1. Reporting and interpreting Bonds
Chapter 10
Reporting and interpreting Bonds
Chapter 10: Reporting and Interpreting Bonds
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Characteristics of Bonds Payable
Two types of cash payment in the bond contract:
1. Principal.
2. Cash interest payments.
Bond Terms
Principal, par value and face value
Contract, stated, or coupon rate of interest
Market, yield, or effective-interest rate
A bond certificate is the bond document that each bondholder receives.
When a company issues its bonds, it specified two types of cash payment in the bond contract:
Principal. This amount is usually a single payment that is made when the bond matures. It is also called the par value or face value. For most individual bonds, the par value is $1,000, but it can be any amount.
Cash interest payments. These payments, which represent an annuity, are computed by multiplying the principal amount times the interest rate stated in the bond contract. This interest is called the contract, stated, or coupon rate of interest. The bond contract specifies whether the interest payments are made quarterly, semiannually, or annually. When you are asked to work problems in which interest payments are made more frequently than once a year, you must adjust both the periodic interest rate and the number of periods. For example, a $1,000 (face value) bond with an annual interest rate of 6 percent and a life of 10 years would pay interest of $30 ($1,000 × 6% × 1/2) for 20 periods (every six months for 10 years, or 10 × 2).
Neither the issuing company nor the underwriter determines the price at which the bonds sell. Instead, the market determines the price using the present value concepts introduced in the last chapter. To determine the present value of the bond, you compute the present value of the principal (a single payment) and the present value of the interest payments (an annuity) and add the two amounts.
Creditors demand a certain rate of interest to compensate them for the risks related to bonds, called the market interest rate (also known as the yield or effective-interest rate ). Because the market rate is the interest rate on debt when it is incurred, it is the rate that should be used in computing the present value of a bond.

3. Reporting Bond Transactions=
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The issue price of the bond is determined by the market, based on the time value of money.
Recall that there are two cash flow streams related to a bond: the principal and the interest. So, to determine the issue price of the bonds, we must determine the present value of the principal payment and the present value of the interest payments. The interest rate used to compute the present value is the market interest rate. The market interest rate is the current rate of interest on debt when incurred. It is also called the yield or effective interest rate.
The present value of a bond (or the bond price) may be the same as par, above par, or below par. If the stated and market interest rates are the same, a bond sells at par; if the market interest rate is higher than the stated rate, a bond sells at a discount; and if the market interest rate is lower than the stated rate, the bond sells at a premium.
When a bond pays an interest rate that is less than the rate creditors demand, they will not buy it unless its price is reduced, in other words, a discount must be provided. On the other hand, when a bond pays an interest rate that is more than creditors demand, they will be willing to pay a premium to buy it. When the bond pays an interest rate that is equal to the rate creditors demand, the bond will sell at par.

4. This bond is issued at a par.
Bonds Issued at Par
On January 1, 2014, AT&T issues $100,000 in bonds having 10% annual stated rate of interest. The bonds mature in 2 years and interest is paid semiannually. The market rate is 10% annually.
This bond is issued at a par. =
On January 1, 2014, AT&T issues $100,000 in bonds having a 10% annual stated rate of interest. The bonds mature in 2 years and interest is paid semiannually. The market rate is 10% annually. Since the stated rate of interest is equal to the market rate of interest, this bond is issued at par.
The journal entry to record the bond issue at par is a debit to Cash and a credit to Bonds Payable for $100,000.

5. Here is the entry to record the maturity of the bonds.
Bonds Issued at Par
Here is the entry made every six months to record the interest payment.
Every six months, the bond interest is paid and recorded by a debit to Bond Interest Expense and a credit to Cash for $5,000. The interest payment is computed as $100,000 times 10% times ½, since the interest is paid semiannually.
At the maturity date, December 31, 2015, the bond debt must be repaid and the entry is a debit to Bonds Payable and a credit to Cash for $100,000.
Here is the entry to record the maturity of the bonds.

