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- 1. Reporting and Interpreting Bonds Chapter 10 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
- 2. Understanding the Business <ul><li>The mixture of debt and equity used to finance a company’s operations is called the capital structure : </li></ul>Debt - funds from creditors Equity - funds from owners
- 3. Characteristics of Bonds Payable <ul><li>Advantages of bonds: </li></ul><ul><li>Stockholders maintain control because bonds are debt, not equity. </li></ul><ul><li>Interest expense is tax deductible. </li></ul><ul><li>The impact on earnings is positive because money can often be borrowed at a low interest rate and invested at a higher interest rate. </li></ul><ul><li>Disadvantages of bonds: </li></ul><ul><li>Risk of bankruptcy exists because the interest and debt must be paid back as scheduled or creditors will force legal action. </li></ul><ul><li>Negative impact on cash flows exists because interest and principal must be repaid in the future. </li></ul>
- 4. Characteristics of Bonds Payable Two types of cash payment in the bond contract: 1. Principal. 2. Cash interest payments. <ul><li>Bond Terms </li></ul><ul><li>Principal, par value and face value </li></ul><ul><li>Contract, stated, or coupon rate of interest </li></ul><ul><li>Market, yield, or effective-interest rate </li></ul>
- 5. Characteristics of Bonds Payable <ul><li>Debenture bonds </li></ul><ul><ul><li>No assets are pledged as guarantee of repayment at maturity. </li></ul></ul><ul><li>Secured bonds </li></ul><ul><ul><li>Specific assets are pledged as guarantee of repayment at </li></ul></ul><ul><ul><li>maturity. </li></ul></ul><ul><li>Callable bonds </li></ul><ul><ul><li>Bond may be called for early retirement by the issuer. </li></ul></ul><ul><li>Convertible bonds </li></ul><ul><ul><li>Bond may be converted to other securities (usually common stock). </li></ul></ul>An indenture is a bond contract that specifies the legal provisions of a bond issue.
- 6. Characteristics of Bonds Payable <ul><li>The bond indenture contains covenants designed to protect the creditors. </li></ul><ul><li>The bond issuer also prepares a prospectus , which describes the company, the bonds, and how the proceeds of the bonds will be used. </li></ul><ul><li>The trustee makes sure the issuer fulfills all of the provisions of the bond indenture. </li></ul>
- 7. Reporting Bond Transactions = < > = < >
- 8. Bonds Issued at Par On January 1, 2011, Burlington Northern Santa Fe (BNSF) 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. = =
- 9. Bonds Issued at Par Here is the entry made every six months to record the interest payment. Here is the entry to record the maturity of the bonds.
- 10. Times Interest Earned Times Interest Earned = Net income + Interest expense + Income tax expense Interest expense The ratio shows the amount of resources generated for each dollar of interest expense. In general, a high ratio is viewed more favorable than a low ratio.
- 11. Bonds Issued at Discount On January 1, 2011, BNSF issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2020) and interest is paid semiannually. The market rate is 12% annually. This bond is issued at a discount. < <
- 12. Bonds Issued at Discount <ul><li>The issue price of a bond is composed of the present value of two items: </li></ul><ul><li>Principal (a single amount) </li></ul><ul><li>Interest (an annuity) </li></ul>First, 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
- 13. Bonds Issued at Discount Now, compute the present value of the interest. <ul><li>The issue price of a bond is composed of the present value of two items: </li></ul><ul><li>Principal (a single amount) </li></ul><ul><li>Interest (an annuity) </li></ul>Market rate of 12% ÷ 2 interest periods per year = 6% Bond term of 10 years × 2 periods per year = 20 periods
- 14. Bonds Issued at Discount Finally, 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. <ul><li>The issue price of a bond is composed of the present value of two items: </li></ul><ul><li>Principal (a single amount) </li></ul><ul><li>Interest (an annuity) </li></ul>
- 15. Bonds Issued at Discount 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.
- 16. Bonds Issued at Discount The discount will be amortized over the 10-year life of the bonds. Two methods of amortization are commonly used: Straight-line Effective-interest.
- 17. Reporting Interest Expense: Straight-line Amortization <ul><li>Identify the amount of the bond discount. </li></ul><ul><li>Divide the bond discount by the number of interest periods. </li></ul><ul><li>Include the discount amortization amount as part of the periodic interest expense entry. </li></ul><ul><ul><li>The discount will be reduced to zero by the maturity date. </li></ul></ul>
- 18. Reporting Interest Expense: Straight-line Amortization BNSF issued their bonds on Jan. 1, 2011. The discount was $11,470. The bonds have a 10-year maturity and $5,000 interest is paid semiannually. Compute the periodic discount amortization using the straight-line method.
