chapter 10 Reporting and Interpreting

Bond Securities

Financial Accounting
9e
Libby • Libby • Hodge

10-1
Understanding the Business

The mixture of debt and equity used to finance a company’s

operations is called the capital structure.

Debt: funds from Equity: funds from

creditors owners

10-2
Characteristics of Bonds Payable
Advantages of bonds
• Stockholders maintain
control because bonds
are debt, not equity.
• Interest expense is tax
deductible.
• The return to
shareholders can be
positive if money is
borrowed at a low
interest rate and
invested to earn a higher
rate.
Disadvantages of bonds
• Risk of bankruptcy exists
because the interest and
debt must be paid back
as scheduled or else
creditors will force legal
action.
• Negative impact on cash
flows exists because
interest and principal
must be repaid at a
specified time in the
future.
10-3
Characteristics of Bonds Payable

Two types of cash payments in the bond indenture:

1. Cash interest payments over the life of the bond
2. Repayment of principal at the maturity date

Bond Terms

1. Principal (aka par value, face value, maturity

value)
2. Coupon rate (aka stated rate, contract rate,
nominal rate)

10-4
Characteristics of Bonds Payable

An indenture is a legal document that describes all the details of a

debt security to potential buyers.

Unsecured (debenture) bonds

No assets are pledged as a guarantee of repayment at maturity.
Secured bonds
Specific assets are pledged as a guarantee of repayment at maturity.
Callable bonds
Bond issuer is allowed to retire the bonds early.
Convertible bonds
Bondholder is allowed to convert the bond into shares of the issuer's
common stock.

10-5
Bond Issuance Process

• The bond issuer prepares a prospectus, which describes the

company and the bonds.

• The prospectus contains covenants designed to protect

the creditors.

• The trustee, an independent party, makes sure the issuer fulfills all
of the provisions of the bond indenture.

10-6
Bond Rating Agencies and Their Assessments
of Default Risk FINANCIAL ANALYSIS

• Because of the large amount of money involved and

the complexities associated with bonds, several
$$$
agencies exist to evaluate the risk that a bond issuer
will not be able to meet the requirements specified in
the prospectus.
• This risk is called default risk. Higher-quality bonds have a lower
default risk, while lower-quality bonds have a higher default risk.

10-7
Relationship between Coupon Rate and Market Rate

Bond Contract Market Rate Bond Price

Less than 10% Premium
Coupon rate
is 10% Exactly 10% Par
Greater than 10% Discount

10-8
Bond Information from the Business Press
FINANCIAL ANALYSIS

Bond prices are reported each day in the business press

$$$
based on transactions that have occurred on the bond
exchange. Formats differ across news outlets.

Issuer Coupon (%) Maturity Current ($) Yield (%)

Apple 3.45 2024 101.29 3.29
Amazon 2.50 2022 94.92 3.20
Walmart 3.30 2024 101.36 3.13

The above reflects that the Amazon bond pays a coupon rate of 2.5
percent, will mature in 2022, and is currently selling for $94.92. The “yield”
reflects that investors who purchase the bond at its current price and hold
it to maturity will earn a return on their investment of 3.2 percent.

10-9
Bonds Issued at Par

On January 1, 2016, Amazon issues $100,000 in bonds having a

10 percent annual stated rate of interest. The bonds mature in two years,
and interest is paid semiannually. The market rate is 10 percent annually.
These bonds are issued at par.

Cash (+A)…………………………………………………………………………..………
100,000
Bonds payable (+L)………………………………………………. 100,000

Interest expense (+E, –SE)…………………………………………………………………………..………

5,000
Cash (–A)………………………………………………....................... 5,000

10-10
Times Interest Earned
KEY RATIO ANALYSIS

$$$
Net Income + Interest Expense +
Times Interest Income Tax Expense
Earned =
Interest Expense

This ratio shows the amount of resources generated for

each dollar of interest expense. In general, a high ratio is
viewed more favorably than a low ratio.

10-11
Bonds Issued at a Discount

On January 1, 2016, Amazon issues $100,000 in bonds having a

10 percent annual stated rate of interest. The bonds mature in two
years, and interest is paid semiannually. The annual market rate of
interest is 12 percent.

These bonds are issued at a discount. Computing the present value

of the principal involves the following information:
Market rate of 12 percent ÷ 2 interest periods per year = 6 percent
Bond term of 2 years × 2 periods per year = 4 periods
First, compute the present value of the principal.

10-12
Bonds Issued at a Discount

Now, compute the present value of the interest.

Market rate of 12 percent ÷ 2 interest periods per year = 6 percent

Bond term of 2 years × 2 periods per year = 4 periods of interest

10-13
Bonds Issued at a Discount

Finally, determine the issue price of the bonds.

The total of $96,535 is less than the face amount of $100,000, so the bonds
are issued at a discount of $3,465.

10-14
Bonds Issued at a Discount

Here is the journal entry to record the bonds issued at a discount.

Cash (+A) …………………………………………96,535

Bond discount (+XL, –L) …………………………………………3,465
Bonds payable (+L) …………….....…………. 100,000

This is a contra-liability account that appears in the liability section of the

balance sheet.

The discount will

be amortized over
the two-
two-year life
of the bonds.