6. Bonds Issued at Discount
On January 1, 2014, AT&T issues $100,000 in bonds having a 10% annual stated rate of interest. The bonds mature in 2 years (Dec. 31, 2015) and interest is paid semiannually. The annual market rate of interest is 12%.
This bond is issued at a discount.
On January 1, 2014, AT&T issues $100,000 in bonds having a 10% annual stated rate of interest. The bonds mature in 2 years and interest is paid semiannually. The annual market rate of interest is 12%.
Since the stated interest rate of 10% is less than the market interest rate of 12%, this bond is issued at a discount.
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7. 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)
First, compute the present value of the principal.
Market rate of 12% ÷ 2 interest periods per year = 6%
Bond term of 2 years × 2 periods per year = 4 periods
Recall that the issue price of a bond is composed of the present value of two items: The principal (a single amount) and the interest (an annuity). First, let’s compute the present value of the principal. Since the principal is a single amount, we need to use the Present Value of a Single Amount table to find the appropriate factor. We need the factor for 4 periods (the number of interest payments) and 6% (the market interest rate for the interest period of 6 months).
Using the table, we find the factor for 4 periods and 6% to be When we multiply the factor times the $100,000 principal, we determine the present value of the principal of $79,210.

8. 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, compute the present value of the interest.
Market rate of 12% ÷ 2 interest periods per year = 6%
Bond term of 2 years × 2 periods per year = 4 periods
Now, let’s compute the present value of the interest. Since the interest payments are an annuity, we need to use the Present Value of an Annuity table to find the appropriate factor. We need the factor for 4 periods (the number of interest payments) and 6% (the market interest rate for the interest period of 6 months).
Using the table, we find the factor for 4 periods and 6% to be When we multiply the factor times the $5,000 interest payment, we determine the present value of the interest to be $17,326.

9. 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, determine the issue price of the bond.
Finally, we can determine the issue price of the bond by adding together the present value of the principal and the present value of the interest payments. Since the present value of the bonds of $96,536 is less than the $100,000 face amount of the bonds, the bonds are issued at a discount of $3,464.
The $96,536 is less than the face amount of $100,000, so the bonds are issued at a discount of $3,464.

10. Bonds Issued at Discount
Here is the journal entry to record the bonds issued at a discount.
Here is the journal entry to record the bond issue at a discount: debit Cash for the present value of $96,536, debit Discount on Bonds Payable for $3,464, and credit Bonds Payable for $100,000. The Discount on Bonds Payable account is a contra-liability account that appears in the liability section of the balance sheet.
This is a contra-liability account that appears in the liability section of the balance sheet.

11. Bonds Issued at Discount
The discount will be amortized over the year life of the bonds.
Here is an example of a bond issued at a discount on AT&T’s balance sheet. The discount will be amortized over the life of the bond. Two methods of amortization are commonly used: Straight-line and Effective-interest.
Two methods of amortization are commonly used:
Straight-line Effective-interest

12. Reporting Interest Expense: Straight-line Amortization
Identify the amount of the bond discount.
Divide the bond discount by the number of interest periods.
Include the discount amortization amount as part of the periodic interest expense entry.
The discount will be reduced to zero by the maturity date.
Using the straight-line method, follow these steps.
First, identify the amount of the bond discount.
Second, divide the bond discount by the number of interest periods.
Third, include the discount amortization amount as part of the periodic interest expense entry. The discount will be reduced to zero by the maturity date.

13. Reporting Interest Expense: Straight-line Amortization
AT&T issued their bonds on Jan. 1, The discount was $3,464. The bonds have a 2-year maturity and $5,000 interest is paid semiannually. Compute the periodic discount amortization using the straight-line method.
AT&T issued their bonds on Jan. 1, The discount was $3,464. The bonds have a 2-year maturity and $5,000 interest is paid semiannually. To compute the periodic discount amortization using the straight-line method, divide the discount by 4 (the number of interest periods) to arrive at the straight-line amortization of $866 per interest period.

