Accounting theory and practice, Volume 2 (of 3) : a textbook for colleges and…

and interest, as: For the payment of interest— (a) Income (b) Participating (c) Unconditional (d) Registered (e) Registered coupon (f) Coupon (g) Interchangeable Etc. For the payment of the principal— (a) Premium (b) Gold (c) Silver (d) Straight (e) Serial (f) Extended (g) Callable (h) Optional (i) Convertible Etc. [50] “The Principles of Bond Investment,” by Lawrence Chamberlain. The issuing corporation often distinguishes its bonds by means of some descriptive adjectives purporting to classify them or indicate their nature. Thus, consolidated first and improvement, general and refunding mortgage, first mortgage extension, general lien railway and land grant, are titles sometimes met, though a simpler title carrying also the interest rate is more common, as general mortgage 4’s of 1965, C. & A. 5’s, Toledo Light & Power 4’s, etc. As listed on the exchange the title usually gives the name of the issuing corporation (i.e., the obligor), the distinctive name of the bond, and its interest rate. Bonds rank very much as mortgages do in the priority of their liens. A first mortgage bond has a first lien on the property securing it; a second mortgage bond has a second lien and its claim is said to be junior to that of the first. No attempt can here be made to explain the distinguishing features of the above-named issues. Attention is called to them only because the reader of a balance sheet—an investor or prospective creditor—often must have a knowledge of the various classes of bonds and a detailed knowledge of the conditions of particular issues. It is obvious that the accountant should have a knowledge of the particular issues of a business in order intelligently to draw up a balance sheet and make a report thereon. Authority for the Issue of Bonds A corporation has generally a charter right to issue bonds for the purpose of securing money, acquiring property, or in payment for labor or financial services rendered. The exercise of this right may be curtailed by, or be dependent upon, authority from a regulating body. Within the corporation itself, the right to issue vests in the stockholders. In some cases a majority vote suffices; in others as many as three-quarters of the votes may be required to authorize the issue. The directors themselves may, upon proper authorization from the stockholders, make the actual issue, and usually the initiative for a bond issue comes from them because they have intimate knowledge of the business and its needs. Financial Considerations Involved in Issue Financial considerations involved in the determination to issue bonds may be reviewed briefly. It is interesting to note that the bond has been used very extensively as a means of securing capital. There is, however, no necessary relationship between the amount of capital raised by stock issues and that raised by bond issues. The sale of additional stock or of bonds or other similar securities is the main source of corporation funds for capital purposes. Some concerns have obtained approximately one-half of their capital through the issue of bonds. Percentages of capital so raised ranging from 15% to 40% are not uncommon. The manner of raising capital is largely a matter of credit, expediency, and the question of fixed operating expenses. It rarely happens that bonds carry with them the privilege of voice in the management of the corporation’s affairs; that is usually limited strictly to the shareholders. Accordingly, the issue of bonds instead of additional stock does not interfere with the management or control of the concern—so long as the contract requirements of the bond issue are adhered to. Because of the definiteness of the income on bonds and usually the greater security of the principal, bonds may often find a market where stocks would not. On the other hand, if the stock can be marketed as advantageously as the bonds, no definite dividend rate is necessarily attached to them. The price at which stocks may be marketed, aside from the features of extra inducement which might influence the market, depends largely upon the prospective income rate judged mostly by what the company has been able to do in the past and any features of present condition or expected future condition which might influence the earning capacity of the corporation. Therefore, unless a dividend rate a little higher than the current interest rate is in prospect, the company usually finds it difficult to market its stock advantageously. Bonds versus Stock Issues The bond market furnishes opportunity for investment to quite a different class of people from those interested in stocks. Security, conservatism, and a definite income are the main elements desired. Thus conditions may oftentimes be such that one market or another may be more favorable for absorbing an issue of securities, dependent on conditions in that market as much as on the credit and standing of the issuing corporation. Aside from these points which are usually given consideration, is the question of how heavy are the fixed charges the corporation can carry. While from the