Chapter 10 Reporting Interpreting Bonds 04 18 2014 Capital Structure Mix of debt and equity a company uses to finance its operations BONDS Securities that corporations and governments issue when they borrow large amounts of money They can be traded and also sold before maturity Characteristics of Bonds Payable Why issue a bond instead of stock Stockholders maintain control Interest Expense is tax deductible The impact on earnings is positive Disadvantages associated with issuing bonds Risk of Bankruptcy interest of bonds is a fixed charge that must be paid whether firm earns income or not Negative impact on cash flows Debt must be paid at specified time firm must generate cash to repay debt Basic Vocabulary Bond Principal the amount to be paid at maturity and on which the periodic cash interest payments are computed Stated Rate Interest rate stated on the bond coupon only used to calculate the cash interest payments stated rate X principal Bond Types Unsecured bond No assets pledged as guarantee Secured bond assets pledged as guarantee Callable bond may be called for early retirement Convertible bond may be converted to common stock Bond Indenture contract that specifies the legal provisions of the bonds contains convenants designed to protect creditors Bond Certificate Bond Coupon Trustee Independent party appointed to represent bond holders Cash Interest Payments Principal x Stated Rate Separate from principal payment Market Rate the amount of compensation creditors demand for the risk of loaning money Rate you use to compute the present value of a bond The price of a bond is determined by the market present value You compute present value of the principal and the present value of the interest payments and add them together Present value of principal Present value of interest payments The present value of a bond can be the same as the principal above or below The interest paid is the interest demanded so the bond perfectly The company can offer the bond at par value so the bond principal BONDS ISSUED AT PAR Stated Rate Market Rate compensates for risk assumed equals the par value of bond Example Bond 500 000 5 years paid annually Stated Rate 8 Market Rate 8 Cash Interest Payment 500 000 x 0 08 40 000 look up present values at 8 for 5 periods 500 000 x 0 6806 340300 40 000 x 3 9927 159700 500 000 Journal entry for bond issuance CASH A 500 000 Bonds Payable L 500 000 Journal entry for interest cash payment Interest Expense E SE 40 000 CASH A 40 000 Journal entry at maturity of bond Bonds Payable L 500 000 CASH A 500 000 BONDS ISSUED AT DISCCOUNT Market Rate of interest is higher than the Stated Rate The bond undercompensates purchasers for risk assumed The company must offer a discount to buyers or no one will buy the The bond price is less than the par value of the bond bond Exercise Bond 100 000 5 years paid annually Stated Rate 6 Market Rate 8 Cash interest payment 100 000 x 0 06 6 000 look up present values at 8 for 5 periods 100 000 x 0 6806 68060 6 000 x 3 9927 23956 92 036 carrying value Discount on bonds payable 100 000 92036 7 964 Journal entry at bond issuance CASH A 92 036 Discount on Bonds Payable XL 7 964 Bonds Payable L 100 000 The bond discount is amortized to each interest period as an increase in interest expense 2 Amortization Methods 1 Straight line method Bond discount number of periods 7 964 5 1593 Discount on bonds Payable Journal entry for interest cash payment Step 3 Interest Expense 7593 Step 2 Discount on Bonds Payable 1593 Step 1 CASH A 6 000 2 Effective Interest Amortization carrying value x market rate 92 036 x 0 08 7363 Interest Expense Journal entry for interest cash payment YEAR 1 Step 2 Interest Expense 7363 Step 3 Discount on Bonds Payable 1363 Step 1 CASH 6 000 TABLE FORMAT Year Carrying Market Interest CASH Discount Carrying rate Expense Amortize value 1 2 8 8 7363 7472 6000 6000 d 1363 1472 End 93399 94871 value Beg 92036 93399 multiply carrying value Beg with market rate to get Interest subtract CASH from Interest Expense to get Discount Amortized Add Carrying value Beg to Discount Amortized to get Carrying Expense Value End Journal entry for interest cash payment YEAR 2 Interest Expense 7 472 Discount on Bonds Payable 1 472 CASH 6 000 BONDS ISSUED AT PREMIUM Market Rate is lower than Stated Rate The bond overcompensates the purchasers interest Exercise rate 8 The buyers are willing to pay extra for the bond to receive excess Bond price is higher than the par value of Bond Bond 100 000 5 years paid semi annually Stated rate 9 Market when you see semiannually divide both rates by two and multiply the number of periods by two 10 year period Stated Rate 4 5 Market Rate 4 Cash interest payment 100 000 x 0 045 4 500 look up present values at 4 for 10 periods 100 000 x 0 6756 67 560 4 500 x 8 1109 36 499 104 059 Premium on bonds Payable 104 059 100 000 4 059 Journal entry to record Bond issuance CASH 104 059 Premium on Bonds payable 4 059 Bonds Payable 100 000 periods 4 059 10 406 Journal entry for interest cash payment Interest Expense 4094 Premium on bonds payable 406 CASH 4500 Effective Interest Amortization Straight Line Amortization Premium on Bonds Payable number of year Carrying Market Interest CASH Premium Carrying value Beg Rate Expense Amortize value 1 2 104 059 103 721 4 4 4162 4149 4500 4500 d 338 351 end 103 721 103 370 Same procedure as in Discount the only difference is that now to get Carrying value end you subtract premium amortized from carrying value beg Journal entry for interest cash payment YEAR 1 Interest Expense 4162 Premium on Bonds payable 338 CASH 4500 Journal entry for interest cash payment YEAR 2 Interest Expense 4149 Premium on Bonds payable 351 CASH 4500 04 18 2014 04 18 2014
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