© the mcgraw-hill companies, inc., 2001 irwin/mcgraw-hill chapter 10 reporting and interpreting...
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© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Chapter 10
Reporting and Interpreting Bonds
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Significant debt needs of a company are often filled
by issuing bonds.
Significant debt needs of a company are often filled
by issuing bonds.
Business BackgroundCapital Structure - Bonds
Bonds Cash
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Business Background
Bonds can be traded on
established exchanges that
provide liquidityliquidity to
bondholders.
Bonds can be traded on
established exchanges that
provide liquidityliquidity to
bondholders.
As liquidity increases . . .
. . . Cost of borrowing decreases.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Business Background
Advantages of bonds:• Bonds are debt, not equity, so the
ownership and control of the company are not diluted.
• Interest expense is tax-deductible.• The low interest rates on bonds
allow for positive financial leverage.
Advantages of bonds:• Bonds are debt, not equity, so the
ownership and control of the company are not diluted.
• Interest expense is tax-deductible.• The low interest rates on bonds
allow for positive financial leverage.
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Business Background
Disadvantages of bonds:• The scheduled interest
payments are legal obligations and must be paid each period.
• A single, large principal payment is required at the maturity date.
Disadvantages of bonds:• The scheduled interest
payments are legal obligations and must be paid each period.
• A single, large principal payment is required at the maturity date.
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Key Ratio Analysis
The debt-equity ratio is an important measure of the balance between debt and
equity.
High debt-equity ratios(Greater than 1 to 1) indicate more leverage and risk.
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1. Face Value = Maturity or Par Value, Principal2. 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 1/1/10Bond Date 1/1/01
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• Senior Debt Senior Debt receives preference over other creditors in the event of bankruptcy or default.
• Subordinated Debt Subordinated Debt is riskier than senior debt.
• Senior Debt Senior Debt receives preference over other creditors in the event of bankruptcy or default.
• Subordinated Debt Subordinated Debt is riskier than senior debt.
Bond Classifications
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Measuring Bonds Payable and Interest Expense
The issue price of the bond is determined by the market, based on the time value of money.
The interest rate used to compute the present value is the market interest ratemarket interest rate.
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Measuring Bonds Payable and Interest Expense
The stated ratestated rate is only used to compute the periodic interest payments.
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Bond Premium and Discounts (See-Saw Diagram)
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Issuing Bonds
On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 6% annually. The bonds mature in 10 years and interest is paid semiannually.
The market rate is 8% annually.
On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 6% annually. The bonds mature in 10 years and interest is paid semiannually.
The market rate is 8% annually.
Are Harrah’s bonds issued at par, at a discount, or at a premium?
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 6%
annually. The bonds mature in 10 years and interest is paid semiannually. The
market rate is 8% annually.
On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 6%
annually. The bonds mature in 10 years and interest is paid semiannually. The
market rate is 8% annually.
Issuing Bonds
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© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds
On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 6%
annually. The bonds mature in 10 years and interest is paid semiannually. The
market rate is 8% annually.
On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 6%
annually. The bonds mature in 10 years and interest is paid semiannually. The
market rate is 8% annually.
Compute the issue price of Harrah’s bonds.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds
Compute the present value of the principal.
Use the present value of a single amount table to find the
appropriate factor.
Use the present value of a single amount table to find the
appropriate factor.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds
Compute the present value of the principal.
Use the market rate of 8% to determine present value. Interest is
paid semiannually, so the rate is i=4% (8% ÷ 2 interest periods per year).
Use the market rate of 8% to determine present value. Interest is
paid semiannually, so the rate is i=4% (8% ÷ 2 interest periods per year).
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds
Compute the present value of the principal.
Though the maturity period is 10 years, there are 2 interest periods per year. For the present value computation, use n=20
(10 years × 2 periods per year).
Though the maturity period is 10 years, there are 2 interest periods per year. For the present value computation, use n=20
(10 years × 2 periods per year).
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds
Compute the present value of the principal.
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Issuing Bonds
Compute the present value of the interest payments.
The interest payment is computed as:
$1,000,000 × 6% × 6/12
= $30,000
The interest payment is computed as:
$1,000,000 × 6% × 6/12
= $30,000
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds
Compute the present value of the interest payments.
Use the same i=4.0% and n=20 used for the present value of the principal,
but use the present value of an annuity table.
Use the same i=4.0% and n=20 used for the present value of the principal,
but use the present value of an annuity table.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds
Compute the present value of the interest payments.
Now, the issue price of the bonds can be computed.
Now, the issue price of the bonds can be computed.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds
Compute the issue price of the bonds.
456,400$ Present Value of the Principal
+ 407,709 Present Value of the Interest
= 864,109$ Present Value of the Bonds
456,400$ Present Value of the Principal
+ 407,709 Present Value of the Interest
= 864,109$ Present Value of the Bonds
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
456,400$ Present Value of the Principal
+ 407,709 Present Value of the Interest
= 864,109$ Present Value of the Bonds
456,400$ Present Value of the Principal
+ 407,709 Present Value of the Interest
= 864,109$ Present Value of the Bonds
Issuing Bonds
Compute the issue price of the bonds.
The $864,109 is less than the face amount of
$1,000,000, so the bonds are issued at a discount of
$135,891.
The $864,109 is less than the face amount of
$1,000,000, so the bonds are issued at a discount of
$135,891.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Recording BondsIssued at a Discount
Prepare the journal entry to record the issuance of the bonds.
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.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Bonds Issued at a DiscountFinancial Statement Presentation
The discount The discount will be will be
amortizedamortized over the 10-over the 10-
year life of the year life of the bonds.bonds.
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Straight-Line Amortization of Bond Discount
Identify the amount of the bond discount.
