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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Reporting and Interpreting Bonds Chapter 10

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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

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10-3 Significant debt needs of a company are often filled by issuing bonds. Understanding the Business: Capital Structure - Bonds BondsCash

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10-4 Understanding the Business As liquidity increases...... cost of borrowing decreases. Bonds can be traded on established exchanges that provide liquidity to bondholders.

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10-5 Learning Objectives Describe the characteristics of bonds.

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10-6 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.

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10-7 Characteristics of Bonds Payable 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.

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10-8 Characteristics of Bonds Payable $ Bond Issue Price $ Bond Certificate At Bond Issuance Date Bonds payable are long-term debt for the issuing company. Company Issuing Bonds Investor Buying Bonds

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10-9 Characteristics of Bonds Payable Periodic Interest Payments $$ Principal Payment at End of Bond Term $$ Company Issuing Bonds Investor Buying Bonds

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10-10 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 1/1/16Bond Date 1/1/06

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10-11 Bond Classifications Debenture bonds Debenture bonds Not secured with the pledge of a specific asset. Callable bonds Callable bonds May be retired and repaid (called) at any time at the option of the issuer. Convertible bonds Convertible bonds May be exchanged for other securities of the issuer (usually shares of common stock) at the option of the bondholder. Debenture bonds Debenture bonds Not secured with the pledge of a specific asset. Callable bonds Callable bonds May be retired and repaid (called) at any time at the option of the issuer. Convertible bonds 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.

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10-12 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.

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10-13 Reporting Bond Transactions When a company issues bonds, it specifies two cash flows related to the transaction: PrincipalInterest PrincipalInterest Assume Dino Oil issues $100,000 in bonds at par on January 1, 2006. The bonds pay 8% interest annually on December 31. What journal entry should be made on January 1, 2006?

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10-14 Reporting Bond Transactions Periodically, interest must be accrued and recorded. The annual interest payment is determined by multiplying the principal amount times the stated interest rate in the bond contract. Assume Dino Oil issues $100,000 in bonds at par on January 1, 2006. The bonds pay 8% interest annually on December 31. What journal entry should be made on December 31, 2006?

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10-15 Reporting Bond Transactions The issue price of the bond is determined by the market, based on the time value of money. market interest rate The interest rate used to compute the present value is the market interest rate.

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10-16 Reporting Bond Transactions = < > = < >

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10-17 Learning Objectives Report bonds payable and interest expense for bonds sold at par and analyze the times interest earned ratio.

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10-18 Bonds Issued at Par On January 1, 2006, 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, 2006, 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. ==

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10-19 Bonds Issued at Par Here is the journal entry to record the issuance of the bonds.

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10-20 Bonds Issued at Par Here is the entry made every six months to record the interest payment.

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10-21 Bonds Issued at Par Here is the entry to record the maturity of the bonds.

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10-22 Key Ratio Analysis 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.

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10-23 Learning Objectives Report bonds payable and interest expense for bonds sold at a discount.

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10-24 Bonds Issued at Discount On January 1, 2006, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2015) and interest is paid semiannually. The market rate is 12% annually. This bond is issued at a discount. On January 1, 2006, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2015) and interest is paid semiannually. The market rate is 12% annually. This bond is issued at a discount. <<

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10-25 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)Principal (a single amount) Interest (an annuity)Interest (an annuity) The issue price of a bond is composed of the present value of two items: Principal (a single amount)Principal (a single amount) Interest (an annuity)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 periods Market rate of 12% ÷ 2 interest periods per year = 6% Bond term of 10 years × 2 periods per year = 20 periods

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10-26 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)Principal (a single amount) Interest (an annuity)Interest (an annuity) The issue price of a bond is composed of the present value of two items: Principal (a single amount)Principal (a single amount) Interest (an annuity)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 periods Market rate of 12% ÷ 2 interest periods per year = 6% Bond term of 10 years × 2 periods per year = 20 periods

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10-27 Bonds Issued at Discount The issue price of a bond is composed of the present value of two items: Principal (a single amount)Principal (a single amount) Interest (an annuity)Interest (an annuity) The issue price of a bond is composed of the present value of two items: Principal (a single amount)Principal (a single amount) Interest (an annuity)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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10-28 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.

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10-29 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.

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10-30 Reporting Interest Expense: Straight-line Amortization Identify the amount of the bond discount. Identify the amount of the bond discount. Divide the bond discount by the number of interest periods. Divide the bond discount by the number of interest periods. Include the discount amortization amount as part of the periodic interest expense entry. 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 discount will be reduced to zero by the maturity date. Identify the amount of the bond discount. Identify the amount of the bond discount. Divide the bond discount by the number of interest periods. Divide the bond discount by the number of interest periods. Include the discount amortization amount as part of the periodic interest expense entry. 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 discount will be reduced to zero by the maturity date.

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10-31 Reporting Interest Expense: Straight-line Amortization Harrah’s issued their bonds on Jan. 1, 2006. 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. Harrah’s issued their bonds on Jan. 1, 2006. 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.

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10-32 Reporting Interest Expense: Straight-line Amortization Here is the journal entry to record the payment of interest and the discount amortization for the six months ending on June 30, 2006.

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10-33 Reporting Interest Expense: Straight-line Amortization As the discount is amortized, the carrying amount of the bonds increases.

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10-34

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10-35 Reporting Interest Expense: Effective-interest Amortization The effective interest method is the theoretically preferred method. The effective interest method is the theoretically preferred method. Compute interest expense by multiplying the current unpaid balance times the market rate of interest. 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 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. The effective interest method is the theoretically preferred method. Compute interest expense by multiplying the current unpaid balance times the market rate of interest. 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 discount amortization is the difference between interest expense and the cash paid (or accrued) for interest.

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10-36 Reporting Interest Expense: Effective-interest Amortization Harrah’s issued their bonds on Jan. 1, 2006. 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, 2006. 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

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10-37 Reporting Interest Expense: Effective-interest Amortization Here is the journal entry to record the payment of interest and the discount amortization for the six months ending on June 30, 2006.

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10-38 Reporting Interest Expense: Effective-interest Amortization As the discount is amortized, the carrying amount of the bonds increases.

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10-39

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10-40 Zero Coupon Bonds Zero coupon bonds do not pay periodic interest. Because there is no interest annuity... deep discount bond This is called a deep discount bond. PV of the Principal = Issue Price of the Bonds

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10-41 Learning Objectives Report bonds payable and interest expense for bonds sold at a premium.

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10-42 Bonds Issued at Premium On January 1, 2006, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2015) and interest is paid semiannually. The market rate is 8% annually. This bond is issued at a premium. On January 1, 2006, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2015) and interest is paid semiannually. The market rate is 8% annually. This bond is issued at a premium. > >

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10-43 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)Principal (a single amount) Interest (an annuity)Interest (an annuity) The issue price of a bond is composed of the present value of two items: Principal (a single amount)Principal (a single amount) Interest (an annuity)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 periods Market rate of 8% ÷ 2 interest periods per year = 4% Bond term of 10 years × 2 periods per year = 20 periods

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10-44 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)Principal (a single amount) Interest (an annuity)Interest (an annuity) The issue price of a bond is composed of the present value of two items: Principal (a single amount)Principal (a single amount) Interest (an annuity)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 periods Market rate of 8% ÷ 2 interest periods per year = 4% Bond term of 10 years × 2 periods per year = 20 periods

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10-45 Bonds Issued at Premium The issue price of a bond is composed of the present value of two items: Principal (a single amount)Principal (a single amount) Interest (an annuity)Interest (an annuity) The issue price of a bond is composed of the present value of two items: Principal (a single amount)Principal (a single amount) Interest (an annuity)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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10-46 Bonds Issued at Premium This is an adjunct-liability account and appears in the liability section of the balance sheet. Here is the journal entry to record the bond issued at a premium.

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10-47 Bonds Issued at Premium The premium will be amortized over the 10- year life of the bonds. Let’s look at the amortization tables using Straight-line and Effective- interest.

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10-48

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10-49 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, 2006.

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10-50 *

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10-51 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, 2006.

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10-52 Learning Objectives Analyze the debt-to-equity ratio.

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10-53 Key Ratio Analysis Debt-to-Equity = Total Liabilities Owners’ 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.

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10-54 Learning Objectives Report the early retirement of bonds.

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10-55 Early Retirement of Debt Occasionally, the issuing company will call (repay early) some or all of its bonds. 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. 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. 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. 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

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10-56 Learning Objectives Explain how financing activities are reported on the statement of cash flows.

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10-57 Focus on Cash Flows Financing Activities – Issuance of bonds (a cash inflow) Retire debt (a cash outflow) Repay bond principal at maturity (a cash outflow) Remember that payment of interest is an operating activity.

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10-58 Chapter Supplement A Bond Calculations Using Excel

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10-59 Bond Calculations Using Excel The issue price of a bond is composed of the present value of two items: Principal (a single amount)Principal (a single amount) Interest (an annuity)Interest (an annuity) The issue price of a bond is composed of the present value of two items: Principal (a single amount)Principal (a single amount) Interest (an annuity)Interest (an annuity)

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10-60 End of Chapter 10

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