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- 1. Reporting and Interpreting Bonds Chapter 10 McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
- 7. Reporting Bond Transactions = < > = < >
- 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. = =
- 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.
- 10. Times Interest Earned 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.
- 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. < <
- 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.
- 16. 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.
- 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.
- 19. Reporting Interest Expense: Straight-line Amortization As the discount is amortized, the carrying amount of the bonds increases.
- 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. Unpaid Balance × Effective Interest Rate × n / 12 $88,530 × 12% × 1 / 2 = $5,312
- 23. Reporting Interest Expense: Effective-interest Amortization As the discount is amortized, the carrying amount of the bonds increases .
- 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. > >
- 30. Bonds Issued at Premium The premium will be amortized over the 10-year life of the bonds.
- 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.
- 33. *
- 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.
- 35. Debt-to-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. Debt-to-Equity = Total Liabilities Stockholders’ Equity
- 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.
- 40. End of Chapter 10
Notas del editor
- Chapter 10: Reporting and Interpreting Bonds
- 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.
- 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. 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.
- 9 A bond certificate is the bond document that each bondholder receives. When a company issues its bonds, it specified two types of cash payment in the bond contract: Principal. This amount is usually a single payment that is made when the bond matures. It is also called the par value or face value. For most individual bonds, the par value is $1,000, but it can be any amount. Cash interest payments. These payments, which represent an annuity, are computed by multiplying the principal amount times the interest rate stated in the bond contract. This interest is called the contract, stated, or coupon rate of interest. The bond contract specifies whether the interest payments are made quarterly, semiannually, or annually. When you are asked to work problems in which interest payments are made more frequently than once a year, you must adjust both the periodic interest rate and the number of periods. For example, a $1,000 (face value) bond with an annual interest rate of 6 percent and a life of 10 years would pay interest of $30 ($1,000 × 6% × 1/2) for 20 periods (every six months for 10 years, or 10 × 2). Neither the issuing company nor the underwriter determines the price at which the bonds sell. Instead, the market determines the price using the present value concepts introduced in the last chapter. To determine the present value of the bond, you compute the present value of the principal (a single payment) and the present value of the interest payments (an annuity) and add the two amounts. Creditors demand a certain rate of interest to compensate them for the risks related to bonds, called the market interest rate (also known as the yield or effective-interest rate ). Because the market rate is the interest rate on debt when it is incurred, it is the rate that should be used in computing the present value of a bond.
- 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. Different types of bonds have different characteristics for good economic reasons. Individual creditors have different risk and return preferences. A retired person may be willing to receive a lower interest rate in return for greater security. This type of creditor might want a mortgage bond that pledges a specific asset as security in case the company cannot repay the bond. Another type of creditor might be willing to accept a low interest rate and an unsecured status in return for the opportunity to convert the bond into common stock at some point in the future. Companies try to design bond features that are attractive to different groups of creditors just as automobile manufacturers try to design cars that appeal to different groups of consumers. Some key types of bonds include: A debenture is an unsecured bond; no assets are specifically pledged to guarantee repayment at maturity. Secured bonds have specific assets pledged as guarantee of repayment at maturity. Callable bonds may be called for early retirement at the option of the issuer. Convertible bonds may be converted to other securities (usually common stock) at the option of the bondholder.
- When a company decides to issue new bonds, it prepares a bond indenture (bond contract) that specifies the legal provisions of the bonds. These provisions include the maturity date, rate of interest to be paid, date of each interest payment, and any conversion privileges. The indenture also contains covenants designed to protect the creditors. Typical indentures include limitations on new debt that the company might issue in the future, limitations on the payment of dividends or requirements for minimums of certain accounting ratios, such as the current ratio. Because covenants may limit the company’s future actions, management prefers those that are least restrictive. Creditors, however, prefer more restrictive covenants, which lessen the risk of the investment. As with any business transaction, the final result is achieved through negotiation. Bond covenants are typically reported in the notes to the financial statements. The bond issuer also 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. Companies might use the money it borrowed to increase working capital, make capital expenditures and repurchase common stock. 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.
- 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. 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.
- 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. Since the stated rate of interest is equal to the market rate of interest, this bond is issued at a par. The journal entry to record the bond issue at par is a debit to Cash and a credit to Bonds Payable for $100,000.
- 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. 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.
- 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. The times interest earned ratio is often misleading for new or rapidly growing companies which tend to invest considerable resources to build their capacity for future operations. In such cases, the times interest earned ratio will reflect significant amounts of interest expense associated with the new capacity but not the income that will be earned with the new capacity. Analysts should consider the company’s long-term strategy when using this ratio. Some analysts prefer to compare interest expense to the amount of cash a company can generate. Because creditors cannot be paid with “income” that is generated, they must be paid with cash.
- On January 1, 2011, 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 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.
- 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). 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.
- 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). 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.
- 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.
- 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.
- Here is an example of a bond issued at a discount on BNSF’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.
- Using the straight-line method, follow these steps. First, identify the amount of the bond discount. Second, divide the bond discount by the number of interest periods. Third, include the discount amortization amount as part of the periodic interest expense entry. The discount will be reduced to zero by the maturity date.
- 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. To compute the periodic discount amortization using the straight-line method, divide the discount by 20, the number of interest periods to arrive at the straight-line amortization of $574 per interest period.
- To record the interest payment and the discount amortization, BNSF’s would debit Interest Expense for $5,574, credit Discount on Bonds Payable for $574, and credit Cash for $5,000. Here is an example of BNSF’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 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.
- 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.