Divide the bond discount by the number of interest periods.
Include the discount amortization amount as part of the periodic interest expense entry.
The discount will be reduced to zero by the maturity date.
Identify the amount of the bond discount.
Divide the bond discount by the number of interest periods.
Include the discount amortization amount as part of the periodic interest expense entry.
The discount will be reduced to zero by the maturity date.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Straight-Line Amortization of Bond Discount
Harrah’s issued their bonds on May 1, 2001. The discount was $135,891. The bonds have a 10-year maturity
and $30,000 interest is paid semiannually.
Compute the periodic discount amortization using the straight-line method.
Harrah’s issued their bonds on May 1, 2001. The discount was $135,891. The bonds have a 10-year maturity
and $30,000 interest is paid semiannually.
Compute the periodic discount amortization using the straight-line method.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Harrah’s issued their bonds on May 1, 2001. The discount was $135,891. The bonds have a 10-year maturity
and $30,000 interest is paid semiannually.
Compute the periodic discount amortization using the straight-line method.
Harrah’s issued their bonds on May 1, 2001. The discount was $135,891. The bonds have a 10-year maturity
and $30,000 interest is paid semiannually.
Compute the periodic discount amortization using the straight-line method.
Straight-Line Amortization of Bond Discount
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Straight-Line Amortization of Bond Discount
Prepare the journal entry to record the payment of interest and the discount amortization for the six months ending on November 1, 2001.
Prepare the journal entry to record the payment of interest and the discount amortization for the six months ending on November 1, 2001.
GENERAL JOURNAL Page 123Date Description Debit Credit
Nov. 1 Interest Expense 36,795 Discount on Bonds Payable 6,795 Cash 30,000To record payment of interest
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Bonds Issued at a DiscountFinancial Statement Presentation
As the discount is
amortized, the carrying
amount of the bonds
increases.
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Zero Coupon Bonds
• Zero coupon bonds do not pay periodic interest.
• Because there is no interest annuity . . .
• This is called a deep discount bonddeep discount bond.• Discount is amortized using
straight line method
PV of the Principal = Issue Price of the BondsPV of the Principal = Issue Price of the Bonds
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds at a Premium
On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years and interest is
paid semiannually. The market rate is 8% annually.
On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years and interest is
paid semiannually. The market rate is 8% annually.
Are Harrah’s bonds issued at par, at a discount, or at a premium?
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years and interest is
paid semiannually. The market rate is 8% annually.
On May 1, 2001, Harrah’s issues $1,000,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years and interest is
paid semiannually. The market rate is 8% annually.
Issuing Bonds at a Premium
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Let’s compute the issue price of the bonds.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds at a Premium
Compute the present value of the principal.
Use the present value of a single amount table to find the
appropriate factor.
Use the present value of a single amount table to find the
appropriate factor.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds at a Premium
Compute the present value of the principal.
Use the market rate of 8% to determine present value. Interest is paid
semiannually, so the rate is i=4.0% (8% ÷ 2 interest periods per year).
Use the market rate of 8% to determine present value. Interest is paid
semiannually, so the rate is i=4.0% (8% ÷ 2 interest periods per year).
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds at a Premium
Compute the present value of the principal.
The maturity period is 10 years, there are 2 interest periods per year. For the present value computation, use n=20
(10 years × 2 periods).
The maturity period is 10 years, there are 2 interest periods per year. For the present value computation, use n=20
(10 years × 2 periods).
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds at a Premium
Compute the present value of the principal.
Next, we compute the present value of the interest payments.
Next, we compute the present value of the interest payments.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds at a Premium
Compute the present value of the interest payments.
The interest payment is computed as:
$1,000,000 × 10% × 6/12
= $50,000
The interest payment is computed as:
$1,000,000 × 10% × 6/12
= $50,000
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds at a Premium
Compute the present value of the interest payments.
Use the same i=4.0% and n=20 that were used to compute the present
value of the principal. Now, however, the factor comes from the present value of an annuity table.
Use the same i=4.0% and n=20 that were used to compute the present
value of the principal. Now, however, the factor comes from the present value of an annuity table.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Issuing Bonds at a Premium
Compute the present value of the interest payments.
Now, the issue price of the bonds can be computed.
Now, the issue price of the bonds can be computed.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
456,400$ Present Value of the Principal
+ 679,515 Present Value of the Interest
= 1,135,915$ Present Value of the Bonds
456,400$ Present Value of the Principal
+ 679,515 Present Value of the Interest
= 1,135,915$ Present Value of the Bonds
Issuing Bonds at a Premium
Compute the issue price of the bonds.
The $1,135,915 is greater than the face amount of $1,000,000, so the bonds are issued at a premium of
$135,915.
The $1,135,915 is greater than the face amount of $1,000,000, so the bonds are issued at a premium of
$135,915.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
GENERAL JOURNAL Page 97Date Description Debit Credit
May 1 Cash 1,135,915 Bonds Payable 1,000,000 Premium on Bonds Payable 135,915
Issuing Bonds at a Premium
Prepare the journal entry to record the issuance of the bonds.
This is called an adjunct account and appears in the liability section.
This is called an adjunct account and appears in the liability section.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Bonds Issued at a PremiumFinancial Statement Presentation
The The premium premium
will be will be amortizedamortized
over the 10-over the 10-year life of year life of the bonds.the bonds.
© The McGraw-Hill Companies, Inc., 2001Irwin/McGraw-Hill
Recording Interest Expense
Amortization of Bond Preemium:
$135,915 / 20 = $6,795.75
Recording Interest Expense:
Bond Interest Expense $43,204
Premium on Bonds 6,796
Cash 50,000