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

2. Do the following problems

3. Long-Term Liabilities
Creditors often require the borrower to pledge specific assets as security for the long-term liability.
Maturity = 1 year or less
Maturity > 1 year
Long-term liabilities are all of the entity’s obligations not classified as current liabilities. Creditors often require the borrower to pledge specific assets as security for the long-term liability.
Current Liabilities
Long-term Liabilities

4. Long-Term Notes Payable and Bonds
Relatively small debt needs can be filled from single sources.
Banks
Insurance Companies
Pension Plans
Companies can raise long-term debt capital directly from a number of financial service organizations including banks, insurance companies, and pension plans. Raising debt from one of these organizations is known as private placement. This type of debt is often called a note payable, which is a written promise to pay a stated sum at one or more specified future dates called the maturity dates.

5. Long-Term Notes Payable and Bonds
Significant debt needs are often filled by issuing bonds to the public.
Bonds
Cash
In many cases, a company’s need for debt capital exceeds the financial ability of any single creditor. In these situations, the company may issue publicly traded debt called bonds. Bonds will be discussed in detail in the next chapter.

6. Understanding the Business
The mixture of debt and equity used to finance a company’s operations is called the capital structure:
Capital structure is the mixture of debt and equity a company uses to finance its operations. Almost all companies employ some debt in its capital structure. Bonds are securities that corporations and governmental units issue when they borrow large amounts of money.
Large corporations need to borrow billions of dollars, which makes borrowing from individual creditors impractical. Instead, these corporations issue bonds to raise debt capital.
Bonds can be traded on established exchanges that provide liquidity to bondholders. The liquidity of bonds offers an important advantage to corporations. By issuing more liquid debt, corporations can reduce the cost of long-term borrowing.
Debt - funds from creditors
Equity - funds from owners

7. 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.
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.
Part I
Advantages of bonds include the following:
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.
Part II
Disadvantages of bonds include the following:
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.

8. Characteristics of Bonds Payable
BOND PAYABLE
Face Value $1,000
Interest 10%
6/30 & 12/31
Maturity Date 1/1/19
Bond Date 1/1/09
1. Face Value (Maturity or Par Value, Principal)
2. Maturity Date
3. Stated Interest Rate
4. Interest Payment Dates
5. Bond Date
A bond certificate must specify certain items in addition to the principal. A bond always specifies a stated rate of interest and the timing of periodic cash interest payments, usually annually or semiannually. Two dates are also specified on the bond certificate. The maturity date is the date the principal must be repaid, and the bond date is the date on which the bond can first be issued. Other factors not specified on the bond certificate but that are important are the market interest rate on the date of the bond issue and the actual issue date of the bond.
Other Factors:
6. Market Interest Rate
7. Issue Date 9

9. Bond Classifications
An indenture is a bond contract that specifies the legal provisions of a bond issue.
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. The indenture also contains covenants designed to protect the creditors.
A debenture is an unsecured bond; no assets are specifically pledged to guarantee repayment.
Callable bonds may be called for early retirement at the option of the issuer.
Convertible bonds may be converted to other securities of the issuer (usually common stock) at the option of the bondholder.

10. 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.
The bond issuer prepares a prospectus, which is a legal document that is given to potential bond investors. The prospectus describes the company, the bonds, and how the proceeds of the bonds will be used. An independent party, called the trustee, is usually appointed to represent the bondholders. A trustee’s duties are to ascertain whether the issuing company fulfills all provisions of the bond indenture.

11. Characteristics of Bonds Payable
Periodic Interest Payments $
Principal Payment at End of Bond Term
$ Bond Issue Price $
Company Issuing Bonds
Investor Buying Bonds
Bond Certificate
Part I
Bonds are issued by corporations to raise money for long-term projects. On the issue date, the investor loans the corporation the issue price of the bonds and receives the bond certificate.
Part II
A bond usually requires the payment of interest over its life with repayment of principal on the maturity date. The bond principal is the amount that is payable at the maturity date and on which the periodic cash interest payments are computed. The principal is also called the par value, face amount, and maturity value.
Bonds payable are long-term debt for the issuing company. 5

12. Reporting Bond Transactions=
<
>
Part I
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.
Part II
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.

13. This bond is issued at a par.
Bonds Issued at Par
On January 1, 2009, 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.
Part I
On January 1, 2009, 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.
Part II
The journal entry to record the bond issue at par is a debit to Cash and a credit to Bonds Payable for $100,000. =

14. 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.
Here is the entry to record the maturity of the bonds.
Part I
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.
Part II
At the maturity date, the bond debt must be repaid and the entry is a debit to Bonds Payable and a credit to Cash for $100,000.

15. Bonds Issued at Discount
On January 1, 2009, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2018) and interest is paid semiannually. The market rate is 12% annually.
This bond is issued at a discount.
On January 1, 2009, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2018) and interest is paid semiannually. The market rate is 12% annually.
Since the stated interest rate of 10% is less than the market interest rate of 12%, this bond is issued at a discount.
<

16. 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, 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
Use the present value of a single amount table to find the appropriate factor.
Part I
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 20 periods (the number of interest payments) and 6% (the market interest rate for the interest period of 6 months).
Part II
Using the table, we find the factor for 20 periods and 6% to be When we multiply the factor times the $100,000 principal, we determine the present value of the principal of $31,180.