- 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. To compute the periodic discount amortization using the effective interest method, multiply the current unpaid balance by the market rate of interest of 12% and multiple by 6/12 (or one half) since interest payments are every six months. This will give us the discount amortization of $312 for the first six months.
- To record the interest payment and the discount amortization, BNSF’s would debit Interest Expense for $5,312, credit Discount on Bonds Payable for $312, and credit Cash for $5,000. Here is an example of BNSF’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. 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.
- 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. The concepts you have learned will help you understand these bonds. For example, a corporation might issue a bond that does not pay periodic cash interest. These bonds are often called zero coupon bonds. Why would an investor buy a bond that did not pay interest? Our discussion of bond discounts has probably given you a good idea of the answer. The coupon interest rate on a bond can be virtually any amount and the price of the bond will be adjusted so that investors earn the market rate of interest. A bond with a zero coupon interest rate is simply a deeply discounted bond that will sell for substantially less than its maturity value.
- On January 1, 2011, 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 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.
- 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). 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.
- 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). 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.
- 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.
- 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 book value of the bond is the sum of the two accounts, Premium on Bonds Payable and Bonds Payable. Here is an example of a bond issued at a premium on BNSF’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 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.
- To record the interest payment and the premium amortization, BNSF’s would debit Interest Expense for $4,320, debit Premium on Bonds Payable for $680, and credit Cash for $5,000.
- 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.
- To record the interest payment and the premium amortization, BNSF’s would debit Interest Expense for $4,544, debit Premium on Bonds Payable for $456, and credit Cash for $5,000.
- 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. Heavy reliance on creditors increases the risk that a company may not be able to meet its contractual financial obligations during a business downturn. The debt-to-equity ratio tells only part of the story with respect to the risks associated with debt. It does not help the analyst understand whether the company’s operations can support its debt. Remember that debt carries an obligation to make cash payments for interest and principal. As a result, most analysts would evaluate the debt-to-equity ratio within the context of the amount of cash the company can generate from operating activities.
- Bonds are normally issued for long periods, such as 20 or 30 years. In several situations, a corporation may decide to retire bonds before their maturity date. A bond with a call feature may be called in for early retirement at the issuer’s option. Typically, the bond indenture includes a call premium for bonds retired before the maturity date, which often is stated as a percentage of par value. In some cases, a company may elect to retire debt early by purchasing it on the open market, just as an investor would. This approach is necessary when the bonds do not have a call feature. It might also be an attractive approach if the price of the bonds fell after the date of issue. What could cause the price of a bond to fall? The most common cause is a rise in interest rates. As you may have noticed during our discussion of present value concepts, bond prices move in the opposite direction of interest rates. If interest rates go up, bond prices fall, and vice versa. When interest rates have gone up, a company that wants to retire a bond before maturity may find buying the bond on the open market is less expensive than paying a call premium. 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.
- 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. Many students are surprised to learn that the payment of interest is not reported in the Financing Activities section of the statement of cash flows. Interest expense is reported on the income statement and is related directly to the computation net income. As a result, U.S. GAAP requires that interest payments be reported in the Cash Flows from Operating Activities section of the statement. Companies are also required to report the amount of cash paid for interest expense each accounting period.
- Supplement A: Bond Calculations Using Excel Instead of using the present value tables in Appendix A, most analysts and accountants use Excel to do the financial computations that are necessary when working with bonds. In Chapter 9, we showed you how to use Excel to compute the present value of both single payment and annuity problems. Because a bond involves both types of payments, you can use that process to compute the present value of each type of payment and add them together. Alternatively, you can use a single Excel process to compute the present value of a bond. To determine the present value of the interest payments, we can use the present value function programmed in Excel by selecting the function button (fx). On the toolbar, click on the insert function button ( f x ). A dropdown box called “insert function” will appear. You will be asked to “type a brief description of what you want to do and click “Go.” You should enter “present value and click the “Go” button. A new screen will appear and you should highlight “PV,” and click on the “OK” button. A new dropdown box will appear. You should enter the amounts from the problem in this box: “Rate” is the market rate of interest per period. “NPER” is the number of periods. “PMT” is the cash interest payment per period. “Fv” is the maturity value of the bond. Notice that when using Excel, these dollar amounts must be entered as negative numbers because they represent payments. Also, you should not enter a comma between the numbers. The final box is “type’ which permits you to do problems involving payments at either the beginning or end of the period. Most problems involve payment at the end of the period, so you do not need to enter anything in this box because the default is for end of period problems. Once you have entered the required data, click on “OK” and Excel will compute this present value and show it on your spreadsheet. The Excel amounts may be slightly different than the amount computed using present value tables because the table numbers have been rounded.
- 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. When a company chooses not to use a discount or premium account, the bond issue is recorded at the issue price (the present value) on the date of issue with a debit to Cash and a credit to Bonds Payable. The only other difference when using this approach is that when interest is recorded, the amounts we previously debited or credited to a discount or premium account will now be debited or credited to the Bonds Payable account. Each period, the amortization of the bond discount increases the bond’s book value (or unpaid balance) of the bond. Likewise, if there is a premium, the amortization of the bond premium decreases the bond’s book value. To illustrate this approach, let’s look at the first two journal entries for the BNSF for bonds issued at a discount. Recall that on January 1, 2011, 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 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. Earlier we determined the issue price of these bond was $88,530. Under this new approach, BNSF will debit Cash and credit Bonds Payable on January 1 for the issue price (the present value) of $88,530. On June 30 when the interest is paid, the difference between the interest expense for the period and the interest paid is credited to the Bonds Payable account. This increases the carrying value of the Bonds Payable account each period so that at maturity the carrying value of the bonds is equal to the maturity value.
- End of chapter 10.