Page 597 - Accounting Principles (A Business Perspective)

15. Long-term financing: Bonds

Companies A and B
Partial Balance Sheets
2010 December 31
Company A Company B
Stockholders' equity:
Paid-in capital:
Common stock $20,000,000 $10,000,000
Retained earnings (11,000,000)(11,000,000)
Total stockholders' equity $ 9,000,000 $ (1,000,000)
A third disadvantage of debt financing is that it also causes a company to experience unfavorable financial
leverage when income from operations falls below a certain level. Unfavorable financial leverage results when
the cost of borrowed funds exceeds the revenue they generate; it is the reverse of favorable financial leverage. In the
previous example, if income from operations fell to USD 1,000,000, the rates of return on stockholders' equity
would be 3 per cent for A and zero for B, as shown in this schedule:
Companies A and B
Income Statements
For the year ended 2010 December 31
Company A Company B
Income from operations $1,000,000 $1,000,000
Interest expense 1,000,000
Income before federal income taxes $1,000,000 $ -0-
Deduct: Federal income taxes (40%) 400,000 -0-
Net income 600,000 $ -0-
Rate of return on stockholders' equity:
Company A ($600,000/$20,000,000) 3%
Company B ($0/$10,000,000) 0%
The fourth disadvantage of issuing debt is that loan agreements often require maintaining a certain amount of
working capital (Current assets - Current liabilities) and place limitations on dividends and additional borrowings.
When a company issues bonds, it incurs a long-term liability on which periodic interest payments must be
made, usually twice a year. If interest dates fall on other than balance sheet dates, the company must accrue interest
in the proper periods. The following examples illustrate the accounting for bonds issued at face value on an interest
date and issued at face value between interest dates.
Bonds issued at face value on an interest date Valley Company's accounting year ends on December 31.
On 2010 December 31, Valley issued 10-year, 12 per cent bonds with a USD 100,000 face value, for USD 100,000.

The bonds are dated 2010 December 31, call for semiannual interest payments on June 30 and December 31, and
mature on 2020 December 31. Valley made the required interest and principal payments when due. The entries for
the 10 years are as follows:
On 2010 December 31, the date of issuance, the entry is:
2010
Dec. 31 Cash (+A) 100,000
Bonds payable (+L) 100,000
To record bonds issued at face
value.
On each June 30 and December 31 for 10 years, beginning 2010 June 30 (ending 2020 June 30), the entry
would be:
Each
year
June 30
And Dec.31 Bond Interest Expense ($100,000 x 0.12 x 6,000
½) (-SE)
Cash (-A) 6,000
To record periodic interest payment.
On 2020 December 31, the maturity date, the entry would be:

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