

	Face value of bond			$1,500,000
	Years to maturity *			10
	Stated interest rate			9.0%
	Effective interest rate			10.0%

	* Worksheet is designed for use with bonds having amaturity of
	12 years or less and paying interestannually.

Answer Section

	Bond issue price				FORMULA1

Amortization Schedule -Straight Line Method
	Cash		Interest	(Disc.)	Bond
Year	Paid	Amortization	Expense	Premium	Carrying Value
0				FORMULA2	FORMULA3
1	FORMULA4	FORMULA5	FORMULA6	FORMULA7	FORMULA8
2	FORMULA9	FORMULA10	FORMULA11	FORMULA12	FORMULA13
3	0	0	0	0	0
4	0	0	0	0	0
5	0	0	0	0	0
6	0	0	0	0	0
7	0	0	0	0	0
8	0	0	0	0	0
9	0	0	0	0	0
10	0	0	0	0	0
11	0	0	0	0	0
12	0	0	0	0	0

Amortization Schedule -Effective Interest Method
	Interest	Cash		(Disc.)	Bond
Year	Expense	Paid	Amortization	Premium	Carrying Value
0				FORMULA14	FORMULA15
1	FORMULA16	FORMULA17	FORMULA18	FORMULA19	FORMULA20
2	FORMULA21	FORMULA22	FORMULA23	FORMULA24	FORMULA25
3	0	0	0	0	0
4	0	0	0	0	0
5	0	0	0	0	0
6	0	0	0	0	0
7	0	0	0	0	0
8	0	0	0	0	0
9	0	0	0	0	0
10	0	0	0	0	0
11	0	0	0	0	0
12	0	0	0	0	0




	Scratch Pad
	Display of relevant cash flows
		Annual	Bond
	Year	Interest	Maturity
	1	135000	0
	2	135000	0
	3	135000	0
	4	135000	0
	5	135000	0
	6	135000	0
	7	135000	0
	8	135000	0
	9	135000	0
	10	135000	1500000
	11	0	0
	12	0	0

cyandonkey117

On January 1, Year 1, DPH, Co. issued a $3,500,000, 5 year bond.Interest will be paid on June 30 and December 31 each year. Thebond has a stated rate of 5% and was issued at 98. Ignore theeffects of taxes for this problem.

31.	(6 points) Make the journal entry for the issuance of thebond.

32.	(16 points) Make the journal entries for the first two interestpayments, assuming that DPH uses the effective interestmethod for amortizing any premiums or discounts on theirdebt. The effect interest rate on the bonds was 5.5%

33.

(15 points) On July 1, Year 4, DPH decided to retire 10% of thebonds in order to avoid violating a debt covenant on their majorline of credit. On that day, the bonds were selling at 101. Makethe journal entry to record the early retirement, assumingthat DPH, Co. uses the straight-line method for amortizingany premiums or discounts on their debt.

34.

(22 points) On August 31st, Year 4, the bonds were selling at97. Because of the good price, DPH decided to retire an additional30% of the bond. Make any necessary journal entries to record therepurchase. Assume that the market price includes anyaccrued interest and that DPH is still using the straight-linemethod.

35.

(16 points) Before recording the bond retirements, DPH reportedthe following information:

Net Sales	$ 8,000,000
Net Income	$ 1,200,000
Current Assets	$ 1,800,000
Total Assets	$ 9,000,000
Current Liabilities	$ 1,350,000
Total Liabilities	$ 6,300,000

Calculate the company's ROA, Debt-to-Equity, and Current Ratiosbefore and after the debt retirement. Assume all other necessaryentries, including any interest on the bonds, have been properlyrecorded. (HINT: Since you don't have beginning values, just usethe ending values for those ratios requiring averages!)

Use the following to answer questions 36-41:

At the end of last year, Tull Co. submitted paperwork to switchfrom a sole proprietor ship to a corporation. Just prior to yearend, the company received final authorization from the state ofIdaho to incorporate. In the articles of incorporation, Tull, Inc.is authorized to issues 1,000,000 shares of $2 par common stock. OnDecember 31st, Mrs. Tull received 250,000 shares of common stock inexchange for her equity in the sole proprietorship.

36.	(3 points) Make the journal entry to record Tull's first equityoffering on January 15th of the current year. The company issued150,000 shares at par value.

37.	(5 points) Make the journal entry to record an additional equityoffering on June 1st. The company issued 60,000 shares for $8 pershare.

