CHAPTER 10 REPORTING AND INTERPRETING BONDS UNDERSTANDING THE BUSINESS its operations Capital structure is the mixture of debt and equity a company uses to finance Bonds are securing that corporations and governmental units issue when they borrow large amounts of money After bonds have been issued they can be traded on established exchanges such as the New York Bond Exchange The ability to sell a bond on the bond exchange is a significant advantage for creditors because it provides them with liquidity or the ability to convert their investments into cash Because most creditors are reluctant to lend money for long periods with no opportunity to receive cash prior to maturity they demand a higher interest rate for long term loans CHARACTERISTICS OF BONDS PAYABLE Both stock and bonds are issued by corporations to raise money for long term purposes Several reasons why a corporation would want to issue bonds vs stocks 1 Stockholders maintain control bondholders do not vote or share in 2 the company s earnings Interest expense is tax deductible the tax deductibility of interest expense reduces the net cost of borrowing In contrast dividends paid on stock are not tax deductible 3 The impact on earnings is positive money can often be bowed at a low interest rate and invested at a higher rate Bonds carry higher risk than equity The major disadvantages are o Risk of bankruptcy o Negative impact on cash flows A bond usually requires the payment of interest over its life with repayment of principal on the maturity date 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 All bonds have a par value which is the amount that will be paid when the A bond always specifies a stated rate of interest and the timing of periodic cash interest payments usually annually or semiannually Different types of bonds have different characteristics for good economic bond matures reasons Companies try to design bon features that are attractive to different groups of creditors just as automobile manufacturers try to design cars that appeal to different groups of consumers When BNSF decides to issue new bonds it prepares a bond indenture that specifies the legal provisions of the bonds These provisions include the maturity date the rate of interest to be paid the date of each interest payment and any conversion privileges 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 Bond covenants are typically reported in the notes o 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 When a bond is issued to an investor the person receives a bond certificate An independent party called the trustee is usually appointed to represent the bondholders A trustee s duties are to ascertain whether the issuing company has fulfilled all provisions of he bond indenture Because of the complexities associated with bonds several agencies exist to evaluate the probability that a bond issuer will not be able to meet the requirements specified in the indenture this risk is called default risk REPORTING BOND TRANSACTIONS There are two types of cash payment in the bond contract 1 Principal single payment made when bond matures 2 Cash interest payments represent annuity Coupon rate of interest The issuing company does not determine the price at which the bonds sell Instead the market determines the price using the present value concepts To determine the present value of the bond you compute the present value of the principal and the present value of the interest payments and add the two amounts Market interest rate is the current rate of interest on a debt when incurred The present value of a bond may be the same as par above par premium or below par discount 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 When a bond pays more than creditors demand they will be willing to pay a premium to buy it Corporations and creditors do not care whether a bond is issued at par at a discount or at a premium because bonds are always priced to provide the market rate of interest Bonds Issued at Par Bonds sell at their par value when buyers are willing to invest in them at the interest rate stated in the bond contract When the effective rate of interest equals the stated rate or interest the present value of the future cash flows associated with a bond always equals the bond s par value amount Bonds may pay interest each month each quarter each half year or each year The present value of the bond is then determined using the interest rate factor for the number of interest periods and the interest rate for each period Interest expense is reported on the income statement Because interest is related to financial activities rather than operating activities it is normally not included in operating expenses on the income statement Instead interest expense is reported as a deductions form operating income Bonds Issued at a Discount When a bond is sold at a discount the bonds payable account is credited for the par amount and the discount is recorded as a debit to discount on bonds payable Note that the discount is recorded in a separate contra liability account as effective interest Companies often use two amortization methods 1 straight line and 2 The effective interest method is the method required by GAAP Companies are permitted to use the straight line method because the results are normally not materially different than those computed using the effective interest method Part A Reporting Interest Expense on Bonds Issued at a Discount Using Straight Line Amortization To amortize the bond discount over the life of BNSF bonds using straight line amortization we allocate an equal dollar amount to each interest period Bonds payable are reported on the balance sheet at their book value At the maturity date of the bonds the unamortized discount is zero At that time the maturity amount of the bonds and the book value are the same Part B Reporting Interest Expense on Bonds Issued at a Discount Using
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