- 19. Reporting Interest Expense: Straight-line Amortization As the discount is amortized, the carrying amount of the bonds increases.
- 21. Reporting Interest Expense: Effective-interest Amortization <ul><li>The effective interest method is the theoretically preferred method. </li></ul><ul><li>Compute interest expense by multiplying the current unpaid balance times the market rate of interest. </li></ul><ul><li>The discount amortization is the difference between interest expense and the cash paid (or accrued) for interest. </li></ul>
- 22. Reporting Interest Expense: Effective-interest Amortization BNSF issued their bonds on Jan. 1, 2011. 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
- 23. Reporting Interest Expense: Effective-interest Amortization As the discount is amortized, the carrying amount of the bonds increases .
- 25. Zero Coupon Bonds <ul><li>Zero coupon bonds do not pay periodic interest. </li></ul><ul><li>This is called a deep discount bond . </li></ul>Because there is no interest annuity, the PV of the Principal = Issue Price of the Bonds
- 26. Bonds Issued at Premium On January 1, 2011, BNSF issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2020) and interest is paid semiannually. The market rate is 8% annually. This bond is issued at a premium. > >
- 27. Bonds Issued at Premium <ul><li>The issue price of a bond is composed of the present value of two items: </li></ul><ul><li>Principal (a single amount) </li></ul><ul><li>Interest (an annuity) </li></ul>First, compute the present value of the principal. Market rate of 8% ÷ 2 interest periods per year = 4% Bond term of 10 years × 2 periods per year = 20 periods
- 28. Bonds Issued at Premium Now, compute the present value of the interest. <ul><li>The issue price of a bond is composed of the present value of two items: </li></ul><ul><li>Principal (a single amount) </li></ul><ul><li>Interest (an annuity) </li></ul>Market rate of 8% ÷ 2 interest periods per year = 4% Bond term of 10 years × 2 periods per year = 20 periods
- 29. Bonds Issued at Premium Finally, 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. <ul><li>The issue price of a bond is composed of the present value of two items: </li></ul><ul><li>Principal (a single amount) </li></ul><ul><li>Interest (an annuity) </li></ul>
- 30. Bonds Issued at Premium The premium will be amortized over the 10-year life of the bonds.
- 32. Reporting Interest Expense: Straight-line Amortization Here is the journal entry to record the payment of interest and the premium amortization for the six months ending on June 30, 2011.
- 33. *
- 34. Reporting Interest Expense: Effective-interest Amortization Here is the journal entry to record the payment of interest and the premium amortization for the six months ending on June 30, 2011.
- 35. Debt-to-Equity This ratio shows the relationship between the amount of capital provided by owners and the amount provided by creditors. In general, a high ratio suggest that a company relies heavily on funds provided by creditors. Debt-to-Equity = Total Liabilities Stockholders’ Equity
- 36. Early Retirement of Debt <ul><li>Occasionally, the issuing company will call (repay early) some or all of its bonds. </li></ul><ul><li>Gains/losses are calculated by comparing the bond call amount with the book value of the bond. </li></ul><ul><ul><ul><li>Book Value > Retirement Price = Gain </li></ul></ul></ul><ul><ul><ul><li>Book Value < Retirement Price = Loss </li></ul></ul></ul>
- 37. Focus on Cash Flows <ul><li>Financing Activities – </li></ul><ul><ul><li>Issue of bonds (cash inflow) </li></ul></ul><ul><ul><li>Retire debt (cash outflow) </li></ul></ul><ul><ul><li>Repay bond principal at maturity (cash outflow) </li></ul></ul>Remember that payment of interest under U.S. GAAP is an operating activity.
- 38. Supplement A: Bond Calculations Using Excel <ul><li>The issue price of a bond is composed of the present value of two items: </li></ul><ul><li>Principal (a single amount) </li></ul><ul><li>Interest (an annuity) </li></ul>
- 39. Supplement B: Bonds Issued at a Discount (without Discount Account) & at a Premium (without Premium Account For financial reporting purposes, it is not necessary to use a discount or premium account when recording bonds sold at a discount or premium.
- 40. End of Chapter 10

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