38.	(3 points) On August 15th, Tull decided to repurchase 15,000shares of common stock in order to improve stock price. Make theappropriate journal entry to record the repurchase if the marketprice for Tull common stock on that day was $6 per share.

39.	(6 points) On November 11th, Tull's management decided that thestock price had increased sufficiently for them to reissue 7,500shares of their treasury stock. Make the entry to record thereissue of these shares if the stock price was $17 per share.

lilachippopotamus490

Bond Accounting

In December 2014, Rene Cook sat in her cubicle trying to remember what she had learned in business school about bonds and bond accounting. Ms. Cook, a new CPA and special assistant in a training assignment with the company president, had just met with David Lyons, president of Lyons Document Storage Corporation. Interest rates had fallen over recent years and he had asked her to think about the consequences issuing new bonds at a lower rate of interest and using the proceeds to repurchase the higher coupon rate bonds that are currently outstanding. My Lyons had asked Rene to focus on how much the companyâs annual interest payments could be reduced, how reported earnings would be affected, and how the refunding would change the companyâs financial position as referenced on the balance sheet, if at all.

The Company

The Lyons Company was a family business in the stationary supply business until the document storage opportunity appeared in the early 1990âs. Lyons Document Storage Corporation was incorporated in 1993 to compete in the emerging and rapidly growing industry that provides secure, off-site storage of documents for other corporate customers. The demand for storage was fueled by the need for corporations to retain records of sales contracts, employment records, compliance records, and other documents. The convenience of secure storage and easy recovery in professionally managed warehouses appealed to corporate clients that wanted to save space in their more expensive office buildings. At the same time, the stationary supply business was growing more competitive with the entrance of Staples, Office Depot and Office Max.

The early 2000âs were difficult for Lyons because there were still differences among management about directions and the companyâs future. A large competitor, Iron Mountain, was expanding rapidly in the United States and internationally. When the decision to focus on document storage was made, it was imperative to move quickly to secure storage space and transportation equipment. Management decided to fund the companyâs growth by issuing debt rather than by issuing additional equity. Lyons had operated conservatively without any long-term debt until it issued bonds in January of 2005. The bonds issued were $10 million in 20-year bonds, offering a coupon rate of 8%, with interest paid semiannually, and sold to yield the 9% market rate of interest at the time.

Current Situation

David Lyons had told Rene Cook that he felt the time might be ripe to refund the 2005 bond issue and replace it with bonds bearing lower interest rates. He had talked with the companyâs investment bankers who had told him that $10 million in new 6% bonds with semiannual interest payments could be issued to provide the company with exactly $10 million, not considering underwriting costs and legal fees that were expected to be nominal. The bonds would pay $300,000 of interest every June 30 and December 31 with a payment of $10 million in principal at the end of 10 years. The new interest payments would be $200,000 less each year than those due on the old bonds, which still had 10 years before they would be paid off. To Lyons, that seemed to offer a saving over the old bonds.

The existing bonds had been issued on January 1, 2005 and would be due December 31, 2024. Interest was paid semiannually to holders of the bonds.

Beginning her research, Rene reached for her copy of Lyons Document Storageâs 2013 Annual Report. (See Exhibit 1 for the Liabilities section of the 2013 Annual Report.) She was confused as to why the liability for the $10 million bonds was only $9.3 million at the end of 2013.

To clarify her understanding, Rene called the companyâs controller, Eric Petro, and learned that the 2005 bonds had been issued at a discount. Only about $9.1 million was received when the bonds were issued. For further information, Petro referred Rene to footnote 8 of the companyâs 2013 financial statements (Exhibit 2).

Next, Rene went to the Internet to determine the market price of the companyâs bonds. The current price was shown as 114.88 â reflecting the 6% yield the market for bonds was currently supporting. This meant that each $1,000 bond would have to be repurchased for $1,148.77. The company would have to spend $11.5 million to retire bonds that would be listed on the December 2014 balance sheet at less than $10 million. The resulting loss would shrink the 2015 projected earnings and slow the growth rate in earnings about which David Lyons was so proud. Rene knew this would not make Mr. Lyons happy. However, the lower interest payments associated with the new bonds would help reduce cash outflows in future years.

1. There is no indication in this case that the 2005 bonds were âcallableâ. Assume that the bonds are callable at 102. That is, there is a 2% call premium over par value. What accounting loss would result if the bonds were called at this price? If the bonds were in fact callable, how would this impact your analysis and recommendation?

ACCTG 101 Lecture Notes - Lecture 12: Income Statement, Issued Shares, Effective Interest Rate

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