NU ACCT 1201 - Chapter 10: Reporting and interpreting Bonds

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Chapter 10: Reporting and interpreting BondsCharacteristics of Bonds Payable Advantages of bonds: Disadvantages 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.- 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.1. Face Value (Maturity or Par Value, Principal)2. Maturity Date3. Stated Interest Rate 4. Interest Payment Dates5. Bond DateInterest or Coupon Payment = Face value * Stated Annual Interest Rate1000*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 rateReporting Bond TransactionsPresent Value of the Principal (a single payment)+ Present Value of the Interest Payments (an annuity)Issue Price of the BondInterest Bond Accounting forRates Price the DifferenceStated = Market Bond =: Par Value There is no differenceRate RatePrice : of the Bond to account for.Stated < MarketBond < Par ValuePrice of the BondThe difference is accountedfor as a bond discount.Rate RateStated > MarketRate RateBond > Par Value The difference is accountedPrice : of the Bond 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. Bonds Issued at DiscountThe issue price of a bond is composed of the present value of two items: • Principal (a single amount)• Interest (an annuity)Date Description Debit CreditJan 1 Cash (+A) 100,000 Bonds Payable (+L) 100,000GENERAL JOURNALDate Description Debit CreditBond Interest Expense (+E, -SE) 5,000 Cash (-A) 5,000GENERAL JOURNALDate Description Debit CreditBonds Payable (-L) 100,000 Cash (-A) 100,000GENERAL J OURNALHere is the entry made every six months to record the interest payment.$100,000 * 10%* ½, since the interest is paid semiannually.On January 1, 2014, AT&T issues $100,000 in bonds having a 10% annual stated rate of interest. The bonds mature in 2 years (Dec. 31, 2015) and interest is paid semiannually. The annual market rate of interest is 12%. This bond is issued ata discount.1. Compute the present value of the principal: Market rate of 12% ÷ 2 interest periods per year = 6%Bond term of 2 years × 2 periods per year = 4 periodsPresent ValueSingle Amount = Principal × Factor (i=6.0%, n=4)79,210$ = 100,000$ × 0.79212. Compute the present value of the interestMarket rate of 12% ÷ 2 interest periods per year = 6%Bond term of 2 years × 2 periods per year = 4 periodsPresent ValueAnnuity = Payment × Factor (i=6.0%, n=4)17,326$ = 5,000$ × 3.4651 $79,210 Present Value of the Principal + 17,326 Present Value of the Interest = $96,536 Present Value of the BondsStraight-line Amortization1. Identify the amount of the bond discount.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 $866 = $3,464# of interest periods 4 Date Description Debit CreditJun 30 Interest Expense (+E, -SE) 5,866 Discount on Bonds Payable (-XL, +L) 866 Cash (-A) 5,000GENERAL JOURNALStraight-Line Amortization TableInterest Interest Discount Unamortized BookDate Payment Expense Amortization Discount Value1/1/2014 3,464$ 96,536$ 6/30/2014 5,000$ 5,866$ 866$ 2,598 97,402 12/31/2014 5,000 5,866 866 1,732 98,268 6/30/2015 5,000 5,866 866 866 99,134 12/31/2015 5,000 5,866 866 - 100,000 Effective-interest AmortizationDate Description Debit CreditJan 1 Cash (+A) 96,536Discount on Bonds Payable (+XL, -L) 3,464 Bonds Payable (+L) 100,000GENERAL JOURNALAT&TPartial Balance SheetAt January 1, 2014Long-Term LiabilitiesBonds Payable, 10% 100,000$ Due Dec. 31, 2015 Less: Bond Discount (3,464) Total L-T Liabilities 96,536$ AT&TPartial Balance SheetAt June 30, 2014Long-Term LiabilitiesBonds Payable, 10% 100,000$ Due Dec. 31, 2015 Less: Bond Discount (2,598) Total L-T Liabilities 97,402$ Stated rate of interest * Face Value * n/1210% * 100,000 * ½ (semi-annual – 6/12)5,000 Interest payment- 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 = $5,792Discount Amortization = Total interest – Cash Paid for interest$792 = $5792 - 5000 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. ‘Zero Coupon Bonds: do not pay periodic interest.Because there is no interest annuity, the PV of the Principal = Issue Price of the BondsThis is called a deep discount bond.Times Interest = Net income + Interest expense + Income tax expenseEarned Interest expense- The ratio shows the amount of resources generated for each dollar


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NU ACCT 1201 - Chapter 10: Reporting and interpreting Bonds

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