14. Reporting Interest Expense: Straight-line Amortization
As the discount is amortized, the carrying amount of the bonds increases.
To record the interest payment and the discount amortization, AT&T’s would debit Interest Expense for $5,866, credit Discount on Bonds Payable for $866, and credit Cash for $5,000.
Here is an example of AT&T’s balance sheet after the first six months. As the discount is amortized, the carrying amount of the bonds increases.

15. Reporting Interest Expense: Straight-line Amortization
An amortization table illustrates the interest payment, interest expense, discount amortization, unamortized discount balance, and the carrying value of the bond for each interest payment period over the life of the bond.
This is an amortization table using the straight-line method. An amortization table illustrates the interest payment, interest expense, discount amortization, unamortized discount balance, and the carrying value of the bond for each interest payment period over the life of the bond.

16. 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 the calculated interest expense and the cash paid (or accrued) for interest.
If you are using the effective-interest method (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 the calculated interest expense and the cash paid (or accrued) for interest.

17. Reporting Interest Expense: Effective-interest Amortization
AT&T issued their bonds on Jan. 1, The issue price was $96,536. The bonds have a 2-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
$96,536 × 12% × 6/12 = $5,792
AT&T issued their bonds on Jan. 1, The issue price was $96,536. The bonds have a 2-year maturity and $5,000 interest is paid semiannually. To compute the periodic discount amortization using the effective interest method, multiply the current unpaid balance by the market rate of interest of 12% and multiple by 6/12 (or one half) since interest payments occur every six months. This will give us the discount amortization of $792 for the first six months.

18. Reporting Interest Expense: Effective-interest Amortization
As the discount is amortized, the carrying amount of the bonds increases.
To record the interest payment and the discount amortization, AT&T’s would debit Interest Expense for $5,792, credit Discount on Bonds Payable for $792, and credit Cash for $5,000.
Here is an example of AT&T’s balance sheet after the first six months. As the discount is amortized, the carrying amount of the bonds increases.

19. Reporting Interest Expense: Effective-interest Amortization
Notice that for the effective-interest method, the amount of interest expense and discount amortization varies each period, unlike under the straight-line method where these were the same each period.
This is an amortization table using the effective-interest method. An amortization table illustrates the interest payment, interest expense, discount amortization, unamortized discount balance, and the carrying value of the bond for each interest payment period over the life of the bond. Notice that for the effective-interest method, the amount of interest expense and discount amortization varies each period, unlike under the straight-line method where these were the same each period. *

20. Bonds Issued at Premium
On January 1, 2014, AT&T issues $100,000 in bonds having a 10% annual stated rate of interest. The bonds mature in 2 years (Dec. 31, 2015) and interest is paid semiannually. The annual market rate of interest is 8%.
This bond is issued at a premium.
On January 1, 2014, AT&T issues $100,000 in bonds having a 10% annual stated rate of interest. The bonds mature in 2 years and interest is paid semiannually. The annual market rate of interest is 8%.
Since the stated interest rate of 10% is greater than the market interest rate of 8%, this bond is issued at a premium.
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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)
First, compute the present value of the principal.
Market rate of 8% ÷ 2 interest periods per year = 4%
Bond term of 2 years × 2 periods per year = 4 periods
Recall that the issue price of a bond is composed of the present value of two items: The principal (a single amount) and the interest (an annuity). First, let’s compute the present value of the principal. Since the principal is a single amount, we need to use the Present Value of a Single Amount table to find the appropriate factor. We need the factor for 4 periods (the number of interest payments) and 4% (the market interest rate for the interest period of 6 months).
Using the table, we find the factor for 4 periods and 4% to be When we multiply the factor times the $100,000 principal, we determine the present value of the principal of $85,480.

22. 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, compute the present value of the interest.
Market rate of 8% ÷ 2 interest periods per year = 4%
Bond term of 2 years × 2 periods per year = 4 periods
Now, let’s compute the present value of the interest. Since the interest payments are an annuity, we need to use the Present Value of An Annuity table to find the appropriate factor. We need the factor for 4 periods (the number of interest payments) and 4% (the market interest rate for the interest period of 6 months).
Using the table, we find the factor for 4 periods and 4% to be When we multiply the factor times the $5,000 interest payment, we determine the present value of the interest to be $18,150.