investor’s viewpoint an income at a fixed rate is highly desirable, from the corporation’s point of view it may impose so great a burden as to eat up all the profits. The bond interest constitutes a fixed charge deductible before the determination of profits. In case of failure to meet the bond interest, the mortgage covering the bonds is subject to foreclosure. Upon foreclosure at forced sale values always shrink greatly, oftentimes the shareholders lose their entire interest in the company, and all the net assets may be taken to satisfy the claims of the bondholders. As compared with an additional issue of stock—common or preference shares, as may best meet the situation—a bond issue may thus be of doubtful value. One of the knotty problems upon a reorganization following insolvency is that of lowering the fixed charges by converting some of the bond issues into preferred stocks in order to prevent the recurrence of operation at a loss and so of inability to meet bond interest. Accounting for Bond Issue Accounting for the bond issue presents much the same problems as those connected with an issue of stock. Inasmuch as most corporation issues are sold in block to a banker who in turn markets them to the investing public, often through a syndicate (or the process may be one of under-writing), there is usually no need for detailed subscription records and accounts. In the case of coupon bonds no record of individual ownership is required because the bonds pass by delivery, possession evidencing ownership and the interest coupon being payable to bearer. In the case of registered bonds, a record of individual holdings must be kept similar to the record of stockholders. The party in whose name the bond is registered on the company’s records is the prima facie owner to whom the periodic interest check is also sent. If the bond is registered as to principal but bears coupons for the interest, records of individual ownership are also required here. Entry of Issue on Books Placing the bond issue on the books is accomplished by either of two methods. Assuming an issue of $500,000 of first mortgage 5% bonds of which $350,000 are sold at par for cash, the balance remaining unissued for the present, the entries would be: _First Method_ (1) Unissued First Mortgage Bonds $500,000.00 First Mortgage Bonds Payable $500,000.00 (2) Cash 350,000.00 Unissued First Mortgage Bonds 350,000.00 Entry (1) is used to make a memorandum entry of the authorized issue. Entry (2) shows the amount sold for cash. The balance in the Unissued Bond account is treated as an offset to the Bonds Payable account. Sometimes the title “Treasury Bonds” is used instead of “Unissued,” but the term is apt to be misleading because of the restricted meaning given the word in connection with treasury stock. _Second Method_ (3) Cash $350,000.00 First Mortgage Bonds Payable $350,000.00 Under the second method, the desired information as to authorized issue would be carried parenthetically in the account title. At the present time the tendency is to deprecate an unnecessary multiplication of accounts as is brought about through the use of memorandum accounts. The second method is therefore the preferred method and in its operation brings onto the books the same information as the first method. Entry of Premium or Discount on Books Bringing the bond premium or discount onto the books is accomplished in the same manner as for stock. Thus, using the above data and assuming $100,000 of the bonds sold at 101 and the remaining $50,000 at 99¾, the entries would be, illustrating only the second method: (4) Cash $101,000.00 First Mortgage Bonds Payable $100,000.00 Premium on First Mortgage Bonds Payable 1,000.00 (5) Cash 99,750.00 Discount on First Mortgage Bonds Payable 250.00 First Mortgage Bonds Payable 100,000.00 Subsequent handling of the premium and discount accounts will be shown on page 368. Bonds may be issued for cash or property, as in the case of stock. Unless there is evidence to the contrary, when bonds are issued for property they are brought onto the books at par value, the courts holding here as with stock that the parties to the transaction (usually the corporation’s directors) are in a better position to judge the value of the property taken over than anyone else. This oftentimes results in an inflation of property values—an injection of water—and should not be countenanced where a true basis for determining the value of the bond is offered. Thus, if almost simultaneously with the issue of the bonds for property, some are sold for cash, the cash price received would usually be a fair basis for booking the premium or discount on those issued for property. The sale for cash must be a bona fide sale in the open market if it is to represent the market’s judgment of the offering. Sometimes an objection is raised to a Bond Discount account appearing on the books; hence the practice, wherever possible, of charging the discount against some asset account as a part of the cost of that asset. When the true nature of bond discount or premium in its relation to the periodic interest charge is appreciated, the objection has