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

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

Characteristics of Bonds Payable Disadvantages of bonds: Risk of bankruptcy exists because the interest and debt must be paid back as scheduled or creditors may force legal action. Negative impact on cash flows exists because interest and principal must be repaid in the future. Advantages of bonds: Stockholders maintain control because bonds are debt, not equity. Interest expense is tax deductible. The impact on earnings may be positive because money can often be borrowed at a low interest rate and invested at a higher interest rate. 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.

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

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.

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 payables are long-term debt for the issuing company. 5

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.

This bond is issued at 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 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. =

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.

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. <

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 .3118. When we multiply the factor times the $100,000 principal, we determine the present value of the principal of $31,180.

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 11.4699. When we multiply the factor times the $5,000 interest payment, we determine the present value of the interest of $57,350.

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.

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.

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 (not GAAP) 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.

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, discount amortization, unamortized discount balance, and the carrying value of the bond for each interest payment period over the life of the bond.

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.

Reporting Interest Expense: Effective-interest Amortization Harrah’s issued their bonds on Jan. 1, 2009. The issue price was $88,530. The bonds have a 10-year maturity and $5,000 interest is paid semiannually. (market rate =12%) 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, 2009. 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.

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.

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.

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. >

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 .4564. When we multiply the factor times the $100,000 principal, we determine the present value of the principal of $45,640.

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 13.5903. When we multiply the factor times the $5,000 interest payment, we determine the present value of the interest of $67,952.

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.

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.

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, 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 interest expense calculated and the cash paid (or accrued) for interest. Let’s look at the interest expense journal entry. *

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, 2009. To record the interest payment and the premium amortization, Harrah’s would debit Interest Expense for $4,544, debit Premium on Bonds Payable for $456, and credit Cash for $5,000.

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

Remember that payment of interest is an operating activity. Focus on Cash Flows Financing Activities – Issuance of bonds (a cash inflow) Retire debt (a cash outflow) Repay bond principal at maturity (a cash outflow) Remember that payment of interest is an operating activity. The issuance of a bond payable is reported as a cash inflow from financing activities on the statement of cash flows. The repayment of principal is reported as a cash outflow from financing activities. You may be surprised to learn that the payment of bond interest is not reported in the Financing Activities section of the statement of cash flows. Interest payments are related directly to the earning of income and are therefore reported in the Operating Activities section of the statement of cash flows.

Debt-to-Equity Ratio 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. The debt-to-equity ratio is computed as total liabilities divided by 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.

Times Interest Earned Ratio Net income + Interest expense + Income tax expense Times Interest Earned = 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. The times interest earned ratio is computed as net income plus interest expense plus income tax expense divided by interest expense. This 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.

End of Chapter 10 End of chapter 10.