chap010

10-1

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Reporting and Interpreting Bonds

Chapter 10

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

10-2

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

10-3

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.

10-4


Two types of cash payment in the bond contract:1. Principal.2. Cash interest payments.

Bond Terms1.Principal, par value and face value2.Contract, stated, or coupon rate of interest3.Market, yield, or effective-interest rate

10-5


Debenture bondsNo assets are pledged as guarantee of repayment at

maturity.

Secured bondsSpecific assets are pledged as guarantee of repayment

at maturity.

Callable bondsBond may be called for early retirement by the issuer.

Convertible bondsBond may be converted to other securities (usually

common stock).

Debenture bondsNo assets are pledged as guarantee of repayment at

maturity.

Secured bondsSpecific assets are pledged as guarantee of repayment

at maturity.

Callable bondsBond may be called for early retirement by the issuer.

Convertible bondsBond may be converted to other securities (usually

common stock).

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

bond issue.

10-6


• The bond indenture contains covenants designed to protect the creditors.

• The bond issuer also prepares a prospectus, which 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.

• The bond indenture contains covenants designed to protect the creditors.

• The bond issuer also prepares a prospectus, which 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.

10-7

Reporting Bond Transactions

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10-8

Bonds Issued at ParOn 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.

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.

= =

10-9

Bonds Issued at ParHere is the entry made every six months to record Here is the entry made every six months to record

the interest payment.the interest payment.

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

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

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

10-10

Times Interest Earned

Times InterestEarned =

Net income + Interest expense + Income tax expense

Interest expense

The ratio shows the amount of resources The ratio shows the amount of resources generated for each dollar of interest generated for each dollar of interest expense. In general, a high ratio is expense. In general, a high ratio is

viewed more favorable than a low ratio.viewed more favorable than a low ratio.

The ratio shows the amount of resources The ratio shows the amount of resources generated for each dollar of interest generated for each dollar of interest expense. In general, a high ratio is expense. In general, a high ratio is

viewed more favorable than a low ratio.viewed more favorable than a low ratio.

10-11

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.




This bond is issued at a discount.

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10-12


The issue price of a bond is composed of the present value

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



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



10-13


Now, compute the present value of the

interest.









10-14


31,180$ Present Value of the Principal

+ 57,350 Present Value of the Interest

= 88,530$ Present Value of the Bonds




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.

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

of $11,470.





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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.

10-16

Bonds Issued at Discount The discount The discount will be will be

amortized over the 10-over the 10-

year life of the year life of the bonds.bonds.

Two methods Two methods of amortization of amortization are commonly are commonly

used:used:

Straight-line

Effective-interest.

10-17

Reporting Interest Expense: Straight-line Amortization

Identify the amount of the Identify the amount of the bond discount.bond discount.

Divide the bond discount by Divide the bond discount by the number of interest the number of interest periods.periods.

Include the discount Include the discount amortization amount as part amortization amount as part of the periodic interest of the periodic interest expense entry.expense entry. The discount will be reduced The discount will be reduced

to zero by the maturity date.to zero by the maturity date.

Identify the amount of the Identify the amount of the bond discount.bond discount.

Divide the bond discount by Divide the bond discount by the number of interest the number of interest periods.periods.

Include the discount Include the discount amortization amount as part amortization amount as part of the periodic interest of the periodic interest expense entry.expense entry. The discount will be reduced The discount will be reduced

to zero by the maturity date.to zero by the maturity date.

10-18


BNSF issued their bonds on Jan. 1, 2011. The BNSF issued their bonds on Jan. 1, 2011. The discount was $11,470. The bonds have a 10-year discount was $11,470. The bonds have a 10-year maturity and $5,000 interest is paid semiannually.maturity and $5,000 interest is paid semiannually.

Compute the periodic discount amortization Compute the periodic discount amortization using the straight-line method. using the straight-line method.

BNSF issued their bonds on Jan. 1, 2011. The BNSF issued their bonds on Jan. 1, 2011. The discount was $11,470. The bonds have a 10-year discount was $11,470. The bonds have a 10-year maturity and $5,000 interest is paid semiannually.maturity and $5,000 interest is paid semiannually.

Compute the periodic discount amortization Compute the periodic discount amortization using the straight-line method. using the straight-line method.

10-19


As the discount is

amortized, the carrying

amount of the bonds

increases.

10-20

Straight-Line Amortization TableInterest Interest Discount Unamortized Book

Date Payment Expense* Amortization* Discount Value1/1/2011 11,470$ 88,530$

6/30/2011 5,000$ 5,574$ 574$ 10,897 89,104 12/31/2011 5,000 5,574 574 10,323 89,677 6/30/2012 5,000 5,574 574 9,750 90,251

12/31/2012 5,000 5,574 574 9,176 90,824 6/30/2013 5,000 5,574 574 8,603 91,398

12/31/2013 5,000 5,574 574 8,029 91,971

6/30/2020 5,000 5,574 574 574 99,426 12/31/2020 5,000 5,574 574 0 100,000

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

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

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

10-21

Reporting Interest Expense: Effective-interest Amortization

The effective interest method The effective interest method is the theoretically preferred is the theoretically preferred method.method.

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

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

The effective interest method The effective interest method is the theoretically preferred is the theoretically preferred method.method.

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

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

10-22


BNSF issued their bonds on Jan. 1, 2011. The BNSF issued their bonds on Jan. 1, 2011. The issue price was $88,530. The bonds have a 10-issue price was $88,530. The bonds have a 10-

year maturity and $5,000 interest is paid year maturity and $5,000 interest is paid semiannually.semiannually.

Compute the periodic discount amortization Compute the periodic discount amortization using the effective interest method. using the effective interest method.

BNSF issued their bonds on Jan. 1, 2011. The BNSF issued their bonds on Jan. 1, 2011. The issue price was $88,530. The bonds have a 10-issue price was $88,530. The bonds have a 10-

year maturity and $5,000 interest is paid year maturity and $5,000 interest is paid semiannually.semiannually.

Compute the periodic discount amortization Compute the periodic discount amortization using the effective interest method. 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

10-23


As the discount is

amortized, the carrying

amount of the bonds

increases.

10-24

Effective-Interest Amortization TableInterest Interest Discount Unamortized Book

Date Payment Expense* Amortization* Discount* Value1/1/2011 11,470$ 88,530$

6/30/2011 5,000$ 5,312$ 312$ 11,158 88,842 12/31/2011 5,000 5,331 331 10,828 89,172 6/30/2012 5,000 5,350 350 10,477 89,523

12/31/2012 5,000 5,371 371 10,106 89,894 6/30/2013 5,000 5,394 394 9,712 90,288

12/31/2013 5,000 5,417 417 9,295 90,705

6/30/2020 5,000 5,890 890 944 99,056 12/31/2020 5,000 5,943 943 0 100,000

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

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

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

10-25

Zero Coupon Bonds

Zero coupon bonds do not pay periodic interest.

This is called a deep discount deep discount bondbond.

Because there is no interest annuity, the

PV of the Principal = Issue Price of the Bonds

Because there is no interest annuity, the

PV of the Principal = Issue Price of the Bonds

10-26

Bonds Issued at Premium




This bond is issued at a premium.




This bond is issued at a premium.

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10-27






First, compute the present value of the

principal.





10-28


Now, compute the present value of the

interest.









10-29








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.

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

premium of $13,592.





10-30


The premium The premium will be will be

amortized over the 10-over the 10-

year life of the year life of the bonds.bonds.

10-31

Straight-Line Amortization TableInterest Interest Premium Unamortized Book

Date Payment Expense* Amortization* Premium* Value1/1/2011 13,592$ 113,592$

6/30/2011 5,000$ 4,320$ 680$ 12,912 112,912 12/31/2011 5,000 4,320 680 12,233 112,233 6/30/2012 5,000 4,320 680 11,553 111,553

12/31/2012 5,000 4,320 680 10,874 110,874 6/30/2013 5,000 4,320 680 10,194 110,194

12/31/2013 5,000 4,320 680 9,514 109,514

6/30/2020 5,000 4,320 680 680 100,680 12/31/2020 5,000 4,320 680 0 100,000

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

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

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

10-32


Here is the journal entry to record the payment Here is the journal entry to record the payment of interest and the premium amortization for of interest and the premium amortization for

the six months ending on June 30, 2011.the six months ending on June 30, 2011.



10-33

Effective-Interest Amortization TableInterest Interest Premium Unamortized Book

Date Payment Expense* Amortization* Premium* Value1/1/2011 13,592$ 113,592$

6/30/2011 5,000$ 4,544$ 456$ 13,136 113,136 12/31/2011 5,000 4,525 475 12,661 112,661 6/30/2012 5,000 4,506 494 12,168 112,168

12/31/2012 5,000 4,487 513 11,654 111,654 6/30/2013 5,000 4,466 534 11,120 111,120

12/31/2013 5,000 4,445 555 10,565 110,565

6/30/2020 5,000 4,076 924 965 100,965 12/31/2020 5,000 4,039 965 0 100,000

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

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

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

*

10-34






10-35

Debt-to-Equity

Debt-to-Equity =Total Liabilities

Stockholders’ Equity

This ratio shows the relationship between This ratio shows the relationship between the amount of capital provided by owners the amount of capital provided by owners and the amount provided by creditors. In and the amount provided by creditors. In

general, a high ratio suggest that a general, a high ratio suggest that a company relies heavily on funds provided company relies heavily on funds provided

by creditors.by creditors.

This ratio shows the relationship between This ratio shows the relationship between the amount of capital provided by owners the amount of capital provided by owners and the amount provided by creditors. In and the amount provided by creditors. In

general, a high ratio suggest that a general, a high ratio suggest that a company relies heavily on funds provided company relies heavily on funds provided

by creditors.by creditors.

10-36

Early Retirement of Debt

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

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

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

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

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

10-37

Focus on Cash FlowsFinancing Activities –

Issue of bonds (cash inflow)Retire debt (cash outflow)Repay bond principal at

maturity (cash outflow)

Remember that payment of interest under U.S. GAAP is

an operating activity.

10-38

Supplement A: Bond Calculations Using Excel

Use the present value function programmed in Excel by selecting the function button (fx ). In the drop down box, type the description "present value" and click the "Go" button. On the next screen, highlight PV and click the "OK" button. Enter the specific information for your problem and click "OK."

Present Value Function in Excel

The issue price of a bond is composed of the present

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

The issue price of a bond is composed of the present

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

10-39

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.

10-40

End of Chapter 10

chap010

Economy & Finance

bond discount

callable bonds bond

convertible bonds bond

disadvantages of bonds

bond contract

bond indenture

bond issuer

interpreting bonds chapter