Reporting and Interpreting Bonds Chapter 10 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc

Reporting and Interpreting Bonds

Chapter 10

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

Do the following problems

• E9-15• E9-16• P9-12

Long-Term Liabilities

Creditors often require the borrower to pledge specific assets as security for the long-term

liability.

Maturity = 1 year or less Maturity > 1 year

Current Liabilities Long-term Liabilities

Long-Term Notes Payable and Bonds

Relatively small debt needs can be filled from single

sources.

Relatively small debt needs can be filled from single

sources.

BanksInsurance

CompaniesPension

Plans

Long-Term Notes Payable and Bonds

Significant debt needs are often filled by issuing bonds to

the public.

Significant debt needs are often filled by issuing bonds to

the public.

CashBonds

Understanding the Business The mixture of debt and equity used to finance a company’s operations is called

the capital structure:

Debt - funds from creditors

Equity - funds from owners

Characteristics of Bonds Payable Advantages of bonds:

• Stockholders maintain control because bonds are debt, not equity.

• Interest expense is tax deductible.• The impact on earnings is positive

because money can often be borrowed at a low interest rate and invested at a higher interest rate.

Advantages of bonds:• Stockholders maintain control

because bonds are debt, not equity.• Interest expense is tax deductible.• The impact on earnings is positive

because money can often be borrowed at a low interest rate and invested at a higher interest rate.

Disadvantages of bonds: Risk of bankruptcy exists

because the interest and debt must be paid back as scheduled or creditors will force legal action.

Negative impact on cash flows exists because interest and principal must be repaid in the future.

Disadvantages of bonds: Risk of bankruptcy exists

because the interest and debt must be paid back as scheduled or creditors will force legal action.

Negative impact on cash flows exists because interest and principal must be repaid in the future.

1. Face Value (Maturity or Par Value, Principal)2. Maturity Date3. Stated Interest Rate 4. Interest Payment Dates5. Bond Date

Characteristics of Bonds Payable

Other Factors:6. Market Interest Rate7. Issue Date

BOND PAYABLE

Face Value $1,000 Interest 10%6/30 & 12/31

Maturity Date 1/1/19Bond Date 1/1/09

Bond Classifications

Debenture bonds Not secured with the pledge of a specific asset.

Callable bonds May be retired and repaid (called) at any time at

the option of the issuer. Convertible bonds

May be exchanged for other securities of the issuer (usually shares of common stock) at the option of the bondholder.

Debenture bonds Not secured with the pledge of a specific asset.

Callable bonds May be retired and repaid (called) at any time at

the option of the issuer. Convertible bonds

May be exchanged for other securities of the issuer (usually shares of common stock) at the option of the bondholder.

An indenture is a bond contract that specifies the legal provisions of a bond

issue.

Characteristics of Bonds Payable• When issuing bonds, potential buyers

of the bonds are given a prospectus.• The prospectus describes the

company, the bonds, and how the proceeds of the bonds will be used.

• The trustee makes sure the issuer fulfills all of the provisions of the bond indenture.

• When issuing bonds, potential buyers of the bonds are given a prospectus.

• The prospectus describes the company, the bonds, and how the proceeds of the bonds will be used.

• The trustee makes sure the issuer fulfills all of the provisions of the bond indenture.

Characteristics of Bonds Payable

$ Bond Issue Price $

Bond Certificate

Bonds payable are long-term debt for the issuing company.

Company Issuing Bonds

Company Issuing Bonds

Investor Buying Bonds

Investor Buying Bonds

PeriodicInterest Payments$ $

Principal Payment at End of

Bond Term$ $

Reporting Bond Transactions

Accounting forthe Difference

Stated Market Bond Par Value There is no differenceRate Rate Price of the Bond to account for.

Stated Market Bond Par Value The difference is accountedRate Rate Price of the Bond for as a bond discount.

Stated Market Bond Par Value The difference is accountedRate Rate Price of the Bond for as a bond premium.

Rates PriceInterest Bond

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Present Value of the Principal (a single payment)+ Present Value of the Interest Payments (an annuity) = Issue Price of the Bond

Bonds Issued at ParOn January 1, 2009, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The

bonds mature in 10 years and interest is paid semiannually. The market rate is 10% annually.

This bond is issued at a par.

