Reporting and Interpreting Bonds

Chapter 10

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

McGraw-Hill/Irwin
10-1

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Understanding the Business

The mixture of debt and equity used
to finance a companys operations is
called the capital structure:

Debt - funds
from creditors
10-2

Equity - funds
from owners

Characteristics of Bonds Payable

10-3

Advantages
Advantages of
ofbonds:
bonds:
Stockholders
Stockholders maintain
maintain
control
controlbecause
becausebonds
bonds
are
aredebt,
debt,not
notequity.
equity.
Interest
Interestexpense
expenseisistax
tax
deductible.
deductible.
The
Theimpact
impact on
onearnings
earningsisis
positive
positivebecause
becausemoney
money
can
canoften
oftenbe
beborrowed
borrowedat
at
aalow
low interest
interestrate
rateand
and
invested
investedat
at aa higher
higher
interest
interest rate.
rate.

Disadvantages
Disadvantagesof
of bonds:
bonds:
Risk
Risk of
of bankruptcy
bankruptcy exists
exists
because
becausethe
theinterest
interestand
and
debt
debtmust
must be
bepaid
paid back
backas
as
scheduled
scheduledor
or creditors
creditors will
will
force
forcelegal
legalaction.
action.
Negative
Negativeimpact
impacton
oncash
cash
flows
flowsexists
exists because
because
interest
interestand
andprincipal
principalmust
must
be
berepaid
repaidin
inthe
thefuture.
future.

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 effectiveinterest rate

10-4

Characteristics of Bonds Payable

An indenture is a bond contract that
specifies the legal provisions of a
bond issue.

Debenture
Debenturebonds
bonds

10-5

No
No assets
assets are
are pledged
pledged as
as guarantee
guarantee of
of repayment
repayment
at
at maturity.
maturity.

Secured
Securedbonds
bonds
Specific
Specific assets
assets are
are pledged
pledged as
as guarantee
guarantee of
of
repayment
repayment at
at
maturity.
maturity.

Callable
Callablebonds
bonds
Bond
Bond may
may be
be called
called for
for early
early retirement
retirement by
by the
the

Characteristics of Bonds Payable

The
The bond
bond indenture
indenture contains
contains
covenants
covenants designed
designed to
to protect
protect
the
the creditors.
creditors.
The
The bond
bond issuer
issuer also
also prepares
prepares aa
prospectus,
prospectus, which
which describes
describes the
the
company,
company,the
the bonds,
bonds, and
and how
how the
the
proceeds
proceeds of
of the
the bonds
bonds will
will be
be
used.
used.
The
The trustee
trustee makes
makes sure
sure the
the
issuer
issuer fulfills
fulfills all
all of
of the
the provisions
provisions
of
of the
the bond
bond indenture.
indenture.
10-6

Reporting Bond Transactions

Present Value of the Principal (a single payment)
+ Present Value of the Interest Payments (an annuity)
= Issue Price of the Bond

10-7

<

<

>

>

Bonds Issued at Par

On
OnJanuary
January 1,
1, 2011,
2011, Burlington
BurlingtonNorthern
Northern Santa
SantaFe
Fe
(BNSF)
(BNSF)issues
issues$100,000
$100,000in
inbonds
bonds having
havingaastated
stated
rate
rateof
of 10%
10%annually.
annually. The
Thebonds
bondsmature
maturein
in10
10
years
yearsand
andinterest
interest isispaid
paid semiannually.
semiannually. The
The
market
market rate
rateisis 10%
10% annually.
annually.
Interest
Rates
Stated
Rate

Market
Rate

10-8

Bond
Price

Accounting for
the Difference

This
Thisbond
bondisisissued
issuedat
ataapar.
par.

Bond
Price

Par Value
of the Bond

There is no difference
to account for.

Bonds Issued at Par

Here
Hereis
isthe
theentry
entrymade
made every
everysix
six months
monthsto
torecord
record
the
theinterest
interest payment.
payment.

Here
Hereis
isthe
theentry
entryto
torecord
recordthe
thematurity
maturity
of
of the
thebonds.
bonds.

10-9

Times Interest Earned

Times Interest
=
Earned

Net income + Interest expense

+ Income tax expense
Interest expense

The
The ratio
ratio shows
shows the
the amount
amountof
ofresources
resources
generated
generated for
for each
each dollar
dollar of
of interest
interest
expense.
expense. In
Ingeneral,
general, aahigh
highratio
ratio is
is
viewed
viewedmore
more favorable
favorablethan
thanaalow
low ratio.
ratio.

10-10

Bonds Issued at Discount

On
On January
January 1,
1, 2011,
2011, BNSF
BNSF issues
issues $100,000
$100,000 in
in
bonds
bonds having
having aa stated
stated rate
rate of
of 10%
10%
annually.
annually. The
The bonds
bonds mature
mature in
in 10
10 years
years
(Dec.
(Dec. 31,
31, 2020)
2020) and
and interest
interest is
is paid
paid
semiannually.
semiannually. The
The market
market rate
rate is
is 12%
12%
annually.
annually.
This
This bond
bond is
is issued
issued at
at aa discount.
discount.
Interest
Rates
Stated
Rate

Market
Rate

<

10-11

Bond
Price
Bond
Price

Par Value
of the Bond

<

Accounting for
the Difference
The difference is accounted
for as a bond discount.

Bonds Issued at Discount

The
Theissue
issueprice
priceof
of aabond
bondis
is
composed
composedof
of the
thepresent
present value
value
of
of two
twoitems:
items:
Principal
Principal (a
(asingle
singleamount)
amount)
Interest
Interest (an
(anannuity)
annuity)

First, compute
the present
value of the
principal.

Market
Market rate
rate of
of 12%
12% 22interest
interest periods
periodsper
per year
year == 6%
6%
Bond
Bondterm
term of
of 10
10 years
years 22 periods
periodsper
peryear
year==20
20periods
periods
Present Value
Single Amount =
$
31,180 =

10-12

Principal
$ 100,000

Factor (i=6.0% , n=20)

0.3118

Bonds Issued at Discount

The
Theissue
issueprice
priceof
of aabond
bondis
is
composed
composedof
of the
thepresent
present value
value
of
of two
twoitems:
items:
Principal
Principal (a
(asingle
singleamount)
amount)
Interest
Interest (an
(anannuity)
annuity)

Now, compute
the present
value of the
interest.

Market
Market rate
rate of
of 12%
12% 22interest
interest periods
periodsper
per year
year == 6%
6%
Bond
Bondterm
term of
of 10
10 years
years 22 periods
periodsper
peryear
year==20
20periods
periods
Present Value
Annuity
=
$
57,350 =

10-13

Payment
$
5,000

Factor (i=6.0% , n=20)

11.4699

Bonds Issued at Discount

The
Theissue
issueprice
priceof
of aabond
bondis
is
composed
composedof
of the
thepresent
present value
value
of
of two
twoitems:
items:
Principal
Principal (a
(asingle
singleamount)
amount)
Interest
Interest (an
(anannuity)
annuity)
$
+
= $

Finally,
determine the
issue price of
the bond.

31,180 Present Value of the Principal

57,350 Present Value of the Interest
88,530 Present Value of the Bonds

The
The $88,530
$88,530 is
is less
less than
than the
the face
face amount
amount of
of
$100,000,
$100,000, so
so the
the bonds
bonds are
are issued
issued at
at aa discount
discount
of
of $11,470.
$11,470.
10-14

Bonds Issued at Discount

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

This
This is
is aa contra-liability
contra-liabilityaccount
account and
and appears
appearsin
in
the
theliability
liabilitysection
section of
of the
the balance
balancesheet.
sheet.
10-15

Bonds Issued at Discount The discount

will be
amortized
over the 10year life of the
bonds.
Two methods
of amortization
are commonly
used:
Straight-line

10-16

Effectiveinterest.

Reporting Interest Expense:

Straight-line Amortization

Identify
Identify the
the amount
amount of
of the
the

bond
bond discount.
discount.