10-15
Reporting Interest Expense on Bonds Issued at a Discount
Using Effective-Interest Amortization

Step 1: Compute interest expense

Bonds Payable Book Value × Market Interest Rate per Period

Step 2: Compute cash owed for interest

Bond Face Value × Coupon Rate per Period

Step 3: Compute amortization amount

Interest Expense − Cash Owed for Interest

10-16
 Bond Discount Amortization Schedule

BOND DISCOUNT AMORTIZATION SCHEDULE

Date (a) (b) (c) (d)
Cash Owed for Interest Amortization Bonds
Coupon Interest Expense of Bond Payable
rate Discount Book Value
(10%)
Beginning of Beginning
$100,000 × Period Book Book Value
(10% × ½ year) Value × (b) – (a) + (c)
(12% × ½ year)
01/01/2016 $96,535
06/30/2016 $5,000 $5,792 $792 97,327
12/31/2016 5,000 5,840 840 98,167
06/30/2017 5,000 5,890 890 99,057
12/31/2017 5,000 5,943 943 100,000
Market interest
rate (12%)
10-17
Reporting Interest Expense on Bonds Issued at a Discount
Using Effective-Interest Amortization

Compute the periodic discount amortization using the effective-

interest method.

Bond Payable Book Value × Market Interest Rate × n/12

$96,535 × 12% × 6/12 = $5,792

10-18
Reporting Interest Expense on Bonds Issued at a Discount
Using Effective-Interest Amortization

Interest expense (+E, –SE) …………………………………………5,792

Bond discount (–XL, +L) ………………………………….. 792
Cash (–A) …………….....……….…....... 5,000

As the discount is
amortized, the bond
discount decreases and
the book value of the
bond increases.

10-19
Bonds Issued at a Premium

On January 1, 2016, Amazon issues $100,000 in bonds having a 10 percent

annual stated rate of interest. The bonds mature in two years, and
interest is paid semiannually. The annual market rate of interest is
8 percent.

These bonds are issued at a premium. Computing the present

value of the principal involves the following information:
Market rate of 8 percent ÷ 2 interest periods per year = 4 percent
Bond term of 2 years × 2 periods per year = 4 periods

10-20
Bonds Issued at a Premium

Now, compute the present

value of the interest.

Market rate of 8 percent ÷ 2 interest periods per year = 4 percent

Bond term of 2 years × 2 periods per year = 4 periods

10-21
Bonds Issued at a Premium

Finally, determine the issue price of the bonds.

The $103,630 is greater than the face amount of $100,000,

so the bonds are issued at a premium of $3,630.

10-22
Bonds Issued at a Premium

Cash (+A)……………………………………………. 103,630

Bond premium (+XL, +L)..…..… 3,630
Bonds payable (+L)………..…..… 100,000

The premium will

be amortized over
the two-
two-year life
of the bonds.

10-23
Reporting Interest Expense on Bonds Issued at a Premium
Using Effective-Interest Amortization
Notice that for the effective-interest method, the amount of interest
expense and premium amortization vary each period, unlike under the
straight-line method, where these are the same each period.
BOND PREMIUM AMORTIZATION SCHEDULE
Date (a) (b) (c) (d)
Amortizatio Bonds
Cash Owed for n of Bond Payable
Interest Interest Expense Premium Book Value
Beginning Period Beginning
$100,000 × Book Value × Book Value
(10% × ½ year) (8% × ½ year) (b) – (a) + (c)
01/01/2016 $103,630
06/30/2016 $5,000 $4,145 $(855) 102,775
12/31/2016 5,000 4,111 (889) 101,886
06/30/2017 5,000 4,075 (925) 100,961
12/31/2017 5,000 4,039 (961) 100,000

10-24
Reporting Interest Expense on Bonds Issued at a Premium
Using 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, 2016.

Interest expense (+E, –SE)................................. 4,145

Bond premium (–L)…………..................……………. 855
Cash (–A)…………...................………………………. 5,000

10-25
Exhibit 10.2
The Change in the Book Value of a Bond Over Time

Bond Issue Maturity

Issue Date Date
Price
Bond payable book value
at end of period

1 2 3 4
At a $103,630
premium

$100,000
At par $100,000 maturity
amount

At a $96,535
discount 1 2 3 4
PERIOD

10-26
Zero Coupon Bonds
FINANCIAL ANALYSIS

$$$
Zero coupon bonds do not pay periodic cash interest.

Because there is no periodic cash paid for interest:

PV of the Principal = Issue Price of the Bonds

Zero coupon bonds are always issued at a deep discount (substantially

less than maturity value).

10-27
Debt-to-Equity
KEY RATIO ANALYSIS

$$$
Total Liabilities
Debt-to-Equity =
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 suggests that a company
relies heavily on funds provided by creditors.

10-28
Early Retirement of Bonds

Occasionally, the issuing company will call (repay early) some or all
of its bonds. When this happens, gains/losses are calculated by
comparing the bond call amount with the book value of the bond.

Book Value > Book Value <

Cash Paid to Cash Paid to
Retire Bonds = Retire Bonds =
GAIN LOSS

10-29
Bonds Payable
FOCUS ON CASH FLOWS

Financing Activities
 Issue bonds (cash inflow)
$$$
 Early retirement of debt (cash outflow)
 Repay bond principal at maturity (cash outflow)

Remember that payment of interest under

U.S. GAAP is an operating cash outflow.

10-30