On January 1, 2009, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The

bonds mature in 10 years and interest is paid semiannually. The market rate is 10% annually.

This bond is issued at a par.

Interest Bond Accounting forRates Price the Difference

Stated Market Bond Par Value There is no differenceRate Rate Price of the Bond to account for.

= =

Date Description Debit Credit

Jan 1 Cash (+A) 100,000 Bonds Payable (+L) 100,000

GENERAL JOURNAL

Bonds Issued at Par


Bond Interest Expense (+E, -SE) 5,000 Cash (-A) 5,000

GENERAL JOURNAL

Here is the entry made every six months to record the interest payment.

Here is the entry made every six months to record the interest payment.


Bonds Payable (-L) 100,000 Cash (-A) 100,000

GENERAL JOURNAL

Here is the entry to record the maturity of the bonds.

Here is the entry to record the maturity of the bonds.

Bonds Issued at DiscountOn January 1, 2009, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The

bonds mature in 10 years (Dec. 31, 2018) and interest is paid semiannually. The market rate is

12% annually.

This bond is issued at a discount.



12% annually.

This bond is issued at a discount.


Stated Market Bond Par Value The difference is accountedRate Rate Price of the Bond for as a bond discount.

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Present ValueSingle Amount = Principal × Factor

Bonds Issued at Discount

Use the present value of a single amount table to find the appropriate factor.


The issue price of a bond is composed of the present value of two items:

•Principal (a single amount)•Interest (an annuity)



Present ValueSingle Amount = Principal × Factor (i=6.0%, n=20)

31,180$ = 100,000$ × 0.3118

First, let’s compute the

present value of the principal.

Market rate of 12% ÷ 2 interest periods per year = 6%

Bond term of 10 years × 2 periods per year = 20 periods



Use the present value of an annuity table to find the appropriate factor.


Present ValueAnnuity = Payment × Factor

Bonds Issued at DiscountThe issue price of a bond is composed

of the present value of two items: •Principal (a single amount)•Interest (an annuity)



Now, let’s compute the

present value of the interest.





Present ValueAnnuity = Payment × Factor (i=6.0%, n=20)

57,350$ = 5,000$ × 11.4699


31,180$ Present Value of the Principal

+ 57,350 Present Value of the Interest

= 88,530$ Present Value of the Bonds





Finally, we can determine the

issue price of the bond.

The $88,530 is less than the face amount of $100,000, so the bonds are issued at a discount

of $11,470.

The $88,530 is less than the face amount of $100,000, so the bonds are issued at a discount

of $11,470.



Jan 1 Cash (+A) 88,530Discount on Bonds Payable (+XL, -L) 11,470 Bonds Payable (+L) 100,000

GENERAL JOURNAL

This is a contra-liability account and appears in the liability section of the balance sheet.

This is a contra-liability account and appears in the liability section of the balance sheet.

Here is the journal entry to record the bond issued at a discount.


Harrah'sPartial Balance Sheet

At January 1, 2009

Long-Term LiabilitiesBonds Payable, 10% 100,000$ Due Dec. 31, 2018 Less: Bond Discount (11,470) Total L-T Liabilities 88,530$

The discount will be amortized

over the 10-year life of the bonds.

Two methods of amortization are commonly used:

Straight-line

Effective-interest.

Reporting Interest Expense: Effective-interest Amortization

The effective interest method is the theoretically preferred method.

Compute interest expense by multiplying the current unpaid balance times the market rate of interest.

The discount amortization is the difference between interest expense and the cash paid (or accrued) for interest.

The effective interest method is the theoretically preferred method.

Compute interest expense by multiplying the current unpaid balance times the market rate of interest.

The discount amortization is the difference between interest expense and the cash paid (or accrued) for interest.


Discount Total Cash PaidAmortization = Interest - for Interest

312$ = 5,312$ - 5,000$

Harrah’s issued their bonds on Jan. 1, 2009. The issue price was $88,530. The bonds have a 10-year maturity

and $5,000 interest is paid semiannually.

Compute the periodic discount amortization using the effective interest method.

Harrah’s issued their bonds on Jan. 1, 2009. The issue price was $88,530. The bonds have a 10-year maturity

and $5,000 interest is paid semiannually.

Compute the periodic discount amortization using the effective interest method.