Divide
Divide the
the bond
bond discount
discount by
by
the
the number
number of
of interest
interest
periods.
periods.

Include
Include the
the discount
discount
amortization
amortization amount
amount as
as part
part
of
of the
the periodic
periodic interest
interest
expense
expense entry.
entry.

The
The discount
discount will
will be
be reduced
reduced
to
to zero
zero by
bythe
the maturity
maturitydate.
date.
10-17

Reporting Interest Expense:

Straight-line Amortization
BNSF
BNSF issued
issued their
their bonds
bonds on
on Jan.
Jan. 1,
1, 2011.
2011. The
The
discount
discount was
was $11,470.
$11,470. The
The bonds
bonds have
have aa 10-year
10-year
maturity
maturity and
and $5,000
$5,000 interest
interest is
is paid
paid semiannually.
semiannually.
Compute
Compute the
the periodic
periodic discount
discount amortization
amortization
using
using the
the straight-line
straight-line method.
method.
Discount
Amortiz ation
$
574
(rounded)

10-18

=
=

Total
Discount
$ 11,470

Number of
Interest Periods
20

Reporting Interest Expense:

Straight-line Amortization

As the
discount is
amortized, the
carrying
amount of the
bonds
increases.
10-19

10-20

Reporting Interest Expense:

Effective-interest Amortization

The
The effective
effective interest
interest method
method
is
is the
the theoretically
theoretically preferred
preferred
method.
method.

Compute
Compute interest
interest expense
expense by
by
multiplying
multiplying the
the current
current unpaid
unpaid
balance
balance times
times the
the market
market rate
rate
of
of interest.
interest.

The
The discount
discount amortization
amortization is
is
the
the difference
difference between
between
interest
interest expense
expense and
and the
the cash
cash
paid
paid (or
(or accrued)
accrued) for
for interest.
interest.
10-21

Reporting Interest Expense:

Effective-interest Amortization
BNSF
BNSF issued
issued their
their bonds
bonds on
on Jan.
Jan. 1,
1, 2011.
2011. The
The
issue
issue price
price was
was $88,530.
$88,530. The
The bonds
bonds have
have aa 1010year
year maturity
maturity and
and $5,000
$5,000 interest
interest is
is paid
paid
semiannually.
semiannually.
Compute
Compute the
the periodic
periodic discount
discount amortization
amortization
using
using the
the effective
effective interest
interest method.
method.
n
Unpaid
UnpaidBalance
Balance Effective
EffectiveInterest
Interest Rate
Rate n//1212
11
$88,530

12%

$88,530 12% //22 == $5,312

$5,312
Discount
Amortiz ation
$
312

10-22

=
=

Total
Interest
$
5,312

Cash Paid
for Interest
$
5,000

Reporting Interest Expense:

Effective-interest Amortization

10-23

As the
discount is
amortized, the
carrying
amount of the
bonds
increases.

10-24

Zero Coupon Bonds

Zero

coupon bonds do not pay

periodic interest.

Because
Because there
there is
is no
no interest
interest annuity,
annuity, the
the
PV
PV of
of the
the Principal
Principal == Issue
Issue Price
Price of
of the
the Bonds
Bonds
This

is called a deep discount

bond.

10-25

Bonds Issued at Premium

On
On January
January 1,
1, 2011,
2011, BNSF
BNSF issues
issues $100,000
$100,000 in
in
bonds
bonds having
having aa stated
stated rate
rate of
of 10%
10%
annually.
annually. The
The bonds
bonds mature
mature in
in 10
10 years
years
(Dec.
(Dec. 31,
31, 2020)
2020) and
and interest
interest is
is paid
paid
semiannually.
semiannually. The
The market
market rate
rate is
is 8%
8%
annually.
annually.
This
This bond
bond is
is issued
issued at
at aa premium.
premium.
Interest
Rates
Stated
Rate

>
10-26

Market
Rate

Bond
Price
Bond
Price

Par Value
of the Bond

>

Accounting for
the Difference
The difference is accounted
for as a bond premium.