no weight. Entry of Interest Payments on Books Booking the payment of the periodic interest is accomplished by a charge to Bond Interest and a credit to Cash. This interest should never be entered in the regular Interest and Discount account. If the bonds are coupon bonds with the coupons redeemable through a designated trust company, a check for the full amount of the interest on the outstanding bonds should be issued and booked as above. If the coupons are redeemable at the company’s office, an entry debiting Bond Interest and crediting Coupons Payable should be made, to record the interest charge and the liability therefor. As the coupons are redeemed, Coupons Payable is charged and Cash credited, any balance remaining in Coupons Payable account representing the liability existing because of coupons not yet presented for redemption. In the case of bonds registered both as to principal and interest, the interest checks made payable to the registered parties constitute a charge to Bond Interest and a credit to Cash. It is sometimes advisable to transfer by one check the total bond interest payable to a special bank account and issue the individual interest checks against this fund. Whenever the books are closed it is always necessary, unless the end of the fiscal period coincides with the bond interest date, to take account of the accrued bond interest as on that date. The adjusting entry here is similar to that for any accrued expense. Relation of Bond Interest to Premium or Discount The main problem in connection with accounting for bond interest is that of the relation between bond premium or discount and the periodic bond interest. At practically any time in the market there is a rate at which the bonds could be sold at par. This rate is known as the effective rate. If a company puts an issue of bonds on the market at a higher rate than this, the market will offer a premium for them. The amount of the premium will be, theoretically, the present value of the periodic sum represented by the difference between the stated bond interest and the effective interest, these periodic payments extending over the life of the bond. In other words, the premium represents the price paid to buy the additional interest, dollar for dollar, on a compound interest basis. The premium is therefore not an earning, an item of income, but is an offset to the excess bond interest. The portion of it applicable to each period represents the excess interest which deducted from the bond interest shows the real or effective cost of the money borrowed and to be paid back. Thus, the bond interest rate based on the money actually received, i.e., par plus premium, is exactly the same as the market or effective rate on par. In other words, the corporation is paying for its actual borrowings simply the current market rate of interest. It is therefore incorrect to show on the books the cost of the loan at any other figure than the effective interest. The actual periodic payment of interest is, however, at the bond interest rate. This must be brought down to the effective rate by application to it of a portion of the premium which represents the sum paid for the privilege of receiving the higher rate of interest. Similarly, bonds are marketed at a discount when the bond interest rate is lower than the market rate prevailing on similar security at the time the bonds are floated. This may be looked upon as a payment by the company in lump sum to compensate a purchaser for the difference in the income on the bond and what he might obtain on the open market. The discount should be applied, therefore, periodically to bring the cost of the loan up to its true figure, viz., the market or effective rate. An illustration will clarify the points of the above discussion. Example of True Interest Cost Assume a 7% bond, interest every six months, payable in 25 years (50 periods), par $1,000, sold in a market whose prevailing interest rate is 6%. By the method developed on page 273, the value of such a bond is found to be $1,128.6488, the premium being $128.6488. At the effective rate the real cost to the issuing company is 3% on $1,128.6488, or $33.8595. The actual sum paid as interest is $35, i.e., 3½% on $1,000. The difference between the effective and actual bond interest, or $1.1405, is the portion of the premium to be used that period in order to reduce the amount of actual interest paid to the real or effective cost of the loan. The bookkeeping entries are: (6) Bond Interest $35.00 Cash $35.00 (7) Premium on Bonds 1.14 Bond Interest 1.14 Similar calculations and entries for each of the succeeding 49 periods would be made, the application of the effective rate always being, of course, to the amortized value of the bond as on that date. This process is called scientific amortization of the premium (or discount) of the bond. Its effect is readily seen to be to spread over the life of the bond the premium (or discount) and so not to take credit for it in a lump sum during the period in which the bond is matured. There are four cases to which this principle of showing the true interest cost is applicable, as follows: