Reporting and Interpreting Bonds Chapter 10 McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc.

Slide 2 McGraw-Hill/Irwin Slide 2 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 1/1/19Bond Date 1/1/09

Slide 3 McGraw-Hill/Irwin Slide 3 Characteristics of Bonds Payable $ Bond Issue Price $ Bond Certificate Bonds payables are long-term debt for the issuing company. Company Issuing Bonds Investor Buying Bonds Periodic Interest Payments $$ Principal Payment at End of Bond Term $$

Slide 4 McGraw-Hill/Irwin Slide 4 Reporting Bond Transactions = < > = < >

Slide 5 McGraw-Hill/Irwin Slide 5 Bonds Issued at Par On January 1, 2013, 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 par. On January 1, 2013, 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 par. ==

Slide 6 McGraw-Hill/Irwin Slide 6 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.

Slide 7 McGraw-Hill/Irwin Slide 7 Bonds Issued at Discount On January 1, 2013, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2023) and interest is paid semiannually. The market rate is 12% annually. This bond is issued at a discount. On January 1, 2013, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2023) and interest is paid semiannually. The market rate is 12% annually. This bond is issued at a discount. <<

Slide 8 McGraw-Hill/Irwin Slide 8 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) 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 periods Market rate of 12% ÷ 2 interest periods per year = 6% Bond term of 10 years × 2 periods per year = 20 periods

Slide 9 McGraw-Hill/Irwin Slide 9 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) 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 periods Market rate of 12% ÷ 2 interest periods per year = 6% Bond term of 10 years × 2 periods per year = 20 periods

Slide 10 McGraw-Hill/Irwin Slide 10 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) 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.

Slide 11 McGraw-Hill/Irwin Slide 11 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.

Slide 12 McGraw-Hill/Irwin Slide 12 Bonds Issued at Discount The discount will be over the 10- year life of the bonds. The discount will be amortized over the 10- year life of the bonds. Two methods of amortization are commonly used: Straight-line (not GAAP) Effective- interest.

Slide 13 McGraw-Hill/Irwin Slide 13

Slide 14 McGraw-Hill/Irwin Slide 14 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.

Slide 15 McGraw-Hill/Irwin Slide 15 Reporting Interest Expense: Effective-interest Amortization Harrah’s issued their bonds on Jan. 1, The issue price was $88,530. The bonds have a 10- year maturity and $5,000 interest is paid semiannually. (market rate =12%) Compute the periodic discount amortization using the effective interest method. Harrah’s issued their bonds on Jan. 1, The issue price was $88,530. The bonds have a 10- year maturity and $5,000 interest is paid semiannually. (market rate =12%) 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

Slide 16 McGraw-Hill/Irwin Slide 16 Reporting Interest Expense: Effective-interest Amortization As the discount is amortized, the carrying amount of the bonds increases.

Slide 17 McGraw-Hill/Irwin Slide 17

Slide 18 McGraw-Hill/Irwin Slide 18 Bonds Issued at Premium On January 1, 2013, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2023) and interest is paid semiannually. The market rate is 8% annually. This bond is issued at a premium. On January 1, 2013, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2023) and interest is paid semiannually. The market rate is 8% annually. This bond is issued at a premium. > >

Slide 19 McGraw-Hill/Irwin Slide 19 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) 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 periods Market rate of 8% ÷ 2 interest periods per year = 4% Bond term of 10 years × 2 periods per year = 20 periods

Slide 20 McGraw-Hill/Irwin Slide 20 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) 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 periods Market rate of 8% ÷ 2 interest periods per year = 4% Bond term of 10 years × 2 periods per year = 20 periods

Slide 21 McGraw-Hill/Irwin Slide 21 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) 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.

Slide 22 McGraw-Hill/Irwin Slide 22 This is an adjunct-liability account and appears in the liability section of the balance sheet. Bonds Issued at Premium The premium will be over the 10- year life of the bonds. The premium will be amortized over the 10- year life of the bonds.

Slide 23 McGraw-Hill/Irwin Slide 23 *

Slide 24 McGraw-Hill/Irwin Slide 24 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,

Slide 25 McGraw-Hill/Irwin Slide 25 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

Slide 26 McGraw-Hill/Irwin Slide 26 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.

Slide 27 McGraw-Hill/Irwin Slide 27 Debt-to-Equity Ratio Debt-to-Equity = Total Liabilities Stockholders’ 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.

Slide 28 McGraw-Hill/Irwin Slide 28 Times Interest Earned Ratio 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.

© 2008 The McGraw-Hill Companies, Inc. End of Chapter 10