17. 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, 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
Use the present value of an annuity table to find the appropriate factor.
Part I
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 20 periods (the number of interest payments) and 6% (the market interest rate for the interest period of 6 months).
Part II
Using the table, we find the factor for 20 periods and 6% to be When we multiply the factor times the $5,000 interest payment, we determine the present value of the interest of $57,350.

18. 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, we can 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 $88,530 is less than the $100,000 face amount of the bonds, the bonds are issued at a discount of $11,470.
The $88,530 is less than the face amount of $100,000, so the bonds are issued at a discount of $11,470.

19. Bonds Issued at Discount
Here is the journal entry to record the bond issued at a discount.
Here is the journal entry to record the bond issue at a discount: debit Cash for the present value of $88,530, debit Discount on Bonds Payable for $11,470, and credit Bonds Payable for $100,000. The Discount on Bonds Payable account is a contra-liability account and appears in the liability section of the balance sheet.
This is a contra-liability account and appears in the liability section of the balance sheet.

20. 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.
Here is an example of a bond issued at a discount on Harrah’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. Let’s take a closer look at these two methods of amortizing the discount.

21. 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 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 interest expense calculated and the cash paid (or accrued) for interest.
Let’s see how this works.

22. 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.
Unpaid Balance × Effective Interest Rate × n/12
$88,530 × 12% × 1/2 = $5,312
Part I
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.
Part II
The unpaid balance (or present value) is $88,530. So, we need to multiply this by the market rate of interest of 12% and multiple by one half, since interest payments are every six months. This will give us the discount amortization of $312 for the first six months.

23. Reporting Interest Expense: Effective-interest Amortization
As the discount is amortized, the carrying amount of the bonds increases.
Part I
To record the interest payment and the discount amortization, Harrah’s would debit Interest Expense for $5,312, credit Discount on Bonds Payable for $312, and credit Cash for $5,000.
Part II
Here is an example of Harrah’s balance sheet after the first six months. As the discount is amortized, the carrying amount of the bonds increases.

24. This is an amortization table using the effective-interest method
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.

25. PV of the Principal = Issue Price of the Bonds
Zero Coupon Bonds
Zero coupon bonds do not pay periodic interest.
Because there is no interest annuity . . .
This is called a deep discount bond.
PV of the Principal = Issue Price of the Bonds
So far, we have discussed common bonds that are issued by many corporations. For a number of reasons, corporations may issue bonds with unusual features. For example, corporations might issue a bond that does not pay periodic cash interest. These bonds are often called zero coupon bonds. A bond with a zero coupon interest rate is simply a deeply discounted bond that will sell for substantially less than its maturity value.

26. Bonds Issued at Premium
On January 1, 2009, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2018) and interest is paid semiannually. The market rate is 8% annually.
This bond is issued at a premium.
On January 1, 2009, Harrah’s issues $100,000 in bonds having a stated rate of 10% annually. The bonds mature in 10 years (Dec. 31, 2018) and interest is paid semiannually. The market rate is 8% annually.
Since the stated interest rate of 10% is greater than the market interest rate of 8%, this bond is issued at a premium.
>

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)
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
Use the present value of a single amount table to find the appropriate factor.
Part I
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 20 periods (the number of interest payments) and 4% (the market interest rate for the interest period of 6 months).
Part II
Using the table, we find the factor for 20 periods and 4% to be When we multiply the factor times the $100,000 principal, we determine the present value of the principal of $45,640.

28. 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, 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
Use the present value of an annuity table to find the appropriate factor.
Part I
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 20 periods (the number of interest payments) and 4% (the market interest rate for the interest period of 6 months).
Part II
Using the table, we find the factor for 20 periods and 4% to be When we multiply the factor times the $5,000 interest payment, we determine the present value of the interest of $67,952.

29. 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, we can 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 $113,592 is greater than the $100,000 face amount of the bonds, the bonds are issued at a premium of $13,592.
The $113,592 is greater than the face amount of $100,000, so the bonds are issued at a premium of $13,592.

30. Bonds Issued at Premium
The premium will be amortized over the 10-year life of the bonds.
This is an adjunct-liability account and appears in the liability section of the balance sheet.
Part I
Here is the journal entry to record the bond issue at a premium: debit Cash for the present value of $113,592, credit Premium on Bonds Payable for $13,592, and credit Bonds Payable for $100,000. The Premium on Bonds Payable account is an adjunct-liability account and appears in the liability section of the balance sheet.
Part II
Here is an example of a bond issued at a premium on Harrah’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. Let’s take a closer look at these two methods of amortizing the premium.

31. This is an amortization table using the straight-line method
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.
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.

32. 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.
Occasionally, the issuing company will call (or repay early) some or all of its bonds. 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