Unpaid Balance × Effective Interest Rate × n/12

$88,530 × 12% × 1/2 = $5,312

Unpaid Balance × Effective Interest Rate × n/12

$88,530 × 12% × 1/2 = $5,312


Jun 30 Interest Expense (+E, -SE) 5,312 Discount on Bonds Payable (-XL, +L) 312 Cash (-A) 5,000

GENERAL JOURNAL


As the discount is amortized, the carrying amount

of the bonds increases.


At June 30, 2009

Long-Term LiabilitiesBonds Payable, 10% 100,000$ Due Dec. 31, 2018 Less: Bond Discount (11,158) Total L-T Liabilities 88,842$

Effective-Interest Amortization TableInterest Interest Discount Unamortized Book

Date Payment Expense* Amortization* Discount* Value1/1/2009 11,470$ 88,530$

6/30/2009 5,000$ 5,312$ 312$ 11,158 88,842 12/31/2009 5,000 5,331 331 10,828 89,172 6/30/2010 5,000 5,350 350 10,477 89,523

12/31/2010 5,000 5,371 371 10,106 89,894 6/30/2011 5,000 5,394 394 9,712 90,288

12/31/2011 5,000 5,417 417 9,295 90,705

6/30/2018 5,000 5,890 890 944 99,056 12/31/2018 5,000 5,943 943 0 100,000

100,000$ 111,470$ 11,470$ * Rounded.

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Zero Coupon Bonds

Zero coupon bonds do not pay periodic interest.

Because there is no interest annuity . . .

This is called a deep discount bond.

PV of the Principal = Issue Price of the BondsPV of the Principal = Issue Price of the Bonds

Bonds Issued at PremiumOn January 1, 2009, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The


8% annually.

This bond is issued at a premium.



8% annually.

This bond is issued at a premium.


Stated Market Bond Par Value The difference is accountedRate Rate Price of the Bond for as a bond premium.

> >

Present ValueSingle Amount = Principal × Factor

Bonds Issued at Premium







Present ValueSingle Amount = Principal × Factor (i=4.0%, n=20)

45,640$ = 100,000$ × 0.4564

First, let’s compute the

present value of the principal.







Present ValueAnnuity = Payment × Factor

Bonds Issued at PremiumThe issue price of a bond is composed

of the present value of two items: •Principal (a single amount)•Interest (an annuity)



Now, let’s compute the

present value of the interest.





Present ValueAnnuity = Payment × Factor (i=4.0%, n=20)

67,952$ = 5,000$ × 13.5903


45,640$ Present Value of the Principal

+ 67,952 Present Value of the Interest

= 113,592$ Present Value of the Bonds





Finally, we can determine the

issue price of the bond.

The $113,592 is greater than the face amount of $100,000, so the bonds are issued at a

premium of $13,592.

The $113,592 is greater than the face amount of $100,000, so the bonds are issued at a

premium of $13,592.


Jan 1 Cash (+A) 113,592 Premium on Bonds Payable (+L) 13,592 Bonds Payable (+L) 100,000

GENERAL JOURNAL

This is an adjunct-liability account and appears in the liability section of the balance sheet.

This is an adjunct-liability account and appears in the liability section of the balance sheet.



At January 1, 2009

Long-Term LiabilitiesBonds Payable, 10% 100,000$ Due Dec. 31, 2018 Add: Bond Premium 13,592 Total L-T Liabilities 113,592$

The premium will be

amortized over the 10-year life of the bonds.

Amortization TableInterest Interest Premium Unamortized Book

Date Payment Expense* Amortization* Premium* Value1/1/2009 13,592$ 113,592$

6/30/2009 5,000$ 12/31/2009 5,000 6/30/2010 5,000

12/31/2010 5,000 6/30/2011 5,000

12/31/2011 5,000

6/30/2018 5,000 - 12/31/2018 5,000 -

100,000$ 86,408$ 13,592$ * Rounded.

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Early Retirement of DebtOccasionally, the issuing

company will call (repay early) some or all of its bonds.

Gains/losses are calculated by comparing the bond call amount with the book value of the bond.

Occasionally, the issuing company will call (repay early) some or all of its bonds.

Gains/losses are calculated by comparing the bond call amount with the book value of the bond.

Book Value > Retirement Price = GainBook Value < Retirement Price = Loss

Documents

Reporting and Interpreting Bonds Chapter 10 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc