Reporting and Interpreting Bonds - PowerPoint Presentation

Slide1

Reporting and Interpreting Bonds

Chapter 10

McGraw-Hill/Irwin

© 2009 The McGraw-Hill Companies, Inc.Slide2

Do the following problemsE9-15E9-16P9-12Slide3

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 LiabilitiesSlide4

Long-Term Notes Payable and Bonds

Relatively small debt needs can be filled from single sources.

Banks

Insurance Companies

Pension PlansSlide5

Long-Term Notes Payable and Bonds

Significant debt needs are often filled by issuing bonds to the public.

Cash

BondsSlide6

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 ownersSlide7

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.

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.Slide8

1. Face Value (Maturity or Par Value, Principal)2. Maturity Date

3. Stated Interest Rate 4. Interest Payment Dates

5. Bond Date Characteristics of Bonds Payable

Other Factors:

6. Market Interest Rate

7. Issue Date

BOND PAYABLE

Face Value $1,000

Interest 10%

6/30 & 12/31

Maturity Date 1/1/19

Bond Date 1/1/09Slide9

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.

An indenture is a bond contract that specifies the legal provisions of a bond issue.Slide10

Characteristics of Bonds PayableWhen 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.Slide11

Characteristics of Bonds Payable

$ Bond Issue Price $

Bond Certificate

Bonds payable are

long-term debt

for the issuing company.

Company Issuing Bonds

Investor Buying Bonds

Periodic

Interest Payments

$

$

Principal

Payment at End of Bond Term

$

$Slide12

Reporting Bond Transactions

=

<

>

=

<

>Slide13

Bonds Issued at 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.

=

=Slide14

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.Slide15

Bonds Issued at Discount

On 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.

<

<Slide16

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)

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 periodsSlide17

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

Bonds Issued at Discount

The 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.

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

Bond term of 10 years × 2 periods per year = 20 periodsSlide18

Bonds Issued at Discount

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

Principal (a single amount)Interest (an annuity)

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.

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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.Slide20

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.Slide21

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. Slide22

Reporting Interest Expense: Effective-interest Amortization

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

= $5,312Slide23

Reporting Interest Expense: Effective-interest Amortization

As the discount is amortized, the carrying amount of the bonds

increases.Slide24
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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 bond

.

PV of the Principal = Issue Price of the BondsSlide26

Bonds Issued at Premium

On 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 8% annually.

This bond is issued at a premium.

>

>Slide27

Bonds Issued at Premium

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)

First, let’s 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 periodsSlide28

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

Bonds Issued at Premium

The 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.

Market rate of 8% ÷ 2 interest periods per year = 4%

Bond term of 10 years × 2 periods per year = 20 periodsSlide29

Bonds Issued at Premium

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

Principal (a single amount)Interest (an annuity)

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.

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This is an adjunct

-liability account

and appears in the liability section of the balance sheet.

Bonds Issued at Premium

The premium will be

amortized

over the 10-year life of the bonds.Slide31
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Early Retirement of Debt

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 = Gain

Book Value < Retirement Price = Loss