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10-1 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Reporting and Interpreting Bonds Chapter 10 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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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 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. 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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10-4 Characteristics of Bonds Payable Two types of cash payment in the bond contract: 1. Principal. 2. Cash interest payments. Bond Terms 1.Principal, par value and face value 2.Contract, stated, or coupon rate of interest 3.Market, yield, or effective- interest rate

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10-5 Characteristics of Bonds Payable Debenture bonds No assets are pledged as guarantee of repayment at maturity. Secured bonds Specific assets are pledged as guarantee of repayment at maturity. Callable bonds Bond may be called for early retirement by the issuer. Convertible bonds Bond may be converted to other securities (usually common stock). Debenture bonds No assets are pledged as guarantee of repayment at maturity. Secured bonds Specific assets are pledged as guarantee of repayment at maturity. Callable bonds Bond may be called for early retirement by the issuer. Convertible bonds Bond may be converted to other securities (usually common stock). An indenture is a bond contract that specifies the legal provisions of a bond issue.

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10-6 Characteristics of Bonds Payable The bond indenture contains covenants designed to protect the creditors. The bond issuer also prepares a prospectus, which 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. The bond indenture contains covenants designed to protect the creditors. The bond issuer also prepares a prospectus, which 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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10-7 Reporting Bond Transactions = < > = < >

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10-8 Bonds Issued at Par On January 1, 2011, Burlington Northern Santa Fe (BNSF) 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, 2011, Burlington Northern Santa Fe (BNSF) 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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10-9 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.

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10-10 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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10-11 Bonds Issued at Discount On January 1, 2011, BNSF issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2020) and interest is paid semiannually. The market rate is 12% annually. This bond is issued at a discount. On January 1, 2011, BNSF issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2020) and interest is paid semiannually. The market rate is 12% annually. This bond is issued at a discount. <<

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10-12 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) First, 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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10-13 Bonds Issued at Discount Now, compute the present value of the interest. 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) 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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10-14 Bonds Issued at Discount Finally, 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. 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)

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10-15 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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10-16 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 Effective- interest.

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10-17 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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10-18 Reporting Interest Expense: Straight-line Amortization BNSF issued their bonds on Jan. 1, 2011. 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. BNSF issued their bonds on Jan. 1, 2011. 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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10-19 Reporting Interest Expense: Straight-line Amortization As the discount is amortized, the carrying amount of the bonds increases.

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10-21 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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10-22 Reporting Interest Expense: Effective-interest Amortization BNSF issued their bonds on Jan. 1, 2011. 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. BNSF issued their bonds on Jan. 1, 2011. 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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10-23 Reporting Interest Expense: Effective-interest Amortization As the discount is amortized, the carrying amount of the bonds increases.

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10-25 Zero Coupon Bonds Zero coupon bonds do not pay periodic interest. deep discount bond This is called a deep discount bond. Because there is no interest annuity, the PV of the Principal = Issue Price of the Bonds Because there is no interest annuity, the PV of the Principal = Issue Price of the Bonds

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10-26 Bonds Issued at Premium On January 1, 2011, BNSF issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2020) and interest is paid semiannually. The market rate is 8% annually. This bond is issued at a premium. On January 1, 2011, BNSF issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2020) and interest is paid semiannually. The market rate is 8% annually. This bond is issued at a premium. > >

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10-27 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) First, 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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10-28 Bonds Issued at Premium Now, compute the present value of the interest. 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) 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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10-29 Bonds Issued at Premium Finally, 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. 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)

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10-30 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.

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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 premium amortization for the six months ending on June 30, 2011.

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10-33 *

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10-34 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, 2011.

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10-35 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.

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10-36 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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10-37 Focus on Cash Flows Financing Activities – Issue of bonds (cash inflow) Retire debt (cash outflow) Repay bond principal at maturity (cash outflow) Remember that payment of interest under U.S. GAAP is an operating activity.

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10-38 Supplement A: Bond Calculations Using Excel 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)

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10-39 Supplement B: Bonds Issued at a Discount (without Discount Account) & at a Premium (without Premium Account For financial reporting purposes, it is not necessary to use a discount or premium account when recording bonds sold at a discount or premium.

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10-40 End of Chapter 10

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