Chapter 10 Reporting and interpreting Bonds Characteristics of Bonds Payable Advantages of bonds 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 1 Face Value Maturity or Par Value Principal 2 Maturity Date 3 Stated Interest Rate 4 Interest Payment Dates 5 Bond Date Disadvantages of bonds 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 Interest or Coupon Payment Face value Stated Annual Interest Rate 1000 10 1 2 semi annual Indenture bond contract that specifies the legal provisions of a bond issue Unsecured debenture bond No assets are pledged as guarantee of repayment at maturity Higher interest rate Secured bonds Specific assets are pledged as guarantee of repayment at maturity Callable bonds Bond may be called for early retirement by the issuer Convertible bonds Bond may be converted to other securities usually common stock Lower return rate Reporting Bond Transactions Present Value of the Principal a single payment Present Value of the Interest Payments an annuity Issue Price of the Bond Interest Rates Stated Market Rate Rate Stated Market Rate Rate Stated Market Rate Rate Bond Price of the Bond Par Value Bond Price Bond Par Value Price of the Bond Par Value Bond of the Bond Price Accounting for the Difference There is no difference to account for The difference is accounted for as a bond discount The difference is accounted for as a bond premium On January 1 2014 AT T issues 100 000 in bonds having 10 annual stated rate of interest The bonds mature in 2 years and interest is paid semiannually The market rate is 10 annually This bond is issued at a par GENERAL JOURNAL Description Date Jan 1 Cash A Bonds Payable L Debit 100 000 Credit 100 000 Here is the entry made every six months to record the interest payment Date GENERAL JOURNAL Description Bond Interest Expense E SE Cash A Debit Credit 5 000 5 000 Date GENERAL J OURNAL Description Bonds Payable L Cash A Debit 100 000 Credit 100 000 100 000 10 since the interest is paid semiannually 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 On January 1 2014 AT T issues 100 000 in bonds having a 10 annual stated rate of interest The bonds mature in 2 years Dec 31 2015 and interest is paid semiannually The annual market rate of interest is 12 This bond is issued at a discount 1 Compute the present value of the principal Market rate of 12 2 interest periods per year 6 Bond term of 2 years 2 periods per year 4 periods Stated rate of interest Face Value n 12 10 100 000 semi annual 6 12 5 000 Interest payment Present Value Single Amount 79 210 Principal 100 000 Factor 0 7921 i 6 0 n 4 Date Jan 1 Cash A GENERAL JOURNAL Description Discount on Bonds Payable XL L Bonds Payable L Debit Credit 96 536 3 464 100 000 2 Compute the present value of the interest Market rate of 12 2 interest periods per year 6 Bond term of 2 years 2 periods per year 4 periods Present Value Annuity Payment 17 326 5 000 Factor 3 4651 i 6 0 n 4 79 210 17 326 96 536 Present Value of the Principal Present Value of the Interest Present Value of the Bonds AT T Partial Balance Sheet At January 1 2014 Long Term Liabilities Bonds Payable 10 Due Dec 31 2015 Less Bond Discount Total L T Liabilities 100 000 3 464 96 536 Straight line Amortization Identify the amount of the bond discount 1 2 Divide the bond discount by the number of interest periods 3 Include the discount amortization amount as part of the periodic interest expense entry The discount will be reduced to zero by the maturity date AT T issued their bonds on Jan 1 2014 The discount was 3 464 The bonds have a 2 year maturity and 5 000 interest is paid semiannually Compute the periodic discount amortization using the straight line method Discount Amortization Total Discount of interest periods GENERAL JOURNAL Date Description Jun 30 Interest Expense E SE Debit Credit 5 866 Discount on Bonds Payable XL L Cash A 866 5 000 866 3 464 4 AT T Partial Balance Sheet At June 30 2014 Long Term Liabilities Bonds Payable 10 Due Dec 31 2015 Less Bond Discount Total L T Liabilities 100 000 2 598 97 402 Straight Line Amortization Table Interest Payment Interest Expense Amortization Discount Discount Unamortized Date 1 1 2014 6 30 2014 12 31 2014 6 30 2015 12 31 2015 5 000 5 000 5 000 5 000 5 866 5 866 5 866 5 866 866 866 866 866 Book Value 96 536 97 402 98 268 99 134 100 000 3 464 2 598 1 732 866 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 the calculated interest expense and the cash paid or accrued for interest AT T issued their bonds on Jan 1 2014 The issue price was 96 536 The bonds have a 2 year maturity and 5 000 interest is paid semiannually Compute the periodic discount amortization using the effective interest method Book Value at the beginning of the year Market rate of Interest n 12 96 536 12 6 12 5 792 Discount Amortization Total interest Cash Paid for interest 792 5792 5000 GENERAL JOURNAL Date Description Jun 30 Interest Expense E SE Debit Credit 5 792 Discount on Bonds Payable XL L Cash A 792 5 000 AT T Partial Balance Sheet At June 30 2014 Long Term Liabilities Bonds Payable 10 Due Dec 31 2015 Less Bond Discount Total L T Liabilities 100 000 2 672 97 328 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 Effective Interest Amortization Table Interest Payment Interest Expense Amortization Discount Discount Unamortized Date 1 1 2014 6 30 2014 12 31 2014 6 30 2015 12 31 2015 5 000 5 000 5 000 5 000 5 792 5 840 5 890 5 943 792 840 890 942 3 464 2 672 1 832 942 Book Value 96 536 97 328 98 168 99 058 100 000 Equals remaining unamortized discount Zero Coupon Bonds do not pay periodic interest Because there is no interest annuity the PV of the Principal Issue Price of the Bonds This is called a deep discount bond Times Interest Net
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