Bonds Issued at Premium

The
Theissue
issueprice
priceof
of aabond
bondis
is
composed
composedof
of the
thepresent
present value
value
of
of two
twoitems:
items:
Principal
Principal (a
(asingle
singleamount)
amount)
Interest
Interest (an
(anannuity)
annuity)

First, compute
the present
value of the
principal.

Market
Marketrate
rateof
of 8%
8%22interest
interestperiods
periodsper
per year
year== 4%
4%
Bond
Bondterm
term of
of 10
10years
years 22periods
periodsper
peryear
year== 20
20periods
periods
Present Value
Single Amount =
$
45,640 =

10-27

Principal
$ 100,000

Factor (i=4.0% , n=20)

0.4564

Bonds Issued at Premium

The
Theissue
issueprice
priceof
of aabond
bondis
is
composed
composedof
of the
thepresent
present value
value
of
of two
twoitems:
items:
Principal
Principal (a
(asingle
singleamount)
amount)
Interest
Interest (an
(anannuity)
annuity)

Now, compute
the present
value of the
interest.

Market
Market rate
rateof
of 8%
8% 22 interest
interestperiods
periods per
per year
year == 4%
4%
Bond
Bondterm
term of
of 10
10 years
years 22 periods
periodsper
peryear
year==20
20periods
periods
Present Value
Annuity
=
$
67,952 =

10-28

Payment
$
5,000

Factor (i=4.0% , n=20)

13.5903

Bonds Issued at Premium

The
Theissue
issueprice
priceof
of aabond
bondis
is
composed
composedof
of the
thepresent
present value
value
of
of two
twoitems:
items:
Principal
Principal (a
(asingle
singleamount)
amount)
Interest
Interest (an
(anannuity)
annuity)

$
+
= $

10-29

Finally,
determine the
issue price of
the bond.

45,640 Present Value of the Principal

67,952 Present Value of the Interest
113,592 Present Value of the Bonds

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

Bonds Issued at Premium

10-30

The premium
will be
amortized
over the 10year life of the
bonds.

10-31

Reporting Interest Expense:

Straight-line Amortization
Here
Here is
is the
the journal
journal entry
entry to
to record
record the
the payment
payment
of
of interest
interest and
and the
the premium
premium amortization
amortization for
for
the
the six
six months
months ending
ending on
on June
June 30,
30, 2011.
2011.

10-32

10-33

Reporting Interest Expense:

Effective-interest Amortization
Here
Here is
is the
the journal
journal entry
entry to
to record
record the
the payment
payment
of
of interest
interest and
and the
the premium
premium amortization
amortization for
for
the
the six
six months
months ending
ending on
on June
June 30,
30, 2011.
2011.

10-34

Debt-to-Equity

Debt-to-Equity

Total Liabilities
Stockholders Equity

This
Thisratio
ratioshows
shows the
therelationship
relationshipbetween
between
the
theamount
amount of
of capital
capital provided
provided by
byowners
owners
and
andthe
theamount
amount provided
provided by
bycreditors.
creditors. In
In
general,
general,aa high
high ratio
ratio suggest
suggest that
that aa
company
companyrelies
relies heavily
heavilyon
on funds
funds provided
provided
by
bycreditors.
creditors.

10-35

Early Retirement of Debt

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

Gains/losses
Gains/losses are
are
calculated
calculated by
by comparing
comparing
the
the bond
bond call
call amount
amount
with
with the
the book
book value
value of
of the
the
bond.
bond.

10-36

Book Value > Retirement Price = Gain

Book Value < Retirement Price = Loss

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.

10-37

Supplement A: Bond Calculations

Using Excel
The
Theissue
issueprice
priceof
ofaabond
bondis
is
composed
composedof
ofthe
thepresent
present
value
valueof
oftwo
twoitems:
items:
Principal
Principal(a
(asingle
single
amount)
amount)
Interest
Interest(an
(anannuity)
annuity)

10-38

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.

10-39

End of Chapter 10

10-40