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

Slide 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

Slide 3 McGraw-Hill/Irwin Slide 3 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 4 McGraw-Hill/Irwin Slide 4 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. 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.

Slide 5 McGraw-Hill/Irwin Slide 5 Reporting Bond Transactions = < > = < >

Slide 6 McGraw-Hill/Irwin Slide 6 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.

Slide 7 McGraw-Hill/Irwin Slide 7 Reporting Interest Expense: Straight-line Amortization Harrah’s issued their bonds on Jan. 1, 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, 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.

Slide 8 McGraw-Hill/Irwin Slide 8 Reporting Interest Expense: Straight-line Amortization As the discount is amortized, the carrying amount of the bonds increases.

Slide 9 McGraw-Hill/Irwin Slide 9

Slide 10 McGraw-Hill/Irwin Slide 10 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 11 McGraw-Hill/Irwin Slide 11 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. 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. 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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Slide 13 McGraw-Hill/Irwin Slide 13 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 14 McGraw-Hill/Irwin Slide 14 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.