23. 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, determine the issue price of the bond.
Finally, we can determine the issue price of the bond by adding together the present value of the principal and the present value of the interest payments. Since the present value of the bonds of $103,630 is greater than the $100,000 face amount of the bonds, the bonds are issued at a premium of $3,630.
The $103,630 is greater than the face amount of $100,000, so the bonds are issued at a premium of $3,630.

24. Bonds Issued at Premium
The premium will be amortized over the year life of the bonds.
Here is the journal entry to record the bond issue at a premium: debit Cash for the present value of $103,630, credit Premium on Bonds Payable for $3,630, and credit Bonds Payable for $100,000. The book value of the bond is the sum of the two accounts, Premium on Bonds Payable and Bonds Payable.
Here is an example of a bond issued at a premium on AT&T’s balance sheet. The premium will be amortized over the life of the bond. Two methods of amortization are commonly used: Straight-line and Effective-interest.

25. Reporting Interest Expense: Straight-line Amortization
An amortization table illustrates the interest payment, interest expense, premium amortization, unamortized premium balance, and the carrying value of the bond for each interest payment period over the life of the bond.
This is an amortization table using the straight-line method. An amortization table illustrates the interest payment, interest expense, premium amortization, unamortized premium balance, and the carrying value of the bond for each interest payment period over the life of the bond.
Using the straight-line method, follow these steps to determine the amount of amortization:
First, identify the amount of the bond premium.
Second, divide the bond premium by the number of interest periods.
Third, include the premium amortization amount as part of the periodic interest expense entry. The premium will be reduced to zero by the maturity date. Let’s look at the interest expense journal entry.

26. Reporting Interest Expense: Straight-line Amortization
Here is the journal entry to record the payment of interest and the premium amortization every six months using the straight-line amortization method.
Every six months, to record the interest payment and the premium amortization, AT&T would debit Interest Expense for $4,092, debit Premium on Bonds Payable for $908, and credit Cash for $5,000.

27. Reporting Interest Expense: Effective-interest Amortization
Notice that for the effective-interest method, the amount of interest expense and premium amortization varies each period, unlike under the straight-line method where these were the same each period.
This is an amortization table using the effective-interest method. An amortization table illustrates the interest payment, interest expense, premium amortization, unamortized premium balance, and the carrying value of the bond for each interest payment period over the life of the bond. Notice that for the effective-interest method, the amount of interest expense and premium amortization varies each period, unlike under the straight-line method where these were the same each period.
If you are using the effective-interest method, compute interest expense by multiplying the current unpaid balance times the market rate of interest. The premium amortization is the difference between the calculated interest expense and the cash paid (or accrued) for interest. *

28. 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, 2014.
To record the interest payment and the premium amortization, AT&T’s would debit Interest Expense for $4,145, debit Premium on Bonds Payable for $855, and credit Cash for $5,000.

29. 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.
Bonds are normally issued for long periods, such as 20 or 30 years. In several situations, a corporation may decide to retire bonds before their maturity date. A bond with a call feature may be called in for early retirement at the issuer’s option. Typically, the bond indenture includes a call premium for bonds retired before the maturity date, which often is stated as a percentage of par value.
In some cases, a company may elect to retire debt early by purchasing it on the open market, just as an investor would. This approach is necessary when the bonds do not have a call feature. It might also be an attractive approach if the price of the bonds fell after the date of issue. What could cause the price of a bond to fall? The most common cause is a rise in interest rates. As you may have noticed during our discussion of present value concepts, bond prices move in the opposite direction of interest rates. If interest rates go up, bond prices fall, and vice versa. When interest rates have gone up, a company that wants to retire a bond before maturity may find buying the bond on the open market is less expensive than paying a call premium.
Gains and losses are calculated by comparing the bond call amount with the book value of the bond. If the book value is greater than the retirement price, a gain is recorded. If the book value is less than the retirement price, a loss is recorded.
Book Value > Retirement Price = Gain
Book Value < Retirement Price = Loss

30. End of Chapter 10
End of chapter 10.